Genasys Inc. - Annual Report: 2003 (Form 10-K)

Effective in October 2002, we reduced our marketing emphasis on our portable consumer product line in order to focus financial, personnel and facility resources on our sound technologies.

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Government Group

Late in fiscal 2003 we organized our Government Group to design, manufacture and market LRAD, NeoPlanar and HSS products for government, military and the developing force protection and emergency response markets. We are actively expanding relationships with government agencies including the Pentagon, U.S. Navy, U.S. Coast Guard, U.S. Army, U.S. Marine Corps, Joint Non-Lethal Weapons Directorate, plus several major port authorities and police departments. During fiscal 2002 we installed HSS and/or NeoPlanar systems in a Navy nuclear aircraft carrier and in a guided-missile destroyer. Commercial deliveries of LRAD products commenced in May 2003.

The landscape of the global defense industry continues to evolve as new events, such as those of September 11, 2001, demand alternative strategic defense initiatives. The defense requirements of the United States have shifted from defending against Cold War era threats to a focus upon the management of one or more regional conflicts, homeland security and proactive threat identification. As a result of this change, the defense industry is influenced by several key factors that also may impact our Government Group:

In February 2003 we entered into two licensing and sales agreements with subsidiaries of General Dynamics Corporation to purchase, market and resell NeoPlanar and HIDA (High Intensity Directional Acoustics) products and components with exclusive rights for specified applications to certain government customers, including the Department of Defense, Department of Homeland Security and certain Federal, State and local agencies. In September 2003, in response to a strategic refocus on core business, the agreement with Bath Iron Works Corporation for NeoPlanar systems was assigned to General Dynamics Armaments and Technical Products, Inc. (GD-ATP), which now has the responsibility for marketing both HIDA and NeoPlanar to U.S. military and government customers. Our agreements with GD-ATP require GD-ATP to purchase components for the respective products directly from us. GD-ATP must purchase minimum quantities of products and/or obtain minimum research and development funding for us in order to maintain exclusivity under each agreement. The agreements with GD-ATP continue through February 2008, and GD-ATP has the option to renew each agreement for an additional five years. Each agreement may be terminated by either party for cause.

Our Government Group personnel provide sales and technical support to General Dynamics. Our personnel also market LRAD (Long Range Acoustic Device), NeoPlanar, and HSS systems to customers outside the scope of our agreements with GD-ATP. Our strategy is to position LRAD, NeoPlanar, and HSS as the premium sound solution product suite for force protection, emergency response, and advanced audio systems throughout government and the security industry, first in the U.S. and then internationally. The following are examples of how our products are being used in force protection:

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We believe other military branches, government agencies and allied forces will employ LRAD systems for long range hailing and warning as part of their force protection strategies.

In October 2003 GD-ATP obtained a contract awarded by the Naval Surface Warfare Center Crane. As a subcontractor for approximately $240,000, we expect to deliver by late December 2003 modified LRADs to support the pan/tilt and remote operation of the Aircraft Carrier Situational Awareness System (ACSAS) and Integrated Radar Optical Sighting & Surveillance System (IROS3). ACSAS and IROS3 are the U.S. Navy’s high profile shipboard force protections systems, expected to be installed on all aircraft carriers and surface combatants to protect against small boat threats in port, restricted waters and littoral zones. LRAD is designed to add capability to the integrated optics, command and control, and lethal weapon suite by providing a simple, repeatable and reliable way to determine intent through long range hailing and warning.

LRAD provides our customers with a breakthrough technology to clearly communicate at ranges in excess of 500 yards with a warning tone in the same device that can change behavior. It was originally conceived to provide a new tool in preventing such incidents as the USS Cole attack. It is demonstrating its value for stand off communications for USN and USCG vessel boarding, crowd control, check point operations, and area denial of personnel. Its applications for shipboard and shore side waterside protection and land mobile vehicles is under test and evaluation by a range of military services, the agencies of the Department of Homeland Security, other government agencies, port authorities, and federal and local law enforcement. Airborne applications are also under review.

NeoPlanar technology provides a next generation communications capability for loud and clear outdoor and indoor public address and emergency response communication for military, government and commercial facilities and areas. Because of its unique capability to increase intelligibility over even high ambient noise plus its robust survivability in most operational environments, NeoPlanar products have a niche for multiple military, government, and force protection applications. Indoors, particularly in large spaces such as aircraft hangars, NeoPlanar provides a high level of clarity due to engineered reduction of multi-path and distortion. For outdoor applications, NeoPlanar extends effective range of clear high fidelity-quality communication to hundreds of yards even over high ambient noise.

We are in the early stages of developing the broad reaching applications of this technology both in new application and replacement speaker markets. The pairing of Neo Planar and HSS technologies offers a significant degree of flexibility for us to engineer acoustic solutions for customers based on intelligibility requirements, and will increasingly support our mission to shape the future of sound.

Suppliers and Manufacturing

We believe establishing and maintaining quality manufacturing capacity is essential to the performance of our products and the growth of our business.

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During fiscal 2003, our manufacturing was spread amongst several internal and external resources. NeoPlanar manufacturing for both commercial and government systems remains located in our Carson City facility. LRAD and HSS manufacturing resources are located in our San Diego facility. During fiscal 2003 we also attempted to manufacture HSS units using a outside contractor. Component and manufacturing startup difficulties required us to re-absorb HSS manufacturing into our San Diego facility.

