Genasys Inc. - Quarter Report: 2002 December (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

For the quarterly period ended December 31, 2002

or

For the transition period from                          to                         .

Commission File Number: 0-24248

AMERICAN TECHNOLOGY CORPORATION

(Exact name of registrant as specified in its charter)

(858) 679-2114

(Registrant’s telephone number, including area code)

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  x  NO  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes  ¨  No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of February 4, 2003.

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AMERICAN TECHNOLOGY CORPORATION

INDEX

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American Technology Corporation

BALANCE SHEETS

(Unaudited)

See accompanying summary of accounting policies and notes to financial statements.

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American Technology Corporation

STATEMENTS OF OPERATIONS

(Unaudited)

See accompanying summary of accounting policies and notes to financial statements.

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American Technology Corporation

STATEMENTS OF CASH FLOWS

(Unaudited)

See accompanying summary of accounting policies and notes to financial statements.

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AMERICAN TECHNOLOGY CORPORATION

NOTES TO INTERIM FINANCIAL STATEMENTS

(Unaudited)

1. OPERATIONS

American Technology Corporation is engaged in design, development and commercialization of sound, acoustic and other technologies. Our primary focus is on marketing four of our proprietary sound reproduction technologies and supplying components based on these technologies to customers.

2. STATEMENT PRESENTATION

The accompanying unaudited interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. In the opinion of management, the interim financial statements reflect all adjustments of a normal recurring nature necessary for a fair presentation of the results for interim periods. Operating results for the three month periods are not necessarily indicative of the results that may be expected for the year. The interim financial statements and notes thereto should be read in conjunction with the Company’s audited financial statements and notes thereto for the year ended September 30, 2002 included in the Company’s annual report on from 10K.

The Company’s financial statements are presented on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The ability of the Company to continue as a going concern is contingent upon it obtaining sufficient financing to sustain its operations and its ability to ultimately generate profits and positive cash flow from operations. The Company has funded its operations primarily through the issuance of securities and debt financings. Other than cash of $453,193 at December 31, 2002 and a subsequent $500,000 increase in 8% secured promissory notes (see note 7), the Company has no other material unused sources of liquidity at this time. Based on our current cash position and projections for future revenues and currently planned expenditures, we will need to raise additional capital of approximately $2 million to continue operations at planned levels during the next twelve months. While we believe that investment capital in sufficient amounts will be available to us, there can be no guarantee that we will be able to raise funds on terms acceptable to us, or at all. The Company has significant debt that comes due in December 2003.

Based on its current plan and assumptions, the Company anticipates that it will be able to meet its cash requirements for the next twelve months. Management believes increased product sales may provide additional operating funds and believes that any additional investment capital will be available if required. Management has significant flexibility to adjust the level of research and development and selling and administrative expenses based on the availability of resources.

Management expects to incur additional operating losses as a result of expenditures for research and development and marketing costs for sound and other products and technologies. The timing and amounts of these expenditures and the extent of the Company’s operating losses will depend on many factors, some of which are beyond management’s control. Management anticipates that the commercialization of the Company’s technologies may require increased operating costs, however management cannot currently estimate the amounts of these costs.

There can be no assurance that any funds required during the next twelve months or thereafter can be generated from operations or that such required funds would be available from the aforementioned or other potential sources. The lack of sufficient funds from operations or additional capital could force the Company to curtail, scale back operations, or cease operations and would therefore have a material adverse effect on the Company’s business.

As such, there is substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments necessary to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the possible inability of the Company to continue as a going concern.

3. NET LOSS PER SHARE

The Company applies Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings Per Share.” SFAS No. 128 provides for the calculation of “Basic” and “Diluted” earnings per share (“EPS”). Basic EPS includes no dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution of securities that could share in the earnings of an entity. The Company’s net losses for the periods presented cause the inclusion of potential common stock instruments outstanding to be antidilutive and, therefore, in accordance with SFAS No. 128, the Company is not required to present a diluted EPS. Convertible preferred stock, convertible promissory notes, stock options and warrants

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AMERICAN TECHNOLOGY CORPORATION

NOTES TO INTERIM FINANCIAL STATEMENTS

(Unaudited)

convertible or exercisable into approximately 5,952,487 and 3,735,957 shares of common stock were outstanding at December 31, 2002 and 2001, respectively. These securities were not included in the computation of diluted EPS because of the net losses but could potentially dilute EPS in future periods.

The provisions of the Company’s Series B Preferred Stock provide for an accretion in the conversion value (similar to a dividend) of 6% or $.60 per share per annum. The Series C Preferred Stock provides for an accretion in the conversion value of 6% or $1.20 per share per annum. The Series D Preferred Stock provides for an accretion in the conversion value of 6% or $0.60 per share per annum. The accrued accretion of the Series B, C and D Preferred Stock for the three months ended December 31, 2002 and 2001 was $38,624 and $19,956, respectively, which increases the net loss available to common stockholders. Net loss available to common stockholders is computed as follows:

4. RECENT ACCOUNTING PRONOUNCEMENTS

In June 2001, the Financial Accounting Standards Board (“FASB”) Finalized FASB Statements No. 141 Business Combinations (SFAS 141) and No. 142; Goodwill and Other Intangible Assets (SFAS 142). SFAS 141 requires the use of the purchase method of accounting and prohibits the use of the pooling-of-interest method of accounting for business combinations initiated after June 30, 2001. SFAS 141 also requires that the Company recognize acquired intangible assets apart from goodwill if the acquired intangible assets meet certain criteria. SFAS 141 applies to all business combinations initiated after June 30, 2001 and for purchase business combinations completed on or after July 1, 2001. It also requires, upon adoption of SFAS 142 that the Company reclassify the carrying amounts of intangible assets and goodwill based on the criteria in SFAS 141.

SFAS 142 requires among other things, that companies no longer amortize goodwill but instead test goodwill for impairment at least annually. In addition, SFAS 142 requires that the Company identify reporting units for the purposes of assessing potential future impairments of goodwill, reassess the useful lives of other existing recognized intangible assets and cease amortization of intangible assets with an indefinite useful life. An intangible asset with an indefinite useful life should be tested for impairment in accordance with the guidance in SFAS 142. SFAS 142 is required to be applied in fiscal years beginning after December 15, 2001 to all goodwill and other intangible assets recognized at that date regardless of when those assets were initially recognized. SFAS 142 requires the Company to complete a transitional goodwill impairment test six months from the date of adoption. The Company is also required to reassess the useful lives of other intangible assets within the first interim quarter after adoption of SFAS 142. The Company has not entered into any business combinations and has no recorded goodwill. The adoption of this statement did not have a material effect on its financial statements.

