Enveric Biosciences, Inc. - Quarter Report: 2003 June (Form 10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

SPATIALIZER AUDIO LABORATORIES, INC.

(Name of Registrant as Specified in its Charter)

920 HAMPSHIRE ROAD, SUITE A-34
WESTLAKE VILLAGE, CALIFORNIA 91361

(Address of Principal Executive Offices)

900 LAFAYETTE STREET, SUITE 710
SANTA CLARA, CALIFORNIA 95050

(Address of Principal Corporate Offices)

TELEPHONE NUMBER: (408) 296-0600

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 þ          NO o

As of August 6, 2003 there were 47,406,939 shares of the Registrant’s Common Stock outstanding.

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PART I. FINANCIAL INFORMATION

ITEM I. FINANCIAL STATEMENTS

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF OPERATIONS
(unaudited)

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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS

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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
(unaudited)

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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(1) Nature of Business

     Spatializer Audio Laboratories, Inc. and subsidiaries (the “Company”) is in the business of developing and licensing technology. The Company sales, research and subsidiary administration are conducted out of facilities in Santa Clara, California.

     The Company’s wholly-owned subsidiary, Desper Products, Inc. (“DPI”), is in the business of developing proprietary advanced audio signal processing technologies and products for consumer electronics, entertainment, and multimedia computing. All Company revenues are generated from this subsidiary.

     The Company’s wholly-owned subsidiary, MultiDisc Technologies, Inc. (“MDT”), was in the business of developing scaleable, modular compact disc (“CD”) and digital versatile disc (“DVD”) server technologies associated with a network based CD/DVD server for internet and intranet applications. Operations of MDT were discontinued in the fourth quarter of 1998 and the assets have been marketed for sale (see Note 9).

(2) Significant Accounting Policies

     Basis of Consolidation — The consolidated financial statements include the accounts of Spatializer Audio Laboratories, Inc. and its wholly-owned subsidiary, Desper Products, Inc. MultiDisc Technologies, Inc. has been presented as a discontinued operation (see Note 9). All significant intercompany balances and transactions have been eliminated in consolidation. Corporate administration is not allocated to subsidiaries.

     Revenue Recognition — The Company recognizes revenue from product sales upon shipment to the customer. License revenues are recognized when earned, in accordance with the contractual provisions. Royalty revenues are recognized upon shipment of products incorporating the related technology by the original equipment manufacturers (OEMs) and foundries.

     Concentration of Credit Risk — Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of cash, cash equivalents and trade accounts receivable. The Company places its temporary cash investments in certificates of deposit in excess of FDIC insurance limits, principally at CitiBank FSB. At June 30, 2003 substantially all cash and cash equivalents were on deposit at two financial institutions.

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     At June 30, 2003, three major customers, not presented in order of importance, each accounted for 10% or more of our total accounts receivable: JVC, Samsung, and Orion Corporation, each of whom accounted for greater than 10% of our total 2002 accounts receivable. One OEM accounted for 36.0%, another accounted for 34%, and another accounted for 20.0% at June 30, 2003.

     The Company performs ongoing credit evaluations of its customers and normally does not require collateral to support accounts receivable. Due to the contractual nature of sales agreements and historical trends, no allowance for doubtful accounts has been provided.

     The Company does not apply interest charges to past due accounts receivable.

     Cash and Cash Equivalents — Cash equivalents consist of highly liquid investments with original maturities of three months or less.

     Customers Outside of the U.S. — Sales to foreign customers were 87% and 64% of total sales in the year to date periods ended June 30, 2003 and 2002, respectively.

     Major Customers — During the quarter ended June 30, 2003, four customers accounted for 25%, 23%, 23% and 13%, respectively, of the Company’s net sales.

     Research and Development Costs — The Company expenses research and development costs as incurred, which is presented as a separate line on the statement of operations.

     Property and Equipment — Property and equipment are stated at cost. Major renewals and improvements are charged to the asset accounts while replacements, maintenance and repairs, which do not improve or extend the lives of the respective assets, are expensed. At the time property and equipment are retired or otherwise disposed of, the asset and related accumulated depreciation accounts are relieved of the applicable amounts. Gains or losses from retirements or sales are credited or charged to income. Property and equipment are depreciated over the useful lives of the asset ranging from 3 years to 5 years under the straight line method.