Going forward, we intend to focus internal resources on our core development and engineering capabilities and engage external partners for other required competencies. We intend to establish manufacturing as an external competency during fiscal 2004 as we embark on volume manufacturing of several product lines. We expect HSS, LRAD and NeoPlanar product lines to ramp production during 2004. Our strategy is to engage established global contract manufacturing partners to meet growing production needs.

We believe contract manufacturing matches our needs for the future. Contract manufacturers are equipped to proportionally scale production operations. We plan to use their staff of manufacturing and tooling engineers to minimize our startup costs. Established contract manufacturers also have existing processes to insure quality and lower costs. We intend to select strategic manufacturing partners that can seamlessly transition our products off shore as warranted for future cost savings.

We are also refining our internal business processes to improve how we design, test and qualify product designs. We are implementing more rigorous manufacturing and quality processes to track production and field failures. Key metrics for line yields, warranty returns, root cause analysis and ongoing reliability testing are being tracked.

Suppliers are key members of our production chain and will be selected and managed accordingly. Of particular importance is our HSS piezo-film supplier which provides significant expertise in the fabrication of component material used in our proprietary HSS emitters. We have recently implemented more stringent testing of this crucial material.

Our HSS emitters and NeoPlanar panels employ film as a key part of the product. LRAD systems employ customized emitters. We have identified suppliers for film and key parts but some are on a sole source basis. Although other suppliers are believed to be available, the disruption and cost of changing suppliers could have a material adverse effect on our financial condition and results of operations.

Customers

For fiscal year ended September 30, 2003, sales to one customer Bath Iron Works Corporation accounted for 24% of revenues, with no other single customer accounting for more than 10% of revenues.

For fiscal year ended September 30, 2002, sales to three customers, Bath Iron Works Corporation, Harman, and Vulcan Northwest, Inc., accounted for approximately 19%, 12% and 11% of sales, respectively, with no other single customer accounting for more the 10% of revenues. Bath Iron Works provided research and development funding for our LRAD technology, Harman licensed our NeoPlanar technology, and Vulcan Northwest purchased NeoPlanar products.

For the fiscal year ended September 30, 2001, sales to two customers, ASI Technology and Vulcan Northwest, Inc., accounted for approximately 23% and 10% of sales, respectively. ASI purchased our jet engine noise cancellation patent and Vulcan Northwest purchased NeoPlanar products. No other single customer accounting for more than 10% of revenues.

Our revenues have relied on major customers in the past. Our goal is to diversify sound technology revenues in future periods but until sufficient revenue volume is achieved, the loss of any customer could have a material adverse effect on our financial condition, results of operations and cash flows.

As we have only recently commenced product manufacturing and sales, with some sales being for evaluation for possible larger future orders, and because our difficulties in bringing HSS to production have resulted in delays in order fulfillment, we do not consider order backlog to be an important index of future performance at this time. Our order backlog was approximately $300,000 at September 30, 2003. Backlog orders are subject to cancellation or rescheduling by our customers.

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Warranties

We generally warrant our products to be free from defects in materials and workmanship for a period up to one year from the date of purchase, depending on the product. The warranty is generally a limited warranty, and in some instances imposes certain shipping costs on the customer. To date we have been providing direct warranty service but in the future may establish warranty service through OEM customers or others. Some of our agreements require OEM customers with certain quantities of product for use as warranty replacements. International market warranties are generally similar to the U.S. market.

Due to performance failures of some of our first generation of HSS systems resulting primarily from a vacuum emitter component, we are voluntarily replacing emitters on approximately 700 Generation I HSS units. At September 30, 2003 we had a warranty reserve of $319,500 primarily for HSS units. Warranty costs on other products have not been material.

Competition

Our technologies and products compete with those of other companies. Many of our present and potential future competitors have, or may have, substantially greater resources to devote to further technological and new product developments. We believe we compete primarily on the originality of our concepts, the uniqueness and quality of our technology and designs, the ease and cost of manufacturing and of implementing our technologies, the ability to meet customer needs to differentiate their products, the strength of our intellectual property and the strength of licensee and contract supply arrangements. We may not however be competitive with the existing or future products, technologies or services of our competitors.

Our HSS and NeoPlanar products are offered by both our Business Group and our Government Group. Although others have attempted to use parametric speaker concepts to produce sound, we do not believe they have progressed to the point of cost-effective and directly competitive commercial products to HSS. Holosonic Research Labs, Inc. produces a parametric speaker called the Audio Spotlight. Sennheiser Electronics has announced a parametric speaker product called the AudioBeam Master. These companies employ electrostatic and piezoelectric emitter devices which we believe are less efficient and more expensive than our proprietary emitters. These parametric speaker competitors or others may however introduce products with features and performance competitive to our products.

We believe our patent portfolio will be a barrier to entrants to penetrate the directed sound market using parametric acoustics. Other companies such as Brown Innovations and others have employed domes and other techniques to try to focus or contain sound for directed sound applications such as point-of-sale. We do not believe these methods are directly competitive to HSS in ease of use, cost and performance.

We also believe our NeoPlanar technology is novel and has distinct market attributes compared to existing and competing flat panel and traditional speaker designs. Other companies that are focusing marketing efforts in the flat panel market segment include, but are not limited to (i) high-end electrostatic flat panel manufacturers such as Martin Logan and others, (ii) NXT Plc and its licensees employing the NXT flat panel technology, which uses a magnetic actuator to produce vibrations over a rigid panel, (iii) NCT Group, Inc. and their Gekko line of flat panel speakers using a comparable actuated panel. We are not aware of companies offering flat panel technology to the government market comparable to our government NeoPlanar Products, but others may introduce products with features and performance competitive to our government NeoPlanar products.

