Genasys Inc. - Quarter Report: 2005 March (Form 10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549 

FORM 10-Q

Commission File Number: 000-24248  

AMERICAN TECHNOLOGY CORPORATION
(Exact name of registrant as specified in its charter) 

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.  x YES   o NO

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of April 28, 2005.

AMERICAN TECHNOLOGY CORPORATION
INDEX

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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements.

American Technology Corporation
BALANCE SHEETS
Unaudited

See accompanying notes to interim financial statements.
(a) Derived from the audited financial statements as of September 30, 2004.

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American Technology Corporation
STATEMENTS OF OPERATIONS
(Unaudited)

See accompanying notes to interim financial statements.

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American Technology Corporation
STATEMENTS OF CASH FLOWS
(Unaudited)

See accompanying notes to interim financial statements.

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1.  OPERATIONS

American Technology Corporation (the Company) is engaged in design, development and commercialization of sound, acoustic and other technologies. The Company produces products based on its HyperSonic® Sound (HSS®), Long Range Acoustic Device (LRAD™), NeoPlanar® and other sound technologies.

The Company’s operations are organized into two segments by the end-user markets they serve. The Commercial Products Group, (Commercial Group), formerly known as the Business Products and Licensing Group, markets and licenses HSS and NeoPlanar products to companies that employ audio in consumer, commercial and professional applications. The Government and Force Protection Systems Group (Government Group) markets LRAD, NeoPlanar, SoundCluster™ and HSS products to government and military customers and to the expanding force protection and commercial security markets.

The Company’s principal markets for its proprietary sound reproduction technologies and products are in North America, Europe and Asia.

The Company continues to be subject to certain risks, including history of net losses and expectation to continue to incur net losses; need for additional capital; potential dilutive impact on its stockholders of the Committed Equity Financing Facility (CEFF) described in Note 11 below; dependence on a limited number of customers; reliance on third party suppliers and manufacturers; competition; the uncertainty of the market for new sound products; limited manufacturing, marketing and sales experience; uncertainty regarding future warranty costs; and the substantial uncertainty of ability to achieve profitability and positive cash flow.

2.  STATEMENT OF PRESENTATION AND MANAGEMENT’S PLAN

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 and six months 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, 2004 included in the Company’s annual report on Form 10-K.

Other than cash of $6,162,409 at March 31, 2005, accounts receivable collections and possible proceeds from the CEFF described in Note 11 below, the Company has no other material unused sources of liquidity at this time. The Company has financed its operations primarily through cash generated from product sales and from financing activities. Management expects to incur additional operating losses during the balance of fiscal 2005 as a result of expenditures for research and development and marketing costs for proprietary sound products. The timing and amounts of these expenditures and the extent of the Company’s operating losses will depend on future product sales levels and other factors, some of which are beyond management’s control. Based on the Company’s cash position and possible proceeds from the CEFF, and assuming currently planned expenditures and level of operations, management believes the Company will have sufficient capital resources for the next twelve months. Management believes increased product sales will provide additional operating funds. 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.

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3.  NET LOSS PER SHARE

Basic earnings (loss) per share includes no dilution and is computed by dividing income (loss) available to common stockholders, after deduction for cumulative imputed and accreted dividends, by the weighted average number of common shares outstanding for the period. Diluted earnings (loss) per share reflects the potential dilution of securities that could share in the earnings of an entity. The Company’s losses for the periods presented cause the inclusion of potential common stock instruments outstanding to be antidilutive. Stock options and warrants exercisable into 4,437,545 shares of common stock were outstanding at March 31, 2005 and stock options, warrants and convertible preferred stock exercisable or convertible into 4,900,870 shares of common stock were outstanding at March 31, 2004. These securities were not included in the computation of diluted earnings (loss) per share because of the losses but could potentially dilute earnings (loss) per share in future periods.

The Company has allocated the proceeds from preferred stock issuances between the preferred stock and warrants and also calculated the beneficial conversion discount for each series of preferred stock. The value of the beneficial conversion discount and the value of the warrants were recorded as a deemed dividend and were accreted over the conversion period of the preferred stock. Net loss available to common stockholders was increased in each period presented in computing net loss per share by the accretion of the value of these imputed deemed dividends. Such imputed deemed dividends were not included in the Company’s stockholders’ equity as the Company has an accumulated deficit. Amounts were included in net loss available to common stockholders. The imputed deemed dividends were not contractual obligations of the Company to pay such imputed dividends. All of the Company’s outstanding shares of Series D and E Preferred Stock were converted to common stock during the quarter ending March 31, 2005.

The provisions of each of the Company’s series of preferred stock also provided for a 6% per annum accretion in the conversion value (similar to a dividend). These amounts also increased the net loss available to common stockholders. Net loss available to common stockholders is computed as follows:

On January 18, 2005, the Company gave notice to all holders of Series D and Series E Preferred Stock that it had elected to convert all of the outstanding shares of Series D and Series E Preferred Stock to common stock. The designations, rights and preferences of the Series D and Series E Preferred Stock permitted the Company to exercise this conversion option if the market price of its common stock exceeded $9.50 for ten consecutive trading days and certain other conditions were satisfied. The price condition was satisfied on January 6, 2005. The conversion of the Series D Preferred Stock was effective on January 18, 2005 and resulted in all 50,000 issued and outstanding shares of Series D Preferred Stock converting into an aggregate of 129,259 shares of common stock. The conversion of the Series E Preferred Stock was effective on February 1, 2005, and resulted in all 233,250 issued and outstanding shares of Series E Preferred Stock converting into an aggregate of 801,306 shares of common stock.

As all the Series D and Series E Preferred Stock was called for conversion as described above, $1,504,711 was accreted in the quarter ending March 31, 2005, in addition to the accretion of $13,940 at the stated rate of 6%, increasing the net loss available to common stockholders for that period.

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4.  STOCK-BASED COMPENSATION

The Company accounts for employee stock-based compensation using the intrinsic value method. In most cases, the Company does not recognize compensation expense for its employee stock option grants, as they have been granted at the fair market value of the underlying Common Stock at the grant date. Had compensation expense for the Company’s employee stock option grants been determined based on the fair value at the grant date for awards through March 31, 2005 consistent with the provisions of Statement of Financial Accounting Standards No. 123, its after-tax net income and after-tax net income per share would have been reduced to the pro forma amounts indicated below:

The Company estimates the fair value of each stock award at the grant date by using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in 2005 and 2004, respectively: dividend yield of zero percent for each period; expected volatility of 53 to 56 percent in 2005 and 75 percent in 2004; risk-free interest rates of 3.82 to 1.84 percent; and expected lives of 2.5 years for each period. The estimated fair value of the options so determined is then amortized to expense over the options’ vesting periods.

5.  RECENT ACCOUNTING PRONOUNCEMENTS

In December 2004, the Financial Accounting Standards Board (FASB) issued Financial Accounting Standard (FAS) 123(R), “Share Based Payment.” Although Statement 123(R) states that it is effective for public companies at the beginning of the first interim or annual period after June 15, 2005, the Securities and Exchange Commission has adopted a rule delaying the required compliance date to the first interim or annual reporting period of the registrant’s first fiscal year beginning on or after June 15, 2005. Therefore, the Company will first be required to comply with Statement 123(R) in the quarter ending December 31, 2005. This statement eliminates the ability to account for share-based compensation using the intrinsic value-based method under APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Statement 123(R) would require the Company to calculate equity-based compensation expense for stock options and employee stock purchase plan rights granted to employees based on the fair value of the equity instrument at the time of grant. Currently, the Company discloses the pro forma net income (loss) and the related pro forma income (loss) per share information in accordance with FAS 123 and FAS 148, “Accounting for Stock-Based Compensation Costs-Transition and Disclosure.” The Company has not evaluated the impact that Statement 123(R) will have on its financial position and results of operations.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs an amendment of ARB 43, Chapter 4.” SFAS No. 151 clarifies that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges and requires the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005. The Company is currently evaluating the financial statement impact of the implementation of SFAS No. 151.

6.  INVENTORIES AND CONTRACT MANUFACTURER

Inventory is stated at the lower of cost, which approximates actual costs on a first-in first-out (FIFO) basis, or market. At March 31, 2005 $597,560 of inventory value was located at the Company’s contract manufacturer in San Jose, California.

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Inventories consisted of the following:

During the six months ended March 31, 2005, the Company shipped materials to it's contract manufacturer, booked an amount due from the contract manufacturer and reduced inventory by $387,889. The Company did not recognize any revenue on these transactions. At March 31, 2005, the remaining balance due from the contract manufacturer, for shipments made to it, was $160,050. The contract manufacturer used these materials to build products for the Company. The above due from the contract manufacturer of $160,050 has been netted against the payable due to the contract manufacturer.

7.  CUSTOMER CONCENTRATION

For the six months ended March 31, 2005, sales to one customer in the Government Group accounted for 82% of total revenues and sales to a second customer in the Government Group, including affiliates of the customer, accounted for 10% of total revenues. For the three months ended March 31, 2005, sales to one customer in the Government Group accounted for 93% of total revenues. At March 31, 2005,this customer accounted for 56% of accounts receivable, and two other customers accounted for 21% and 14% of accounts receivable. No other customer accounted for more than 10% of accounts receivable at March 31, 2005. For the six months ended March 31, 2004, sales to three customers in the Government Group accounted for 41%, 32% and 11% of total revenues respectively. For the three months ended March 31, 2004, sales to two customers in the Government Group accounted for 62% and 17% of total revenues. At March 31, 2004, the accounts receivable from these two customers accounted for 66% and 12% of accounts receivable respectively and no other customer accounted for more than 10% of accounts receivable. Management believes that the loss of any one of these significant customers would have a material adverse effect on the Company’s results of operations and financial condition.