     Intangible Assets — Intangible assets consist of patent costs and trademarks which are amortized on a straight-line basis over the estimated useful lives of the patents which range from five to twenty years. The weighted average useful life of patents was approximately 12 years.

     Earnings Per Share — Basic earnings (loss) per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of

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common stock that then shared in the earnings of the entity. The following table presents contingently issuable shares, options and warrants to purchase shares of common stock that were outstanding at June 30, 2003 and 2002 which were not included in the computation of diluted loss per share because the impact would have been antidilutive or less than $0.01 per share:

During the three months ended June 30, 2003, 200,000 options were granted to officers and board members for annual board member compensation and 100,000 options had expired.

     Impairment of Long-Lived Assets and Assets to be Disposed of - The Company adopted the provisions of SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of, on January 1, 1996. This Statement requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amounts of the assets exceed the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.

     Segment Reporting - The Financial Accounting Standards Board issued Statement No. 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS No. 131”), in June 1997. SFAS No. 131 establishes standards for the way public business enterprises are to report information about operating segments in annual financial statements and requires enterprises to report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. It replaces the “industry segment” concept of SFAS No. 14, Financial Reporting for Segments of a Business Enterprise, with a “management approach” concept as to basis for identifying reportable segments. SFAS 131 is effective for financial statements for fiscal years beginning after December 15, 1997. The Company adopted SFAS 131 in December 1997. MDT is considered a discontinued operation as of September 1998. As of June 30, 2003, the Company has only one operating segment, DPI, the Company’s Audio Signal Processing business.

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     Income Taxes - Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

     Recent Accounting Pronouncements - The FASB recently issued the following statements: FASB 146 — Accounting for Costs Associated with Exit or Disposal Activities, FASB 147 — Acquisitions of Certain Financial Institutions, FASB 148 - Accounting for Stock-Based Compensation. These FASB statements did not, or are not expected to, have a material impact on the Company’s financial position and results of operations. FASB 149 Amendment on Statement 133 on Derivative Instruments and FASB 150 Accounting for Certain Financial Instruments.

     Use of Estimates - Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates.

     Fair Value of Financial Instruments - The fair and carrying values of cash equivalents, accounts receivable, accounts payable, short-term debt to a related party and accrued liabilities and those potentially subject to valuation risk at December 31, 2002 and June 30, 2003 approximated fair value due to their short maturity or nature.

     The fair values of notes payable at December 31, 2002 and June 30, 2003 are materially consistent with the related carrying values based on current rates offered to the Company for instruments with similar maturities.

     Discontinued Operation - In September 1998, the Board of Directors approved a plan to refocus corporate activities on the Company’s core audio business, Desper Products, Inc. In conjunction to this strategic refocusing, the Company permanently suspended operations of MDT and placed the business and its related patent portfolio up for sale. The Company is accounting for the on-going operating and termination expenses of MDT as a discontinued operation (see Note 9).

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(3) Property and Equipment

     Property and equipment, as of December 31, 2002 and June 30, 2003, consists of the following, net of a reserve for impairment loss in 1998 in accordance with application of SFAS 121:

(4) Intangible Assets

     Intangible assets, as of December 31, 2002 and June 30, 2003 consist of the following:

Estimated amortization is as follows:

(5) Notes Payable to Related Parties

     The Company was indebted to the Desper Family Trust, a related party, in the amount of $112,500 at June 30, 2003. This amount bears interest at a fixed rate of 10% annually and is due on demand.

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(6) Shareholders’ Equity

     During the quarter ended June 30, 2003, no shares were issued or converted.

     During the year ended December 31, 2002, shares were issued or converted as follows:

Capitalization

Series A Preferred Stock: On December 26, 2002 the Company filed a Certificate of Elimination with the Delaware Secretary of State stating that no shares of the Corporations Series A Preferred Stock are outstanding and that no shares of the Series A Preferred Stock will be issued.