Our LRAD technology is offered by our Government Group. We are not aware of competitors who have achieved the sound output for both voice and warning tone, high directivity, light weight and other attributes necessary to accomplish the government’s desired specifications for force protection hailing and non-lethal weapon applications. Others may however introduce products with features and performance competitive to our LRAD products.

We believe our PureBass woofer technology offered by our Business Group has distinct cost performance benefits versus competitive woofer technology but it will compete with a large number of woofers offered by competitors.

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Our sound reproduction methods, especially NeoPlanar and PureBass, also compete with traditional loudspeakers. Many international and specialty manufacturers provide loudspeakers and are both competitors and prospective OEMs or licensees. We also compete with branded loudspeaker manufacturers. In general our competitors have substantially greater financial, technical and marketing resources and have proven technology and products, marketing data, customer relationships and distribution channels. Our technologies may not be competitive in the entrenched loudspeaker market with these or other customers.

There are also continuing attempts by a large number of competitors to innovate new methods of sound reproduction to overcome limitations of traditional loudspeakers. It is possible that alternate technologies and systems that would be directly competitive with our sound technology have been developed but are unknown to us. Such systems may also currently be in development, and may be developed by others in the future.

Seasonality

Since our sales of sound products is just developing we have not experienced any significant seasonality trends to date. Seasonality trends may however present in the future. Government business tends to be seasonal due to the U.S. Government procurement cycle, with the quarter ending September 30 usually producing relatively higher sales and the quarter ending December 31 usually producing relatively lower sales. Our Government Group business is expected to experience this seasonality in the future.

Government Regulation and Environmental Matters

Certain of our electronic products are subject to various regulations and are required to meet the specifications of agencies such as the Federal Communications Commission (the “FCC”). We believe we are in substantial compliance with all current applicable regulations, and that we have all material governmental permits, licenses, qualifications and approvals currently required for our operations.

Our Hypersonic Sound technology is subject to control under the Radiation Control for Health and Safety Act of 1968, and the associated regulations promulgated by the Food and Drug Administration, as an electrical emitter of ultrasonic vibrations. Under the terms of such regulations, we were required to provide an abbreviated report to the FDA describing the technology, which we submitted in August 2001. The FDA may respond to such report and request changes or safeguards to the technology, but it has not done so to date. We will also be required to notify the FDA in writing should an HSS product be found to have a defect relating to safety of use due to the emission of electronic product radiation. We do not believe our HSS technology poses any human health risks. However, it is possible that we, or one of our OEM customers or licensees, could be required to modify the technology, or a product incorporating the technology, to comply with requirements that may be imposed by the FDA.

Our products are being produced to standard product safety requirements for sale in the United States and to similar requirements for sale in Europe and Canada. We expect to meet the electrical and other regulatory requirements for electronic systems or components we sell throughout the world.

Some of our products, especially LRAD, may be subject to certain export controls by the U.S. government in accordance with various statutory authorities, including the Export Administration Act of 1979, the International Emergency Economic Powers Act, the Trading with the Enemy Act of 1917 and the Arms Export Control Act of 1976. These export control laws and regulations affect the export of products and services to foreign customers, potential customers and business partners, as well as to fellow ATC employees, foreign regulatory bodies and foreign persons generally.

Export jurisdiction over products and services appearing on the United States Munitions List (USML) resides with the U.S. Department of State, and such products and services are subject to the Arms Export Control Act and the International Traffic in Arms Regulations. We do not believe any of our products and services are on the USML. However, there is a possibility that the U.S. Department of State may consider our HIDA technology and related items, technical data and services to be “directed energy weapons,” as contemplated by Category XVIII of the USML. If such a determination is made, we must register with the Office of Defense Trade Controls (DTC) and receive an export license from the DTC prior to the export of HIDA technology and related items, technical data and services.

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Products, technical data and services exported by us and not appearing on the USML are subject to the export jurisdiction of the U.S. Department of Commerce, pursuant to the Export Administration Act and the Export Administration Regulations.

In general, U.S. Government licenses or other approvals must be obtained before exports of USML items, related technical data and services are made; and may also be required before such items, data and services are re-exported or transferred from one foreign person to another foreign person. There can be no assurance that such licenses or approvals will be granted. Also, licenses or approvals may be granted with limitations, provisos or other requirements imposed by the U.S. Government as a condition of approval, which may affect the scope of permissible activity under the license or approval.

As a defense contractor or subcontractor, our contract costs may be subject to audit and review by the U.S. Government. Audits and investigations are conducted from time to time to determine if performance and administering of U.S. Government contracts are compliant with applicable contractual requirements, and procurement and other applicable Federal statutes and regulations. Under present U.S. Government procurement regulations, if indicted or adjudged in violation of procurement or other Federal civil laws, a contractor or subcontractor, such as us, could be subject to fines, penalties, repayments or other damages. U.S. Government regulations also provide that certain findings may lead to suspension or debarment from eligibility for awards of new U.S. Government contracts for up to three years. In addition, U.S. Government foreign export privileges could be suspended or revoked.

Although we do not have any regulatory action pending against us, any such action could have a material adverse impact on our business, financial condition, results of operations and cash flows.

We do not believe we are materially affected, nor do we expect to be materially affected, by the costs and effects of compliance with environmental laws.

Intellectual Property Rights and Proprietary Information

We operate in an industry where innovations, investment in new ideas and protection of resulting intellectual property rights are important to success. We rely on a variety of intellectual property protections for our products and technologies, including patent, copyright, trademark and trade secret laws, and contractual obligations, and we pursue a policy of vigorously enforcing such rights.

