INTERLINK ELECTRONICS INC - Annual Report: 2002 (Form 10-K)

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

FORM 10-K

          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.

          Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

          Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

          On June 28, 2002 (the last business day of the registrant’s most recently completed second fiscal quarter), the aggregate market value of the shares of Common Stock held by non-affiliates of the registrant was $42,737,941 based upon the last sale price reported for such date on the Nasdaq National Market. Shares of common stock held by officers and directors of the registrant are not included in the computations, however, the registrant made no determination that such individuals are “affiliates” within the meaning of Rule 405 of the Securities Act of 1933.

          As of March 20, 2003 the number of shares of the registrant’s Common Stock outstanding was 9,778,593.

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INTERLINK ELECTRONICS, INC.
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Documents incorporated by reference:
          Portions of Registrant’s Proxy Statement for its 2003 Annual Meeting of Stockholders are incorporated by reference into Part III of this report.

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PART I

Overview

          We are a leader in the development of intuitive interface devices for a variety of home and business applications. Our products enable a user to control and communicate with various audio-visual products such as  business presentation projectors, digital televisions (directly or through set-top boxes) and other information display systems by providing an intuitive device on which the user can remotely input a variety of commands. Our patented touchpad technologies capture electronic signature and character input for digital recognition for e-commerce and other digital communication applications. Our products incorporate patented sensor and wireless communication technologies, proprietary applications and ergonomic designs. Our traditional business has been in the business presentation market where we are the leading supplier of intuitive interface devices to most of the manufacturers of business presentation systems and to leading resellers of business communication products.  Based on our suite of intuitive interface technologies, in recent years, we entered two new markets: home entertainment and electronic transactions. By building partnerships with providers of complementary software and hardware technologies, we market our products for use with information display systems as digital interface technology is incorporated into them.  We also manufacture and sell a variety of electronic components, such as touchpads, specialty mice and rugged input devices for computer, automotive and medical applications.

          We are a leading supplier of intuitive interface devices and components for the business presentation market, where we sell both to original equipment manufacturers (OEMs) and directly to consumers through reseller channels. Our OEM customers include presentation system manufacturers, such as InFocus Corporation, NEC Corporation, Sony Corporation, Compaq Computer Corporation, Dell Computer Corporation and Toshiba Corporation.

          We also design, manufacture, license and sell a broad variety of specialty components incorporating our technologies, such as pointing devices and industrial sensor products for the computer, automotive and medical device markets.

          In 1999, we entered the electronic document management and business-to-business electronic commerce markets, which we refer to collectively as the E-transactions market, by introducing our ePad electronic signature capture device. The ePad captures signatures electronically and permits these signatures to be bound to an electronic document, allowing a recipient to verify that an electronic document has not been tampered with since the signature was recorded.

          In 2000, we began marketing IntuiTouch technology that enables users to easily control the various applications emerging in the home entertainment market, such as interactive television. We sell a sensor component to Microsoft for their Xbox home entertainment system.

Market Background

          Business Communications Market.  We are the dominant supplier of remote input devices to the business communications market, supplying the majority of all remote input devices used to control presentation projectors.  This market consists of electronic presentation devices that enable mixed-media

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presentations using PowerPoint or other commonly available presentation software, including both locally contained presentations and video-conferencing presentations distributed to multiple locations. As computer technology has replaced traditional presentation devices such as slide and overhead projectors, the mechanisms to control the presentation process have undergone a similar evolution.  Similarly, the advent of broadband communication technologies has enabled developments in video-conferencing that permit sophisticated, interactive presentations to be made at multiple locations and to be controlled from a single location.  Today, it is possible for a presenter to control various characteristics of a sophisticated audio-visual presentation using a small, remote device.  Unlike slide presentations, which cannot be edited, or overhead presentations that can be edited only by standing over the projector and writing with a pen or grease pencil, the modern, computer-driven presentation can be controlled, edited, amplified, distributed and otherwise manipulated electronically.  This demands a wireless device that can transmit a wide variety of commands and support complex control functions in an intuitive manner. For the presenter and audiences benefit, it is important that the control process not detract from the presentation. Our OEM customers have recently introduced business communications hardware that will significantly reduce the size and weight and increase the resolution and brightness of presentation devices such as projectors and the processing power of computers that support them. Increased portability will enable many users to travel with a complete presentation system capable of fitting in a standard briefcase.

          Home Entertainment Market.   The use of remote devices to control household entertainment systems has been growing for at least the last quarter century.  Two recent developments, however, have dramatically increased the complexity of the processes that these devices must control.  These developments are the advent of digital cable and satellite delivery systems and the introduction and widespread use of the Internet.  Early remotes used to control broadcast, and later analog cable, television were relatively simple devices that permitted the viewer to turn the set on or off, change channels and adjust volume.  Today’s television viewer may wish to control a variety of information or entertainment systems, including cable or satellite input, VCR’s, DVD players and audio systems or to participate in the increasing number of interactive options being presented by content providers.  The recent advent of digital cable and satellite networks creates substantial new opportunities for interaction for the viewer.  Digital cable and satellite networks offer or can offer consumers electronic program guides, voice telephony, e-mail, e-commerce and other services through the television. For example, a television viewer may, after viewing a movie, wish to order a copy on DVD, or the viewer of a news program or television commercial may wish to obtain additional information by visiting a related website. These new applications are creating a need for interactive capability in the home entertainment markets.

          The Internet has grown rapidly over the past several years and is now used by tens of millions of people for entertainment, education and e-commerce. The increasing popularity of the Internet and the established popularity of television have led a growing number of home computer users to simultaneously access Internet content while they watch television. This convergence of television and computer technologies has enabled a wide range of new communication and entertainment applications.