Series B Preferred Stock: On December 26, 2002 the Company filed a Certificate of Elimination with the Delaware Secretary of State stating that no shares of the Corporations Series B Preferred Stock are outstanding and that no shares of the Series B Preferred Stock will be issued.

Series B-1 Redeemable Convertible Preferred Stock: On November 6, 2002 the Board of Directors Designated a Series B-1 Preferred Stock. The series has a par value of $0.01 and a stated value of $10.00 per share US and is designated as a liquidation preference. The stock will rank prior to the Company’s common stock. No dividends will be paid on the Series B-1 Preferred Stock. Conversion rights exist on or after January 1, 2003 to convert the Series B-1 Preferred Stock to common at a certain formula. At December 29, 2005 certain mandatory conversion requirements exist subject to a certain formula. The Series B-1 Preferred Stock has no voting power. Certain restrictions on trading exist based on date sensitive events. In December 2002, 87,967 shares of Series B-1 Preferred Stock were issued in exchange for the Series B Preferred Stock and 14,795 shares were issued in lieu of the adjusted accrued dividends on the Series B Preferred Stock.

(7)  Escrowed Performance Shares

     In December 1996, the Company accepted the terms outlined by the British Columbia Securities Commissions (“BCSC”) for the release of the Company’s 5,776,700 escrowed “Performance Shares” from Canadian Escrow into a new escrow arrangement with the Company. The overall modification was approved by the Company’s shareholders in August 1996. Under the revised arrangement, the performance shares were released automatically as follows: 20% on June 22, 2000; 30% on June 22, 2001; and 30% on June 22, 2002. Under the revised escrow arrangement, the performance shares vested, provided the individual had not voluntarily terminated his/her relationship with the Company prior to applicable vesting dates.

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     Based on the revised escrow arrangement, which primarily converted the escrow shares release from performance criteria to a time-based criteria, the Company recorded as compensation expense the excess of the fair market value of the 5,776,700 performance shares on the date the Company accepted the terms of the new escrow arrangement over the purchase price of such escrow shares.

     All of the performance shares are included in the issued and outstanding shares. As of June 30, 2003, all performance shares under the escrow arrangement have been released.

(8) Stock Options

     In 1995, the Company adopted a stock option plan (the “Plan”) pursuant to which the Company’s Board of Directors may grant stock options to directors, officers and employees. The stockholder approved Plan authorizes grants of options to purchase authorized but unissued common stock up to 10% of total common shares outstanding at each calendar quarter, 4,740,694 as of June 30, 2003. Stock options are granted with an exercise price equal to the stock’s fair market value at the date of grant. Stock options have five-year terms and vest and become fully exercisable up to three years from the date of the grant.

     At June 30, 2003, there were 2,069,194 additional shares available for grant under the Plan. The per share weighted-average fair value of stock options granted during the first 6 months of 2003 was $0.02 on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: expected dividend yield 0%, risk-free interest rate of 1.5%, expected volatility of 30% and expected life of 5 years.

     The Company applies APB Opinion No. 25 in accounting for its Plan and, accordingly, no compensation cost has been recognized for the fair value of its stock options in the consolidated financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, the Company’s net income (loss) would have been increased to the pro forma amounts indicated below:

     Pro forma net income (loss) reflects only options granted since December 31, 1994. Therefore, the full impact of calculating compensation cost for stock options under SFAS No. 123 is not reflected in the pro forma net loss amounts presented above because compensation cost is reflected over the options’ vesting period and compensation cost for options granted prior to January 1, 1995 is not considered.

     Stock option activity during the periods indicated is as follows:

     At June 30, 2003, the number of options exercisable was 2,668,332 and the weighted-average exercise price of those options was $0.24.

(9) Discontinued Operation

     On September 25, 1998, the Board of Directors determined that it would be unable to raise the necessary capital required to properly commercialize the MDT technology. Therefore, the Company ceased funding the operations of MDT and is actively seeking to sell the assets and technology. All employees of MDT have been terminated and the Company has vacated the MDT facilities.