We have a substantial base of intellectual property assets. We own 31 U.S. patents and have approximately 31 U.S. patents (and additional foreign applications) pending on our sound technologies. Our issued patents expire between 2006 and 2023. We are preparing and intend to file other sound technology patent applications. We own one U.S. patent on a portable consumer product and two U.S. patents on other technology. We purchased and own one patent on transducer technology primarily targeted for government applications. We target our patent coverage to provide protection in the major manufacturing and commercial centers of the world.

In addition to such factors as innovation, technological expertise and experienced personnel, we believe that a strong patent position is important to compete effectively in the sound reproduction industry. We believe this is especially important to protect our leadership position in parametric acoustics (HSS). The following table lists some of our key HSS patents and patent applications and the inventions they cover:

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The following table lists some of our other key sound patents and patent applications and the inventions they cover:

We have an ongoing policy of filing patent applications to seek protection for novel features of our products and technologies. Prior to the filing and granting of patents, our policy is to disclose key features to patent counsel and maintain these features as trade secrets prior to product introduction. We cannot assure you that any additional patents on our products or technology will be granted.

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We are investing significant management, legal and financial resources toward our technology patents. The electronics industry is characterized by frequent litigation regarding patent and other intellectual property rights. Others, including academic institutions and competitors, hold numerous patents in electronics and sound reproduction. Although we are not aware of any existing patents that would materially inhibit our ability to commercialize our sound technology, others may assert claims in the future. Such claims, with or without merit, may have a material adverse effect on our financial condition or results of operations.

The validity of our existing patents has not been adjudicated by any court. Competitors may bring legal action to challenge the validity of our existing or future patents or may attempt to circumvent the protection provided by such patents. The failure to obtain patent protection or the loss of patent protection on our existing and future technologies or the circumvention of our patents by competitors could have a material adverse effect on our ability to compete successfully.

We generally take advantage of the Patent Convention Treaty procedures for patent protection in foreign countries. This procedure is more cost efficient, but results in a delay in the application and issuance of foreign patents; however, any resulting foreign patents, if and when issued, enjoy the same priority date as U.S. counterparts.

We also file for trade name and trademark protection when appropriate. We are the owner of federally registered trademarks including HYPERSONIC®, HSS®, SFT®, STRATIFIED FIELD®, PMT®, NEOPLANAR®, PUREBASS® and SHAPING THE FUTURE OF SOUND®. Trade names or trademarks may not be successfully maintained, defended or protected.

Our policy is to enter into nondisclosure agreements with each employee and consultant or third party to whom any of our proprietary information is disclosed. These agreements prohibit the disclosure of confidential information to others, both during and subsequent to employment or the duration of the working relationship. There can be no assurance, however, that these agreements will not be breached, that we will have adequate remedies for any breach or that our trade secrets will not otherwise become known or be independently developed by competitors.

Under a technology license agreement we assumed in connection with our acquisition of the NeoPlanar Technology, we are obligated to pay Bohlender-Graebener Corporation, the former owner of the technology, a royalty for all film purchases for the technology. We were further obligated to pay a minimum royalty to maintain exclusivity, which we elected not to pay in 2002. Bohlender-Graebener Corporation has asserted that the minimum royalty for 2002 is due. We have a non-binding agreement with Bohlender-Graebener Corporation to settle its allegation and to buy out future royalties, which agreement is subject to the completion of definitive documentation. See Part I, Item 3 discussion below under the caption “Legal Proceedings.”

We are obligated to pay a $2.50 per unit royalty on one electronic component for our HSS product. We are also obligated to pay Elwood G. Norris, our Chairman, a 2% royalty on net sales from certain of our technologies, of which only HSS is a current offering of our company. The royalty obligation continues until at least March 1, 2007, and for any longer period during which we sell products or license technologies subject to any patent assigned to us by Mr. Norris. No royalties were paid under this agreement in the fiscal years ended September 30, 2003 or 2002, as such royalties were waived by Mr. Norris. We may owe royalties in future periods based on actual sales or technology revenues.

Research and Development

The sound reproduction market is subject to rapid changes in technology and designs with frequent improvements and new product introductions. We believe our future success will depend on our ability to enhance and improve existing technologies and to introduce new technologies on a competitive basis. Accordingly, we have in the past, and we expect in the future, to engage in significant research and development activities.

For the fiscal years ended September 30, 2003, 2002 and 2001 we spent $2,437,591, $3,537,355 and $3,136,109 respectively, on company-sponsored research and development, and $55,760, $84,708, and $-0- on customer-sponsored research and development. Future levels of research and development expenditures will vary depending on the timing of further new product development and the availability of funds to carry on additional research and development on currently owned technologies or in other areas.

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Executive Officers

Our current executive officers of American Technology Corporation and their ages and business experience for the last five years are set forth below.

Elwood G. Norris, age 65, has been a Director of our company since August 1980. Mr. Norris served as Chief Executive Officer from October 2000 until February 2003. He currently serves as Chairman of the Board, an executive position. He served as President from August 1980 to February 1994. Mr. Norris managed our research and development activities as Chief Technology Officer through December 2000. From 1988 to November 1999 he was a director and Chairman of e.Digital Corporation, a public company engaged in electronic product development, distribution and sales. During that period he also held various other executive officer positions at e.Digital. From August 1989 to October 1999 he served as director and held various executive officer positions with Patriot Scientific Corporation, a public company engaged in the development of microprocessor technology. He is an inventor with over 44 U.S. patents, primarily in the fields of electrical and acoustical engineering. He is the inventor of our HyperSonic Sound and other technologies.