In August 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations.” SFAS No. 143 requires the fair value of a liability for an asset retirement obligation to be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. SFAS No. 143 is effective for the Company for the fiscal year ending September 30, 2003. The adoption of this statement did not have a material impact on its financial statements.

In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lives Assets”. SFAS 144 requires that those long-lived assets be measured at the lower of carrying amount or fair value, less cost to sell, whether reported in continuing operations or in discontinued operations. Therefore, discontinued operations will no longer be measured at net realizable value or include amounts for operating losses that have not yet occurred. SFAS 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001 and, generally, is to be

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AMERICAN TECHNOLOGY CORPORATION

NOTES TO INTERIM FINANCIAL STATEMENTS

(Unaudited)

applied prospectively. The Company believes the adoption of this statement will have no material impact on its financial statements.

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB No. 4, 44 and 64, Amendment of FASB No. 13, and Technical Corrections. SFAS rescinds FASB No. 4 Reporting Gains and Losses from Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. This statement also rescinds SFAS No. 44 Accounting for Intangible Assets of Motor Carriers and amends SFAS No. 13, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. This statement is effective for fiscal years beginning after May 15, 2002. The Company does not expect the adoption of this statement to have a material effect on its financial statements.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 addresses accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized and measured initially at fair value when the liability is incurred. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The Company does not expect the adoption of this statement to have a material effect on its financial statements.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an Amendment of FASB Statement No. 123.” This statement amends SFAS No. 123, “Accounting for Stock-Based Compensation”, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company adopted the disclosure requirements effective December 31, 2002, in its financial statements.

5. INVENTORIES

Inventories are valued at the lower of cost or market. Cost is determined using the first-in, first-out (FIFO) method. Inventories consist of the following:

6. PURCHASED TECHNOLOGY

In April 2000, the Company acquired all rights to certain loudspeaker technology owned by David Graebener (“Graebener”), Stephen M. Williams (“Williams”) and Hucon Limited, a Washington corporation (“Hucon”). The purchase price consisted of $300,000 cash plus 200,000 shares of common stock. The 200,000 shares of common stock were issued in June 2000 and were valued at $962,500. The Company agreed to pay up to an additional 159,843 shares of common stock to Williams and Graebener contingent upon the achievement of certain performance milestones relating to gross revenues received by the Company from the purchased technology. Shares not earned within four years will be cancelled. In fiscal 2002 a total of 50,000 contingent shares were issued leaving an additional 109,843 shares that may be issued. Contingent shares are recorded as compensation expense when earned. The Company agreed to employ Mr. Williams and Mr. Graebener for a term of three years subject to certain terms and conditions. No compensation expense was earned during the three months ended December 31, 2002.

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AMERICAN TECHNOLOGY CORPORATION

NOTES TO INTERIM FINANCIAL STATEMENTS

(Unaudited)

7. SENIOR SECURED AND CONVERTIBLE SUBORDINATED PROMISSORY NOTES

8% Senior Secured Promissory Notes

On September 30, 2002, the Company issued to accredited investors 8% Senior Secured Promissory Notes (“Senior Notes”) for cash proceeds of $1,500,000. The Senior Notes bear interest at a rate of eight percent (8%) per annum on the principal outstanding until the earlier to occur of (i) December 31, 2003 or (ii) when declared due and payable by the Holder upon the occurrence of an Event of Default (the “Maturity Date”). Interest is payable on a quarterly basis with the first payment due January 2, 2003. The Senior Notes are secured by accounts receivable, certain equipment and inventory. Subsequent to December 31, 2002, the Company received an additional $500,000 in cash proceeds from the issuance of Senior Notes to one accredited investor. The terms of this note will be the same as the 8% Senior Secured Notes discussed above.

12% Convertible Subordinated Promissory Notes

In September and October 2001, the Company sold for cash in a private offering an aggregate of $2,025,000 of unsecured 12% Convertible Subordinated Promissory Notes (“Notes”) to accredited investors and related parties. The Notes were originally due December 31, 2002, but the maturity date was extended to December 31, 2003 by amendment dated November 19, 2002. The principal and interest amount of each Note may, at the election of the Note holder, be converted one or more times into fully paid and nonassessable shares of common stock, at a price of $2.00 per share. The Notes may be called by the Company for conversion if the market price exceeds $5.00 per share for five days and certain conditions are met. Each purchaser was granted a warrant to purchase one common share of the Company at $2.00 per share until September 30, 2006 (the “Warrant”) for each $2.00 of Notes (aggregate Warrants exercisable into 1,012,500 shares). At December 31, 2002, the Notes could have been converted into 1,163,445 shares of common stock.

The Notes and Warrants have antidilution rights reducing the conversion and exercise price for certain issuances of equity securities by the Company at an effective price below the applicable conversion or exercise price. In connection with the Notes and Warrants, the Company recorded a $2,025,000 discount to the notes to reflect the value of the beneficial conversion feature of the Notes and the value of the Warrants. The Warrants were valued using the Black-Scholes model with a dividend yield of zero percent; expected volatility of 89 to 90 percent; risk free interest rate of 4 percent; and an expected life of five years. The value was reflected as a discount to the debt. This debt discount is being amortized as non-cash interest expense over the original term of the Notes. For the quarter ended December 31, 2002, $405,000 was amortized as non-cash interest expense.

8. STOCKHOLDERS’ DEFICIT

The Company has 10,000 shares of Series C Preferred Stock outstanding convertible into 40,615 shares of Common stock as of December 31, 2002. The dollar amount of Series C Preferred Stock, increased by $1.20 per share accretion per annum and other adjustments, is convertible one or more times into fully paid shares of common stock at a conversion price which is the lower of (i) $8.00 per share or (ii) 92% of the average of the five days closing bid market price prior to conversion, but in no event less than $5.75 per share. The shares of Series C Preferred Stock may be called by the Company for conversion if the market price of the common stock exceeds $20.00 per share for ten days and certain conditions are met. The Series C Preferred Stock is subject to automatic conversion on March 31, 2003.