     Based on this action, the Company is treating MDT as a discontinued operation. Accordingly, the balance sheet and statement of operations of MDT are not consolidated in the continuing operations of the Company, but rather are disclosed as Net Liabilities of Discontinued Operation and Loss From Discontinued Operation, respectively. At December 31, 2002, after four years of inactivity and inability to sell the assets, the remaining balance of $71,045 was eliminated.

(10) Commitments and Contingencies

     In connection with the downsizing of the Company in 1998, a number of employees were terminated and have filed, on various dates, employment and compensation related claims with the California State labor authorities. All but two of these claims have been settled. Two former officers and employees of MDT filed labor and employment termination related claims before the Labor Commissioner in 2000 seeking

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approximately $400,000 each which was allegedly due under each of their respective employment agreements, which claims, if resolved in favor of the claimants, could be material to the financial statements of the Company. The Labor Commissioner postponed those proceedings while other litigation proceeded in the Superior Court, Orange County seeking declaratory relief to bar the labor claims, as well as return of intellectual property and unspecified damages for breaches of the former officers’ and employees’ employment agreements. These employees, however, filed for personal bankruptcy and as a result, the state court proceeding was postponed and then dismissed primarily because of the bankruptcies. The claims became inactive. While bankruptcy for one employee has been dismissed the claims have not been reactivated. We also anticipate that, from time to time, we may be named as a party to other legal proceedings that may arise in the ordinary course of our business.

(11) Profit Sharing Plan

     The Company has a 401(k) profit sharing plan covering substantially all employees, subject to certain participation and vesting requirements. The Company may elect to make discretionary contributions to the Plan, but has never done so over the life of the Plan.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion in conjunction with our unaudited consolidated financial statements and notes included herein. The results described below are not necessarily indicative of the results to be expected in any future period. Certain statements in this discussion and analysis, including statements regarding our strategy, financial performance and revenue sources, are forward-looking statements based on current expectations and entail various risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements. Readers are referred to the section entitled “Certain Factors That May Affect Future Results” contained herein which identify important risk factors that could cause actual results to differ from those contained in the forward looking statements.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. In consultation with our Board of Directors and Audit Committee, we have identified three accounting policies that we believe are important in gaining an understanding of our financial statements. These are important accounting policies that require management’s most difficult, subjective judgments.

The first critical accounting policy relates to revenue recognition. We recognize revenue from product sales upon shipment to the customer. License revenues are recognized when earned, in accordance with the contractual provisions. Royalty revenues are recognized upon shipment of products incorporating the related technology by the original equipment manufacturers (OEMs) and foundries.

The second critical accounting policy relates to research and development expenses. We expense all research and development expenses as incurred. Costs incurred to establish the technological feasibility of our algorithms (which is the primary component of our licensing) is expensed as incurred and included in Research and Development expenses. Such algorithms are refined based on customer requirements and licensed for inclusion in the customer’s specific product. There are no production costs to capitalize as defined in Statement on Financial Accounting Standards No. 86.

The third critical accounting policy relates to intangible assets. Our intangible assets consist primarily of patents. We capitalize all costs directly attributable to patents, consisting primarily of legal and filing fees, and amortize such costs over the remaining life of the patent (which range from 4 to 16 years) using the straight-line method. In accordance with SFAS 142, “Goodwill and Other Intangible Assets”, only intangible assets with definite lives are amortized. Non-amortized intangible assets are instead subject to annual impairment testing.

Results of Operations

Revenues

     Revenue decreased to $251,000 in the three months ended June 30, 2003 from $471,000 in the comparable period last year, a decrease of 47%. Revenue in the six-months ended June 30, 2003 decreased to $583,000 from $911,000 in the comparable period last year. The decline in revenue resulted from the expiration of a licensing agreement with a major computer account in January 2003 and the effects of outsourcing by our existing DVD player accounts to manufacturers in China and other manufacturers who decline to pay for such software or with whom we do not have licensing arrangements.