Kalani Jones, age 40, joined our company as Vice President of Operations in September 2003 and later that month assumed the position of Chief Operating Officer. From October 1999 to November 2002 he was Vice President Engineering and Product Operations for Tachyon Inc., a San Diego provider of satellite networking solutions. From 1997 to 1999 he was Senior Director for Program Management at IOMEGA and previously held engineering management positions at General Instrument and TRW. From November 2002 until being recruited by the Company, Mr. Jones was a self-employed entrepreneur developing technology based remote monitoring solutions. Mr. Jones obtained a M.S.E.E. degree in Digital Communications and Digital Signal Processing from USC in 1988 and a B.S.E.E. in Electrical and Computer Engineering from California State Polytechnic University in 1984.

Carl Gruenler, age 50, was appointed Vice President of Military Operations in June 2003. He manages the Government Group. He assumed additional responsibilities as Interim Chief Financial Officer in November 2003. From May 1998 to June 2003 he served as Smart Wing Program Manager for the Combat Patrol and Reconnaissance Wing as a Captain in the United States Navy. He was responsible for identifying and developing new integrated systems for physical security/access control, waterside force protection and mobile computing. Mr. Gruenler’s prior business experience includes serving as president of Thomas D. Mangelsen, Inc., a national retail, manufacturing and distribution company; chief financial officer of Automated Monitoring and Control International, Inc., a railroad systems technology company; and a project manager/financial analyst at Union Pacific Railroad. He holds an M.B.A. from the University of Nebraska-Lincoln (1981) and a BS in Business Administration from Oral Roberts University in (1975).

Bruce Ehlers, age 45, was appointed Vice President of Engineering in October 2003. From May 1999 to March 2003 Mr. Ehlers was assistant vice president at Copper Mountain Networks where he was responsible for Copper Mountain’s hardware and embedded software development, engineering services and engineering program management. From January 1997 to May 1999 Mr. Ehlers was senior director of Research and Development at Iomega’s Mobile Storage Division. While at Iomega, he lead research and development for Iomega’s new generation of tape and miniature, removable disk drives. He has held previous engineering management positions at General Instrument, Cipher Data Products and TRW. He holds a BSEE (1980) and MSEE (1981) from Purdue University.

Joseph A. Zerucha, age 40, was appointed as Vice President of Sales and Marketing in December 2003. From December 2002 to December 2003, Mr. Zerucha was President of Liberties Consulting, where he established and trained sales teams and implemented innovative marketing and management strategies for a variety of clients. From April 2001 to November 2002, he was Chief Operating Officer and Treasurer of Tachyon, Inc., a provider of broadband connectivity and Internet services to large enterprises and governmental entities. He served as President for a division of Clear Channel Communications from May 1999 to April 2001 where he was responsible for build-out of a new industry-leading audio distribution platform. From 1995 to May 1999 he was Director of Worldwide Sales and Channel Development for ViaSat, Inc., a maker of satellite communications equipment and software.

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Employees

At December 1, 2003, in addition to our five executive officer employees, we employed 41 full-time persons. Of such employees, 13 are in research and development, 17 in production and materials control, five in general and administrative and six in marketing, sales and licensing. We also lease technical personnel from time to time on an as needed basis and use outside consultants for various services. We have not experienced any work stoppages and are not a party to a collective bargaining agreement and we consider our relations with our employees to be good.

Risk Factors

An investment in our company involves a high degree of risk. In addition to the other information included in this Report, you should carefully consider the following risk factors in evaluating an investment in our company. You should consider these matters in conjunction with the other information included or incorporated by reference in this Report.

We have a history of net losses. We expect to continue to incur net losses and we may not achieve or maintain profitability.

We have incurred significant operating losses and anticipate continued losses in fiscal 2004. At September 30, 2003, we had an accumulated deficit of $36,367,057. 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 are an early stage company introducing new products and technologies. If commercially successful products are not produced in a timely manner, we may be unprofitable or forced to cease operations.

Our HSS, NeoPlanar, PureBass and LRAD 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 us or by original equipment manufacturers (OEMs) due to the inherent risks of technology development, new product introduction, limitations on financing, manufacturing problems, competition, obsolescence, loss of key technical personnel and other factors. 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 products has taken longer than anticipated by management and could be subject to additional delays. Customers may not wait for our products and may elect to purchase products from competitors. We have experienced manufacturing quality control problems with some of our initial commercial HSS units, and we may not be able to resolve future manufacturing problems in a timely and cost effective manner. 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 products hare never been produced in quantity, and we may incur significant and unpredictable warranty costs as these products are mass produced. We have incurred substantial warranty costs related to our first generation HSS systems, which caused a negative gross margin for the fiscal year ended September 30, 2003.

None of our products has been mass produced, and certain of our technologies, including HSS and LRAD, are substantially different from proven, mass produced sound transducer designs. We may incur substantial and unpredictable warranty costs from post-production product or component failures. We generally warrant our products to be free from defects in materials and workmanship for a period up to one year from the date of purchase, depending on the product.

Due to performance failures of components in some of our first generation of HSS systems, we are voluntarily replacing emitters on an estimated 700 Generation I HSS units. At September 30, 2003 we had a warranty reserve of $319,500, with $275,000 scheduled for this replacement program. During fiscal 2003 we incurred warranty expense of $313,187, substantially all for HSS units. These warranty costs caused us to have a negative gross margin for fiscal 2003. Future warranty costs could further adversely affect our financial position, results of operations and business prospects.