8.  INTANGIBLES

Patents are carried at cost and, when granted, are amortized over their estimated useful lives. The carrying value of patents is periodically reviewed and impairments, if any, are recognized when the expected future benefit to be derived from an individual intangible asset is less than its carrying value. Patents consisted of the following:

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9.  PRODUCT WARRANTY COST

The Company establishes a warranty reserve based on anticipated warranty claims at the time product revenue is recognized. Factors affecting warranty reserve levels include the number of units sold and anticipated cost of warranty repairs and anticipated rates of warranty claims. The Company evaluates the adequacy of the provision for warranty costs each reporting period.

Changes in the warranty reserve during the three and six months ended March 31, 2005 and 2004 were as follows:

10.  UNSECURED SUBORDINATED PROMISSORY NOTES

In December 2004, the Company sold an aggregate of $2,000,000 of 8% unsecured subordinated promissory notes due December 31, 2006. Interest on these notes accrues at the rate of 8% per year and is due and payable quarterly in arrears. For the three and six months ended March 31, 2005, we recorded interest on these notes of $39,452 and $42,959, respectively. The Company is required to use 40% of the net proceeds of any future equity financing to prepay these notes, including any amounts the Company raises pursuant to the CEFF described in Note 11 below. The Company may prepay the notes at its discretion at any time without penalty after June 30, 2005.

In connection with the issuance of these notes, the purchasers were granted warrants to purchase an aggregate of 150,000 shares of its common stock. The exercise price of the warrants was $9.28 per share for purchasers who were directors, officers, employees or consultants of the Company, or affiliates of such persons, and $8.60 per share for other purchasers. Warrants exercisable for 75,000 shares were issued at each such exercise price. The fair value of such warrants, which amounted to $723,000, and closing costs of $20,977 have been recorded as debt discount to be amortized over the term of the notes. The following variables were used to determine the fair value of the warrants under the Black-Scholes option pricing model: volatility of 56%, term of five years, risk free interest of 2.97% and underlying stock price equal to fair market value at the time of grant. For the three and six months ended March 31, 2005, $90,734 and $98,793,respectively, of debt discount was amortized.

A trust affiliated with an officer, director and significant stockholder of the Company purchased one of the aforementioned promissory notes in the principal amount of $500,000 and received a warrant exercisable for 37,500 shares with an exercise price of $9.28 per share.

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11.  STOCKHOLDERS’ EQUITY

Summary

The following table summarizes changes in equity components from transactions during the six months ended March 31, 2005:

As of March 31, 2005, all previously outstanding shares of Series D and Series E Preferred Stock were converted into an aggregate of 930,565 shares of common stock.

Committed Equity Financing Facility

In December 2004, the Company entered into a $25 million Committed Equity Financing Facility (CEFF) with Kingsbridge Capital Limited, a firm specializing in financing small to medium sized technology-based companies. The CEFF allows the Company to sell to Kingsbridge, subject to certain significant limiting conditions, a maximum of 3,684,782 shares of its common stock at a price between 88% and 92% of the volume weighted average price during 15 day purchase periods.

As part of the arrangement, the Company issued a warrant to Kingsbridge to purchase 275,000 shares of its common stock at a price of $8.60 per share. The warrant is exercisable beginning six months after the date of issuance and for a period of five years thereafter. The Company also agreed to file a registration statement for the resale of shares acquired under the CEFF, or upon exercise of the warrant, within 45 days after entering into the agreement for the CEFF. In January 2005 the Company filed the required resale registration statement. The registration statement has not yet been declared effective. The 3,684,782 share maximum also includes any shares that the Company may issue in lieu of paying Kingsbridge liquidated damages in the event that registration statement is unavailable for the resale of the securities purchased by Kingsbridge under the CEFF once the registration statement has been declared effective. The Company has no obligation to draw down all or any portion of the commitment during its 24-month term.

The Company is obligated to use 40% of the proceeds it may receive from the CEFF or other equity financings to prepay any outstanding interest and principal on the notes described in Note 10 above. The Company may also be required to pay liquidated damages of up to $2,500,000 in the event that a registration statement is not available for the resale of securities purchased by Kingsbridge under the CEFF. The Company has also agreed to pay to a consultant, who is not an affiliate of the Company or Kingsbridge, a finder fee equal to 4% of the first $5 million raised under the CEFF, 3% for the second $5 million raised under the CEFF, 2% for the third $5 million raised under the CEFF, and 1.5% for any additional amounts raised.

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The fair value of the warrant at the date of issuance, which amounted to $843,105, and legal, audit and associated fees of $193,079 were recorded as prepaid transaction costs. These costs will be reclassified to equity once the registration statement is declared effective or upon exercise of the warrant. The following variables were used to determine the fair value of the warrant under the Black-Scholes option pricing model: volatility of 56%, term of 5.5 years, risk free interest of 2.97% and underlying stock price equal to fair market value at the time of issuance. The warrant has been accounted for as a derivative instrument in accordance with Emerging Issues Task Force (EITF) 00-19 “Accounting for Derivative Financial Instruments, Indexed to, and Potentially Settled in a Company’s Own Stock.” As a derivative, the fair value of the warrant is recorded as a liability at its estimated fair value at each balance sheet date until the effective date of the related registration statement, or upon warrant exercise, when the warrant liability, as may be further revalued, will be reclassified to equity. Changes in the fair value of the warrant are recorded as other income or expense in the accompanying income statement. For the three months ended March 31, 2005, $682,210 was recorded as unrealized gain for the change in valuation of the fair value of the warrant. For the period measured from the issuance date of December 14, 2004 until March 31, 2005, $267,931 was recorded as an unrealized expense for the change in valuation of the fair value of the warrant.

Stock Options

During the six months ended March 31, 2005, the Company recorded non-cash compensation expense of $266,963 for the extension of time to exercise stock options for former employees relating to an aggregate of 92,675 shares of common stock. For the three and six months ended March 31, 2005, the Company also recognized $1,540 and $3,080 of non-cash compensation expense, respectively, for the value of options granted to non-employees. These options were valued in the same manner as described in Note 4 for employee options. There were no non-cash compensation expenses for the quarter ended March 31, 2004 or for the six months ended March 31, 2004.

The following table summarizes information about stock option activity during the six months ended March 31, 2005:

Options outstanding are exercisable at prices ranging from $2.50 to $10.06 and expire over the period from 2005 to 2010 with an average life of 3.1 years.

Stock Purchase Warrants

The following table summarizes information about warrant activity during the six months ended March 31, 2005:

At March 31, 2005, the following stock purchase warrants were outstanding arising from offerings and other transactions, each exercisable into one common share:

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12.  BUSINESS SEGMENT DATA

The Company is engaged in design, development and commercialization of sound, acoustic and other technologies. The Company’s operations are organized into two segments by the end-user markets they serve. The Company’s reportable segments are strategic business units that sell the Company’s products to distinct distribution channels. The Commercial Products Group (Commercial Group) markets and licenses HSS and NeoPlanar sound products to companies that employ audio in consumer, commercial and professional applications. The Government and Force Protection Systems Group (Government Group) markets LRAD, NeoPlanar, Sound Cluster and HSS sound products to government and military customers and to the expanding force protection and commercial security markets. The segments are managed separately because each segment requires different selling and marketing strategies as the class of customers within each segment is different.

The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company does not allocate operating expenses or assets between its two reportable segments. Accordingly the measure of profit for each reportable segment is gross profit.

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13.  LEGAL PROCEEDINGS

In September 2003, the Company filed a complaint against eSoundIdeas, Inc., in the Superior Court of California, County of San Diego, alleging breach of contract and seeking a declaratory judgment 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. The Company 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, the Company 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 three cases were consolidated upon motion by the defendants and order of the court. The defendants filed a cross-action in the consolidated action alleging fraud, breach of contract in connection with the ESI License Agreement and the options, 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, and violation of California Business and Professions Code §17200. The Company filed its answer to the second amended cross-complaint in August 2004.

In April 2005, the Company, ESI and its two principals entered into a Settlement Agreement and Mutual Release. As part of the settlement, the Company agreed to pay $150,000, which was previously recorded as a general and administrative expense, and to issue 17,500 shares of common stock to ESI, for which the fair market value as of April 27, 2005 was $140,175, which was recorded in the quarter ended March 31, 2005 as a general and administrative expense. In addition, Mr. Endsley and Mr. Paschall will be entitled to receive an aggregate commission equal to 1% of net sales from April 1, 2005 to September 28, 2007, of the Company’s HSS products specifically targeted for use in North America in the point of sale/purchase, kiosk, display, event, trade show and exhibit markets, subject to a maximum aggregate commission of $500,000. The Company also granted the recipients of the shares “piggyback” rights to have their shares included on future registration statements that the Company might file.

