SOCKET MOBILE, INC. - Quarter Report: 2005 September (Form 10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-Q

  For the quarterly period ended September 30, 2005

OR

Commission file number 1-13810

SOCKET COMMUNICATIONS, INC.
(Exact Name of Registrant as Specified in its Charter)

37400 Central Court, Newark, CA 94560
(Address of principal executive offices including zip code)

(510) 744-2700
(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. YES[X] NO[  ]

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES[  ] NO[X]

Number of shares of Common Stock ($0.001 par value) outstanding as of October 31, 2005 was 30,203,924 shares.

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Item 1. Financial Statements (Unaudited)

See accompanying notes.
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See accompanying notes.

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See accompanying notes.

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SOCKET COMMUNICATIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 1 - Basis of Presentation

The accompanying unaudited consolidated financial statements of Socket Communications, Inc. and its wholly owned subsidiaries (the "Company") have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for fair presentation have been included. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in the Company's Annual Report on Form 10-K for the year ended December 31, 2004.

NOTE 2 - Summary of Significant Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expense during the reporting period. Actual results could differ from those estimates, and such differences may be material to the financial statements.

The Company makes adjustments to the value of inventory based on estimates of potentially excess and obsolete inventory after considering forecasted demand and forecasted average selling prices. However, forecasts are subject to revisions, cancellations, and rescheduling. Actual demand will inevitably differ from anticipated demand, and such differences may have a material effect on the financial statements.

The Company accounts for employee stock options in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25), and the Company has adopted the disclosure-only alternative described in Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (SFAS 123). The Company has elected to follow APB No. 25 and related interpretations in accounting for its employee stock options because the alternative fair value accounting provided for under SFAS 123 requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, the Company generally does not record compensation expense because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant. Pro forma information regarding net loss and loss per share available to common shareholders is required by SFAS 123, and such information has been determined as if the Company had accounted for its employee stock options under the fair value method.

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Had compensation cost for the Company's stock-based compensation plans been determined based on the fair value at the grant dates for awards under those plans consistent with the method of SFAS 123, the Company's per share results would have changed to the pro forma net loss amounts indicated below:

The fair value of these options was estimated at the date of grant using the Black-Scholes option pricing model. Weighted average assumptions for the comparable three and nine month periods presented are as follows:

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility and expected option life. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of the Company's employee stock options.

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On April 14, 2005, the Securities and Exchange Commission (SEC) announced a delay in implementing the option expensing requirements set forth in Financial Accounting Standards Board Statement No. 123(R), "Share-Based Payment" ("SFAS 123R"). The new effective date for compliance with the provisions of SFAS 123R is the first quarter of a public entity's first fiscal year beginning after June 15, 2005. The Company expects to adopt the provisions of SFAS 123R in its first quarter of fiscal 2006. SFAS 123R, will replace SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123") and supercedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS 123R requires all share-based awards to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. The pro forma disclosures previously permitted under SFAS 123 will no longer be an alternative to financial statement recognition. Under SFAS 123R, the Company must determine the appropriate fair value model to be used for valuing share-based awards, the amortization method for compensation cost, and the transition method to be used at date of adoption. The transition methods include prospective and retroactive adoption alternatives. Under the retroactive method, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that compensation expense be recorded for all unvested stock options and restricted stock at the beginning of the first quarter of adoption of SFAS 123R, while the retroactive methods would record compensation expense for all unvested stock options and restricted stock beginning with the first period restated. The Company is evaluating the requirements of SFAS 123R and expects that the adoption of SFAS 123R will have a material adverse impact on its consolidated results of operations and earnings per share. The Company has not yet determined the method of adoption or the effect of adopting SFAS 123R, and has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123.

NOTE 3 - Inventories

Inventories consist principally of raw materials and sub-assemblies, which are stated at the lower of cost (first-in, first-out) or market.

NOTE 4 - Bank Financing Arrangements

On March 7, 2005, the Company agreed with its bank to extend the term of the existing credit facility by an additional year, which will now expire on March 4, 2007. The credit facility under the credit agreement allows the Company to borrow up to $4,000,000 based on the level of qualified domestic and international receivables, which are $2,500,000 and $1,500,000, respectively, at the lender's index rate based on prime plus 0.5%. The rates in effect on September 30, 2005 were 7.25% for both the domestic and international lines. At September 30, 2005, outstanding amounts borrowed from the lines were $1,560,431 and $693,405, respectively, which were the approximate amounts available from the lines. These amounts outstanding at September 30, 2005 were repaid in October 2005. Under the credit agreement, the Company must maintain quarterly minimum tangible net worth equal to $5,100,000, plus 75% of quarterly net profits and 75% of net proceeds from equity and subordinated debt financing transactions beginning September 30, 2004. At September 30, 2004, outstanding amounts borrowed from the Company's bank lines were $1,258,405 and $739,076, respectively, which were the approximate amounts available from those lines. The amounts outstanding at September 30, 2004 were repaid in October 2004.

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NOTE 5 - Series F Convertible Preferred Stock Financing

On March 21, 2003, the Company sold 276,269 units at a price of $7.22 per unit (total of $2,000,000 gross cash proceeds) in a private equity placement. Each unit consisted of one share of the Company's Series F convertible preferred stock (the "Series F Preferred Stock") and a three-year warrant to purchase three shares of the Company's common stock. Two directors of the Company invested an aggregate of $115,000 in the financing. Each share of Series F Preferred Stock is convertible, in whole or in part, into 10 shares of common stock at the option of the holder at any time for a period of three years following the date of sale, with a mandatory conversion date on March 21, 2006. The originally issued Series F Preferred Stock was convertible into a total of 2,762,690 shares of common stock at a conversion price of $0.722 per share, subject to certain adjustments. An additional 828,807 shares of common stock were issuable upon exercise of the originally issued warrants at an exercise price of $0.722 per share. In addition, the Company issued five-year warrants to the placement agent to acquire up to 718,300 shares of common stock at $0.722 per share. Using a Black-Scholes valuation model with the following assumptions: 0.0% dividend yield rate, risk free interest rates of 1.9% and 2.81%, respectively, for the investors and placement agent, $0.73 per share fair value of common stock, $0.722 exercise price, a life of three years and five years, respectively, for the investors and placement agent, and a volatility of 0.911, $296,494 of the proceeds were attributed to the warrants issued to investors, and the warrants issued to the placement agent were valued at $366,333, which was included in the cost of the financing. The Company recorded a one-time accretion charge of $296,494 in the first quarter of 2003 reflecting the discount from market resulting from the allocation of the proceeds to the investor warrants.