In May 2002, the Company sold 235,400 shares of Series D Convertible Preferred Stock (“Series D Stock”), at $10.00 per share for gross cash proceeds of $2,354,000. A total of 250,000 shares of Series D Stock have been authorized. The dollar amount of Series D Stock, increased by $0.60 per share accretion per annum and other adjustments, is convertible one or more times into fully paid shares of common stock at a conversion price which is the lower of (i) $4.50 per share or (ii) 90% of the volume weighted average market price for the five days prior to conversion, but in no event less than $2.00 per share, subject to adjustment, provided however, that no such conversion could be made prior to January 1, 2003 at a conversion price of less than $4.50 per share. The shares of Series D Stock may be called by the Company for conversion if the market price of the common stock exceeds $9.50 per share for ten days and certain conditions are met. The Series D Stock is subject to automatic conversion on March 31, 2006. The purchasers of the Series D Stock were granted warrants to purchase an aggregate of 517,880 common shares of the Company at $4.50 per share until March 31, 2007 (“D Warrants”). The Series D Stock and the D Warrants have antidilution rights reducing the floor conversion and warrant exercise price for certain issuances of equity securities by the Company at an effective price below the applicable floor conversion or warrant exercise price. In connection with the Series D Stock financing, the Company incurred closing costs of $78,752. As of December 31, 2002 the Series D Stock (based on 360-day year) would have been convertible into 1,223,822 shares of common stock.

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AMERICAN TECHNOLOGY CORPORATION

NOTES TO INTERIM FINANCIAL STATEMENTS

(Unaudited)

In connection with the Series D Stock and D Warrants, the Company recorded $994,310 and $871,000 as the value of the discount at issuance of the Series D Stock and the value of the warrants, respectively. The warrants were valued using the Black-Scholes model with a dividend yield of zero percent; expected volatility of 78 percent; risk free interest rate of 4.94 percent; and an expected life of five years. For the three months ended December 31, 2002, $64,059 and $56,115 was amortized as a deemed dividend.

Subsequent to December 31, 2002, 150,400 shares of Series D Stock were converted into 572,778 shares of common stock.

The following table summarizes changes in equity components from transactions during the three months ended December 31, 2002:

The following table summarizes information about stock option activity during the three months ended December 31, 2002:

Options outstanding are exercisable at prices ranging from $2.50 to $9.03 and expire over the period from 2001 to 2006 with an average life of 3 years.

At December 31, 2002, the Company had the following warrants outstanding arising from offerings and other transactions, each exercisable into one Common Share:

At December 31, 2002, the Company has two stock-based employee compensation plans. The Company accounts for those plans under the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees, and related Interpretations”. No stock-based employee compensation cost is reflected in net loss available to common shareholders, as all options granted under those plans had an exercise price equal to or greater than the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net loss available to common shareholders and basic and diluted loss per common share if the Company had applied the fair value recognition provisions of SFAS No. 123:

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AMERICAN TECHNOLOGY CORPORATION

NOTES TO INTERIM FINANCIAL STATEMENTS

(Unaudited)

9. INCOME TAXES

At September 30, 2002, a valuation allowance has been provided to offset the net deferred tax asset as management has determined that it is more likely than not that the deferred tax asset will not be realized. The Company has for federal income tax purposes net operating loss carryforwards of approximately $23,259,000 which expire through 2022 of which certain amounts are subject to limitations under the Internal Revenue Code of 1986, as amended.

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

THE FOLLOWING DISCUSSION INCLUDES FORWARD-LOOKING STATEMENTS WITH RESPECT TO OUR FUTURE FINANCIAL PERFORMANCE. ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE CURRENTLY ANTICIPATED AND FROM HISTORICAL RESULTS DEPENDING UPON A VARIETY OF FACTORS, INCLUDING THOSE DESCRIBED BELOW UNDER THE SUB-HEADING, “BUSINESS RISKS.” ALSO SEE OUR ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED SEPTEMBER 30, 2002.

Overview

We are focused on commercializing our proprietary HyperSonic Sound (“HSS”), NeoPlanar, PureBass and HIDA sound technologies. Our HyperSonic Sound technology employs a laser-like beam to project sound to any listening environment. Our NeoPlanar technology is a thin film magnetic speaker that uses unique films and materials, which we believe results in superior sound quality and volume for any given size with low distortion. PureBass is an extended range woofer designed to complement our HSS, NeoPlanar technologies and other high performance satellite systems. Our HIDA technology employs proprietary techniques and components to produce variable intensity directional acoustical sound intended for use as a hailing device or supercharged megaphone or as a non-lethal weapon. Our strategy is to commercialize these technologies through licensing and product sales to customers, distributors and OEMs. We believe our HSS, NeoPlanar and PureBass technologies meet customer and OEM requirements. These technologies have been licensed to OEMs and are being transferred to production. We expect product sales and royalties to commence in fiscal 2003 from these technologies. We are also producing HSS and NeoPlanar systems for sale to customers, distributors and OEMs. We are in the early stage of sales and licensing of our sound technologies with many customers purchasing systems for evaluation and demonstration.

We incurred net losses of $8,220,132, $5,046,219 and $3,068,046 in the fiscal years ended September 30, 2002, 2001 and 2000 and a net loss of $1,731,645 for the three months ended December 31, 2002. We have substantial research and development and general administrative expenses, and our revenues from our audio technologies and portable consumer products have not yet been sufficient to offset these costs. We expect to incur additional operating losses during the balance of fiscal 2003, and we anticipate that we will need to raise additional capital to meet anticipated operating costs. See “Liquidity and Capital Resources” below. As a result of our need for capital and our net losses to date, our independent auditors noted in their audit report on our financial statements for the fiscal year ended September 30, 2002 substantial doubt about our ability to continue as a going concern. We will need to generate additional revenue to achieve profitability and generate positive cash flow from operations in future periods.

We license our technologies for production by others. When we license an audio technology, we typically receive a flat fee up-front, with the balance of payments based upon a percentage of net revenues of the products in which our technology is incorporated. Revenues from up-front license fees are recognized ratably over the specified term of the particular license. Contract fees are recorded as services are performed.

In other instances we supply complete systems or components used in other products to customers, distributors or OEMs. In these cases we include our intellectual property fees in the selling prices of the systems or components. We currently produce HSS systems and NeoPlanar panels which are installed as a component of a sound system.

Our various technologies are high risk in nature. Unanticipated technical obstacles can arise at any time and disrupt sales or licensing activities and result in lengthy and costly delays. There can be no assurance commercially viable sound products offered by us or by our customers, distributors or OEMs will meet with market acceptance or that such products will perform on a cost-effective basis.