          We believe that the home entertainment market offers a new, large market opportunity for multi-functional, intuitive interface devices. The advent of advanced television viewing devices (such as, flat panel displays), digital cable, satellite TV and similar broadband delivery systems is increasing programming choices. It is widely anticipated that computer and television technologies will continue to converge and that the consumer will be able, through a single electronic system, to view television programming, control other entertainment components, access the Internet, participate in on-line commerce, send and receive e-mail and participate in audio and video telephone calls.

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          We believe the market for intuitive interface devices will develop as advanced television viewing devices proliferate and subscribers have increased access to digital set-top boxes. We believe that, as digital set-top boxes are deployed and broadband services such as Internet access become available, consumers will seek new control devices that are more sophisticated, flexible, and intuitive than traditional television remotes or the combination of a remote and wireless keyboard.

          E-transactions Market.  The rapid growth of the electronic document management and business-to-business e-commerce markets has created a need for electronic document and approval authentication methods that can serve as an electronic substitute for the signature on paper documents. For the recipient of an electronic document to have confidence that the document was approved in the form in which it appears on his or her computer screen, it is necessary to have a reliable mechanism that captures a signature, binds the signature to the document, and verifies the identity of the approving person and the integrity of the document in the form in which it was approved. We believe there will be a sizeable market for an electronic signature capture product in electronic document management applications, especially in consumer “turnstile” environments such as retail point-of-sale, financial and insurance services.

          Specialty Components Market.  Using our original FSR technology, we sell sensors that permit control of various processes based on the amount of force applied to an input device.  We continue to market these devices, both as stand-alone products and as components sold to OEMs for use in their products.  We believe that this market is stable and do not expect significant change in the scope of our specialty products business.

          For a description of revenue and gross profit by market segment, see Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The Need for Intuitive Interface Devices

          We believe traditional remote control devices are not well suited for evolving user requirements. In the home environment, entertainment systems are increasing in complexity, more applications and content can be accessed on each system, and multiple components of a system are often used simultaneously. Business presentation devices are also offering more sophisticated control options.  However, the remote control devices that are typically used to control applications and systems in the home and business environment are not intuitive and are often difficult to use. They contain many buttons, which require users to memorize or look up each function of each button. Users often need several control devices, such as a remote and a wireless keyboard, to access multiple applications, such as digital TV content, Internet-based communication and commerce, and the telephone. The multiplicity of individual devices or buttons or sequences of buttons on a single device required to control the related system also requires the user to look directly at the interface device in order to select the correct button or button sequence.  This is distracting in the case of business presentations and may be undesirable in the home entertainment environment if the user is in a darkened room or does not want to miss something in the visual presentation. 

          The typical remote control device operates on infrared, or IR, technology, which does not work well over long distances or if there are intervening objects, such as furniture. Although, some remote communication functions are best addressed using IR technology and the majority of current systems are set to up receive IR signals, by itself IR technology has significant limitations. IR signals also interfere with each other, which prevents the use of multiple IR signals in a single room, significantly limiting

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interactivity between the remote and the multiple devices it controls and making bi-directional communication impossible. Finally, traditional IR technology is slow and narrows bandwidth, limiting the complexity of data that can be transmitted.

          In the e-transactions market, businesses seeking to automate workflow or conduct e-commerce transactions need a hardware and software solution that can be used to capture signatures, bind them to documents, and authenticate and verify them. There are few cost-effective turnkey solutions commercially available that can be deployed, requiring businesses to develop proprietary software and hardware solutions.

The Interlink Solution

          We use our suite of proprietary intuitive interface technologies to create devices that enable users to operate and control computers, televisions, projectors and other complex electronic systems. By enabling interactivity between interface devices and the systems they control, we allow users to interact directly with menu-driven application programs resident in the controlled system through an on-screen display. Our devices enable the use of high bandwidth applications such as telephony and provide an intuitive interface for applications encompassing the functions typically associated with computers, such as browsing the Internet and sending and receiving e-mail. For instance, our new interface device for next generation digital set-top boxes integrates cursorless navigation, text entry, freehand writing and drawing and voice transmission capabilities within a single lightweight, hand-held platform. The device enables total control of various home entertainment options available yet retain a highly intuitive user interface and a sleek ergonomic design.

          Our interface devices offer a number of benefits not available using traditional technologies:

          Easy-to-Use Sensor Technology.  The vast majority of our products include our patented FSR technology. The FSR, or Force Sensing Resistor, combined with other Interlink Electronics technologies, creates a pointing device that responds to pressure and can accept input from a finger or a pen. It also consumes minimal power, making it ideal for use in a battery powered interface device. In conjunction with patent-pending pad-to-screen mapping and gestures technology, our FSR touchpads provide an intuitive means of communicating with a wide array of applications and systems. The FSR is also ideally suited for capturing high resolution electronic signatures.

          Innovative Software Applications.  Our pad-to-screen, or PTS mapping technology, for which we have a patent, allows a user to touch a point on an FSR touchpad to activate a button or menu item in a corresponding on-screen location. This capability eliminates the need to click or cursor through various intervening menu items. Using PTS mapping, a user can easily and quickly perform a number of complex functions without looking at the remote device, including the operation of a virtual keyboard activated through the touchpad but appearing on the monitor.

          Our “gesture” technology, for which we have issued and pending patents, allows the user to input or write commands on a screen by touching and moving a finger or pen on a touchpad. For example, a channel can be changed by tracing the channel number on the touchpad or, if a higher or lower channel is desired, by swiping to the right or left, as applicable, and continuing to touch the touchpad to scroll through the channel numbers. Other commands, such as play, record or pause are accomplished by making gestures that mimic the standard symbols for those functions appearing on VCRs, DVD players and other playback and recording devices.

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          Enhanced Wireless Communications Technology.  In addition to our patented wireless protocol, RemoteLink, we have developed expertise in industry wireless protocol standards, such as IR, radio frequency (RF) and Bluetooth.  Our patented RemoteLink wireless communications technology retains the IR technology necessary to communicate with most of today’s information and entertainment systems and combines it with RF technology to overcome most of the shortcomings of traditional IR technology.