The Series F Preferred Stock automatically converts into common stock on March 21, 2006 and automatically converts earlier in the event of a merger or consolidation of the Company, subject to certain conditions. The holders of Series F Preferred Stock have voting rights equal to the number of shares of common stock issuable upon conversion. In the event of liquidation, holders of Series F Preferred Stock are entitled to liquidation preferences over common stockholders equal to their initial investment plus all accrued but unpaid dividends. Dividends accrue at the rate of 8% per annum and are payable quarterly in cash or in common stock, at the option of the Company. Dividends accrued for the three and nine months ended September 30, 2005 were $12,087 and $36,461, respectively, which were paid in cash subsequent to the end of each of the respective quarters. During the third quarter of 2005, no holders of Series F Preferred Stock elected to convert their shares into common stock, leaving 83,023 shares of Series F Preferred Stock outstanding at September 30, 2005. Dividends accrued for the three and nine months ended September 30, 2004 were $12,288, and $37,905, respectively, which were paid in cash subsequent to each of the respective quarters. During the third quarter of 2004, holders of 1,131 shares of Series F Preferred Stock elected to convert their shares into 11,310 shares of common stock, leaving 83,823 shares of Series F Preferred Stock outstanding at September 30, 2004.

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NOTE 6 - Intangible Assets

On July 15, 2004 the Company acquired U.S. Patent 5,902,991 entitled Card Shaped Computer Peripheral Device from Khyber Technologies, Inc. The patent covers the design and functioning of plug-in bar code scanners, bar code imagers and RFID products. The patent was purchased for $600,000 and has been capitalized as an intangible asset. The patent is being amortized on a straight line basis over its estimated useful life of ten years.

During the first quarter of 2002, the Company acquired intangible assets in conjunction with the acquisition of Nokia's CompactFlash Bluetooth Card business and related product line technology. These intangible assets were valued at $980,000, and consisted of purchased technology and a licensing agreement. Estimated useful lives of the acquired assets at the time of acquisition ranged from one to three years. During the first quarter of 2005, the Company completed amortization of all acquired Nokia intangibles. Intangible assets of $723,750 from a prior acquisition in 2000 consist of developed software and technology with estimated lives at the time of acquisition ranging from 2.5 to 8.5 years. At December 31, 2004, existing licensing agreements with a book value of $37,733 was reclassified as an intangible asset and will be amortized over its remaining life of three years.

Amortization of all intangible assets for the three and nine months ended September 30, 2005 was $36,044 and $166,999, respectively, compared to $106,787 and $290,361, respectively, for the same periods in 2004. Intangible assets as of September 30, 2005 consisted of the following:

Based on definite lived intangible assets recorded at September 30, 2005, and assuming no subsequent impairment of the underlying assets, the annual amortization expense is expected to be as follows:

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NOTE 7 - Net Income (Loss) Per Share

The Company calculates earnings per share in accordance with Financial Accounting Standards Board Statement No. 128, Earnings per Share.

The following table sets forth the computation of basic and diluted net income per share:

NOTE 8 - Income Taxes

There were no provisions for federal or state income taxes for the three and nine months ended September 30, 2005. Earnings in the three and nine months ended September 30, 2005 were immaterial and continued earnings are not assured. The Company had immaterial net income in 2004, its first profitable year. The Company has maintained a full valuation allowance for all deferred tax assets.

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NOTE 9 - Segment Information

The Company operates in one segment, data collection and connection solutions for mobile electronic devices. The Company markets its products in the United States and foreign countries through its sales personnel and distributors. Information regarding geographic areas for the three and nine months ended September 30, 2005 and 2004 are as follows:

Export revenues are attributable to countries based on the location of the customers. The Company does not hold long-lived assets in foreign locations.

Major customers who accounted for at least 10% of the Company's total revenues during the three and nine months ended September 30, 2005 and 2004 were as follows:

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

This Quarterly Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements include statements forecasting future financial results and operating activities, market acceptance of our products, expectations for general market growth of handheld computers and other mobile computing devices, growth in demand for our products, expansion of the markets that we serve, expansion of the distribution channels for our products, adoption of our embedded products by third-party manufacturers of electronic devices, and the timing of the introduction and availability of new products, as well as other forecasts discussed under "Management's Discussion and Analysis of Financial Condition and Results of Operations." Words such as "may," "will," "predicts," "anticipates," "expects," "intends," "plans," believes," "seeks," "estimates," variations of such words, and similar expressions are intended to identify such forward-looking statements. Such forward-looking statements are based on current expectations, estimates, and projections about our industry, management's beliefs, and assumptions made by management. These forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties, and assumptions that are difficult to predict; therefore, actual results and outcomes may differ materially from what is expressed or forecasted in any such forward looking statements. Such factors include but are not limited to, the risk of delays in the availability of our products due to technological, market or financial factors including the availability of necessary working capital, our ability to successfully introduce and market future products, our ability to effectively manage and contain our operating costs, the availability of announced handheld computer hardware and software that our products are intended to work with, product delays associated with new model introductions and product changeovers by the makers of products that our products are intended to work with, continued growth in demand for handheld computers, market acceptance of emerging standards such as Bluetooth and Wireless LAN and of our related connection and data collection products, the ability of our strategic partnerships to benefit our business as expected, our ability to enter into additional distribution relationships, or other factors described in this Form 10-Q including "Other Factors Affecting Future Operations" and recent 10-K and 10-Q reports filed with the Securities and Exchange Commission. We assume no obligation to update such forward-looking statements or to update the reasons why actual results could differ materially from those anticipated in such forward-looking statements.

You should read the following discussion in conjunction with the interim condensed consolidated financial statements and notes included elsewhere in this report, the Company's annual financial statements in the 10-K, and other information contained in other reports and documents filed from time to time with the Securities and Exchange Commission.

Revenue

We design, manufacture and sell data collection and connectivity products for use with mobile electronic devices, including handheld computers, tablet computers, notebook computers, and Smartphones. We also design, manufacture and sell serial products that connect mobile electronic devices to peripheral and other electronic devices, and sell embedded products that are designed to be embedded within third party mobile electronic devices. Total revenue for the three and nine months ended September 30, 2005 of $6.5 million and $19.1 million, respectively, represented an increase of 6% and a decrease of 3% from revenue of $6.2 million and $19.7 million for the corresponding periods one year ago.

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Our products may be classified into four broad product families:

• Our data collection products consist of bar code scanning and Radio Frequency Identification (RFID) products that plug into or connect cordlessly to handheld computers, tablet computers, notebook computers and Smartphones, and turn these devices into portable bar code scanners or RFID readers that can be used in various retail and industrial workplaces. We have developed extensive data collection software called SocketScan that supports all of our data collection products, and have software developer kits that assist developers in integrating our SocketScan software into their applications. Our bar code scanning products include CompactFlash and SDIO plug-in bar code scanners for linear (1D) and two-dimensional bar code scanning (2D), and a stand alone hand bar code scanner that connects using Bluetooth wireless technology for short-range cordless connectivity. Our initial RFID product was a CompactFlash card for reading RFID tags using our SocketScan software. In the third quarter of 2005, we introduced our combination CompactFlash RFID reader/bar code scanning card that incorporates both data capture technologies in a single device. Data collection products represented approximately 38 percent and 39 percent of our revenue for the three and nine months ended September 30, 2005.

