INTERLINK ELECTRONICS INC - Quarter Report: 2007 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2007

or

For the transition period from                  to                 

Commission File No. 0-21858

INTERLINK ELECTRONICS, INC.

(Exact name of registrant as specified in its charter)

(805) 484-8855

(Registrant’s telephone number, including area code)

Not applicable.

(Former name, former address and former fiscal year if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days.     Yes   x     No   ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer   ¨             Accelerated filer   ¨             Non-accelerated filer   x

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

Shares of Common Stock Outstanding, at November 9, 2007: 13,749,310

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INTERLINK ELECTRONICS, INC.

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PART I – FINANCIAL INFORMATION

INTERLINK ELECTRONICS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(IN THOUSANDS, EXCEPT PAR VALUE)

The accompanying notes are an integral part of these consolidated financial statements.

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INTERLINK ELECTRONICS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

(IN THOUSANDS, EXCEPT PER SHARE DATA)

The accompanying notes are an integral part of these consolidated financial statements.

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INTERLINK ELECTRONICS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(IN THOUSANDS)

The accompanying notes are an integral part of these consolidated financial statements.

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INTERLINK ELECTRONICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

FOR THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006 AND AS OF SEPTEMBER 30, 2007

AND DECEMBER 31, 2006 (UNAUDITED)

The financial information as of September 30, 2007, and for the three and nine month periods ended September 30, 2007 and 2006 in the accompanying Condensed Consolidated Financial Statements is unaudited. Such information does, however, reflect all adjustments (consisting only of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of results for the interim periods. These Condensed Consolidated Financial Statements should be read in conjunction with the audited financial statements and related notes for the fiscal year ended December 31, 2006, which are included in Amendment No. 1 to our Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 30, 2007.

The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for the full year.

On August 31, 2007, we completed the sale of our OEM Remotes and Branded Products business segments for an aggregate cash purchase price of $11,500,000, subject to certain post-closing price adjustments. In connection with the sale of these business segments, we paid cash fees to an investment bank of $760,000. Please see Note 3 for additional information regarding this sale. As a result of the sale, the financial information included in the accompanying Condensed Consolidated Financial Statements is presented in accordance with Statement of Financial Accounting Standards 144 – Accounting for Impairment or Disposal of Long-Lived Assets (“SFAS 144”), which requires us to present the sale of these assets on a discontinued operations basis. The balance sheet at December 31, 2006 has been adjusted to reflect the assets and liabilities of the OEM Remotes and Branded Products segments as held for sale. Additionally, the statements of operations and cash flows have been adjusted to reflect the results of these segments as discontinued operations for the periods presented.

The accompanying Condensed Consolidated Financial Statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The raising of $5 million through a private placement of convertible notes and warrants with existing institutional shareholders on July 19, 2007, which is described more fully in Note 7, below and the sale of certain assets on August 31, 2007 for $11.5 million, which is described in the previous paragraph, will allow the Company to operate with existing funds for the foreseeable future. As of September 30, 2007, the Company had cash, cash equivalents, and short-term investments of approximately $14.9 million, which included $1.4 million of restricted cash, portions of which must be held in escrow pursuant to the terms of the asset sale. On November 8, the Company restated and amended its line of credit to allow for borrowings up to $5 million based on eligible accounts receivable and certain other covenants. The Company had no borrowings on the line of credit as of September 30, 2007 and total indebtedness for money borrowed of $5,078,000.

Revenue Recognition. The Company recognizes revenue in accordance with SEC Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition.” SAB No. 104 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) a fee that is fixed and determinable; and (4) collectibility that is reasonably assured. Determination of criteria (3) and (4) require management’s judgment regarding the fixed nature of the fee charged for services rendered and products delivered and the collectibility of those fees. To satisfy these criteria, the Company: (1) inputs orders based upon receipt of a customer purchase order; (2) records revenue upon shipment of goods and when risk of loss and title transfer; (3) confirms pricing through the customer purchase order; and (4) validates creditworthiness through past payment history, credit agency reports and other financial data. All customers have warranty rights and some customers also have explicit or implicit rights of return. The Company complies with Statement of Financial Accounting Standards No. 48 with respect to sell-through and returns and the related recording of reserves for potential customer returns. Should changes in conditions cause management to determine the revenue recognition criteria are not met for certain future transactions, such as a determination that collectibility was not reasonably assured, revenue could be adversely affected.