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Gross Profit

     Gross profit decreased to $228,000 (91% of revenue) in the three months ended June 30, 2003 from $431,000 (92% of revenue) in the comparable period last year, a decrease of 47%. Gross profit for the six-months ended June 30, 2003 declined to $525,000 (90% of revenue) compared to $843,000 (92% of revenue) in the comparable period last year. The decline in gross profit resulted from decreased revenue. The slight decline in gross margin reflects a greater mix of commissionable foreign revenue due to the expiration of the licensing agreement with a domestic computer account.

Operating Expenses

     Operating expenses increased to $438,000 (175% of revenue) in the three months ended June 30, 2002 from $428,000 (91% of revenue) in the comparable period last year, an increase of 2%. Operating expenses in the six-months ended June 30, 2003 decreased to $805,000 (87% of revenue) from $817,000 (89% of revenue) in the comparable period last year, a decrease of 1%. The increase in operating expenses for the three-months ended June 30, 2003 result primarily from increased legal and accounting expenses arising from new stringent requirements of the Sarbanes-Oxley Act, as well as higher insurance and public company expenses. Current operating expense levels reflect a baseline for a public company, regardless of fluctuations in revenue levels.

General and Administrative

     General and administrative expenses increased to $236,000 (94% of revenue) in the three months ended June 30, 2003 from $183,000 (39% of revenue) in the comparable period last year, an increase of 27%. General and administrative expenses decreased to $393,000 (67% of revenue) in the six-months ended June 30, 2003 from $318,000 (35% of revenue) in the comparable period last year, an increase of 22%. The increase in general and administrative expense result primarily from increase in public company expenses: legal, accounting, annual meeting/proxy and insurance expenses.

Research and Development

     Research and development expenses decreased to $102,000 (41% of revenue) in the three months ended June 30, 2003 from $119,000 (46% of revenue) in the comparable period last year, a decrease of 14%. Research and development expenses decreased to $211,000 (36% of revenue) in the six-months ended June 30, 2003 from $243,000 (27% of revenue) in the comparable period last year, a decrease of 13%. The decrease in research and development in the three and six month periods result from decreased use of consultants and a greater focus on in-house applications development.

     Research and development activities comprised our continued efforts to identify, validate, and develop new products at Desper Products Inc. Specific engineering efforts were directed toward productizing new audio enhancement technology, including Spatializer Audio Alchemy and Spatializer Natural Headphone, porting support of Spatializer N-2-2 Ultra™ to current and potential licensees during the quarter, development of products to support our Internet applications initiative and unannounced collaborations.

Sales and Marketing

     Sales and marketing expenses decreased to $100,000 (40% of revenue) in the three months ended June 30, 2002 from $126,000 (27% of revenue) in the comparable period last year, a decrease of 21%. Sales and marketing expenses increased to $202,000 (35% of revenue) in the six-months ended June 30, 2003 from $256,000 (28% of revenue) in the comparable period last year, a decrease of 212%. The decrease is attributed to the conversion of a full-time support position to part-time, at a lower pay rate.

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Other Income and Expense

     Income and other expense consist primarily of interest earned on short-term investments and interest paid on related party debt. Other iIncome and expense decreased to ($3,037) from $267 in the prior year comparable period. Other income and expense in the six months ended June 30, 2003 decreased to ($3,358) from $944 in the comparable period last year. The decrease is due to somewhat lower cash investments, lower interest rates and interest on a premium financing of the director’s and officer’s liability policy in 2003.

Net Income (Loss)

     Net loss increased to ($212,000) (-84% of revenues), $0.00 per share, in the three months ended June 30, 2003 from net income $3,000 (1% of revenues), $0.00 per share in the comparable period last year. Net loss increased to ($287,000) (0% of revenue), ($0.01) per share, in the six-months ended June 30, 2003 from net income of $24,000 (3% of revenue), $0.00 per share in the comparable period last year. The increased net loss for the three and six month periods are primarily the result of the decrease in revenue.

Liquidity and Capital Resources

     At June 30, 2003, we had $788,000 in cash and cash equivalents as compared to $859,000 at December 31, 2002. The decrease in cash and cash equivalents is attributed to the net loss, partially offset by collections on accounts receivable. We had working capital of $891,000 at June 30, 2003 as compared with working capital of $1,125,000 at December 31, 2002.