• Our connectivity products are connection devices that can be plugged into standard expansion slots in handheld computers, tablet computers, notebook computers and Smartphones, or connect to these devices over wireless and wired connections. These products allow users to connect their devices to the Internet via mobile or wired phone services, or to private networks, or to communicate with other electronic devices such as desktop computers, other handheld, tablet and notebook computers, Smartphones and printers. Wireless connection products include plug-in cards using Bluetooth wireless technology for short-range wireless connectivity, and plug-in cards for connecting to local wireless networks and "hot spots" using the Wireless LAN 802.11 (or Wi-Fi) standard, including extensive communications software to enable the use of these products. Cabled connection products include modems for telephone connections and Ethernet cards for local area network connections. Our products enabled with Bluetooth wireless technology are of two types: those that add Bluetooth wireless technology to mobile devices, and those that work with devices that are enabled with Bluetooth wireless technology. Those that add Bluetooth wireless technology include our CompactFlash and SDIO Bluetooth plug-in cards, our Bluetooth embedded modules, and our Bluetooth USB adapter for Windows notebooks and desktops. Bluetooth functions are becoming more widely built into mobile devices, which will reduce demand for this category of product. Connectivity products which utilize Bluetooth wireless technology as a connection mechanism and work with other products enabled with Bluetooth wireless technology consist of our Cordless GPS receiver and our Cordless modem. Our GPS receiver collects and sends satellite positioning data to a PDA or notebook for use with GPS maps and routing software. Connectivity products represented approximately 33 percent and 34 percent of our revenue for the three and nine months ended September 30, 2005.
  
  

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• Our embedded products and services consist of Bluetooth modules, interface chips, and engineering design services to install these products. Our Bluetooth modules allow manufacturers of handheld computers and other devices to build wireless connection functions into their products using Bluetooth wireless technology for short-range wireless connectivity. Our interface chips allow manufacturers of wide area network cards and other devices to transfer information to and from handheld or notebook computers. Embedded products and services represented approximately 14 percent and 13 percent of our revenue for the three and nine months ended September 30, 2005.

• Our serial products add connection ports to notebooks, tablets and handheld computers that allow users to connect these portable computers to standard peripherals and to other electronic devices with serial connections over cables or using Bluetooth wireless technology for short-range wireless connectivity. Serial products represented approximately 13 percent of our revenue for the three and nine months ended September 30, 2005.

Our data collection product revenues were $2.5 million for the three months ended September 30, 2005, compared to $2.8 million for the same period one year ago. A revenue decline from the comparable three months of 2004 of $0.5 million for our bar code laser scanner system, and a decline of $0.1 million in sales of our SDIO In-Hand Scan card, were partially offset by revenue growth of $0.3 million from our Cordless Hand Scanner, which began shipping to customers in the second quarter of 2004. Revenue from our primary scanning product, the CompactFlash In-Hand Scan card, was flat from the comparable three month period one year ago. Delays in the transition to new models by the major PDA manufacturers through the first half of 2005 and long lead times needed by customers to complete their product testing and field trials slowed data collection orders in the third quarter of 2005 compared to the same period one year ago. Our data collection product revenues were $7.5 million for the nine month period ended September 30, 2005, compared to $7.6 million for the same period one year ago. Revenue declined from the comparable nine months by $0.4 million for our primary scanning product, the CompactFlash In-Hand Scan card. We also experienced a decline of $0.7 million from our bar code laser scanner system, and a decline of $0.3 million in sales of our SDIO In-Hand Scan card. Partially offsetting these declines was growth of $1.3 million from our Cordless Hand Scanner. Our data collection revenues for the first nine months of 2005 were affected by the transitions to new models by the major PDA manufacturers begun in the latter half of 2004, which were not fully resolved until late in the second quarter of 2005. In addition, the introduction of an operating system upgrade, Windows Mobile 5.0, announced in September 2005 by the major PDA manufacturers may continue to slow customer deployment of our data collection products until tested with the new operating system. Our data collection products are sold both through general distribution and through value added resellers, who contract with customers to provide scanning solutions. Our products are becoming more widely adopted by the value added reseller community for lightweight portable scanning.

Our connectivity product revenues were $2.2 million for the three months ended September 30, 2005, compared to $1.6 million for the same period one year ago. The revenue increase from the comparable three months of 2004 was attributable to increases of $0.2 million in each of our Bluetooth plug-in product and Modem plug-in product lines, and an additional revenue increase totaling $0.3 million from our Wireless LAN plug-in cards, our Bluetooth GPS receiver with navigation kit, and our accessory products, including the Mobile Power Pack introduced in the fourth quarter of 2004, were partially offset by decreases in sales of our Ethernet plug-in products. Our connectivity product revenues were $6.6 million for the nine month period ended September 30, 2005, compared to $6.5 million for the same period one year ago. Revenue increases in the comparable nine months of 2005 of $0.4 million in our Modem plug-in products, increases of $0.3 million in our Ethernet plug-in products, and increases in our accessory products, including the Mobile Power Pack, were partially offset by declines of $0.4 million in sales of our Wireless LAN plug-in cards, and declines of $0.3 million in sales of our Bluetooth plug-in products. Our connectivity revenues for the first nine months of 2005 were negatively affected though the first half of 2005 by the transitions to new models by the major PDA manufacturers begun in the latter half of 2004, which were not fully resolved until late in the second quarter of 2005. In addition, the introduction of an operating system upgrade, Windows Mobile 5.0, announced in September 2005 by the major PDA manufacturers may continue to slow customer deployment of our connectivity products until tested with the new operating system.

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Our embedded products and services revenues were $0.9 million for the three months ended September 30, 2005, compared to $0.8 million in the same period one year ago. The revenue increase for the comparable three months was attributable to an increase of $0.3 million from sales of our Bluetooth modules due to higher order levels by customers delivering new products, which was partially offset by declines of $0.2 million in sales of our proprietary ASIC chip from slowdowns in customer orders. Our embedded products and services revenues were $2.5 million for the nine month period ended September 30, 2005, compared to $2.7 million for the same period a year ago. Revenue declines in the comparable nine months of $0.5 million in our proprietary ASIC chip from slowdowns in customer orders in each of the three quarters in 2005, and $0.1 million in engineering service revenues, were partially offset by increases of $0.4 million in sales of our Bluetooth modules. Sales of our embedded Bluetooth cards were flat in each of the comparable periods.

Our serial product revenues were $0.9 million for the three months ended September 30, 2005, compared to $1.0 million for the same period one year ago. Our serial product revenues were $2.5 million for the nine month period ended September 30, 2005, compared to $2.9 million for the same period one year ago. Revenue declines of $0.3 million and $0.5 in the three and nine month comparable periods, respectively, in sales of our standard serial PC Card products were partially offset by increased sales of our cordless Bluetooth serial adapter in each of the comparable periods. Our CF Card product sales were relatively flat in each of the comparable periods. Standard peripheral connection cards are primarily sold to connect peripheral devices or other electronic equipment to notebook computers.