The Company may at times be involved in litigation in the ordinary course of business. The Company will also, from time to time, when appropriate in management’s estimation, record adequate reserves in the Company’s financial statements for pending litigation. Except as set forth above, there are no pending material legal proceedings to which the Company is a party or to which any of its property is subject.

14.  INCOME TAXES

At March 31, 2005, 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. At September 30, 2004 the Company had for federal income tax purposes net operating loss carryforwards of approximately $37,400,000, which expire through 2025 of which certain amounts are subject to significant limitations under the Internal Revenue Code of 1986, as amended.

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

The following discussion should be read in conjunction with the accompanying unaudited interim financial statements and the related notes included under Item 1 of this Quarterly Report on Form 10-Q, together with Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2004.

The following discussion provides an overview of our results of operations for the three and six months ended March 31, 2005 and 2004. Significant period-to-period variances in the statements of operations are discussed under the caption “Results of Operations.” Our financial condition and cash flows are discussed under the caption “Liquidity and Capital Resources.”

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Forward Looking Statements

This report contains certain statements of a forward-looking nature relating to future events or future performance. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the only means of identifying forward-looking statements. Prospective investors are cautioned that such statements are only predictions and that actual events or results may differ materially. In evaluating such statements, prospective investors should specifically consider various factors identified in this report, including the matters set forth below under the caption “Business Risks”, which could cause actual results to differ materially from those indicated by such forward-looking statements.

Overview

We are an innovator of proprietary sound reproduction technologies and products. We believe our innovative proprietary sound technologies provide us a significant competitive advantage in our principal markets. We believe we are the leader in developing and commercializing parametric loudspeakers, branded as HyperSonic® sound or HSS®. We believe we are also the leader in developing and commercializing high intensity directed acoustical devices, branded as our Long Range Acoustic Device or LRAD™. We have filed over 70 patent applications in the United States, and over 90 patent applications internationally covering our various sound technologies and products.

We make significant investments in research and development to expand our technology and product portfolio. We are expanding our LRAD product family, introducing a new NeoPlanar product line for emergency notification and general announcement markets which require high intelligibility, and utilizing our products to provide solutions for difficult acoustic challenges. We offer our products for sale worldwide, but expect our largest markets to be the United States, Europe and Asia.

Our four major products from our technology portfolio are listed below.

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We believe we are uniquely equipped to provide our technologies and products in rapidly growing markets for new sound applications not currently served by conventional sound devices and as an alternative to conventional loudspeakers. We believe market factors such as the rapid growth of plasma and flat panel screens offer significant growth opportunities for our HSS focused sound solutions. We also believe that the growth in defense and homeland security and related protection spending by commercial customers provides a growing market for our sound products to be used for intelligible communication over long distances.

Our primary products sold to date have been LRAD and HSS products. These products are currently manufactured for us by Pemstar, Inc., an established contract manufacturer with multiple locations worldwide. Our sales have been highly dependent on large orders from a few customers. We target our products for sale worldwide, but expect the largest markets to be the U.S., Europe and Asia. To date, our sales have been made in U.S. Dollars and we do not expect currency fluctuations to have a material impact on our operations.

Overall Performance

Our second fiscal quarter, ended March 31, 2005, showed a substantial increase in revenues over the same period in the prior fiscal year. However, due to significant increases in operating expenses for the quarter, net loss for the fiscal quarter ended March 31, 2005 was higher than for the same period in the prior fiscal year. Our revenues for the three months ended March 31, 2005 were $2,817,393, compared to $1,493,250 for the three months ended March 31, 2004, an increase of 89%. Our gross profit for the three months ended March 31, 2005 was 48% of revenues, compared to 37% of revenues for the comparable period in the prior fiscal year. We recorded a gross profit of $1,363,427 for the three months ended March 31, 2005, which was higher than the gross profit of $548,026 for the three months ended March 31, 2004. Operating expenses increased from $1,723,720 for the three months ended March 31, 2004 to $3,546,429 for the three months ended March 31, 2005. In addition, for the three months ended March 31, 2005, there was a non-cash gain on derivative revaluation of $682,210 associated with the decrease in value of the warrant we issued to Kingsbridge Capital, and for the six months ended March 31, 2005 there was a non-cash expense of $267,931 associated with the increase in value of the same warrant. There were no corresponding entries for the same periods in the prior fiscal year. Our net loss increased from $1,165,196 for the three months ended March 31, 2004 to $1,613,016 for the three months ended March 31, 2005.

We are continuing to focus our efforts on near-term revenue and gross margin improvement from our existing, marketable products. We have filled key management and operations positions and increased personnel in our sales and marketing and engineering departments. While new hires have necessarily resulted in increased expenses, we believe these new hires are important to near-term revenue and gross margin improvements. We are currently focusing our resources primarily on sales, marketing, engineering and production of existing products. We are closely monitoring expenses for our Advanced Development department, charged with development of new products. Our policy is to establish a compelling business case for each Advanced Development initiative.

Our various technologies are high risk in nature. 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. Unanticipated technical or manufacturing obstacles can arise at any time and disrupt sales or licensing activities and result in lengthy and costly delays.  See “Business Risks” below.

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Recent Developments

In April 2005, we entered into a Settlement Agreement and Mutual Release with eSoundIdeas, Inc., its two principals and a related partnership, which we refer to collectively as the ESI Parties. Pursuant to the Settlement Agreement, we and the ESI Parties settled litigation arising out of a dispute regarding a license and marketing agreement that we terminated in May 2003, and regarding stock options issued to each of the principals in April 2001 which expired unexercised following termination of consulting services provided to us by these principals. As part of the settlement, the Company agreed to pay $150,000, which was previously recorded as a general and administrative expense, and to issue 17,500 shares of common stock to the ESI Parties, for which the fair market value as of April 27, 2005 was $140,175, which was recorded in the quarter ended March 31, 2005 as a general and administrative expense. We granted the recipients of these shares “piggyback” rights to have their shares included on future registration statements that we might file. In addition, the ESI Parties will be entitled to receive an aggregate commission equal to 1% of net sales from April 1, 2005 to September 28, 2007, of our HSS products specifically targeted for use in North America in the point of sale/purchase, kiosk, display, event, trade show and exhibit markets, subject to a maximum aggregate commission of $500,000. We and the ESI Parties have executed a mutual release of claims, and have agreed to dismiss with prejudice the pending litigation among us.

In May 2005, Carl Gruenler, Vice President, Government and Force Protection Systems Group, left our company. Kalani Jones, President and Chief Operating Officer, will assume Mr. Gruenler's duties in the interim until we locate a replacement for Mr. Gruenler.

Critical Accounting Policies

We have identified the policies below as critical to our business operations and the understandings of our results of operations. Our accounting policies are more fully described in our financial statements located in Item 1 of Part I, “Financial Statements.”

The methods, estimates and judgments we use in applying our accounting policies, in conformity with generally accepted accounting principles in the United States, have a significant impact on the results we report in our financial statements. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. The estimates affect the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or 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.

Revenue Recognition.  We currently derive our revenue primarily from two sources: (i) component and product sale revenues and associated engineering and installation, which we refer to collectively as Product Sales and (ii) contract and license fee revenue. Product Sales revenues are recognized in the periods that products are shipped to customers, FOB shipping point or destination, when a signed contract exists, the fee is fixed and determinable, collection of resulting receivables is probable and there are no remaining obligations. Revenues from engineering contracts are recognized based on milestones or completion of the contracted services. 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 ultimate customer accepts the product and collectibility is reasonably assured. Revenues from up-front license and other fees and annual license fees are generally recognized ratably over the specified term of the particular license or agreement.

Valuation of Intangible Assets.  Intangible assets include purchased technology and patents, which are amortized over their estimated useful lives. We must make judgments and estimates regarding the future utility and carrying value of intangible assets. The carrying values of such assets are periodically reviewed and impairments, if any, are recognized when the expected future benefit to be derived from an individual intangible asset is less than its carrying value. In fiscal 2004, we reviewed the carrying value of our intangible assets and reduced the carrying value of these assets by $37,798. Our judgments and estimates regarding carrying value and impairment of intangible assets have an impact on our financial statements.

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Warranty Reserve.  We establish a warranty reserve based on anticipated warranty claims at the time product revenue is recognized. These warranties require us to make estimates regarding the amount and costs of warranty repairs we expect to make over a period of time. Factors affecting warranty reserve levels include the number of units sold and anticipated cost of warranty repairs and anticipated rates of warranty claims. We evaluate the adequacy of the provision for warranty costs each reporting period. See Note 9 to our financial statements for additional information regarding warranties. The estimates we use have an impact on our financial statements. In the three and six months ended March 31, 2005, we recorded a net warranty reduction of $158,886 and $76,723, respectively, as a result of the following: 1) we reduced the warranty reserve that we had previously established in fiscal 2003 for HSS Generation 1 products, primarily as a result of the expiration of time to return failed HSS Generation 1 product to the company for replacement, and 2) we recorded a warranty provision for current sales of all products.

Derivative Instruments. We account for the warrant issued in December 2004 in conjunction with the Committed Equity Financing Facility with Kingsbridge Capital Limited as a derivative financial instrument. As a derivative, the fair value of the warrant is recorded as a liability in the balance sheet and changes in the fair value of the warrant are recognized as other income or expense during each period. The fair value of the warrant is expected to change primarily in response to changes in our stock price.