Accounts Receivable and Allowance for Doubtful Accounts. The Company’s accounts receivable are unsecured and are at risk to the extent such amounts become uncollectible. The Company continually monitors individual account receivable balances, and provides 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. The Company generally offers 30-day payment terms, however, some distributors in the divested Branded Products business segment and some of our Japanese OEM customers require as long as 120-day payment terms.

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Reserve for Estimated Product Returns. While not an explicit part of the Company’s terms and conditions of product sales, the Company does, on a discretionary basis, grant product exchanges for its distribution and reseller customers in its divested Branded Products business segment for similar products of equal value if these exchanges meet certain other criteria. The Company estimates future product returns based on recent return history, inventory status and product “sell-through” statistics received from its major distributors, discussions regarding product sales activity with its major reseller customers, and current industry product and technology trends. Management judgment is required in evaluating the relative significance of the aforementioned data and in the determination of the estimated value of the returns reserve. If actual returns are greater than management’s estimate, revenues in the subsequent period will be adversely affected.

Inventories. Inventories are stated at the lower of cost or market and include material, labor, and factory overhead. Cost is determined using the first in – first out cost method.

Inventory Reserve. At each balance sheet date the Company evaluates ending inventories for excess quantities and obsolescence. This evaluation includes analyses of forecasted sales levels by product and historical demand. The Company writes off inventories that are considered obsolete. Remaining inventory balances are adjusted to approximate the lower of 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 internal 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. As part of the process of preparing financial statements, as required by Statement of Financial Accounting Standards (“SFAS”) No. 109 “Accounting For Income Taxes”, the Company is required to estimate income taxes in each of the jurisdictions in which it operates. This process involves estimating actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in the accompanying consolidated balance sheet. The Company must then assess the likelihood that deferred tax assets will be recovered from future taxable income and to the extent it believes that recovery is not likely, must establish a valuation reserve. To the extent we establish a reserve or increase this reserve in a period, the Company must include an expense within the tax provision in the statements of operations.

Significant management judgment is required in determining the Company’s provision for income taxes, deferred tax asset and liabilities and any valuation reserve recorded against net deferred tax assets. Management continually evaluates its deferred tax asset as to whether it is likely that the deferred tax asset will be realized.

When tax returns are filed, it is highly likely that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination.

Interest and penalties associated with unrecognized tax benefits are classified as interest and other expense in the statement of income.

Foreign Exchange Exposure. The Company has established relationships with most of the major OEMs in the divested OEM Remotes market, and, to a lesser extent, in its retained Specialty Components business segment. Many of these OEMs are based in Japan and approximately 19%, 20% and 28% of the Company’s revenues for the years ended December 31, 2006, 2005 and 2004, respectively, came from Japanese customers. The Company expects its exposure to Asian currencies to continue to represent approximately 25% of its revenues after the divestiture of the OEM Remotes and Branded Products business segments. Revenues from these customers are denominated in Japanese yen and as a result the Company is subject to foreign currency exchange rate fluctuations in the yen/dollar exchange rate. From time to time, the Company uses foreign currency forward and average rate option contracts to hedge this exposure. The Company uses revenue forecasts from its Japanese subsidiary to determine the amount of forward or option contracts to purchase and the Company attempts to enter into these contracts when it believes the yen value is relatively strong against the U.S. dollar. To

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the extent that the Company’s revenue forecast may be inaccurate or the timing of forecasting the yen’s strength is wrong, the Company’s actual hedge gains or losses may not necessarily correlate with the effect of foreign currency rate fluctuations on its revenues. The Company marks these contracts to market value and the gain or loss from these contracts is recorded in revenue of the related business segment. These hedge transactions are classified as economic hedges and do not qualify for hedge accounting under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”). In addition, because the Company’s 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. During the three and nine month periods ended September 30, 2007 and 2006, the Company did not use foreign currency forward or average rate option contracts to hedge this exposure.

Valuation of Derivative Instruments. SFAS 133 requires bifurcation of embedded derivative instruments and measurement of fair value for accounting purposes. Derivative liabilities are adjusted to reflect fair value at each period end, with any increase or decrease in the fair value being recorded in results of operations as Adjustments to Fair Value of Derivatives. The effects of interactions between embedded derivatives are calculated and accounted for in arriving at the overall fair value of the financial instruments. In addition, the fair values of freestanding derivative instruments such as warrant derivatives are valued using Lattice models.