Gross Margins

Gross margins for the three and nine month periods ended September 30, 2005 were 50% in both periods compared to margins of 52% and 51% in the comparable periods in 2004. We generally price our products as a markup from our cost, and we offer discount pricing to our customers for higher volume purchases. Margin reductions in the comparable periods of 2005 from volume sales of our data collection products, and overall margin reductions across our remaining product lines from a change in product sales mix, were partially offset by margin improvements from cost reductions on specific products in each of our product lines in the three and nine month comparable periods. Our average target gross margin is 50%, and we expect the gross margin to fluctuate within a narrow range from quarter to quarter.

Research and Development Expense

Research and development expense for the three months ended September 30, 2005 was $0.8 million, a decrease of 6% compared to research and development expense of $0.9 million in the corresponding period one year ago. Research and development expense for the nine months ended September 30, 2005 was $2.6 million, a 4% decrease compared to research and development expense of $2.7 million in the corresponding period one year ago. Reductions in each of the comparable periods were primarily attributable to reduced consulting and professional fees and outside services related to the timing of development projects. Expenses are expected to increase in the fourth quarter of 2005.

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Sales and Marketing Expense

Sales and marketing expense for the three months ended September 30, 2005 was $1.7 million, an increase of 16% compared to sales and marketing expense of $1.4 million in the corresponding period one year ago. Sales and marketing expense for the nine month period ended September 30, 2005 was $4.8 million, an increase of 10% compared to sales and marketing expense of $4.4 million in the corresponding period one year ago. Half of the increase in each of the comparable periods was from increased personnel costs related to staffing key sales and marketing positions. Additional increases were from higher levels of advertising and promotion, and travel related expense compared to the same periods one year ago. Expenses are expected to increase in the fourth quarter of 2005.

General and Administrative Expense

General and administrative expense for the three months ended September 30, 2005 was $0.6 million, a decrease of 21% compared to general and administrative expense of $0.7 million in the corresponding period one year ago. General and administrative expense for the nine month period ended September 30, 2005 was $2.0 million, a decrease of 20% compared to general and administrative expense of $2.5 million in the corresponding period one year ago. Decreases of $0.2 million and $0.6 million, respectively, in the comparable three and nine month periods of 2005 were due to reduced legal and professional fees related to the patent infringement complaint by Khyber Technologies Corporation, which was settled in the beginning of the third quarter of 2004. An additional decrease in the comparable nine month periods was from reduced costs of business insurance. Partially offsetting these decreases in the comparable nine month periods were increases of $0.2 million in professional fees related primarily to Sarbanes-Oxley compliance requirements completed in the first quarter of 2005. Expenses are expected to increase in the fourth quarter of 2005.

Amortization of Intangibles

On July 15, 2004, the Company acquired U.S. Patent 5,902,991 entitled Card Shaped Computer Peripheral Device from Khyber Technologies, Inc. The patent covers the design and functioning of plug-in bar code scanners, bar code imagers and RFID products. The patent was purchased for $600,000 and has been capitalized as an intangible asset. The patent is being amortized on a straight line basis over a ten year period. During the first quarter of 2002, the Company acquired intangible assets in conjunction with the acquisition of Nokia's CompactFlash Bluetooth Card business and related product line technology. These intangible assets were valued at $980,000, and consisted of purchased technology and a licensing agreement. Estimated useful lives of the acquired assets at the time of acquisition ranged from one to three years. At March 31, 2005 all components of the acquired Nokia intangibles were fully amortized. Intangible assets of $723,750 from a prior acquisition in 2000 consist of developed software and technology with estimated lives at the time of acquisition ranging from 2.5 to 8.5 years. At December 31, 2004, a licensing agreement with a book value of $38,000 was reclassified as an intangible asset and will be amortized over its remaining life of three years. Amortization charges for the three and nine months ended September 30, 2005 were $36,000 and $167,000, respectively, compared to $107,000 and $290,000 for the same periods one year ago. The lower amortization charges in 2005 are due to components of intangible property becoming fully amortized.

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Interest Income, Interest Expense, Net

Interest income reflects interest earned on cash balances. Interest income was $27,000 and $59,000 for the three and nine month periods ended September 30, 2005, respectively, compared to interest income of $8,000 and $27,000, respectively, for the comparable periods one year ago. Higher levels of interest income reflect higher average rates of return on cash balances on hand during the three and nine months of 2005 compared to the same periods one year ago.

Interest expense of $800 and $3,400 for the three and nine months ended September 30, 2005 is related to interest on equipment lease financing obligations. Interest expense of $400 and $7,900 for the three and nine months ended September 30, 2004 is related to interest on equipment lease financing obligations and the outstanding note payable balance due to Nokia for acquisition of their Bluetooth CompactFlash Card business and related product line technology in March 2002. Lower interest expense in the first nine months of 2005 reflects the repayment of the note payable to Nokia in April 2004.

Preferred Stock Dividends and Accretion of Preferred Stock

Preferred stock dividends for the three and nine months ended September 30, 2005 were $12,100 and $36,500, respectively, accrued at the rate of 8% per annum on Series F Preferred Stock issued in March 2003. Dividends on the Series F Preferred Stock for the three and nine months ended September 30, 2004 were $12,300 and $37,900, respectively. Lower dividends in the three and nine month periods in 2005 reflect lower shares outstanding compared to the same periods one year ago. Dividends were paid in cash subsequent to each of the quarters in 2005 and 2004.

Income Taxes

There were no provisions for federal or state income taxes for the three and nine months ended September 30, 2005. Earnings in the three and nine months ended September 30, 2005 were immaterial and continued earnings are not assured. The Company had immaterial net income in 2004, its first profitable year. The Company has maintained a full valuation allowance for all deferred tax assets.

Liquidity and Capital Resources

We were profitable in the first nine months of 2005, but only to the extent of $37,000. Fiscal 2004 was our first profitable year, which included our first profitable quarter, the first quarter of 2004. Historically we have financed our operations through the sale of equity securities, equipment financing, and revolving bank lines of credit. Since our inception we have raised approximately $51 million in equity capital. Prior to 2004 we incurred significant quarterly and annual operating losses in every fiscal period. Ongoing profitability is not assured. Adoption of SFAS 123R in the first quarter of 2006 will negatively impact our operating results.