          Widely Accepted Functional and Ergonomic Designs.  Our intuitive interface devices reflect our strong focus on functionality and ergonomics. We maintain an active product design effort and devote considerable attention to issues related to ease of use of our products. An example of the results of these efforts is our patented ClickTrigger button incorporated in a number of our products, which enables the user to click on an icon on a monitor by squeezing a button with his or her index finger in a motion similar to pulling a trigger.

The Interlink Strategy

          We intend to use our suite of technologies to become the leading provider of intuitive interface devices for the home and business markets through the implementation of the following strategies:

          We Will Work With Home Entertainment Industry Innovators To Develop Intuitive Interface Devices For Interactive Applications. We will foster adoption of our intuitive interface devices for the home entertainment market by building technology partnerships with a variety of technology providers, such as manufacturers of digital set-top boxes, front and rear projectors and plasma displays and developers of software applications. Because many of our OEM customers in the business communications market are also participants in the market for home entertainment systems, we expect to use our relationships with them to facilitate the widespread adoption of our intuitive interface devices in the home entertainment market. Additionally, we will continue to support the usage of our FSR technology in the Microsoft Xbox program and any related products.

          We Will Aggressively Market Our ePad Product Line to the E-transactions Market.  We will foster adoption of our ePad product line in the e-transactions market by expanding distribution channels and building strategic relationships with key software and systems integrators to develop turnkey solutions for deployment in large corporate settings. To foster adoption of the ePad in the electronic document management market, we are working with electronic signature software companies like Silanis Technology, Inc., Valyd, Inc. and Communication Intelligence Corporation.

          We Will Maintain Our Leadership Position in the Business Communications Market.  We will seek to maintain our leadership position in the business communications market by continuing to provide our OEM and reseller customers with innovative products that are responsive to consumer needs. We also expect to introduce products for related ancillary markets, such as conference room and video conferencing controllers and conferencing automation products.

          We Will Develop Proprietary Applications to Expand Our Penetration into New Markets.  We will develop either for ourselves or in partnership with other companies, software applications that enhance the functionality of our intuitive interface devices and will seek to license such applications where possible. We intend to work with our customers and development partners to identify and develop applications that will meet customer needs and, where appropriate, to license these applications.

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          We Will Enhance Our Current Technology and Develop or Acquire New Technology and Applications. We will maintain an active technology development program that will enable us to enhance our current touchpad and wireless communication technologies and develop new technologies and applications for them. We believe this continuing development will allow us to increase our market share in the markets in which we compete and identify new markets where our technologies can provide us with a competitive advantage. Where appropriate, we may acquire technologies from others or acquire companies that own or are developing technologies that we believe would allow us to enhance our product offerings.

Products

          We have four principal product lines targeted at the business communications, home entertainment, e-transactions and specialty components markets.

           Business Communication Products.  Our remote interface devices are used by the business communications market to control presentation systems such as projectors. Our traditional interface devices incorporate a pointing button to control the cursor and one or more function selection buttons. These products range from a simple interface device with only a pointing device and a single click button to devices with 30 function keys. Most of these products incorporate our patented ClickTrigger button.

          We sell interface devices in the business communication market principally to OEMs and as branded products through a variety of distributors and value added resellers. Our current OEM customers include some of the largest presentation system manufacturers, including; InFocus Corporation, NEC Corporation, Sony Corporation and Toshiba Corporation. Although most business presentation devices are made by Japanese companies, the United States represents the largest market for these products. Accordingly, our OEM sales are concentrated in Japan and managed by our Japanese subsidiary while our branded sales are primarily U.S.-based.

          In 2002, our business communication products accounted for 64% of our sales. Our dominant market share of the OEM market causes our sales of business communication products to mirror trends in the presentation industry.  This was the case in 2001, when inventory adjustments and generally poor economic conditions resulted in reduced demand for new business presentation systems.  However, our relationships with our principal customers in these markets remains strong and, in some cases, is strengthening.  In 2002, our business communication revenues began to recover as we added new OEM customers and expanded our Interlink branded product business.

          Home Entertainment Products.  The IntuiTouch product, our prototype intuitive interface device for home entertainment systems such as digital set-top boxes, is based on a technological platform similar to our most advanced business communications devices. The pad-centric remote device integrates mouse pointing, text entry, freehand writing and drawing and voice transmission capabilities. The device enables total control of the variety of home entertainment options available yet retains a highly intuitive user interface and an ergonomic design.

          Economic conditions in 2001 and 2002 resulted in substantial reductions in the rate of deployment of new broadband systems.  Accordingly, our home entertainment development efforts have been focused on the design of interface devices that will be needed to support the advanced viewing devices that will be offered to consumers over the next few years, such as front and rear projectors, HDTV and plasma displays.  We are working both directly with the manufacturers of these devices and, at the chip level,

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with innovators of new projection and television technologies in an effort to integrate our interactive communication devices with their products and technologies.   A number of the companies expected to have significant offerings in the digital home entertainment market are our customers in our business communications segment.  We believe that our strong relationship with these customers affords us an opportunity to work with them as they expand into this new market and we are actively pursuing these opportunities.

          We also make an important component of Microsoft’s Xbox game controller.  This sensor is based on our patented FSR technology and is included in our home entertainment segment because of its application.  In 2002, the majority of our revenue from home entertainment came from sales of the Xbox component.

          E-transactions Products.  Our standard ePad product consists of an FSR touchpad mounted in a plastic case and connected by a serial or U.S.B. cable to a computer. Like all of our touchpads, it is actuated using a finger, electronic pen or any other device capable of exerting pressure at a given point on the sensor. In 2002, we introduced ePad-Ink, an LCD-based signature capture product. The ePad products capture and bind signatures to electronic documents. We work with major electronic signature software application developers to provide turnkey solutions to end-users. Depending on the software used with it, the ePad device can perform a variety of document authentication functions, such as alerting a reader if any change has been made to a document since it was transmitted by the sender or verifying the authenticity of the signature.