Significant increases in the fair value of our stock could give rise to significant expense in the period of the change. Likewise, a reduction in our stock price could give rise to significant income in the period of the change. The warrant liability will be reclassified to equity as of the effective date of the related registration statement, or upon the exercise of the warrant.

Guarantees and Indemnifications. Under our bylaws, we have agreed to indemnify our officers and directors for certain events. We also enter into certain indemnification agreements in the normal course of our business. We have no liabilities recorded for such indemnities.

Deferred Tax Asset. We have provided a full valuation reserve related to our substantial deferred tax asset as management has not determined that it is more likely than not that the deferred tax asset will not be realized. 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. Congress passed the American Jobs Creation Act of 2004 in October 2004. The new law contains numerous changes to existing tax laws, including both domestic and foreign tax incentives. We have not yet determined what impact, if any, this new law may have on our deferred tax asset, or our future results of operations and financial condition.

Legal Proceedings. We are currently involved in certain legal proceedings. We estimate the range of liability relating to pending litigation, where the amount and range of loss can be estimated. We record our best estimate of a loss when the loss is considered probable. Where a liability is probable and there is a range of estimated loss with no best estimate in the range, we record the minimum estimated liability related to the claim. As additional information becomes available, we assess the potential liability related to our pending litigation and revise our estimates.

Valuation of Inventory. Our inventory is comprised of raw materials, assemblies and finished products that we intend to sell to our customers. We must periodically make judgments and estimates regarding the future utility and carrying value of our inventory. The carrying value of our inventory is periodically reviewed and impairments, if any, are recognized when the expected future benefit from our inventory is less than its carrying value. In the quarter ended March 31, 2005, we reviewed the carrying value of our inventory and increased the reserve for obsolescence to $349,986, primarily for raw materials and finished goods that were used on our older HSS products for which there is anticipated to be reduced demand.

Results of Operations

Revenues

Revenues for the six months ended March 31, 2005 were $7,226,306, which was a 219% increase over the $2,268,028 in revenues for the six months ended March 31, 2004. Revenues for the six months ended March 31, 2005 and March 31, 2004 included $7,161,206 and $2,111,834 of product sales, and $65,100 and $156,194 of contract and license revenues, respectively. The increase in product sales was primarily due to increased sales of LRAD products by our Government Group.

Revenues for the three months ended March 31, 2005 were $2,817,393, which was an 89% increase over the $1,493,250 in revenues for the three months ended March 31, 2004. Revenues for the three months ended March 31, 2005 included $2,814,293 of product sales and $3,100 of contract and license revenues. Revenues for the three months ended March 31, 2004 consisted entirely of product sales. The increase in revenues was primarily due to increased sales of LRAD products by our Government Group.

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At March 31, 2005, we had $300,000 in deferred revenue or deposits for existing contracts, agreements and licenses.

We have only a limited record of recurring sales, so we do not consider order backlog to be an important index of future performance at this time. Our backlog is affected by the timing of large orders and order deliveries, especially to government customers. Our order backlog was approximately $128,017 at March 31, 2005 and approximately $600,000 at March 31, 2004. Backlog orders are subject to modification, cancellation or rescheduling by our customers. Future shipments may also be delayed due to production delays, component shortages and other production and delivery related issues.

Our Commercial Products Group, or Commercial Group, markets and licenses HSS and NeoPlanar products to companies, which employ audio in consumer, commercial and professional applications. Our Government and Force Protection Systems Group, or Government Group, markets LRAD, NeoPlanar, SoundCluster and HSS products to government and military customers and to the expanding force protection and commercial security markets.

Presented below is a summary of revenues by business segment:

Commercial Group revenues for all reported periods consisted primarily of HSS and Neoplanar product sales. The decrease in Commercial Group revenues for the three and six months ended March 31, 2005 compared to the comparable prior fiscal periods was due to a shift in marketing focus from multiple small volume sales to pursuit of high volume contracts which require much longer sales cycles.

Government Group revenues for all reported periods consisted primarily of sales of LRAD and, NeoPlanar products and engineering services such as installation design and support. These revenues are derived primarily from a limited number of large orders and the timing of follow-on orders, if any, is difficult to predict. Government Group revenues for the three and six months ended March 31, 2005 were $2,707,870 and $6,929,434 respectively, and consisted primarily of LRAD product sales and engineering services. Government Group sales for the three and six month periods ended March 31, 2004 were $1,038,094 and $1,730,933, respectively, and consisted primarily of LRAD and NeoPlanar product sales and engineering services.

For the six months ended March 31, 2005, sales to one customer in the Government Group accounted for 82% of total revenues and sales to a second customer in the Government Group, including affiliates of the customer, accounted for 10% of total revenues. For the three months ended March 31, 2005, sales to one customer in the Government Group accounted for 93% of total revenues. For the six months ended March 31, 2004 sales to two customers in the Government Group accounted for 41% and 32% of total revenues, respectively, and sales to one customer in the Commercial Group accounted for 11% of total revenues. For the three months ended March 31, 2004, sales to one customer in the Government Group accounted for 62% of total revenues, and sales to one customer in the Commercial Group accounted for 17% of total revenues. The loss of any one of these significant customers would have a material adverse effect on our results of operations and financial condition.

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Gross Profit

Presented below is the gross profit or loss by business segment:

The overall gross profit for the six months ended March 31, 2005 was $4,244,637, or 59% of revenues, compared to gross profit of $914,326 or 40% of revenues for the comparable period of the prior fiscal year. The significant improvement in gross profit as a percentage of revenues reflected improved gross profit in our Government Group, offset in part by increased gross losses in our Commercial Group.

The overall gross profit for the three months ended March 31, 2005 was $1,363,427 or 48% of revenues, compared to gross profit of $548,026 or 37% of revenues for the comparable period of the prior fiscal year. Gross profit as a percentage of revenues improved over the comparable period of the prior fiscal year as a result of improved gross profit in our Government Group, offset in part by increased gross losses in our Commercial Group.

We experienced gross losses in our Commercial Group for the three and six months ended March 31, 2005 of $408,137 and $612,433 respectively, as limited sales were not sufficient to absorb fixed manufacturing overhead costs and substantial reserves were taken for obsolete and slow moving inventory particularly for our older HSS products. For the three and six months ended March 31, 2004, we had gross losses in our Commercial Group of $73,180 and $76,292 respectively, primarily as a result of limited sales compared to fixed overhead and warranty costs. During fiscal year 2003 and fiscal 2004 we changed our HSS Generation 1 emitter design to eliminate the requirement for a vacuum in the emitter, and we improved film quality. During fiscal 2004, we made further raw material improvements in the electronics and the manner in which the film and emitters are produced. We believe that future generations of our products will be more reliable. We expect that warranty costs will decrease in fiscal 2005, and that as the volume of HSS product sales grow, we will achieve positive gross margins in future periods.

Gross profit for our Government Group for the three and six months ended March 31, 2005, was $1,771,564 and $4,857,070 respectively compared to $621,206 and $991,118 for the three and six months ended March 31, 2004. Gross profit percentage continues to be highly dependent on sales prices, volumes, purchasing costs and overhead allocations. Our various sound products have different margins, so product sales mix will materially affect gross profits. In addition, we continue to make model updates and changes including raw material and component changes, which change product costs. We therefore do not believe that historical gross profit margins should be relied upon as an indicator of future gross profit margins.

Selling, General and Administrative Expenses

Selling, general and administrative expenses as a percentage of revenues were 57% for the six months ended March 31, 2005 compared to 95% for the six months ended March 31, 2004. These costs for the six months ended March 31, 2005 totaled $4,089,951, which represents an increase from selling general and administrative expenses of $2,151,786 for the six months ended March 31, 2004.

The overall increase for the six months ended March 31, 2005 included the following:

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Selling, general and administrative expenses as a percentage of sales were 74% for the three months ended March 31, 2005 compared to 72% for the three months ended March 31, 2004. These costs for the three months ended March 31, 2005 totaled $2,094,036, which represents an increase from selling, general and administrative expenses of $1,079,472 for the three months ended March 31, 2004.

The overall increase for the three months ended March 31, 2005 included the following:

We expect selling, general and administrative expenses to increase in future periods as we increase our marketing efforts for our proprietary sound technologies. We will also incur substantial additional expense over the remainder of fiscal 2005 to improve and document our internal control over financial reporting in anticipation of management’s required assessment of the effectiveness of our internal control over financial reporting and the attestation of such assessment by our independent registered public accounting firm, required by Section 404 of the Sarbanes-Oxley Act of 2002 in connection with our report on Form 10-K for the fiscal year ending September 30, 2005.

Research and Development Expenses

Research and development expenses increased by $1,819,789 from $1,093,219 for the six months ended March 31, 2004 to $2,913,008 for the six months ended March 31, 2005. Research and development expenses as a percentage of sales were 40% for the six months ended March 31, 2005 compared to 48% for the six months ended March 31, 2004.

The overall increase for the six months ended March 31, 2005 included the following:

Research and development expenses increased by $808,145 from $644,248 for the three months ended March 31, 2004 to $1,452,393 for the three months ended March 31, 2005. Research and development expenses as a percentage of sales were 52% for the three months ended March 31, 2005 compared to 43% for the three months ended March 31, 2004.