     At June 30, 2003, we had a related party obligation of $112,500 which bears interest of 10% per annum, which we pay on a current basis. The debt is due on demand.

     We expect our future cash flow will come primarily from the audio signal processing licensing, Original Equipment Manufacturers’ (“OEM”) royalties and from possible common stock issuances including warrants and options. We are actively engaged in negotiations for additional audio signal processing licensing arrangements which we anticipate should generate additional cash flow without imposing any substantial costs on our business.

     We anticipated a wind down in early 2003 of our licensing program with a large computer account as that customer completes its migration to its latest operating system. This was partially offset by added or expanded relationships with JVC and Orion and this year. Our liquidity was also negatively impacted by the effects of outsourcing by one of our major DVD player accounts to manufacturers in China and other manufacturers who decline to pay for such software or with whom we do not have licensing arrangements. While we expect to replace a portion of this business by entering into direct licensing agreements with some third party manufacturers, and with other new business development opportunities in the latter stages of negotiation, design cycle times can be lengthy and subject to unforeseen delays. As such, although we currently expect some of these new opportunities to begin generating new revenues in the fourth quarter of 2003, our ability to generate additional short-term revenues, and our visibility remains limited, due to the design cycle lead times and unforeseen delays outlined above. If these conditions continue, this would negatively impact our cash flow, which if constrained into 2004, will require further reductions in overhead expense and impair our ability to most effectively compete in the marketplace. We are currently exploring ways to further reduce our cost structure while at the same time identifying revenue generating opportunities that can be fast tracked to revenue generation. Spatializer Audio Alchemy and Spatializer Interactive are two such initiatives to generate short-term revenue.

     The operations of our business, and those of our competitors, is also impacted by the continued trend in the semiconductor industry to offer free, but minimal audio solutions to certain product classes to maintain and attract market share. This challenges our ability to convert business opportunities to licensing agreements in those segments that allow us to maintain or rapidly increase revenue. As a result, we must

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develop and license our products and software solutions in a market that treats some audio products, including those of our competitors, on a commodity basis in those cases where the OEM product is considered a commodity product. While our software applications deliver what we and most manufacturers who listen to it believe is a significantly superior audio experience, the competitive market forces that pressure manufacturers to reduce their costs may create some resistance to new technology adoption or use. In addition, certain of our competitors appear to be pursuing a business plan that disregards commercially reasonable pricing to achieve a larger market penetration even if the penetration will not provide viable margins or returns.

     We have responded by offering additional products targeted to each price/quality segment of the market and continue to aggressively pursue new opportunities in emerging product categories and complements to our existing core business. In addition, our products have been positioned as a means for manufacturers to save money while delivering an enhanced audio experience. Nevertheless, these market conditions and competitive forces make it more challenging for us, and our rational commercial competitors, to enhance their operating results.

     To the extent we maintain or exceed our current projected revenues and are not required to fund contingencies, we expect to continue to draw on our current cash reserves, but adequately maintain our liquidity position at least on a short term basis. To the extent that we do not achieve current and projected operating levels or are required to fund contingencies, we will be required to accelerate use of our cash reserves and this will impact our longer term liquidity. As such, we believe our liquidity position may be subject to fluctuation or additional stress, but manageable in the short-term.

     If we are forced to accelerate use of our cash reserves above current or projected levels due to delays in closing new licensing arrangements, launch of new royalty bearing products by our customers, or to fund contingencies, we may be required in the near term, to consider, if available, new sources of debt or equity financing, which may have a dilutive effect on our existing shareholders. Further, we cannot assure you that debt or equity financing will be available as required. Even if financing were available, it may not be on terms that are favorable to us or sufficient for our needs.

     We wish to achieve accelerated growth, support our Audio Alchemy and Spatializer Interactive initiatives and in general, take advantage of the dynamic market forces in which we operate, rather than to be affected by them. We will continue to seek, consider, and evaluate other capital or business arrangements with financial and or strategic participants or investors as such opportunities become available to us on terms that enhance shareholder value and support our business strategy.