          Since our introduction of the ePad product, we have devoted considerable resources to marketing to the financial services and insurance industries, where we believe there is an obvious opportunity based on cost savings and efficiency.  The sales cycle for larger customers is 18 to 24 months; usually involving an extensive trial and evaluation period.  The poor economic climate for information technology spending in 2001 and 2002 has severely impacted the industry’s ability to gain momentum.

          Specialty Components.  Our specialty components business consists primarily of two product lines. We sell integrated pointing solutions to manufacturers of notebook computers and industrial computers. We also sell a diverse assortment of custom-designed sensors for non-computer applications, such as for use in medical devices as safety switches.   This business has been relatively stable for several years, varying only with general economic conditions.  In 2000 and the first three quarters of 2001, we received significant royalty revenue from the license of some of our technology to a former affiliate.  The payments ended in the third quarter of 2001 and we do not anticipate significant licensing revenue in the future.

Technologies

          Force Sensing Resistors.  Our products incorporate one or more FSRs. A basic FSR sensor can detect and accurately measure a force applied to it, thereby enabling precise control of the process applying the force. A more complex sensor, known as a “four zone” sensor, has four sensors arranged in a two-by-two square with an actuator placed directly where the four sensors touch. By toggling the actuator in any direction, an operator can control the direction and speed of a cursor on a computer screen. An FSR sensor can also serve as a touchpad by incorporating a two-dimensional grid capable of measuring the location and intensity of pressure applied at any set of coordinates on the grid. In contrast to most standard touchpads, FSR touchpads can also measure the amount of pressure applied at any point on the grid, thereby creating a three-dimensional characterization of input along X, Y, and P axes. This type of device

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is useful for functions such as handwriting input, where not only the outline of the signature but the pressure applied in writing it can be measured, or computer cursor control, where variable cursor speed is desirable.

          Our FSR sensors can be as thin as one-hundredth of an inch, making them particularly well suited for use where space is a critical issue, as in notebook and sub-notebook keyboards. In touchpad applications, they consume significantly less power than do capacitive touchpads, the principal competing technology. FSRs are therefore an appropriate choice for wireless applications. Also, unlike capacitive touchpads which react to the electrical capacitance in a human finger, FSRs react to pressure from any object and therefore support pen input. FSR sensors have no moving parts and can be packaged in a sealed environment. They are therefore highly reliable, retaining their performance through tens of millions of actuations, even in adverse environments involving heat, moisture, and chemical contamination.

          FSR sensors are manufactured using screen printing techniques. All proprietary aspects of the manufacturing process are conducted in-house at Interlink to maintain quality and protect the force sensing technology. While electronic screen printing is a common process in various technology industries, the quality and precision of printing required to make high-quality FSR sensors greatly exceeds the standards applicable in most other industries. We have developed significant expertise in the manufacture of FSR sensors, and believe this experience would be difficult to replicate over the short term. In the FSR manufacturing process, printed sheets of FSR semiconductor material and the corresponding conductor patterns are laminated to form the FSR sandwich structure using inexpensive sheet adhesives. The assembled sheets are die cut and suitable connectors are attached.

          RemoteLink.  Our RemoteLink technology uses a proprietary optical carrier design to provide a relatively high speed, multi-channel, digital or analog, optical communications link that does not interfere with, or become contaminated by, signals from IR remote controls. RemoteLink can be configured to support multiple users and simultaneous channels operating over a number of carrier frequency spectrums, including the 1 to 6 megahertz range. RemoteLink’s bandwidth supports wireless data transmissions of up to 100 kilobits per second and a 6 kilohertz bandwidth analog transmission at distances of up to 10 meters. RemoteLink technology can simultaneously transmit data, voice and legacy IR codes. RemoteLink technology’s ability to transmit legacy IR codes makes it compatible with existing remote controls.

          Applications.  We have created a number of applications that allow our hardware technologies to support specific functions. These applications, for example, enable our FSR-based touchpads to support PTS mapping and gesture control. We expect to develop, or work with others to develop, new applications that will allow our intuitive interface devices to control an ever increasing number of interactive functions.

Sales and Marketing

          We employ a direct sales team of six people in the U.S. and three in Japan. Each sales team is supported by inside sales personnel, product managers and application engineers. For our branded products, we also use value-added resellers, system integrators and distributors throughout the U.S. and Europe.

          For OEM sales, we use public relations activity, direct advertising and trade show participation to

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generate product awareness. Promising sales leads and known industry targets are followed up with sales visits. Depending on forecast volume and required lead times, we may sell component solutions, ready-to-integrate modules, complete solutions or totally custom products. As necessary, application engineers support and visit customers to promote ease of integration. A successful OEM sale will generally take from 6 to 18 months from the initial visit to the first shipment. However, once obtained, an OEM customer usually offers us a more predictable revenue stream.

          For branded products, we use public relations, third-party product reviews, trade shows and direct advertising to generate customer awareness. Direct sales calls are made to potential distributors and specialty resellers. Once a customer relationship is established, we support these customers with co-op advertising, sales “spiffs,” end-user rebates and other promotions.

          Current distribution channels for our branded products consist of distributors such as Ingram Micro, catalogs and specialty resellers targeting corporate accounts. We market to these channels with direct sales through our employees. In Europe we use distributors and specialty resellers. We use these distribution channels not only to increase branded product sales but also to establish customer demand for new products that generate OEM sales.

          We anticipate using our relationships with our existing business communication OEM customers to facilitate the introduction of our products in the home entertainment market. We also are forming relationships with software and graphic display microcontroller developers to enhance that market’s acceptance of our products and technologies. We anticipate using similar sales and marketing techniques as those described above once we become established in this market.

          For e-transactions sales, we use public relations activity, direct advertising and trade show participation to generate product awareness. Promising sales leads and known industry targets are followed up with sales visits. To a lesser extent, we leverage the sales and marketing resources of our software partners.

