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Hauppauge Digital Inc (HAUP) SEC Filing 10-K Annual report for the fiscal year ending Friday, September 30, 2005

Hauppauge Digital Inc

CIK: 930803 Ticker: HAUP

Investor Contacts: Gerald Tucciarone
Chief Financial Officer
631/434-1600 extension 306

HAUPPAUGE DIGITAL REPORTS FISCAL 2005
YEAR END FINANCIAL RESULTS
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Fiscal year sales increase 20%,to a new annual high, led by increase in OEM sales of WinTV-PVR products
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HAUPPAUGE, NY - December 23, 2005 - Hauppauge Digital, Inc. (NASDAQ: HAUP), a leading developer of digital video TV and data broadcast receiver products for personal computers, today reported financial results for the fiscal fourth quarter and fiscal year ended September 30, 2005.
 
FOURTH QUARTER RESULTS
 
Net sales were $15.4 million for the fourth quarter compared to $16.5 million for the previous year’s fourth quarter, a decrease of approximately 7%. Despite the growth of sales of our new WinTV-HVR series of hybrid video recorders, overall European retail sales of our older analog TV product line experienced a sharp drop off.
 
Gross profit percentage was 21.71% for the fourth quarter compared with a gross profit of 25.58% for the previous year’s fourth quarter. Higher sales of lower margin OEM products coupled with the drop in European retail sales were the primary items driving the gross profit percent decrease.
 
Selling, General and Administrative costs increased by $165,413. Increased promotional expenses related to marketing programs were the main forces driving the increase.
 
The Company recorded a net loss for the fourth fiscal quarter of $864,371, compared to a net income of $119,261 for the fourth fiscal quarter ended September 30, 2004. Net loss per share was $0.09 on a basic and diluted basis compared to net income per share of $0.01 on a basic and diluted basis for the prior year’s fourth quarter.
 

The following information was filed by Hauppauge Digital Inc (HAUP) on Wednesday, December 28, 2005 as an 8K 2.02 statement, which is an earnings press release pertaining to results of operations and financial condition. It may be helpful to assess the quality of management by comparing the information in the press release to the information in the accompanying 10-K Annual Report statement of earnings and operation as management may choose to highlight particular information in the press release.

 

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-K

 

ANNUAL REPORT
PURSUANT TO SECTIONS 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF MAY 1934

 

(Mark One)

 

ý

 

ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

 

 

 

For the fiscal year ended             September 30, 2005

 

 

 

OR

 

 

 

 

 

o

 

TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

 

 

 

For the transition period from                        to                        

 

 

 

 

 

Commission file number        1-13550

 

HAUPPAUGE DIGITAL, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

11-3227864

 

 

(State or other jurisdiction of

 

(I.R.S Employer

 

incorporation or organization)

 

Identification No.)

 

 

 

 

 

91 Cabot Court, Hauppauge, New York

 

11788

 

(Address of principal executive offices)

 

(Zip Code)

 

Issuer’s telephone number, including area code           (631) 434-1600

 

Securities registered pursuant to Section 12 (b) of the Act:

 

None

 

Securities registered pursuant to Section 12 (g) of the Act:

 

$.01 par value Common Stock

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

 

o Yes

 

ý No

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.

 

o Yes

 

ý No

 

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 twelve (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 ninety (90) days.

 

ý Yes

 

o NO

 

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

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange act).

 

o YES

 

ýNO

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange act).

 

o YES

 

ý NO

 

The aggregate market value of the voting stock held by non-affiliates of the registrant as of the close of business on March 31, 2005 was approximately $ 30,731,140. Non-affiliates include all stockholders other than officers, directors and 5% stockholders of the Company. Market value is based upon the price of the Common Stock as of the close of business on March 31, 2005 which was $4.23 per share as reported by NASDAQ.

 

As of December 14, 2005, the number of shares of Common Stock $0.01 par value outstanding was 9,586,831 (exclusive of treasury shares).

 

 



 

PART I

 

Special Note Regarding Forward Looking Statements

 

This Annual Report contains forward-looking statements as that term is defined in the federal securities laws.  The events described in forward-looking statements contained in this Annual Report may not occur.  Generally these statements relate to business plans or strategies, projected or anticipated benefits or other consequences of our plans or strategies, projected or anticipated benefits from acquisitions to be made by us, or projections involving anticipated revenues, earnings or other aspects of our operating results.  The words “may,” “will,” “expect,” “believe,” “anticipated,” “project,” “plan,” “intend,” “estimate,” and “continue,” and their opposites and similar expressions are intended to identify forward-looking statements.  We caution you that these statements are not guarantees of future performance or events and are subject to a number of uncertainties, risks and other influences (including, but not limited to, those set forth in “Item 1A —Risk Factors”, many of which are beyond our control, that may influence the accuracy of the statements and the projections upon which the statements are based.  Any one or more of these uncertainties, risks and other influences could materially affect our results of operations and whether forward looking statements made by us ultimately prove to be accurate.  Our actual results, performance and achievements could differ materially from those expressed or implied in these forward-looking statements.  We undertake no obligation to publicly update or revise any forward-looking statements, whether from new information, future events or otherwise.  All cautionary statements made in this Annual Report should be read as being applicable to all related forward-looking statements wherever they appear.

 

ITEM 1.          BUSINESS

 

All references herein to “us”, “we” or “the Company” include Hauppauge Digital, Inc., our wholly-owned subsidiaries and their subsidiaries, unless otherwise indicated or the context otherwise requires.

 

We engineer, develop, subcontract for manufacture, market and sell products for the personal computer (“PC”) market and the Apple® Macintosh® market.  We also offer products for the home entertainment market.

 

We have five primary product categories: personal video recorders for personal computers and Macintosh computers, analog TV receivers for PCs, digital TV receiver products for PCs, hybrid video recorders for PCs and MediaMVP digital media players for home networks. We also have a software based application that records TV shows on a personal computer for playback on a Sony Playstation Portable (PSP), Apple video iPod and other portable players.

 

Our WinTV-PVR personal video recorders allow PC users to watch and record TV on their PC or laptop computers. The WinTV-PVR products include hardware MPEG encoders (called “HardPVR®”), which improve the performance of TV recording and add instant replay and program pause functions, plus also enable the ‘burning’ of TV recordings onto DVD or CD media.  Our myTV-PVRs from our Eskape Labs division allow users of Apple®Macintosh® computers to watch and record TV on their Macintosh computers.

 

Our WinTV® analog TV receivers allow personal computer users to watch television on their PC screen in a resizable window, and also enable recording of TV shows to a hard disk using our software recording technology called “SoftPVR®”. Our Eskape™ Labs products allow users of Apple®Macintosh® computers to watch television on their computer screen.

 

Our WinTV digital receivers can receive digital TV transmissions broadcast in the various digital TV formats and display the digital TV show in a re-sizeable window on a user’s PC screen. Our Digital Entertainment Center products (“DEC”) allow users to receive digital TV broadcasts and display the digital TV on either a TV set or a PC screen.

 



 

Our Hybrid video recorders provide the user with the capability to watch both analog and digital TV.  For a region that is transitioning over to digital TV, the user can watch both analog and digital broadcasts. For a region that has not switched over to digital broadcasts, this product provides an economic way to enjoy the future benefits of digital TV while still having the ability to watch analog TV.

 

Our MediaMVP™ was designed to allow PC users to play digital media such as digital music, digital pictures and digital videos on a TV set via a home network.

 

Our “Wing” software, which we anticipate selling in early 2006, enables the user to record TV shows on a personal computer for playback on the Sony Playstation Portable (PSP), Apple iPod and other portable video players. Wing can also convert existing TV recordings to the PSP and iPod formats. With the emergence and popularity of portable video players, our Wing product provides an easy solution for recording live TV shows for playback on these devices.

 

We sell our products through computer and electronic retailers, computer products distributors and original equipment manufacturers (OEMs”).

 

OUR STRATEGY

 

Since our entry into the PC video market in 1991, management believes that we have become a leader in bringing TV content to PCs by focusing on four primary strategic fronts:

 

                                          innovating and diversifying our products

                                          introducing new and desirable features in our products

                                          expanding our domestic and intenational sales and distribution channels

                                          forging strategic relationships with key industry players

 

As more people are looking to their PCs for a total entertainment experience, we believe that our products are able to enhance the capabilities of the multimedia PC to enable it to become a one-stop integrated entertainment system. We feel our current and future products have the potential to be ubiquitous in PC-based home entertainment systems.

 

Our engineering group works on updating our current products to add new and innovative features that the marketplace seeks, while remaining vigilant in trying to ensure that our products are compatible with new operating systems. This work is done in addition to our research and development efforts in designing, planning and building new products.

 

We believe that strategic relationships with key suppliers, OEMs, technology providers, and internet and e-commerce solutions providers give us important advantages in developing new technologies and marketing our products.  By jointly working with, and sharing our engineering expertise with a variety of other companies, we seek to leverage our investment in research and development and minimize time to market.

 

Our domestic and international sales and marketing team cultivates a variety of distribution channels comprised of computer and electronic retailers, computer products distributors and OEMs.  Electronic retailers include retail stores, web stores and third-party catalogs, both print and on-line, among others.  We work closely with our retailers to enhance sales through joint advertising campaigns and promotions. We believe that developing our international presence contributes to our strategic position, allowing us to benefit from investments in product development, and more firmly establishing our Hauppauge®, WinTV®, MediaMVP™ and DEC brand names in the international marketplace. We currently have nine sales offices in countries outside of the U.S. In fiscal 2004, we established a new sales and R&D facility in Taiwan to service the growing Asian market.

 

We seek to maintain and improve our profit margins by, among other things, outsourcing our production to

 

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contract manufacturers suited to accommodate the type and volume of our needs. We also leverage international supplier relationships to assist us in receiving competitive prices for the component parts we buy. We believe this two-tiered approach allows us to be the lowest cost / highest quality producer in our marketplace. Successfully engineering products to have low production costs and commonality of parts along with the use of single platforms for multiple models are other important ways that we believe our design and build strategy contribute to our financial performance.

 

PRODUCTS

 

We have five primary product categories: analog TV receiver products, digital TV receiver products, personal video recorders, hybrid video recorders and MediaMVP digital media players for home networks. We also have a software based application that records TV shows on a personal computer for playback on a Sony Playstation Portable (PSP), Apple video iPod and other portable players.

 

See “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements comprising part of this Annual Report on Form 10-K for additional information relating to our operating segments.

 

Analog TV Products

 

Our analog TV receiver products enable a PC user to watch TV in a resizable window on a PC. Our software controls functions such as channel change, volume adjustment, freeze frame, and channel scan. Our analog receiver products include audio functions that allow sound to be heard while watching TV or video. The audio can be connected to speakers or to a PC’s sound card.

 

(i)            WinTV® TV Receiver Products

 

The WinTV analog TV receiver products include 125-channel cable-ready TV tuners with automatic channel scan and a video digitizer which allows the user to capture still and motion video images.  Some of our analog products allow the user to listen to FM radio, video-conference over the internet (with the addition of a camera or camcorder), enjoy the benefits of stereo surround sound with Dolby™-Pro Logic and control these functions with a handheld remote control. In Europe, our WinTV® analog TV receiver products can be used to receive teletext data broadcasts, which allow the reception of digital data that is transmitted along with the “live” TV signal.

 

The WinTV-GO-Plus is our low-cost, single slot internal board. Apart from allowing users to watch TV on their PC, it enables users to snap still and motion video images and video-conference over the internet with the addition of a camera or camcorder.  Step up models from the WinTV®-GO add features such as FM radio and a remote control.

 

Some WinTV analog TV receiver products are available as external devices which connect to the PC through the USB port.  The board included in the USB models is encased in an attractive plastic shell making USB models freely portable from PC to PC and from one desktop, laptop or notebook computer to another.  In fiscal 2004, we added a new USB2.0 product, the WinTV-USB2, to our product portfolio.

 

Over fiscal 2003, we also added a software-based TV recording feature to all analog WinTV products. Marketed under the SoftPVR® name, this feature allows consumers to record their TV shows to their hard disk. SoftPVR is not as powerful as our hardware MPEG encoder-based WinTV-PVR products, but does allow rudimentary television recording capabilities. SoftPVR is available on both the internal WinTV-PCI boards and the external WinTV-USB products.

 

(ii)           Eskape™ Labs Products

 

Our Eskape™ Labs product line delivers TV for Apple® Macintosh® computers. The video is sent to the

 

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Apple®Macintosh® computer through the USB port and as a result, there is no complicated installation process. Eskape products are available for all Apple® Macintosh® users from the on-the-go iBooks™ to G5™ power users.  All our Eskape™ Labs products are QuickTime® compatible.

 

MyTV.PVR is a USB based personal video recorder. It allows a Mac user to watch, pause and record TV on their Mac screen. MyTV.PVR includes a hardware MPEG-2 encoder so the Mac does not slow down while watching or recording TV.

 

MyTV2GO and MyTV2GO-FM are the lower priced models of the “My” line. They enable users to bring TV to their iMacs™, PowerBooks™ and G3™, G4™ and G5™ Macintosh® models through USB ports.  Our Eskape™ products also include a 125-channel cable-ready TV tuner and the capability to “grab” picture files and short movie files from the users’ TV, video cassette recorder or camcorder and save these files to disk.  The additional attraction of MyTV2GO-FM over the MyTV2GO is that it allows users to listen to and record FM radio.

 

MyTV and MyTV-FM are similar to MyTV2GO and MyTV2Go-FM, respectively, except that the MyTV2GO products include full-frame rate Motion JPEG video capture functions for superior video compression, video quality and lip synchronization.

 

MyCapture II allows users to capture video on their iMac™, iBook™, PowerBook™ or G3™/G4™/G5™ Macintosh® without opening their computer. MyCapture II delivers smooth, full frame rate video capture. To achieve the highest quality video capture over USB, MyCapture II utilizes the same state-of-the-art Motion JPEG hardware compression used in more expensive professional solutions. It supports NTSC and PAL video sources from S-video and composite video connections.  MyCapture II is ideal for QuickTime®-enabled websites and for web publishers.

 

WinTV-PVR Personal Video Recorder products

 

Our WinTV-PVR TV recording products include all of the basic features of our analog TV receiver products, such as TV on the PC screen, channel changing and volume adjustment. They also add the ability to record TV shows to disk using a built-in high quality hardware MPEG 2 encoder. This technology allows a typical desktop computer system to record up to hundreds of hours of video to disk, limited only by the size of the disk (or storage medium). In addition, the WinTV-PVR user can pause a live TV show, and then resume watching the TV show at a later time. The maximum amount of recording time and the maximum amount of paused TV is dependent upon the hard disk space available on the PC.