Stock-based Compensation. On January 1, 2006, the Company adopted SFAS 123(R), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. SFAS 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006. The Company’s financial statements as of and for the quarter and nine months ended September 30, 2007 and 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, the Company’s financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Stock-based compensation expense recognized under SFAS 123(R) for employees and directors for the quarters ended September 30, 2007 and 2006 were $797,000 and $1,062,000 respectively. Stock-based compensation expense recognized under SFAS 123(R) for employees and directors for the nine months ended September 30, 2007 and 2006 were $2,567,000 and $3,209,000 respectively. The effect on basic and diluted earnings per share for the quarters ended September 30, 2007 and 2006 were $(0.06) and $(0.08) per share, respectively. The effect on basic and diluted earnings per share for the nine months ended September 30, 2007 and 2006 were $(0.19) and $(0.23) per share, respectively. As of September 30, 2007, the Company has $2,077,000 of unrecognized stock based compensation cost related to non-vested stock options. This cost is expected to be recognized over a weighted average period of 2.75 years.

During the quarter and nine months ended September 30, 2007, the Company granted options to acquire 45,000 and 942,375 shares, respectively of its Common Stock at an average exercise price of $1.65 and $2.41 per share, respectively. The estimated fair value of all awards granted during the quarter and nine months ended September 30, 2007 was $52,000 and $1,324,000, respectively of which $434,000 was recorded as of September 30, 2007. There were no stock options exercised during the three and nine months ended September 30, 2007. SFAS 123(R) requires companies to estimate the fair value of share-based payment awards to employees and directors on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s Statement of Operations. Stock-based compensation expense recognized in the Statement of Operations for the quarter and nine months ended September 30, 2007 and 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of January 1, 2006 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123 and included compensation expense for the share-based payment awards granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). For stock-based awards issued to employees and directors, stock-based compensation is attributed to expense using the straight-line single option method, which is consistent with how the prior period pro forma information was provided. As stock-based compensation expense recognized in the Statement of Operations for the quarter ended September 30, 2007 is based on awards that vest, SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. For the quarter and nine months ended September 30, 2007, forfeitures for employees were calculated to be 12.34% while forfeitures for executives were estimated to be 3%, with the total forfeitures for the quarter ended September 30, 2007 totaling $81,000 and $195,000 for the three and nine months ended September 30, 2007, respectively.

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For the three months ended September 30, 2007, the Company has recorded the following charges within the Condensed Consolidated Statement of Operations for stock based compensation: $133,000 in cost of sales, $172,000 in product development and research expenses, and $492,000 in selling, general and administrative expenses. For the nine months ended September 30, 2007, the Company has recorded the following charges within the Condensed Consolidated Statement of Operations for stock based compensation: $444,000 in cost of sales, $553,000 in product development and research expenses, and $1,569,000 in selling, general and administrative expenses.

The Company’s determination of fair value of share-based payment awards to employees and directors on the date of grant uses the Black-Scholes model, which is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables. These variables include, but are not limited to, the expected stock price volatility over the expected term of the awards, and actual and projected employee stock option exercise behaviors. The Company estimates expected volatility using historical data. The expected term is estimated using the “safe harbor” provisions under SAB 107.

The weighted average fair value at the date of grant for stock options granted during the nine months ended September 30, 2006 and September 30, 2007 was $2.35 and $1.51 per option, respectively. The fair value of options at the date of grant was estimated using the Black-Scholes model with the following weighted average assumptions:

A summary of the Company’s non-vested shares as of September 30, 2007 and changes during the nine months ended September 30, 2007 is presented below:

The Company has adopted the simplified method provided in SFAS 123(R) to use for calculating the beginning balance of the additional paid in capital pool (“APIC pool”) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC pool and Statement of Cash Flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123R. The Company has not recognized excess tax benefits related to employee stock based compensation and, therefore, does not currently have an APIC pool.