Our future is largely dependent upon the success of our sound technologies. We invest significant funds in research and development and on patent applications related to our proprietary technologies. There can be no assurance our technologies will achieve market acceptance sufficient to sustain operations or achieve future profits. See “Business Risk” below.

Effective in October 2002, we discontinued our portable consumer product line in order to focus financial, personnel and facility resources on our sound technologies, which we expect to provide substantially all of our fiscal 2003 revenues. For the three months ended December 31, 2002 and for fiscal 2002 we recorded revenues of $83,221 and $301,116, respectively for portable consumer products. These revenues represented products sourced by us, private labeled under our name and resold to sporting good stores and other retailers. Historically, portable consumer product revenues accounted for the majority of our revenues.

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Demand for our sound technologies and products is subject to significant month to month variability resulting from seasonal demand fluctuations and the limited number of customers and market penetration achieved by us to date. Further, we expect future sales may be concentrated with a limited number of customers. We are also reliant on outside suppliers for components of our products and outside manufacturers for assembly and there can be no assurance of future supply. The markets for our products and future products and technologies are subject to rapidly changing customer tastes and a high level of competition. Demographic trends in society, marketing and advertising expenditures, and product positioning in retail outlets, technological developments, seasonal variations and general economic conditions influence demand for our products. Because these factors can change rapidly, customer demand can also shift quickly. We may not be able to respond to changes in customer demand because of the time required to change or introduce products, production limitations and/or limited financial resources.

Critical Accounting Policies

We have identified the policies below as critical to our business operations and the understandings of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations when such policies affect our reported and expected financial results.

In the ordinary course of business, we have made a number of estimates and assumptions relating to the reporting of results of operations and financial condition in the preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America. Actual results could differ significantly from those estimates under different assumptions and conditions. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require our most difficult, subjective, and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

We do not have off-balance sheet arrangements, financings, or other relationships with unconsolidated entities or other persons, also known as “special purpose entities” (SPEs).

Revenue Recognition

We derive our revenue primarily from two sources: (i) product revenue and (ii) contract and license fee revenue. Product revenues are recognized in the periods that products are shipped to customers, FOB shipping point, if a signed contract exists, the fee is fixed and determinable, collection of resulting receivables is probable and there are no resulting obligations. Revenues from ongoing per unit license fees are earned based on units shipped incorporating our patented proprietary technologies and are recognized in the period when the manufacturers’ units shipped information is available to us and collectibility is reasonably assured. Revenues from up-front license and other fees and annual license fees are recognized ratably over the specified term of the particular license or agreement.

Research and Development Expenses

Research and development expenses are salaries and related expenses associated with the development of our proprietary sound technologies and include compensation paid to engineering personnel and fees to outside contractors and consultants.

Deferred Tax Asset

We have provided a full valuation reserve related to our substantial deferred tax assets. In the future, if sufficient evidence of our ability to generate sufficient future taxable income in certain tax jurisdictions becomes apparent, we may be required to reduce our valuation allowances, resulting in income tax benefits in our consolidated statement of operations. We evaluate the realizability of the deferred tax assets and assess the need for valuation allowance quarterly. The utilization of the net operating loss carryforwards could be substantially limited due to restrictions imposed under federal and state laws upon a change in ownership.

Results of Operations

Total revenues for the three month periods ended December 31, 2002 and 2001 were $423,299 and $256,621, respectively. Product sales for the three months ended December 31, 2002 were $387,967 a 72% increase from the comparable three month total of $224,954 for the prior year. For the three months ended December 31, 2002 product sales included $83,221 of consumer portable product sales and $304,746 from the sale of NeoPlanar, HIDA and HSS products. Consumer product sales were historically volatile due to changing customers and product offerings and reliance on a limited number of customers. Since we have discontinued our portable consumer products line, fiscal 2003 revenues for these products will be substantially below those for fiscal 2002, and will be limited to sales of inventory on hand. Sales of sound products are also expected to be volatile as a result of manufacturing startup requirements and the need to recruit new customers for products not previously available in the marketplace.

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Contract and license revenues for the quarters ended December 31, 2002 and 2001 were $35,332 and $31,667, respectively. We recognize upfront fees and advance revenues over the term of respective license agreements. At December 31, 2002 and September 30, 2002 we had $250,001 and $276,667, respectively, collected and recorded as unrecognized revenue for existing contracts and licenses.

At December 31, 2002, we had open purchase orders for approximately $129,700 of product, of which approximately $41,687 had been received as customer deposits. We expect to fill these orders during the second quarter ending March 31, 2003. There was no material backlog at December 31, 2001. Subsequent to December 31, 2002, we received purchase orders for approximately $240,000 for military product expected to ship during our fiscal third quarter ending June 30, 2003. Anticipated shipments are subject to change due to a variety of factors, many outside our control. Our customers may modify or cancel orders and delay or change schedules. Shipments may also be delayed due to production delays, component shortages and other production related issues.

Cost of revenues for the three months ended December 31, 2002 was $321,635 resulting in a gross profit of $101,664 or 24%. This compares to a gross profit of $140,162 or 55% for the comparable period of the prior year. It is difficult to compare historical gross profit percentages due to changes in contract and license revenues as a percentage of total revenues and changes in the product mix in each year. The lower gross profit percentage in the three months ended December 31, 2002 resulted from lower margins on consumer product sales, establishing a warranty reserve and startup production costs for HSS and NeoPlanar products. Gross profit percentage is highly dependent on sales prices, volumes, purchasing costs and overhead allocations. Overall gross margins will also be impacted by future contract and licensing revenues and the types of products sold to customers. Margins may vary significantly from period to period.

Selling, general and administrative expenses for the three months ended December 31, 2002 and 2001 were $756,317 and $492,656, respectively. The $263,661 increase resulted from an increase in legal costs of $159,448, an increase in insurance of $13,312, an increase in personnel costs of $85,674 and an increase of $8,284 for print advertising. The increase in personnel costs included two new hires and the reassignment of one person from research and development support staff to sales and marketing duties. We may expend additional resources on marketing our sound technologies in future quarters, which may increase selling, general and administrative expenses in future periods.

Research and development expenses for the three months ended December 31, 2002 were $581,421 compared to $893,937 for the comparable three months of the prior year. The $312,516 decrease resulted from a reduction of $216,670 for supplies and materials used in the development of our sound technologies, a $46,578 decrease in personnel costs from the reassignment of one person to selling, general and administrative expense and a decrease of $20,387 for consulting services. Research and development costs vary quarter by quarter due to the timing of projects, the availability of funds for research and development and the timing and extent of use of outside consulting, design and development firms. We expect that fiscal 2003 research and development costs may be at lower levels than the prior year based on current staffing and budgeting as we focus resources on sales of products from developed technologies.