Certain Factors That May Affect Future Results

     This report includes forward-looking statements made pursuant to the safe harbor provision of the Private Securities Litigation Reform Act of 1995. Except for historical matters, the matters discussed are forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933, as amended, that reflect our current views with respect to future events and financial performance. These forward-looking statements are subject to certain risks and uncertainties which could cause actual results to differ materially from historical results or those anticipated. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. The risk factors, discussed below, among other possible factors, could cause actual results to differ materially from historical or anticipated results. More information about potential factors that could affect our business and financial results is included in our Annual Report on Form 10-K for the year ended December 31, 2002, and our other Securities and Exchange Commission filings.

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Because The Market In Which We Operate Is Highly Competitive, We Face Significant Pricing Pressure and Competition.

     We are seeking commercial acceptance of our products in highly competitive markets. Certain of our competitors appear to be pursuing a business plan that disregards commercially reasonable pricing to achieve a larger market penetration even if the penetration will not provide for viable margins or returns. We have responded by offering additional products targeted to each price and quality segment of the market and continues to aggressively pursue new opportunities in emerging product categories and complements to our existing core business. In addition, our products have been positioned as a means for manufacturers to save money while delivering an enhanced audio experience. Nevertheless, these market conditions and competitive forces make it more challenging for us, and its rational commercial competitors, to enhance their operating results. There is no assurance that our present or contemplated future products will achieve or maintain sufficient commercial acceptance, or if they do, that functionally equivalent products will not be developed by current or future competitors who had access to significantly greater resources or which are willing to “give away” their products.

If New Product Development Is Delayed, We Will Experience Delays In Revenues And Competitive Products May Reach The Market Before Our Products.

     Since our inception, we have experienced delays in bringing new products to market and commercial application as a result of delays inherent in technology development, financial resource limits and industry responses and maturity. These delays have resulted in delays in the timing of revenues and product introduction. In the future, delays in new product development or technology introduction on behalf of us, our original equipment manufacturers of consumer electronics and multimedia computer products (OEMs), integrated circuit (IC) foundries or our software producers and marketers could result in further delays in revenues and could allow competitors to reach the market with products before us. In view of the emerging nature of the technology involved, and the rapidly changing character of the entire media, internet and computer markets, our expansion into other technology areas and the uncertainties concerning the ability of our current products and new products to achieve meaningful commercial acceptance, there can be no assurance of when or if we will achieve or sustain profitability.

     We expect that we will continue to be dependent upon a limited number of OEMs for a significant portion of our net sales in future periods, although no OEM is presently obligated either to purchase a specified amount of products or to provide us with binding forecasts of product purchases for any period. Our four largest customers as of June 30, 2003 accounted for 25%, 23%, 23% and 13% of our net sales for six months ended June 30, 2003. The loss of any one of our major customers or licensees would significantly reduce our revenues and harm our ability to achieve or sustain acceptable levels of operating results. The loss, or signing of a similarly sized account or accounts would have a material short term impact on our operations and there is no assurance that we will not lose all or some of the revenues from one or more of these accounts. While we are working to broaden the sources of our royalty streams, there can be no assurance that we will be successful in retaining or attracting such key accounts and broadening such revenue stream sources.

     Our products are typically one of many related products used by consumer electronic users. Demand for our products is therefore subject to many risks beyond our control, including, among others:

     •     competition faced by our OEM customers in their particular end markets;

     •     the technical, sales and marketing and management capabilities of our OEM customers;

     •     the pressure faced by our OEM customers to reduce cost;

     There can be no assurance that we will not lose sales in the future as a result of the pressure to reduce costs faced by our customers. The reduction of orders from our significant OEM customers, or the discontinuance of our products by our end users may subject us to potential adverse revenue fluctuations.

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Because The Technology Environment In Which We Operate Is Rapidly Changing, We May Not Be Successful In Establishing And Maintaining The Technological Superiority Of Our Products Over Those Of Our Competitors.