Manufacturing

          We manufacture all FSR sensors at our facility in Camarillo, California. This facility is capable of operating on a single, double, or triple shift basis, as volume dictates. We acquire raw materials and components from a number of sources, mostly within the United States. We have worked closely with a small group of manufacturers to create new materials optimized for FSR usage; most of which are supplied to us on an exclusive basis. The raw materials are processed into their final form using proprietary material and methods. We contract with several manufacturers in China to conduct most of our high volume, non-FSR manufacturing operations.

          In late 2001, we formed Interlink Electronics Asia Pacific (IEAP), to coordinate our non-US manufacturing activities.  Based in Hong Kong, this wholly owned subsidiary purchases components, assembles them into kits and distributes the kits to various contract manufacturers for assembly.  IEAP began shipping its first products in February 2002. 

Competition

          We face competition from larger, more established companies that can produce lower cost products using more mature technologies. Many of these companies have greater financial, engineering

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and manufacturing resources than we do and have long-standing customer relationships with key potential customers. While we believe our technologies are superior, these competitors may develop or acquire enhanced technologies sufficient to maintain or improve their market share. Moreover, competitive pricing pressures on our OEM customers’ products may force them to choose lower cost, less sophisticated solutions from our competitors.

          In the business communications market, our competitors include Hoshiden Corporation and SMK Corporation. In the home entertainment and e-transactions markets, we face competition from Koninklijke Philips Electronics N.V., Wacom Technology Co. and other smaller companies.

          We believe we can continue to compete effectively by continuing to develop patented technologies that increase the functionality of the products of our OEM customers. To maintain our patented technology advantage, we will continue to invest heavily in product and advanced technology development. By manufacturing most of our non-FSR components in countries with lower labor costs, we can continue to offer high volume, low cost solutions.

Research and Development

          The business communications, home entertainment and e-transactions markets are characterized by rapid and continuous technological development of the systems with which our products interface. For example, in the business communications market, the computerized projector has rapidly become a powerful, lightweight machine that is easily portable by its user. To maintain our competitive position, we believe we must develop, in a timely manner, new interface technologies and products and enhance our existing technologies and products. Accordingly, we allocate a significant amount of our financial resources to engineering, product and advanced technology development. We also maintain close relationships with our customers, which helps us anticipate their product needs.

          We employ 33 people in our product design, engineering support and advanced technology departments in the US and in Japan. As appropriate, we engage outside software development firms to facilitate the integration of our products into our customers’ products.

          Most of our current research and development efforts are focused on further development of our intellectual property surrounding pad-centric input devices and technologies and the wireless communication protocols. Ongoing efforts are directed at enhancing the ergonomics of our interface designs, such as touchpad input and our ClickTrigger control.

Patents and Intellectual Property

          We regularly file patent applications and continuations to cover both new and improved methods of manufacturing FSR sensors and non-FSR based technologies.

          Aspects of our technology are protected by more than 65 patents issued or pending in the United States and abroad, as well as by trade secrets and proprietary knowledge. Products incorporating our force sensing technologies are sold under trademarks issued or pending in the United States and various other countries.  U.S. patents covering various materials and processes used in our current generation of products, as well as new devices for angle and displacement sensing, were granted during 1995 and our ClickTrigger design was afforded patent protection in 1997. We have also received U.S. patents and continue to prosecute filed U.S. and foreign patent applications regarding the design, and

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several key operating features, of our RemoteLink technology.

          The first of the our patents for FSR, which cover certain aspects of the use of an uneven surface to produce variable resistance, expired on September 24, 1999. We have continued our efforts to improve the design, formulation, and manufacture of our sensors. Some of these improvements are maintained as trade secrets, while U.S. and foreign patents have been applied for with respect to others. The other U.S. and foreign patents we hold at this time, covering various apparatus, processes and methods related to force sensing technology, began expiring last year and the remainder will expire between now and 2015.

          We have also developed certain manufacturing processes and other methods of applying our patented technology that we protect as trade secrets. We believe these trade secrets are important for the effective and efficient use of the patented technology and that a competitor with a right to use the patented technology would be required to develop comparable manufacturing and other processes to compete effectively. We require our employees to sign nondisclosure agreements and seek to limit access to sensitive information to the greatest practical extent.

          We actively enforce our patents. When a potential infringing company is identified, we first seek to notify the company of our patent rights. Historically, we have been successful in negotiating license arrangements. If an agreement cannot be reached, we will pursue legal remedies.

          While we believe our patents afford some competitive advantage, such protection is limited by the resources available to us to identify potential infringements and to defend our rights against infringement. The extent of the protection offered by any patent is subject to determinations as to its scope and validity that would be made only in litigation. We cannot be sure that our patents will afford meaningful protection from competition.

Employees

          We had 108 full-time employees in the United States as of December 31, 2002; 100 at our corporate offices and manufacturing facilities in California, and eight at our regional sales offices. Our Japanese subsidiary had 30 employees and 12 employees were located in Hong Kong at our Chinese subsidiary on that date.

Available Information

          We file annual reports, quarterly reports, proxy statements and other information with the Securities and Exchange Commission (SEC). You may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains our reports, proxy statements, and other information.  The SEC’s Internet address is http://www.sec.gov.

          We also make available free of charge through our Internet website the Company’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8K and, if applicable, amendments to those reports as soon as reasonably practical after we file such materials with the SEC (http://www.interlinkelectronics.com).

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          Our corporate offices and principal manufacturing facilities are located in a 35,333 square foot leased facility in Camarillo, California. The lease on the Camarillo premises runs until August 2003 (which we intend to renew) and provides for an average monthly rent payment of $20,681. We believe that a facility of this size will be adequate to meet our requirements for at least the next 12 months. Our two regional sales offices operate out of leased facilities. Our Japanese subsidiary, Interlink Electronics, K.K., leases office space in Tokyo.  Our Hong Kong subsidiary leases office and warehouse space in Hong Kong and mainland China.