As part of an overall strategy to focus our efforts on higher margin emerging markets, we sold (the “Sale”) our OEM Remotes and Branded Products business segments in August of 2007. The Company believes that Sale will provide the Company with the capital necessary to advance its strategic business initiatives and to allow the Company to focus on the two business segments it feels have the greatest potential for long-term profitable growth: E-transactions and Specialty Components. The Sale was an asset sale, and included the inventory, accounts receivable, fixed assets, intangibles, accounts payable, related intellectual property rights and other assets that constituted the operations of the divested units.

The Company’s Condensed Consolidated Financial Statements have been reclassified for all periods presented to reflect the OEM Remotes and Branded Products segments as discontinued operations in accordance with SFAS 144. Accordingly, the revenues, costs and expenses directly associated with the OEM Remotes and Branded Products segments have been reclassified as discontinued operations on the Condensed Consolidated Statements of Operations for all periods presented. Additionally, assets and liabilities of the OEM Remotes and Branded Products segments have been reclassified as held for sale on the Company’s Condensed Consolidated Balance Sheets for all periods presented, and the Company’s Condensed Consolidated Statements of Cash Flows have been reclassified to reflect the OEM Remotes and Branded Products segments as discontinued operations for all periods presented. Corporate expenses such as general corporate overhead and interest have not been allocated to discontinued operations.

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Income (loss) from discontinued operations, net of tax is summarized as follows (in thousands):

The gain, net of tax on the sale of the OEM Remotes and Branded Products segments, as reflected in the accompanying Condensed Consolidated Statements of Operations, is summarized as follows (in thousands):

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Amounts on the Condensed Consolidated Balance Sheets as of September 30, 2007 and December 31, 2006 attributable to the discontinued operations are as follows (in thousands):

As part of the Sale, the Company entered into an Escrow Agreement that required $1.4 million of the purchase price to be put into an escrow account to provide for, among other things, a source of recovery for any amounts owing to the purchaser from the Company pursuant to certain indemnification provisions and post-closing adjustment provisions of the Asset Purchase Agreement. The Escrow Agreement states that 70% and 30% of the $1.4 million, net of any disputed amounts, if any, will be released 12 months and 18 months from the date of the Sale, respectively.

Net inventories consisted of the following (in thousands):

The change in the reserves for excess and obsolete inventory in primarily the result of inventory that was reserved for as of December 31, 2006 being scrapped during the nine month ended September 30, 2007.

In December 2006, the Company entered into a Loan and Security Agreement (the “Agreement”) with a bank that provides for a line of credit with a maximum borrowing limit of $5 million. The line of credit is secured by the Company’s accounts receivable and other assets. Under the one-year term of the Agreement, which expires on December 18, 2007, the Company has the ability to draw cash borrowings against the line up to 80% of its eligible accounts receivable as defined in the Agreement. Payments against this line of credit are due upon demand if certain conditions in the Agreement are not met. On July 18, 2007, the line of credit was amended a second time (the “July Amendment”). The July Amendment amended certain definitions in the line of credit that governs the $5 million borrowing limit to allow for the sale of the convertible notes and warrants described below in Note 7. The July 2007 Amendment also reduced the Company’s borrowing limits

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under the Agreement as follows: for advances, $0, and for letters of credit, foreign exchange contract reserves and cash management services, $150,000 in the aggregate. On November 8, 2007, the line of credit was amended and restated to allow the Company to draw cash borrowings against the line up to 80% of its eligible accounts receivable through December 18, 2009.

On July 19, 2007, we issued 8% Convertible Notes (each a “Note” and collectively, the “Notes”), in an aggregate principal amount of $5,000,000, and warrants (each a “Warrant” and collectively, the “Warrants”) exercisable for up to 1,984,125 shares of Common Stock in a private placement (the “Financing”) pursuant to an exemption from registration provided by Regulation D under the Securities Act, as amended (the “Securities Act”), and Rule 506 thereunder. The Notes mature on July 19, 2010, and some or all of the outstanding principal balance and unpaid interest may be converted into Common Stock at any time before the maturity date at a conversion price of $1.26 per share (subject to adjustment). Interest on the Notes accrues and is payable semiannually on January 15th or July 15th of each year. The Warrants expire on July 19, 2012, and may be exercised at any time prior to expiration on a cash or cashless basis at an exercise price of $1.51 per share (subject to adjustment). The Company received net proceeds of approximately $4,923,153 from the sale of the Notes, which takes into account estimated legal and other fees of $76,847 incurred in connection with the Financing.