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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 have included sales of portable consumer products.. The majority of our fiscal 2003 revenues were generated from our sound reproduction technologies, and we expect these to be the source of substantially all of our future revenues. 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:

Some or all of these factors could adversely affect demand for OEM products incorporating our sound reproduction products or 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:

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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 LRAD 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 customer 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 customer 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.

We may face personal injury and other liability claims that harm our reputation and adversely affect our sales and financial condition.

Some of our products are capable of sufficient acoustic output to cause damage to human hearing or human health if used improperly, such as when the products are used at close ranges or for long periods of exposure. A person injured in connection with the use of our products may bring legal action against us to recover damages on the basis of theories including personal injury, negligent design, dangerous product or inadequate warning. We may also be subject to lawsuits involving allegations of misuse of our products. Our product liability insurance coverage may be insufficient to pay all such claims. Product liability insurance may become too costly for us or may become unavailable for us in the future. We may not have sufficient resources to satisfy any product liability claims not covered by insurance which would materially and adversely affect our financial position. Significant litigation could also result in a diversion of management’s attention and resources, and negative publicity.

We may not be successful in obtaining the necessary licenses required for us to sell some of our products abroad.

Licenses for the export of certain of our products may be required from government agencies in accordance with various statutory authorities, including the Export Administration Act of 1979, the International Emergency Economic Powers Act, the Trading with the Enemy Act of 1917 and the Arms Export Control Act of 1976. We may not be able to obtain the necessary licenses in order to conduct business abroad. In the case of certain sales of defense equipment and services to foreign governments, the U.S. Department of State must notify Congress at least 15 to 30 days, depending on the size and location of the sale, prior to authorizing these sales. During that time, Congress may take action to block the proposed sale. Failure to receive required licenses or authorization would hinder our ability to sell some of our products outside the United States.

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Our operations could be harmed by factors including political instability, natural disasters, fluctuations in currency exchange rates and changes in regulations that govern international transactions.

We expect to sell or products worldwide. The risks inherent in international trade may reduce our international sales and harm our business and the businesses of our customers and our suppliers. These risks include:

These and other risks may preclude or curtail international sales or increase the relative price of our products compared to those manufactured in other countries, reducing the demand for our products.

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.

Our business is highly dependent on our level of sales to General Dynamics Armament and Technical Products, Inc., which has exclusive rights to market defined applications to various end user customers. The success of that company’s marketing efforts will significantly affect our results of operations in future periods.

In February 2003 we entered into two licensing and sales agreements with subsidiaries of General Dynamics Corporation to purchase, market and resell NeoPlanar and HIDA (High Intensity Directional Acoustics) products and components exclusively for specified applications to certain government customers. In September 2003, the agreement with Bath Iron Works Corporation for NeoPlanar systems was assigned to General Dynamics Armaments and Technical Products, Inc.  (GD-ATP), which now has the responsibility for marketing both HIDA and NeoPlanar under the contracts. These agreements continue through February 2008, and GD-ATP has the option to renew each agreement for an additional five years. See Part I, Item 1 discussion above under the caption “Government Group.”

Bath Iron Works Corporation has been our largest customer, accounting for approximately 24% of revenues in fiscal 2003 and 19% of revenues in fiscal 2002. Our future sales to GD-ATP may be affected adversely by various factors relating to GD-ATP’s business plans, marketing efforts, allocation of resources, strategic focus, liquidity, results of operation and financial position. As a consequence, our results of operation and financial position will be materially and adversely affected by the reduction, delay or cancellation of GD-ATP orders, or by the failure of GD-ATP to grow sales to its exclusive customers.

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, distribution, 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, government and sound reproduction markets to assist us in producing, distributing, marketing and selling products that include our sound technologies.

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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 will be dependent on outside manufacturers, and we do not have established manufacturing relationships to support our production schedules.

During fiscal 2003, we terminated our manufacturing relationship with HST, Inc., formerly our sub-contract manufacturer of our HSS and NeoPlanar products. In addition, Amtec Manufacturing, previously the sole manufacturer of our Pure Bass subwoofer units, recently went out of business. In addition to in-house manufacturing of our products, we will need to establish relationships with outside manufacturers to be able to be able to meet our production schedules. Failure to establish quality contract manufacturing could reduce future revenues, adversely affecting financial condition and results of operations.

We rely on outside suppliers to provide a large number of components incorporated in our products.

Our products have a large number of components produced by outside suppliers. In addition, for certain of these items, we qualify only a single source, which can magnify the risk of shortages and decrease our ability to negotiate with our suppliers on the basis of price. In particular, we depend on our HSS piezo-film supplier to provide expertise and materials used in our proprietary HHS emitters. If shortages occur, or if we experience quality problems with suppliers, then our production schedules could be significantly delayed or costs significantly increased, which would have a material adverse effect on our business, liquidity, results of operation and financial position.

Our contracts and subcontracts that are funded by the U.S. government or foreign governments are subject to government regulations and audits and other requirements.

Government contracts require compliance with various contract provisions and procurement regulations. The adoption of new or modified procurement regulations could have a material adverse effect on our business, financial condition or results of operations or increase the costs of competing for or performing government contracts. If we violate any of these regulations, then we may be subject to termination of these contracts, imposition of fines or exclusion from government contracting and government-approved subcontracting for some specific time period. In addition, our contract and subcontract costs and revenues may be subject to adjustment as a result of audits by government auditors.

We derive revenue from government contracts and subcontracts, which are often non-standard, may involve competitive bidding, may be subject to cancellation with or without penalty and may produce volatility in earnings and revenue.