          We are not engaged in any litigation that we expect will have a material adverse effect on our business, financial condition or results of operation. From time to time, we are involved in various legal actions which arise in the ordinary course of business. We do not believe that losses incurred, if any, will have a significant impact on the Company’s financial position or results of operations.

          There were no matters submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the year ended December 31, 2002.

          The following table contains information as of March 9, 2003 with respect to each person who is an executive officer of Interlink:

          E. Michael Thoben, III has served as Interlink’s president, chief executive officer and chairman of the board of directors since 1994. From 1990 to 1994, he served as Interlink’s president and a director. Prior to joining Interlink in 1990, Mr. Thoben was employed by Polaroid Corporation for 11 years, as the manager of one of Polaroid’s seven strategic business units on a worldwide basis. Mr. Thoben holds a B.S. degree from St. Xavier University and has taken graduate management courses at the Harvard Business School and The Wharton School of Business.

          Paul D. Meyer has served as Interlink’s chief financial officer since December 1996. From 1994 to 1996, he served as vice president—finance, and from 1989 to 1994 he served as controller. From May 1988 to December 1989, Mr. Meyer served as controller for Dix-See Sales Company. From September 1985 to May 1988, he served as corporate accounting manager for Bell Industries. Mr. Meyer was employed at Price Waterhouse from 1983 to 1985. Mr. Meyer is a Certified Public Accountant and

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holds a B.A. degree in economics from the University of California, Los Angeles.

          Tamio Mori has served as the president and general manager of Interlink Electronics K.K., Interlink’s 80% owned Japanese subsidiary, since 1993. Prior to Interlink, Mr. Mori served in increasingly senior positions for 22 years with Mitsubishi Petrochemical Corporation, most recently as Assistant General Manager of New Business Development.  He has a M.S. in Chemical Engineering and a B.S. in Organic Chemistry from Waseda University.

          Michael W. Ambrose has served as Interlink’s vice president—engineering since June 1999. Between March 1998 and June 1999, he was director of engineering. From August 1995 to February 1998, he served as the director of marketing of Communication Intelligence Corp., a computer software company specializing in software for mobile computing, e-signatures and computer security. Prior to August 1995, he was employed by Logitech Inc., a computer peripherals company, as the general manager of its Gazelle Business Unit and as vice president of product marketing for Gazelle Graphic Systems. Mr. Ambrose holds a B.S. degree in electrical engineering from Washington State University.

PART II

          Our common stock trades on the Nasdaq National Market under the symbol “LINK.” The following table sets forth the high and low closing prices for the common stock as reported on the Nasdaq National Market for the quarters indicated. These prices do not include retail markups, markdowns or commissions. The prices reflect a three-for-two stock split effected as a stock dividend on shares of our common stock outstanding on March 20, 2000.

          On March 20, 2003, the closing price of the common stock on the Nasdaq National Market was $2.65. As of March 20, 2003 there were approximately 1,500 shareholders of record of our common stock. We believe the number of beneficial owners is substantially greater than the number of record holders because a large portion of Interlink’s outstanding common stock is held of record in broker “street names” for the benefit of individual investors. As of March 20, 2003 there were 9,778,593 shares outstanding.

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          We have never declared or paid cash dividends on our common stock. Payment of any cash dividends will depend on the results of our operations, our financial condition and our capital expenditure plans, as well as other factors our board of directors may consider relevant. We presently intend to retain any earnings for use in our business and, therefore, do not anticipate paying any cash dividends in the foreseeable future.

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          The selected financial data presented below was derived from the consolidated financial statements of the Company and should be read in conjunction with the financial statements, the notes thereto and the other financial information included therein.

⁽¹⁾ As adjusted for the three-for-two stock split effected as a stock dividend to stockholders of record on March 20, 2000.

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Critical Accounting Policies

Material accounting policies that we believe are the most critical to an investor’s understanding of our financial results and condition and require complex management judgment are discussed below.

Revenue Recognition.  We recognize revenue in accordance with SEC Staff Accounting Bulletin (SAB) No. 101, “Revenue Recognition in Financial Statements”, as amended by SAB No. 101A and No. 101B.  SAB No. 101 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and determinable; and (4) collectibility is reasonably assured.  Determination of criteria (3) and (4) require management’s judgments regarding the fixed nature of the fee charged for services rendered and products delivered and the collectibility of those fees. To satisfy the criteria, we: (1) input orders based upon receipt of a customer purchase order; (2) record revenue upon shipment of goods or otherwise complying with the terms of the purchase order; (3) confirm pricing through the customer purchase order; and (4) validate creditworthiness through past payment history, credit agency reports and other financial data. Other than through warranty rights, our customers do not have explicit or implicit rights of return.  Should changes in conditions cause management to determine the revenue recognition criteria are not met for certain future transactions, such as a determination that an outstanding account receivable has become uncollectible, revenue recognized for any reporting period could be adversely affected.

Accounts Receivable and Allowance for Doubtful Accounts.  Our accounts receivable are unsecured, and we are at risk to the extent such amounts become uncollectible. We continually monitor individual account receivable balances, and provide for an allowance of doubtful accounts at the time collection may become questionable based on payment performance or age of the receivable and other factors related to the customer’s ability to pay.

Inventory Reserve.  At each balance sheet date, we evaluate our ending inventories for excess quantities and obsolescence.  This evaluation includes analyses of forecast sales levels by product and historical demand.  We write off inventories that are considered obsolete.  Remaining inventory balances are adjusted to approximate the lower of our cost or market value and result in a new cost basis in such inventory until sold.  If future demand or market conditions are less favorable than our projections, additional inventory write-down may be required, and would be reflected in cost of sales in the period the revision is made.

Provision for Income Tax.  We first achieved profitable operations in 1995.  Because of net operating loss  (NOL) carryforwards available both for our U.S.-based and Japan-based operations, we did not accrue income tax expense until 1999.  In that year, due to the expiration or full utilization of NOL carryforwards in California and Japan, we began to record a provision for income tax expense in those jurisdictions. By the end of 2000, we also began to accrue an income tax benefit related to our federal NOL carryforwards to be used in future periods. However, in mid-2001, we began to record quarterly tax losses and suspended any further recognition of NOL carryforward tax benefits. In fourth quarter, 2002, we recorded a valuation allowance against the deferred tax asset balance as it appears more likely than not that we would be unable to realize it in future periods.

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Foreign Exchange Exposure.  We have established relationships with most of the major OEMs in the business communications market. Many of these OEMs are based in Japan and approximately 40% and 30% of our 2001 and 2002 revenues, respectively, came from Japanese customers. Revenues from these customers are denominated in Japanese yen and as a result we are subject to foreign currency exchange rate fluctuations in the yen/dollar exchange rate. We use foreign currency forward contracts to hedge this exposure. The gain or loss from these contracts is recorded in business communications revenue. In addition, because our Japanese subsidiary’s functional currency is the yen, the translation of the net assets of that subsidiary into the consolidated results will fluctuate with the yen/dollar exchange rate. The following table illustrates the impact of foreign currency fluctuations on our yen-denominated revenues and the effectiveness of our foreign currency hedging activity (in thousands):

Historical Factors Affecting Financial Performance

          We were incorporated in California in February 1985 and reincorporated in Delaware in July 1996. Our stock was first listed on the Nasdaq National Market in June, 1993.

          From the inception of the Company, we developed and refined our Force Sensing Resistor, or FSR, technology and sold it to customers for electronic, musical, medical, industrial and other applications, which we now refer to as the specialty components market. This business segment is characterized by customers who have long design cycles and, once a technology is designed, retain that technology for a relatively long period of time. We expect this segment to experience only limited growth  due to the limited resources we can allocate to it.

          In 1992, we introduced our first Interlink-branded computer-pointing device, PortaPoint, and in 1994, we introduced our first wireless pointing device.  The device, called RemotePoint, established Interlink as a leading supplier of branded and OEM remote controls and other products for the computerized presentation system market. This business segment has been a greatest growth driver over the last five years and, in 2002, constituted 64% of our overall sales. Within the OEM element of this segment, we have key customers both in the US and in Japan and thus we have been affected by the performance of each of these economies. Despite our dominant OEM market share, no one customer constitutes 10% or more of our consolidated 2002 sales. Beginning in 2001, we began a renewed effort to expand our branded products product line and our branded products distribution channel.

          In 1999, we introduced the electronic signature capture product, ePad, for our e-transactions market. Since then, we introduced ePad-Point of Sale and ePad-Ink. To date, much of the success in this segment has occurred with large corporate accounts in financial services, insurance and medical industries. Typically these accounts buy 3,000 to 5,000 units and purchase them all at the initial deployment; consequently revenues in this segment have been relatively variable from quarter to quarter.

          In 2000, we first demonstrated IntuiTouch technology for the home entertainment market.  Due to the general economic decline, the home entertainment market suffered a downturn beginning in 2001. In

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mid-2001, we scaled back our efforts related to interactive television. In 2001 and 2002, the Microsoft Xbox program constituted a high percentage of our home entertainment revenues.         

          Prior to 1999, operations was a net user of cash that we funded through existing cash balances, private placements of equity and to a lesser extent, bank and lease financing. In 1999, operations was a net provider of cash, generating $2.9 million. In 2000, 2001 and 2002, operations was essentially cash flow break-even to marginally positive.

          In response to the economic slowdown in mid-2001, we restructured our operations and increased our inventory and bad debt reserves by $2 million and $300,000 respectively.  In 2002, we wrote-off $2.3 million in obsolete and excess inventories related to our Japanese subsidiary.

          We licensed certain technology related to the production of FSR sensors to International Electronics and Engineering (IEE), a former affiliate based in Luxembourg, for use in connection with sales of sensors to the automotive industry. We received significant payments under this license agreement commencing in 2000 ($2.5 million) and continuing through the third quarter of 2001 ($1.5 million).  No further payments are due under this agreement. We have occasionally licensed other aspects of our technology in connection with the settlement of intellectual property disputes and expect to continue to do so in the future.  However, there are no current contingencies under which we would earn significant licensing revenue. 

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Fiscal Year Ended December 31, 2002 Compared with Fiscal Year Ended December 31, 2001

Business Segment Overview – Fiscal 2002 Compared to Fiscal 2001

          Fiscal 2002 and 2001 revenue and gross profit by market segment are shown in the following table:

Business Communications

          Our principal source of revenue continues to be our business communications market.  Sales in this segment recorded a net decline of 2% in fiscal 2002 as compared to fiscal 2001. However, the quarterly sales decline due to overall economic conditions that began in first quarter 2001, reversed direction in first quarter 2002 and recorded a sequential quarterly improvement throughout 2002. This improvement was led by increased revenue in our U.S.-based OEM business, which increased 43% over 2001 due the addition of new customers.  Our Japan-based OEM business declined 28% compared to 2001 due to lower unit sales with existing customers.  Our OEM business comprised 65% of total business communications revenues in 2002 as compared to 74% 2001. Our branded business also improved 37% over 2001 with the expansion of our branded product line and increased number of distribution and reseller customers.

          Fiscal 2002 gross profit margins for the business communications segment declined as compared to fiscal 2001 due to the $2.3 million write-off of obsolete inventories in fourth quarter 2002 related to

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our Japanese subsidiary partially offset by the improving product mix of branded products.

Home Entertainment

          Revenues in the home entertainment segment for fiscal 2002 increased by 26% over fiscal 2001 due to the success of the Microsoft Xbox program. The Xbox program accounted for 92% and 75% of total home entertainment revenues in 2002 and 2001, respectively.