The conversion price under the Notes and the exercise price under the Warrants are subject to adjustment upon the occurrence of certain events including the issuance of stock dividends to existing Common Stock holders, or a stock split. Also, the holders of Notes and Warrants are entitled to receive the economic benefit of any reorganization, consolidation or merger of Interlink which results in a payment in shares, other securities or property to our Common Stock holders.

In connection with the placement of the Notes and Warrants, we entered into a registration rights agreement dated July 19, 2007 with the selling securityholders under which we agreed to register with the Securities and Exchange Commission (the “SEC”) the Common Stock underlying the Notes and Warrants for resale to the public. The registration rights agreement also provides for payment of liquidated damages by the Company if (i) the registration statement covering the shares to be registered pursuant to the registration rights agreement is not filed by August 20, 2007, (ii) after a registration statement is filed with the SEC such registration statement is not declared effective, except under certain conditions, on or prior to October 18, 2007 or (iii) after such registration statement has been declared effective, sales of Common Stock cannot be made pursuant to the registration statement, then in any of these and specified other circumstances enumerated in registration rights agreement, the Company must pay to each holder of the Notes, Warrants or shares of Common Stock required to be registered an amount equal to 1.5% of the aggregate amount invested by each such investor for each 30 day period (or pro rata portion of such 30 day period) of such delinquency. Notwithstanding the foregoing, the registration rights agreement provides that liquidated damages will not accrue (the “Damages Exception”) if the SEC takes the position that the offering of some or all of the shares underlying the Notes and Warrants is not eligible to be made on a delayed or continuous basis pursuant to Rule 415 promulgated under the Securities Act. The registration statement on Form S-1 filed by the Company pursuant to the registration rights agreement has been filed, but has not yet become effective. The Company has received comments from the SEC, including a comment concerning the Company’s eligibility to register the securities on a delayed or continuous basis pursuant to Rule 415. The Company is currently discussing with the investors whether the SEC’s comment with respect to Rule 415 falls within the provisions of the Damages Exception.

The Company evaluated the Warrants under EITF 00-19 and determined that the Warrants qualified for liability treatment and has recorded the warrants as a derivative liability under FAS 133. The initial fair value of the Warrants was $1,145,000 which has been recorded with an offset to discount on the convertible note payable. The Company determined that the conversion feature on the convertible notes qualified for exemption from bifurcation and liability treatment as it is considered a conventional convertible instrument under EITF 00-19. The Company calculated a beneficial conversion feature, resulting in a discount of $479,000 at the time of the transaction.

The original value of the Parisian feature of the derivative liabilities for the Notes and Warrants were $6,000 and 12,000 respectively on July 19, 2007. These amounts are being amortized and charged as interest expense over the three year term of the convertible notes. In addition, the adjustment to fair value of these Parisian features will be made each reporting period. Accordingly, $96,000 and $33,000 of increased fair value for the Notes and Warrants, respectively was recorded as interest charges for the period ended September 30, 2007 and included in the Net fair value of the notes.

The Company amortizes its discounts on the interest method which resulted in an interest expense of $220,000 for the period from July 19, 2007 to September 30, 2007.

The Warrants and embedded derivatives outstanding at September 30, 2007 were again valued at fair value using a Lattice fair value model, resulting in an increase in the fair value of the related liabilities of approximately $622,000 which was recorded through the results of operations as a charge to interest expense in the consolidated statement of operations.

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The following table summarizes the activity of Notes, Warrants and discounts outstanding at September 30, 2007 (unaudited), (in thousands):

Under the terms of the Company’s 1996 Stock Incentive Plan, officers and key employees may be granted non-qualified or incentive stock options and outside directors and independent contractors of the Company may be granted non-qualified stock options. The aggregate number of shares which may be issued under the Plan is 7,250,000. New options are granted at fair market value on the date of grant and generally vest ratably over 36 months and have a ten-year term but terminate earlier if employment is terminated. As of September 30, 2007, options for 6,517,000 shares of stock have been granted (3,615,000 are outstanding and 2,902,000 have been exercised, forfeited or expired) and 733,000 options were available for grant. Activity under the Plan for the first nine months of 2007 is summarized as follows (in thousands, except per share information):

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The vested and exercisable stock options outstanding as of September 30, 2007 have a weighted average remaining contractual life of 70 months and have no intrinsic value. The following table summarizes information about stock options outstanding under the Plan as of September 30, 2007, (in thousands, except contractual life and exercise price per share information):

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For all periods presented, per share information was computed pursuant to provisions of the Statement of Financial Accounting Standards No. 128, “Earnings Per Share,” issued by the Financial Accounting Standards Board (“FASB”). The computation of earnings per share basic is based upon the weighted average number of common shares outstanding during the periods presented. Earnings per share diluted also includes the effect of common shares contingently issuable from options and warrants in periods in which they have a dilutive effect.