 

The WinTV-PVR user can record a TV show to the hard disk using a TV scheduler and then play the recording back, edit it, and record the show onto a CD-ROM or DVD-ROM, using a CD or DVD writer, for playback on a home DVD player or on a PC.  The user can re-size the window during viewing, recording or playback.  Our WinTV-PVR products also provide for instant replay and are available in both internal and external USB models.

 

In fiscal 2003, we introduced several new models with new price points and feature sets.  The WinTV-PVR-250 was introduced, replacing the WinTV-PVR-pci model. The WinTV-PVR-250 provides better quality video and audio at a lower price point than prior models. The WinTV-PVR-350 is similar to the WinTV-PVR-250, but adds a hardware MPEG video decoder which allows recorded TV shows to be played back on a TV set. The WinTV-PVR-usb2 has similar hardware and software capabilities to the WinTV-PVR-250, but it is an external device which connects to a PC or laptop via a USB port.

 

In fiscal 2004, we introduced the WinTV-PVR-150 and the WinTV-PVR-500. The WinTV-PVR-150 is a low cost version with similar features as the WinTV-PVR-250.  At a price point of $99, the WinTV-PVR-150 is our lowest cost personal video recorder. The WinTV-PVR-500 is a dual tuner personal video recorder. It can record

 

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one TV channel while the PC displays TV from another channel.

 

An added feature to the WinTV-PVR-150, WinTV®-PVR-250, WinTV-PVR-500 and WinTV-PVR-USB2 is that they support Microsoft®’s Windows® XP Media Center Edition.  Microsoft’s Windows XP Media Center Edition integrates digital entertainment experiences including “live” television, PVR, digital music, digital video, DVDs and pictures.  Users can pause, jump forward or watch “live” TV, record a program or a whole series, and manage all their digital music, home movies, videos, photos and DVDs on the PC.  Users can also access and control this new entertainment device with a large, easy-to-use-on-screen menus and the Media Center Remote Control.

 

We provide Microsoft certified Media Center drivers for these products to OEMs and VARs for integration into their Windows XP Media Center PC systems.

 

In fiscal 2005, we introduced new models of the WinTV-PVR-USB2, WinTV-PVR-150 and WinTV-PVR-500 for use in the emerging market for Windows Media Center Edition (MCE) upgrades.  Some Media Center PCs are sold without TV tuners, and we created special models of WinTV-PVR products to add TV, remote control and optionally FM radio to those MCE PCs.

 

Each of the certified WinTV-PVR’s contain a high-quality hardware MPEG encoder, which enables Windows® XP Media Center Edition to record TV shows to the PC’s hard disk.  At the best quality setting, approximately one hour of television can be recorded on two gigabytes of disk space.  Microsoft’s Windows XP Media Center Edition includes an Electronic Program Guide so that users can schedule their TV recording automatically.

 

Digital TV Products

 

(i)            Digital TV Receivers for the International Market

 

In mid-2004, the we started to revamp its entire line of digital TV receivers for the international market. The first product, the WinTV-NOVA-T, was launched June 2004. This is a low cost DVB-T receiver for the UK, German and French markets.

 

In fiscal 2005, the we introduced the WinTV-HVR series, which combines a digital TV receiver with an analog TV receiver into one unit. We introduced the WinTV-HVR-1100 and WinTV-HVR-1300 in fiscal 2005. The WinTV-HVR-1100 is a low cost version of the hybrid video recorder, while the WinTV-HVR-1300 is a high performance version. The WinTV-HVR-1300 has a built-in hardware TV recorder, similar to what is used in the WinTV-PVR-150.

 

(ii)           Digital Entertainment Center (“DEC”)

 

Our DEC products, introduced in Europe during fiscal 2002, are set top boxes that enable analog TV sets to receive digital satellite and digital terrestrial broadcasts. DEC products enable an owner of an analog TV set to enjoy the benefits of digital broadcasts, such as a greater choice of channels, clearer picture quality and superior audio quality.  The multi-purpose DEC set top box displays new digital channels while continuing to allow a TV to display analog programs. DEC set top boxes have the ability to receive, decode and display wide screen broadcasts, and can re-format the wide screen broadcast to fit older analog TV models without the need to purchase a costly digital ready TV.  Digital radio, interactive television services and digital teletext are other features that the DEC set top boxes deliver.  We hope to develop future product generations that could enable a user to connect to a PC or Notebook computer and record digital TV programs to the computer’s hard drive, permitting the user to record and later playback the recorded video in full digital quality on the user’s TV screen or computer monitor.

 

In fiscal 2004, we introduced the DEC1100-T, a low cost digital TV receiver “box” for the free-to-air digital TV

 

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markets in the UK and Germany.

 

(iii)          Digital TV Receivers for the U.S. market

 

In fiscal 2004, Hauppauge discontinued selling its WinTV-HD and WinTV-D products due to poor sales. The U.S. market for high definition TV has not achieved the same penetration as has the rest of the world for free-to-air digital TV.  We are currently reevaluating product directions for the U.S. digital TV market.

 

Hybrid Video Recorder Products

 

Our Hybrid video recorder family of products, which were introduced during the latter part of fiscal 2005,  enable a user to watch or record and analog and digital TV on your PC.  For an end user that lives in an area that is broadcasting both analog and digital TV, this product provides the end user the flexibility to switch to analog and digital automatically.  For regions that have not switched over to digital signals, our hybrid video recorders give you the ability to watch analog TV yet also provide you with the future capability to watch digital TV.

 

Media MVP™

 

The MediaMVP™ is a Linux-based digital media, and is one of a new class of PC products which link TV sets and PCs. Media, such as music, digital pictures, and digital videos, are transmitted from the PC, where they are stored, to the MediaMVP™, where they are converted from a digital format into an analog format, enabling playback on a TV connected to the MediaMVP™. MediaMVP™ was introduced to the market in fiscal 2003, but first customer shipments were not made until the beginning of fiscal 2004.

 

The MediaMVP™ enables users to watch and listen to PC-based videos, music and pictures on their TV sets through a home network.  The MediaMVP™ connects to TV sets or home theater systems and, via an Ethernet network, plays back MP3 music, MPEG-1 and MPEG-2 videos, JPEG and GIF digital pictures that have been recorded and stored on a PC. The MediaMVP™ decodes this media and then outputs video through composite and S-Video connections for the best video quality on TV sets, and audio through stereo audio output connectors to TV sets or home theater systems.

 

The MediaMVP™ also provides an on-TV-screen display of media directory listings. It receives commands from the supplied remote control, and sends these commands to the PC server. The TV menus are created on the PC server, sent over the Ethernet LAN and displayed by the MediaMVP™’s browser. The MediaMVP™’s remote control allows a user to pause, fast forward and rewind through videos, plus pause music and picture shows. A user can adjust the audio volume from MediaMVP™’s remote control, avoiding the need to use the TV’s remote control.

 

Other Products

 

(i)                                     Video Capture Products

 

Our ImpactVCB Video Capture Board (“ImpactVCB”) is a low cost PCI board for high performance access to digitized video.  Designed for PC-based video conferencing and video capture in industrial applications, the ImpactVCB features “live” video-in-a-window, still image capture and drivers for Windows® 2000, Windows® XP, Windows® NT and Windows® 98. There are third party drivers and applications for use with the Linux operating system.

 

Our USB Live is an easy way to watch video, grab images and video conference on the PC with the addition of a camera.  It plugs into the PC’s USB port for easy installation and brings video into users’ PCs from their camcorder or VCR.  Users can create video movies, save still and motion video images onto their hard disk with

 

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our software, and video conference over the internet with the addition of a camera or camcorder.

 

 Software Recording Products

 

Our “Wing” software, which we anticipate selling in early 2006,  enables the user to record TV shows on a personal computer for playback on the Sony Playstation Portable (PSP), Apple iPod and other portable video players. Wing can also convert existing TV recordings to the PSP and iPod formats. With the emergence and popularity of portable video players, our Wing product provides an easy solution for recording live TV shows for playback on these devices. With the emergence and popularity of portable video players, our Wing software provides and easy solution for recording live TV shows for playback on these portable video player devices.

 

TECHNOLOGY

 

Analog TV Technology

 

We have developed five generations of products which convert analog video into digital video since our first such product was introduced in 1991.

 

The first generation of WinTV® products put the TV image on the PC screen using chroma keying, requiring a dedicated “feature connector cable” between the WinTV® and the VGA (video) board. Our initial customers were mostly professional PC users, such as financial market professionals who needed to be able to view stock market related TV shows while spending many hours on their PCs, who found having TV in a window on their desktop useful and entertaining.

 

In 1993, we invented a technique called “smartlock”, which eliminated the need for the “feature connector cable.” In 1994, we introduced the WinTV®-Celebrity generation of TV tuner boards based on this smartlock technology, greatly improving customer satisfaction. At the time, our CinemaPro series of WinTV® boards then used smartlock and other techniques to further reduce cost and improve performance.

 

In June 1996, we introduced the WinTV®-PCI line of TV tuner boards for PCs. These boards were developed to eliminate the relatively expensive smartlock circuitry and memory used on the WinTV®-Celebrity and CinemaPro products. The WinTV®-PCI used a technique called “PCI Push” and was designed to be used in the then emerging Intel® Pentium® market. These Pentium®-based PCs had a new type of system expansion “bus”, called the PCI bus, which allowed data to be moved at a much higher rate than the older ISA bus, which the previous WinTV® generations used. The “PCI Push” technique moves the video image 30 times per second (in Europe the image is moved 25 times per second) over the PCI bus.  In addition to being less expensive to manufacture, the WinTV®-PCI had higher digital video movie capture performance than the previous generations, capturing video at up to 30 quarter screen frames per second.  With this higher performance capture capability, the WinTV®-PCI found new uses in video conferencing, video surveillance and internet streaming video applications.

 

The fourth generation analog TV receivers are the WinTV®-PVR models which were first developed during fiscal 2000 and introduced to the market in early fiscal 2001. The WinTV®-PVRs include both internal PCI and external USB TV receivers which are designed to add the ability to record TV shows to a PC’s hard disk. The core technology in the WinTV®-PVR products is a hardware MPEG encoder, which compresses analog video from a TV tuner or external video source into an MPEG format in real time. MPEG is the compression format used on DVDs and for the transmission of digital TV.  This MPEG encoder is a purchased chip, to which we add our driver and application software to create the recording and program pause functions. Our WinTV®2000 application was enhanced to add the functions needed to record, pause and play back TV on a PC screen.

 

Digital TV Technology

 

Our WinTV®-D board, developed during the 1999 fiscal year and delivered to the market in the beginning of

 

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fiscal 2000, was the first digital TV receiver for the U.S. market which allowed PCs to receive, display and record digital TV signals, in addition to watching conventional analog TV.  The software to control the digital TV reception is based on our WinTV®-2000 software, which was developed during fiscal 1999.  In fiscal 1999, we also introduced the WinTV®-DVB board for the European market. This board brings digital TV to PCs, and is based on the European Digital Video Broadcast standard.  Both the WinTV®-D and the WinTV®-DVB have the ability to receive special data broadcasts which some broadcasters may send along with the digital TV signal, in addition to displaying digital TV in a resizable window. Data broadcasts on digital TV are transmitted at several million bits per second. Our proprietary software can decode and display some of these special data broadcasts. We intend to work on standardized reception and display software, if such broadcasts become standardized.

 

Our MediaMVP™ contains our newest technology. Based on the Linux operating system, the MediaMVP™ works in a client/server system with a PC, communicating with the PC ‘server’ and receiving digital media from the PC and displaying the media on a TV set. The core technology to the MediaMVP™ comprises the configuration and enhancements to the Linux operating system, the user interface displayed on the TV set, and the technology to transmit digital media reliably over the local area network.

 

RESEARCH AND DEVELOPMENT

 

Our development efforts are currently focused on extending the range and features of the WinTV®PVR products, developing additional externally attached TV products and additional high-definition digital TV products. We are also developing more highly integrated versions of hardware products to further improve performance and price points, and new versions of software to add features, improve ease of use, and provide support for new operating systems.

 

As of date of this Annual Report on Form 10-K, we have three research and development (“R & D”) operations: one based in our Hauppauge, New York headquarters, one based in California and one based in Taiwan, ROC.  The California R&D operation develops the Eskape™ Labs products, while the New York R&D and Taiwan operation is aimed at extending the range and features of the WinTV-PVR products, developing additional externally attached TV products, additional high-definition digital TV products and portable digital players.

 

The technology underlying our products and certain other products in the computer industry, in general, is subject to rapid change, including the potential introduction of new types of products and technologies, which may have a material adverse impact upon our business.

 

We maintain an ongoing R & D program. Our future success, of which there can be no assurances, will depend, in part, on our ability to respond quickly to technological advances by developing and introducing new products, successfully incorporating such advances in existing products, and obtaining licenses, patents, or other proprietary technologies to be used in connection with new or existing products. We continue to invest in R&D. We spent approximately $2,494,000, $2,021,000 and $1,902,000 for R & D expenses for the years ended September 30, 2005, 2004 and 2003, respectively.  There can be no assurance that our future research and development will be successful or that we will be able to foresee, and respond to, advances in technological developments and to successfully develop other products. Additionally, there can be no assurances that the development of technologies and products by competitors will not render our products or technologies non-competitive or obsolete.  See “Item 1A- Risk Factors.”

 

PRODUCTION AND SUPPLIERS

 

We design the hardware for most models of the WinTV, MediaMVP and Eskape Labs products, and also write the operating software to be used in conjunction with many versions of the popular Microsoft Windows and Apple Macintosh operating systems, including Windows XP, Windows98, WindowsMe, WindowsNT and Windows2000. We subcontract the manufacturing and assembly of most of these products to independent third

 

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parties at facilities in various countries. We monitor and test the quality of the completed products at our facilities in the U.S. (Hauppauge, New York), Singapore, and Ireland before packaging the products and shipping them to our customers. We also buy from others finished products such as the DEC and WinTV-DVB products, that we have not designed but are sold under our name, on an OEM basis.

 

Certain component parts, such as TV tuners, video decoder chips and software compression chips, plus certain assembled products, such as the DEC and WinTV-DVB, that are essential to our business are available from a single source or limited sources.  Other essential component parts that are generally available from multiple sources may be obtained by us from only a single source or limited sources because of pricing concerns. See “Item 1A - Risk Factors.”

 

Components are subject to industry wide availability and pricing pressures. Any availability limitations, interruption in supplies, or price increases could have a material adverse effect on our business, operating results and financial condition. In addition, our new products may initially utilize custom components obtained from only one source. We typically attempt to evaluate and qualify additional suppliers for these components.

 

Where a product utilizes a new component, initial capacity constraints of the supplier of that component may exist until such time as the supplier’s yields have matured.

 

Components are normally acquired through purchase orders, either issued by us or by our contract manufacturers, typically covering our requirements for a 60-120 day period from the date of issue. Purchased assembled products are normally covered by longer term purchase orders.