Our government business has involved and is expected in the future to involve providing products and services under contracts or subcontracts with U.S. federal, state, local and foreign government agencies. Obtaining contracts and subcontracts from government agencies is challenging, and contracts often include provisions that are not standard in private commercial transactions. For example, government contracts may:

Securing government contracts can be a protracted process involving competitive bidding. In many cases, unsuccessful bidders may challenge contract awards, which can lead to increased costs, delays and possible loss of the contract for the winning bidder.

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Our Government Group revenues are materially dependant on acceptance of our LRAD products by government, military and developing force protection and emergency response agencies, and if these agencies do not purchase our products, our revenues will be adversely affected.

If our LRAD product is not widely accepted by the government, military and the developing force protection and emergency response markets, we may not be able to identify other markets. Government, military and the developing force protection and emergency response agencies may be influenced by claims or perceptions that long range hailing devices are unsafe or may be used in an abusive manner. Sales of our products to these agencies may also be delayed or limited by these claims or perceptions.

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 for 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 litigation against us that questions our intellectual property rights. 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 Chairman. 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, and we may not 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 Series D and Series E Preferred Stock financings may result in dilution to our common stockholders. The holders of Series D and Series E 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 the outstanding Series D and Series E Preferred Stock.

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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 cannot however be lower than $2.00. 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. As of September 30, 2003, the outstanding 50,000 shares of Series D Preferred Stock were convertible into an aggregate of 120,556 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 was initially $4.50 per share, but was reduced to $3.01 per share as a result of anti-dilution provisions in the warrants. The exercise price for warrants on 495,880 common shares will be subject to further reduction if we sell securities for less than an effective price of $3.01 per share.

The holders of our outstanding shares of Series E Preferred Stock may convert these shares into shares of our common stock at a conversion price equal to the lower of $3.25 or 90% of volume-weighted average price of our common stock for the five trading days prior to conversion. The conversion rate cannot however be lower than $2.00. As of September 30, 2003, the 263,250 outstanding shares of Series E Preferred Stock were convertible into an aggregate of 838,890 common shares. The Series E Warrants on 454,547 common shares also contain an antidilution adjustment for certain security sales by the Company below $3.25 per share.

Holders of our common stock could experience substantial dilution from the conversion of the Series D and Series E Preferred Stock and exercise of the related warrants. As a result of the floating conversion price, the holders of Series D and Series E Preferred Stock will receive more common shares on conversion if the price of our common shares declines. To the extent that the Series D or Series E 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 or Series E 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 and Series E 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 and Series E 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 and Series E 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 SmallCap 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 2. Properties

Our executive offices and our research and development and operational facilities are located at 13114 Evening Creek Drive South, San Diego, California. Our lease for this space expired in July 2003, but we continue to occupy the space on a month to month basis. We are in the process of negotiating an amendment of our lease agreement to extend the term through July 2006. We occupy approximately 23,500 square feet of office, laboratory, production and warehouse space in these premises with aggregate monthly payments of approximately $16,000, exclusive of utilities and costs. This monthly rent is expected to increase to approximately $28,200 per month upon execution of the lease amendment.  We intend to reduce our square footage in August 2004, which would reduce our aggregate monthly payments under the amended lease.

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We rent on a monthly basis office space utilized for development and production of our NeoPlanar technology, located at 3170 Research Way, Unit 81, Carson City, Nevada. We occupy approximately 2,200 square feet with a monthly payment of $1,210 excluding utilities.

Our east coast office for the Government Group is located at 1 Main Street, Topsham, Maine. We have a one year lease expiring in August 2004 for 600 square feet of office space with a monthly payment of $919.

We believe these facilities are adequate to meet our needs for the next twelve months given current plans. However should we expand our operations, we may be required to obtain additional space or alternative space. We believe there is adequate availability of office and development space in the general vicinity to meet our future needs.

Item 3. Legal Proceedings

In September 2003, we filed a complaint against eSOUNDideas, Inc., in the Superior Court of California, County of San Diego, alleging breach of contract and seeking a declaratory judgement to the effect that a License, Purchase and Marketing Agreement dated September 28, 2000 (the ESI License Agreement) with eSOUNDideas, a California partnership, was properly terminated in May 2003. The principals of eSOUNDideas are Greg O. Endsley and Douglas J. Paschall.  The principals also founded a corporation, eSOUNDideas, Inc., which purported to assume the contractual obligations of eSOUNDideas.  We amended the complaint in November 2003 to include eSOUNDideas (the general partnership), Mr. Endsley and Mr. Paschall as defendants.  For convenience, the following discussion refers to eSOUNDideas and eSOUNDideas, Inc. collectively as ESI.  In November 2003, we filed complaints in the Superior Court of California, County of San Diego, against Mr. Endsley and Paschall seeking declaratory judgments that options granted to each of Mr. Endsley and Mr. Paschall in April 2001 were terminated in October 2002.

The ESI License Agreement formerly appointed ESI as an exclusive distributor of HSS products specifically targeted to the point of sale/purchase, kiosk and display, and the event, trade show and exhibit markets in North America for five years.  In June 2002, we and ESI purported to enter into an amendment to the ESI License Agreement, extending the term to ten years commencing on the first delivery of a commercial HSS product to an end user, and eliminating minimum purchase requirements for the first three years. We believe the amendment was invalid as it was given in consideration for a large order from ESI which was later withdrawn by ESI due to a dispute over the payment and delivery terms of such order. In May 2003, we gave notice to ESI of termination of the ESI License Agreement. We based our termination on our belief that ESI had failed to fulfill certain covenants contained in the ESI License Agreement related to efforts and resources required to maximize the distribution and sales of HSS products in its product categories.  Under the terms of the ESI License Agreement, the termination was effective immediately, but ESI had sixty days to cure conditions giving rise to termination and reinstate the agreement.  ESI did not tender a cure within such sixty day period.