We recorded in selling, general and administrative expenses $3,600 for the three months ended December 31, 2001 for services paid through the issuance of 1,425 shares of common stock.

We experienced a loss from operations of $1,236,074 during the three months ended December 31, 2002, compared to a loss from operations of $1,246,431 for the comparable three months ended December 31, 2001. The $10,357 decrease is primarily due to the decrease in research and development costs for the first quarter of fiscal 2002.

Interest expense of $497,902 for the three months ended December 31, 2002 included $405,000 of noncash amortization of debt discount, $61,611 of accrued interest on convertible subordinated promissory notes and $31,291 of accrued interest on senior secured promissory notes.

The net loss available to common stockholders for the three months ended December 31, 2002 and 2001 of $1,890,443 and $1,729,097, respectively, included $38,624 of accretion on the Series C and Series D Preferred Stock also included is $64,059 on Series D Preferred Stock imputed deemed dividends based on discount at issuance and $56,115 on imputed deemed dividends on warrants issued in connection with the Series D Preferred Stock. The net loss available to common stockholders for the three months ended December 31, 2001 of $1,729,097 included $19,956 of accretion on the Series B and Series C Preferred Stock.

We have federal net loss carryforwards of approximately $23,259,000 for federal tax purposes expiring through 2022. The amount and timing of the utilization of our net loss carryforwards may be limited under Section 382 of the Internal

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Revenue Code. A valuation allowance has been recorded to offset the related net deferred tax asset as management was unable to determine that it is more likely than not that the deferred tax asset will be realized.

Future operations are subject to significant variability as a result of licensing activities, product sales and margins, timing of new product offerings, the success and timing of new technology exploitation, decisions regarding future research and development and variability in other expenditures.

Liquidity and Capital Resources

We have experienced significant negative cash flow from operating activities developing and introducing our sound technologies. Due to our need for additional capital and our net losses, our independent auditors have noted in their report on our financial statements a substantial doubt about our ability to continue as a going concern. Our negative cash flow from operating activities was $1,337,347 for the first fiscal quarter of 2003. As of December 31, 2002, the net loss of $1,731,645 included certain expenses not requiring the use of cash totaling $619,354. In addition, cash was used in operating activities through an increase of $351,930 in inventories, a $59,370 increase in accounts receivable, an increase of $8,125 in prepaid expenses and other. Cash provided by operating activities included a $71,984 increase in accrued liabilities and an $122,385 increase in accounts payable.

At December 31, 2002, we had gross accounts receivable of $191,048 as compared to $131,677 at September 30, 2002. This represented approximately 54 days of sales. Terms with individual customers vary greatly. Large retail chains often require 90-120 day terms on sales on portable consumer products. We typically require pre-payment or a maximum of thirty day terms for our sound technology products. Our receivables can vary dramatically due to overall sales volumes and due to quarterly and seasonal variations in sales and timing of shipments to and receipts from large customers.

For the three months ended December 31, 2002, we used approximately $9,701 for the purchase of laboratory and computer equipment and made a $24,823 investment in patents and new patent applications. We anticipate a continued investment in patents in fiscal 2003. Dollar amounts to be invested on these patents are not currently estimable by management.

At December 31, 2002, we had negative working capital of $3,985,886 compared to working capital of $554,713 at September 30, 2002.

We have financed our operations primarily through the sale of preferred stock, exercises of stock options, sale of convertible and non-convertible notes, proceeds from the sale of investment securities and margins from product sales. At December 31, 2002, we had cash of $453,193, representing a decrease of $1,354,527 from cash at September 30, 2002. The decrease resulted primarily from cash used in operating activities. In February 2003, we sold an additional $500,000 8% Senior Secured Promissory Note due December 31, 2003 to one accredited investor. The terms of this note are identical to the other 8% Senior Secured Notes described in Part II, Item 5 of our Form 10-K for the year ended September 30, 2002. Based on our current cash position and assuming (a) currently planned expenditures and level of operations, (b) continuation of product sales and (c) expected royalty and licensing proceeds; we believe we will require approximately $2 million of additional cash for operations for the next twelve months. We believe increased sales of HSS and NeoPlanar products may provide a portion of this cash. We believe that any required investment capital will be available to us, but there can be no guarantee that we will be able to raise funds on terms acceptable to us, or at all. We have significant flexibility to adjust the level of research and development and selling and administrative expenses based on the availability of resources. However reductions in expenditures could delay development and adversely affect our ability to generate future revenues.

Any equity-based source of additional funds could be dilutive to existing equity holders and the dilution could be material. The lack of sufficient funds from operations or additional capital could force us to curtail or scale back operations and would therefore have an adverse effect on our business. Other than cash and cash equivalents, we have no unused sources of liquidity at this time. We expect to incur additional operating losses as a result of expenditures for research and development and marketing costs for our sound products and technologies. The timing and amounts of these expenditures and the extent of our operating losses will depend on many factors, some of which are beyond our control. Accordingly, there can be no assurance that our current expectations regarding required financial resources will prove to be accurate. We anticipate that the commercialization of our technologies may require increased operating costs; however, we cannot currently estimate the amounts of these costs.

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Contractual Commitments and Commercial Commitments

The following table summarizes our contractual obligations, including purchase commitments at December 31, 2002, and the effect such obligations are expected to have on our liquidity and cash flow in future periods:

Employment Agreements

The Company has entered into five employment agreements with executive officers and key employees. These agreements are each for one to three-year terms expiring from February 2003 to October 2005. Certain of the agreements provide for up to twelve months severance for certain terminations and payments for the term of the agreement (or in one case twelve months, if longer) on certain changes in control.

New Accounting Pronouncements

A number of new pronouncements have been issued for future implementation as discussed in the footnotes to our interim financial statements (see page 6, Note 4). As discussed in the notes to the interim financial statements, the implementation of these new pronouncements is not expected to have a material effect on our financial statements.

Business Risks

You should consider each of the following factors as well as the other information in this Quarterly Report in evaluating our business and our prospects. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently consider immaterial may also impair our business operations. If any of the following risks actually occur, our business and financial results could be harmed. In that case the trading price of our common stock could decline. You should also refer to the other information set forth in this Quarterly Report and in our Annual Report on Form 10-K for the fiscal year ended September 30, 2002, including our financial statements and the related notes.

We have a history of net losses. We expect to continue to incur net losses and we may not achieve or maintain profitability. Our independent auditors have raised substantial doubt about our ability to continue as a going concern.

We have incurred significant operating losses and anticipate continued losses in fiscal 2003. At December 31, 2002 we had an accumulated deficit of $29,871,689. Due to our net losses and our need for additional capital to sustain operations, our independent auditors have noted in their report on our financial statements a substantial doubt about our ability to continue as a going concern. We need to generate additional revenue to be profitable in future periods. Failure to achieve profitability, or maintain profitability if achieved, may cause our stock price to decline.

We will need additional capital to support our operations during the next twelve months. If additional capital is not available, we may have to curtail or cease operations.

Our current plans indicate we will need at least $2.0 million in additional capital to support our planned level of operations for the next twelve months. Due to our need for additional capital and our net losses, our independent auditors have noted in their report on our financial statements a substantial doubt about our ability to continue as a going concern. A portion of these funds may be generated from operations from licensing and HSS product sales. The actual amount of funds that we will need will be determined by many factors, some of which are beyond our control, and we may need funds sooner than currently anticipated. These factors include:

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When we require additional funds, general market conditions or the then-current market price of our common stock may not support capital raising transactions. If we require additional funds and we are unable to obtain them on a timely basis or on terms favorable to us, we may be required to scale back our research and development efforts, sell or license some or all of our technology or assets or curtail or cease operations. If we raise additional funds by selling additional shares of our capital stock or securities convertible into common stock, the ownership interest of our stockholders will be diluted.

We have substantial debt which adversely affects us.

We have a substantial amount of debt, including the following as of February 4, 2003:

The substantial amount of our indebtedness impacts us in a number of ways:

These factors generally place us at a disadvantage to our less leveraged competitors. Any or all of these factors could cause our stock price to decline.

We may not have sufficient funds to pay the $4.76 million balance on promissory notes due December 31, 2003.

We have issued convertible subordinated promissory notes in the aggregate face amount of $2.025 million, and senior secured promissory notes in the aggregate face amount of $2.0 million. All of these notes mature on December 31, 2003, and if they are not sooner paid or, in the case of the convertible notes, converted, we will owe $4,761,750 million in principal and accrued interest on that date.

We have a right to force conversion of the amounts due under the convertible subordinated promissory notes to common shares at conversion price of $2.00 per share, but we can exercise that right only if our stock price exceeds $5.00 per share for five trading days in a row, and we have on file with the SEC an effective registration statement for the resale of such shares. The convertible note holders may voluntarily convert the notes to common shares at a conversion price of $2.00 per share any time before payment, but they are not obligated to do so unless the conditions for mandatory conversion are met. If our stock price is below $2.00 per share at December 31, 2003, it is unlikely any remaining holders will elect to convert, and the notes will be due and payable unless they are renegotiated. Even if our stock price exceeds $2.00 per share on that date or before, some or all of the holders may not elect to convert their notes. During the last 30 trading days, the closing sale price of our common shares has ranged from $3.06 to $4.20.

We may not have sufficient funds available to make the required maturity payments. If we do not have sufficient funds, one or more note holders could declare its note in default. The senior secured promissory notes are secured by our accounts receivable, equipment, goods, instruments and inventory. If we default on the payment of such notes, the holders will have the right to take control of all of the assets which secure the notes.

Although the convertible subordinated notes are unsecured, those note holders could obtain a judgment and enforce that judgment by taking control of some or all of our assets. Upon default, note holders could also commence involuntary

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bankruptcy proceedings, which could significantly impair our business and the value of your stock. Even if we do have sufficient funds to pay those notes at maturity, such payments could impair our ability to meet other critical operating expenses, and could require us to scale back our research and development efforts, sell or license some or all of our technology or assets or curtail or cease operations.

We are an early stage company introducing new technologies. If commercially successful products do not result from our efforts, we may be unprofitable or forced to cease operations.

Our HSS, NeoPlanar, PureBass and HIDA technologies have only recently been introduced to market and are still being improved. Commercially viable sound technology systems may not be successfully and timely produced by OEMs due to the inherent risks of technology development, new product introduction, limitations on financing, competition, obsolescence, loss of key technical personnel and other factors. Our revenues from our sound technology have been limited to date, and we cannot guarantee significant revenues in the future. The development and introduction of our sound technology has taken longer than anticipated by management and could be subject to additional delays. Products employing our sound technology may not achieve market acceptance. Our various sound projects are high risk in nature, and unanticipated technical obstacles can arise at any time and result in lengthy and costly delays or result in a determination that further exploitation is unfeasible. If we do not successfully exploit our technology, our financial condition and results of operations and business prospects would be adversely affected.

Our portable consumer products have been the primary source of our historical revenues. You cannot rely on period-to-period comparisons of our results of operations as an indication of future performance.

To date, we have derived most of our revenues from the sale of portable consumer electronics products. We expect future revenues will primarily be generated from our proprietary sound reproduction and other electronic technologies, but there can be no assurance we will achieve substantial revenues from these technologies. If we do not achieve substantial revenues from these technologies, you may not be able to rely on period-to-period comparisons of our results of operations as an indication of future performance.

We do not have the ability to predict future operating results. Our quarterly and annual revenues will likely be subject to fluctuations caused by many factors, any of which could result in our failure to achieve our revenue expectations.

Our historical revenues derived almost exclusively from portable consumer products, and we expect a majority of future revenues to be generated from our sound reproduction technologies. Revenues from our sound reproduction technologies are expected to vary significantly due to a number of factors. Many of these factors are beyond our control. Any one or more of the factors listed below or other factors could cause us to fail to achieve our revenue expectations. These factors include:

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Some or all of these factors could adversely affect demand for OEM products incorporating our sound reproduction technologies, and therefore adversely affect our future operating results.

Most of our operating expenses are relatively fixed in the short term. We may be unable to rapidly adjust spending to compensate for any unexpected sales or license revenue shortfalls, which could harm our quarterly operating results. We do not have the ability to predict future operating results with any certainty.

Our expenses may vary from period to period, which could affect quarterly results and our stock price.

If we incur additional expenses in a quarter in which we do not experience increased revenue, our results of operations would be adversely affected and we may incur larger losses than anticipated for that quarter. Factors that could cause our expenses to fluctuate from period to period include:

Sound reproduction markets are subject to rapid technological change, so our success will depend on our ability to develop and introduce new technologies.