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Cash provided by operating activities was $1.8 million in the first nine months of 2005 and $0.3 million in the first nine months of 2004. Cash provided from our net income adjusted for non-cash items was $0.6 million in the first nine months of 2005 compared to $0.9 million in the first nine months of 2004. Adjustments for non-cash items, including depreciation, amortization of intangibles, gains and losses on foreign currency forward exchange contracts, foreign currency translation losses, and changes in deferred rent, totaled $0.5 million in the first nine months of 2005 and $0.7 million in the first nine months of 2004. Changes in working capital balances in the first nine months of 2005 resulted in a source of cash of $1.2 million, and were primarily from reductions in levels of inventory, decreases in receivables due to early collections from key distributors, and increases in payables, partially offset by increases in prepaid assets. Changes in working capital balances resulted in a use of cash of $0.6 million in the first nine months of 2004 primarily from increases in inventories and prepaid expenses, partially offset by reductions in accounts receivables and increases in deferred revenue and payables.

Cash used in investing activities was $0.4 million in the first nine months of 2005 compared to $0.9 million in the first nine months of 2004. Investing activities in 2005 primarily reflect the cost of new computer hardware and software, and tooling costs. Investing activities in the first nine months of 2004 primarily reflect the purchase costs of a patent for $0.6 million in July of 2004, and costs of new computer hardware and software, and tooling.

Cash used in financing activities was $0.7 million in the first nine months of 2005 compared to cash provided of $0.1 million in the first nine months of 2004. Financing activities in the first nine months of 2005 consisted primarily of a net decrease in the amounts drawn on our bank lines of credit, payment of cash dividends, and payments on capital leases partially offset by proceeds from the exercise of stock options. Financing activities in 2004 consisted primarily of a net increase in the amounts drawn at the end of each quarter on our bank lines of credit, proceeds from the exercise of stock options and warrants, partially offset by payments on the note payable to Nokia.

Our cash balances at September 30, 2005 were $6.6 million, including cash of $2.3 million drawn against our bank line of credit. In March 2004, we extended our bank line of credit agreement which will now expire on March 4, 2007. We have warrants outstanding from our private placement financings and outstanding employee stock options that, if exercised, would further increase our cash and equity balances. We believe our existing cash, plus our ability to reduce costs, and the bank line, will be sufficient to meet our funding requirements at least through September 30, 2006. If we maintain and increase annual profitability from revenue growth, we anticipate requirements for cash will include funding of higher receivable and inventory balances, and increasing expenses including more employees to support our growth and increases in the cost of salaries, benefits, and related support costs for employees. If we cannot maintain profitability, we will not be able to support our operations from positive cash flows, and we would use our existing cash to support operating losses. Should the need arise, we cannot assure you that additional capital will be available on acceptable terms, if at all, and any such terms may be dilutive to existing stockholders. Although we do not anticipate the need to raise additional capital at this time to fund our operations, we may raise additional capital if market conditions are appropriate.

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The Company's contractual cash obligations at September 30, 2005 are outlined in the table below:

Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements as defined in Item 303 of Regulation S-K.

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Other Factors Affecting Future Operations

We have a history of operating losses, and may not achieve ongoing profitability.

We incurred a net loss of $404,000 in the first quarter of 2005. We were profitable in the first nine months of 2005, but only to the extent of $37,000. For the fiscal year ended December 31, 2004, we were profitable but only to the extent of $288,000, and for the fiscal year ended December 31, 2003 we incurred net losses of $1,952,000. Prior to 2003, we incurred significant operating losses in each financial period since our inception. To maintain annual profitability, we must accomplish numerous objectives, including growth in our business and the development of successful new products. We cannot foresee with any certainty whether we will be able to achieve these objectives in the future. Accordingly, we may not generate sufficient net revenue to achieve ongoing annual profitability. If we cannot achieve profitability, we will not be able to support our operations from positive cash flows, and we would use our existing cash to support operating losses, and would be required to seek financing which would be dilutive to our shareholders. If we are unable to secure the necessary capital to replace that cash, we may need to suspend some or all of our current operations.

We will be required beginning in the first quarter of 2006 to expense as compensation options granted under our employee stock plans, and as a result we expect our net income and earnings per share will be reduced, we may have net losses, and we may find it necessary to change our business practices to attract and retain employees.

Historically, we have used stock options as a key component of our employee compensation packages. We believe that stock options provide an incentive to our employees to maximize long-term stockholder value and, through the use of vesting, encourage valued employees to remain with us. The expensing of employee stock options will adversely affect our net income and earnings per share and may cause us to record net losses. In particular, we would not have been profitable in the second or third quarter of 2005, nor profitable in any of the quarters in fiscal 2004, if we had been required to expense options during those periods. In addition, we may decide in response to the effects of expensing stock options on our operating results to reduce the number of stock options granted to employees or to grant options to fewer employees. This could adversely affect our ability to retain existing employees and attract qualified candidates, and also could increase the cash compensation we would have to pay to them.

We may require additional capital in the future, but that capital may not be available on reasonable terms, if at all, or on terms that would not cause substantial dilution to your stock holdings.

Although we do not anticipate the need to raise additional capital during the next twelve months to fund our operations, we may incur operating losses in future quarters and may need to raise capital to fund these losses. Our forecasts are highly dependent on factors beyond our control, including market acceptance of our products and sales of handheld computers. If capital requirements vary materially from those currently planned, we may require additional capital sooner than expected. There can be no assurance that such capital will be available in sufficient amounts or on terms acceptable to us, if at all. In addition, the availability of our bank line is dependent upon our meeting certain covenants including a tangible net worth covenant, and future operating losses could cause us to lose the availability of our bank line as a result of becoming non-compliant with these covenants.

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A significant portion of our revenue currently comes from two distributors, and any decrease in revenue from these distributors could harm our business.

A significant portion of our revenue comes from two distributors, Tech Data Corp. and Ingram Micro, Inc., which together represented approximately 45 and 42 percent of our worldwide revenue in the first nine months of fiscal 2005 and fiscal year 2004, respectively. We expect that a significant portion of our revenue will continue to depend on sales to Tech Data Corp. and Ingram Micro, Inc. We do not have long-term commitments from Tech Data Corp. or Ingram Micro, Inc. to carry our products. Either could choose to stop selling some or all of our products at any time, and each of these companies also carries competitive products. If we lose our relationship with Tech Data Corp. or Ingram Micro, Inc., we could experience disruption and delays in marketing our products.

If the market for mobile personal computers fails to grow, we would not achieve our sales projections.

Substantially all of our products are designed for use with mobile personal computers, including handhelds, notebook computers, tablets and Smartphones. If the mobile personal computer industry does not grow, if its growth slows, or if product changeovers by mobile computer manufacturers and partners cause delays in the market, as we experienced in the first half of 2005, we would not achieve our sales projections.

Our sales would be hurt if the new technologies used in our products do not become widely adopted, or are adopted slower than expected.

Many of our products use new technologies, such as and 2D bar code scanning and RFID, which are not yet widely adopted in the market. If these technologies fail to become widespread, or are adopted slower than expected, our sales will suffer.

If third parties do not produce and sell innovative products with which our products are compatible, we may not achieve our sales projections.