 

If the supply of a key component, or a purchased assembled product, were to be delayed or curtailed, or in the event a key manufacturing vendor delays shipment of completed products to us or our contract manufacturer, our ability to ship products in desired quantities, and in a timely manner, will be adversely affected. Our business and financial performance will likely be adversely affected, depending on the time required to obtain sufficient quantities from the original source or, if possible, to identify and obtain sufficient quantities from an alternative source. We attempt to mitigate these potential risks by working closely with our key suppliers on product introduction plans, strategic inventories, coordinated product introductions, and internal and external manufacturing schedules and levels.

 

We have, from time to time, experienced significant price increases and limited availability of certain components. Similar occurrences in the future could have a material adverse effect on our business, operating results and financial condition.

 

During fiscal 2005 and fiscal 2004, other than for purchased assembled products like the DEC, WinTV-DVB and WinTV-USB2, all manufacturing was performed by two unrelated contract manufacturers in Asia, which produce products for our domestic, Asian and European markets. Product design specifications are provided to ensure proper assembly. Contract manufacturing is primarily done on a consignment basis, in which we provide all the significant component parts and we pay for assembly charges and for certain parts for each board produced. Some boards are purchased on a turnkey basis, in which all components and labor are provided by the manufacturer, and the manufacturing price includes parts and assembly costs. We monitor the quality of the finished product produced by our contract manufacturers. We have qualified five contract manufacturers who are capable of producing our products to our standards, but only utilize two out of the five contract manufacturers. During fiscal 2005, these two contract manufacturers handled all of our domestic and international production. If demand were to increase dramatically, we believe additional production could be absorbed by these and the other qualified contract manufacturers.

 

During a portion of fiscal 2003, we produced some of our European products through a contract manufacturer in Austria. The production was done on a consignment basis with assembly, testing and reworks being handled there.  The packaging and shipping of the product to customers was done at our Ireland facility. By shifting the

 

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production of boards sold in Europe to a European facility, we saved on shipping costs and duties on boards entering Europe.  For fiscal 2005 and 2004, we did not engage any contract manufacturers in Europe.

 

CUSTOMER SERVICE AND TECHNICAL SUPPORT

 

We maintain customer service and technical support departments in our Hauppauge, New York headquarters, as well as in the U.K., Germany, France, Italy, Scandinavia, Taiwan, the Netherlands and in Singapore. Technical support is provided to help with installation problems or pre-sale and post-sale questions on our products, while customer service provides repair service.

 

CUSTOMERS AND MARKETS

 

We primarily market our products to the consumer market. To reach this market, we sell to a network of computer retailers in the U.S., Europe and Asia and through computer products distributors. To attract new users to our products, from time to time we run special promotions and participate in cooperative advertising with computer retailers. We actively participate in trade shows to educate and train key computer retail marketing personnel. Most of our sales and marketing budget is aimed at the consumer market.

 

Apart from the typical home user, we also target business users. One example of a business application is in the securities brokerage industry where our product is primarily used to display financial TV shows in a window on a broker’s PC screen while the PC continues to receive financial information. We have sold our WinTV® products on an OEM basis to two large financial services information providers for incorporation into their workstations, and several independent financial institutions. This market segment is typically project-based.

 

We also offer our products to PC OEMs that either embed a WinTV® product in a PC that they sell, or sell the WinTV® as an accessory to the PC.

 

Distribution to the Retail Market

 

During fiscal 2005, net sales to distributors and retailers totaled approximately $57,800,000, or 74% of our net sales compared to approximately $55,495,000 or 85% and $44,404,000 or 87%, for the years ended September 30, 2004 and 2003, respectively.  We have no exclusive distributor or retailer and sell through a multitude of retailers and distributors. For fiscal 2005, we had no single customer which accounted for more than 10% of our net sales. For fiscal 2004, we had one customer (Ingram Micro Macrotron) which accounted for about 12% of our net sales.

 

Sales to OEMs

 

The OEM business is one where a PC manufacturer incorporates our products into an item sold under the OEM’s label. Factors that could impact the expansion of our OEM business include the ability to successfully negotiate and implement new agreements with OEMs. The OEM business is often project based, where the OEM builds a specially configured PC to implement a project for a customer.

 

OEM sales do not require the same level of marketing, promotional and product support as retail sales. As a result of the lower sales and marketing support OEM support costs, OEM sales usually yield lower gross profit margins than retail sales.

 

Our sales to OEMs totaled approximately $20,657,000, $9,844,000 and $6,552,000 for the years ended September 30, 2005, 2004 and 2003, respectively.  We sold our products to a variety of OEM customers, none of which accounted for more than 10% of total sales in any of the three years ended September 30, 2005. Sales to OEM customers accounted for approximately 26%, 15% and 13% of our net sales for fiscal 2005, 2004 and 2003, respectively.

 

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Marketing and Sales

 

We market our products both domestically and internationally through our sales offices in the U.S. (New York and California), Germany, the United Kingdom, France, Taiwan and Singapore, plus through independent sales representative offices in the Netherlands, Spain, Scandinavia, Poland and Italy. For the fiscal years ended September 30, 2005, 2004 and 2003, approximately 46%, 34% and 32% of our net sales were made within the U.S., respectively, while approximately 54%, 66% and 68% were made outside the United States, respectively.

 

Our WinTV®-PCI, WinTV-USB, WinTV-PVR-150/250/350/USB2 products and digital WinTV®-DVB products contributed 10.57%, 8.30%, 33.90% and 13.89% respectively of our consolidated revenue for fiscal year 2005 and our hybrid video recorder products, which were introduced during fiscal 2005, contributed 4.21% of our consolidated revenue.

 

Our WinTV®-PCI, WinTV®-USB, WinTV®-PVR-250/350/USB2  products and digital WinTV®-DVB products contributed 18.65%, 15.33%, 21.12% and 19.63% respectively of our consolidated revenue for fiscal year 2004 and 28.18%, 15.61%, 14.44% and 24.33% respectively of our consolidated revenue for fiscal year 2003.

 

More information on our geographic segments can be obtained from “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the notes to the “Consolidated Financial Statements which comprise part of this Annual Report on Form 10-K.

 

From time to time we advertise our products in a number of PC magazines. We also participate in retailers’ market promotion programs, such as store circulars and promotions and retail store displays.  These in-store promotional programs, magazine advertisements, plus a public relations program aimed at editors of key PC computer magazines and an active web site on the internet, are the principal means of getting our product introduced to end users. Our sales in computer retail stores are closely related to the effectiveness of these programs, along with the technical capabilities of the products. We also list our products in catalogs of various mail order companies and attend worldwide trade shows.

 

We currently have 12 sales people located in Europe, 3 sales people in the Far East and 3 sales people in the U.S., located in New York and California. In addition to our sales people we also utilize the services of 7 manufacturer representatives in the United States and 5 manufacturer representatives in Europe.

 

See “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations” with reference to a discussion on the impact seasonality has on our sales.

 

FOREIGN CURRENCY FLUCTUATIONS

 

For each of the past three fiscal years, at least 50 %  of our sales were generated by our European subsidiary and were:

 

                  Invoiced in local currency - primarily the Euro

                  Collected in local currency - primarily the Euro

 

On the supply side, since we predominantly deal with North American and Asian suppliers and contract manufacturers,  approximately 75% of our inventory required to support our European sales are purchased and paid in U.S. Dollars.

 

The combination of sales billed in Euros supported by inventory purchased in U.S. dollars results in an absence of a natural local currency hedge. Consequently, our financial results are subject to market risks resulting from the fluctuations in the Euro to U.S. Dollar exchange rates.

 

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We attempt to reduce these risks by entering into foreign exchange forward contracts with financial institutions. The purpose of these forward contracts is to hedge the foreign currency market exposures underlying the U.S. Dollar denominated inventory purchases required to support our European sales.

 

We do not try to hedge against all possible foreign currency exposures because of the inherent difficulty in estimating the volatility of the Euro. The contracts we procure are specifically entered into to as a hedge against forecasted or existing foreign currency exposure.  We do not enter into contracts for speculative purposes. Although we maintain these programs to reduce the short term impact of changes in currency exchange rates,  long term strengthening or weakening of the U.S. dollar against the Euro impacts our sales, our gross profit, operating income and retained earnings. Factors that could impact the effectiveness of our hedging program are:

 

                  volatility of the currency markets

                  availability of hedging instruments

                  accuracy of our inventory forecasts

 

Additionally, there is the risk that foreign exchange fluctuations will make our products less competitive in foreign markets, which would substantially reduce our sales.

 

As of September 30, 2005, we had foreign currency contracts outstanding of approximately $3,028,000 against the delivery of the Euro. These contracts expire from October 2005 through December 2005.  Our accounting policies for these instruments designate such instruments as cash flow hedging transactions. We do not enter into such contracts for speculative purposes. We record all derivative gains and losses on the balance sheet as a component of stockholders’ equity under the caption “Accumulated other comprehensive income (loss)”.  We recorded a gain of $235,817 for the twelve months ended September 30, 2005 on our statement of comprehensive income (loss).  As of September 30,  2005, a deferred gain of $136,418, reflecting the cumulative mark to market gains of our derivatives,  was recorded on our balance sheet as a component of accumulated other comprehensive income in our equity section.

 

We use the average monthly forward contract exchange rate to translate our Euro denominated sales into our U.S. dollar reporting currency. For the twelve month period ending September 30, 2005, the use of the monthly average spot rate instead of the average monthly forward contract exchange rate to value Euro denominated sales would have resulted in an increase in sales of $612,092. This sales increase is related to our contracts that closed during these periods and the changes in the fair value of our derivative contracts.  For the twelve month period ending September 30, 2004, the use of the monthly average spot rate instead of the average monthly forward contract exchange rate to value Euro denominated sales would have resulted in a sales increase of $909,326.

 

See “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations” with reference to the impact of foreign currency exchange fluctuations.

 

COMPETITION

 

Our business is subject to significant competition. Competition exists from larger companies that possess substantially greater technical, financial, human, sales and marketing resources than we do. The dynamics of competition in this market involve short product life cycles, declining selling prices, evolving industry standards and frequent new product introductions.  We compete against companies such as ATI Technologies Inc. and Pinnacle Systems, Inc.  Our MediaMVP™ and DEC products compete in the consumer electronics market, where competition comes from Sony Corp., Toshiba Corporation, Cisco Systems Inc. and others.

 

We believe that competition from new entrants will increase as the market for digital video in a PC expands.

 

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There can be no assurance that we will not experience increased competition in the future. Such increased competition may have a material adverse affect on our ability to successfully market our products. Competition is expected to remain intense and, as a result, we may lose some of our market share to our competitors. Further, we believe that the market for our products will continue to be price competitive and thus we could continue to experience lower selling prices, lower gross profit margins and reduced profitability levels for such products than in the past.

 

Though management believes that the delivery of TV via the internet will become more popular in the future, we believe that TV delivered to the PC via cable, broadcast or satellite will continue to dominate. As our products connect directly to cable, broadcast and satellite receivers, and deliver a high quality image, we view our products as the preferred way to watch TV on the PC versus the delivery of TV via the internet.

 

PATENTS, COPYRIGHTS AND TRADEMARKS

 

With the proliferation of new products and rapidly changing technology, there is a significant volume of patents and other intellectual property rights held by third parties. There are a number of companies that hold patents for various aspects of the technologies incorporated in some of the PC and TV industries’ standards.  Given the nature of our products and development efforts, there are risks that claims associated with such patents or intellectual property rights could be asserted by third parties against us.  We expect that parties seeking to gain competitive advantages will increase their efforts to enforce any patent or intellectual property rights that they may have.  The holders of patents from which we may have not obtained licenses may take the position that it is required to obtain a license from them.

 

If a patent holder refuses to offer such a license or offers such a license on terms unacceptable to us, there is a risk of incurring substantial litigation or settlement costs regardless of the merits of the allegations or which party eventually prevails. If we do not prevail in a litigation suit, we may be required to pay significant damages and/or cease sales and production of infringing products and accordingly, may incur significant defense costs.  Additionally, we may need to attempt to design around a given technology, although there can be no assurances that this would be possible or economical.

 

We currently use technology licensed from third parties in certain products.  Our business, financial condition and operating results could be adversely affected by a number of factors relating to these third-party technologies, including:

 

                                          failure by a licensor to accurately develop, timely introduce, promote or support the technology

                                          delays in shipment of products

                                          excess customer support or product return costs due to problems with licensed technology and

                                          termination of our relationship with such licensors

 

We may not be able to adequately protect our intellectual property through patent, copyright, trademark and other means of protection.  If we fail to adequately protect our intellectual property, our intellectual property rights may be misappropriated by others, invalidated or challenged, and our competitors could duplicate our technology or may otherwise limit any competitive technological advantage we may have. Due to the rapid pace of technological change, we believe our success is likely to depend more upon continued innovation, technical expertise, marketing skills and customer support and service rather than upon legal protection of our proprietary rights. However, we shall aggressively assert our intellectual property rights when necessary.

 

Even though we independently develop most of our products, our success will depend, in a large part, on our ability to innovate, obtain or license patents, protect trade secrets and operate without infringing on the proprietary rights of others. We maintain copyrights on certain of our designs and software programs, but currently we have no patent on the WinTV® board or other products as we believe that such technology cannot be patented.

 

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On March 18, 2003, the trade name “Hauppauge” was registered with the United States Patent and Trademark Office. On December 27, 1994, our trademark, “WinTV®”, was registered with the United States Patent and Trademark Office. In fiscal 2004 we registered with the United States Patent and Trademark Office the trade names SoftPVR®, HardPVR® and MediaMVP®.

 

See “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

EMPLOYEES

 

As of September 30, 2005, we employed 138 people domestically and internationally, including our executive officers, all of which are full-time, none of which are represented by a union.

 

CORPORATE STRUCTURE

 

Hauppauge Digital Inc. was incorporated in the state of Delaware on August 2, 1994. Listed below is a chart depicting our corporate structure.
 

Corporate Organization Chart

 

Hauppauge Digital Inc. was incorporated in Delaware and is the parent holding Company.  Our subsidiaries function as follows:

 

Hauppauge Computer Works, Inc., incorporated in New York,  is our United States operating Company.  It has locations in Hauppauge, New York and Danville, California. The Hauppauge location functions as our world wide Company headquarters and houses the Executive Officers and is responsible for

 

                                          Sales

                                          Technical Support

                                          Research and Development

                                          Warehousing and shipping

                                          Finance and Administrative

 

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                                          Inventory planning and forecasting

 

Hauppauge Computer Works, Inc. is in turn the holding company of a foreign sales corporation, Hauppauge Computer Works, Ltd (incorporated in the U.S. Virgin Islands).