Common Stock equivalents are calculated using the treasury stock method. Under the treasury stock method, the proceeds from the assumed conversion of options and warrants are used to repurchase outstanding shares using the average market price for the period.

The following table contains information necessary to calculate loss per share (in thousands):

The following table provides the data required to calculate comprehensive loss (in thousands):

After the Asset Sale, the Company has two remaining business segments: E-transactions and Specialty Components. The Company evaluates the performance of these segments based on their revenue and gross profit. The Company does not consistently allocate any other income, expenses or assets to these segments nor does it track revenue by product. Reportable segment information for the nine months ended September 30, 2007 and 2006 is as follows (in thousands):

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Geographic Information—The Company attributes revenues to different geographic areas on the basis of the location of the customer. The Company’s revenues and long-lived assets by geographic area for the nine months ended September 30, 2007 and 2006 are as follows (in thousands):

Major Customers—In the first nine months of 2007 and 2006, no customers represented 10% or more of total revenues. Two customers accounted for 27% and 19% of accounts receivable at September 30, 2007 while one of the same customers accounted for 15% and a different customer accounted for 11% of the accounts receivable at September 30, 2006.

Major Suppliers—The Company buys certain dies and adhesives, that are used in various products, from single source suppliers. Due to a limited number of suppliers for these items, a sudden change to a different supplier could cause delays in manufacturing.

In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“FAS 109”). This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition of tax benefits, classification on the balance sheet, interest and penalties, accounting in interim periods, disclosure, and transition. The Company adopted FIN 48 effective January 1, 2007. The Company or one of its subsidiaries files income tax returns in the U.S. federal jurisdiction, and various states and foreign jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2000. As a result of the implementation of Interpretation No. 48, the Company did not recognize any increase in the liability for unrecognized tax benefits. In addition, the Company did not record a cumulative effect adjustment related to the adoption of FIN 48.

The Inland Revenue Department (IRD) of Hong Kong commenced an examination of the Company’s Hong Kong income tax returns for 2003 through 2005 in the first quarter of 2007 that is anticipated to be completed in the 2007 fiscal year. Due to delinquencies in filing annual tax returns for the 2003, 2004 and 2005 fiscal years, the IRD has assessed certain adjustments to the Company’s overall reported losses in Hong Kong for those periods stated above. These adjustments have resulted in additional income tax assessments and cash payments that have been made for 2003, 2004 and 2005 totaling $456,000 as of the date of this filing. The Company does not anticipate any further adjustments will be made.

On November 8, 2007, the Loan and Security Agreement governing the Company’s existing $5 million line of credit was amended and restated to extend the term of the Loan and Security Agreement by two years and to allow for cash borrowings against the line up to $5 million up to based on 80% of the Company’s eligible accounts receivable (as defined in the security agreement) and other criteria. The Loan and Security Agreement, as amended, expires on November 8, 2009. As of November 13, 2007, the Company had no borrowings drawn against the line of credit.

Legal Matters—On November 15, 2005, a class action alleging violations of federal securities laws was filed against the Company and two of its current and former officers in the United States District Court for the Central District of

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California. The complaint alleges that, between April 24, 2003 and November 1, 2005, the Company and two of its current and former officers made false and misleading statements and failed to disclose material information regarding the Company’s results of operations and financial condition. The complaint includes claims under the Securities Act of 1933, as amended (the “Securities Act”) and Exchange Act of 1934, as amended (the “Exchange Act”) and seeks unspecified damages and legal expenses.