Our success is dependent upon the ability of third parties in the mobile personal computer industry to complete development of products that include or are compatible with our technology and then to sell these products into the marketplace. Our ability to generate increased revenue depends significantly on the commercial success of Windows-powered handheld devices, particularly the Pocket PC, and other devices, such as the line of handhelds with expansion options offered by Palm and the adoption of Smartphones for business use. If manufacturers are unable or choose not to ship new products such as Pocket PC and other Windows-powered devices or Palm devices on schedule, or experience difficulties with new product transitions that cause delays in the market as we experienced in the first half of 2005, or if these products fail to achieve or maintain market acceptance, the number of our potential new customers would be reduced and we would not be able to meet our sales expectations.

We could face increased competition in the future, which would adversely affect our financial performance.

The market for handheld computers in which we operate is very competitive. Our future financial performance is contingent on a number of unpredictable factors, including that:

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• Some of our competitors have greater financial, marketing, and technical resources than we do;
  
• We periodically face intense price competition, particularly when our competitors have excess inventories and discount their prices to clear their inventories; and
  
• Certain original equipment manufacturers of personal computers, mobile phones and handheld computers offer built in functions, such as Bluetooth wireless technology, WiFi, GPS, or bar code scanning, that compete with our products.

Increased competition could result in price reductions, fewer customer orders, reduced margins, and loss of market share. Our failure to compete successfully against current or future competitors could harm our business, operating results and financial condition.

If we fail to develop and introduce new products rapidly and successfully, we will not be able to compete effectively, and our ability to generate sufficient revenues will be negatively affected.

The market for our products is prone to rapidly changing technology, evolving industry standards and short product life cycles. If we are unsuccessful at developing and introducing new products and services on a timely basis that include the latest technologies conforming with the newest standards and that are appealing to end users, we will not be able to compete effectively, and our ability to generate significant revenues will be seriously harmed.

The development of new products and services can be very difficult and requires high levels of innovation. The development process is also lengthy and costly. Short product life cycles expose our products to the risk of obsolescence and require frequent new product introductions. We will be unable to introduce new products and services into the market on a timely basis and compete successfully, if we fail to:

• identify emerging standards in the field of mobile computing products;
  
• enhance our products by adding additional features;
  
• invest significant resources in research and development, sales and marketing, and customer support;
  
• maintain superior or competitive performance in our products; and
• anticipate our end users' needs and technological trends accurately

We cannot be sure that we will have sufficient resources to make adequate investments in research and development or that we will be able to identify trends or make the technological advances necessary to be competitive.

If we do not correctly anticipate demand for our products, our operating results will suffer.

The demand for our products depends on many factors and is difficult to forecast. We expect that it will become more difficult to forecast demand as we introduce and support more products and as competition in the market for our products intensifies. If demand increases beyond forecasted levels, we would have to rapidly increase production at our third-party manufacturers. We depend on suppliers to provide additional volumes of components, and suppliers might not be able to increase production rapidly enough to meet unexpected demand. Even if we were able to procure enough components, our third-party manufacturers might not be able to produce enough of our devices to meet our customer demand. In addition, rapid increases in production levels to meet unanticipated demand could result in higher costs for manufacturing and supply of components and other expenses. These higher costs could lower our profit margins. Further, if production is increased rapidly, manufacturing yields could decline, which may also lower operating results.

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If demand is lower than forecasted levels, we could have excess production resulting in higher inventories of finished products and components, which could lead to write-downs or write-offs of some or all of the excess inventories. Lower than forecasted demand could also result in excess manufacturing capacity at our third-party manufacturers and in our failure to meet some minimum purchase commitments, each of which may lower our operating results.

We depend on alliances and other business relationships with a small number of third parties, and a disruption in any one of these relationships would hinder our ability to develop and sell our products.

We depend on strategic alliances and business relationships with leading participants in various segments of the communications and mobile personal computer markets to help us develop and market our products. Our strategic partners may revoke their commitment to our products or services at any time in the future or may develop their own competitive products or services. Accordingly, our strategic relationships may not result in sustained business alliances, successful product or service offerings, or the generation of significant revenues. Failure of one or more of such alliances could result in delay or termination of product development projects, failure to win new customers, or loss of confidence by current or potential customers.

We have devoted significant research and development resources to design activities for Windows-powered mobile products and, more recently, to design activities for Palm devices, Smartphones using Windows Mobile and Symbian System 60 and 80 operating systems, and handheld computers from Research-in-Motion. Such design activities have diverted financial and personnel resources from other development projects. These design activities are not undertaken pursuant to any agreement under which Microsoft, Palm, Symbian or Research-in-Motion are obligated to continue the collaboration or to support the products produced from the collaboration. Consequently, these organizations may terminate their collaborations with us for a variety of reasons, including our failure to meet agreed-upon standards or for reasons beyond our control, such as changing market conditions, increased competition, discontinued product lines, and product obsolescence.

We rely primarily on distributors, resellers, retailers and original equipment manufacturers to sell our products, and our sales would suffer if any of these third parties stops selling our products effectively.

Because we sell our products primarily through distributors, resellers, retailers and original equipment manufacturers, we are subject to risks associated with channel distribution, such as risks related to their inventory levels and support for our products. Our distribution channels may build up inventories in anticipation of growth in their sales. If such growth in their sales does not occur as anticipated, the inventory build up could contribute to higher levels of product returns. The lack of sales by any one significant participant in our distribution channels could result in excess inventories and adversely affect our operating results.

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Our agreements with distributors, resellers, retailers and original equipment manufacturers are generally nonexclusive and may be terminated on short notice by them without cause. Our distributors, resellers, retailers and original equipment manufacturers are not within our control, are not obligated to purchase products from us, and may offer competitive lines of products simultaneously. Sales growth is contingent in part on our ability to enter into additional distribution relationships and expand our retail sales channels. We cannot predict whether we will be successful in establishing new distribution relationships, expanding our retail sales channels or maintaining our existing relationships. A failure to enter into new distribution relationships or to expand our retail sales channels could adversely impact our ability to grow our sales.

We allow our distribution channels to return a portion of their inventory to us for full credit against other purchases. In addition, in the event we reduce our prices, we credit our distributors for the difference between the purchase price of products remaining in their inventory and our reduced price for such products. Actual returns and price protection may adversely affect future operating results, particularly since we seek to continually introduce new and enhanced products and are likely to face increasing price competition.

Our intellectual property and proprietary rights may be insufficient to protect our competitive position.

Our business depends on our ability to protect our intellectual property. We rely primarily on patent, copyright, trademark, trade secret laws, and other restrictions on disclosure to protect our proprietary technologies. We cannot be sure that these measures will provide meaningful protection for our proprietary technologies and processes. We cannot be sure that any patent issued to us will be sufficient to protect our technology. The failure of any patents to provide protection to our technology would make it easier for our competitors to offer similar products. In connection with our participation in the development of various industry standards, we may be required to license certain of our patents to other parties, including our competitors, that develop products based upon the adopted standards.