 

HCW Distributing Corp., incorporated in New York, is an inactive Company

 

Hauppauge Digital Taiwan was incorporated during fiscal 2004 in Taiwan, ROC and is responsible for:

 

                                          Sales administration for Asia and China

                                          Research and development activities

 

Hauppauge Digital Europe S.à.r.l,  incorporated in Luxembourg, is our European subsidiary.  It has the following wholly-owned subsidiaries:

 

                                          Hauppauge Digital Asia Pte Ltd (incorporated in Singapore)

                                          Hauppauge Computer Works, GmbH (incorporated in Germany)

                                          Hauppauge Computed Works Limited (incorporated in the United Kingdom)

                                          Hauppauge Computer Works S.à.r.l. (incorporated in France)

 

The subsidiaries above function as sales and commission agents, and are primarily responsible for:

 

                                          Directing and overseeing European sales, marketing and promotional efforts

                                          Procuring sales and servicing customers

                                          Sales administration

                                          Technical support

                                          Product and material procurement support

                                          Contract manufacturer and production support

 

In addition to Hauppauge Digital Europe S.à.r.l’s wholly owned subsidiaries,  Hauppauge Digital Europe S.à.r.l also has a branch office in Blanchardstown, Ireland, which functions as our European distribution center and is responsible for:

 

                                          Warehousing of product

                                          Shipment of product

                                          Repair center

                                          European logistics center

 

Our executive offices are located at 91 Cabot Court, Hauppauge, New York 11788, and our telephone number at that address is (631) 434-1600.  Our internet address is http://www.hauppauge.com.

 

ITEM  1A.      RISK FACTORS

 

Because of the following factors, as well as other variables affecting operating results and financial condition, past performance my not be a reliable indicator of future performance, and historical trends should not be used to anticipate results or trends for future periods.

 

If TV technology for the PC, or our implementation of this technology, is not accepted, we will not be able to sustain or expand our business.

 

Our future success depends on the growing use and acceptance of TV and video applications for PCs. The market for these applications is still evolving, and may not develop to the extent necessary to

 

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enable us to further expand our business. We have invested, and continue to invest, significant time and resources in the development of new products for this market.

 

Our:

                  dependence on sales of TV and video products for the PC

                  lack of market diversification

                  lack of development of the market for our products

                  potential inability to remain ahead of the development of competing technologies

 

could each have a material adverse effect on our business, operating results and financial condition.

 

We rely upon sales of a small number of product lines, and the failure of any one product line to be successful in the market could substantially reduce our sales.

 

We currently rely upon sales from our internal and external products to generate a majority of our sales. While we continue to develop additional products within these and other product lines, there can be no assurance that we will be successful in doing so. Consequently, if the existing or future products are not successful, sales could decline substantially, which would have a material adverse effect on our business, operating results and financial condition.

 

We rely heavily on the success of dealers and OEMs to market, sell and distribute our products. If these resellers do not succeed in effectively distributing our products, our sales could be reduced.

 

These resellers may not effectively promote or market our products or they may experience financial difficulties and even close operations.  These dealers and retailers are not contractually obligated to sell our products. Therefore, they may, at any time:

 

                                    refuse to promote our products and

                                    discontinue the use of our products in favor of a competitor’s product

 

Also, with this distribution channel standing between us and the actual end user, we may not be able to accurately gauge current demand and anticipate future demand for our products.  For example, dealers may place large initial orders for a new product just to keep their stores stocked with the newest products and not because there is a significant demand for them.

 

Our distribution network includes several consumer channels, including large distributors of products to computer software and hardware retailers, which in turn sell products to end users.  They also sell consumer products directly to certain retailers. Rapid change and financial difficulties of distributors have characterized distribution channels for consumer retail products. These arrangements have exposed us to the following risks, among others:

 

                              we may be obligated to provide price protection to certain retailers and distributors and, while certain agreements limit the conditions under which products can be returned, we may be faced with product returns or price protection obligations

                              the distributors or retailers may not continue to stock and sell our products and

                              retailers and retail distributors often carry competing products

 

If these resellers do not succeed in effectively distributing our products, this could have a material adverse effect on our business, operating results and financial condition.

 

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We operate in a highly competitive market, and many of our competitors have much greater resources, which may make it difficult for us to remain competitive.

 

Our business is subject to significant competition. Competition exists from larger companies that possess substantially greater technical, financial, human, sales and marketing resources than we do. The dynamics of competition in this market involve short product life cycles, declining selling prices, evolving industry standards and frequent new product introductions.  We compete against companies such as ATI Technologies Inc. and Pinnacle Systems, Inc.  Our MediaMVP™ and DEC products compete in the consumer electronics market, where competition comes from Sony Corp., Toshiba Corporation, Cisco Systems Inc. and others.

 

We believe that competition from new entrants will increase as the market for digital video in a PC expands. There can be no assurance that we will not experience increased competition in the future. Such increased competition may have a material adverse affect on our ability to successfully market our products. Competition is expected to remain intense and, as a result, we may lose some of our market share to our competitors. Further, we believe that the market for our products will continue to be price competitive and thus we could continue to experience lower selling prices, lower gross profit margins and reduced profitability levels for such products than in the past.

 

Rapid technological changes and short product life cycles in our industry could harm our business.

 

The technology underlying our products and other products in the computer industry, in general, is subject to rapid change, including the potential introduction of new types of products and technologies, which may have a material adverse impact upon our business, operating results and financial condition.  We will need to maintain an ongoing research and development program, and our potential future success, of which there can be no assurances, will depend, in part, on our ability to respond quickly to technological advances by developing and introducing new products, successfully incorporating such advances in existing products, and obtaining licenses, patents, or other proprietary technologies to be used in connection with new or existing products.  We expended approximately $2,494,000, $2,021,000 and $1,902,000 for research and development expenses for the years ended September 30, 2005, 2004 and 2003, respectively. There can be no assurance that our research and development will be successful or that we will be able to foresee and respond to such advances in technological developments and to successfully develop additional products. Additionally, there can be no assurances that the development of technologies and products by competitors will not render our products or technologies non-competitive or obsolete.

 

If TV or video capabilities are included in PCs or in operating systems, it could result in a reduction in the demand for add-on TV and video devices. Although we believe that our software is a competitive strength, as operating systems such as Windows move to integrate and standardize software support for video capabilities, we will be challenged to further differentiate our products. Our operating results and ability to retain our market share are also dependent on continued growth in the underlying markets for PC, TV and video products.

 

We may not be able to timely adopt emerging industry standards, which may make our products unacceptable to potential customers, delay our product introductions or increase our costs.

 

Our products must comply with a number of current industry standards and practices established by various international bodies. Failure to comply with evolving standards, including video compression standards, TV transmission standards, and PC interface standards, will limit acceptance of our products by the market. If new standards are adopted in the industry, we will be required to adopt those standards in our products. It may take a significant amount of time to develop and design products incorporating these new standards, and we may not succeed in doing so. We may also become dependent upon products developed by third parties and have to pay royalty fees, which may be substantial, to the developers of the technology that constitutes the newly adopted standards.

 

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We are heavily dependent upon foreign markets for sales of our products, primarily the European market, and adverse changes in these markets could reduce our sales.

 

Our future performance will likely be dependent, in large part, on our ability to continue to compete successfully in the European markets, where a large portion of our current and potential customers are located. Our ability to compete in these markets will depend on many factors, including:

 

                                          the economic conditions in these regions

                                          the stability of the political environment in these regions

                                          adverse changes in the relationships between major countries in these regions

                                          the state of trade relations among these regions and the United States

                                          restrictions on trade in these regions

                                          the imposition or changing of tariffs by the countries in these regions on products of the type that we sell

                                          changes in the regulatory environment in these regions

                                          export restrictions and export license requirements

                                          restrictions on the export of critical technology

                                          our ability to develop PC TV products that meet the varied technical requirements of customers in each of these regions

                                          our ability to maintain satisfactory relationships with our foreign customers and distributors

                                          changes in freight rates

                                          our ability to enforce agreements and other rights in the countries in these regions

                                          difficulties in staffing and managing international operations

                                          difficulties assessing new and existing international markets and credit risks

                                          potential insolvency of international customers and difficulty in collecting accounts

 

If we are unable to address any of these factors, it could have a material adverse effect on our business, operating results and financial condition.

 

We are heavily dependent upon foreign manufacturing facilities for our products, primarily facilities in Europe and Asia, which exposes us to additional risks.

 

The majority of our products are built at contract manufacturing facilities in Asia and Europe. Our ability to successfully build products at overseas locations will depend on several factors, including:

 

                                          the economic conditions in these regions

                                          the stability of the political environment in these regions

                                          adverse changes in the relationships between major countries in these regions

                                          the state of trade relations among these regions and the United States

                                          restrictions on trade in these regions

                                          the imposition or changing of tariffs by the countries in these regions on products of the type that we sell

                                          changes in the regulatory environment in these regions

                                          import restrictions and import license requirements

                                          our ability to maintain satisfactory relationships with our foreign manufacturers

                                          changes in freight rates

                                          difficulties in staffing and managing international operations

                                          potential insolvency of vendors and difficulty in obtaining materials

 

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If we are unable to address any of these factors, it could have a material adverse effect on our business, operating results and financial condition.

 

Foreign currency exchange fluctuations could adversely affect our results.

 

For each of the past three fiscal years, at least 50 % of our sales were generated by our European subsidiary and were:

 

                  Invoiced in local currency-primarily the Euro

                  Collected in local currency-primarily the Euro

 

On the supply side, since we predominantly deal with North American and Asian suppliers and contract manufacturers,  approximately 75% of our inventory required to support our European sales are purchased and paid in U.S. Dollars.

 

The combination of sales billed in Euros supported by inventory purchased in U.S. dollars results in an absence of a natural local currency hedge. Consequently, our financial results are subject to market risks resulting from the fluctuations in the Euro to U.S. Dollar exchange rates.

 

We attempt to reduce these risks by entering into foreign exchange forward contracts with financial institutions. The purpose of these forward contracts is to hedge the foreign currency market exposures underlying the U.S. Dollar denominated inventory purchases required to support our European sales.

 

We do not try to hedge against all possible foreign currency exposures because of the inherent difficulty in estimating the volatility of the Euro. The contracts we procure are specifically entered into to as a hedge against forecasted or existing or foreign currency exposure.  We do not enter into contracts for speculative purposes. Although we maintain these programs to reduce the short term impact of changes in currency exchange rates,  long term strengthening or weakening of the U.S. dollar against the Euro impacts our sales, our gross profit, operating income and retained earnings. Factors that could impact the effectiveness of our hedging program are:

 

                  volatility of the currency markets

                  availability of hedging instruments

                  accuracy of our inventory forecasts

 

Additionally, there is the risk that foreign exchange fluctuations will make our products less competitive in foreign markets, which would substantially reduce our sales.

 

See “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations” with reference to the impact of foreign currency exchange fluctuations.

 

We may be unable to develop new products that meet customer requirements in a timely manner.

 

Our success is dependent on our ability to continue to introduce new products with advanced features, functionality and performance that our customers demand. We may not be able to introduce new products on a timely basis, that are accepted by the market, and that sell in quantities sufficient to make the products viable for the long-term. Sales of new products may negatively impact sales of existing products.  In addition, we may have difficulty establishing our products’ presence in markets where it does not currently have significant brand recognition.

 

We may experience declining margins.

 

We may experience declining gross margins due to the following factors, among others:

 

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                                          changes in foreign currency exchange rates

                                          larger sales mix of lower margin products

                                          possible future allowances for excess inventory

                                          increases in costs charged by contract manufacturers

                                          increases in duty and tariff rates

                                          increases in shipping costs

                                          lower average selling prices

                                          increases in material acquisition costs and

                                          different gross margins for like products in different markets

 

Consequently, as margins may decline, our profitability will be more dependent upon effective cost management controls.  There can be no assurances that such cost and management controls can be implemented and maintained, and if implemented, that they will be successful.

 

We have experienced, and expect to continue to experience, intense downward pricing pressure on our products, which could substantially impair our operating performance.

 

We are experiencing, and are likely to continue to experience, downward pricing pressure on our products. As a result, we have experienced, and we expect to continue to experience, declining average sales prices for our products. Increases in the number of units that we are able to sell and reductions in per unit costs may not be sufficient to offset reductions in per unit sales prices, in which case our net income would be reduced and we could incur losses. Since we typically negotiate supply arrangements far in advance of delivery dates, we may need to commit to price reductions for our products before we are aware of how, or if, these cost reductions can be obtained. As a result, any current or future price reduction commitments and our inability to respond to increased price competition could have a material adverse effect on our business, operating results and financial condition.

 

We are dependent upon contract manufacturers for our production.  If these manufacturers do not meet our requirements, either in volume or quality, then we could be materially harmed.

 

During fiscal 2005, we subcontracted the manufacturing and assembly of our products to three independent third parties at facilities in various countries.

 

Relying on subcontractors involves a number of significant risks, including:

 

              loss of control over the manufacturing process

              potential absence of adequate production capacity

              potential delays in production lead times

              unavailability of certain process technologies

              reduced control over delivery schedules, manufacturing yields, quality and costs, and

              unexpected increases in component costs

 

We may need to hold more inventory than is immediately required to compensate for potential manufacturing disruptions.

 

If our significant subcontractors become unable or unwilling to continue to manufacture these products in required volumes, we will have to identify qualified alternate subcontractors. Additional qualified subcontractors may not be available, or may not be available on a timely or cost competitive basis. Any interruption in the supply of, or increase in, the cost of the products manufactured by third party subcontractors could have a material adverse effect on our business, operating results and financial condition.

 

22



 

We are dependent upon single or limited source suppliers for our components and assembled products.  If these suppliers do not meet the demand, either in volume or quality, then we could be materially harmed.

 

If the supply of a key component or assembled product, such as the DEC and WinTV®-DVB, were to be delayed or curtailed or in the event a key manufacturing or sole vendor delays shipment of such components or completed products, our ability to ship products in desired quantities and in a timely manner would be adversely affected. Our business, operating results and financial condition could also be adversely affected, depending on the time required to obtain sufficient quantities from the original source or, if possible, to identify and obtain sufficient quantities from an alternative source. We attempt to mitigate these potential risks by working closely with our key suppliers on product introduction plans, strategic inventories, coordinated product introductions, and internal and external manufacturing schedules and levels.  We are also seeking out alternative sources for assembled products, making us less dependent on a single or limited source.

 

We may need to hold more inventory than is immediately required to compensate for potential component shortages or discontinuation. This could lead to an increase in the costs of manufacturing or assembling our products.

 

If any single or limited source supplier becomes unable or unwilling to continue to supply these components or assembled products in required volumes, we will have to identify and qualify acceptable replacements or redesign our products with different components.  Additional sources may not be available, or product redesign may not be feasible on a timely basis. Any interruption in the supply of or increase in the cost of the components and assembled products provided by single or limited source suppliers could have a material adverse effect on our business, operating results and financial condition.

 

We may incur excessive expenses if we are unable to accurately forecast sales of our products.