On November 3, 2006, the Court appointed new lead plaintiffs. On January 16, 2007, the lead plaintiffs filed an amended complaint. The amended complaint also includes claims under the Securities Act and the Exchange Act and seeks unspecified damages and legal expenses. On February 22, 2007, defendants filed a motion to dismiss the amended complaint. On September 26, 2007, the Court issued an order granting defendants’ motion in part and denied it in part. The Court gave plaintiffs 21 days to amend the complaint. On October 11, 2007, the parties filed a stipulation requesting that the Court extend the deadline for the filing of an amended complaint by sixty (60) days so that the parties could pursue settlement discussions. On October 12, 2007, the Court signed the parties’ stipulation. Plaintiffs have until December 16, 2007 to file an amended complaint. The Company has recorded approximately $263,000 in expenses for 2006 and has incurred no costs to date in 2007 in connection with the class action proceeding. Because the case is at a preliminary stage, it is not possible to predict with reasonable certainty the final outcome of this matter.

On January 24, 2006, a shareholder’s derivative action was filed against two of the Company’s current and former officers and the members of its Board of Directors in the Central District of California. The derivative complaint contains the same factual allegations as the class action complaint and sought to recover unspecified damages from the defendants, as well as forfeiture of their equity-based compensation and contribution from them in the event that the Company is found to have violated the federal securities laws. Following a motion made by the defendants to dismiss, or in the alternative, stay the derivative action, the plaintiff voluntarily dismissed the derivative action without prejudice on June 14, 2006.

On August 17, 2006, the plaintiff re-filed the derivative action in California state court. The re-filed complaint alleges securities-related violations of the California Corporations Code, as well as various common law and Delaware corporate law claims. The members of the Company’s Board of Directors are no longer named as defendants. Plaintiffs seek treble damages based on the difference between the prices at which the named defendants sold their shares and the market value that those shares would have had at the time of such sales but for the allegedly false and misleading financial statements, as well as contribution from the defendants in the event that the Company is found to have violated the federal securities laws and other unspecified damages.

On November 17, 2006, defendants removed the derivative action to federal court. On January 9, 2007, the court stayed the derivative action pending the defendants’ filing of an answer in the securities class action. That stay is still in effect as of the date of the filing of this Report. Because the case is at a preliminary stage, it is not possible to predict with reasonable certainty the final outcome.

In connection with the class action and the derivative proceedings described above, the Company voluntarily contacted the SEC in 2006 to inform the SEC of both proceedings. Soon thereafter, the SEC responded with several inquiries, to which the Company responded promptly. The Company has not received any further inquiries from the SEC, however, the SEC may at any time resume its inquiries into the basis of the class action and derivative proceedings. Other than the amounts described above, the Company cannot estimate the possible loss or range of loss, if any, associated with the resolution of the class action and derivative proceedings. While it intends to vigorously defend against these allegations, the Company cannot predict the final disposition of these matters or whether the Company will be liable for amounts not covered by insurance. There is no assurance that the ultimate resolutions of these matters will not result in a material adverse effect on the Company’s business, financial condition or results of operations.

In addition to the matters identified above, from time to time, the Company is involved in various legal actions that arise in the ordinary course of business.

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Overview

We develop, manufacture, market and sell intuitive interface devices and components for a variety of business and home applications worldwide. We generate revenues from the sale of our hardware products, including pen input and signature pads, integrated cursor control devices and interactive remote input devices. Some of these products, particularly our E-transactions products, incorporate software that we have developed internally or that we license from third parties. To date, we have not had significant sales of software products that have not been incidental to the related hardware product.

On August 31, 2007, the Company sold its OEM Remotes and Branded Products segments for a purchase price of $11.5 million, subject to certain post-closing adjustments. Accordingly, Management’s Discussion and Analysis of Financial Condition and Results of Operations is a comparative discussion of the Company’s two continuing business segments: E-transactions and Specialty Components. We have addressed our Specialty Components market since our inception in 1985, and our E-transactions market since 1999.

Gross profit margins fluctuate significantly from quarter to quarter due to various factors, including the allocation of unabsorbed overhead costs and the mix of products produced and sold. We expect quarterly gross profit margins to continue to fluctuate in the future.

The Company continues to incur losses as a result of various factors, including fluctuating quarterly sales levels due to market conditions and customer ordering patterns, fluctuations in gross profit margins due in part to the unabsorption of manufacturing costs, increases in operating costs, inventory reserve adjustments, and increased compliance and regulatory costs.

The relative revenue and gross profit contributions of our continuing business segments is provided below in Results of Operations-Business Segment Overview.