We also generally enter into confidentiality agreements with our employees, distributors, and strategic partners, and generally control access to our documentation and other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use our products, services, or technology without authorization, develop similar technology independently, or design around our patents.

Effective copyright, trademark, and trade secret protection may be unavailable or limited in certain foreign countries. Furthermore, certain of our customers have entered into agreements with us which provide that the customers have the right to use our proprietary technology in the event we default in our contractual obligations, including product supply obligations, and fail to cure the default within a specified period of time.

We may become subject to claims of intellectual property rights infringement, which could result in substantial liability.

In the course of operating our business, we may receive claims of intellectual property infringement or otherwise become aware of potentially relevant patents or other intellectual property rights held by other parties. Many of our competitors have large intellectual property portfolios, including patents that may cover technologies that are relevant to our business. In addition, many smaller companies, universities, and individuals have obtained or applied for patents in areas of technology that may relate to our business. The industry is moving towards aggressive assertion, licensing, and litigation of patents and other intellectual property rights.

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If we are unable to obtain and maintain licenses on favorable terms for intellectual property rights required for the manufacture, sale, and use of our products, particularly those products which must comply with industry standard protocols and specifications to be commercially viable, our results of operations or financial condition could be adversely impacted.

In addition to disputes relating to the validity or alleged infringement of other parties' rights, we may become involved in disputes relating to our assertion of our own intellectual property rights. Whether we are defending the assertion of intellectual property rights against us or asserting our intellectual property rights against others, intellectual property litigation can be complex, costly, protracted, and highly disruptive to business operations by diverting the attention and energies of management and key technical personnel. Plaintiffs in intellectual property cases often seek injunctive relief, and the measures of damages in intellectual property litigation are complex and often subjective or uncertain. Thus, any adverse determinations in this type of litigation could subject us to significant liabilities and costs.

New industry standards may require us to redesign our products, which could substantially increase our operating expenses.

Standards for the form and functionality of our products are established by standards committees. These separate committees establish standards, which evolve and change over time, for different categories of our products. We must continue to identify and ensure compliance with evolving industry standards so that our products are interoperable and we remain competitive. Unanticipated changes in industry standards could render our products incompatible with products developed by major hardware manufacturers and software developers. Should any major changes, even if anticipated, occur, we would be required to invest significant time and resources to redesign our products to ensure compliance with relevant standards. If our products are not in compliance with prevailing industry standards for a significant period of time, we would miss opportunities to have our products specified as being in compliance with standards for new hardware components designed by mobile computer manufacturers and original equipment manufacturers.

Undetected flaws and defects in our products may disrupt product sales and result in expensive and time-consuming remedial action.

Our hardware and software products may contain undetected flaws, which may not be discovered until customers have used the products. From time to time, we may temporarily suspend or delay shipments or divert development resources from other projects to correct a particular product deficiency. Efforts to identify and correct errors and make design changes may be expensive and time consuming. Failure to discover product deficiencies in the future could delay product introductions or shipments, require us to recall previously shipped products to make design modifications, or cause unfavorable publicity, any of which could adversely affect our business and operating results.

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Our quarterly operating results may fluctuate in future periods, which could cause our stock price to decline.

We expect to experience quarterly fluctuations in operating results in the future. We generally ship orders as received, and as a result we may have little backlog. Quarterly revenue and operating results therefore depend on the volume and timing of orders received during the quarter, which are difficult to forecast. Historically, we have often recognized a substantial portion of our revenue in the last month of the quarter. This subjects us to the risk that even modest delays in orders may adversely affect our quarterly operating results. Our operating results may also fluctuate due to factors such as:

• the demand for our products;
  
• the size and timing of customer orders;
  
• unanticipated delays or problems in our introduction of new products and product enhancements;
  
• the introduction of new products and product enhancements by our competitors;
  
• the timing of the introduction of new products that work with our connection products;
  
• changes in the proportion of revenues attributable to royalties and engineering development services;
  
• product mix;
  
• timing of software enhancements;
  
• changes in the level of operating expenses;
  
• competitive conditions in the industry including competitive pressures resulting in lower average selling prices; and
  
• timing of distributors' shipments to their customers.
  

Because we base our staffing and other operating expenses on anticipated revenue, delays in the receipt of orders can cause significant variations in operating results from quarter to quarter. As a result of any of the foregoing factors, our results of operations in any given quarter may be below the expectations of public market analysts or investors, in which case the market price of our Common Stock would be adversely affected.

The loss of one or more of our senior personnel could harm our existing business.

A number of our officers and senior managers have been employed for nine to thirteen years by us, including our President, Chief Financial Officer, Chief Technical Officer, Vice President of Marketing, and Senior Vice President for Business Development/General Manager Development Services. Our future success will depend upon the continued service of key officers and senior managers. Competition for officers and senior managers is intense, and there can be no assurance that we will be able to retain our existing senior personnel. The loss of one or more of our officers or key senior managers could adversely affect our ability to compete.

If we are unable to attract and retain highly skilled sales and marketing and product development personnel, our ability to develop new products and product enhancements will be adversely affected.

We believe our ability to achieve increased revenues and to develop successful new products and product enhancements will depend in part upon our ability to attract and retain highly skilled sales and marketing and product development personnel. Our products involve a number of new and evolving technologies, and we frequently need to apply these technologies to the unique requirements of mobile connection products. Our personnel must be familiar with both the technologies we support and the unique requirements of the products to which our products connect. Competition for such personnel is intense, and we may not be able to attract and retain such key personnel. In addition, our ability to hire and retain such key personnel will depend upon our ability to raise capital or achieve increased revenue levels to fund the costs associated with such key personnel. Failure to attract and retain such key personnel will adversely affect our ability to develop new products and product enhancements.

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We may not be able to collect revenues from customers who experience financial difficulties.

Our accounts receivable are derived primarily from distributors and original equipment manufacturers. We perform ongoing credit evaluations of our customers' financial conditions but generally require no collateral from our customers. Reserves are maintained for potential credit losses, and such losses have historically been within such reserves. However, many of our customers may be thinly capitalized and may be prone to failure in adverse market conditions. Although our collection history has been good, from time to time a customer may not pay us because of financial difficulty, bankruptcy or liquidation.

We may be unable to manufacture our products, because we are dependent on a limited number of qualified suppliers for our components.

Several of our component parts, including our serial interface chip, our Ethernet chip, and our bar code scanning modules, are produced by one or a limited number of suppliers. Shortages could occur in these essential components due to an interruption of supply or increased demand in the industry. If we are unable to procure certain component parts, we could be required to reduce our operations while we seek alternative sources for these components, which could have a material adverse effect on our financial results. To the extent that we acquire extra inventory stocks to protect against possible shortages, we would be exposed to additional risks associated with holding inventory, such as obsolescence, excess quantities, or loss.

Our operating results could be harmed by economic, political, regulatory and other risks associated with export sales.

Export sales (sales to customers outside the United States) accounted for approximately 34 percent of our revenue in the first nine months of fiscal 2005 and 37 percent of our revenue in the fiscal year 2004. Accordingly, our operating results are subject to the risks inherent in export sales, including:

• longer payment cycles;
  
• unexpected changes in regulatory requirements, import and export restrictions and tariffs;
  
• difficulties in managing foreign operations;
  
• the burdens of complying with a variety of foreign laws;
  
• greater difficulty or delay in accounts receivable collection;
  
• potentially adverse tax consequences; and
  
• political and economic instability.

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Our export sales are predominately denominated in United States dollars and in Euros for our sales to European distributors. Accordingly, an increase in the value of the United States dollar relative to foreign currencies could make our products more expensive and therefore potentially less competitive in foreign markets. Declines in the value of the Euro relative to the United States dollar may result in foreign currency losses relating to collection of Euro denominated receivables.

Our operations are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure, and other events beyond our control.

Our corporate headquarters are located near an earthquake fault. The potential impact of a major earthquake on our facilities, infrastructure, and overall business is unknown. Additionally, we may experience electrical power blackouts or natural disasters that could interrupt our business. Should a disaster be widespread, such as a major earthquake, or result in the loss of key personnel, we may not be able to implement our disaster recovery plan in a timely manner. Any losses or damages incurred by us as a result of these events could have a material adverse effect on our business.

The sale of a substantial number of shares of Common Stock could cause the market price of our Common Stock to decline.

Sales of a substantial number of shares of our Common Stock in the public market could adversely affect the market price for our Common Stock. The market price of our Common Stock could also decline if one or more of our significant stockholders decided for any reason to sell substantial amounts of our Common Stock in the public market.

As of October 31, 2005, we had 30,203,924 shares of Common Stock outstanding. Substantially all of these shares are freely tradable in the public market, either without restriction or subject, in some cases, only to S-3 or S-8 prospectus delivery requirements and, in other cases, only to manner of sale, volume, and notice requirements of Rule 144 under the Securities Act.

As of October 31, 2005, we had 83,023 shares of Series F Preferred Stock outstanding that are convertible into 830,230 shares of Common Stock, and will be automatically converted on March 20, 2006.

As of October 31, 2005 we had 7,905,777 shares subject to outstanding options under our stock option plans, and 681,353 shares were available for future issuance under the plans. We have registered the shares of Common Stock subject to outstanding options and reserved for issuance under our stock option plans. Accordingly, shares underlying vested options will be eligible for resale in the public market as soon as the options are exercised.

As of October 31, 2005, we had warrants outstanding to purchase a total of 1,717,674 shares of our Common Stock at exercise prices ranging from $0.722 to $2.73. A portion of these warrants expire in March 2006 and are expected to be exercised. All such warrants may be exercised at any time, and the shares issuable upon exercise may be resold, either without restrictions or subject, in some cases, only to S-3 prospectus delivery requirements, and, in some cases, only to manner of sale, volume, and notice requirements of Rule 144.

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Volatility in the trading price of our Common Stock could negatively impact the price of our Common Stock.

During the period from January 1, 2004 through October 31, 2005, our Common Stock price fluctuated between a high of $4.40 and a low of $1.00. The trading price of our Common Stock could be subject to wide fluctuations in response to many factors, some of which are beyond our control, including general economic conditions and the outlook of securities analysts and investors on our industry. In addition, the stock markets in general, and the markets for high technology stocks in particular, have experienced high volatility that has often been unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the trading price of our Common Stock.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to invested cash. Our cash is invested in short-term money market investments backed by U.S. Treasury notes and other investments that mature within one year and whose principal is not subject to market rate fluctuations. Accordingly, interest rate declines would adversely affect our interest income but would not affect the carrying value of our cash investments. Based on a sensitivity analysis of our cash investments during the quarter ended September 30, 2005, a decline of 1% in interest rates would reduce our quarterly interest income by approximately $10,800.

Our bank credit line facilities of up to $4.0 million have variable interest rates based upon the lender's index rate plus 0.5% for both the domestic line (up to $2.5 million) and the international line (up to $1.5 million). Accordingly, interest rate increases would increase our interest expense on outstanding credit line balances. We utilized our credit line facility only at the end of each quarter in 2005 and each of the quarters in 2004, and therefore did not subject ourselves to interest rate exposure. Based on a sensitivity analysis, an increase of 1% in the interest rate would increase our borrowing costs by $10,000 for each $1 million of borrowings, if outstanding for the entire year, against our bank credit facility or a maximum of $40,000 if we utilized our entire credit line.

Foreign Currency Risk

A substantial majority of our revenue, expense and purchasing activities are transacted in U.S. dollars. However, we require our European distributors to purchase our products in Euros, we pay the expenses of our European subsidiary in Euros, and we expect to enter into selected future purchase commitments with foreign suppliers that may be paid in the local currency of the supplier. To date we have not been subjected to significant losses from material foreign currency fluctuations. Based on a sensitivity analysis of our net foreign currency denominated assets and subsidiary expenses at the beginning, during and at the end of the quarter ended September 30, 2005, an adverse change of 10% in exchange rates would result in a decrease in our net income for the third quarter by approximately $55,000, if left unprotected. For the third quarter of 2005 the total net adjustment for the effects of changes in foreign currency on cash balances, collections, payables, and derivatives was a net gain of $5,800. We hedge a portion of our European receivable balances denominated in Euros to reduce the foreign currency risk associated with these assets. We will continue to monitor and assess the risk associated with these exposures and may at some point in the future take additional actions to mitigate these risks.

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Item 4. Controls and Procedures

(a) Evaluation of disclosure controls and procedures

Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is (i) recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (ii) accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

(b) Changes in internal control over financial reporting

There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 6. Exhibits

Exhibits

31.1 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

SOCKET COMMUNICATIONS, INC.
Registrant

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Index to Exhibits

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Exhibit 31.1

CERTIFICATIONS

I, Kevin J. Mills, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Socket Communications, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and we have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and

(d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

(Index)

CERTIFICATIONS

I, David W. Dunlap, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Socket Communications, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and we have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and

(d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

(Index)

Exhibit 32.1

CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER
PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

I, Kevin J. Mills, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Quarterly Report of Socket Communications, Inc. on Form 10-Q for the quarter ended September 30, 2005 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such Quarterly Report on Form 10-Q fairly presents in all material respects the financial condition and results of operations of Socket Communications, Inc.

I, David W. Dunlap, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Quarterly Report of Socket Communications, Inc. on Form 10-Q for the quarter ended September 30, 2005 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such Quarterly Report on Form 10-Q fairly presents in all material respects the financial condition and results of operations of Socket Communications, Inc.