The overall increase for the three months ended March 31, 2005 included the following:

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Research and development expenses vary period to period 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 research and development expenses for the remainder of fiscal 2005 to be higher than the corresponding periods of fiscal 2004.

Loss From Operations

Loss from operations was $2,758,322 for the six months ended March 31, 2005 compared to $2,330,679 for the six months ended March 31, 2004. The increase in loss from operations was due to a $3,757,954 increase in total operating expenses, offset in part by an increase of $3,330,311 in gross profit. Losses from operations are expected to continue in the current fiscal year.

Loss from operations was $2,183,002 for the three months ended March 31, 2005 compared to $1,175,694 for the three months ended March 31, 2004. The increase in loss from operations reflected a $1,822,709 increase in total operating expenses, offset in part by an increase of $815,401 in gross profit.

Other Income (Expense)

We recorded $569,986 of other income and $381,544 of other expense for the three and six months ended March 31, 2005, compared with $10,498 and $29,056 of other income for the three and six months ended March 31, 2004. Other income for the three months ended March 31, 2005 included $682,210 of non-cash derivative revaluation income related to the decrease in the fair value during the three months ended March 31, 2005 of the warrant issued to Kingsbridge Capital Limited. Other expense for the six months ended March 31, 2005 included $267,931 of non-cash derivative revaluation expense related to the increase in the fair value of such warrant measured from the issuance date of December 14, 2004 to March 31, 2005. We also incurred interest expense of $130,631 and $142,961 and recognized $18,407 and $29,348 of interest income from invested cash balances during the three and six months ended March 31, 2005. During the three and six months ended March 31, 2004, we recorded interest expense of $993 and $1,809, respectively, and $11,491 and $30,865, respectively, of interest income from invested cash balances.

Net Loss

Net loss for six months ended March 31, 2005 was $3,139,866 compared to net loss of $2,301,623 for the six months ended March 31, 2004. Net loss for the three months ended March 31, 2005 was $1,613,016 compared to net loss of $1,165,196 for the three months ended March 31, 2004. The increase in net loss during the 2005 periods resulted primarily from higher operating expenses, offset in part by increases in gross margins. The non-cash derivative revaluation expense recorded for the three and six months ended March 31, 2005 contributed to increased net loss for the six month period and reduced the net loss for the three month period.

Net Loss Available to Common Stockholders

Net loss available to common stockholders was increased in each period presented in computing net loss per share by the accretion of the value of imputed deemed dividends arising from the beneficial conversion discount and the value of warrants associated with convertible preferred stock outstanding during each period. The imputed deemed dividends were not contractual obligations to pay such imputed dividends. Net loss available to common stockholders is also increased by the 6% accretion (similar to a dividend) on outstanding preferred stock. These amounts aggregated $1,518,651 and $1,796,426 for the three and six months ended March 31, 2005, and $406,846 and $700,551 for the three and six months ended March 31, 2004. Accordingly, the net loss available to common stockholders was $3,131,667 and $4,936,292 for the three and six months ended March 31, 2005, and $1,572,042 and $3,002,174 for the three and six months ended March 31, 2004.

On January 18, 2005, we gave notice to all holders of Series D and Series E Preferred Stock that we had elected to convert the shares of Series D and Series E Preferred Stock to common stock. All 50,000 issued and outstanding shares of Series D Preferred Stock converted into an aggregate of 129,259 shares of common stock on the date of notice, and all 233,250 issued and outstanding shares of Series E Preferred Stock converted into an aggregate of 801,306 shares of common stock on February 1, 2005. As all the Series D and Series E Preferred Stock was called for conversion as described above, $1,504,711 was accreted in the second fiscal quarter, in addition to the accretion of $13,940 at the stated rate of 6%, and increased the net loss available to common stockholders.

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Liquidity and Capital Resources

We have experienced significant negative cash flow from operating activities including developing and introducing our proprietary sound technologies. Our net cash used in operating activities was $1,712,084 for the six months ended March 31, 2005 compared to $3,658,752 for the six months ended March 31, 2004. For the six months ended March 31, 2005, the net loss of $3,139,866 included certain expenses not requiring the use of cash totaling $1,012,080. For the six months ended March 31, 2005, cash was used in operating activities through an increase of $493,601 in inventory, an increase of $29,773 in prepaid expenses and an increase of $16,357 in warranty payments. Cash was provided in operating activities through a decrease of $432,244 in accounts receivable, an increase of $523,189 in accounts payable and accrued liabilities.

At March 31, 2005, we had accounts receivable of $494,503 as compared to $926,747 at September 30, 2004. The balance at March 31, 2005 represented approximately 35 days of revenues. One customer accounted for 56% of accounts receivable and two other customers accounted for 21% and 14% of accounts receivable at March 31, 2005, No other customer accounted for more than 10% of accounts receivable at March 31, 2005. Terms with individual customers vary greatly. We typically require pre-payment or a maximum of thirty-day terms for our proprietary sound technology products. Our receivables can also vary substantially due to overall sales volumes and due to quarterly and seasonal variations in sales and timing of shipments to and receipts from large customers and the timing of contract payments.

For the six months ended March 31, 2005 and March 31, 2004 we used cash of $355,995 and $104,765, respectively for the purchase of equipment and software and made investments of $144,420 and $204,819, respectively in patents and new patent applications. We anticipate a continued investment in patents for the balance of fiscal 2005.

Cash from financing activities provided $4,195,940 and $697,540 for the six months ended March 31, 2005 and March 31, 2004. During the six months ended March 31, 2005, we received $2,000,000 from the sale of unsecured promissory notes, $1,661,277 from the exercise of common stock warrants and $643,802 from the exercise of stock options. During the six months ended March 31, 2004, we received $50,000 from the exercise of common stock warrants and $653,202 from the exercise of common stock options.

At March 31, 2005, we had working capital of $4,690,763 compared to working capital of $3,472,984 at September 30, 2004.

In December 2004, we sold for cash in a private offering an aggregate of $2,000,000 of unsecured subordinated promissory notes due December 31, 2006. In connection with the financing, we also issued five-year warrants to purchase an aggregate of 150,000 shares, 75,000 of which have an exercise price of $9.28 per share, and 75,000 of which have an exercise price of $8.60 per share. A trust affiliated with Elwood G. Norris, our Chairman and the beneficial owner of 19.5% of our common stock before the financing, purchased a note in the principal amount of $500,000 and received a warrant exercisable for 37,500 shares with an exercise price of $9.28 per share.

In December 2004, we entered into a Committed Equity Financing Facility (CEFF) with Kingsbridge Capital Limited, pursuant to which Kingsbridge committed, subject to certain significant limiting conditions, to purchase up to $25 million of our common stock to support future growth. As part of the arrangement, we issued a warrant to Kingsbridge to purchase 275,000 shares of our common stock at a price of $8.60 per share. The warrant is exercisable beginning six months after the date of grant and for a period of five years thereafter. Subject to certain conditions and limitations, from time to time under the CEFF, we may require Kingsbridge to purchase newly-issued shares of our common stock at a price that is between 88% and 92% of the volume weighted average price during a 15 day purchase period, and thereby raise capital as required, at the time, price and in the amounts deemed suitable to us. For each election to sell shares to Kingsbridge, we select the lowest threshold price at which our stock may be sold, but the threshold price cannot be lower than $3.00 per share. Our agreement with Kingsbridge permits Kingsbridge to terminate the CEFF if Kingsbridge determines that a material and adverse event has occurred affecting the business, operations, properties or financial condition of our company, or if any situation occurs that would interfere with our ability to perform any of our obligations under the agreement.

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The CEFF requires us to have a resale registration statement filed within 45 days of entering into the CEFF, and to use commercially reasonable efforts to have such registration statement declared effective by the Securities and Exchange Commission (SEC) within 45 days or 120 days of filing, depending on whether the SEC elects to review the registration statement. The required registration statement was filed in January 2005. The resale statement has not yet been declared effective. We cannot elect to sell shares to Kingsbridge until the registration statement is effective.

In certain instances, we may be required to pay liquidated damages or other amounts resulting from the unavailability of a registration statement. For further details, see “Business Risks” below.

Based on such factors as market conditions, financing needs and the time required for the SEC to declare the resale registration statement effective, we currently expect that we may begin to utilize the CEFF during fiscal 2005 in order to fund working capital requirements. However, the timing and extent of our ability to utilize the CEFF is uncertain. We are obligated to use 40% of the proceeds we may receive from the CEFF to prepay any outstanding interest and principal on the notes sold in December 2004. Under the rules of the Nasdaq Stock Market, the maximum number of shares we may sell to Kingsbridge without approval of our stockholders is 3,684,782, which includes any shares we may issue in lieu of paying liquidated damages, but excludes the warrant shares. This limitation may further reduce the amount of proceeds we are able to obtain from the CEFF. We agreed to pay to a consultant a finder fee equal to 4% of the first $5 million raised under the CEFF, 3% for the second $5 million raised under the CEFF, 2% for the third $5 million raised under the CEFF, and 1.5% for any additional amounts raised under the CEFF. See “Business Risks” below for a discussion of other risks associated with the CEFF.

Other than cash, cash equivalents and the CEFF, we have no other 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.

Principal factors that could affect the availability of our internally generated funds include:

Principal factors that could affect the availability to obtain cash from external sources include:

Based on our cash position, and assuming currently planned expenditures and level of operations, we believe we will have sufficient cash for operations for the next twelve months. We believe increased sales of LRAD, HSS and, to a lesser extent, NeoPlanar products will continue to contribute cash in fiscal 2005. We believe that any investment capital we may require 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 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.

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Contractual Commitments and Commercial Commitments

The following table summarizes our contractual obligations at March 31, 2005, and the effect such obligations are expected to have on our liquidity and cash flow in future periods:

The Company had no material purchase obligations at March 31, 2005.

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 Note 5).

Business Risks

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. Our results of operations or financial condition could be seriously harmed, and the trading price of our common stock may decline due to any of these or other risks.

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 the remainder of fiscal 2005. At March 31, 2005, we had an accumulated deficit of $45,467,359. 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 may need additional capital for growth.  

Our current plans indicate that depending on sales, we may need additional capital to support our growth. We may generate a portion of these funds from operations.

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. Principal factors that could affect the availability of our internally generated funds 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.

If our stock price falls below $3.41 per share we will be unable to draw down on the CEFF unless the stock price increases. The potential unavailability of this facility would negatively affect our financing activities.  

We have entered into a Committed Equity Financing Facility, or CEFF, with Kingsbridge Capital Limited. Under the terms of our agreement with Kingsbridge, we may, at our sole discretion, sell to Kingsbridge, and Kingsbridge would be obligated to purchase, shares of our common stock for up to $25 million in proceeds to us. The price at which we may sell shares of common stock under the agreement is based on a discount to the volume weighted average market price of the common stock for fifteen trading days following each of our elections to sell shares. For each election to sell shares, we select the lowest threshold price at which our stock may be sold, but the threshold price cannot be lower than $3.00 per share. In the event the market price of our common stock falls below $3.41 per share, which after giving effect to the discount would result in a price per share lower that the $3.00 minimum threshold price, the CEFF will not be an available source of financing. Our stock has traded below $3.41 per share during many in the past, including most recently during May 2003. In addition, we are obligated to use 40% of the proceeds we may raise from the CEFF to prepay any outstanding interest and principal on promissory notes we sold in December 2004 with an aggregate principal amount of $2,000,000. Our agreement with Kingsbridge permits Kingsbridge to terminate the CEFF if Kingsbridge determines that a material and adverse event has occurred affecting the business, operations, properties or financial condition of our company, or if any situation occurs that would interfere with our ability to perform any of our obligations under the agreement.

If we are unable to draw down on the CEFF, and are otherwise unable to obtain capital from other sources on a timely basis or on terms favorable to us, we may be required to scale back our marketing and research and development efforts, sell or license some or all of our technology or assets or curtail or cease operations.

If Kingsbridge determines that a material and adverse event has occurred that affects our company, we will be unable to draw down on the CEFF. The potential unavailability of this facility would negatively affect our financing activities.

Our agreement with Kingsbridge permits Kingsbridge to terminate the CEFF if Kingsbridge determines that a material and adverse event has occurred affecting the business, operations, properties or financial condition of our company, or if any situation occurs that would interfere with our ability to perform any of our obligations under the agreement. If we are unable to draw down on the CEFF, and are otherwise unable to obtain capital from other sources on a timely basis or on terms favorable to us, we may be required to scale back our marketing and research and development efforts, sell or license some or all of our technology or assets or curtail or cease operations.

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Each advance under the CEFF is limited. We may not draw down on the CEFF when Kingsbridge beneficially owns in excess of 9.9% of our outstanding shares. The potential unavailability of this facility would negatively affect our financing activities.

Each draw down election we make is limited to a maximum of 3% of our market capitalization at the time of the election, and cannot in any case exceed $10 million. We must also wait at least five trading days after the end of a fifteen trading day draw down period before we can commence the next draw down. In addition, the CEFF limits the beneficial ownership of Kingsbridge to 9.9% of our outstanding common stock, which percentage includes any shares of common stock purchased pursuant to the CEFF, that we may issue as liquidated damages, and issued upon exercise of the warrant. Depending on the market price of our common stock and Kingsbridge’s other holdings of our common stock, this restriction may limit the maximum amount we can draw down under the CEFF. If Kingsbridge’s beneficial ownership were to exceed 9.9% of our outstanding common stock, together with the total amount of our common stock that would be outstanding upon completion of a draw down, we would not be able to draw down on the Committee Equity Facility until such time as Kingsbridge sells enough shares of our common stock or our number of shares of common stock outstanding increases, which may not occur. Therefore, we may not be able to draw down on the full $25 million commitment.

Our sales of stock to Kingsbridge will be discounted to market price, so our stockholders will experience immediate dilution in the value of their shares if we sell shares to Kingsbridge under the CEFF.

The issuance of shares under the CEFF will have a dilutive impact on other stockholders, and the issuance or even potential issuance of such shares could have a negative effect on the market price of our common stock. In addition, if we draw down the CEFF, we will issue shares to Kingsbridge at a discount ranging from 8% to 12% of the daily volume weighted average prices of our common stock during the fifteen day trading period after initiation of each draw down. Issuing shares at such a discount will further dilute the interests of other stockholders. The 9.9% limitation on Kingsbridge’s beneficial ownership will not prevent Kingsbridge from selling some of its holdings and then receiving additional shares, such that the total number of shares that we may sell to Kingsbridge under the CEFF and it resells is greater than 9.9% of our outstanding stock.

There are a large number of shares underlying the CEFF that we are in the process of registering in a registration statement, and the sale of these shares may depress the price of our common stock.

To the extent that Kingsbridge sells shares of our common stock issued under the CEFF under an effective registration statement, our stock price may decrease due to the additional selling pressure in the market. The perceived risk of dilution from sales of stock to or by Kingsbridge may cause holders of our common stock to sell their shares, which could contribute to a decline in our stock price.

The sale of shares underlying the CEFF could encourage short sales by third parties, which could contribute to the future decline of our stock price.

A significant downward pressure on the price of our common stock caused by the sale of material amounts of common stock under the CEFF could encourage short sales by third parties. In a short sale, a prospective seller borrows stock from a stockholder or broker and sells the borrowed stock. The prospective seller hopes that the stock price will decline, at which time the seller can purchase shares at a lower price to repay the lender. The seller profits when the stock price declines because it is purchasing shares at a price lower than the sale price of the borrowed stock. Such sales could place downward pressure on the price of our common stock by increasing the number of shares being sold, which could contribute to the future decline of our stock price.

We cannot predict the actual number of shares that we will issue under the CEFF, in any particular draw down, or in total. The number of shares we will issue will fluctuate based on the market price of our stock over the fifteen trading days after we give a draw down notice for each draw down period.

The actual number of shares that we will issue under the CEFF in any particular draw down, and in total, is uncertain. Subject to the limitations in our agreement with Kingsbridge, we have the discretion to draw down funds at any time throughout the term of the CEFF, and we have not determined the amount of proceeds, if any, we will seek to raise through the CEFF. Also, the number of shares we must issue after giving a draw down notice will fluctuate based on the market price of our stock over the fifteen trading days after we give a draw down notice, and Kingsbridge will receive more shares if our stock price declines. Assuming the volume weighted average price of our common stock is $8.36 per share, which was the closing sale price reported on the NASDAQ SmallCap Market on April 15, 2005, and we elected to draw down a total of $10 million under the CEFF, we would issue 1,329,080 shares of common stock to Kingsbridge, representing 5.9% of our common stock outstanding as of April 15, 2005, after giving effect to the sale of such shares. Using the same assumptions and conditions but with elections by us to draw down the full $25 million under the CEFF, we would issue 3,322,700 shares of common stock to Kingsbridge, representing 13.5% of our common stock outstanding on April 15, 2005, after giving effect to the sale of such shares. During the one year period ended April 15, 2005, our stock price as reported on the NASDAQ SmallCap Market ranged from a high of $11.55 to a low of $4.38.

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The above estimates of the number of shares to be sold assume that our stock price would remain constant during each fifteen trading day draw down period, and across all draw down periods. This assumption is not realistic, particularly since during each fifteen trading day draw down period, Kingsbridge is permitted to sell the shares to be issued with respect to each trading day once the discount purchase price for such day (and therefore the number of shares to be purchased for such day) is determined. These permitted sales during a draw down period may cause the volume weighted average price of our common stock to decline on immediately subsequent days, resulting in the sale of additional shares to Kingsbridge on immediately subsequent days for the same monetary proceeds to us. The further sale of shares priced on those immediately subsequent days could then cause further price declines on later days, resulting in the sale of increasing numbers of shares for the same monetary proceeds as the draw down period progresses.

Furthermore, Kingsbridge’s 9.9% beneficial ownership limitation is determined on, and based on the amount of our common stock outstanding on, each settlement date. As the number of shares outstanding on each settlement date increases, Kingsbridge may be required to purchase more shares of our common stock during a draw down period than would have been apparent on the date that we sent the draw down notice to Kingsbridge.

We may issue additional common stock in the future, including shares under our CEFF, and this stock may reduce the value of your common stock.  

As a result of the CEFF or other financings, we may issue additional shares of common stock without further action by our stockholders. Moreover, the economic and voting interests of each stockholder will be diluted as a result of such issuances. Although the number of shares of common stock that stockholders presently own will not decrease, such shares will represent a smaller percentage of our total shares that will be outstanding after such events. If we satisfy the conditions that allow us to draw down the entire $25 million available under the CEFF, and we choose to do so, then generally, as the market price of our common stock decreases, the number of shares we will have to issue upon each draw down on the CEFF increases, to a maximum of 3,684,782 shares we may issue without stockholder approval. Drawing down on the CEFF when the price of our common stock is decreasing will have an additional dilutive effect to your ownership percentage and may result in additional downward pressure on the price of our common stock.

Sales of common stock issuable on the exercise of outstanding options and warrants, including the warrant held by Kingsbridge, may depress the price of our common stock.

As of April 15, 2005, there were options granted to our employees, directors and consultants to purchase 2,129,311 shares of our common stock. As of April 15, 2005, there were warrants granted to investors to purchase 2,308,234 shares of our common stock, including the warrant issued to Kingsbridge exercisable for 275,000 shares. The exercise prices for the options and warrants range from $2.00 to $11.00 per share. In the future we may issue additional convertible securities, options and warrants. The issuance of shares of common stock issuable upon the exercise of convertible securities, options or warrants could cause substantial dilution to holders of common stock, and the sale of those shares in the market could cause the market price of our common stock to decline. The potential dilution from these shares could negatively affect the terms on which we could obtain equity financing.

Our CEFF imposes certain liquidated damages which may impair our liquidity and ability to raise capital.  

The terms of the CEFF require us to pay liquidated damages in the event that a registration statement is not available for the resale of securities purchased by Kingsbridge under the CEFF. These liquidated damages provisions generally require us to pay an amount based on the decline in value, if any, of shares held by Kingsbridge during the time a registration statement is unavailable. The liquidated damages could severely affect our liquidity, or to the extent we are permitted to and decide to pay such damages through the issuance of common stock, cause significant dilution to our common stockholders.

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We may not issue convertible securities with a floating or adjustable discount to the price of our common stock during the two year term of the Common Equity Financing Facility without the prior written consent of Kingsbridge, which consent we may not be able to obtain. These restrictions may affect our ability to raise capital.

During the two-year term of the proposed CEFF, without the prior written consent of Kingsbridge, we are prohibited from issuing securities that are, or may become, convertible or exchangeable into shares of common stock where the purchase, conversion or exchange price for such common stock is determined using a floating or otherwise adjustable discount to the market price of the common stock (including pursuant to an equity line or other financing that is substantially similar to an equity line with an investor other than Kingsbridge). In the past, we met our capital needs through the sale of preferred stock and convertible notes which had floating price features. We may have difficulty raising capital if Kingsbridge does not consent to our use of such securities in the future. If we are unable to raise capital from Kingsbridge or from sources that do not demand a floating price feature, we may have to severely curtail our operations, which could cause a significant decrease in the price of our common stock.

Our ability to draw down on the CEFF may be limited under the rules of the NASDAQ Stock Market.

Under the rules of the NASDAQ Stock Market, the approval of our stockholders is required for the sale of shares to Kingsbridge totaling more than 20% of our issued and outstanding shares at the time we entered into the agreement with Kingsbridge. If our average sale price to Kingsbridge is below $6.78 per share (equivalent to a volume weighted average price of $7.54 per share, assuming a 10% discount for all sales) and we elect to draw the full $25 million commitment, it would require that we issue more than 20% of our issued and outstanding shares at the time we entered into the agreement with Kingsbridge and we would need to seek stockholder approval to do so. The $6.78 average sale price mentioned above assumes that we have not issued Kingsbridge any shares in lieu of paying liquidated damages that may be owed to Kingsbridge in the event that the availability of its registration statement is suspended. If we issue shares to Kingsbridge in lieu of payment of liquidated damages, the average sale price (and the volume weighted average price) would need to be higher in order to elect to draw the full $25 million commitment without stockholder approval. If we are unable to obtain such stockholder approval, our ability to raise capital under the CEFF will be impaired. If we are unable to obtain capital from other sources on a timely basis or on terms favorable to us, we may be required to scale back our marketing and research and development efforts, sell or license some or all of our technology or assets or curtail or cease operations.

One customer accounted for approximately 93% of our revenues for the three months ended March 31, 2005, two customers accounted for 92% of our revenues for the six months ended March 31, 2005, and we continue to be dependent on a few large customers.

ADS, Inc., a prime vendor to the U. S. military, accounted for 93% of net revenues for the three months ended March 31, 2005. For the six months ended March 31, 2005, ADS accounted for 82% of our revenues and a second customer and its affiliates accounted for 10% of our revenues. These customers have the right to cease doing business with us at any time. If this were to occur and we could not replace them, our net revenues could decline substantially. Any such decline could result in us incurring net losses, increasing our accumulated deficit and causing us to need to raise additional capital to fund our operations.

We must expand our customer base in order to grow our business.

To grow our business, we must fulfill orders from our existing customers, obtain additional orders from our existing customers, develop relationships with new customers and obtain and fulfill orders from new customers. We cannot guarantee that we will be able to increase our customer base. Further, even if we do obtain new customers, we cannot guarantee that those customers will purchase from us enough quantities of our product or at product prices that will enable us to recover our costs in acquiring those customers and fulfilling those orders. Whether we will be able to sell more of our products will depend on a number of factors, including:

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The growth of our Government Group revenues is materially dependent 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.

Although our LRAD products are designed for use by both government and commercial customers, our LRAD products have, to date, been predominantly sold for government use. Within the Government Group, our largest customer is a reseller of our products to end users in various branches of the military such as the U.S. Navy, U.S. Marine Corps, U.S. Army and the Department of Homeland Security. We have only recently achieved significant sales of LRAD products, and the product has not yet been widely accepted in the government market. Furthermore, the force protection and emergency response market is itself an emerging market, which is changing rapidly. 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, and we may fail to achieve our sales projections.

Perceptions that long range hailing devices are unsafe or may be used in an abusive manner may hurt sales of our LRAD products which could cause our revenues to decline.

Potential customers for our LRAD products, including government, military and 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. These claims or perceptions could cause our product sales to decline. In addition, if these agencies have these perceptions, it will be difficult for us to grow our customer base beyond these markets. These factors could reduce future revenues, adversely affecting our financial condition and results of operations.

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 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 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 products have been limited to date and we cannot guarantee significant revenues in the future. The development and introduction of our products took longer than anticipated by management and the introduction of new products could also be subject to delays. Customers may not wait for newer versions of existing products or new products and may elect to purchase products from competitors. We experienced quality control problems with some of our initial commercial HSS units, and we may not be able to resolve future similar 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 have never been produced in quantity, and we may incur significant and unpredictable warranty costs as these products are mass produced.

None of our products has been produced in sufficient quantities to be considered mass produced. Our technologies 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.

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At March 31, 2005, we had a warranty reserve of $238,837. We recorded substantial warranty reserves for early versions of our HSS products and have little history to predict future warranty costs. Future warranty costs could further adversely affect our financial position, results of operations and business prospects.

We could incur charges for excess and obsolete inventory.

Due to rapidly changing technology and uneven customer demand, product cycles tend to be short and the value of our inventory may be adversely affected by changes in technology that affect our ability to sell the products in our inventory. Therefore, periodically, it may be necessary to write off inventory as excess or obsolete.

While we will make every attempt to successfully manage product transition, including inventory control of older generation products when introducing new products, we have previously experienced and may, in the future, experience reductions in sales of older generation products as customers delay or defer purchases in anticipation of new product introductions. We currently have established reserves for slow moving or obsolete inventory. The reserves we have established for potential losses due to obsolete inventory may, however, prove to be inadequate and may give rise to additional charges for obsolete or excess inventory.

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.

We expect our sound proprietary reproduction technologies will be the source of substantially all of our future revenues. Revenues from our sound proprietary 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 our 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: 

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.

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 well-established markets. As a result, our technologies, even if successful, may become obsolete before we recoup our investment.

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Our competitive position will be seriously damaged if we cannot obtain patent protection for important differentiating aspects of our products or otherwise protect intellectual property rights in our technology.

We rely on a combination of contracts and trademark, patent and trade secret laws to establish and protect our proprietary rights in our technology. However, we may not be able to prevent misappropriation of our intellectual property, our competitors may be able to independently develop and the agreements we enter into may not be enforceable.

Our success, in part, depends on our ability to obtain and enforce intellectual property protection for our technology, particularly our patents. There is no guarantee any patent will issue on any patent application that we have filed or may file. Claims allowed from existing or pending patents may not be of sufficient scope or strength to protect the economic value of our technologies. Further, any patent that we may obtain will expire, and it is possible that it may be challenged, invalidated or circumvented. If we do not secure and maintain patent protection for our technology and products, our competitive position will be significantly harmed because it will be much easier for competitors to sell products similar to ours. Alternatively, a competitor may independently develop or patent technologies that are substantially equivalent to or superior to our technology. For example, patent protection on our LRAD product is limited, and we may not be able to prevent others from introducing products with similar functionality. If this happens, any patent that we may obtain may not provide protection and our competitive position could be significantly harmed.

As we expand our product line or develop new uses for our products, these products or uses may be outside the protection provided by our current patent applications and other intellectual property rights. In addition, if we develop new products or enhancements to existing products we cannot assure you that we will be able to obtain patents to protect them. Even if we do receive patents for our existing or new products, these patents may not provide meaningful protection. In some countries outside of the United States where our products can be sold or licensed, patent protection is not available. Moreover, some countries that do allow registration of patents do not provide meaningful redress for violations of patents. As a result, protecting intellectual property in these countries is difficult and our competitors may successfully sell products in those countries that have functions and features that infringe on our intellectual property.

We may initiate claims or litigation against third parties in the future for infringement of our proprietary rights or to determine the scope and validity of our proprietary rights or the proprietary rights of our competitors. These claims could result in costly litigation and divert the efforts of our technical and management personnel. As a result, our operating results could suffer and our financial condition could be harmed.

Our competitive position will be seriously damaged if our products are found to infringe on the intellectual property rights of others.

Other companies and our competitors may currently own or obtain patents or other proprietary rights that might prevent, limit or interfere with our ability to make, use or sell our products. As a result, we may be found to infringe the intellectual property rights of others. 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. In the event of a successful claim of infringement against us and our failure or inability to license the infringed technology, our business and operating results could be adversely affected. Any litigation or claims, whether or not valid, could result in substantial costs and diversion of our resources. An adverse result from intellectual property litigation could force us to do one or more of the following:

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If we are forced to take any of the foregoing actions, we could face substantial costs and shipment delays and our business could be seriously harmed. Although we carry general liability insurance, our insurance may not cover potential claims of this type or be adequate to indemnify us for all liability that may be imposed.

In addition, it is possible that our customers or end users may seek indemnity from us in the event that our products are found or alleged to infringe the intellectual property rights of others. Any such claim for indemnity could result in substantial expenses to us that could harm our operating results.

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, for example, the Trading with the Enemy Act of 1917, the Arms Export Control Act of 1976, the Export Administration Act of 1979, or the International Emergency Economic Powers Act, as well as their implementing regulations and executive orders.

In the case of certain agreements involving equipment or services controlled under the International Traffic in Arms Regulations (ITAR) and sold at specified dollar volumes, the U.S. Department of State must notify Congress at least 15 to 30 days, depending on the intended overseas destination, prior to authorizing these sales. During that time, Congress may take action to block the proposed sale. Based on our current product lines, we do not anticipate the congressional notification requirement to have an immediate impact; however, as our product lines expand, this notification requirement could impact our ability to sell certain controlled products or services in the international market.

The need for export licenses and, when required, Congressional notification, can introduce a period of delay in our ability to consummate international transactions. Because issuance of an export license is wholly within the discretion of the controlling U.S. government agency, it is possible that, in some circumstances, we may not be able to obtain the necessary licenses for some potential transactions.

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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.

Commercialization of our proprietary 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 proprietary sound technologies and products.

An important part of 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 proprietary 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 third party manufacturers.  

We do not have the capacity to manufacture all of our products internally and we are therefore dependent on third party manufacturers. At present, we manufacture NeoPlanar and SoundCluster internally only in small quantities and would need to outsource our manufacturing if sales of these products were to increase significantly. In addition, we established a manufacturing relationship with Pemstar, Inc. in fiscal 2004 to manufacture our LRAD and HSS products. We do not have a formal written agreement with Pemstar. Pemstar, or any other contract manufacturing partner, may not be able or willing to manufacture products for us in the quantities and at the level of quality that we require. If we need to seek additional third party manufacturers for our products, we may not be able to obtain acceptable replacement manufacturing sources on a timely basis. An extended interruption in the supply of our products could result in a substantial loss of sales. In addition, any actual or perceived degradation of product quality as a result of our reliance on third party manufacturers may have an adverse effect on sales or result in increased product returns and buybacks. Failure to maintain quality contract manufacturing could reduce future revenues, adversely affecting financial condition and results of operations.

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 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 HSS 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 Group 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.

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, and Kalani Jones, our President and Chief Operating Officer. We are dependent on our ability to retain and motivate high quality personnel, especially highly skilled technical personnel. Our future success and growth also depends 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 not address successfully the problems encountered in connection with any potential future acquisitions.

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We expect to continue to consider opportunities to acquire or make investments in other technologies, products and businesses that could enhance our capabilities, complement our current products or expand the breadth of our markets or customer base. We have limited experience in acquiring other businesses and technologies. Potential and completed acquisitions and strategic investments involve numerous risks, including:

If we fail to properly evaluate and execute acquisitions and strategic investments, our management team may be distracted from our day-to-day operations, our business may be disrupted and our operating results may suffer. In addition, if we finance acquisitions by issuing equity or convertible debt securities, our stockholders would be diluted.

We are subject to increased costs as a result of newly adopted accounting and SEC regulations.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, our management will be required by the end of fiscal 2005 to perform an evaluation of our internal control over financial reporting and have our independent auditor attest to that evaluation. Compliance with these requirements is expected to be expensive and time consuming. If we fail to timely complete this evaluation, or if our independent registered public accounting firm cannot timely attest to our evaluation, we could be subject to regulatory scrutiny and a loss of public confidence in our internal control over financial reporting.

In designing and evaluating our internal control over financial reporting, we recognize that any internal control or procedure, no matter how well designed and operated, can provide only reasonable assurance of achieving desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. No system of internal control can be designed to provide absolute assurance of effectiveness and any material failure of internal control over financial reporting could materially impact our reported financial results and the market price of our stock could significantly decline. In addition, adverse publicity related to a material failure of internal control over financial reporting would have a negative impact on our reputation and business.

Changes in stock option accounting rules may adversely impact our reported operating results prepared in accordance with generally accepted accounting principles, our stock price and our competitiveness in the employee marketplace.

Technology companies in general and our company in particular have a history of depending upon and using broad based employee stock option programs to hire, incentivize and retain employees in a competitive marketplace. Currently, we do not recognize compensation expense for stock options issued to employees or directors, except in limited cases involving modifications of stock options, and we instead disclose in the notes to our financial statements information about what such charges would be if they were expensed. An accounting standard setting body has recently adopted a new accounting standard that will require us to record equity-based compensation expense for stock options and employee stock purchase plan rights granted to employees based on the fair value of the equity instrument at the time of grant. We will be required to record these expenses beginning with our first quarter of fiscal 2006, which ends December 31, 2005. The change in accounting rules will lead to increased reported net loss or, should we become profitable, a decrease in reported earnings. This may negatively impact our future stock price. In addition, this change in accounting rules could impact our ability to utilize broad based employee stock plans to reward employees and could result in a competitive disadvantage to us in the employee marketplace.

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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 offerings 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 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 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 flows due to adverse changes in market prices, including interest rate risk and other relevant market rate or price risks. We do not use derivative financial instruments in our investment portfolio.

We are exposed to market risk associated with our issuance of a warrant to Kingsbridge Capital Limited for 275,000 shares. Because this warrant is classified as a liability on our balance sheet, we must calculate the fair value of the warrant at the end of each quarter and record the change in fair value over the quarter to other income or expense until the related registration statement is effective, until the warrant is fully exercised, or until the expiration of the warrant in June 2010. Accordingly, we are incurring risk associated with increases or decreases in the market price of our stock, which will directly impact the fair value calculation and the non-cash charge or credit recorded to our statement of operations for future quarters. For example, if our stock price increases by 20% during the quarter ending June 30, 2005 from its March 31, 2005 value, the registration statement is not effective and all other inputs into the Black-Scholes valuation model remain unchanged from March 31, 2005, we would record approximately $353,516 of other expense for the period ended June 30, 2005. If our stock price decreased by 20% during the quarter ending June 30, 2005 from its March 31, 2005 value, and all other inputs into the Black-Scholes valuation model remain unchanged from March 31, 2005, we would record approximately $330,763 as other income.

We are also exposed to some market risk through interest rates, related to our investment of current cash and cash equivalents of approximately $6.2 million. Based on this balance, a change of one percent in interest rate would cause a change in interest income of $62,000. The risk is not considered material and we manage such risk by continuing to evaluate the best investment rates available for short-term high quality investments.

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Item 4. Controls and Procedures.

We maintain disclosure controls and procedures designed to ensure that material information related to us, including our consolidated subsidiaries, is recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms.

Limitations. Our management, including our co-principal executive officers and principal financial officer, does not expect that our disclosure control or internal controls over financial reporting will prevent all errors or all instances of fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of control is based in part upon certain assumptions about the likelihood of future events, and any design may not succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitation of a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

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PART II. OTHER INFORMATION

Item 1.  Legal Proceedings.

Reference is made to Note 13 of our Notes to Interim Financial Statements included in Part I, Item 1 of this report for information regarding Legal Proceedings.

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds.

None.

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.

On May 9, 2005, Carl Gruenler, Vice President, Government and Force Protection Systems Group, left our company. Mr. Gruenler had been employed under the terms of a letter agreement amended on July 30, 2003. The letter agreement provided for an annual base salary of $110,000, and an annual performance bonus of up to 10% of base salary to be determined by the Compensation Committee and the Board of Directors. Mr. Gruenler's annual base salary at the time of separation was $250,000, and he participated in our broad-based commission plan in lieu of the annual performance bonus contemplated by his letter agreement. Mr. Gruenler's employment was terminable at-will by us or by Mr. Gruenler for any reason, with or without notice. Our employment arrangement with Mr. Gruenler was terminated in conjunction with his departure.

The foregoing disclosure is made in lieu of disclosure under Item 1.02 on Form 8-K.

Item 6. Exhibits

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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.