The defendants in these cases have filed a cross-complaint against us alleging breach of contract in connection with the ESI License Agreement and the stock options granted to Mr. Endsley and Mr. Paschall, breach of the implied covenant of good faith and fair dealing, intentional interference with contract, negligent interference with contract, intentional interference with prospective economic advantage, negligent interference with prospective economic advantage, defamation, fraud, and violation of California Business and Professions Code §17200.  The defendants seek actual and punitive damages in unstated amounts and other relief.

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We intend to vigorously pursue our complaints against the defendants in these cases, and to vigorously challenge the defendants’ cross-complaint.

Related to our April 2000 purchase of the NeoPlanar speaker technology, we have been in dispute with a predecessor owner of the technology regarding a minimum film royalty for 2002 of approximately $228,000. We agreed to arbitrate the dispute in front of a single arbitrator in Seattle, Washington.  The technology purchase agreement required a minimum royalty in 2002 to maintain exclusive film supply. We believe the minimum royalty for 2002 was not due and film exclusivity was terminated. In September 2003 we accrued $292,500 as the estimated cost to settle this matter and to buyout all future per unit film royalties. In December 2003 we reached a non-binding agreement to settle this matter for a payment of $25,000 and the issuance of 50,000 shares of common stock. However, the definitive documentation for this settlement is still under negotiation and the dispute may not therefore settle on the foregoing terms.

In August 2003 we reached an agreement and in September 2003 we settled litigation related to the termination of an outside contract manufacturer, Horizon Sports Technologies, Inc. d/b/a HST. As part of the settlement we acquired raw materials and equipment for production valued at approximately $145,000. We paid settlement costs of $313,000 and recorded additional settlement costs for the $585,000 value assigned to 100,000 shares of common stock issued to HST. As part of the settlement, HST also entered into a nonexclusive royalty-bearing license to manufacture and sell speakers based on our Stratified Field technology and PureBass subwoofer technology and we transferred to HST tooling valued at approximately $43,000.

From time to time we are involved in routine litigation incidental to the conduct of our business. Expect as set forth above, there are currently no material pending legal proceedings to which we are a party or to which any of our property is subject.

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

None.

PART II

Item 5. Market for Registrant’s Common Equity and Related Shareholder Matters

Market Information

Our common stock is traded and quoted on NASDAQ SmallCap Market under the symbol “ATCO”. The market for our common stock has often been sporadic and limited.

The following table sets forth the high and low bid quotations for our common stock for the fiscal years ended September 30, 2002 and 2003:

The above quotations reflect inter-dealer prices, without retail markup, markdown or commission and may not represent actual transactions.

We had 1,131 holders of record of our common stock at December 23, 2003 with 19,439,157 shares issued and outstanding. We have never paid a cash dividend on our common stock and do not expect to pay dividends in the foreseeable future.

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At September 30, 2003, we had five equity incentive plans under which equity securities are or have been authorized for issuance to our employees, consultants or directors: the 2002 Stock Option Plan, the 1997 Stock Option Plan, the 1997 Employee Stock Compensation Plan, the 1992 Incentive Stock Option Plan, and the 1992 Non-Statutory Stock Option Plan. All of these plans have been approved by our stockholders. In addition, from time to time we issued to employees, directors and service providers special stock options and warrants to purchase common shares, and these grants were not approved by stockholders. The following table gives information as of September 30, 2003:

Recent Sales of Unregistered Securities

No securities were sold within the past three years, which were not registered under the Securities Act that were not previously reported in prior quarterly or annual filings or described in the following paragraphs.

On July 11, 2003, we entered into a Securities Purchase Agreement with certain institutional investors pursuant to which we issued and sold 1,818,180 shares of our common stock at a purchase price of $5.50 per share. In connection with such financing, we also issued warrants to the investors to purchase 454,547 shares of common stock with an exercise price of $6.75 per share. The warrants are exercisable until July 10, 2007. These securities were offered and sold without registration under the Securities Act of 1933 without registration under the Securities Act of 1933 to a limited number of accredited investors in reliance upon the exemption provided by Rule 506 of Regulation D thereunder, and may not be offered or sold in the United States in the absence of an effective registration statement or exemption from the registration requirements under the Securities Act. An appropriate legend was placed on the shares and the warrants issued, and will be placed on the shares issuable upon exercise of the warrants, unless registered under the Securities Act prior to issuance. In connection with this financing, we entered into a Registration Rights Agreement with the investors, pursuant to which we agreed to prepare and file, within 30 days following the issuance of the securities, a registration statement covering the resale of the common stock sold and issuable upon the exercise of the warrants. We were required to have such registration statement declared effective within 90 days following the date of the issuance of the securities. The registration statement was filed on August 4, 2003, and declared effective by the SEC on August 18, 2003. We paid a placement fee of 5% of the gross proceeds to Olympus Securities, LLC.

On September 30, 2003 we issued 100,000 shares of common stock to HST, Inc. in connection with the settlement agreement described above under the heading “Legal Proceedings”. These securities were offered and sold without registration under the Securities Act of 1933 without registration under the Securities Act of 1933 to one accredited investor in reliance upon the exemption provided by Rule 506 of Regulation D thereunder, and may not be offered or sold in the United States in the absence of an effective registration statement or exemption from the registration requirements under the Securities Act. An appropriate legend was placed on the shares.

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