          Home entertainment gross profit margin percentage declined in 2002 as compared to 2001 due to the shift of the product mix to higher volume-lower profit margin programs (e.g. the Xbox program) and away from lower volume-higher profit margin programs.

E-Transactions

          E-transactions segment revenues increased 80% in 2002 as compared to 2001 due to an increase in the number of larger volume customers and a slight improvement in the general economic climate for corporate capital expenditures for information technology products.  Also, in late 2002, we introduced an addition to the ePad product line, ePad-Ink.

          Gross profit margins for e-transactions for 2002 remained consistent with 2001.

Specialty Components

          Specialty components revenues declined in 2002 as compared to 2001 due to the termination in third quarter 2001 of the licensing agreement with IEE. 2001 revenues associated with the IEE program totaled $1.5 million. No further payments are due under this agreement.

          Gross profit margins as a percentage of sales for the specialty components segment improved in 2002 over 2001 due to the allocation to this segment of a portion of the $2 million write-off of obsolete inventory recorded in second quarter, 2001.                   

Results of Operations – Fiscal 2002 Compared to Fiscal 2001

          The following table presents our historical operating results for the periods indicated as a percentage of revenues:

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          Consolidated revenues decreased 1% from $25.3 million in 2001 to $25.0 million in 2002 due to the reasons described in the business segment analysis above.

          Gross profit as a percentage of sales declined to 32% in 2002 from 35% in 2001 due to the reasons described in the business segment analysis above.

          Product development and research expense decreased 5% from $3.5 million in 2001 to $3.3 million, in 2002. This decrease is a result of a 20% reduction in the usage of outside development firms and a 5% lower headcount as part of the cost reduction plan initiated in mid-2001.

          Selling, general and administrative expense decreased 10% from $8.3 million in 2001 to $7.5 million in 2002. This decrease is a result of the cost reduction programs initiated in mid-2001 and maintained throughout 2002. The key factors of the cost reduction plan were a 5% reduction in personnel across all departments, a hiring and salary freeze and a reduction in outside marketing costs.

          Other income in 2001 reversed to a net expense in 2002 due to the lower interest rates achievable on cash investments. In 2001, we recorded an additional deferred tax asset of $701,000 related to our federal net operating loss carryforwards.  Due to a lack of quarterly profitability, we suspended further additions to the deferred tax asset in the fourth quarter of 2001 and in the fourth quarter of 2002 we recorded a valuation allowance against the remaining balance ($1.3 million) by recording a tax expense.

          Net loss increased from a loss of $2.0 million in 2001 to a loss of $4.3 in 2002 due to the reasons above.

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Fiscal Year Ended December 31, 2001 Compared with Fiscal Year Ended December 31, 2000

Business Segment Overview – Fiscal 2001 Compared to Fiscal 2000

          Fiscal 2001 and 2000 revenue and gross profit by market segment are shown in the following table:

Business Communications

          Sales in the business communications segment recorded a decline of 21% in fiscal 2001 as compared to fiscal 2000. The decline is due to the general overall decline in worldwide economies, but specifically as it impacts corporate spending on technology in the US as well as in Japan.

          Fiscal 2001 gross profit margins for the business communications segment showed a net improvement as compared to fiscal 2000 due to the improving product mix of branded products partially offset by the impact of the $2.0 million inventory reserve adjustment recorded in the second quarter of 2001.

Home Entertainment

          Revenues in the home entertainment segment for fiscal 2001 decreased by 31% over fiscal 2000 due to the slowdown in the interactive television market.

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          Home entertainment gross profit margin percentage for 2001 remained consistent with 2000.

E-Transactions

          E-transactions segment revenues increased 8% in 2001 as compared to 2000 due to sales success with a greater number of larger accounts as compared to 2000.

          Gross profit margins for e-transactions for 2001 remained consistent with 2000.

Specialty Components

          Specialty components revenues declined 36% in 2001 as compared to 2000 due to lower licensing revenues for the IEE royalty agreement  ($1.5 million in 2001 as compared to $2.5 million in 2000) coupled with lower sales of notebook computer touchpads.

          Gross profit margins for the specialty components segment declined in 2001 as compared to 2000 due to the allocation to this segment of a portion of the $2 million write-off of obsolete inventory recorded in the second quarter of 2001.

Results of Operations – Fiscal 2001 Compared to Fiscal 2000

          The following table presents our historical operating results for the periods indicated as a percentage of revenues:

          Consolidated revenues decreased 25% from $33.9 million in 2000 to $25.3 million in 2001 due to the reasons described above.

          Gross profit as a percentage of sales declined to 35% in 2001 from 42% in 2000 due to the reasons described above.

          Product development and research expense increased 9% from $3.2 million in 2000 to

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$3.5 million in 2001. This increase is a result of our product development investment in both the home entertainment and e-transaction segments.

          Selling, general and administrative (SG&A) expense increased 9% from $7.6 million in 2000 to $8.3 million in 2001. The higher dollar amount in 2001 reflects a full year expense for employees hired in 2000 for the e-transactions and home entertainment segments, coupled with the $300,000 increase to bad debt reserves in the third quarter of 2001.

          The downturn in sales coupled with the inventory and bad debt adjustments yielded a 2001 operating loss of $3.0 million as compared to an operating income of $3.6 million in 2000.

          In 2001, we recorded an additional deferred tax asset of $701,000 related to our federal net operating loss carryforwards.  Due to a lack of quarterly profitability, we suspended further additions to the deferred tax asset in the fourth quarter of 2001.

          Net income decreased from $3.1 million in 2000 to a net loss of $2.0 million in 2001, primarily for the reasons described above.

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Quarterly Results of Operations

          The following table presents unaudited consolidated statement of operations data for each of the eight quarters ended December 31, 2002, as well as such data expressed as a percentage of revenue. We believe that all necessary adjustments have been included to fairly present the quarterly information when read in conjunction with the consolidated financial statements. The operating results for any quarter are not necessarily indicative of the results for any subsequent quarter.