Current Opportunities and Challenges

As part of an overall strategy to deemphasize our declining margin businesses and focus our efforts on higher margin emerging markets, we sold our OEM Remotes and Branded Products business segments in August of 2007. The Company believes that sale of these business units will provide the Company with the capital necessary to advance its strategic business initiatives and to allow the Company to focus on the two business segments it feels have the greatest potential for long-term profitable growth: E-transactions and Specialty Components. While the higher margins in our retained businesses are anticipated to result in improved cash flow by the end of fiscal 2008 and into the future, we support a constant level of fixed general and administrative expenses with a revenue base that has been reduced by half, which is likely to result in continued net losses and may affect our ability to generate positive cash flow. Our principal challenge, therefore, is to grow our E-transactions and Specialty Components business segments to achieve the revenue levels, cost efficiencies and profitability that will sustain and justify our continued investments in these segments. Our ability to manage this challenge will define the level of our success over the next two to three years.

A considerable portion of our effort has been and will continue to be directed at emerging markets such as our E-transactions market where our success depends, in part, on our ability to accurately forecast the nature, amount and timing of market requirements in an environment in which historical precedent is limited or non-existent. We rely on information generated by our internal staff and industry partners and on independent market studies for forecasts of market demand in our focus areas, but these studies are themselves based on limited empirical data. An inaccurate forecast of market demand in any of our core market areas would impact our short-term performance and could impact our competitive position and, therefore, our long-term performance.

The Company is making significant efforts to provide our Specialty Components markets with products that use our proprietary FSR technology. Our strategy of becoming profitable in this business segment within the next year relies on the Company being able to create and timely deliver new products to key customers. The inability to timely develop and deliver these products to our customers will impact our ability to become profitable in our Specialty Components business segment in the timeframe we are anticipating.

Management faces the constant challenge of balancing the Company’s investment in new technology, product development and marketing initiatives against the objective of steady earnings growth. A decision to make a significant investment in a new technology, product or marketing effort may have a short-to-medium term negative impact on earnings even if the investment proves to be justified. Because we intend to pursue a growth strategy, it is probable that we will make investments in new business opportunities that will increase operating costs, decrease margins and negatively impact earnings until the investment produces significant revenue growth.

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Our revenue from continuing operations was $4.7 million for the three months ended September 30, 2007 and $12.7 million for the nine months ended September 30, 2007. The Company’s current projections show that we will see revenue growth in our two remaining business segments in comparable periods in 2008. The Company does not expect to see operating expenses, as a percentage of revenues, to remain at the levels reflected in the condensed Consolidated Statements of Operations. We expect that certain operating expenses will increase, but we project that other operating expenses, like many general and administrative expenses, will remain relatively constant in 2008 or decline. If revenues grow as projected over the coming quarters, operating expenses will likely not experience the same relative growth rate, with the result that operating expenses, as a percentage of revenues, should decrease.

Our quarterly results are often affected by volatility in orders for a particular product. Sales of our E-transactions products to large institutions are typically made pursuant to large purchase orders, which can be one-time events or can occur at widely-dispersed intervals. Other factors that could cause our estimates to be wrong or could result in trends that are not apparent from our financial statements are described under “Risk Factors” in Part II below.

The accompanying Condensed Consolidated Financial Statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The raising of $5 million through a private placement of convertible notes and warrants with existing institutional shareholders on July 19, 2007, which is described more fully in Note 7 to the Condensed Consolidated Financial Statements and the sale of certain assets on August 31, 2007 for $11.5 million, which is described in Note 3 to the Condensed Consolidated Financial Statements, will allow the Company to operating with existing funds for the foreseeable future. As of September 30, 2007, the Company had cash, cash equivalents, and short-term investments of approximately $14.9 million, which included $1.4 million of restricted cash, portions of which must be held in escrow pursuant to the terms of the Asset Sale. On November 8, the Company restated and amended it line of credit to allow for borrowings up to $5 million based on eligible accounts receivable and certain other covenants. The Company had no borrowings on the line of credit as of September 30, 2007 and total indebtedness for money borrowed of $5,078,000.

Business Segment Overview – Three and Nine Months Ended September 30, 2007 Compared To Three and Nine Months Ended September 30, 2006:

For the three and nine months ended September 30, 2007 and 2006, revenue and gross profit by market segment are shown in the following table: