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Nano Magic Inc. - Quarter Report: 2005 September (Form 10-Q)

Form 10-Q
 
Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
 
FORM 10-Q
 
ý  Quarterly report under Section 13 or 15(d) of the Securities Exchange Act of 1934
 
For the quarterly period ended September 30, 2005
 
¨ Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 
COMMISSION FILE NO. 1-11602
 
NANO-PROPRIETARY, INC.
(Exact name of registrant as specified in its charter)
 

 
TEXAS
76-0273345
(State or other jurisdiction of
(I.R.S. Employer Identification No.)
incorporation or organization)
 
 
 

 
3006 Longhorn Blvd., Suite 107
 
Austin, Texas
78758
(Address of principal executive offices)
(Zip Code)

 
(512) 339-5020
(Registrant's telephone number, including area code)
 
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
 
    x  Yes    o  No
 
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)
 
    x  Yes    o  No
 
As of October 21, 2005, the registrant had 99,746,440 shares of common stock, par value $.001 per share, issued and outstanding.
 


NANO-PROPRIETARY, INC.
 
INDEX
 

 
Page
 
 
 
 
 
 
 
 
 
 
 
 
3
 
 
 
 
 
 
 
4
 
 
 
 
 
 
 
5
 
 
 
 
 
 
6
 
 
 
 
 
 
9
 
 
 
 
 
13
       
 
13
 
 
 
 
 
 
 
 
 
 
14
 
 
 
 
 
15
 
 
 
 
16

 


PART I.  FINANCIAL INFORMATION
 
ITEM 1.  FINANCIAL STATEMENTS
 
NANO-PROPRIETARY, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
 

 
ASSETS
  
(Unaudited)
September 30,
2005
  
 
December 31,
2004
  
Current assets:
  
 
  
 
  
Cash and cash equivalents
  
$
932,638
  
$
901,585
  
Accounts receivable, trade - net of allowance for doubtful accounts
    
64,851
   
6,735
 
Prepaid expenses and other current assets
    
132,493
   
85,135
 
 
    
   
 
                Total current assets
    
1,129,982
   
993,455
 
 
    
   
 
Property and equipment, net
    
111,067
   
141,373
 
Other assets
    
9,540
   
9,540
 
                Total assets
  
$
1,250,589
  
$
1,144,368
  
 
    
   
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
   
   
 
 
    
   
 
Current liabilities:
    
   
 
Accounts payable
  
$
184,099
  
$
140,597
  
Obligations under capital lease
    
11,535
   
21,430
 
Accrued liabilities
    
72,623
   
74,956
 
Deferred Revenue
    
-
   
54,985
 
 
    
   
 
                Total current liabilities
    
268,257
   
291,968
 
 
    
   
 
Obligations under capital lease
    
-
   
5,944
 
 
    
   
 
 Total Liabilities
    
268,257
   
297,912
 
 
    
   
 
Commitments and contingencies
    
-
   
-
 
 
    
   
 
Stockholders' (deficit):
    
   
 
     Preferred stock, $1.00 par value, 2,000,000 shares authorized;
            No shares issued and outstanding
    
-
   
-
 
     Common stock, $.00l par value, 120,000,000 shares authorized,
            99,214,047 and 97,246,422 shares issued and outstanding at
            September 30, 2005 and December 31, 2004, respectively
    
99,214
   
97,246
 
Additional paid-in capital
    
84,404,984
   
80,822,625
 
Accumulated deficit
    
(83,521,866
)
  
(80,073,415
)
 
    
   
 
                Total stockholders equity
    
982,332
   
846,456
 
 
    
   
 
                Total liabilities and stockholders equity
  
$
1,250,589
  
$
1,144,368
  
 
 
See notes to consolidated financial statements.
 


NANO-PROPRIETARY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
 
 
 
For the Three Months
Ended September 30,
  
For  the Nine Months
Ended September 30,
  
 
  
2005
  
 2004
  
 2005
  
 2004
  
Revenues
    
   
   
   
 
Government contracts
  
$
85,697
  
$
90,501
  
$
173,307
  
$
222,179
  
Royalties
    
-
   
1,122
   
3,897
   
1,122
 
Other
    
160,220
   
8,850
   
226,072
   
55,548
 
          Total Revenues
    
245,917
   
100,473
   
403,276
   
278,849
 
 
    
   
   
   
 
Research and development
    
620,079
   
635,105
   
1,875,371
   
1,916,512
 
Selling, general and administrative expenses
    
640,481
   
573,706
   
1,999,564
   
1,357,738
 
Royalty expense
    
-
   
-
   
-
   
500,000
 
 
    
   
   
   
 
Operating costs and expenses
    
1,260,560
   
1,208,811
   
3,874,935
   
3,774,250
 
 
    
   
   
   
 
Loss from operations
    
(1,014,643
)
  
(1,108,338
)
  
(3,471,659
)
  
(3,495,401
)
 
    
   
   
   
 
Other income (expense), net
    
   
   
   
 
Interest Expense
    
(381
)
  
(1,224
)
  
(2,287
)
  
(3,493
)
Interest Income
    
9,946
   
9,028
   
25,495
   
23,065
 
Other
    
-
   
-
   
-
   
125
 
 
    
   
   
   
 
 Loss from continuing operations before taxes
    
(1,005,078
)
  
(1,100,534
)
  
(3,448,451
)
  
(3,475,704
)
 
    
       
   
 
 Provision for taxes
    
-
   
-
   
-
   
-
 
 
    
   
   
   
 
Net loss
 
$
(1,005,078
)
$
(1,100,534
)
$
(3,448,451
)
$
(3,475,704
)
     
   
   
   
 
Loss per share
                          
 
    
   
       
 
Basic and Diluted
  
$
(0.01
)
$
(0.01
)
$
(0.03
)
$
(0.04
)
     
   
   
   
 
Weighted average shares outstanding
                          
 
    
   
   
   
 
Basic and Diluted
    
99,179,808
   
96,800,352
   
98,729,768
   
96,450,666
 

 
See notes to consolidated financial statements.
 


 
NANO-PROPRIETARY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
     
For  the Nine Months Ended
September 30, 
  
     
2005 
    
2004 
  
Cash flows from operating activities:
          
 Net loss
  
$
(3,448,451
)
$
(3,475,704
)
Adjustments to reconcile net loss to net
          
cash used in operating activities:
          
Depreciation and amortization expense
    
42,258
   
38,864
 
Gain on sale of fixed assets
    
-
   
(125
)
Options issued for services
    
19,339
   
116,600
 
Non-cash variable option pricing expense
    
70,050
   
(297,300
)
Changes in assets and liabilities:
          
Accounts receivable, trade
    
(58,116
)
  
(20,131
)
Prepaid expenses and other current assets
    
(47,358
)
  
(71,233
)
Accounts payable and accrued liabilities
    
(13,816
)
  
115,185
 
 
          
Total adjustments
    
12,357
   
(118,140
)
 
          
Net cash used in operating activities
    
(3,436,094
)
  
(3,593,844
)
 
         
Cash flows from investing activities:
          
Capital expenditures
    
(11,952
)
  
(95,331
)
Proceeds from sale of fixed assets
    
-
   
125
 
       Net cash used in investing activities
    
(11,952
)
  
(95,206
)
 
          
Cash flows from financing activities:
          
Repayment of notes payable
    
(15,839
)
  
(14,337
)
Proceeds of stock issuance, net of costs
    
3,494,938
   
1,640,709
 
 
          
       Net cash provided by financing activities
    
3,479,099
   
1,626,372
 
 
          
Net increase (decrease) in cash and cash equivalents
    
31,053
   
(2,062,678
)
 
          
Cash and cash equivalents, beginning of period
    
901,585
   
3,564,570
 
 
          
Cash and cash equivalents, end of period
  
$
932,638
  
$
1,501,892
  

 
See notes to consolidated financial statements.
 


 
NANO-PROPRIETARY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 

 
1.    Basis of Presentation
 
The consolidated financial statements for the three and nine month periods ended September 30, 2005 and 2004 have been prepared by us without audit pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, all adjustments necessary to present fairly our financial position, results of operations, and cash flows as of September 30, 2005 and 2004, and for the periods then ended, have been made. Those adjustments consist of normal and recurring adjustments. The consolidated balance sheet as of December 31, 2004, has been derived from the audited consolidated balance sheet as of that date.
 
Certain information and note disclosures normally included in our annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. These consolidated financial statements should be read in conjunction with a reading of the financial statements and notes thereto included in our Annual Report on Form 10-K/A for the fiscal year ended December 31, 2004, as filed with the U.S. Securities and Exchange Commission.
 
The results of operations for the three and nine month periods ended September 30, 2005, are not necessarily indicative of the results to be expected for the full year.
 
2.    Supplemental Cash Flow Information
 
Cash paid for interest for the nine months ended September 30, 2005 and 2004, was $2,287 and $3,493 respectively. During the nine months ended September 30, 2005 and 2004, we had non-cash transactions related to variable option pricing and options issued to a consultant. These transactions are described in greater detail in Note 3.
 
3.    Stockholders’ Equity
 
In the nine months ended September 30, 2005, we issued 1,200,000 restricted shares of our common stock and received net proceeds of $3,000,000 in an exempt offering under Regulation D of the Securities Act of 1933. We issued 767,625 shares of our common stock and received $494,938 in connection with the exercise of employee stock options, primarily by former employees.
 
In the nine months ended September 30, 2004, we issued 401,887 restricted shares of our common stock and received net proceeds of $1,065,000 in an exempt offering under Regulation D of the Securities Act of 1933. We issued 799,464 shares of our common stock and received $557,309 in connection with the exercise of employee stock options, primarily by former employees, and issued 20,000 shares and received $18,400 in connection with the exercise of warrants.
 
In April 2001, the Company repriced a total of 900,500 options to lower the exercise price of these options to $1.50, which was approximately 160% of the market price of the stock at the time of the repricing. The repricing of these options resulted in a new measurement date for accounting purposes and reclassification of these options as variable plan awards beginning on the date of the repricing. The Company previously accounted for these option grants as fixed plan awards. From the date of the repricing through December 31, 2003, the quoted value of the Company’s common stock exceeded the exercise price and remained above it, closing at $2.73 per share on December 31, 2003. The Company recorded $749,755 in non-cash option expense for the cumulative effects of the repricing and increased additional paid-in capital by the same amount in 2003. During the nine months ended September 30, 2004, the price of the Company’s common stock declined and closed at $2.13 on September 30, 2004. The Company reversed $297,300 of the previously recorded expense in the nine months ended September 30, 2004, as a result of this price decline. During the nine months ended September 30, 2005, the priced of the Company’s common stock increased from its closing price of $2.17 on December 31, 2004 to $2.41 on September 30, 2005. As a result, the company recorded $70,050 in non-cash option expense and increased additional paid-in capital by the same amount in the nine months ended September 30, 2005.
 
In the nine months ended September 30, 2005, the Company issued 20,000 options to a consultant, 10,000 with an exercise price of $2.54 per share and 10,000 with an exercise price of $2.86 per share. In connection with these options, the Company recorded $19,339 as an expense during the period. In the nine months ended September 30, 2004, we issued 100,000 options to a consultant with an exercise price of $3.08 per share. In connection with the options, we recorded $116,600 as an expense during the period.
 



 
NANO-PROPRIETARY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
4.    Contingencies
 
Litigation
 
We are a defendant in minor lawsuits described in greater detail in our 2004 annual report on Form 10-K/A. We expect any potential eventual payment to have no material affect on the financial statements.
 
In April 2005, we filed suit against Canon, Inc. and Canon USA, Inc. in the U.S. District Court for the Western District of Texas, Austin Division. We are seeking a declaratory judgment that new SED color television products, scheduled to be manufactured by Canon and/or Toshiba beginning in 2005, are not covered under a 1999 patent license agreement that we have with Canon.  We assert that Canon is improperly using our patented technology to produce surface conductor electron emitter display screens (SED) for a new generation of flat screen color televisions. We also assert that a joint venture formed by Canon and Toshiba Corporation to produce the SED display screens, SED, Inc., is not a licensed subsidiary under the 1999 agreement and that Canon is improperly transferring its license rights under Nano-Proprietary's patents to the joint venture and Toshiba. The suit also contained three additional claims related to a Lanham Act violation by Canon, tortuous interference by Canon, and a breach of covenant of good faith and fair dealings against Canon. Canon filed its response in July 2005 denying liability in the matter. In September 2005, Canon filed a motion to dismiss Canon USA, Inc. from the case and dismiss the Lanham Act claim, the tortuous interference claim, and the breach of covenant of good faith and fair dealings. In October 2005, the judge in the case denied Canon’s motion to dismiss Canon, USA, Inc. and the breach of covenant of good faith and fair dealings claim. The judge granted Canon’s motion, without prejudice, to dismiss the Lanham Act claim and the tortuous interference claim. Dismissal without prejudice allows us to re-file these claims at any time if additional evidence supporting these claims becomes available to us in the discovery process. The first two claims described above were not at issue in the dismissal motion by Canon. The case is currently in the discovery phase and a trial date has been set for March 2007.
 
5.    Business Segments
 
Following is information related to our business segments for the nine months ended September 30, 2005 and 2004:
 
 
  
ANI
  
EBT
  
All Other
  
Total
  
2005
  
 
  
 
  
 
  
 
  
Revenue
 
$
403,276
  
$
-
  
$
-
  
$
403,276
  
 
    
   
   
   
 
Profit (Loss)
   
(2,791,244
)
  
-
   
(657,207
)
  
(3,448,451
)
 
    
   
   
   
 
Expenditures for
   
   
   
   
 
     long-lived assets
    
8,297
   
-
   
3,655
   
11,952
 
 
    
   
   
   
 
2004
    
   
   
   
 
Revenue
 
$
278,849
  
$
-
  
$
-
  
$
278,849
  
 
    
   
   
   
 
Profit (Loss)
   
(3,122,054
)
  
107,297
    
(460,947
)
  
(3,475,704
)
 
    
   
   
   
 
Expenditures for
   
   
   
   
 
     long-lived assets
    
92,958
   
-
   
2,373
   
95,331
 

 


NANO-PROPRIETARY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
6.    Recently Issued Accounting Standards
 
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R (Revised 2004), Share-Based Payment ("SFAS No. 123R"), which requires that the compensation cost relating to share-based payment transactions be recognized in financial statements based on the provisions of SFAS 123 issued in 1995. The Company currently accounts for stock-based compensation using APB 25 and discloses pro forma compensation expense quarterly and annually by calculating the stock option grants' fair value using the Black-Scholes model and disclosing the impact on net income and earnings (loss) per share in a Note to the Consolidated Financial Statements. Upon adoption, pro forma disclosure will no longer be an alternative. SFAS 123R is effective for the first annual period beginning after June 15, 2005. Accordingly, we will adopt this provision for its financial statements for the quarter ended March 31, 2006. The financial impact of adopting SFAS 123R cannot be predicted, however it will likely have a material impact on the Company’s financial statements.
 
7.    Subsequent Events
 
We received $48,000 and issued 50,000 shares of common stock in connection with the exercise of stock options during the period from October 1, 2005 through October 21, 2005. We also issued 482,393 shares of our common stock for $1,000,000 in a private placement under rule 506 of Regulation D of the Securities Act of 1933.
 


ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following is management’s discussion and analysis of certain significant factors that have affected our financial position and operating results during the periods included in the accompanying consolidated financial statements.
 
FORWARD-LOOKING STATEMENTS
 
This Form 10-Q contains certain forward-looking statements that we believe are within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created by such acts. For this purpose, any statements that are not statements of historical fact may be deemed to be forward-looking statements, including the statements under "Management's Discussion and Analysis of Financial Condition and Results of Operations" regarding our strategy, future operations, future expectations or future estimates, financial position and objectives of management. Those statements in this Form 10-Q containing the words "believes," "anticipates," "plans," "expects" and similar expressions constitute forward-looking statements, although not all forward-looking statements contain such identifying words. These forward-looking statements are based on our current expectations and are subject to a number of risks, uncertainties and assumptions relating to our operations, results of operations, competitive factors, shifts in market demand and other risks and uncertainties.
 
Although we believe that the assumptions underlying our forward-looking statements are reasonable, any of the assumptions could be inaccurate and actual results may differ from those indicated by the forward-looking statements included in this Form 10-Q. In light of the significant uncertainties inherent in the forward-looking statements included in this Form 10-Q, you should not consider the inclusion of such information as a representation by us or anyone else that we will achieve such results. Moreover, we assume no obligation to update these forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting such forward-looking statements.
 
Nine months ended September 30, 2005 and 2004
 
OVERVIEW
 
During the nine months ended September 30, 2005, our primary revenues were earned as a result of reimbursed research expenditures at our Applied Nanotech, Inc. (“ANI”) subsidiary. We continued to incur substantial expenses in support of the development of our proprietary Carbon Nanotube Based Field Emission (“CFE”) Technology and other technologies. As more fully discussed in our Annual Report on Form 10-K/A for the year ended December 31, 2004, we expect to incur additional research and development expenses throughout 2005 in developing our technology. We are focused on licensing our technology and obtaining sufficient revenue to cover our ongoing research expenditures.
 
OUTLOOK
 
We expect our present cash balance of approximately $1.7 million as of the date of this filing, when combined with expected revenue sources, to enable us to operate at least through the end of the first quarter 2006. We have a plan to achieve profitability in 2006. There can be no assurance that we will achieve profitability, or even break-even, in the future. To the extent our revenues do not allow us to break-even, or if the timing of revenues does not match with expenses, we could be required to raise additional funds through the issuance of debt or equity securities to enable us to maintain operations at the present level. The mix of revenues received could also cause the revenues required to reach break-even to increase. If revenue producing projects require unanticipated expenses, or heavier than anticipated use of outside services or materials, we may be unable to achieve profitability at the expected level of revenues.
 
We have developed a plan to allow ourselves to maintain operations until we are able to sustain ourselves on our own revenue. Our plan is primarily dependent on raising funds through the licensing of our technology and reimbursed research contracts. Our current cash of approximately $1.7 million as of the date of this filing is sufficient to allow us to maintain operations through at least the end of the first quarter 2006. We expect additional revenue producing projects or license agreements to be finalized during that time period. We believe that we have the ability to continue to raise funding, if necessary, to enable us to continue operations until our plan can be completed.
 


ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (cont.)
 

 
This plan is based on current development plans, current operating plans, the current regulatory environment, historical experience in the development of electronic products and general economic conditions. Changes could occur which would cause certain assumptions on which this plan is based to be no longer valid. Although we do not expect funding our operations to be a problem, if adequate funds are not available from operations, or additional sources of financing, we may have to eliminate, or reduce substantially, expenditures for research and development, testing and production of its products, or obtain funds through arrangements with other entities that may require us to relinquish rights to certain of our technologies or products. Such results would materially and adversely affect us.
 
RECENT DEVELOPMENTS
 
In April 2005, we filed suit against Canon, Inc. and Canon USA, Inc. in the U.S. District Court for the Western District of Texas, Austin Division. We are seeking a declaratory judgment that new SED color television products, scheduled to be manufactured by Canon and/or Toshiba beginning in 2005, are not covered under a 1999 patent license agreement that we have with Canon.  We assert that Canon is improperly using our patented technology to produce surface conductor electron emitter display screens (SED) for a new generation of flat screen color televisions. We also assert that a joint venture formed by Canon and Toshiba Corporation to produce the SED display screens, SED, Inc., is not a licensed subsidiary under the 1999 agreement and that Canon is improperly transferring its license rights under Nano-Proprietary's patents to the joint venture and Toshiba. The suit also contained three additional claims related to a Lanham Act violation by Canon, tortuous interference by Canon, and a breach of covenant of good faith and fair dealings against Canon. Canon filed its response in July 2005 denying liability in the matter. In September 2005, Canon filed a motion to dismiss Canon USA, Inc. from the case and dismiss the Lanham Act claim, the tortuous interference claim, and the breach of covenant of good faith and fair dealings. In October 2005, the judge in the case denied Canon’s motion to dismiss Canon, USA, Inc. and the breach of covenant of good faith and fair dealings claim. The judge granted Canon’s motion, without prejudice, to dismiss the Lanham Act claim and the tortuous interference claim. Dismissal without prejudice allows us to re-file these claims at any time if additional evidence supporting these claims becomes available to us in the discovery process. The first two claims described above were not at issue in the dismissal motion by Canon. The case is currently in the discovery phase and a trial date has been set for March 2007. Our attorneys are handling this on contingency, so continued activity in this case will not be an unmanageable drain on our resources.
 
In the nine months ended September 30, 2005, we received two new Small Business Innovation Research (SBIR) grants, totaling approximately $165,000, from the U.S. Air Force. One of these grants relates to the development of low-maintenance sensors, the other relates to carbon nanotube based radar applications. Both of the projects are expected to be completed by the end of first quarter of 2006.
 
In July 2005, our Applied Nanotech, Inc. subsidiary completed a license agreement with Kelman, Ltd for ANI’s proprietary Hydrogen Sensor technology. Under the terms of this agreement, Kelman has the exclusive right through June 30, 2006 to use ANI’s Hydrogen Sensors in power transformers. Kelman can extend this exclusivity period on a year by year basis by making certain pre-defined minimum royalty payments. ANI will also initially manufacture and sell hydrogen sensors to Kelman.
 
In October 2005, we issued 482,393 shares of our common stock for $1,000,000 in a private placement under rule 506 of Regulation D of the Securities Act of 1933.
 
RECENT ACCOUNTING PRONOUNCEMENTS
 
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R (Revised 2004), Share-Based Payment ("SFAS No. 123R"), which requires that the compensation cost relating to share-based payment transactions be recognized in financial statements based on the provisions of SFAS 123 issued in 1995. The Company currently accounts for stock-based compensation using APB 25 and discloses pro forma compensation expense quarterly and annually by calculating the stock option grants' fair value using the Black-Scholes model and disclosing the impact on net income and earnings (loss) per share in a Note to the Consolidated Financial Statements. Upon adoption, pro forma disclosure will no longer be an alternative. SFAS 123R is effective for the first annual period beginning after June 15, 2005. Accordingly, we will adopt this provision for its financial statements for the quarter ended March 31, 2006. The financial impact of adopting SFAS 123R cannot be predicted, however it will likely have a material impact on the Company’s financial statements.
 


ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (cont.)
 

 
FINANCIAL CONDITION AND LIQUIDITY
 
Our cash position remained virtually unchanged during the period. At September 30, 2005, we had cash and cash equivalents in the amount of $932,638 as compared with cash and cash equivalents of $901,585 at December 31, 2004. This increase in cash is primarily the result of cash provided by financing activities, offset by cash used in operating activities.
 
As described in greater detail in the notes to the financial statements, we received net proceeds of $3,494,938 from the issuance of common stock related to private placements and option exercises during the nine months ended September 30, 2005 (the “2005 Period”), as compared with $1,640,709 from the issuance of common stock during the nine months ended September 30, 2004 (the “2004 Period”). The majority of the common stock issued in the 2005 Period was the result of the private placement in February 2005 in which 1,200,000 shares of stock were issued in exchange for net proceeds of $3,000,000.
 
Our cash used in operating activities decreased from $3,593,844 in the 2004 Period to $3,436,094 in the 2005 Period. This is primarily the result of operating factors discussed below in the “Results of Operations” section. We expect our cash used in operating activities to decrease in future quarters in 2005 as a result of increasing revenues, while expenses remain relatively constant.
 
We used net cash of $95,206 for investing activities in the 2004 Period related to the purchase of research equipment, compared with cash used in investing activities related to equipment purchases of $11,952 in the 2005 Period. We expect cash used in investing activities to remain at relatively insignificant levels for the balance of 2005.
 
The principal source of our liquidity has been funds received from exempt offerings of common stock. In the event that we need additional funds, we may seek to sell additional debt or equity securities. While we expect to be able to obtain any funds needed for operations, there can be no assurance that any of these financing alternatives can be arranged on commercially acceptable terms. We believe that our success in reaching profitability will be dependent on our patent portfolio and upon the viability of products using our technology and their acceptance in the marketplace, as well as our ability to obtain additional debt or equity financings in the future, if needed.
 
We expect to continue to incur substantial expenses for research and development ("R&D"). Further, we believe that certain products that may be developed by potential licensees of our technology may not be available for commercial sale or routine use for a period of one to two years. Others are expected to be available in 2005. While we would likely receive initial license payments, ongoing royalty streams related to those licenses will not be available until potential licensees have introduced products using our technology. Therefore, it is possible that the commercialization of our existing and proposed products may require additional capital in excess of our current funding. We do, however, have a plan to operate profitably in 2006 based on the receipt of research funding and other revenues. Achievement of at least break-even would enable us to continue our research without seeking additional debt or equity financing.
 
Because the timing and receipt of revenues from the license or royalty agreements will be tied to the achievement of certain product development, testing and marketing objectives, which cannot be predicted with certainty, there may be substantial fluctuations in our results of operations. If revenues do not increase as rapidly as anticipated, or if product development and testing require more funding than anticipated, we may be required to curtail our operations or seek additional financing from other sources. The combined effect of the foregoing may prevent us from achieving sustained profitability for an extended period of time.
 
RESULTS OF OPERATIONS
 
Our loss for the third quarter ended September 30, 2005 was $1,005,078 as compared with the loss of $1,100,534 for the same period last year. The main reason for the decreased loss in 2005 was the increased revenue in 2005. Our loss of $3,448,451 for the nine months ended September 30, 2005 was slightly lower than the loss of $3,475,704 for the nine months ended September 30, 2004. This decreased loss was the result of reasons set forth below. We expect our quarterly loss to be reduced in the fourth quarter of 2005 from the losses incurred in the first three quarters of 2005.
 


ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (cont.)
 
Our revenues for the quarter ended September 30, 2005, totaled $245,917 compared to $100,473 for the same quarter of 2004. For the nine-month period ended September 30, 2005 (the “2005 Period”), our revenues were $403,276 as compared with $278,849 for the nine-month period ended September 30, 2004 (the “2004 Period”). The revenues in both periods were all from ANI and substantially all the result of reimbursed research expenditures. The majority of revenues in the 2004 Period came from government contracts. In the 2005 Period, the majority of the revenue came from private sources. At the present stage of our development, significant conclusions can’t be drawn from comparing revenues from period to period. Our business strategy is built on developing a royalty stream from licensing our intellectual property. To supplement this, we also seek funding from both governmental and private sources to help fund our research. Until we are able to develop a steady revenue stream from royalties, our revenues will tend to fluctuate greatly from quarter to quarter and may not be a significant source of operating cash for us. Our private research funding tends to come in large amounts at sporadic times.
 
We have three government programs in progress at September 30, 2005, and we have a revenue backlog of $77,289 related to those contracts. We have a total revenue backlog of $470,139 as of September 30, 2005. We had a total revenue backlog of $212,722 as of September 30, 2004, all of which related to one government contract. Our ability to perform continued research, or fulfill our backlog, should not require significant additional personnel.
 
We incurred research and development expenses of $1,875,371 for the 2005 Period, which was similar to the amount of $1,916,512 incurred in the 2004 Period. The majority of our research and development expenditures are relatively fixed and include salaries and related cost, facilities costs, etc. The variable portion relates to spending on outside materials and consultants and was relatively similar from year to year. We expect total research and development expense to remain relatively constant in the fourth quarter of 2005. Research and development expenditures could increase if we received funding for any significant new projects, however that would result in an increase in revenue as well.
 
Our selling, general, and administrative expenses were $1,999,564 for the 2005 Period, compared with $1,357,738 for the 2004 Period - an increase of $641,826. The majority of this increase, or $367,350, was the result of a non-cash item related to variable option pricing. In April 2001, we repriced a total of 900,500 options to lower the exercise price of these options to $1.50, which was approximately 160% of the market price of the stock at the time of the repricing. The repricing of these options resulted in a new measurement date for accounting purposes and reclassification of these options as variable plan awards beginning on the date of the repricing. The Company previously accounted for these option grants as fixed plan awards. In 2003, our common stock price exceeded the exercise price for the first time since the repricing and remained above it, closing at $2.73 per share on December 31, 2003. The Company recorded $749,755 in non-cash option expense for the cumulative effects of the repricing and increased additional paid in capital by the same amount in 2003.
 
During the nine months ended September 30, 2004, the price of our common stock declined and closed at $2.13 on September 30, 2004. We reversed $297,300 of the previously recorded expense in the nine months ended September 30, 2004, as a result of this price decline. During the 2005 Period, we recorded an additional expense of $70,050. The remainder of the increase relates primarily to human resource related costs, including salary and consulting fees paid to a new hire, as well as significant out of pocket expenses related to the Canon lawsuit, which were approximately $110,000 during the period. Our attorneys are handling the Canon litigation on contingency, however we are responsible for out of pocket costs, including local counsel in Austin Texas.
 
Our royalty expense was $500,000 in the 2004 Period. The royalty expense results from minimum payments due in connection with our Keesman patent license. We had no such expense in the 2005 Period. No further future minimum royalty payments are due under this agreement, and we expect royalty expense in future periods to be highly correlated with royalty income.
 
Our interest expense and interest income remained substantially the same in the two periods. Our only remaining interest expense relates to capital leases. Our interest income is a result of the investment of excess funds in short term interest bearing instruments, primarily certificates of deposit, commercial paper, and money market funds. We expect both to remain relatively insignificant in the foreseeable future.
 


ITEM 3.       QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
We do not use any derivative financial instruments for hedging, speculative, or trading purposes. Our exposure to market risk is currently immaterial.
 

 
ITEM 4.       CONTROLS AND PROCEDURES
 
Evaluation of Disclosure Controls and Procedures. Based on their evaluation, as of the end of the period covered by this Quarterly Report on Form 10-Q, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) the principal executive officer and principal financial officer of the Company have each concluded that such disclosure controls and procedures are effective and sufficient to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission’s rules and forms and that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.
 
Changes in Internal Control Over Financial Reporting. There have not been any changes in the Company’s internal control over financial reporting that occurred during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
 

 

 


PART II. OTHER INFORMATION
 
ITEM 1.  LEGAL PROCEEDINGS
 
In April 2005, we filed suit against Canon, Inc. and Canon USA, Inc. in the U.S. District Court for the Western District of Texas, Austin Division. We are seeking a declaratory judgment that new SED color television products, scheduled to be manufactured by Canon and/or Toshiba beginning in 2005, are not covered under a 1999 patent license agreement that we have with Canon.  We assert that Canon is improperly using our patented technology to produce surface conductor electron emitter display screens (SED) for a new generation of flat screen color televisions. We also assert that a joint venture formed by Canon and Toshiba Corporation to produce the SED display screens, SED, Inc., is not a licensed subsidiary under the 1999 agreement and that Canon is improperly transferring its license rights under Nano-Proprietary's patents to the joint venture and Toshiba. The suit also contained three additional claims related to a Lanham Act violation by Canon, tortuous interference by Canon, and a breach of covenant of good faith and fair dealings against Canon. Canon filed its response in July 2005 denying liability in the matter. In September 2005, Canon filed a motion to dismiss Canon USA, Inc. from the case and dismiss the Lanham Act claim, the tortuous interference claim, and the breach of covenant of good faith and fair dealings. In October 2005, the judge in the case denied Canon’s motion to dismiss Canon, USA, Inc. and the breach of covenant of good faith and fair dealings claim. The judge granted Canon’s motion, without prejudice, to dismiss the Lanham Act claim and the tortuous interference claim. Dismissal without prejudice allows us to re-file these claims at any time if additional evidence supporting these claims becomes available to us in the discovery process. The first two claims described above were not at issue in the dismissal motion by Canon. The case is currently in the discovery phase and a trial date has been set for March 2007.
 

 

 

 


ITEM 6.     EXHIBITS AND REPORTS ON FORM 8-K
 
       (a)     Exhibits: See Index to Exhibits on page 17 for a descriptive response to this item.
 


SIGNATURES
 
Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
 
NANO-PROPRIETARY, INC.
(Registrant)
 
 
Date:     October 28, 2005
     /s/ Marc W. Eller
Marc W. Eller
Chairman and Chief Executive
Officer (Principal Executive Officer)
 
 
Date:     October 28, 2005
     /s/ Douglas P. Baker 
Douglas P. Baker
Chief Financial Officer
(Principal Financial Officer and Principal
Accounting Officer)
 
 

 


INDEX TO EXHIBITS
 
The following documents are filed as part of this Report:
 
Exhibit
  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
17