Technology and standards in the sound reproduction markets evolve rapidly, making timely and cost-effective product innovation essential to success in the marketplace. The introduction of products with improved technologies or features may render our technologies obsolete and unmarketable. If we cannot develop products in a timely manner in response to industry changes, or if our technologies do not perform well, our business and financial condition will be adversely affected. The life cycles of our technologies are difficult to estimate, particularly those such as HSS and HIDA for which there are no established markets. As a result, our technologies, even if successful, may become obsolete before we recoup our investment.

Our HSS technology is subject to government regulation, which could lead to unanticipated expense or litigation.

Our HyperSonic Sound technology emits ultrasonic vibrations, and as such is regulated by the Food and Drug Administration. In the event of certain unanticipated defects in an HSS product, a licensee or we may be required to comply with FDA requirements to remedy the defect and/or notify consumers of the problem. This could lead to unanticipated expense, and possible product liability litigation against a licensee or us. Any regulatory impediment to full commercialization of our HSS technology, or any of our other technologies, could adversely affect our results of operations. For a further discussion of the regulation of our HSS technology, see Part I, Item 1 of our Annual Report on Form 10-K, under the heading “Government Regulation.”

Many potential competitors who have greater resources and experience than we do may develop products and technologies that make ours obsolete.

Technological competition from other and longer established electronic and loudspeaker manufacturers is significant and expected to increase. Most of the companies with which we expect to compete have substantially greater capital resources, research and development staffs, marketing and distribution programs and facilities, and many of them have substantially greater experience in the production and marketing of products. In addition, one or more of our competitors may have developed or may succeed in developing technologies and products that are more effective than any of ours, rendering our technology and products obsolete or noncompetitive.

Commercialization of our sound technologies depends on collaborations with other companies. If we are not able to maintain or find collaborators and strategic alliance relationships in the future, we may not be able to develop our sound technologies and products.

As we do not have the production, marketing and selling resources to commercialize our products on our own, our strategy is to establish business relationships with leading participants in various segments of the electronics and sound reproduction markets to assist us in producing, marketing and selling products that include our sound technologies.

Our success will therefore depend on our ability to maintain or enter into new strategic arrangements with partners on commercially reasonable terms. If we fail to enter into such strategic arrangements with third parties, our financial condition, results of operations, cash flows and business prospects will be adversely affected. Any future relationships may require us to share control over our development, manufacturing and marketing programs or to relinquish rights to certain versions of our sound and other technologies.

We are dependent on outside suppliers, including HST, Inc. Disruptions in supply could adversely affect us.

We have developed a strategic manufacturing relationship with HST, Inc. providing for sub-contract manufacturing of our HSS and NeoPlanar products. The loss or disruption of HST, Inc. as a supplier could have a negative impact on our

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financial condition and results of operations. We also have a manufacturing arrangement with Amtec Manufacturing for our PureBass subwoofer units. These are sole supplier arrangements, and the loss or a disruption of supply could have a negative impact on our ability to introduce these technologies in volume. Once introduced in volume, the loss or disruption of supply could reduce future revenues, adversely affecting financial condition and results of operations.

Any inability to adequately protect our proprietary technologies could harm our competitive position.

We are heavily dependent on patent protection to secure the economic value of our technologies. We have both issued and pending patents on our sound reproduction technologies and we are considering additional patent applications. Patents may not be issued from some or all of our pending applications. Claims allowed from existing or pending patents may not be of sufficient scope or strength to protect the economic value of our technologies. Issued patents may be challenged or invalidated. Further, we may not receive patents in all countries where our products can be sold or licensed. Our competitors may also be able to design around our patents. The electronics industry is characterized by vigorous protection and pursuit of intellectual property rights or positions, which have resulted in significant and often protracted and expensive litigation. There is currently no pending intellectual property litigation against us. Third parties may charge that our technologies or products infringe their patents or proprietary rights. Problems with patents or other rights could potentially increase the cost of our products, or delay or preclude our new product development and commercialization. If infringement claims against us are deemed valid, we may be forced to obtain licenses, which might not be available on acceptable terms or at all. Litigation could be costly and time-consuming but may be necessary to protect our future patent and/or technology license positions, or to defend against infringement claims. A successful challenge to our sound technology could have a negative effect on our business prospects.

If our key employees do not continue to work for us, our business will be harmed because competition for replacements is intense.

Our performance is substantially dependent on the performance of our executive officers and key technical employees, including Elwood G. Norris, our CEO. We are dependent on our ability to retain and motivate high quality personnel, especially highly skilled technical personnel. Our future success and growth also depend on our continuing ability to identify, hire, train and retain other highly qualified technical, managerial and sales personnel. Competition for such personnel is intense, there can be no assurance that we will be able to attract, assimilate or retain other highly qualified technical, managerial or sales personnel in the future. The inability to attract and retain the necessary technical, managerial or sales personnel could cause our business, operating results or financial condition to suffer.

We may issue preferred stock in the future, and the terms of the preferred stock may reduce the value of your common stock.

We are authorized to issue up to 5,000,000 shares of preferred stock in one or more series. Our board of directors may determine the terms of future preferred stock without further action by our stockholders. If we issue additional preferred stock, it could affect your rights or reduce the value of your common stock. In particular, specific rights granted to future holders of preferred stock could be used to restrict our ability to merge with or sell our assets to a third party. These terms may include voting rights, preferences as to dividends and liquidation, conversion and redemption rights, and sinking fund provisions.

Our convertible subordinated note financing may result in dilution to our common stockholders.

Dilution of the per share value of our common shares could result from the conversion of most or all of the convertible subordinated notes we sold in September and October of 2001. Holders of these notes may convert the principal balance of these notes and all accrued interest into shares of our common stock at a conversion price of $2.00. The conversion price may be adjusted downward if we sell securities for less than an effective price of $2.00 per share. We have the right to require conversion of the notes after our stock trades above $5.00 per share for five consecutive trading days and we have an effective registration statement for the resale of the conversion shares. We intend to exercise this right as soon as we are able. In addition, the purchasers in these transactions received warrants to purchase one common share for each $2.00 in note principal purchased. The exercise price is $2.00 per share, subject to downward adjustment if we sell securities for less than an effective price of $2.00 per share. We initially issued $2.025 million in principal amount of convertible subordinated notes, which as of December 31, 2002 were convertible into an aggregate of 1,163,445 common shares, and 1,012,500 warrants, all of which are outstanding. The 12% convertible subordinated notes are due December 31, 2003, and accrue interest at 12% per annum.

Holders of our common stock could experience substantial dilution form the conversion of the convertible subordinated notes and exercise of the related warrants. In the event the conversion or exercise price is lower than the actual trading price on the day of conversion or exercise, the holder could immediately sell all of its converted common shares and exercised warrant shares, which would have a dilutive effect on the value of the outstanding common shares. Even the mere perception of eventual sales of common shares issued on the conversion of the convertible subordinated notes or exercise of the related warrants could lead to a decline in the trading price of our common stock.

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Our Series D Preferred Stock financing may result in dilution to our common stockholders. The holders of Series D Preferred Stock will receive more common shares on conversion if the market price of our common stock declines.

Dilution of the per share value of our common shares could result from the conversion of most or all of the Series D Preferred Stock we sold in May 2002. We issued a total of 235,400 shares of our Series D Preferred Stock in the financing, 150,400 of which have been converted into 572,778 common shares and 85,000 of which remain outstanding. The holders of our outstanding shares of Series D Preferred Stock may convert these shares into shares of our common stock at a conversion price equal to the lower of $4.50 or 90% of volume-weighted average price of our common stock for the five trading days prior to conversion. The conversion rate could not however be lower than $4.50 before December 31, 2002, or lower than $2.00 after December 31, 2002. The $2.00 floor price may however be adjusted downward if we sell securities for less than an effective price of $2.00 per share. Accordingly, the outstanding 85,000 shares of Series D Preferred Stock are presently convertible into an aggregate of 303,528 common shares. In addition, the Series D Preferred Stock purchasers received warrants to purchase 2.2 common shares for each share of Series D Preferred Stock purchased. The exercise price of the warrants is $4.50 per share, subject to downward adjustment if we sell securities for less than an effective price of $4.50 per share. We may call the Series D Preferred Stock for conversion if the market price of the common stock exceeds $9.50 per share for ten consecutive trading days and we have an effective registration statement for the resale of the conversion shares.

Holders of our common stock could experience substantial dilution from the conversion of the Series D Preferred Stock and exercise of the related warrants. As a result of the floating conversion price, the holders of Series D Preferred Stock will receive more common shares on conversion if the price of our common shares declines. To the extent that the Series D stockholders convert and then sell their common shares, the common stock price may decrease due to the additional shares in the market. This could allow the Series D stockholders to receive greater amounts of common stock, the sales of which would further depress the stock price. Furthermore, the significant downward pressure on the trading price of our common stock as Series D Preferred Stock and related warrant holders convert or exercise these securities and sell the common shares received could encourage short sales by the holders of Series D Preferred Stock and the related warrants, or other stockholders. This would place further downward pressure on the trading price of our common stock. Even the mere perception of eventual sales of common shares issued on the conversion of the Series D Preferred Stock or exercise of the related warrants could lead to a decline in the trading price of our common stock.

Our stock price is volatile and may continue to be volatile in the future.

Our common stock trades on the NASDAQ Small Cap Market. The market price of our common stock has fluctuated significantly to date. In the future, the market price of our common stock could be subject to significant fluctuations due to general market conditions and in response to quarter-to-quarter variations in:

The stock market in recent years has experienced extreme price and volume fluctuations that have affected the market price of many technology companies, and that have often been unrelated or disproportionate to the operating performance of companies.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Market risk represents the risk of loss that may impact our financial position, results of operations or cash due to adverse changes in market prices, including interest rate risk and other relevant market rate or price risks.

We are exposed to some market risk through interest rates, related to our investment of our cash of $453,193 at December 31, 2002. Based on this balance, a change of one percent in interest rate would cause a change in interest income of $4,532. We do not consider this risk to be material, and we manage the risk by continuing to evaluate the best investment rates available for short-term high quality investments.

We have no activities in long-term indebtedness and our other investments are insignificant. At the present time we do not have any significant foreign sales or foreign currency transactions.

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Item 4. Controls and Procedures

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

From time to time we are involved in routine litigation incidental to the conduct of our business. There are currently no material pending legal proceedings to which we are a party or to which any of our property is subject.

Item 2. Changes in Securities

On November 19, 2002, we and the holders of the 12% Convertible Subordinated Notes agreed to extend the maturity date of such notes from December 31, 2002 to December 31, 2003. The notes accrue interest at the rate of 12% per annum until maturity. Holders of these notes may convert the principal balance of these notes and all accrued interest into shares of our common stock at a conversion price of $2.00. The conversion price may be adjusted downward if we sell securities for less than an effective price of $2.00 per share. We have the right to require conversion of the notes after our stock trades above $5.00 per share for five consecutive trading days and we have an effective registration statement for the resale of the conversion shares. We intend to exercise this right as soon as we are able. In addition, the purchasers in these transactions received warrants to purchase one common share for each $2.00 in note principal purchased. The exercise price is $2.00 per share, subject to downward adjustment if we sell securities for less than an effective price of $2.00 per share. We initially issued $2.025 million in principal amount of convertible subordinated notes, which as of January 15, 2003, were convertible into an aggregate of 1,285,270 common shares and 1,012,500 warrants, all of which are outstanding. The holders of the convertible notes have piggyback registration rights for the shares obtainable upon conversion of the notes and exercise of the associated warrants.

The notes were modified without registration under the Securities Act of 1933 in reliance on Section 3(a)(9) of the Securities Act. The modification involved solely existing security holders and no commission or other remuneration was paid or given directly or indirectly for soliciting such modification.

Item 3. Defaults Upon Senior Securities

Not applicable

Item 4. Submission of Matters to a Vote of Security Holders

Not applicable

Item 5. Other Information

Not applicable

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Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits:

(b) Reports on Form 8-K

On October 7, 2002, we filed a Form 8-K continuing disclosure in Item 5 and exhibits in Item 7.

On October 15, 2002, we filed a Form 8-K continuing disclosure in Item 5 event.

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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.

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CERTIFICATIONS

I, Elwood G. Norris, certify that:

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the Evaluation Date); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

Dated: February 12, 2003

/s/      ELWOOD G. NORRIS  

Elwood G. Norris,

Chief Executive Officer and Chairman (Principal Executive Officer)

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I, Renee Warden, certify that:

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the Evaluation Date); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

Dated: February 12, 2003

/s/ RENEE WARDEN

Renee Warden

Chief Accounting Officer, Treasurer and Secretary (Principal Financial Officer)

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