 

We generally ship products within one to four weeks after receipt of orders. Therefore, our sales backlog is typically minimal. Accordingly, our expectations of future net sales and our product manufacturing and materials planning are based largely on our own estimates of future demand and not on firm customer orders.

 

If we obtain orders in excess of our internal forecasts, we may be unable to timely increase production to meet demand which could have a material adverse effect on our business, operating results and financial condition.  If our net sales do not meet expectations, our business, operating results and financial condition would be adversely affected, we may be burdened with excess inventory, and we may be subject to excess costs or inventory write-offs.

 

We may experience a reduction in sales if we are unable to respond quickly to changes in the market for our products.

 

Our net sales can be affected by changes in the quantity of products that our distributor and OEM customers maintain in their inventories. We may be directly and rapidly affected by changes in the market, including the impact of any slowdown or rapid increase in end user demand. Despite efforts to reduce distribution channel inventory exposure, distribution partners and OEM customers may still choose to alter their inventory levels, which could cause a reduction in our net sales; this could have a material adverse effect on our business, operating results and financial condition.

 

We may accumulate inventory to minimize the impact of shortages from manufacturers and suppliers, which may result in obsolete inventory that we may need to write off resulting in losses.

 

Managing our inventory is complicated by fluctuations in the demand for our products as well as the issues of using contract manufacturers and procuring components from suppliers mentioned above. As we must plan to have sufficient quantities of products available to satisfy our customers’ demands, we sometimes accumulate inventory for a period of time to minimize the impact of possible insufficient capacity or availability of components from our manufacturers and suppliers. Although we expect to sell the inventory within a short period of time, products may remain in inventory for extended periods of time and may become obsolete

 

23



 

because of the passage of time and the introduction of new products or new components within existing products. In these situations, we would be required to write off obsolete inventory which could have a material adverse effect on our business, operating results and financial condition.

 

We may need financing, and may not be able to raise financing on favorable terms, if at all, which could limit our ability to grow and increase our costs.

 

We anticipate that we may need to raise additional capital in the future to continue our long term expansion plans, to respond to competitive pressures or to respond to unanticipated requirements. We cannot be certain that we will be able to obtain additional financing on commercially reasonable terms, if at all. Our failure or inability to obtain financing on acceptable terms could require us to limit our plans for expansion, incur indebtedness that has high rates of interest or substantial restrictive covenants, issue equity securities that will dilute existing stockholders’ holdings or discontinue a portion of our operations, each of which could have a material adverse effect on our business, operating results and financial condition.

 

We may become involved in costly intellectual property disputes.

 

With the proliferation of new products and rapidly changing technology, there is a significant volume of patents and other intellectual property rights held by third parties. There are a number of companies that hold patents for various aspects of the technologies incorporated in some of the PC and TV industries’ standards.  Given the nature of our products and development efforts, there are risks that claims associated with such patents or intellectual property rights could be asserted by third parties against us.  We expect that parties seeking to gain competitive advantages will increase their efforts to enforce any patent or intellectual property rights that they may have.  The holders of patents from which we may have not obtained licenses may take the position that it is required to obtain a license from them.

 

If a patent holder refuses to offer such a license or offers such a license on terms unacceptable to us, there is a risk of incurring substantial litigation or settlement costs regardless of the merits of the allegations, or which party eventually prevails. If we do not prevail in a litigation suit, we may be required to pay significant damages and/or to cease sales and production of infringing products and accordingly, may incur significant defense costs.  Additionally, we may need to attempt to design around a given technology, although there can be no assurances that this would be possible or economical.

 

We currently use technology licensed from third parties in certain products.  Our business, financial condition and operating results could be adversely affected by a number of factors relating to these third-party technologies, including:

 

                                          failure by a licensor to accurately develop, timely introduce, promote or support the technology

                                          delays in shipment of products

                                          excess customer support or product return costs due to problems with licensed technology; and

                                          termination of our relationship with such licensors

 

We may be unable to enforce our intellectual property rights.

 

We may not be able to adequately protect our intellectual property through patent, copyright, trademark and other means of protection. If we fail to adequately protect our intellectual property, our intellectual property rights may be misappropriated by others, invalidated or challenged, and our competitors could duplicate our technology or may otherwise limit any competitive technological advantage we may have. Due to the rapid pace of technological change, we believe our success is likely to depend more upon continued innovation, technical expertise, marketing skills and customer support and service rather than upon legal protection of our proprietary rights. However, we intend to aggressively assert our intellectual property rights when necessary.

 

24



 

Even though we typically develop our products independently, our success, of which there can be no assurances,  will depend, in a large part, on our ability to innovate, obtain or license patents, protect trade secrets, copyrights and trademarks, and draw upon our proprietary technology without infringing on the proprietary rights of others. We maintain copyrights on our designs and software programs, but currently we have no patent on the WinTV® board as we believe that such technology cannot be patented.

 

We have no patents issued or pending that relate to our technology. We are subject to a number of risks relating to intellectual property rights, including the following:

 

                                          the means by which we seek to protect our proprietary rights may not be adequate to prevent others from misappropriating our technology or from independently developing or selling technology or products with features based on or similar to our products

                                          our products may be sold in foreign countries that provide less protection to intellectual property than is provided under U.S. laws; and

                                          our intellectual property rights may be challenged, invalidated, violated or circumvented and may not provide us with any competitive advantage

 

We may not be able to attract and retain qualified managerial and other skilled personnel.

 

Our success, of which there can be no assurances, depends, in part, on our ability to identify, attract, motivate and retain qualified managerial, technical and sales personnel. Our success, of which there can be no assurances, is dependent on our ability to manage effectively the enhancement and introduction of existing and new products and the marketing of such products. We are particularly dependent on our ability to identify, attract, motivate and retain qualified managers, engineers and salespersons. The loss of the services of a significant number of engineers or sales people or one or more senior officers or managers could be disruptive to product development efforts or business relationships and could seriously harm our business.

 

We depend on a limited number of key personnel, and the loss of any of their services could adversely affect our future growth and profitability and could substantially interfere with our operations.

 

Our products are complex and our market is evolving. The success of our business depends in large part upon the continuing contributions of our management and technical personnel. The loss of the services of any of our key officers or employees could adversely affect our future growth and profitability and could have a material adverse effect on our business, operating results and financial condition.

 

Our dependence upon our key officers and employees is increased by the fact that they are responsible for our sales and marketing efforts, as well as our overall operations. We do not have key person life insurance policies covering any of our employees other than Mr. Plotkin, our Chairman of the Board, Chief Executive Officer, President, Chief Operating Officer and Vice President of Marketing and the insurance coverage that we have on him may be insufficient to compensate us for the loss of his services.

 

We may not be able to effectively integrate businesses or assets that we acquire

 

We may identify and pursue acquisitions of complementary companies and strategic assets, such as customer bases, products and technology. However, there can be no assurance that we will be able to identify suitable acquisition opportunities.

 

If any such opportunity involves the acquisition of a business, we cannot be certain that:

 

                                          we will successfully integrate the operations of the acquired business with our own

                                          all the benefits expected from such integration will be realized

                                          management’s attention will not be diverted or divided, to the detriment of current operations

 

25



 

                                          amortization of acquired intangible assets will not have a negative effect on operating results or other aspects of our business

                                          delays or unexpected costs related to the acquisition will not have a detrimental effect on the combined business, operating results and financial condition

                                          customer dissatisfaction with, or performance problems at, an acquired company will not have an adverse effect on our reputation; and

                                          respective operations, management and personnel will be compatible

 

In most cases, acquisitions will be consummated without seeking and obtaining stockholder approval, in which case stockholders will not have an opportunity to consider and vote upon the merits of such an acquisition. Although we will endeavor to evaluate the risks inherent in a particular acquisition, there can be no assurance that we will properly ascertain or assess such risks.

 

Our products could contain defects, which could result in delays in recognition of sales, loss of sales, loss of market share, or failure to achieve market acceptance, or claims against us.

 

We develop complex products for TV and video processing. Despite testing by our engineers, subcontractors and customers, errors may be found in existing or future products. This could result in, among other things, a delay in recognition of sales, loss of sales, loss of market share, failure to achieve market acceptance or substantial damage to our reputation. We could be subject to material claims by customers, and may need to incur substantial expenses to correct any product defects. We do not have product liability insurance to protect against losses caused by defects in our products, and we also do not have “errors and omissions” insurance. As a result, any payments that we may need to make to satisfy our customers may be substantial and may result in a substantial charge to earnings.

 

We may experience fluctuations in our future operating results, which will make predicting our future results difficult.

 

Historically, our quarterly and annual operating results have varied significantly from period to period, and we expect that our results will continue to do so. These fluctuations result from a variety of factors, including:

 

                                          market acceptance of our products

                                          changes in order flow from our customers, and their inability to forecast their needs accurately

                                          the timing of our new product announcements and of announcements by our competitors

                                          increased competition, including changes in pricing by us and our competitors

                                          delays in deliveries from our limited number of suppliers and subcontractors; and

                                          difficulty in implementing effective cost management constraints

 

As our sales are primarily to the consumer market, we have experienced certain seasonal revenue trends. Our peak sales quarter, due to holiday season sales of computer equipment, is our first fiscal quarter (October to December), followed by our second fiscal quarter (January to March). In addition, our international sales, mostly in the European market, were 54%, 66% and 68% of sales for the years ended September 30, 2005, 2004 and 2003 respectively. Our fiscal fourth quarter sales (July to September) can be potentially impacted by the reduction of activity experienced in Europe during the July and August summer holiday period. Accordingly, any sales or net income in any particular period may be lower than the sales and net income in a preceding or comparable period. Period-to-period comparisons of our results of operations may not be meaningful, and should not be relied upon as indications of our future performance. In addition, our operating results may be below the expectations of securities analysts and investors in future periods. Failure to meet such expectations, should such an event occur, will likely cause our share price to decline.

 

26



 

Our Common Stock price is highly volatile.

 

The market price of our Common Stock has been, and may continue to be, subject to a high degree of volatility. Numerous factors may have a significant impact on the market price of our Common Stock, including:

 

              general conditions in the PC and TV industries

              product pricing

              new product introductions

              market growth forecasts

              technological innovations

              mergers and acquisitions

              announcements of quarterly operating results

              overall U.S. and international economic health

              stability of the U.S. and international securities markets

 

In addition, stock markets have experienced extreme price volatility and broad market fluctuations in recent years. This volatility has had a substantial effect on the market price of securities issued by many high technology companies in many cases for reasons unrelated to the operating performance of the specific companies. The price of our Common Stock has experienced volatility not necessarily related to our performance.

 

Our Amended and Restated By-Laws and the Rights Agreement in which we are party to may have anti-takeover effects, limiting the ability of outside stockholders to seek control of management, and any premium over market price that an acquirer might otherwise pay may be reduced and any merger or takeover may be delayed.

 

Effective August 16, 2001, the Board of Directors unanimously approved Amended and Restated By-laws for us (the “By-Laws”).  The By-Laws do not permit stockholders to call a special meeting of stockholders and consequently, an expensive proxy contest cannot occur other than in connection with the annual meeting of stockholders.  The By-laws also impose strict requirements for shareholder proposals and nominations of prospective Board members other than those nominated by or at the discretion of the Board of Directors.  These amendments may collectively or individually impact a person’s decision to purchase voting securities in our Company and may have anti-takeover effects in that any merger or takeover may be delayed.  Accordingly, any premium over market price that an acquirer might otherwise pay may be reduced.

 

On July 19, 2001, the Board of Directors declared a dividend distribution of one Right for each outstanding share of the our Common Shares to stockholders of record at the close of business on August 5, 2001.  Each Right entitles the registered holder to purchase from us one Common Share at a purchase price of $11.00 per share, subject to adjustment and terms set out in the Rights Agreement between us and North American Transfer Agent, as Rights Agent.  The Rights may have certain anti-takeover effects.  The Rights will cause substantial dilution to a person or group that attempts to acquire us in a manner which causes the Rights to become discount Rights unless the offer is conditional on a substantial number of Rights being acquired.  Accordingly, any premium over market price that an acquirer might otherwise pay may be reduced.

 

No dividends and none anticipated.

 

We have never paid any cash dividends on our common stock and do not contemplate or anticipate paying any cash dividends on our Common Stock in the foreseeable future. It is currently anticipated that earnings, if any, will be used to finance the development and expansion of the business.

 

From time to time, information provided by us, statements made by our employees or information provided in our Securities and Exchange Commission filings, including information contained in this Annual Report on Form 10-K, may contain forward looking information. Our actual future results may differ materially from those projections or statements made in such forward looking information as a result of various risks and uncertainties, including, but not limited to, rapid changes in technology, lack of funds for research and

 

27



 

development, competition, proprietary patents and rights of others, loss of major customers, loss of sources of supply for our components, non-availability of management, government regulation, currency fluctuations and our inability to profitably sell our products. The market price of our Common Stock may be volatile at times in response to fluctuations in our quarterly operating results, changes in analysts’ earnings estimates, market conditions in the computer hardware industry, seasonality of the business cycle, as well as general conditions and other external factors.

 

ITEM  1B.      UNRESOLVED STAFF COMMENTS

 

Not applicable

 

ITEM  2.         DESCRIPTION OF PROPERTY

 

We occupy a facility located in Hauppauge New York and use it for executive offices and for the testing, storage and shipping of our products.  In February 1990, Hauppauge Computer Works, Inc., a wholly-owned subsidiary of ours (“HCW”), entered into a lease (the “1990 Lease”), with Ladokk Realty Co., a real estate partnership which is principally owned by Kenneth Plotkin, our Chairman of the Board, Chief Executive Officer, President, Chief Operating Officer and Vice President of Marketing and the holder of approximately 8.8% of our Common Shares as of September 30, 2005,  Dorothy Plotkin, the wife of Kenneth Plotkin, holder of approximately 5.9% of our Common Shares as of September 30, 2005 and Laura Aupperle, believed by us to be the holder of approximately 10.5% of our Common Shares, including Common Shares attributed to the Estate of Kenneth R. Aupperle.  Ladokk Realty Co., LLC is the successor to Ladokk Realty Co.  As of February 2004, the 1990 Lease provided for annual rent of approximately $454,000, payable monthly, and subject to 5% annual increases effective February 1st of each year.  We were also obligated to pay real estate taxes and operating costs of maintaining the premises subject to the 1990 Lease.  Until February 17, 2004, the premises subject to such lease were subject to two mortgages guaranteed by us.

 

On February 17, 2004, HCW and Ladokk terminated the 1990 Lease and HCW entered into a new lease agreement with Ladokk Realty Co., LLC (the “2004 Lease”).  The 2004 Lease term is for five years and terminates on February 16, 2009.  The annual rent under the 2004 Lease is $360,000, payable monthly.  We are also obligated to pay real estate taxes and operating costs of maintaining the premises subject to such lease.  Concurrently with the new lease, Ladokk completed a refinancing of its mortgages, and the new lender did not require us to sign a guarantee.  Accordingly, we no longer guarantee the landlord’s mortgages.

 

Our Audit Committee is in the process of evaluating the 2004 lease. See “Item 13, Certain Relationships and Related Transactions”.

 

Our subsidiary, Hauppauge Computer Works, Inc., occupies a shared office facility at the Danville Business Center in Danville, California.  We use the California office as our western region sales office and for marketing our Eskape™ Labs product line.  The lease expires on May 31, 2006 and requires us to pay an annual rent, which includes telecommunications services, of approximately $11,500.

 

Our German subsidiary, Hauppauge Computer Works GmbH, occupies approximately 6,000 square feet in Mönchengladbach, Germany. It is used as our European sales office and customer support center.  It also has a product demonstration room and a storage facility.  Hauppauge Computer Works GmbH pays an annual rent of approximately $52,000 for this facility pursuant to a rental agreement, which expires on October 31, 2006.

 

Our Singapore subsidiary, Hauppauge Digital Asia Pte. Ltd., occupies approximately 5,400 square feet in Singapore, which it uses as a sales and administration office and for the testing, storage and shipping of our products. The lease expires on November 30, 2006 and calls for an annual rent of approximately $61,000. The rent includes an allocation for common area maintenance charges.

 

28



 

On May 1, 2001, Hauppauge Digital S.à.r.l. commenced a lease of a 15,642 square foot building in Blanchardstown, Dublin, Ireland.  The facility houses our European warehousing and distribution center.  The lease, which is for the standard twenty-five year term in Ireland with the right to terminate on the fifth and tenth year of the lease, calls for an annual rent of approximately $127,200.  The rent includes an allocation for common area maintenance charges.

 

ITEM 3.          LEGAL PROCEEDINGS

 

We were involved in arbitration proceedings before the American Arbitration Association, which had been brought against us by the estate of the late Mr. Kenneth Aupperle, one of our founders and former President (“Estate”).  The Estate was claiming property rights and interest in our Company, certain amounts due and owing to the Estate based on various corporate agreements with Mr. Aupperle and certain insurance policies,  which amounts were claimed to be not less than $2,500,000. On April 19, 2004, the arbitration panel awarded the Estate a total of $206,250.  No other fees or expenses were awarded.  We accrued a charge of $206,250 in the second quarter of fiscal year 2004 to cover the award. The award was paid in May 2004.

 

ITEM 4.          SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

The following proposals were submitted to the stockholders for approval at the Annual Meeting of Stockholders held on July 25, 2005  at our offices:

 

Proposal No. 1:   Election of Directors

 

The following directors were elected by the votes indicated:

 

 

 

For

 

Withheld

 

Kenneth Plotkin

 

8,434,358

 

54,002

 

Bernard Herman

 

8,223,243

 

351,117

 

Robert S. Nadel

 

8,492,009

 

46,351

 

Christopher G. Payan

 

8,491,559

 

46,801

 

Neal Page

 

8,493,509

 

44,851

 

Seymour G. Siegel

 

8,491,359

 

47,001

 

 

29



 

PART II

 

ITEM 5.          MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

(a)           The principal market on which our common stock (the “Common Stock”) is traded is the over-the- counter market.  The Common Stock is quoted on the NASDAQ National Market and its symbol is HAUP.  The table below sets forth the high and low bid prices of our Common Stock as furnished by NASDAQ for the periods indicated. Quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions.

 

Fiscal Year Ended
September 30, 2005

 

High

 

Low

 

First Quarter

 

6.19

 

3.37

 

Second Quarter

 

6.24

 

3.96

 

Third Quarter

 

4.32

 

3.45

 

Fourth Quarter

 

4.22

 

3.34

 

 

Fiscal Year Ended
September 30, 2004

 

High

 

Low

 

First Quarter

 

2.98

 

2.28

 

Second Quarter

 

8.15

 

2.31

 

Third Quarter

 

9.73

 

5.25

 

Fourth Quarter

 

5.31

 

3.10

 

 

(b)           We have been advised by our transfer agent, North American Transfer Co. that the approximate number of holders of record of our Common Stock as of June 17, 2005 was 161.  We believe there are in excess of 5,400 beneficial holders of our Common Stock.

 

(c)          No cash dividends have been paid during the past two years. We have no present intention of paying any cash dividends in our foreseeable future and intend to use our net income, if any, in our operations.

 

The table below summarized repurchases of our common stock under our stock repurchase program:

 

 

 

 

 

 

 

 

 

Maximum

 

 

 

 

 

 

 

Total number

 

number

 

 

 

Total

 

Average

 

of shares

 

of shares

 

 

 

Number

 

Price

 

purchased as

 

that may yet

 

 

 

of shares

 

Paid per

 

part of publicly

 

be purchased

 

 

 

Purchased

 

Share

 

announced plan

 

under the plan

 

Purchases as of September 30, 2003

 

542,067

 

$

2.76

 

542,067

 

307,933

 

August 1 to August 31

 

15,000

 

3.44

 

15,000

 

292,933

 

September 1 to September 30

 

10,000

 

3.54

 

10,000

 

282,933

 

Purchases as of September 30, 2004

 

567,067

 

$

2.79

 

567,067

 

282,933

 

October 1 to October 31

 

5,000

 

3.49

 

5,000

 

277,933

 

February 1 to February 28

 

20,000

 

4.57

 

20,000

 

257,933

 

March 1 to March 31

 

10,000

 

4.08

 

10,000

 

247,933

 

April 1 to April 30

 

5,200

 

4.39

 

5,200

 

242,733

 

August 1 to August 31

 

280

 

3.75

 

280

 

242,453

 

Purchases as of September 30, 2005

 

607,547

 

$

2.89

 

607,547

 

242,453

 

 

On November 8, 1996, we approved a stock repurchase program.  The program authorizes us to repurchase up to 850,000 shares of our own stock. The stock repurchase program was extended by a resolution of our Board of Directors on December 17, 1997.

 

The information required by this Item regarding equity compensation plans is incorporated by reference to Item 12 of this Annual Report on Form 10-K.

 

30



 

ITEM 6.          SELECTED FINANCIAL DATA

 

The following selected financial data with respect to our financial position and our results of operations for each of the five years in the period ended September 30, 2005 set forth below has been derived from our audited consolidated financial statements. The selected financial information presented below should be read in conjunction with the Consolidated Financial Statements and related notes thereto and “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this Annual Report on Form 10-K.

 

Consolidated Statement of Operations Data

 

2005

 

2004

 

2003

 

2002

 

2001

 

 

 

(in thousands, except for per share amounts)

 

Net Sales

 

$

78,458

 

$

65,339

 

$

50,956

 

$

42,797

 

$

50,910

 

Cost of sales

 

60,599

 

48,045

 

38,715

 

31,661

 

42,056

 

Gross Profit

 

17,859

 

17,294

 

12,241

 

11,136

 

8,854

 

Selling, general and administrative expenses

 

13,903

 

12,320

 

10, 818

 

9,069

 

10,282

 

Research & development expenses

 

2,494

 

2,021

 

1,902

 

1,592

 

1,510

 

Legal expenses related to arbitration and litigation proceedings

 

 

354

 

78

 

 

 

Arbitration proceeding

 

 

206

 

 

 

 

Litigation proceeding

 

 

427

 

 

 

 

Write off of goodwill

 

 

 

 

 

702

 

Litigation settlement

 

 

 

 

 

213

 

Income (loss) from operations

 

1,462

 

1,966

 

(557

)

475

 

(3,853

)

 

 

 

 

 

 

 

 

 

 

 

 

Other Income (Expense):

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

13

 

7

 

16

 

35

 

42

 

Interest expense

 

 

 

 

 

(31

)

Life insurance proceeds

 

 

 

 

 

2,000

 

Foreign currency

 

61

 

2

 

34

 

(93

)

(9

)

Income (loss) before taxes

 

1,536

 

1,975

 

(507

)

417

 

(1,851

)

Income tax provision

 

149

 

150

 

307

 

69

 

750

 

Income (loss) before cumulative effect of a change in accounting principle

 

1,387

 

1,825

 

(814

)

348

 

(2,601

)

Cumulative effect of a change in accounting principle

 

 

 

 

 

319

 

Net income (loss)

 

$

1,387

 

$

1,825

 

$

(814

)

$

348

 

$

(2,282

)

Per share results-basic:

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before cumulative effect of a change in accounting principle

 

$

0.15

 

$

0.20

 

$

(0.09

)

$

0.04

 

$

(0.29

)

Cumulative effect of a change in accounting principle

 

$

 

$

 

$

 

$

 

$

0.03

 

Net income (loss) per share-basic

 

$

0.15

 

$

0.20

 

$

(0.09

)

$

0.04

 

$

(0.26

)

Per share results-diluted:

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before cumulative effect of a change in accounting principle

 

$

0.14

 

$

0.19

 

$

(0.09

)

$

0.04

 

$

(0.29

)

Cumulative effect of a change in accounting principle

 

$

 

$

 

$

 

$

 

$

0.03

 

Net income (loss) per share-diluted

 

$

0.14

 

$

0.19

 

$

(0.09

)

$

0.04

 

$

(0.26

)

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

 

 

Basic

 

9,431

 

8,999

 

8,867

 

8,887

 

8,910

 

Diluted

 

9,988

 

9,668

 

8,867

 

9,002

 

8,910

 

Consolidated Balance Sheet Data (at period end):

 

 

 

 

 

 

 

 

 

 

 

Working capital

 

$

15,335

 

$

13,760

 

$

10,860

 

$

11,266

 

$

10,258

 

Total assets

 

32,116

 

32,071

 

21,650

 

19,846

 

18,784

 

Stockholders’ equity

 

15,941

 

14,327

 

11,468

 

11,967

 

11,686

 

 

31



 

ITEM 7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Results of operations

Twelve months ended September 30, 2005 compared to September 30, 2004.

 

Results of operations for the twelve months ended September 30, 2005 compared to September 30, 2004 are as follows:

 

 

 

Twelve

 

Twelve

 

 

 

 

 

 

 

 

 

 

 

Months

 

Months

 

 

 

 

 

 

 

 

 

 

 

Ended

 

Ended

 

Variance

 

Percentage of sales

 

 

 

9/30/05

 

9/30/04

 

$

 

2005

 

2004

 

Variance

 

Net Sales

 

$

78,457,785

 

$

65,339,583

 

$

13,118,202

 

100.00

%

100.00

%

0

 

Cost of sales

 

60,599,066

 

48,045,365

 

12,553,701

 

77.24

%

73.53

%

3.71

%

Gross Profit

 

17,858,719

 

17,294,218

 

564,501

 

22.76

%

26.47

%

-3.71

%

Gross Profit%

 

22.76

%

26.47

%

-3.71

%

 

 

 

 

 

 

Expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales & Marketing

 

9,907,606

 

8,383,807

 

1,523,799

 

12.63

%

12.83

%

-0.20

%

Technical Support

 

516,533

 

463,412

 

53,121

 

0.66

%

0.71

%

-0.05

%

Legal expenses related to litigation & arbitration proceedings

 

 

354,050

 

(354,050

)

0.00

%

0.54

%

-0.54

%

General & Administrative

 

3,479,278

 

3,472,586

 

6,692

 

4.44

%

5.32

%

-0.88

%

Total Selling, General and Administrative costs

 

13,903,417

 

12,673,855

 

1,229,562

 

17.73

%

19.40

%

-1.67

%

Research & Development

 

2,493,710

 

2,020,824

 

472,886

 

3.18

%

3.09

%

0.09

%

Total expenses

 

16,397,127

 

14,694,679

 

1,702,448

 

20.91

%

22.49

%

-1.58

%

Net operating income before arbitration & litigation

 

1,461,592

 

2,599,539

 

(1,137,947

)

1.85

%

3.98

%

-2.13

%

Arbitration & litigation items:

 

 

 

 

 

 

 

 

 

 

 

 

 

Arbitration proceeding

 

 

206,250

 

(206,250

)

0.00

%

0.32

%

-0.32

%

Litigation proceeding

 

 

427,000

 

(427,000

)

0.00

%

0.65

%

-0.65

%

Net operating income

 

1,461,592

 

1,966,289

 

(504,697

)

1.85

%

3.01

%

-1.16

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other income :

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

13,684

 

6,054

 

7,630

 

0.02

%

0.01

%

0.01

%

Foreign currency

 

60,833

 

2,302

 

58,531

 

0.08

%

0.00

%

0.08

%

Total other income

 

74,517

 

8,356

 

66,161

 

0.10

%

0.01

%

0.09

%

Income before taxes on income

 

1,536,109

 

1,974,645

 

(438,536

)

1.95

%

3.02

%

-1.07

%

Taxes on income

 

149,356

 

149,497

 

(141

)

0.19

%

0.23

%

-0.04

%

Net income

 

$

1,386,753

 

$

1,825,148

 

$

(438,395

)

1.76

%

2.79

%

-1.03

%

 

Net sales for the twelve months ended September 30, 2005 increased $13,118,202 compared to the twelve months ended September 30, 2004 as shown on the table below. 

 

 

 

 

 

 

 

Increase
(decrease)

 

Increase

 

Percentage of sales by

 

 

 

Twelve Months

 

Twelve Months

 

Dollar

 

(decrease)

 

Geographic region

 

Location

 

ended 9/30/05

 

ended 9/30/04

 

Variance

 

Variance%

 

2005

 

2004

 

Domestic

 

$

36,508,354

 

$

22,219,561

 

$

14,288,793

 

64

%

46

%

34

%

Europe

 

39,928,765

 

42,249,996

 

(2,321,231

)

-5

%

51

%

65

%

Asia

 

2,020,666

 

870,026

 

1,150,640

 

132

%

3

%

1

%

Total

 

$

78,457,785

 

$

65,339,583

 

$

13,118,202

 

20

%

100

%

100

%

 

The primary factors contributing the sales increase were:

 

      Increased volume of PVR-150 Amity 2 OEM sales due to increased program volume of $10,311,218

      Stronger demand for retail PVR-150/350 Amity 2 products due to exposure generated from media center system sales of $5,801,072

      Increased Nova-T terrestrial PCI and USB sales of $4,264,999

      Increased PVR-USB sales due to price reduction and media center awareness of $1,978,093

      Introduction of hybrid video recorder boards of $3,299,196

 

32



 

      Increase in our average Euro to USD contract rate of about 6.58% (1.2690 versus 1.1907) for the twelve months ended September 30, 2005 compared to the twelve months ended September 30, 2004, which yielded higher converted Euro to USD sales

 

The sales increases were offset by the following negative trends:

 

      Decrease in PCI analog product sales of $3,687,740

      Decrease in USB analog sales of $3,507,691

      Decrease in Digital video satellite product of $2,847,484

      Decrease in Media MVP sales-primarily due initial fiscal 2004 introductory sales of $1,719,641

      Decrease in DEC set top digital boxes of $420,548

 

Net sales to domestic customers were 46% of net sales for the twelve months ended September 30, 2005 compared to 34% for the twelve months ended September 30, 2004.  Net sales to European customers were 51% of net sales for the twelve months ending September 30, 2005 and 65% for the twelve months ended September 30 2004.  Net Sales to Asian customers were 3% for the periods ending September 30, 2005 and 1% for the twelve months ended September 30, 2004.

 

Seasonal nature of sales

 

Percent of sales by quarter-fiscal 2003 through fiscal 2005

 

 

As the chart above indicates, there is a seasonal pattern to our quarterly sales.  Listed below are the primary causes of our seasonal sales:

 

      Our product is sold through retail outlets or to Original Equipment Manufacturers (OEM’s) who include our product in their computer system. Spurred on by the holiday spending, our sales during our first fiscal quarter, which encompasses the holiday season, have historically been the highest of our fiscal year.

      Our fiscal second quarter is historically our second best sales quarter.  Post holiday sales, mid year school computer purchases and disposable income generated from year end bonuses, gift certificates, holiday cash gifts fuel the sales of our second quarter.

      We sell over 50% of our sales into the European market.  During the latter part of our fiscal third quarter and into the first half of our fiscal fourth quarter, we experience a slowdown due to the summer holiday period in Europe. We also see decreased spending in the U.S during the summer months.  This has historically caused sales of our fiscal third quarter and fourth quarter to be the lowest for the year.

 

Although our strategy has been to diversify our sales to minimize the seasonal nature of our business, we anticipate similar seasonal trends for the near term future.

 

33



 

Gross Profit

 

Gross profit increased $564,501 for the twelve months ended September 30, 2005 compared to the twelve months ended September 30, 2004.

 

The increases and (decreases) in the gross profit are detailed below:

 

 

 

Increase

 

 

 

(decrease)

 

Due to increased sales

 

$

4,514,903

 

Lower gross profit on retail products due sales mix

 

(477,378

)

Effect on gross margin due to lower margin OEM sales

 

(2,263,760

)

Due to increases in labor related and other costs

 

(1,209,264

)

Total increase in gross profit

 

$

564,501

 

 

Gross profit percentage for the twelve months ended September 30, 2005 was 22.76% compared to 26.47% for the twelve months ended September 30, 2004, a decrease of 3.71%.

 

The increases and (decreases) in the gross profit percent are detailed below:

 

 

 

Increase

 

 

 

(decrease)

 

Lower gross profit on retail products due sales mix

 

(0.61

)%

Effect on gross margin due to lower margin OEM sales

 

(2.89

)%

Due to increases in labor related and other costs

 

(0.21

)%

Net decrease in gross profit percent

 

(3.71

)%

 

The decrease in the gross profit percent of 3.71% was primarily due to:

 

      Lower gross profit percent on retail sales which resulted in a decrease of 0.61%

 

A combination of lower maturing product sales and the market dynamics for new products resulted in a sales mix which yielded a lower gross profit percentage compared to fiscal 2004

 

      High sales percentage of OEM sales which resulted in a decrease of 2.89%

 

OEM sales, which yielded a gross profit of 13.35% accounted for 26.33% of sales for the twelve months ended September 30, 2005, as opposed to 12.43% of sales at a gross profit of 10.79% for the twelve months ended September 30, 2004.

 

    Labor related and other costs which resulted in a gross profit decrease of 0.21%

 

 Labor related and other costs contributed to a 0.21% decrease in gross profit percent compared to the twelve months ended September 30, 2004.  This was due to the increase in labor related and other costs of 23.28% exceeding the increase in net sales of 20.08%.

 

34



 

Volatility of Gross Profit percent:

 

Gross profit percent (%) by quarter-fiscal 2003 through fiscal 2005

 

 

The chart above details the quarterly fluctuations in gross profit percent. Over the last twelve quarters ending with the fourth quarter of fiscal 2005, the gross profit percent has ranged from a low of 21.71% to a high of 29.34%.

 

Factors affecting the volatility of our gross profit percent are:

 

      Mix of product.  Gross profit percents vary within our retail family of products as well as for OEM products. Varying sales mix of these different product lines affect the quarterly gross profit percentage.

      Fluctuating quarterly sales caused by seasonal trends.  Embedded as a component of cost of sales are certain fixed costs, mainly for production, warehouse labor and the overhead cost of our Ireland distribution facility. Due to this, when unit and dollar sales decline due to seasonal market trends, these fixed costs get spread over lower unit and dollar sales, which increase the product unit costs and increase the fixed costs as a percentage of sales.

      Competitive pressures. Our market is constantly changing with new competitors joining our established competitors. These competitive pressures from time to time result in declining prices, which can reduce gross profit.

      Supply of component parts. In times when component parts are in short supply, we have to manage price increases. Conversely, when component parts’ supply is high, we may be able to secure price decreases.

      Sales volume.  As unit sales volume increases, we have more leverage in negotiating volume price decreases with our component suppliers and our contract manufacturers.

      Cost reductions. We evaluate the pricing we receive from our suppliers and our contract manufacturers and we are constantly looking to achieve component part and contract manufacturer cost reductions.

      Volatility of fuel prices.  Increases in fuel costs are reflected in the amounts we pay for the delivery of product from our suppliers and the amounts we pay for deliveries to our customers. Therefore, increasing fuel prices increase our freight costs and negatively impact our gross profit.

 

Managing product mix through market strategy and new products, moderating seasonal trends, efficiently managing shipments and achieving cost reductions are a Company priority and critical to our competitive position in the market.  Although our goal is to optimize gross profit and minimize gross profit fluctuations, in light of the dynamics of our market, we anticipate the continuance of gross profit percent fluctuations.

 

The chart below illustrates the components of Selling, General and Administrative costs, inclusive of legal expenses related to litigation and arbitration proceedings:

 

35



 

 

 

Twelve months ended September 30,

 

 

 

Dollar Costs

 

Percentage of Sales

 

 

 

 

 

 

 

Increase

 

 

 

 

 

Increase

 

 

 

2005

 

2004

 

(Decrease)

 

2005

 

2004

 

(decrease)

 

Sales and Marketing

 

$

9,907,606

 

$

8,383,807

 

$

1,523,799

 

12.63

%

12.83

%

-0.20

%

Technical Support

 

516,533

 

463,412

 

53,121

 

0.66

%

0.71

%

-0.05

%

Legal expenses related to litigation & arbitration proceedings

 

 

354,050

 

(354,050

)

0.00

%

0.54

%

-0.54

%

General and Administrative

 

3,479,278

 

3,472,586

 

6,692

 

4.44

%

5.32

%

-0.88

%

Total

 

$

13,903,417

 

$

12,673,855

 

$

1,229,562

 

17.73

%

19.40

%

-1.67

%

 

Selling, General and Administrative expenses increased $1,229,562 from the prior year.  As a percentage of sales, Selling, General and Administrative expenses decreased by 1.67% when compared to the twelve months ended September 30, 2004.

 

The increase in Sales and Marketing expense of $1,523,799, which accounted for approximately 124% of the total increase in Selling, General and Administrative expenses, was mainly due to:

 

      Increases caused by the strengthening of the Euro to the U.S dollar of $250,133, which accounted for about 16% of the total increase. The average Euro to USD conversion rate was $1.2714 for the twelve months ended September 30, 2005 compared to $1.2176 for the twelve months ended September 30, 2004

      Increased commission costs of $199,612 due higher sales

      Increased European advertising and promotional expense of $597,874 due to more programs run in response to competitive pressures

      Increased domestic advertising and promotional expense of $81,249 due increase in marketing expenses related to sales volume

      Higher European rep costs of $ 105,571 due to addition of reps and additional support personnel

      Higher sales compensation of $54,890 due addition of OEM sales person

      Higher sales office expenses of $174,678 due to personnel and overhead increases

      Increased travel due more sales personnel of $50,540

      Higher trade show expenses of $38,131

 

Technical support expenses increased $53,121 due additional personnel required to handle the increased calls due to the expanded sales volume.

 

The increase in General and Administrative expenses, excluding legal expenses related to litigation and arbitration proceedings, of $6,692 was primarily due to:

 

      Lower compensation of $209,589 due to the resignation in early fiscal 2005 of a senior Company officer and the Company’s internal counsel

      Increased Directors fees of $61,055

      Increased professional fees of $106,535 related to Sarbanes Oxley section 404 compliance work

      Increased bad debt expense of $50,000 related to a customer chapter 11 filing

 

36



 

Selling general and administrative expenses changes as a percent of sales

 

Selling, General and Administrative expenes as a percentage of sales by quarter

 

 

The chart above details the quarterly fluctuations for technical support, general and administrative, sales and marketing and total selling, general and administrative expenses.  Due to the a preponderance of fixed costs coupled with the seasonal nature of our business, over the last twelve quarters ending with the fourth quarter of fiscal 2005, the pattern of selling general and administrative as a percent of sales is as follows:

 

      Selling, general and administrative expenses as a percent of sales have been the lowest during our first quarter, due to our first quarter yielding quarterly sales that are the highest for the fiscal year.

      Selling, general and administrative expenses as a percent of sales have been the second lowest during the second quarter, due to our second quarter yielding quarterly sales that are the second highest for the fiscal year.

      Selling, general and administrative expenses for the third and fourth quarters are the highest as a percent of sales, reflecting the seasonal trend which yields the lowest quarterly sales of the fiscal year.

      Selling, general and administrative expenses as a percent of sales for the twelve months ended September 30, 2005 declined to its lowest level in three years, the result of increased sales over the prior two fiscal years.

 

We expect the historical seasonal nature of our business to continue for the near future. Due to this, we expect selling, general and administrative expenses as a percentage of sales to reflect a trend that is similar to the historical trends we have experienced over the prior three fiscal years.

 

Research and development expenses

 

Research and Development expenses increased $472,886.  The increase was mainly due to:

 

      Increased compensation expense of $87,069 due to the full year operation during fiscal 2005 of our Taiwan based Engineering department, which was opened in March 2004

      Staff additions in the U.S.  Engineering department

      Increased program development expenses of $190,170 due to a larger volume of programs in progress during fiscal 2005

 

37



 

Arbitration Proceeding

 

We were involved in arbitration proceedings before the American Arbitration Association, which had been brought against us by the estate of the late Mr. Kenneth Aupperle, one of our founders and former President (“Estate”).  The Estate was claiming property rights and interest in our Company, certain amounts due and owing to the Estate based on various corporate agreements with Mr. Aupperle and certain insurance policies, which amounts were claimed to be not less than $2,500,000. On April 19, 2004, the arbitration panel awarded the Estate a total of $206,250.  No other fees or expenses were awarded.  We accrued a charge of $206,250 in the second quarter of fiscal year 2004 to cover the award. The award was paid in May 2004.

 

Litigation Proceeding

 

In March 2002, Polywell International, Inc. (“Polywell”), a supplier of cables to us, commenced an action seeking $339,520 in damages plus exemplary damages, attorney’s fees, costs and interest with relation to certain unpaid invoices.  We paid these invoices to the sales representative, who subsequently failed to forward the payments to Polywell.  We had dealt with this sales representative over a number of years, who also represented himself as Polywell’s payment and collection agent.

 

The case went to trial and was heard before a jury in the United States District Court in the Northern District of Texas, Dallas Division.  Since we had dealt with the said sales representative for several years with respect to all purchasing and payment issues, we believed that paying the invoices to this sales representative was tantamount to paying Polywell.  The jury however ruled in favor of Polywell and the court granted Polywell a judgment against our Company, awarding an amount of $339,520 to Polywell. In addition, the we were obligated to pay Polywell’s attorney’s fees and interest.

 

We accrued a charge of $500,000 during the second fiscal quarter of fiscal 2004 to cover the award. Subsequent negotiation reduced the award to $427,000, and we paid the award in June 2004.  The reduction in the final award was reflected in our fiscal 2004 third quarter results.

 

Other income

 

Other income for the twelve months ended September 30, 2005 was $74,517 compared to other income of $8,356 for the twelve months ended September 30, 2004 as detailed below:

 

 

 

 

Twelve months ended September 30,

 

 

 

2005

 

2004

 

Interest income

 

$

13,684

 

$

6,054

 

Foreign currency transaction gains (losses)

 

60,833

 

2,302

 

Total other income (expense)

 

$

74,517

 

$

8,356

 

 

Re-measurement of accounts denominated in currencies other than the Euro

 

We follow the rules prescribed in paragraph 16 of SFAS 52 “Foreign Currency Translation”, which states that accounts denominated in a currency other than an entities functional currency, excluding inter-company accounts which are long term in nature, need to be re-measured into the entities functional currency, and any gain or loss from this re-measurement are included in the determination of net income and are booked as other income (loss) section under the description foreign currency transaction gains (losses).

 

Accumulated other comprehensive income (loss)

 

The Euro is the functional currency of the Company’s European subsidiary, HDE Sarl.  Assets and liabilities of this subsidiary are translated to U.S. Dollars at the exchange rate in effect at the end of each reporting period, while equity accounts are translated to U.S. Dollars at the historical rate in effect at the date of the contribution.  Operating results are translated to U.S. Dollars at the average prevailing exchange rate for the period, with the exception of sales which are translated to U.S. Dollars at the average monthly forward

 

38



 

exchange contract rate. The use of differing exchange rates results in foreign currency translation gains or losses. Since the Euro denominated accounts on HDE Sarl’s books result in a net asset position (total Euro assets are in excess of Euro liabilities), an increase in the Euro value results in a deferred gain for the translation of Euro accounts to U.S. Dollars. We had a translation gain of $1,074,910 recorded on the balance sheet as of September 30, 2004. For the twelve months ended September 30, 2005, we recorded on the balance sheet deferred translation losses of $528,558 resulting in a translation gain of $546,352 recorded as a component of accumulated other comprehensive income as of September 30, 2005.

 

We use forward exchange contracts to reduce our exposure to fluctuations in foreign currencies.  Mark to market gains and losses on these open contracts result from the difference between the USD value of our open foreign currency forward contracts at the average contract rate as opposed to the same contracts translated at the month end forward rate.  We qualify for cash flow hedge accounting as prescribed under SFAS 133, which allows us to record the mark to market gains and losses in the equity section of our balance sheet under accumulated other comprehensive income.  We had a mark to market losses of $99,399 recorded on the balance sheet as of September 30, 2004.  For the twelve months ended September 30, 2005, we recorded, as component of other comprehensive income, a mark to market gain of $235,817 resulting in a $136,418 mark to market gain recorded on the balance sheet as of September 30, 2005.

 

As stated above, accumulated other comprehensive income (loss) consists of two components:

 

      Translation gains and losses

      FAS 133 mark to market gains and losses on our open foreign exchange contracts

 

The table below details the gains and losses recorded for the components that make up the accumulated other comprehensive income amount of $682,770 recorded on our balance sheet as of September 30, 2005:

 

 

 

Balance
As of
Sep. 30,
2004

 

Oct 04 to
Dec 04
Gains
(losses)

 

Balance
As of
Dec 31
2004

 

Jan 05 to
Mar 05
Gains
(losses)

 

Balance
As of
Mar 31
2005

 

Apr 05 to
June 05
Gains
(losses)

 

Balance
As of
June 30
2005

 

Jul 05 to
Sept 05
Gains
(losses)

 

Balance
As of
Sept 30
2005

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Translation adjustments

 

$

1,074,910

 

$

584,261

 

$

1,659,171

 

$

(237,461

)

$

1,421,710

 

$

(528,645

)

$

893,065

 

$

(346,713

)

$

546,352

 

Fas 133 mark to market adjustment

 

(99,399

)

(279,791

)

(379,190

)

406,300

 

27,110

 

182,258

 

209,368

 

$

(72,950

)

136,418

 

 

 

$

975,511

 

$

304,470

 

$

1,279,981

 

$

168,839

 

$

1,448,820

 

$

(346,387

)

$

1,102,433

 

$

(419,663

)

$

682,770

 

 

Tax provision

 

Our net tax provision for the year ended September 30, 2005 and 2004 is as follows:

 

 

 

Twelve months ended September 30,

 

 

 

2005

 

2004

 

Tax expense (benefit) attributable to U.S operations

 

$

345,000

 

$

(521,000

)

Tax expense on foreign operations

 

109,356

 

134,497

 

State taxes

 

20,000

 

15,000

 

Federal income taxes-AMT

 

20,000

 

 

Net operating loss utilization

 

(345,000

)

 

Deferred tax asset valuation allowance

 

 

521,000

 

Net tax provision

 

$

149,356

 

$

149,497

 

 

For four out of the last five fiscal years, our domestic operation has incurred losses.  With the close of fiscal 2005, we analyzed the future realization of our deferred tax assets as of September 30, 2005 and we concluded that under the present circumstances, it would be appropriate for us to continue to record a valuation allowance against our deferred tax asset.

 

As a result of all of the above items mentioned in the Management’s Discussion and Analysis of Financial Condition and Results of Operations, we had net income of $1,386,753 for the twelve months ended September 30, 2005, which resulted in basic net income per share of $0.15 and diluted net income per share of $0.14 on weighted average basic and diluted shares of 9,431,695 and 9,988,646, respectively, compared to net income of $1,825,148 for the twelve months ended September 30, 2004, which resulted in basic net income

 

39



 

per share of $0.20 and diluted net income per share of $0.19 on weighted average basic and diluted shares of 8,999,266 and 9,668,223, respectively.

 

Options to purchase 48,453 and 123,701 shares of common stock at prices ranging $4.40 to $ 8.75 and $5.25 and $10.06, respectively, were outstanding for the twelve month period ending September 30, 2005 and 2004, respectively, but were not included in the computation of diluted earnings per share because they were anti-dilutive

 

40



 

Results of operations

Twelve months ended September 30, 2004 compared to September 30 2003.

 

Results of operations for the twelve months ended September 30, 2004 compared to September 30, 2003 are as follows:

 

 

 

Twelve

 

Twelve

 

 

 

 

 

 

 

 

 

 

 

Months

 

Months

 

 

 

 

 

 

 

 

 

 

 

Ended

 

Ended

 

Variance

 

Percentage of sales

 

 

 

9/30/04

 

9/30/03

 

$

 

2004

 

2003

 

Variance

 

Net Sales

 

$

65,339,583

 

$

50,956,034

 

$

14,383,549

 

100.0

%

100.0

%

0

 

Cost of sales

 

48,045,365

 

38,715,103

 

9,330,262

 

73.53

%

75.98

%

-2.45

%

Gross Profit

 

17,294,218

 

12,240,931

 

5,053,287

 

26.47

%

24.02

%

2.45

%

Gross Profit %

 

26.47

%

24.02

%

2.45

%

 

 

 

 

 

 

Expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales & Marketing

 

8,383,807

 

7,145,730

 

1,238,077

 

12.83

%

14.02

%

-1.19

%

Technical Support

 

463,412

 

420,566

 

42,846

 

0.71

%

0.83

%

-0.12

%

Legal expenses related to litigation & arbitration proceedings

 

354,050

 

78,052

 

275,998

 

0.54

%

0.15

%

0.39

%

General & Administrative

 

3,472,586

 

3,251,763

 

220,823

 

5.32

%

6.38

%

-1.06

%

Total Selling, General and Administrative costs

 

12,673,855

 

10,896,111

 

1,777,744

 

19.40

%

21.38

%

-1.98

%

Research & Development

 

2,020,824

 

1,901,843

 

118,981

 

3.09

%

3.73

%

-0.64

%

Total expenses

 

14,694,679

 

12,797,954

 

1,896,725

 

22.49

%

25.11

%

-2.62

%

Net operating income (loss) before arbitration & litigation

 

2,599,539

 

(557,023

)

3,156,562

 

3.98

%

-1.09

%

5.07

%

Arbitration & litigation items:

 

 

 

 

 

 

 

 

 

 

 

 

 

Arbitration proceeding

 

206,250

 

 

206,250

 

0.32

%

0.00

%

0.32

%

Litigation proceeding

 

427,000

 

 

427,000

 

0.65

%

0.00

%

0.65

%

Net operating income (loss)

 

1,966,289

 

(557,023

)

2,523,312

 

3.01

%

-1.09

%

4.10

%

Other income:

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

6,054

 

15,858

 

(9,804

)

0.01

%

0.03

%

-0.02

%

Foreign currency

 

2,302

 

34,023

 

(31,721

)

0.00

%

0.06

%

-0.06

%

Total other income

 

8,356

 

49,881

 

(41,525

)

0.01

%

0.09

%

-0.08

%

Income before taxes on income

 

1,974,645

 

(507,142

)

2,481,787

 

3.02

%

-1.00

%

4.02

%

Taxes on income

 

149,497

 

306,890

 

(157,393

)

0.23

%

0.60

%

-0.37

%

Net income (loss)

 

$

1,825,148

 

$

(814,032

)

$

2,639,180

 

2.79

%

-1.60

%

4.39

%

 

Net sales for the twelve months ended September 30, 2004 increased $14,383,549 compared to the twelve months ended September 30, 2003 as shown on the table below. 

 

 

 

 

 

 

 

Increase
(decrease)

 

Increase

 

Percentage of sales by

 

 

 

Twelve Months

 

Twelve Months

 

Dollar

 

(decrease)

 

Geographic region

 

Location

 

ended 9/30/04

 

ended 9/30/03

 

Variance

 

Variance %

 

2004

 

2003

 

Domestic

 

$

22,219,561

 

$

16,163,782

 

$

6,055,779

 

37

%

34

%

32

%

Europe

 

42,249,996

 

34,082,082

 

8,167,914

 

24

%

65

%

67

%

Asia

 

870,026

 

710,170

 

159,856

 

23

%

1

%

1

%

Total

 

$

65,339,583

 

$

50,956,034

 

$

14,383,549

 

28

%

100

%

100

%

 

The primary factors contributing the sales increase were:

 

      Stronger demand for retail WinTV-PVR-150/250/350 products due to exposure generated from Media Center awareness of $6,444,137

      Increased PVR-USB sales due to introduction of lower cost model and Media Center awareness of $3,558,178

      Increased sales of OEM PVR-150/250 for Media Center products of $3,290,471

      Higher sales of USB products of $2,059,285

      Introduction in fiscal 2004 of MediaMVP product of $2,052,140

      Increased DVB sales in Europe of $1,445,420

      Increase in our average Euro to USD contract rate of about 18.1% (1.1907 versus 1.0081) for the twelve months ended September 30, 2004 over the same period of last year, which yielded higher converted Euro to USD sales

 

The increases were offset by:

 

41



 

      Decrease in low end analog WinTV sales of $2,177,697

      Decrease in Digital Entertainment Center (DEC) sales of $1,017,642

      Lower domestic digital and video editing sales of $139,116

      $90,000 reduction in sales for price protection due to anticipated price reductions on older products

      Increase in sales return reserve of $320,000 to reflect increased prior six month sales level and residual product returns on in-warranty products

 

Net sales to domestic customers were 34% of net sales for the twelve months ended September 30, 2004 compared to 32% for the twelve months ended September 30, 2003.  Net sales to European customers were 65% of net sales for the twelve months ending September 30, 2004 and 67% for the twelve months ended September 30 2003.  Net Sales to Asian customers were 1% for the periods ended September 30, 2004 and September 30, 2003.

 

Seasonal nature of sales

 

Percent of sales by quarter-fiscal 2002-2004

 

 

As the chart above indicates, there is a seasonal pattern to our quarterly sales.  Listed below are the primary causes of our seasonal sales:

 

      Our product is sold through retail outlets or to OEM’s who include our product as a component of their system. Spurred on by the holiday spending, our sales during our first fiscal quarter, which encompasses the holiday season, have historically been the highest of our fiscal year.

      Our fiscal second quarter is historically our second best sales quarter.  Post holiday sales, mid year school sales, disposal income generated from year end bonuses, gift certificates, holiday cash gifts and mid year school purchases fuel the sales of our second quarter.

      We sell over 60% of our sales into the European market.  During our fiscal third quarter we begin to experience a slowdown due to the summer holiday period in Europe. We also see decreased spending in the U.S during the summer months.  This has historically caused sales for our fiscal third quarter for be the lowest for the year.

      During the latter part of August and into September, which is the last half of our fiscal fourth quarter, sales activity begins to increase. The increase is fueled by computer spending for school needs, the replenishment of stock in the European market and the start of the product ramp up for the holiday season. This post summer sales activity has resulted in our fourth quarter being the third best sales quarter of our fiscal year.

 

Although our strategy has been to diversify our sales to minimize the seasonal nature of our business, we anticipate similar seasonal trends for the near term future.

 

42



 

Gross Profit

 

Gross profit increased $5,053,287 for the twelve months ended September 30, 2004 compared to the twelve months ended September 30, 2003.

 

The increases and (decreases) in the gross profit are detailed below:

 

 

 

Increase

 

 

 

(decrease)

 

Due to increased sales

 

$

4,654,110

 

Increase in gross margin on non OEM products

 

2,495,494

 

Effect on gross margin due to lower margin OEM sales

 

(740,717

)

Price protection

 

(90,000

)

Due to increases in labor related and other costs

 

(1,265,600

)

Total increase in gross profit

 

$

5,053,287

 

 

Gross profit percentage for the twelve months ended September 30, 2004 was 26.47% compared to 24.02% for the twelve months ended September 30, 2003, an increase of 2.45%.

 

The increases and (decreases) in the gross profit percent are detailed below:

 

 

 

Increase

 

 

 

(decrease)

 

Increase in gross margin on non OEM products

 

3.97

%

Effect on gross margin due to lower margin OEM sales

 

(1.18

)%

Price protection

 

(0.10

)%

Due to increases in labor related and other costs

 

(0.24

)%

Net increase in gross profit

 

2.45

%

 

The increase in the gross profit margin on non-OEM products of 3.97% was primarily due to:

 

      Cost reductions attained during fiscal 2003 and the first half of fiscal 2004

      Increase in our average Euro to USD contract rates, used to convert Euro sales to U.S. dollar sales of about 15.2.% for the three months ended September 30, 2004 (1.2144 versus 1.0543) and 18.1% (1.1907 versus 1.0081) for the twelve months ended September 30, 2004 over the same periods of last year. Since about 75% of our European inventory is purchased in U.S. dollars, while most of the European sales are invoiced in Euros or British Pound Sterling, we benefit from the higher converted Euro to U.S. dollar sales, which are sold against either stable or declining U.S. dollar unit inventory cost

 

The decrease in the gross profit percentage of 1.18% attributable to the mix of OEM sales for the twelve months ended September 30 2004 was due to the following :

 

      Increase in OEM sales. Sales of OEM boards for the twelve months ended September 30, 2004 were $8,118,511 or 12.43% of sales compared to $4,828,040 or 9.47% of sales for the twelve months ended September 30, 2003. The higher mix of lower margin OEM sales for fiscal 2004 compared to fiscal 2003 resulted in a decrease in gross profit percent of 1.18% compared to the prior year.

      The decrease in the gross profit percent of 0.24% attributable to labor related and other costs for the twelve months ended September 30, 2004 was due to the percentage increase in labor related and other costs for the twelve months ended September 30, 2004 over the twelve months ended September 30, 2003 of 32% exceeding the 28% increase in sales.

 

43



 

Volatility of Gross Profit percent:

 

Gross profit percent

 

 

The chart above details the quarterly fluctuations in gross profit percent. Over the last twelve quarters ending with the fourth quarter of fiscal 2004, the gross profit percent has ranged from a low of 22.52% to a high of 29.34%.

 

Factors affecting the volatility of our gross profit percent are:

 

      Mix of product. Gross profit percents vary within our retail family of products as well as for OEM products. Varying sales mix of these different products affect the monthly gross profit percentage.

      Fluctuating quarterly sales caused by seasonal trends.  Embedded as a component of cost of sales are certain fixed costs, mainly for production and warehouse labor and the overhead cost of our Ireland distribution facility. Due to this, when unit and dollar sales decline due to seasonal market trends, these fixed costs get spread over lower units, thus increasing product unit costs causing these fixed costs to grow as a percentage of sales.

      Competitive pressures. Our market is constantly changing with new competitors joining our established competitors. These competitive pressures from time to time result in declining prices, which can reduce gross profit.

      Supply of component parts. In times when component parts are in short supply, we have to manage price increases. Consequently, when component part’ supply is high, we may be able to secure price decreases.

      Sales volume.  As unit sales volume increases, we have more leverage in negotiating volume price decreases with our component suppliers and our contract manufacturers.

      Cost reductions. We evaluate the pricing we receive from our suppliers and our contract manufacturers and we are constantly looking to achieve component part and contract manufacturer cost reductions.

 

Managing product mix, moderating seasonal trends and achieving cost reductions are a Company priority and critical to our competitive position in the market.  Although our goal is to optimize gross profit and minimize gross profit fluctuations, we anticipate the continuance of gross profit percent fluctuations.

 

The chart below illustrates the components of Selling, General and Administrative costs, inclusive of legal expenses related to litigation and arbitration proceedings:

 

 

 

Twelve months ended September 30,

 

 

 

Dollar Costs

 

Percentage of Sales

 

 

 

 

 

 

 

Increase

 

 

 

 

 

Increase

 

 

 

2004

 

2003

 

(Decrease)

 

2004

 

2003

 

(decrease)

 

Sales and Marketing

 

$

8,383,807

 

$

7,145,730

 

$

1,238,077

 

12.83

%

14.02

%

-1.19

%

Technical Support