     We operate in a technology environment which is competitive and rapidly changing. While our software applications deliver what we, and most manufacturers who listen to it, believe is a significantly superior audio experience, the competitive market forces that pressure manufacturers to reduce their costs may create some resistance to new technology adoption or use. Our future success is dependent on establishing and maintaining the technological superiority of our products over those of competitors, our ability to successfully identify and bring other compatible technologies and products to market and a recognition by the market of product value. We compete with a number of entities that produce various stereo audio enhancement processes, technologies and products in both traditional two-speaker environments such as consumer electronics and multimedia computing, and in multi-channel, multi-speaker applications such as Home Theater. In the field of 3-D or “virtual audio”, our principal competitors are SRS Labs, Inc., QSound Labs, Inc. and Dolby Laboratories or technologies and products developed by other companies, including entities that have business relationships with us. There can be no assurance that we will be able to favorably compete in this market in the future.

Our Operating Results Fluctuate.

     We experienced a loss from operations in 2001 but were profitable in 1999, 2000 and 2002. We experienced small losses in the last quarter of 2002, the first quarter of 2003 and a larger loss in the second quarter of 2003. While our objective and full effort is on managing a growing and profitable business, due to the market conditions and risk factors outlined above and its impact on fluctuations in operating expenses and revenues , we cannot provide assurance that we will be able to generate a positive profit position in any given future period.

If We Are Unable To Attract And Retain Our Key Personnel, We May Not Be Able To Successfully Operate Our Business.

     Our future success primarily depends on the abilities and efforts of a small number of individuals, with particular management obligations and technical expertise. Loss of the services of any of these persons could adversely affect our business prospects. There is no assurance that we will be able to retain this group or successfully recruit other personnel, as needed. We compete with other enterprises with stronger financial resources and larger staffs that may offer employment opportunities to our staff which are more desirable than those which we are able to offer. Failure to maintain skilled personnel with the software and engineering skills critical to our business could have an adverse impact upon our business, the results of our operations and our prospects. Currently, we have an employment agreement with Henry R. Mandell with a term expiring in November 2004.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     There were no material changes during the six months ended June 30, 2003 to our exposure to market risk for changes in interest rates.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

     Our principal executive officer and principal financial officer has carried out an evaluation of the effectiveness of our “disclosure controls and procedures” as of June 30, 2003 (as defined in the Securities

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Exchange Act of 1934 Rules 13a-15(e) and 15(d)-15(e)). Based on that evaluation, this officer has concluded that as of June 30, 2003, our disclosure controls and procedures were adequate.

Internal Control Over Financial Reporting

     During the period covered by this report, there have been no changes in our internal control over financial reporting that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

We periodically are subject to legal proceedings from time to time in the ordinary course of our business. Litigation is subject to inherent uncertainties. Were an unfavorable ruling to occur, there exists the possibility of a material adverse impact on our results of operations of the period in which the ruling occurs. Our estimate of the potential impact on our financial position or overall results of operations for such legal proceedings could change in the future.

ITEM 2. CHANGES IN SECURITIES

None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

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

On June 16, 2003 we held our Annual Meeting of Shareholders. Proxies for the Annual Meeting were solicited pursuant to Regulation 14A under the Securities Exchange Act of 1934. There was no solicitation in opposition to management’s nominees as listed in the Proxy Statement and all of such nominees were elected.

At the Annual Meeting, the following persons were elected by the vote indicated as directors to serve until the Annual Meeting of Stockholders to be held in 2006:

The two directors whose terms of office continued after the Annual Meeting were James D. Pace and Gilbert N. Segel whose terms expire in 2004. Stephen W. Desper, whose term of office expired at the Annual Meeting, declined nomination for another term.

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ITEM 5. OTHER INFORMATION

None

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a)  Exhibits

(b) Reports on Form 8-K:

On May 19, 2003, we filed a Current Report on Form 8-K regarding a press release issued with earnings information for the quarter ended March 31, 2003. The information furnished in the report shall not be deemed to be filed for purposes of Section 18 of the Securities Exchange Act of 1934.

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SIGNATURES

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

Dated: August 12, 2003