UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
 
(Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended June 30, 2005
 
OR
 
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ________ to ________
 
Commission file number 0-17219 
 
CLEARONE COMMUNICATIONS, INC.
(Exact name of registrant as specified in its charter)
 
Utah
 
87-0398877
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)

1825 Research Way
Salt Lake City, Utah 84119
(Address of principal executive offices, including zip code)

(801) 975-7200
(Registrant’s telephone number, including area code)
 
Securities registered under Section 12(b) of the Act: None

Securities registered under Section 12(g) of the Act: Common Stock, $0.001 par value
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨  No x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act.  Yes ¨  No x
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes ¨  No x
 
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 the Form 10-K or any amendment to this Form 10-K. ¨
 



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Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and larger accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
 
Larger Accelerated Filer ¨ Accelerated Filer ¨ Non-Accelerated Filer x
 
Indicate by check mark whether the issuer is a shell company (as defined in Rule 12b-2 of the Securities Act.
Yes ¨  No x
 
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. The aggregate market value of the 10,415,962 shares of voting common stock held by non-affiliates was approximately $24,894,000 at December 31, 2005, based on the $2.39 closing price for the Company’s common stock on the Pink Sheets on such date.
 

APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS
 
Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13, or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes ¨  No ¨
 
(APPLICABLE ONLY TO CORPORATE REGISTRANTS)
 
Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date. The number of shares of ClearOne common stock outstanding as of June 30, 2005 and February 28, 2006, were 11,264,233 and 12,184,727, respectively.
 
DOCUMENTS INCORPORATED BY REFERENCE

List hereunder the following documents if incorporated by reference and the part of the Form 10-K (e.g., Part I, Part II, etc.) into which the document is incorporated: (1) any annual report to security holders; (2) any proxy or information statement; and (3) any prospectus filed pursuant to Rule 424(b) or (c) under the Securities Act of 1933. The listed documents should be clearly described for identification purposes (e.g., annual report to security holders for fiscal year ended December 24, 1980).

None.

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DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS
 
This report contains forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements reflect our views with respect to future events based upon information available to us at this time. These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially from these statements. Forward-looking statements are typically identified by the use of the words “believe,” “may,” “could,” “will,” “should,” “expect,” “anticipate,” “estimate,” “project,” “propose,” “plan,” “intend,” and similar words and expressions. Examples of forward-looking statements are statements that describe the proposed development, manufacturing, and sale of our products; statements that describe our results of operations, pricing trends, the markets for our products, our anticipated capital expenditures, our cost reduction and operational restructuring initiatives, and regulatory developments; statements with regard to the nature and extent of competition we may face in the future; statements with respect to the sources of and need for future financing; and statements with respect to future strategic plans, goals, and objectives. Forward-looking statements are contained in this report under “Description of Business” included in Item 1 of Part I, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Qualitative and Quantitative Disclosures About Market Risk” included in Items 7 and 7A of Part II of this Annual Report on Form 10-K. The forward-looking statements are based on present circumstances and on our predictions respecting events that have not occurred, that may not occur, or that may occur with different consequences and timing than those now assumed or anticipated. Actual events or results may differ materially from those discussed in the forward-looking statements as a result of various factors, including the risk factors discussed in this report under the caption “Description of Business: Risk Factors.” These cautionary statements are intended to be applicable to all related forward-looking statements wherever they appear in this report. The cautionary statements contained or referred to in this report should also be considered in connection with any subsequent written or oral forward-looking statements that may be issued by us or persons acting on our behalf. Any forward-looking statements are made only as of the date of this report and ClearOne assumes no obligation to update forward-looking statements to reflect subsequent events or circumstances.
 
CAUTIONARY STATEMENT REGARDING THE FILING DATE OF THIS REPORT AND THE ANTICIPATED FUTURE FILINGS OF ADDITIONAL PAST-DUE REPORTS
 
This Annual Report on Form 10-K for the fiscal year ended June 30, 2005 is first being filed in March 2006. The Company is in the process of preparing its Quarterly Reports on Form 10-Q for the quarters ended September 30, 2005 and December 31, 2005 and plans to file such reports at the earliest practicable date. Shareholders and others are cautioned that the financial statements included in this report are over eight months old and are not necessarily indicative of the operating results that may be expected for the fiscal year ending June 30, 2006. Shareholders and others should also be aware that the staff of the Salt Lake District Office of the Securities and Exchange Commission (“SEC”) intended to recommend to the Commission that administrative proceedings be instituted to revoke the registration of the Company’s common stock based on the Company’s failure to timely file annual and quarterly reports with the Commission. The Company provided the staff with a so-called “Wells Submission” setting forth its position with respect to the staff’s intended recommendation. To date, the Commission has not instituted an administrative proceeding against the Company; however, there can be no assurance that the Commission will not institute an administrative proceeding in the future or that the Company would prevail if an administrative proceeding were instituted.
 
PART I
 
References in this Annual Report on Form 10-K to “ClearOne,” “we,” “us,” or “the Company” refer to ClearOne Communications, Inc., a Utah corporation, and, unless the context otherwise requires or is otherwise expressly stated, its subsidiaries.
 

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ITEM 1. DESCRIPTION OF BUSINESS
 
Overview
 
We are an audio conferencing products company. We develop, manufacture, market, and service a comprehensive line of audio conferencing products, which range from tabletop conferencing phones to professionally installed audio systems. We also manufacture and sell document and education cameras and conferencing furniture. We have a strong history of product innovation and plan to continue to apply our expertise in audio engineering to developing innovative new products. We believe the performance and reliability of our high-quality audio products create a natural communication environment, which saves organizations of all sizes time and money by enabling more effective and efficient communication between geographically separated businesses, employees, and customers.
 
Our products are used by organizations of all sizes to accomplish effective group communication. Our end-users range from some of the world’s largest and most prestigious companies and institutions to small and medium-sized businesses, educational institutions, and government organizations. We sell our products to these end-users primarily through a distribution network of independent distributors who in turn sell our products to dealers, systems integrators, and value-added resellers. The Company also sells products on a limited basis directly to dealers, systems integrators, value-added resellers, and end-users.
 
Our Internet website address is www.clearone.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to such reports are available, free of charge, on our Internet website under “ClearOne Info—Investor Relations—SEC,” as soon as reasonably practicable after we file electronically such material with, or furnish it to, the SEC.
 
For a discussion of certain risks applicable to our business, results of operations, financial position, and liquidity see the risk factors described in “Risk Factors” below.
 
Significant Events
 
The SEC Action. A comprehensive review of our previously issued consolidated financial statements was undertaken during fiscal 2003 after it was determined that the statements were not prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”). As a result of this review, we restated our previously reported consolidated financial statements for the fiscal years ended June 30, 2002 and 2001 as well as our previously reported consolidated financial statements for the first quarter of fiscal 2003 (“Previously Reported Statements”).
 
ClearOne’s Previously Reported Statements were the subject of a civil action filed by the SEC on January 15, 2003 against ClearOne and the persons then acting as its chief executive and chief financial officers. The complaint generally alleged that the defendants had engaged in a program of inflating ClearOne’s revenues, net income, and accounts receivable by engaging in improper revenue recognition. On December 4, 2003, we settled the SEC action by entering into a consent decree in which, without admitting or denying the allegations of the complaint, we consented to the entry of a permanent injunction prohibiting future securities law violations. No fine or penalty was assessed against ClearOne as part of the settlement.
 
Securities Delisted from NASDAQ Stock Market and Pink Sheets, LLC. Our common stock was delisted from the NASDAQ National Market System on April 21, 2003 and has been quoted on the National Quotation Bureau’s Pink Sheets on an unsolicited basis since that time. On February 10, 2006, the Pink Sheets blocked publication of quotations for our common stock on its public website due to our failure to file current public information.
 
We intend to relist our common stock on NASDAQ Capital Market at the earliest practicable date, once we meet all listing criteria. Certain key listing criteria include the following:
 
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·  
a shareholders’ equity of $5.0 million, a market value of listed securities of $50.0 million, or a net income from continuing operations (in the latest fiscal year or in two of the last three fiscal years) of $750,000;
·  
a market value of publicly held shares of $5.0 million;
·  
a minimum bid price of $4.00 for 90-days prior to applying for listing;
·  
three market makers;
·  
distribution of an annual report;
·  
a shareholders meeting; and
·  
other corporate governance requirements.

The Shareholder Class Action. On June 30, 2003, a consolidated complaint was filed against ClearOne, eight of our present or former officers and directors, and our former auditor, Ernst & Young, by a class consisting of purchasers of the Company’s common stock during the period from April 17, 2001 through January 15, 2003. The allegations in the complaint were essentially the same as those contained in the SEC Action described above. On December 4, 2003, we, on behalf of the Company and all other defendants with the exception of Ernst & Young, entered into a settlement agreement with the class pursuant to which we agreed to pay the class $5.0 million and issue the class 1.2 million shares of our common stock. The cash payment was made in two equal installments, the first on November 10, 2003 and the second on January 14, 2005. On May 23, 2005, the court order was amended to provide that odd-lot numbers of shares (99 or fewer shares) would not be issued from the settlement fund and claimants who would otherwise be entitled to receive 99 or fewer shares would be paid cash in lieu of such odd-lot numbers of shares. On September 29, 2005, we completed our obligations under the settlement agreement by issuing a total of 1,148,494 shares of our common stock to the plaintiff class, including 228,000 shares previously issued in November 2004, and paying an aggregate of $126,705 in cash in lieu of shares to those members of the class who would otherwise have been entitled to receive an odd-lot number of shares or who resided in states in which there was no exemption available for the issuance of shares. The cash payments were calculated on the basis of $2.46 per share which was equal to the higher of (i) the closing price for our common stock as reported by the Pink Sheets on the business day prior to the date the shares were mailed or (ii) the average closing price over the five trading days prior to such mailing date.
 
Changes to Management and Board of Directors. Since January 2003, we have changed all members of our executive management team. Three of our former directors are no longer serving in such positions and we have appointed two new directors, both of whom are independent directors that serve on our Audit Committee. In January 2003, Frances Flood, our former Chairman and Chief Executive Officer, and Susie Strohm, our former Chief Financial Officer, were placed on administrative leave and they subsequently resigned from their positions. Michael Keough was then appointed as our Chief Executive Officer, Gregory Rand was appointed as our President and Chief Operating Officer, and George Claffey was appointed as our Chief Financial Officer. All three subsequently resigned for personal reasons at various times during calendar 2004 and on July 8, 2004, Zeynep “Zee” Hakimoglu was appointed as our President and Chief Executive Officer and Donald Frederick was appointed as our Chief Financial Officer. On November 15, 2004 Joseph Sorrentino was appointed as our Vice-President of Worldwide Sales and Marketing. On January 4, 2005, Werner Pekarek was appointed as our Vice-President of Operations. Mr. Frederick resigned on September 15, 2005 and on September 20, 2005, Craig Peeples, our Corporate Controller, was appointed as our Interim Chief Financial Officer. Additionally, on February 7, 2006, DeLonie Call, Vice-President - Human Resources, resigned in connection with the elimination of her position due to a restructuring of the executive team to match the change in size and structure of our organization.
 
Potential SEC Administrative Action. ClearOne has been advised by the staff of the Salt Lake District Office of the SEC that the staff intended to recommend to the Commission that administrative proceedings be instituted to revoke the registration of the Company’s common stock based on the Company’s failure to timely file annual and quarterly reports with the Commission. The Company provided the staff with a so-called “Wells Submission” setting forth its position with respect to the staff’s intended recommendation. To date, the Commission has not instituted an administrative proceeding against the Company; however, there can be no assurance that the Commission will not institute an administrative proceeding in the future or that the Company would prevail if an administrative proceeding were instituted.
 

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Changes in Type and Scope of Operations
 
Acquisitions of E.mergent, Inc. and OM Video. During fiscal 2002 and fiscal 2003, we entered the audiovisual integration services business through the acquisitions of E.mergent, Inc. and Stechyson Electronics, Ltd., doing business as OM Video (“OM Video”). Our management at that time believed such acquisitions would complement our existing operations and our core competencies and allow us to acquire market share in the audiovisual integration services industry. However, our entry into the services business was perceived as a threat by our systems integrators and value-added resellers, since we began competing against many of them for sales. The acquisitions were not successful and the remaining operations were sold in fiscal 2004 and fiscal 2005. As discussed in more detail in Item 1. Description of Business. Acquisitions and Dispositions, we recorded impairment charges related to such acquisitions in the aggregate amount of approximately $26.0 million in the fiscal 2003 consolidated financial statements.
 
Sale of our U.S. Audiovisual Integration Services. On May 6, 2004, we sold certain assets of our U.S. audiovisual integration services operations (a portion of E.mergent, Inc.) to M:Space, Inc. (“M:Space”) for no cash compensation. M:Space is a privately held audiovisual integration services company. In exchange for M:Space assuming obligations for completion of certain customer contracts and satisfying maintenance contract obligations to existing customers, we transferred to M:Space certain assets including inventory valued at $573,000. The operations of the U.S. audiovisual integration services have been classified as discontinued operations in the consolidated financial statements.
 
Sale of Conferencing Services Business. On July 1, 2004, we sold our conferencing services business segment to Clarinet, Inc., an affiliate of American Teleconferencing Services, Ltd. doing business as Premiere Conferencing (“Premiere”) for $21.3 million. Of the purchase price, $1.0 million was placed into an 18-month Indemnity Escrow account and an additional $300,000 was placed into a working capital escrow account. We received the $300,000 working capital escrow funds approximately 90 days after the execution date of the contract. We received the $1.0 million in the Indemnity Escrow account in January 2006. The conferencing services operations have been classified as discontinued operations in the June 30, 2005 consolidated financial statements.
 
Sale of OM Video. On March 4, 2005, we sold all of the issued and outstanding stock of our Canadian subsidiary, ClearOne Communications of Canada, Inc. (“ClearOne Canada”) to 6351352 Canada Inc., a Canada corporation (the “OM Purchaser”). ClearOne Canada owned all the issued and outstanding stock of Stechyson Electronics Ltd., which conducts business under the name OM Video. We agreed to sell the stock of ClearOne Canada for $200,000 in cash; a $1.3 million note receivable which is due over a 15-month period, with interest accruing on the unpaid balance at the rate of 5.3 percent per year; and contingent consideration ranging from 3 percent to 4 percent of related gross revenues over a five-year period. We have presented all OM Video activities in discontinued operations in the June 30, 2005 consolidated financial statements. In June 2005, we were advised that the OM Purchaser had settled an action brought by the former employer of certain of OM Purchaser’s owners and employees alleging violation of non-competition agreements. The settlement reportedly involved a cash payment and an agreement not to sell certain products for a period of one year. Through December 2005, OM Purchaser had made all payments required under the note; however, OM Purchaser failed to make any subsequent, required payments under the note receivable. We are currently considering our collection options.
 
Following the disposition of operations in the video conferencing technology and products (which occurred prior to fiscal 2005), audiovisual integration services, and conferencing services businesses, we returned to our core competency of developing, manufacturing, and marketing audio conferencing products, which is where we intend to keep our focus for the foreseeable future.
 
Business Strategy
 
Our goal is to maintain our market leadership in the professional or installed segment of the audio conferencing systems market, while building market leadership in the tabletop conferencing space. In addition, we have created a new conferencing category with the RAV platform and continue to develop additional new products as we build what we believe to be the most complete audio conferencing product line on the market. The principal components of our strategy to achieve this goal are:
 

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Provide a superior conferencing experience
 
We have been developing audio technologies since 1981 and believe we have established a reputation for providing some of the highest quality group audio conferencing solutions in the industry. Our proprietary audio signal processing technologies have been the core of our professional conferencing products and are the foundation for our new product development in other conferencing categories. We plan to build upon our reputation of being a market leader and continue to provide the highest quality products and technologies to the customers and markets we serve.
 
Offer greater value to our customers
 
To provide our customers with audio conferencing products that can offer high value, we are focused on listening to our customers and delivering products to meet their needs. By offering high quality products that are designed to solve conferencing ease-of-use issues and are easy to install, configure, and maintain, we believe we can provide greater value to our customers and enhance business communications and decision-making. Specific feedback from our customer and channel partners led to the development of the Converge 560 and 590 professional conferencing systems, which began shipping in November 2005.
 
Leverage and extend ClearOne technology leadership and innovation
 
We have sharpened our focus on developing cutting edge audio conferencing products and are committed to incorporating the latest technologies into our new and existing product lines. Key to this effort is adopting emerging technologies such as Voice over Internet Protocol (“VoIP”), wireless connectivity, the convergence of voice and data networks, exploring new usage models for our premium audio conferencing technology, and international standards based conferencing products. As an example, in February 2006 we began shipping our first VoIP tabletop conference phones called MAXAttach IP™ and MAX IP™, which are based on the SIP signaling protocol.
 
Expand and strengthen strong sales channels
 
We have made significant efforts to expand and strengthen strong domestic and international sales channels through the addition of key distributors and dealers that expand beyond our traditional audio-video (“AV”) channels that carry our professional conferencing line. We plan to continue to add new distribution partners, with specific emphasis on bolstering distribution to the Information Technology (“IT”), telephony channels, and PC reseller channels, where we see opportunity for our MAX® tabletop audio conferencing products, including our new VoIP MAX phones; our RAV™ audio conferencing systems; our conferencing peripherals, including the AccuMic® product line; our new tabletop controller; and other products currently in development.
 
Broaden our product offerings
 
We offer a full suite of audio conferencing products, ranging from high-end, professionally installed audio conferencing systems used in executive boardrooms, courtrooms, and auditoriums, to premium conferencing systems, to tabletop conferencing phones used in conference rooms and offices, and to personal conferencing devices. We plan to continue to broaden our product offerings to meet the evolving needs of our customers, address changes in the markets we currently serve, and effectively target new markets for our products.
 
Develop strategic partnerships
 
To stay on the leading edge of product development, we plan to continue to identify partners with technology and expertise in areas strategic to our growth objectives. We will also work to develop partnerships with leaders in markets complimentary to conferencing who can benefit from our audio products and technologies and through whom we can access new market growth opportunities.
 
Strengthen existing customer relationships through dedicated support
 
We have developed outstanding technical and sales support teams that are dedicated to providing customers with the best available service and support. We believe our technical support is recognized as among the best in the industry and we will continue to invest in the necessary resources to ensure that our customers have access to the information and support they need to be successful in using our products.
 

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Markets and Products
 
We currently conduct most of our operations in the audio conferencing products industry. We also previously operated in the conferencing services segment until July 1, 2004 (fiscal 2005), when we sold our conferencing services business to Clarinet, Inc., an affiliated of American Teleconferencing Services, Ltd., doing business as Premiere Conferencing (“Premiere”) and in the business services segment until March 4, 2005 (fiscal 2005), when we sold the remaining operations in that area to 6351352 Canada Inc. For additional financial information about our segments, see Note 24 to Consolidated Financial Statements, which are included in this report.
 
Products Segment
 
The performance and reliability of our high-quality conferencing products enable effective and efficient communication between geographically separated businesses, employees, and customers. We offer a full range of audio conferencing products, from high-end, professionally installed audio conferencing systems used in executive boardrooms, courtrooms, classrooms, and auditoriums, to tabletop conference phones used in conference rooms and offices, and to personal conferencing devices. Many of our products feature our proprietary Distributed Echo Cancellation® and noise cancellation technologies to enhance communication during a conference call by eliminating echo and background noise. They may also feature proprietary audio processing technologies such as adaptive modeling and first-microphone priority, which combine to deliver clear, crisp, full-duplex audio. This enables natural communication between distant conferencing participants similar to that of being in the same room.
 
We believe the principal drivers of demand for audio conferencing products are: the increasing availability of easy-to-use audio conferencing equipment; the improving voice quality of audio conferencing systems compared to telephone handset speakerphones; and the trend of global, regional, and local corporate expansion. Other factors that we expect to have a significant impact on the demand for audio conferencing systems are the availability of a wider range of affordable audio conferencing products for small businesses and home offices; the growth of distance learning and corporate training programs and the number of teleworkers; the decrease in the amount of travel within most enterprises for routine meetings; and the transition to the Internet Protocol (“IP”) network from the traditional public switched telephone network (“PSTN”). We expect these growth factors to be offset by direct competition from high-end telephone handset speakerphones and new competitors in the audio conferencing space, the technological volatility of IP-based products, and continued pressures on enterprises to reduce spending.
 
Professional Audio Conferencing Products
 
We have been developing high-end, professionally installed audio conferencing products since 1991 and believe we have established strong brand recognition for these products worldwide. Our professional audio conferencing products include the XAP® and PSR1212 product lines. The XAP® line includes our most powerful, feature-rich products, with the latest advances in technology and functionality. It has more processing power than our legacy Audio Perfect® products and contains noise cancellation technology in addition to our Distributed Echo Cancellation® technology found in the Audio Perfect® product line. The PSR1212 is a digital matrix mixer that provides advanced audio processing, microphone mixing, and routing for local sound reinforcement.
 
The XAP® and PSR1212 products are comprehensive audio processing systems designed to excel in the most demanding acoustical environments and routing configurations. These products are also used for integrating high-quality audio with video and web conferencing systems.
 
On March 30, 2005, we formalized our decision to discontinue our Audio Perfect® product line. The last orders for our Audio Perfect® products were received on June 30, 2005 and the last build of Audio Perfect® products was during the first quarter of fiscal 2006. We will continue to inventory parts for warranty and warranty repair service and will continue to service these products for a five-year period based on a two-year warranty and three-year repair period based on parts availability.
 
In November 2005, we introduced the Converge™ 560 and Converge™ 590 professional conferencing systems. Our customers had asked for a professional audio solution that was less expensive and would fit the budgetary requirements for a mid-range conference room. The products are positioned between XAP and RAV, both in terms of functionality and price, and are a perfect fit for rooms requiring customized microphone and speaker configurations (up to 9 microphones can be connected) along with connectivity to video and web conferencing systems. The Converge products also offer speech lift to amplify a presenter’s voice in the local room.
 

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In February 2006, ClearOne announced the new Tabletop Controller for the XAP platform. This affordable solution gives XAP users the ability to easily start and navigate an audio conference without the need for touch panel control systems, which can be expensive, complex, or intimidating to users. The dial pad on the device resembles a telephone keypad for instant familiarity, and users can dial a conference call as easily as dialing a telephone, with little or no training required. The Tabletop Controller can cost thousands less than touch-screen panel control systems and its simplified setup for the user-definable keys can save customers programming time and expense as well. Along with its sleek, functional design, this latest offering from ClearOne delivers what we believe to be the most cost-effective, attractive and easy-to-use control solution for XAP systems on the market.
 
Premium Conferencing Systems
 
In June 2004, we announced our RAV™ audio conferencing system and we started shipping the product in November 2004. RAV™ is a complete, out-of-the-box system that includes an audio mixer, Bose® loudspeakers, microphones, and a wireless control device. In February 2005, we introduced a wired control device as a part of our RAV™ audio conferencing system offering. The RAV™ product uniquely combines the sound quality of a professionally installed audio system with the simplicity of a conference phone and can be easily connected to industry common rich-media devices, such as video or web conferencing systems, to deliver enhanced audio performance.
 
RAV™ offers many powerful audio processing technologies from our professional audio conferencing products without the need for professional installation and programming. It features Distributed Echo Cancellation®, noise cancellation, microphone gating, and a drag-and-drop graphical user interface for easy system setup, control, and management.
 
Tabletop Conferencing Phones
 
In December 2003, we began shipping our MAX® line of tabletop conferencing phones. These phones incorporate the high-end echo cancellation, noise cancellation, and audio processing technologies found in our professional audio conferencing products.
 
The MAX® product line is comprised of the MAX® Wireless, MAXAttach™ Wireless, MAXAttach™, MAX® EX, MAXAttach IP™, and MAX IP™ tabletop conferencing phones. MAX Wireless was one of the industry’s first wireless conferencing phone on the market. Designed for use in executive offices or small conference rooms with multiple participants, MAX Wireless can be moved from room to room within 150 feet of its base station. MAXAttach Wireless began shipping in May 2005 and is believed to be the industry’s first dual-phone, completely wireless solution. This system gives customers tremendous flexibility in covering larger conference room areas.
 
The MAXAttach and MAX EX wired phones feature a unique capability - instead of just adding extension microphones for use in larger rooms, MAXAttach daisy-chains up to four complete phones together. This provides even distribution of microphones, loudspeakers, and controls for better sound quality and improved user access in medium to large conference rooms. In addition, all MAXAttach wired versions can be separated and used as single phones in smaller conference rooms.
 
Our latest additions to the MAX family are the MAXAttach IP and MAX IP, ClearOne’s first VoIP conference phones, which are based on the industry-standard SIP signaling protocol. These phones feature the same ability to daisy-chain up to four phones together, providing outstanding room coverage that we believe other VoIP conference phones on the market cannot match.
 

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Other Products
 
We complement our audio conferencing products with microphones, document and education cameras, and conferencing-specific furniture. Our microphones are designed to improve the audio quality in audio, video, and web conferencing applications. They feature echo cancellation and audio processing technologies and can be used with personal computers, video conferencing systems, or installed audio conferencing systems. Our cameras can be used in professional conferencing or educational settings. They make possible the presentation of materials and images such as full-color documents, 3-D objects and images from a variety of sources, including computers, microscopes, and multimedia devices. Our wide selection of wood, metal, and laminate conferencing furniture features audiovisual carts; plasma screen carts and pedestals; and video conferencing carts, tables, cabinets, and podiums.
 
Marketing and Sales
 
We use a two-tier distribution model, in which we primarily sell our products directly to a worldwide network of independent audiovisual, information technology, and telecommunications distributors, who then sell our products to independent systems integrators, dealers, and value-added resellers, who in turn work directly with the end-users of our products on product fulfillment and installation. We also sell our products on a limited basis directly to certain dealers, systems integrators, and value-added resellers. In addition, we regularly participate in conferencing forums, trade shows, and industry promotions.
 
In fiscal 2005, approximately $23.4 million, or 74.1 percent, of our total product sales were generated in the United States and product sales of approximately $8.2 million, or 25.9 percent, were generated outside the United States. Revenue from product customers outside of the United States accounted for approximately 25.9 percent of our total sales from continuing operations for fiscal 2005, 22.7 percent for fiscal 2004, and 32.3 percent for fiscal 2003. We sell our products in more than 70 countries worldwide. We anticipate that the portion of our total revenue from international sales will continue to increase as we further enhance our focus on developing new products, establishing new channel partners, strengthening our presence in key growth areas, and improving product localization with country-specific product documentation and marketing materials.
 
Distributors
 
We sell our products directly to approximately 70 distributors throughout the world. Distributors buy our products at a discount from list price and resell them on a non-exclusive basis to independent systems integrators, dealers, and value-added resellers. Our distributors maintain their own inventory and accounts receivable and are required to provide technical and non-technical support for our products to the next level of distribution participants. We work with our distributors to establish appropriate inventory stocking levels. We also work with our distributors to maintain relationships with our existing systems integrators, dealers, and value-added resellers and to establish new distribution participant relationships.
 
Independent Integrators and Resellers
 
Our distributors sell our products worldwide to approximately 1,000 independent systems integrators, telephony value-added resellers, IT value-added resellers and PC resellers on a non-exclusive basis. While dealers, resellers, and systems integrators all sell our products directly to the end-users, systems integrators typically add significant value to each sale by combining our products with products from other manufacturers as part of an integrated system solution. Dealers and value-added resellers usually buy our products in large volumes and may bundle our products with products from other manufacturers for resale to the end-user. We maintain close working ties in the field with our reseller partners and offer them education and training on all of our products.
 
Trade Shows and Industry Forums
 
We regularly attend industry forums and exhibit our products at trade shows, including Infocomm, National Systems Contractors Association (“NSCA”), National Science Teachers Association (“NSTA”), and Audio Visual Innovations University (“AVI University”), that focus on areas relevant to our business to ensure our products remain highly visible to distributors and dealers and to keep abreast of market trends.
 

10


Customers
 
We do not believe that any end-user accounted for more than 10 percent of our total revenue during fiscal 2005, 2004, or 2003. In fiscal 2005, revenues in our product segment included sales to three distributors that represented approximately 63.2 percent of the segment’s revenues. (For additional financial information about our segments or geographic areas, see Note 24 to Consolidated Financial Statements, which is included in this report.) As discussed above, these distributors facilitate product sales to a large number of resellers, and subsequently to their end-users, none of which is known to account for more than 10 percent of our revenues from product sales. Nevertheless, the loss of one or more distributors could reduce revenues and have a material adverse effect on our business and results of operations. As of June 30, 2005, our shipped orders on which we had not recognized revenues were $5.1 million and our backlog of unshipped orders was $175,000.
 
Competition
 
The conferencing products market is characterized by intense competition and rapidly evolving technology. We compete with businesses having substantially greater financial, research and development, manufacturing, marketing, and other resources. If we are not able to continually design, manufacture, and successfully introduce new or enhanced products or services that are comparable or superior to those provided by our competitors and at comparable or better prices, we could experience pricing pressures and reduced sales, profit margins, profits, and market share, each of which could have a materially adverse effect on our business.
 
We have no single competitor for all of our product offerings, but we compete with various companies within each product category. We believe we compete successfully as a result of the high quality of our products and technical support services as well as the strength of our brand.
 
With respect to our products, we believe the principal factors driving sales are product design, quality, and functionality of products; establishment of brand name recognition; pricing; access to and penetration of distribution channels; quality of customer support; and a significant customer base.
 
In the professional audio conferencing systems market, our main competitors include Biamp Systems and Polycom, along with several other companies. According to industry sources, during the 2003, 2004, and 2005 calendar year, we had the largest share of the installed segment of the conferencing systems market, which we target with our professional audio conferencing products. ClearOne significantly contributed to the professional conferencing space with the introduction of the Audio Perfect™ (“AP”) product line several years ago and we believe we continue to enjoy a strong reputation with the AV integrators and AV consultants for our product features, audio quality, and technical support.
 
We believe we created a new audio conferencing category with the introduction of the RAV™ platform, which we have called premium conferencing. RAV is a unique product with capabilities we do not believe can be found on any other competing system.
 
In the tabletop conferencing space, our primary competitors are Polycom, Konftel, Panasonic and a number of other smaller manufacturers. During the 2005 calendar year, we significantly increased our position in the tabletop market. We believe our MAX products are more competitively priced than Polycom’s comparable products, and we believe our unique ability to attach multiple phones together for increased coverage has given us opportunities to solve customer problems that our competition cannot currently solve.
 
Our microphones compete with the products of Audio Technica, Global Media, Shure, and others. In the markets for our document cameras, competitors include Elmo, Ken-a-Vision, Samsung, Sony, Wolfvision, and other manufacturers. Our conferencing furniture products compete primarily with the products of Accuwood, Comlink, and Video Furniture International.
 
In each of the markets in which we compete, most of our competitors may have access to greater financial, technical, manufacturing, and marketing resources, and as a result they could respond more quickly or effectively to new technologies and changes in customer preferences. No assurances can be given that we can continue to compete effectively in the markets we serve.
 

11


Regulation
 
The European Parliament has published a directive on the Restriction on Use of Hazardous Substances Directive (the “RoHS Directive”), which restricts the use of certain hazardous substances in electrical and electronic equipment beginning July 1, 2006. In order to comply with this directive, it has become necessary to re-design the majority of our product line and switch over to components that do not contain the restricted substances, such as lead, mercury, and cadmium. This process involves procurement of the new compliant components, engineering effort to integrate and test them, and re-submitting the products for emissions, safety and telephone line interface compliance testing and approval. This effort has consumed resources and time that would otherwise have been spent on new product development, which will continue until the product line has been updated. In addition, because this has essentially become a worldwide issue for all electronics manufacturers who wish to sell into the European market, we have seen increased lead times for compliant components because of the increased demand. This is an issue that is not unique to ClearOne.
 
The European Parliament has also published a directive on Electronic and Electrical Waste Management (the “WEEE Directive”), which makes producers of certain electrical and electronic equipment financially responsible for collection, reuse, recycling, treatment, and disposal of equipment placed on the European Union market after August 13, 2005. We are currently compliant in terms of the labeling requirements, and have finalized the recycling processes with the appropriate entities within Europe. According to the directive, distributors of our product are deemed producers and must comply with this directive by contracting with a recycler for the recovery, recycling, and reuse of product.
 
Seasonality
 
Our audio conferencing products revenue has historically been strongest during the second and fourth quarters. Our camera product line revenue is usually strongest during the third and fourth quarters. There can be no assurance that any historic sales patterns will continue and, as a result, sales for any prior quarter are not necessarily indicative of the sales to be expected in any future quarter.
 
Product Development
 
We are committed to research and development and view our continued investment in research and development as a key ingredient to our long-term business success. Our research and development expenditures were approximately $5.3 million in fiscal 2005, $4.2 million in fiscal 2004, and $3.3 million in fiscal 2003.
 
Our core competencies in research and development include many audio technologies, including telephone echo cancellation, acoustic echo cancellation, and noise cancellation. Our ability to use digital signal processing technology to perform audio processing operations is also a core competency. Our research and development efforts are supported by an internal computer-aided design team that creates electrical schematics, printed circuit board designs, mechanical designs, industrial designs, and manufacturing documentation. We believe the technology developed through this interactive process is critical to the performance of our products. We also believe that ongoing development of our core technological competencies is vital to maintaining and increasing future sales of our products and to enhancing new and existing products.
 
Manufacturing
 
Prior to June 20, 2005, we manufactured and assembled most of our products in our manufacturing facility located at our corporate headquarters in Salt Lake City, Utah. We subcontract the manufacture of our MAX product line to a third-party contract manufacturer located in China. We manufacture our furniture product line in our manufacturing facility located in Champlin, Minnesota.
 

12


On June 20, 2005, we began transitioning the manufacturing of most of our products to a third-party manufacturer. On August 1, 2005, we entered into a Manufacturing Agreement pursuant to which we agreed to outsource our Salt Lake City manufacturing operations to this third-party manufacturer (“TPM”). The agreement is for an initial term of three years, which shall automatically be extended for successive and additional terms of one year each unless terminated by either party upon 120 days advance notice at any time after the second anniversary of the agreement. The agreement generally provides, among other things, that TPM shall: (i) furnish the necessary personnel, material, equipment, services, and facilities to be the exclusive manufacturer of substantially all the products that were previously manufactured at our Salt Lake City, Utah manufacturing facility and the non-exclusive manufacturer of a limited number of products, provided that the total cost to ClearOne (including price, quality, logistic cost, and terms and conditions of purchase) is competitive; (ii) provide repair service, warranty support, and proto-type services for new product introduction on terms to be agreed upon by the parties; (iii) purchase certain items of our manufacturing equipment; (iv) lease certain other items of our manufacturing equipment and have a one-year option to purchase such leased items; (v) have the right to lease our former manufacturing employees from a third-party employee leasing company; and (vi) purchase the parts and materials on hand and in transit at our cost for such items with the purchase price payable on a monthly basis when and if such parts and materials are used by TPM. The parties also entered into a one-year sublease for approximately 12,000 square feet of manufacturing space located in our headquarters in Salt Lake City, Utah, which sublease may be terminated by either party upon 90 days notice, which TPM has elected to terminate effective May 31, 2006. The agreement provides that products shall be manufactured pursuant to purchase orders submitted by us at purchase prices to be agreed upon by the parties, subject to adjustment based upon such factors as volume, long range forecasts, change orders, etc. We also granted TPM a right of first refusal to manufacture new products developed by us at a cost to ClearOne (including price, quality, logistic cost, and terms and conditions of purchase) that is competitive.
 
We believe the long-term benefits from our manufacturing outsourcing strategy include:
 
·  
Avoidance of a significant investment in upgrading our manufacturing infrastructure;
 
·  
Achievement of a rapid International Standards Organization certification of our products by partnering with an outsource manufacturer that was International Standards Organization certified;
 
·  
Scale-ability in our manufacturing process without major investment or major restructuring costs; and
 
·  
Achievement of future cost reductions on manufacturing costs and inventory costs based upon increased economies of scale in material and labor.
 
For risks associated with our manufacturing strategy please see “Risk Factors” in Item 1.
 
Intellectual Property and Other Proprietary Rights
 
We believe that our success depends in part on our ability to protect our proprietary rights. We rely on a combination of patent, copyright, trademark, and trade secret laws and confidentiality procedures to protect our proprietary rights. The laws of foreign countries may not protect our intellectual property to the same degree as the laws of the United States.
 
We generally require our employees, customers, and potential distribution participants to enter into confidentiality and non-disclosure agreements before we disclose any confidential aspect of our technology, services, or business. In addition, our employees are routinely required to assign to us any proprietary information, inventions, or other technology created during the term of their employment with us. These precautions may not be sufficient to protect us from misappropriation or infringement of our intellectual property.
 
We currently have several patents issued or pending that cover our conferencing products and technologies. The expiration dates of issued patents range from 2009 to 2010. We hold registered trademarks for ClearOne, XAP, MAX, AccuMic, Audio Perfect, Distributed Echo Cancellation, Gentner, and others. We have also filed for trademarks for RAV and others.
 

13


Employees
 
 
Employees of as
 
Feb. 28, 2006
June 30, 2005
June 30, 2004
June 30, 2003
Sales, marketing, and
       
customer support
44
45
51
49
Product development
47
43
41
20
Operations support
19
20
40
40
Administration
15
18
29
30
U.S. business services
0
0
0
29
Conferencing services
0
0
76
61
OM Video
0
0
27
34
Total
125
126
264
263

 
As of February 28, 2006, we had 125 employees, 121 of whom were employed on a full-time basis, with 44 in sales, marketing, and customer support; 47 in product development; 19 in operations support; and 15 in administration, including finance. Of these employees, 97 were located in our Salt Lake City office, 21 in other U.S. locations, five in the United Kingdom and two in Asia. None of our employees are subject to a collective bargaining agreement and we believe our relationship with our employees is good.
 
As of June 30, 2005, following the sale of our conferencing services business, OM Video, and the outsourcing of our Salt Lake City manufacturing operations, we had 126 employees, 124 of whom were employed on a full-time basis, with 45 in sales, marketing, and customer support; 43 in product development; 20 in operations support, and 18 in administration, including finance. Of these employees, 94 were located in our Salt Lake City office, 25 in other U.S. locations, five in the United Kingdom and two in Asia.
 
Acquisitions and Dispositions
 
During the fiscal year ended June 30, 2001, we completed the sale of the assets of the remote control portion of our RFM/Broadcast division to Burk Technology, Inc. During the fiscal year ended June 30, 2002, we completed the acquisition of E.mergent, Inc., an audiovisual integration services provider and manufacturer of cameras and conferencing furniture. During the fiscal year ended June 30, 2003, we sold our broadcast telephone interface products, including the digital hybrid and TS-612 product lines, to Comrex Corporation and completed the acquisition of Stechyson Electronics Ltd., doing business as OM Video, an audiovisual integration services company. During fiscal 2004, we sold our U.S. audiovisual integration services business to M:Space, Inc. During fiscal 2005, we sold our conferencing services segment to Premiere and we sold our Canadian audiovisual integration services business to 6351352 Canada Inc. The total consideration for each acquisition was based on negotiations between ClearOne and the acquired company or its shareholders that took into account a number of factors of the business, including historical revenues, operating history, products, intellectual property, and other factors. Each acquisition was accounted for under the purchase method of accounting. Each acquisition is summarized below and is discussed in more detail in the footnotes to the June 30, 2005 consolidated financial statements included in this report.
 
Sale of Assets to Burk Technology. On April 12, 2001, we sold the assets of the remote control portion of our RFM/Broadcast division to Burk Technology, Inc. (“Burk”), a privately held developer and manufacturer of broadcast facility control systems products, for $750,000 in cash at closing, $1.8 million in the form of a seven-year promissory note, with interest at the rate of 9.0 percent per year, and up to $700,000 as a commission over a period of up to seven years. We realized a pre-tax gain on the sale of $187,000 for fiscal 2005, $93,000 for fiscal 2004, and $318,000 for fiscal 2003. As of June 30, 2005, $1.5 million of the promissory note remained outstanding and we had received $20,000 in commissions.
 
On August 22, 2005, we entered into a Mutual Release and Waiver Agreement with Burk pursuant to which Burk paid us $1.3 million in full satisfaction of the promissory note, which included a discount of $119,000. As part of the Mutual Release and Waiver Agreement, we waived any right to future commission payments from Burk and we granted mutual releases to one another with respect to claims and liabilities. Accordingly, the total pre-tax gain on the sale was approximately $2.4 million.
 

14


E.mergent Acquisition. On May 31, 2002, we completed our acquisition of E.mergent pursuant to the terms of an Agreement and Plan of Merger dated January 21, 2002 whereby we paid $7.3 million of cash and issued 868,691 shares of common stock valued at $16.55 per share to former E.mergent stockholders.
 
In addition to the shares of our common stock issued, we assumed all options to purchase E.mergent common stock that were vested and outstanding on the acquisition date. These options were converted into rights to acquire a total of 4,158 shares of our common stock at a weighted average exercise price of $8.48 per share. A value of approximately $49,000 was assigned to these options using the Black-Scholes option pricing model with the following assumptions: expected dividend yield of 0 percent, risk-free interest rate of 2.9 percent, expected volatility of 81.8 percent, and an expected life of two years.
 
As of the acquisition date, we acquired tangible assets consisting of cash of $68,000, accounts receivable of $2.2 million, inventory of $3.3 million, property and equipment of $475,000 and other assets of $1.3 million. We assumed liabilities consisting of accounts payable of $1.3 million, line of credit borrowings of $484,000, unearned maintenance revenue of $873,000, accrued compensation (other than severance) and other accrued liabilities of $656,000. We incurred severance costs of approximately $468,000 related to the termination of four E.mergent executives and seven other E.mergent employees as a result of duplication of positions upon consummation of the acquisition. In June 2002, $52,000 was paid to such individuals. The severance accrual of $416,000 as of June 30, 2002 was paid during the fiscal year ended June 30, 2003.
 
With the assistance of a third-party valuation firm and after considering the facts and circumstances surrounding the acquisition, we recorded intangible assets related to customer relationships, patents, a non-compete agreement, and goodwill. Amortization expense of $437,000 was recorded for customer relationships, patents, and a non-compete agreement during fiscal 2003. Customer relationships had estimated useful lives of 18 months to three years and patents had estimated useful lives of fifteen years. The term of the non-compete agreement was three years. In accordance with SFAS No. 142, no amortization expense was recorded for goodwill.
 
Our management, at the time, believed the E.mergent acquisition would complement our existing operations and that core competencies would allow us to acquire market share in the audiovisual integration industry. However, our entry into the services business was perceived as a threat by our systems integrators and value-added resellers, since we began competing against many of them for sales. In order to avoid this conflict and to maintain good relationships with our systems integrators and value-added resellers, we decided to stop pursuing new services contracts in the fourth quarter of the fiscal year ended June 30, 2003 which was considered a triggering event for evaluation of impairment. Ultimately, we exited the U.S. audiovisual integration market and subsequently sold our U.S. audiovisual integration business to M:Space in May 2004. (See Sale of our U.S. Audiovisual Integration Services below.) Although we continue to sell camera and furniture products acquired from E.mergent, our decision to exit the U.S. integration services market adversely affected future cash flows. We determined that a triggering event occurred in the fourth quarter of the fiscal year ended June 30, 2003. We performed an impairment test and determined that an impairment loss on the integration services-related E.mergent assets of approximately $12.5 million should be recognized. We also determined that an impairment loss on other acquired E.mergent assets of approximately $5.1 million should be recognized. The U.S. audiovisual integration business operations and related net assets are included in discontinued operations in the accompanying June 30, 2005 consolidated financial statements.
 
Sale of Broadcast Telephone Interface Business to Comrex. On August 23, 2002, we entered into an agreement with Comrex Corporation (“Comrex”), pursuant to which Comrex agreed to pay ClearOne $1.3 million in exchange for certain inventory associated with our broadcast telephone interface product line and the provision of a perpetual software license to use our technology related to broadcast telephone interface products along with one free year of maintenance and support, and transition services for 90 days following the effective date of the agreement. The transition services included training, engineering assistance, consultation, and development services. We recognized approximately $0, $130,000, and $1.1 million in business services revenue related to this transaction for the fiscal years ended June 30, 2005, 2004, and 2003.
 
We also entered into a manufacturing agreement to continue to manufacture additional product for Comrex until August 2003 on a when-and-if needed basis. Comrex agreed to pay the Company for any additional product on a per item basis of cost plus 30 percent. During the fiscal years ended June 30, 2005, 2004, and 2003, we have recognized $0, $387,000 and $783,000, respectively, in product revenue related to the manufacture of additional product from Comrex.
 

15


OM Video Acquisition. On August 27, 2002, we purchased all of the outstanding shares of Stechyson Electronics Ltd., doing business as OM Video, headquartered in Ottawa, Canada. Under the terms of the agreement, the shareholders of OM Video received $6.3 million in cash at closing. During the fiscal years ended June 30, 2003 and 2004, we paid an additional $500,000 of a potential $600,000 that was held back pending the continued accuracy of certain representations and warranties associated with the acquisition. During the second quarter of fiscal 2003, we also paid $750,000 of a potential $800,000 earn-out provision. The earn-out provision was not considered as part of the original purchase price allocation and was recorded as additional consideration and booked to goodwill. No further payment related to the holdback or contingent consideration will be paid. Accordingly, the total cash payments associated with the acquisition were approximately $7.5 million.
 
As of the acquisition date, we acquired tangible assets consisting of cash of $193,000, accounts receivable of $470,000, inventory of $122,000, property and equipment of $145,000, and prepaid expenses of $6,000. We assumed liabilities consisting primarily of accrued liabilities of $378,000 and accrued tax liabilities of $221,000. We obtained a non-compete agreement with a term of two years from a former owner of OM Video.
 
Our management, at the time, believed the OM Video acquisition would complement the Company’s existing operations and that core competencies would allow the Company to acquire market share in the audiovisual integration industry. However, our entry into the services business was perceived as a threat by our systems integrators and value-added resellers, since we began competing against many of them for sales. In order to avoid this conflict and to maintain good relationships with our systems integrators and value-added resellers, we deemphasized the audiovisual integration market serving the Ottawa Canada region beginning in the fourth quarter of the fiscal year ended June 30, 2003. This decision was considered a triggering event for evaluation of impairment. On June 30, 2003, we performed an impairment test and determined that an impairment loss on the OM Video assets of approximately $8.4 million should be recognized. On March 4, 2005, we sold all of our Canadian audiovisual integration business to 6351352 Canada, Inc. (See Sale of OM Video - Canadian Audiovisual Integration Services below.)
 
Sale of our U.S. Audiovisual Integration Services. On May 6, 2004, we sold certain assets of our U.S. audiovisual integration services operations to M:Space, Inc. (“M:Space”) for no cash compensation. M:Space is a privately held audiovisual integration services company. In exchange for M:Space assuming obligations for completion of certain customer contracts, and satisfying maintenance contract obligations to existing customers, we transferred to M:Space certain assets including inventory valued at $573,000. We recognized a pre-tax loss on the sale of $276,000 during the fiscal year ended June 30, 2004. We continue to sell camera and furniture products acquired through the E.mergent acquisition.
 
Sale of our Conferencing Services. In April 2004, our Board of Directors appointed a committee to explore opportunities to sell the conferencing services business component. We decided to sell this component primarily because of decreasing margins and investments in equipment that we believed would have been required in the near future. On July 1, 2004, we sold our conferencing services business segment to Premiere. Consideration for the sale consisted of $21.3 million in cash. Of the purchase price $300,000 was placed into a working capital escrow account and an addition $1.0 million was placed into an 18-month Indemnity Escrow account. We received the $300,000 working capital escrow funds approximately 90 days after the execution date of the contract. We received the $1.0 million in the Indemnity Escrow account in January 2006. Additionally, $1.4 million of the proceeds was utilized to pay off equipment leases pertaining to assets being conveyed to Premiere. We realized a pre-tax gain on the sale of $17.4 million during the fiscal year ended June 30, 2005.
 
Sale of OM Video - Canadian Audiovisual Integration Services. On March 4, 2005, we sold all of the issued and outstanding stock of our Canadian subsidiary, ClearOne Canada to 6351352 Canada Inc., a Canada corporation. ClearOne Canada owned all the issued and outstanding stock of Stechyson Electronics, Ltd., which conducts business under the name OM Video. We agreed to sell the stock of ClearOne Canada for $200,000 in cash; a $1.3 million note payable over a 15-month period, with interest accruing on the unpaid balance at the rate of 5.3 percent per year; and contingent consideration ranging from 3.0 percent to 4.0 percent of related gross revenues over a five-year period. In June 2005, we were advised that the OM Purchaser had settled an action brought by the former employer of certain of OM Purchaser’s owners and employees alleging violation of non-competition agreements. The settlement reportedly involved a cash payment and an agreement not to sell certain products for a period of one year. Based on an analysis of the facts and circumstances that existed on March 4, 2005, and considering the guidance from Topic 5U of the SEC Rules and Regulations, “Gain Recognition on the Sale of a Business or Operating Assets to a Highly Leveraged Entity,” the gain is being recognized as cash is collected. The Company realized a pre-tax gain on the sale of $295 for the fiscal year ended June 30, 2005. As of December 31, 2005, all payments had been received and $854,000 of the promissory note remained outstanding; however, OM Purchaser failed to make any subsequent, required payments on the note receivable. We are currently considering our collection options.
 

16


ITEM 1A. RISK FACTORS
 
Investors should carefully consider the risks described below. The risks described below are not the only ones we face, and there are risks that we are not presently aware of or that we currently believe are immaterial that may also impair our business operations. Any of these risks could harm our business. The trading price of our common stock could decline significantly due to any of these risks, and investors may lose all or part of their investment. In assessing these risks, investors should also refer to the other information contained or incorporated by reference in this Annual Report on Form 10-K, including our June 30, 2005 consolidated financial statements and related notes.
 
Risks Relating to Our Business
 
We face intense competition in all of the markets for our products and services; our operating results will be adversely affected if we cannot compete effectively against other companies.
 
As described in more detail in the section entitled “Competition,” the markets for our products and services are characterized by intense competition and pricing pressures and rapid technological change. We compete with businesses having substantially greater financial, research and development, manufacturing, marketing, and other resources. If we are not able to continually design, manufacture, and successfully introduce new or enhanced products or services that are comparable or superior to those provided by our competitors and at comparable or better prices, we could experience pricing pressures and reduced sales, profit margins, profits, and market share, each of which could have a materially adverse effect on our business.
 
Difficulties in estimating customer demand in our products segment could harm our profit margins.
 
Orders from our distributors and other distribution participants are based on demand from end-users. Prospective end-user demand is difficult to measure. This means that our revenues in any fiscal quarter could be adversely impacted by low end-user demand, which could in turn negatively affect orders we receive from distributors and dealers. Our expectations for both short- and long-term future net revenues are based on our own estimates of future demand.
 
Revenues for any particular time period are difficult to predict with any degree of certainty. We usually ship products within a short time after we receive an order; so consequently, unshipped backlog has not been a good indicator of future revenues. We believe that the current level of backlog will fluctuate dependent in part on our ability to forecast revenue mix and to plan our manufacturing accordingly. A significant portion of our customers’ orders are received in the last month of the quarter. We budget the amount of our expenses based on our revenue estimates. If our estimates of sales are not accurate and we experience unforeseen variability in our revenues and operating results, we may be unable to adjust our expense levels accordingly and our profit margins will be adversely affected.
 
Our profitability may be adversely affected by our continuing dependence on our distribution channels.
 
We market our products primarily through a network of distributors who in turn sell our products to systems integrators, dealers, and value-added resellers. All of our agreements with such distributors and other distribution participants are non-exclusive, terminable at will by either party and generally short-term. No assurances can be given that any or all such distributors or other distribution participants will continue their relationship with us. Distributors and to a lesser extent systems integrators, dealers, and value-added resellers cannot easily be replaced and the loss of revenues and our inability to reduce expenses to compensate for the loss of revenues could adversely affect our net revenues and profit margins.
 
Although we rely on our distribution channels to sell our products, our distributors and other distribution participants are not obligated to devote any specified amount of time, resources, or efforts to the marketing of our products or to sell a specified number of our products. There are no prohibitions on distributors or other resellers offering products that are competitive with our products and most do offer competitive products. The support of our products by distributors and other distribution participants may depend on the competitive strength of our products and the price incentives we offer for their support. If our distributors and other distribution participants are not committed to our products, our revenues and profit margins may be adversely affected.
 

17


We depend on an outsourced manufacturing strategy.
 
In August 2005, we entered into a manufacturing agreement with a domestic manufacturing services provider, to be the exclusive manufacturer of substantially all the products that were previously manufactured at our Salt Lake City, Utah manufacturing facility. This manufacturer is currently the primary manufacturer of substantially all of our products, except our MAX® product line and our furniture product line, and if this manufacturer experiences difficulties in obtaining sufficient supplies of components, component prices become unreasonable, an interruption in its operations, or otherwise suffers capacity constraints, we would experience a delay in shipping these products which would have a negative impact on our revenues. Currently, we have no second source of manufacturing for substantially all of our products.
 
We have an agreement with an international manufacturer for the manufacture of our MAX® product line. We use a facility in China. Should there be any disruption in services due to natural disaster, economic or political difficulties in China, quarantines or other restrictions associated with infectious diseases, or other similar events, or any other reason, such disruption would have a material adverse effect on our business. A delay in shipping these products due to an interruption in the manufacturer’s operations would have a negative impact on our revenues. Operating in the international environment exposes us to certain inherent risks, including unexpected changes in regulatory requirements and tariffs, and potentially adverse tax consequences, which could materially affect our results of operations.
 
Product obsolescence could harm demand for our products and could adversely affect our revenues and our results of operations.
 
Our industry is subject to rapid and frequent technological innovations that could render existing technologies in our products obsolete and thereby decrease market demand for such products. If any of our products become slow-moving or obsolete and the recorded value of our inventory is greater than its market value, we will be required to write-down the value of our inventory to its fair market value, which would adversely affect our results of operations. In limited circumstances, we are required to purchase components that our outsourced manufacturers use to produce and assemble our products. Should technological innovations render these components obsolete, we will be required to write-down the value of this inventory, which could adversely affect our results of operations.
 
Product development delays or defects could harm our competitive position and reduce our revenues.
 
We have, in the past, and may again experience, technical difficulties and delays with the development and introduction of new products. Many of the products we develop contain sophisticated and complicated components and utilize manufacturing techniques involving new technologies. Potential difficulties in the development process that could be experienced by us include difficulty in:
 
·  
meeting required specifications and regulatory standards;
 
·  
meeting market expectations for performance;
 
·  
hiring and keeping a sufficient number of skilled developers;
 
·  
having the ability to identify problems or product defects in the development cycle; and
 
·  
achieving necessary manufacturing efficiencies.
 
Once new products reach the market, they may have defects, which could adversely affect market acceptance of these products and our reputation. If we are not able to manage and minimize such potential difficulties, our business could be negatively affected.
 

18


If we are unable to protect our intellectual property rights or have insufficient proprietary rights, our business would be materially impaired.
 
We currently rely primarily on a combination of trade secrets, copyrights, trademarks, patents, and nondisclosure agreements to establish and protect our proprietary rights in our products. No assurances can be given that others will not independently develop similar technologies, or duplicate or design around aspects of our technology. In addition, we cannot assure that any patent or registered trademark owned by us will not be invalidated, circumvented or challenged or that the rights granted thereunder will provide competitive advantages to us. Litigation may be necessary to enforce our intellectual property rights. We believe our products and other proprietary rights do not infringe upon any proprietary rights of third parties; however, we cannot assure that third parties will not assert infringement claims in the future. Our industry is characterized by vigorous protection of intellectual property rights. Such claims and litigation are expensive and could divert management’s attention, regardless of their merit. In the event of a claim, we might be required to license third-party technology or redesign our products, which may not be possible or economically feasible.
 
We currently hold only a limited number of patents. To the extent that we have patentable technology for which we have not filed patent applications, others may be able to use such technology or even gain priority over us by patenting such technology themselves.
 
International sales account for a significant portion of our net revenue and risks inherent in international sales could harm our business.
 
International sales represent a significant portion of our total product sales. For example, international sales represented 25.9 percent of our total product sales for fiscal 2005, 22.7 percent for fiscal 2004, and 32.3 percent for fiscal 2003. We anticipate that the portion of our total product revenue from international sales will continue to increase as we further enhance our focus on developing new products, establishing new distribution partners, strengthening our presence in key growth areas, and improving product localization with country-specific product documentation and marketing materials. Our international business is subject to the financial and operating risks of conducting business internationally, including:
 
·  
unexpected changes in, or the imposition of, additional legislative or regulatory requirements;
 
·  
fluctuating exchange rates;
 
·  
tariffs and other barriers;
 
·  
difficulties in staffing and managing foreign sales operations;
 
·  
import and export restrictions;
 
·  
greater difficulties in accounts receivable collection and longer payment cycles;
 
·  
potentially adverse tax consequences;
 
·  
potential hostilities and changes in diplomatic and trade relationships;
 
·  
disruption in services due to natural disaster, economic or political difficulties, quarantines, or other restrictions associated with infectious diseases.
 
Our sales in the international market are denominated in U.S. Dollars, with the exception of sales through our wholly owned subsidiary, OM Video, whose sales were denominated in Canadian Dollars until March 4, 2005, when the subsidiary was sold to a third party. Consolidation of OM Video’s financial statements with ours, under U.S. GAAP, required remeasurement of the amounts stated in OM Video’s financial statements to U.S. Dollars, which was subject to exchange rate fluctuations. We did not undertake hedging activities that might have protected us against such risks.
 

19


We may not be able to hire and retain highly skilled employees, which could affect our ability to compete effectively and may cause our revenue and profitability to decline.
 
We depend on highly skilled technical personnel to research and develop, market, and service new and existing products. To succeed, we must hire and retain employees who are highly skilled in the rapidly changing communications and Internet technologies. Individuals who have the skills and can perform the services we need to provide our products and services are in great demand. Because the competition for qualified employees in our industry is intense, hiring and retaining employees with the skills we need is both time-consuming and expensive. We might not be able to hire enough skilled employees or retain the employees we do hire. Our inability to hire and retain employees with the skills we seek could hinder our ability to sell our existing products, systems, or services or to develop new products, systems, or services with a consequent adverse effect on our business.
 
Our reliance on third-party technology or license agreements.
 
We have licensing agreements with various suppliers for software and hardware incorporated into our products. These third-party licenses may not continue to be available to us on commercially reasonable terms, if at all. The termination or impairment of these licenses could result in delays of current product shipments or delays or reductions in new product introductions until equivalent designs could be developed, licensed, and integrated, if at all possible, which would have a material adverse effect on our business.
 
Our sales depend to a certain extent on government funding and regulation.
 
In the audio conferencing products market, the revenues generated from sales of our audio conferencing products for distance learning and courtroom facilities are dependent on government funding. In the event government funding for such initiatives was reduced or became unavailable, our sales could be negatively impacted. Additionally, many of our products are subject to governmental regulations. New regulations could significantly impact sales in an adverse manner.
 
Environmental laws and regulations subject us to a number of risks and could result in significant costs and impact on revenue
 
The European Parliament has published a directive on the Restriction on Use of Hazardous Substances Directive (the “RoHS Directive”), which restricts the use of certain hazardous substances in electrical and electronic equipment beginning July 1, 2006. In order to comply with this directive, it has become necessary to re-design the majority of our product line and switch over to components that do not contain the restricted substances, such as lead, mercury, and cadmium. This process involves procurement of the new compliant components, engineering effort to integrate and test them, and re-submitting the products for emissions, safety and telephone line interface compliance testing and approval. This effort has consumed resources and time that would otherwise have been spent on new product development, which will continue until the product line has been updated. In addition, because this has essentially become a worldwide issue for all electronics manufacturers who wish to sell into the European market, we have seen increased lead times for compliant components because of the increased demand. This is an issue that is not unique to ClearOne.
 
The European Parliament has also published a directive on Electronic and Electrical Waste Management (the “WEEE Directive”), which makes producers of certain electrical and electronic equipment financially responsible for collection, reuse, recycling, treatment, and disposal of equipment placed on the European Union market after August 13, 2005. We are currently compliant in terms of the labeling requirements, and have finalized the recycling processes with the appropriate entities within Europe. According to the directive, distributors of our product are deemed producers and must comply with this directive by contracting with a recycler for the recovery, recycling, and reuse of product.
 
We may have difficulty in collecting outstanding receivables.
 
We grant credit without requiring collateral to substantially all of our customers. In times of economic uncertainty, the risks relating to the granting of such credit would typically increase. Although we monitor and mitigate the risks associated with our credit policies, we cannot ensure that such mitigation will be effective. We have experienced losses due to customers failing to meet their obligations. Future losses could be significant and, if incurred, could harm our business and have a material adverse effect on our operating results and financial condition.
 

20


Interruptions to our business could adversely affect our operations.
 
As with any company, our operations are at risk of being interrupted by earthquake, fire, flood, and other natural and human-caused disasters, including terrorist attacks and disease. Our operations are also at risk of power loss, telecommunications failure, and other infrastructure and technology based problems. To help guard against such risks, we carry business interruption loss insurance with coverage of up to $5.4 million to help compensate us for losses that may occur.
 
Risks Relating to Our Company
 
Our stock price fluctuates as a result of the conduct of our business and stock market fluctuations.
 
The market price of our common stock has experienced significant fluctuations and may continue to fluctuate significantly. The market price of our common stock may be significantly affected by a variety of factors, including:
 
·  
statements or changes in opinions, ratings, or earnings estimates made by brokerage firms or industry analysts relating to the market in which we do business or relating to us specifically;
 
·  
disparity between our reported results and the projections of analysts;
 
·  
the shift in sales mix of products that we currently sell to a sales mix of lower-margin product offerings;
 
·  
the level and mix of inventory levels held by our distributors;
 
·  
the announcement of new products or product enhancements by us or our competitors;
 
·  
technological innovations by us or our competitors;
 
·  
quarterly variations in our results of operations;
 
·  
general market conditions or market conditions specific to technology industries;
 
·  
domestic and international economic conditions;
 
·  
the adoption of the new accounting standard, SFAS 123R, “Share-Based Payments” which will require us to record compensation expense for certain options issued under our “1998 Stock Option Plan” before July 1, 2005 and for all options issued or modified after June 30, 2005;
 
·  
our ability to report financial information in a timely manner; and
 
·  
the markets in which our stock is traded.
 
Many of our officers and key personnel have recently joined the company or have only worked together for a short period of time.
 
We have recently made several significant changes to our senior management team. In July 2004, we named a new President and Chief Executive Officer, who had been serving as our Vice-President of Product Development since December 2003. In addition, we hired a new Chief Financial Officer in July 2004, a Vice-President of Worldwide Sales and Marketing in November 2004, and a Vice-President of Operations in January 2005. In January 2005, we named a new Vice-President of Product Line Management, who had been serving as our Director of Research and Development. In September 2005, our Chief Financial Officer resigned his position and our Corporate Controller was named our Interim Chief Financial Officer. In February 2006, we eliminated the position of Vice-President of Human Resources. As a result of these recent changes in senior management, many of our officers and other key personnel have only worked together for a short period of time. The failure to successfully integrate senior management could have an adverse impact on our business operations, including reduced sales, confusion with our channel partners, and delays in new product introductions.
 

21


Our directors and officers own 18.2 percent of the Company and may exert significant influence over us.
 
Our officers and directors together have beneficial ownership of approximately 18.2 percent of our common stock (including options that are currently exercisable or exercisable within 60 days of February 28, 2006). With this significant holding in the aggregate, the officers and directors, acting together, could exert a significant degree of influence over us and may be able to delay or prevent a change in control.
 
ITEM 1B. UNRESOLVED STAFF COMMENTS
 
Not applicable.
 
ITEM 2. PROPERTIES 
 
We currently occupy three leased buildings or offices, all of which are used in connection with the products segment of our business. The following table presents our utilization of these spaces:
 
Location
Operations
Square Footage
Status
Expiration of Lease Agreement
Active Leases at June 30, 2005
     
Salt Lake City, UT
Company headquarters
39,760
Continuing
October 2006
Salt Lake City, UT
Manufacturing facility
12,000
Partially subleased
October 2006
Champlin, MN
Furniture manufacturing
17,520
Continuing
September 2007
Berkshire,
       
United Kingdom
Sales office
250
Continuing
90 days notice
         
Terminated Leases, i.e., per contract terms, sale of entity, or through early termination
 
Dublin, Ireland
Research and development office
4,639
Early buyout
November 2002
Des Moines, IA
Sales office
1,146
Lease terminated
December 2002
Woburn, MA
ClearOne, Inc. acquisition
2,206
Early buyout
September 2003
Golden Valley, MN
U.S. audiovisual installation services
25,523
Early buyout
June 2004
Westmont, IL
U.S. audiovisual installation services
2,608
Lease expired
July 2004
Nuremberg, Germany
Sales office
2,153
Early buyout
December 2004
Ottawa, Canada
Canadian audiovisual installation services
16,190
Sold entity
March 2005

Our principal administrative, sales, marketing, customer support, and research and development facility is located in our headquarters in Salt Lake City, Utah. Most of our warehousing operations are also located in our Salt Lake City headquarters. We currently occupy a 51,760 square-foot facility under the terms of an operating lease expiring in October 2006. Of the 51,760 square feet, we sublet 12,000 square feet to our domestic manufacturer, as discussed below. We believe the facility will be reasonably adequate to meet our needs through October 2006; however, we are currently evaluating our needs for fiscal 2007 and beyond. Prior to the sale of our conferencing services business, this component conducted its business from our Salt Lake City headquarters and from July 1, 2004 through February 28, 2005, we sublet 5,416 square feet of space in our headquarters building to Premiere, the purchaser of our conferencing services business.
 
On August 1, 2005, we entered into a one-year sublease with respect to the 12,000 square foot manufacturing facility in our headquarters building in connection with the outsourcing of our manufacturing operations. This manufacturer pays rent in the amount of $11,040 per month and either party may terminate the lease for any reason upon 90 days written notice or 60 days written notice to the other party of material breach of the agreement. Such space had been provided to this manufacturer on a rent-free basis from June 20 to July 31, 2005, pending execution of definitive agreements. On March 2, 2006, this manufacturer provided the Company with written notice of its intent to terminate the lease on May 31, 2006.
 

22


Our conference furniture manufacturing and warehousing operations are conducted from a facility totaling 17,520 square feet located in Champlin, Minnesota. We lease this facility under a lease agreement that expires in September 2007. We believe the facility will be reasonably adequate to meet our needs for the next 12 months.
 
Our wholly owned United Kingdom subsidiary, ClearOne Communications Limited UK, rents an office in Oxfordshire, England, consisting of 250 square feet. The office space is rented under a managed office arrangement which requires 90 days notice to terminate the agreement.
 
Our wholly owned subsidiary, Gentner Communications Ltd. - Ireland, leased an office in Dublin, Ireland for research and development related to video conferencing. The facility consisted of 431 square meters, of which we sublet 129 square meters to a third party effective July 2002. We negotiated an early buyout of the lease effective November 2002.
 
Our U.S. audiovisual integration services operations rented sales offices located in Des Moines, Iowa on a month-to-month basis but such leases were terminated in December 2002.
 
We leased an office in Woburn, Massachusetts that we initially acquired through the purchase of ClearOne, Inc. in July 2000. The facility consisted of 2,206 square feet. We negotiated an early buyout of the lease effective September 2003.
 
Our U.S. audiovisual integration services operations were mainly conducted from a facility totaling 25,523 square feet located in Golden Valley, Minnesota. We leased these facilities under a lease agreement that expired in December 2004. We negotiated an early buyout of the lease effective June 2004.
 
Our U.S. audiovisual integration services operations leased a sales office in Westmont, Illinois pursuant to a lease that expired in July 2004. The facility consisted of 2,608 square feet.
 
Our wholly owned subsidiary, ClearOne Communications EuMEA, GmbH, leased an office in Nuremberg, Germany, consisting of 200 square meters. This office was closed in December 2004 and the lease was terminated.
 
Our wholly owned subsidiary, ClearOne Communications of Canada, Inc. doing business as OM Video, leased a facility in Ottawa, Canada consisting of 16,190 square feet, in which our Canadian audiovisual integration services operations were conducted. We leased this facility under a lease agreement that expired in July 2005. As discussed herein, we sold this subsidiary in March 2005.
 
ITEM 3. LEGAL PROCEEDINGS
 
In addition to the legal proceedings described below, we are also involved from time to time in various claims and other legal proceedings which arise in the normal course of our business. Such matters are subject to many uncertainties and outcomes that are not predictable. However, based on the information available to us as of February 28, 2006 and after discussions with legal counsel, we do not believe any such other proceedings will have a material, adverse effect on our business, results of operations, financial position, or liquidity, except as described below.
 
The SEC Action. On January 15, 2003, the SEC filed a civil complaint against ClearOne; Frances Flood, then ClearOne’s Chairman, Chief Executive Officer, and President; and Susie Strohm, then ClearOne’s Chief Financial Officer, in the U.S. District Court for the District of Utah, Central Division. The complaint alleged that from the quarter ended March 31, 2001, the defendants engaged in a program of inflating ClearOne’s revenues, net income, and accounts receivable by engaging in improper revenue recognition in violation of U.S. GAAP and Section 17(a) of the Securities Act of 1933 and Sections 10(b), 13(a), and 13(b) of the Securities Exchange Act of 1934 and various regulations promulgated thereunder. Following the filing of the complaint, we placed Ms. Flood and Ms. Strohm on administrative leave and they subsequently resigned from their positions with the Company. On December 4, 2003, we settled the SEC Action by entering into a consent decree in which, without admitting or denying the allegations of the complaint, we consented to the entry of a permanent injunction prohibiting future securities law violations. No fine or penalty was assessed against the Company as part of the settlement.
 

23


On February 20, 2004, Ms. Flood and Ms. Strohm settled the SEC action by entering into consent decrees wherein, without admitting or denying the allegations of the complaint, they each consented to the entry of a permanent injunction prohibiting future violations of the antifraud, reporting, and issuer books and records requirements of the federal securities laws. The order against Ms. Flood also provided for disgorgement in the amount of $71,000 along with prejudgment interest of $2,882, a civil penalty in the amount of $71,000, and prohibited Flood from acting as an officer or director of any issuer that has a class of securities registered pursuant to Section 12 of the Exchange Act or that is required to file reports pursuant to Section 15(d) of the Exchange Act. The order against Ms. Strohm also provided for disgorgement in the amount of $25,000 together with prejudgment interest in the amount of $1,015 and a civil penalty in the amount of $25,000. The final settlement of the SEC action as to Ms. Flood and Ms. Strohm satisfied the condition precedent contained in the employment separation agreements entered into by the Company with each of such persons on December 5, 2003 (See Item 11. Executive Compensation: Employment Contracts and Termination of Employment and Change-in-Control Arrangements).
 
U.S. Attorney’s Investigation. As previously announced on January 28, 2003, the Company has been advised that the U.S. Attorney’s Office for the District of Utah has begun an investigation stemming from the complaint in the SEC action described above. No pleadings have been filed to date and the Company intends on cooperating fully with the U.S. Attorney’s Office should any developments occur in the future.
 
The Whistleblower Action. On February 11, 2003, our former Vice-President of Sales filed a whistleblower claim with the Occupational Safety and Health Administration (“OSHA”) under the employee protection provisions of the Sarbanes-Oxley Act alleging that the Company had wrongfully terminated his employment for reporting the Company’s alleged improper revenue recognition practices to the SEC in December 2002, which precipitated the SEC action against the Company. In February 2004, OSHA issued a preliminary order in favor of the former officer, ordering that he be reinstated with back pay, lost benefits, and attorney’s fees. The former officer had also filed a separate lawsuit against the Company in the United States District Court for the District of Utah, Central Division, alleging various employment discrimination claims. In May 2004, the Administrative Law Judge approved a settlement agreement with the former officer pursuant to which he released the Company from all claims asserted by him in the OSHA proceeding and the federal court action in exchange for a cash payment by the Company. The settlement did not have a material impact on the Company's results of operations or financial position. 
 
The Shareholders’ Class Action. On June 30, 2003, a Consolidated Complaint was filed in the U.S. District Court for the District of Utah, Central Division, against the Company, eight present or former officers and directors of the Company, and Ernst & Young LLP (“Ernst & Young”), the Company’s former independent public accountants, by a class consisting of purchasers of the Company’s common stock during the period from April 17, 2001 through January 15, 2003. The action followed the consolidation of several previously filed class action complaints and the appointment of lead counsel for the class. The allegations in the complaint were essentially the same as those contained in the SEC complaint described above. On December 4, 2003, the Company, on behalf of itself and all other defendants with the exception of Ernst & Young, entered into a settlement agreement with the class pursuant to which we agreed to pay the class $5.0 million and issue the class 1.2 million shares of our common stock. The cash payment was made in two equal installments, the first on November 10, 2003 and the second on January 14, 2005. On May 23, 2005, the court order was amended to require the Company to pay cash in lieu of stock to those members of the class who would otherwise have been entitled to receive fewer than 100 shares of stock. On September 29, 2005, we completed our obligations under the settlement agreement by issuing a total of 1,148,494 shares of our common stock to the plaintiff class, including 228,000 shares previously issued in November 2004, and we paid an aggregate of $126,705 in cash in lieu of shares to those members of the class who would otherwise have been entitled to receive an odd-lot number of shares or who resided in states in which there was no exemption available for the issuance of shares. The cash payments were calculated on the basis of $2.46 per share which was equal to the higher of (i) the closing price for our common stock as reported by the Pink Sheets on the business day prior to the date the shares were mailed or (ii) the average closing price over the five trading days prior to such mailing date.
 

24


The Shareholder Derivative Actions. Between March and August 2003, four shareholder derivative actions were filed in the Third Judicial District Court of Salt Lake County, State of Utah, by certain shareholders of the Company against various present and past officers and directors of the Company and against Ernst & Young. The complaints asserted allegations similar to those asserted in the SEC complaint and shareholders’ class action described above and also alleged that the defendant directors and officers violated their fiduciary duties to the Company by causing or allowing the Company to recognize revenue in violation of U.S. GAAP and to issue materially misstated financial statements and that Ernst & Young breached its professional responsibilities to the Company and acted in violation of U.S. GAAP and generally accepted auditing standards by failing to identify or prevent the alleged revenue recognition violations and by issuing unqualified audit opinions with respect to the Company’s fiscal 2002 and 2001 financial statements. One of these actions was dismissed without prejudice on June 13, 2003. As to the other three actions, our Board of Directors appointed a special litigation committee of independent directors to evaluate the claims. That committee determined that the maintenance of the derivative proceedings against the individual defendants was not in the best interest of the Company. Accordingly, on December 12, 2003, we moved to dismiss those claims. In March 2004, our motions were granted, and the derivative claims were dismissed with prejudice as to all defendants except Ernst & Young. The Company was substituted as the plaintiff in the action and is now pursuing in its own name the claims against Ernst & Young.
 
The Insurance Coverage Action. On February 9, 2004, ClearOne and Edward Dallin Bagley (“Bagley”), a director and significant shareholder of ClearOne, jointly filed an action in the United States District Court for the District of Utah, Central Division, against National Union Fire Insurance Company of Pittsburgh, Pennsylvania (“National Union”) and Lumbermens Mutual Insurance Company of Berkeley Heights, New Jersey (“Lumbermens Mutual”), the carriers of certain prior period directors and officers’ liability insurance policies, to recover the costs of defending and resolving claims against certain of our present and former directors and officers in connection with the SEC complaint, the shareholders’ class action, and the shareholder derivative actions described above, and seeking other damages resulting from the refusal of such carriers to timely pay the amounts owing under such liability insurance policies. This action has been consolidated into a declaratory relief action filed by one of the insurance carriers on February 6, 2004 against ClearOne and certain of its current and former directors. In this action, the insurers assert that they are entitled to rescind insurance coverage under our directors and officers’ liability insurance policies, $3.0 million of which was provided by National Union and $2.0 million which was provided by Lumbermens Mutual, based on alleged misstatements in our insurance applications. In February 2005, we entered into a confidential settlement agreement with Lumbermens Mutual pursuant to which ClearOne and Bagley received a lump-sum cash amount and the plaintiffs agreed to dismiss their claims against Lumbermens Mutual with prejudice. The cash settlement is held in a segregated account until the claims involving National Union have been resolved, at which time the amounts received in the action will be allocated between the Company and Bagley. The amount distributed to the Company and Bagley will be determined based on future negotiations between the Company and Bagley. The Company cannot currently estimate the amount of the settlement which it will ultimately receive. Upon determining the amount of the settlement which the Company will ultimately receive, the Company will record this as a contingent gain. On October 21, 2005, the court granted summary judgment in favor of National Union on its rescission defense and accordingly entered a judgment dismissing all of the claims asserted by ClearOne and Mr. Bagley. In connection with the summary judgment, the Company has been ordered to pay approximately $59,000 in expenses. However, due to the Lumbermens Mutual cash proceeds discussed above and the appeal to the summary judgment discussed below, this potential liability has not been recorded in the balance sheet as of June 30, 2005. On February 2, 2006, the Company and Mr. Bagley filed an appeal to the summary judgment granted on October 21, 2005 and intend to vigorously pursue the appeal and any follow-up proceedings regarding their claims against National Union, although no assurances can be given that they will be successful. The Company and Mr. Bagley have entered into a Joint Prosecution and Defense Agreement in connection with the action and the Company is paying all litigation expenses except litigation expenses which are solely related to Mr. Bagley’s claims in the litigation. (See “Item 13. Certain Relationships and Related Transactions”.)
 
Wells Submission. We have been advised by the staff of the Salt Lake District Office of the SEC that the staff intended to recommend to the Commission that administrative proceedings be instituted to revoke the registration of the Company’s common stock based on the Company’s failure to timely file annual and quarterly reports with the Commission. The Company provided the staff with a so-called “Wells Submission” setting forth its position with respect to the staff’s intended recommendation. To date, the Commission has not instituted an administrative proceeding against the Company, however, there can be no assurance that the Commission will not institute an administrative proceeding in the future or that the Company would prevail if an administrative proceeding were instituted.
 

25


The Pacific Technology & Telecommunications Collection Action. On August 12, 2003, we initiated a commercial arbitration proceeding against Pacific Technology & Telecommunications (“PT&T”), a former distributor, seeking to collect approximately $1.8 million that PT&T owed ClearOne for inventory it purchased and received but did not pay for. PT&T denied our claim and asserted counterclaims. Subsequently, on April 20, 2004, PT&T filed for protection under Chapter 7 of the United States Bankruptcy Code, which had the effect of staying the proceeding. Following PT&T’s bankruptcy filing, the Company negotiated a settlement with the bankruptcy trustee. Under the settlement, which has been approved by the bankruptcy court, the Company paid $25,000 and obtained the right to recover all unsold ClearOne inventory held by PT&T and the right to pursue on the basis of an assignment any claims that PT&T may have against any of its own officers or directors, subject, however, to a maximum recovery of $800,000. The Company is currently in the process of investigating whether any such claims exist and, if so, whether it would be in the Company’s best interest to pursue them given the anticipated legal expenses and the uncertainties of being able to collect any resulting favorable judgment. The settlement also resulted in the release and dismissal with prejudice of all of PT&T’s claims against the Company. To date, the Company has not recovered any inventory held by PT&T.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
No matters were submitted to a vote of our security holders during fiscal 2005.
 

26


PART II
 
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
 
Market Information
 
From April 21, 2003 until February 10, 2006, our common stock was quoted on an unsolicited basis on the National Quotation Bureau’s Pink Sheets under the symbol “CLRO.” On February 10, 2006, the Pink Sheets blocked the publication of quotations for our common stock on its public website due to our failure to file current public information. The following table sets forth the high and low bid quotations for the common stock for the last two fiscal years as provided by Pink Sheets.
 
   
2005
 
2004
 
   
High
 
Low
 
High
 
Low
 
First Quarter
 
$
5.70
 
$
3.50
 
$
2.15
 
$
1.70
 
Second Quarter
   
4.80
   
3.55
   
4.35
   
1.78
 
Third Quarter
   
4.30
   
3.00
   
7.96
   
3.70
 
Fourth Quarter
   
3.65
   
2.25
   
6.50
   
4.40
 

 
On February 28, 2006, the high and low sales prices for our common stock on the Over-the-Counter Bulletin Board were $2.90 and $2.70, respectively.
 
Shareholders
 
As of February 28, 2006, there were 12,184,727 shares of our common stock issued and outstanding and held by approximately 618 shareholders of record. This number counts each broker dealer and clearing corporation, who hold shares for their customers, as a single shareholder.
 
Dividends
 
We have not paid a cash dividend on our common stock and do not anticipate doing so in the foreseeable future. We intend to retain earnings to fund future working capital requirements, infrastructure needs, growth, and product development.
 
Securities Authorized for Issuance under Equity Compensation Plans
 
We currently have two equity compensation plans in effect, our 1990 Incentive Plan (the “1990 Plan”) and our 1998 Stock Option Plan (the “1998 Plan”), both of which provide for the grant of stock options to employees, directors and consultants. As of June 30, 2005, there were 30,750 options outstanding under the 1990 Plan with no additional options available for grant under such plan, and 1,462,362 options outstanding under the 1998 Plan with 735,514 options available for grant in the future. The Company has determined not to permit the exercise of stock options granted under the 1990 Plan or the 1998 Plan until such time as we are current in the filing of periodic reports with the SEC. The Company also provided for an extension of the exercise period of certain options to prevent them from expiring without the holder having had the opportunity to exercise them.
 

27


The following table sets forth information as of June 30, 2005 with respect to compensation plans under which equity securities of ClearOne are authorized for issuance.
 
 
Number of securities to be issued upon exercise of outstanding options, warrants, and rights
Weighted-average exercise price of outstanding options, warrants and rights
Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
 
(a)
(b)
( c )
Equity compensation
     
plans approved by
     
security holders
1,493,112
$6.21
735,514
Equity compensation
     
plans not approved by
     
security holders
-
-
-
Total
1,493,112
$6.21
735,514

Recent Sales of Unregistered Securities: Use of Proceeds from Registered Securities. On September 29, 2005, we completed our obligations under the settlement agreement in the class action lawsuit by issuing a total of 1,148,494 shares of our common stock to the plaintiff class, including 228,000 shares previously issued in November 2004, and paying an aggregate of $126,705 in cash in lieu of shares to those members of the class who would otherwise have been entitled to receive an odd-lot number of shares or who resided in states in which there was no exemption available for the issuance of shares. The shares were issued in reliance on the exemption from the registration requirements of the Securities Act provided by Section 3(a)(10) thereof.
 
Issuer Purchases of Equity Securities. During the fiscal year ended June 30, 2005, ClearOne did not purchase any of its equity securities.
 
Cancellation of Shares of Executive Officers. As discussed herein in “Item 11: Executive Compensation: Employment Contracts and Termination of Employment and Change-in-Control Arrangements,” on December 5, 2003, the Company entered into employment separation agreements with each of Frances Flood, the Company’s former Chairman, Chief Executive Officer, and President, and Susie Strohm, the Company’s former Chief Financial Officer, which generally provided that such persons would resign from their positions and employment with the Company, and the Company would make one-time, lump-sum payments to such persons in consideration of their surrender and delivery to the Company of shares of the Company’s common stock and Company stock options and their release of claims against the Company. Ms. Flood surrendered and returned 35,000 shares of the Company’s common stock and 706,434 stock options (461,433 of which were vested) and Ms. Strohm surrendered and returned 15,500 shares of the Company’s common stock and 268,464 stock options (171,963 of which were vested) to the Company. These shares were retired in May 2004 and were valued by the Company at $63,000 in the fiscal 2004 consolidated statement of shareholders’ equity. On July 15, 2004, an agreement was entered into with Angelina Beitia, the Company’s former Vice-President, which generally provided for a lump-sum payment of $100,000 and her surrendered and delivery to the Company of 145,000 stock options (10,624 of which were vested). On February 20, 2006, an agreement was entered into with DeLonie Call, the Company’s former Vice-President, which generally provided for a severance payment of $93,300 and her surrender and delivery to the Company of 145,000 stock options (86,853 of which were vested).
 
Employee Stock Purchase Program. We have an Employee Stock Purchase Program (“ESPP”). A total of 500,000 shares of common stock were reserved for issuance under the ESPP. During the fiscal year ended June 30, 2005, no shares of common stock were issued under the ESPP and compensation expense was $0. The program was suspended during fiscal 2003 due to the Company’s failure to remain current in its filing of periodic reports with the SEC. We are currently evaluating the possible reinstatement of this program after the Company becomes current with its filing of periodic reports with the SEC.
 

28


ITEM 6. SELECTED FINANCIAL DATA
 
The following selected financial data has been derived from our audited consolidated financial statements for the fiscal years ended June 30, 2005, 2004, 2003, 2002, and 2001. The data in the table below has been adjusted to reflect discontinued operations of a portion of our business services segment and our conferencing services segment as held for sale. The information set forth below is not necessarily indicative of results of future operations, and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes thereto included elsewhere in this Form 10-K.
 
SELECTED CONSOLIDATED FINANCIAL DATA
(in thousands, except share data)
 
   
Years Ended June 30,
 
   
2005
 
2004
 
2003
 
2002
 
2001
 
Operating results:
                     
Revenue
 
$
31,645
 
$
27,966
 
$
28,566
 
$
26,253
 
$
22,448
 
Costs and expenses:
                               
   Cost of goods sold
   
14,951
   
16,379
   
18,115
   
13,884
   
9,204
 
   Marketing and selling
   
9,070
   
8,497
   
7,070
   
7,010
   
5,273
 
   General and administrative
   
5,489
   
6,767
   
5,915
   
4,376
   
2,612
 
   Settlement in shareholders' class action
   
(2,046
)
 
4,080
   
7,325
   
-
   
-
 
   Research and product development
   
5,305
   
4,237
   
3,281
   
3,810
   
2,747
 
   Impairment losses
   
180
   
-
   
5,102
   
7,115
   
-
 
   Restructuring charge
   
110
   
-
   
-
   
-
   
-
 
   Purchased in-process research and development
   
-
   
-
   
-
   
-
   
728
 
Operating (loss) income
   
(1,414
)
 
(11,994
)
 
(18,242
)
 
(9,942
)
 
1,884
 
   Other income (expense), net
   
318
   
(261
)
 
48
   
288
   
188
 
(Loss) Income from continuing operations before income taxes
   
(1,096
)
 
(12,255
)
 
(18,194
)
 
(9,654
)
 
2,072
 
Benefit (provision) for income taxes
   
3,248
   
736
   
1,352
   
173
   
(403
)
Income (loss) from continuing operations
   
2,152
   
(11,519
)
 
(16,842
)
 
(9,481
)
 
1,669
 
Income (loss) from discontinued operations
   
13,923
   
1,632
   
(19,130
)
 
2,820
   
1,949
 
Net income (loss)
 
$
16,075
 
$
(9,887
)
$
(35,972
)
$
(6,661
)
$
3,618
 
                                 
Earnings (loss) per common share:
                               
Basic earnings (loss) from continuing operations
 
$
0.19
 
$
(1.04
)
$
(1.50
)
$
(0.99
)
$
0.19
 
Diluted earnings (loss) from continuing operations
 
$
0.17
 
$
(1.04
)
$
(1.50
)
$
(0.99
)
$
0.18
 
Basic earnings (loss) from discontinued operations
 
$
1.25
 
$
0.15
 
$
(1.71
)
$
0.30
 
$
0.23
 
Diluted earnings (loss) from discontinued operations
 
$
1.13
 
$
0.15
 
$
(1.71
)
$
0.30
 
$
0.21
 
Basic earnings (loss)
 
$
1.44
 
$
(0.89
)
$
(3.21
)
$
(0.69
)
$
0.42
 
Diluted earnings (loss)
 
$
1.30
 
$
(0.89
)
$
(3.21
)
$
(0.69
)
$
0.39
 
Weighted average shares outstanding:
                               
Basic
   
11,177,406
   
11,057,896
   
11,183,339
   
9,588,118
   
8,593,725
 
Diluted
   
12,332,106
   
11,057,896
   
11,183,339
   
9,588,118
   
9,194,009
 


   
As of June 30,
 
   
2005
 
2004
 
2003
 
2002
 
2001
 
Financial data:
                     
Current assets
 
$
34,879
 
$
27,202
 
$
29,365
 
$
52,304
 
$
20,264
 
Property, plant and equipment, net
   
2,805
   
4,027
   
4,320
   
4,678
   
3,021
 
Total assets
   
38,021
   
32,156
   
35,276
   
63,876
   
25,311
 
Long-term debt, net of current maturities
   
-
   
240
   
931
   
-
   
-
 
Capital leases, net of current maturities
   
-
   
2
   
9
   
41
   
48
 
Total shareholders' equity
   
24,911
   
9,006
   
18,743
   
53,892
   
20,728
 

 

29


Quarterly Financial Data (Unaudited)
 
The following table is a summary of unaudited quarterly financial information for the years ended June 30, 2005 and 2004.
 
   
Fiscal 2005 Quarters Ended
     
   
(in thousands)
     
   
Sept. 30
 
Dec. 31
 
Mar. 31
 
June 30
 
Total
 
Net revenue
 
$
6,747
 
$
8,692
 
$
7,103
 
$
9,103
 
$
31,645
 
Cost of goods sold
   
(3,797
)
 
(3,948
)
 
(3,180
)
 
(4,026
)
 
(14,951
)
Marketing and selling
   
(2,086
)
 
(2,341
)
 
(2,151
)
 
(2,492
)
 
(9,070
)
General and administrative
   
(1,435
)
 
(1,388
)
 
(1,287
)
 
(1,379
)
 
(5,489
)
Settlement in shareholders' class action
   
1,020
   
734
   
855
   
(563
)
 
2,046
 
Research and product development
   
(1,105
)
 
(1,282
)
 
(1,423
)
 
(1,495
)
 
(5,305
)
Impairment losses
   
-
   
-
   
-
   
(180
)
 
(180
)
Restructuring charge
   
-
   
-
   
-
   
(110
)
 
(110
)
Other income (expense)
   
34
   
64
   
95
   
125
   
318
 
(Loss) income from continuing operations before income taxes
   
(622
)
 
531
   
12
   
(1,017
)
 
(1,096
)
Benefit (provision) for income taxes
   
232
   
(198
)
 
(5
)
 
3,219
   
3,248
 
(Loss) income from continuing operations
   
(390
)
 
333
   
7
   
2,202
   
2,152
 
Income from discontinued operations
   
13,346
   
73
   
388
   
116
   
13,923
 
Net income
 
$
12,956
 
$
406
 
$
395
 
$
2,318
 
$
16,075
 
                                 
Basic income (loss) earnings per common share:
                               
Continuing operations
 
$
(0.04
)
$
0.03
 
$
-
 
$
0.20
 
$
0.19
 
Discontinued operations
   
1.20
   
0.01
   
0.03
   
0.01
   
1.25
 
Basic income (loss) earnings per common share
 
$
1.16
 
$
0.04
 
$
0.03
 
$
0.21
 
$
1.44
 
Diluted income (loss) earnings per common share:
                               
Continuing operations
 
$
(0.03
)
$
0.02
 
$
-
 
$
0.18
 
$
0.17
 
Discontinued operations
   
1.08
   
0.01
   
0.03
   
0.01
   
1.13
 
Diluted income (loss) earnings per common share
 
$
1.05
 
$
0.03
 
$
0.03
 
$
0.19
 
$
1.30
 

   
Fiscal 2004 Quarters Ended
     
   
(in thousands)
     
   
Sept. 30
 
Dec. 31
 
Mar. 31
 
June 30
 
Total
 
Net revenue
 
$
7,737
 
$
6,715
 
$
6,652
 
$
6,862
 
$
27,966
 
Cost of goods sold
   
(5,165
)
 
(3,278
)
 
(4,392
)
 
(3,544
)
 
(16,379
)
Marketing and selling
   
(2,012
)
 
(2,004
)
 
(2,129
)
 
(2,352
)
 
(8,497
)
General and administrative
   
(1,583
)
 
(1,639
)
 
(1,738
)
 
(1,807
)
 
(6,767
)
Settlement in shareholders' class action
   
-
   
(2,100
)
 
(3,240
)
 
1,260
   
(4,080
)
Research and product development
   
(925
)
 
(829
)
 
(1,112
)
 
(1,371
)
 
(4,237
)
Other income (expense)
   
1
   
(65
)
 
(2
)
 
(195
)
 
(261
)
Loss from continuing operations before income taxes
   
(1,947
)
 
(3,200
)
 
(5,961
)
 
(1,147
)
 
(12,255
)
Benefit for income taxes
   
123
   
109
   
426
   
78
   
736
 
Loss from continuing operations
   
(1,824
)
 
(3,091
)
 
(5,535
)
 
(1,069
)
 
(11,519
)
Income (loss) from discontinued operations
   
661
   
(66
)
 
690
   
347
   
1,632
 
Net loss
 
$
(1,163
)
$
(3,157
)
$
(4,845
)
$
(722
)
$
(9,887
)
                                 
Basic (loss) earnings per common share:
                               
Continuing operations
 
$
(0.16
)
$
(0.28
)
$
(0.50
)
$
(0.10
)
$
(1.04
)
Discontinued operations
   
0.06
   
-
   
0.06
   
0.03
   
0.15
 
Basic (loss) earnings per common share
 
$
(0.10
)
$
(0.28
)
$
(0.44
)
$
(0.07
)
$
(0.89
)
Diluted (loss) earnings per common share:
                               
Continuing operations
 
$
(0.16
)
$
(0.28
)
$
(0.50
)
$
(0.10
)
$
(1.04
)
Discontinued operations
   
0.06
   
-
   
0.06
   
0.03
   
0.15
 
Diluted (loss) earnings per common share
 
$
(0.10
)
$
(0.28
)
$
(0.44
)
$
(0.07
)
$
(0.89
)


30


ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion should be read in conjunction with our June 30, 2005 Consolidated Financial Statements and related Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. This discussion contains forward-looking statements based on current expectations that involve risks and uncertainties, such as our plans, objectives, expectations, and intentions, as set forth under “Disclosure Regarding Forward-Looking Statements.” Our actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth in the following discussion and under the caption “Risk Factors” in Item 1. Description of Business and elsewhere in this Annual Report on Form 10-K. Unless otherwise indicated, all references to a year reflect our fiscal year that ends on June 30.
 
CRITICAL ACCOUNTING POLICIES
 
Our discussion and analysis of our results of operations and financial position are based upon our consolidated financial statements, which have been prepared in conformity with U.S. generally accepted accounting principles. We review the accounting policies used in reporting our financial results on a regular basis. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We evaluate our assumptions and estimates on an ongoing basis and may employ outside experts to assist in our evaluations. We believe that the estimates we use are reasonable; however, actual results could differ from those estimates. Our significant accounting policies are described in Note 2 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K. We believe the following critical accounting policies affect our more significant assumptions and estimates that we used to prepare our consolidated financial statements.
 
Revenue and Associated Allowances for Revenue Adjustments and Doubtful Accounts
 
Included in continuing operations are two sources of revenue: (i) product revenue, primarily from product sales to distributors, dealers, and end-users; and (ii) business services revenue, which includes one software license agreement associated with our broadcast telephone interface product line, a perpetual software license to use the Company’s technology, along with one free year of maintenance and support, and transition services for 90 days.
 
Product revenue is recognized when (i) the products are shipped, (ii) persuasive evidence of an arrangement exists, (iii) the price is fixed and determinable, and (iv) collection is reasonably assured. Beginning in 2001, we modified our sales channels to include distributors. These distributors were generally thinly capitalized with little or no financial resources and did not have the wherewithal to pay for these products when delivered by us. Furthermore, in a substantial number of cases, significant amounts of inventories were returned or never paid for and the payment for product sold (to both distributors and non-distributors) was regularly subject to a final negotiation with our customers. As a result of such negotiations, we routinely agreed to significant concessions from the originally invoiced amounts to facilitate collection. These practices continued to exist through the fiscal year ended June 30, 2003.

Accordingly, amounts charged to both distributors and non-distributors were not considered fixed and determinable or reasonably collectible until cash was collected and thus, there was a delay in our recognition of revenue and related cost of goods sold from the time of product shipment until invoices were paid. As a result, the June 30, 2003 balance sheet reflects no accounts receivable or deferred revenue related to product sales. During the fiscal year ended June 30, 2004, we recognized $5.2 million in revenues and $1.7 million in cost of goods sold that were deferred in prior periods since cash had not been collected as of the end of the fiscal year ended June 30, 2003. 
 
During the fiscal years ended June 30, 2005 and 2004, we had in place improved credit policies and procedures, an approval process for sales returns and credit memos, processes for managing and monitoring channel inventory levels, better trained staff, and discontinued the practice of frequently granting significant concessions from the originally invoiced amount. As a result of these improved policies and procedures, we extend credit to customers who we believe have the wherewithal to pay.
 

31


We provide a right of return on product sales to distributors. Currently, we do not have sufficient historical return experience with our distributors that is predictive of future events given historical excess levels of inventory in the distribution channel. Accordingly, revenue from product sales to distributors is not recognized until the return privilege has expired, which approximates when product is sold-through to customers of the Company’s distributors (dealers, system integrators, value-added resellers, and end-users). Although, certain distributors provide certain channel inventory amounts, we make judgments and estimates with regard to the amount of inventory in the entire channel, for all customers and for all channel inventory items, and the appropriate revenue and cost of goods sold associated with those channel products. Although these assumptions and judgments regarding total channel inventory revenue and cost of goods sold could differ from actual amounts, we believe that our calculations are indicative of actual levels of inventory in the distribution channel.  As of June 30, 2004, we deferred $6.2 million in revenue and $2.4 million in cost of goods sold related to products sold where return rights had not lapsed. As of June 30, 2005, we deferred $5.1 million in revenue and $2.3 million in cost of goods sold related to products sold where return rights had not lapsed. The amounts of deferred cost of goods sold were included in consigned inventory.
 
We offer rebates and market development funds to certain of our distributors based upon volume of product purchased by such distributors. We record rebates as a reduction of revenue in accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-22, “Accounting for Points and Certain Other Time-Based or Volume-Based Sales Incentive Offers, and Offers for Free Products or Services to Be Delivered in the Future.” Beginning January 1, 2002, we adopted EITF Issue No. 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).” We continue to record rebates as a reduction of revenue in the period revenue is recognized.
 
We provide advance replacement units to end-users on defective units of certain products within 90 days of purchase date by the end-user. Since the purpose of these units are not revenue generating, we track the units due from the end-user, valued at retail price, until the defective unit has been returned, but no receivable balance is maintained on our balance sheet. Retail price value of in-transit advance replacement units was $81,000 and $91,000, as of June 30, 2005 and 2004, respectively.
 
We offer credit terms on the sale of our products to a majority of our customers and perform ongoing credit evaluations of our customers’ financial condition. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability or unwillingness of our customers to make required payments based upon our historical collection experience and expected collectibility of all accounts receivable. Our actual bad debts in future periods may differ from our current estimates and the differences may be material, which may have an adverse impact on our future accounts receivable and cash position.
 
Goodwill and Purchased Intangibles
 
We assess the impairment of goodwill and other identifiable intangibles annually or whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Some factors we consider important which could trigger an impairment review include the following:
 
·  
Significant underperformance relative to projected future operating results;
 
·  
Significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and
 
·  
Significant negative industry or economic trends.
 
If we determine that the carrying value of goodwill and other identified intangibles may not be recoverable based upon the existence of one or more of the above indicators of impairment, we would typically measure any impairment based on a projected discounted cash flow method using a discount rate determined by us to be commensurate with the risk inherent in our current business model. We evaluate goodwill for impairment at least annually.
 

32


On July 1, 2002, we completed our transitional goodwill and purchased intangibles impairment tests outlined under Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” which required the assessment of goodwill and purchased intangibles for impairment, and in the fourth quarter of fiscal 2003, we completed our annual impairment tests. As of June 30, 2003, we determined that our goodwill assets and purchased intangible assets were impaired and we recorded an impairment charge of $25.5 million related to these assets. We plan to conduct our annual impairment tests in the fourth quarter of every fiscal year, unless impairment indicators exist sooner. Screening for and assessing whether impairment indicators exist or if events or changes in circumstances have occurred, including market conditions, operating fundamentals, competition, and general economic conditions, requires significant judgment. Additionally, changes in the high-technology industry occur frequently and quickly. Therefore, there can be no assurance that a charge to operations will not occur as a result of future purchased intangible impairment tests.
 
Accounting for Income Taxes

We are subject to income taxes in both the United States and in certain non-U.S. jurisdictions. We estimate our current tax position together with our future tax consequences attributable to temporary differences resulting from differing treatment of items, such as deferred revenue, depreciation, and other reserves for tax and accounting purposes. These temporary differences result in deferred tax assets and liabilities. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income, prior year carryback, or future reversals of existing taxable temporary differences. To the extent we believe that recovery is not more likely than not, we establish a valuation allowance against these deferred tax assets. Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance recorded against our deferred tax assets. To the extent we establish a valuation allowance in a period, we must include and expense the allowance within the tax provision in the consolidated statement of operations.
 
Lower-of-Cost or Market Adjustments and Reserves for Excess and Obsolete Inventory
 
We account for our inventory on a first-in, first-out (“FIFO”) basis, and make appropriate adjustments on a quarterly basis to write-down the value of inventory to the lower-of-cost or market.
 
In order to determine what, if any, inventory needs to be written down, we perform a quarterly analysis of obsolete and slow-moving inventory. In general, we write-down our excess and obsolete inventory by an amount that is equal to the difference between the cost of the inventory and its estimated market value if market value is less than cost, based upon assumptions about future product life-cycles, product demand, and market conditions. Those items that are found to have a supply in excess of our estimated demand are considered to be slow-moving or obsolete and the appropriate reserve is made to write-down the value of that inventory to its realizable value. These charges are recorded in cost of goods sold. At the point of the loss recognition, a new, lower-cost basis for that inventory is established and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. If there were to be a sudden and significant decrease in demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to increase our inventory allowances, and our gross profit could be adversely affected.
 
BUSINESS OVERVIEW
 
We are an audio conferencing products company. We develop, manufacture, market, and service a comprehensive line of audio conferencing products, which range from tabletop conferencing phones to professionally installed audio systems. We believe we have a strong history of product innovation and plan to continue to apply our expertise in audio engineering to developing innovative new products. The performance and reliability of our high-quality solutions create a natural communication environment, which saves organizations of all sizes time and money by enabling more effective and efficient communication between geographically separated businesses, employees, and customers.
 

33


DISCUSSION OF OPERATIONS
 
Results of Operations
 
The following table sets forth certain items from our consolidated statements of operations (in thousands) for the fiscal years ended June 30, 2005, 2004, and 2003, together with the percentage of total revenue which each such item represents:
 
   
Year Ended June 30,
 
   
(in thousands)
 
   
2005
 
2004
 
2003
 
       
% of Revenue
     
% of Revenue
     
% of Revenue
 
Revenue
 
$
31,645
   
100.0%
 
$
27,966
   
100.0%
 
$
28,566
   
100.0%
 
Cost of goods sold
   
14,951
   
47.2%
 
 
16,379
   
58.6%
 
 
18,115
   
63.4%
 
Gross profit
   
16,694
   
52.8%
 
 
11,587
   
41.4%
 
 
10,451
   
36.6%
 
Operating expenses:
         
 
                       
Marketing and selling
   
9,070
   
28.7%
 
 
8,497
   
30.4%
 
 
7,070
   
24.7%
 
General and administrative
   
5,489
   
17.3%
 
 
6,767
   
24.2%
 
 
5,915
   
20.7%
 
Settlement in shareholders' class action
   
(2,046
)
 
-6.5%
 
 
4,080
   
14.6%
 
 
7,325
   
25.6%
 
Research and product development
   
5,305
   
16.8%
 
 
4,237
   
15.2%
 
 
3,281
   
11.5%
 
Impairment losses
   
180
   
0.6%
 
 
-
   
0.0%
 
 
5,102
   
17.9%
 
Restructuring charge
   
110
   
0.3%
 
 
-
   
0.0%
 
 
-
   
0.0%
 
Total operating expenses
   
18,108
   
57.2%
 
 
23,581
   
84.3%
 
 
28,693
   
100.4%
 
Operating loss
   
(1,414
)
 
-4.5%
 
 
(11,994
)
 
-42.9%
 
 
(18,242
)
 
-63.9%
 
Other income (expense), net
   
318
   
1.0%
 
 
(261
)
 
-0.9%
 
 
48
   
0.2%
 
Loss from continuing operations before income taxes
   
(1,096
)
 
-3.5%
 
 
(12,255
)
 
-43.8%
 
 
(18,194
)
 
-63.7%
 
Benefit for income taxes
   
3,248
   
10.3%
 
 
736
   
2.6%
 
 
1,352
   
4.7%
 
Income (loss) from continuing operations
   
2,152
   
6.8%
 
 
(11,519
)
 
-41.2%
 
 
(16,842
)
 
-59.0%
 
Income (loss) from discontinued operations, net of tax
   
13,923
   
44.0%
 
 
1,632
   
5.8%
 
 
(19,130
)
 
-67.0%
 
Net income (loss)
 
$
16,075
   
50.8%
 
$
(9,887
)
 
-35.4%
 
$
(35,972
)
 
-125.9%
 

Our revenue increased 10.8 percent over the three-year period from $28.6 million in fiscal 2003 to $31.6 million in fiscal 2005. During the fiscal years ended June 30, 2005, 2004, and 2003, we introduced several new products in our products segment, including our MAX® tabletop audio conferencing products; our RAV™ audio conferencing systems; and our conferencing peripherals, including the AccuMic® product line. During the fiscal year ended June 30, 2005 settlement in shareholders’ class action expense decreased $6.1 million from fiscal 2004 levels due to a quarterly mark-to-market adjustment of the liability associated with our December 2003 settlement agreement, while general and administrative (“G&A”) expense for the fiscal years ended June 30, 2004 and 2003 were significantly higher due to professional fees associated with the settlement agreement and other related lawsuits. During this period, we changed our business mix through one acquisition and three dispositions. Additionally, we reclassified our U.S. audiovisual integration services business component, our conferencing services component, and our Canadian audiovisual integration services business component to discontinued operations.
 
The following is a discussion of our results of operations for our fiscal years ended June 30, 2005, 2004, and 2003. For each of our business segments, we discuss revenue and gross profit. All other items are discussed on a consolidated basis.
 

34


Fiscal Year Ended June 30, 2005 (“Fiscal 2005”)
Compared to Fiscal Year Ended June 30, 2004 (“Fiscal 2004”)
 
Revenue
 
For the fiscal years ended June 30, 2005 and 2004, revenues by business segment were as follows:
 
   
Year Ended June 30,
 
   
(in thousands)
 
   
2005
 
2004
 
       
% of Revenue
     
% of Revenue
 
Product
 
$
31,645
   
100.0%
 
$
27,836
   
99.5%
 
Business services
   
-
   
0.0%
 
 
130
   
0.5%
 
Total
 
$
31,645
   
100.0%
 
$
27,966
   
100.0%
 
 
Product. Product revenue increased $3.8 million, or 13.7 percent, in fiscal 2005 compared to fiscal 2004. The increase in revenue was primarily due to increased professional audio conferencing products sales and the introduction of new products including the MaxAttach and RAV products. During the fiscal year ended June 30, 2005, we recognized $1.1 million in net revenues for product revenue that was deferred in prior periods where return rights had not lapsed as of the end of the fiscal year ended June 30, 2004.
 
The following table relates to individual unit shipments to our distributors for certain of our product lines for the fiscal years ended June 30, 2005 and 2004 and due to our current revenue recognition policy will not tie directly to recognized revenues:
 
 
Year Ended June 30,
 
(by individual unit)
 
2005
2004
Professional audio conferencing
10,786
10,576
Premium and tabletop conferencing
11,782
9,813

Business Services. Business services revenue decreased $130,000, or 100.0 percent, in fiscal 2005 compared to fiscal 2004. During fiscal 2004, we recognized $130,000 in revenue due to the sale of a software license associated with our telephone interface products to Comrex.
 
Total Revenue. Total revenue increased $3.7 million, or 13.2 percent, in fiscal 2005 compared to fiscal 2004. The overall increase in revenue during fiscal 2005 was attributable to our products segment. Product revenue from sales outside of the United States accounted for 25.9 percent of total revenue for fiscal 2005 and 22.7 percent of total revenue for fiscal 2004.
 

35


Costs of Goods Sold and Gross Profit
 
Costs of goods sold (“COGS”) from the product segment includes expenses associated with finished goods purchased from outsourced manufacturers, the manufacture of our products, including material and direct labor, our manufacturing and operations organization, tooling amortization, warranty expense, freight expense, royalty payments, and the allocation of overhead expenses.
 
   
Year Ended June 30,
 
   
(in thousands)
 
   
2005
 
2004
 
       
% of Revenue
     
% of Revenue
 
Cost of goods sold
                 
Product
 
$
14,951
   
47.2%
 
$
16,379
   
58.6%
 
Business services
   
-
   
0.0%
 
 
-
   
0.0%
 
Total
 
$
14,951
   
47.2%
 
$
16,379
   
58.6%
 
                           
Gross profit
                         
Product
 
$
16,694
   
52.8%
 
$
11,457
   
41.0%
 
Business services
   
-
   
0.0%
 
 
130
   
0.4%
 
Total
 
$
16,694
   
52.8%
 
$
11,587
   
41.4%
 

COGS decreased by approximately $1.4 million, or 8.7 percent, to $15.0 million in fiscal 2005 compared with $16.4 million in fiscal 2004. The decrease in COGS from fiscal 2004 to fiscal 2005 was primarily attributable to a decrease in our obsolete product inventory write-offs of $2.4 million, a $777,000 decrease in our manufacturing absorption costs due to cost cutting and improving efficiency, a $114,000 decrease in our inventory adjustments due to a higher emphasis on inventory accuracy, partially offset by a $2.0 million increase in standard COGS from fiscal 2004 to fiscal 2005 due to higher product revenue and sales mix.
 
During the fiscal year ended June 30, 2005, there was only an $84,000, favorable, impact on net COGS due to deferrals of the COGS related to the deferral of product revenue in prior periods where return rights had not lapsed as of the end of the fiscal year ended June 30, 2004.
 
Our gross profit from continuing operations was 52.8 percent in fiscal 2005 compared to 41.4 percent in fiscal 2004. The increase in gross profit is mostly due to the increase in revenue of professional conferencing products which has a higher gross margin than our premium and tabletop conferencing products. The increase in gross profit was also impacted by reduced inventory write-offs, cost cutting, and improved efficiencies.
 
Operating Expenses
 
Our operating expenses were $18.1 million in fiscal 2005, a decrease of $5.5 million, or 23.2 percent, from $23.6 million in fiscal 2004. The decrease in operating expenses from fiscal 2004 to fiscal 2005 is primarily related to a decrease in expenses related to the settlement in the shareholders’ class action and other general and administrative expenses partially offset by increased marketing and selling and research and product development employee-related expenses. The following is a more detailed discussion of expenses related to marketing and selling, general and administrative, settlement in shareholders’ class action, research and product development, and impairment and restructuring charges.
 

36


Marketing and selling expenses. Marketing and selling expenses include selling, customer service, and marketing expenses such as employee-related costs, allocations of overhead expenses, trade shows, and other advertising and selling expenses. Total marketing and selling expenses increased $573,000, or 6.7 percent, to $9.1 million in fiscal 2005 compared with fiscal 2004 expenses of $8.5 million. As a percentage of revenues, marketing and selling expenses were 28.7 percent in fiscal 2005 and 30.4 percent in fiscal 2004. The increase in marketing and selling expenses from fiscal 2004 to fiscal 2005 was primarily attributable to an increase in U.S. and Asia employee-related expenses of $581,000 associated with the hiring of additional sales positions and increased benefits-related costs, severance payments of $175,000 to the former employees of the Germany office, as well as early buyout costs on leased office space and automobiles of $78,000 associated with the closure of our Germany office partially offset by a decrease of $193,000 in our marketing department due to a change in the non-employee related expense structure of the department after the departure of our Vice-President of Marketing.
 
General and administrative expenses. G&A expenses include employee-related costs, professional service fees, allocations of overhead expenses, litigation costs, including costs associated with the SEC investigation and subsequent litigation, and corporate administrative costs, including finance and human resources. Total G&A expenses decreased $1.3 million, or 18.9 percent, to $5.5 million in fiscal 2005 compared with fiscal 2004 expenses of $6.8 million. As a percentage of revenues, G&A expenses were 17.3 percent in fiscal 2005 and 24.2 percent in fiscal 2004.

   
Year Ended June 30,
 
   
(in thousands)
 
   
2005
 
2004
 
Total G&A before discontinued operations
 
$
5,742
 
$
9,703
 
               
OM Video G&A
   
(253
)
 
(1,113
)
Conferencing services G&A
   
-
   
(1,036
)
U.S. business services G&A
   
-
   
(787
)
Total G&A from continuing operations
 
$
5,489
 
$
6,767
 
               
Professional fees (SEC investigation and subsequent litigation)
 
$
997
 
$
936
 
Professional fees (Other)
   
1,993
   
1,944
 
Severance payments to executives
   
-
   
544
 
Other general and administrative expense
   
2,499
   
3,343
 
Total G&A from continuing operations
 
$
5,489
 
$
6,767
 

We attribute the decrease in G&A as a percentage of revenues to 17.3 percent in 2005 from 24.2 percent in 2004 to a decrease of $544,000 for severance payments to executives partially offset by a $61,000 increase in professional fees associated with the SEC investigation and subsequent litigation and a $49,000 increase in other professional fees, including accounting and audit fees. Other G&A expense decreased an additional $844,000 mostly due to a reduction in salaries and benefits-related costs of $771,000, reflecting an average headcount of 33 and 19 for fiscal 2004 and 2005, respectively, as well as a decrease in directors and officers insurance premiums of $106,000.
 
Settlement in shareholders’ class action expense. We attribute the decrease in settlement in shareholders’ class action expense as a percentage of revenue to (6.5) percent in 2005 from 14.6 percent in 2004 to a $6.1 million reduction to a quarterly mark-to-market of the liability associated with the 1.2 million shares of common stock that were issued in November 2004 (fiscal 2005) and September 2005 (fiscal 2006) to class members and their legal counsel as part of the December 2003 (fiscal 2004) settlement agreement. This mark-to-market of the stock to reflect the current liability amount associated with the 1.2 million shares is based upon the closing price of the Company’s common stock at the end of each quarter until the shares were issued.
 

37


Research and product development expenses. Research and product development expenses include research and development, product management, and engineering services, and test and application expenses, including employee-related costs, outside services, expensed materials, depreciation, and an allocation of overhead expenses. Total research and product development expenses increased $1.1 million, or 25.2 percent, to $5.3 million in fiscal 2005 compared with fiscal 2004 expenses of $4.2 million. As a percentage of revenues, research and product development expenses were 16.8 percent in fiscal 2005 and 15.2 percent in fiscal 2004. The increase in product development expenses from fiscal 2004 to fiscal 2005 was due to an increase in salaries and benefit-related costs of $1.3 million associated with the hiring of additional personnel and development costs associated with new product development, reflecting an average headcount of 31 and 39 for fiscal 2004 and 2005, respectively, and an increase in depreciation expense of $69,000 associated with the purchase of computer hardware and software in relation to product development, partially offset by a decrease research and development material-related expense of $188,000 and a reduction in professional services of $87,000.
 
Impairment and Restructuring charges. During fiscal 2005, we recorded an impairment charge of $180,000 and a restructuring charge of $110,000, shown as a restructuring reserve on the balance sheet, during the fiscal year ended June 30, 2005 as a result of our outsourcing of our Salt Lake City manufacturing operations. The impairment charge consisted of the disposal of certain property and equipment of $180,000 that was not purchased by our domestic manufacturer and that we did not believe was likely to be sold. The restructuring charge consisted of severance and other employee termination benefits of $70,000 related to a workforce reduction of approximately 20 employees who were transferred to an employment agency used by this manufacturer to transition the workforce and charges of $40,000 related to our manufacturing facilities that we would no longer use.
 
Operating loss. For fiscal 2005, our operating loss decreased $10.6 million, or 88.2 percent, to $1.4 million on revenue of $31.6 million, from an operating loss of $12.0 million on revenue of $28.0 million in fiscal 2004. The factors affecting this decrease in operating loss were a decrease in general and administrative expenses of $1.3 million, a decreased in settlement in shareholders’ class action of $6.1 million, and an increase in gross profit of $5.1 million, partially offset by an increase in research and product development expenses of $1.1 million, an increase in marketing and selling expenses of $573,000, and a restructuring and related impairment charge of $290,000 related to our decision to outsource our U.S. product manufacturing.
 
Other income (expense), net. Other income (expense), net, includes our interest income, interest expense, capital gains, gain (loss) on the disposal of assets, and currency gain (loss). Other income was $318,000 in fiscal 2005, an increase of $579,000, or 221.8 percent, from expense of ($261,000) in fiscal 2004. The increase in other income in fiscal 2005 was primarily due to an increase in interest income associated with our marketable securities, a decrease in interest expense related to our early pay-off of the Oracle system-related note payable, and a loss of approximately $113,000 on the disposal of certain property and equipment that was not repeated in fiscal 2005.
 
Net loss from continuing operations before income taxes. Net loss from continuing operations decreased $11.2 million, or 91.1 percent to $1.1 million in fiscal 2005 compared with fiscal 2004 net loss from continuing operations of $12.3 million. As a percentage of revenues, net loss from continuing operations was 3.5 percent in fiscal 2005 and 43.8 percent in fiscal 2004. We attribute the change in loss to the results of operations as described above.
 
Benefit for income taxes. Benefit for income taxes from continuing operations was $3.2 million in fiscal 2005 and $736,000 in fiscal 2004. The benefit for income taxes from continuing operations from fiscal 2005 resulted primarily from a change in the valuation allowance of $2.6 million attributable to continuing operations that offset gains from discontinued operations and from the decrease in deferred tax assets. Certain income and expenses in our consolidated statements of operations are either not includable or not deductible for income tax purposes. These items include tax-exempt interest, research and development credits, sale of our investment in OM Video, impairment charges, certain meals and entertainment expenses, and certain goodwill amortization. In addition, during fiscal 2005, the Company’s net deferred tax assets decreased and, therefore, the valuation allowance needed to offset this balance decreased creating a benefit to the Company’s tax provision. Given the Company’s history of consecutive years of losses from continuing operations, we followed the guidance of SFAS 109, “Accounting for Income Taxes,” and recorded a valuation allowance against certain deferred tax assets where it is not considered more likely than not that the deferred tax assets will be realized. As of June 30, 2005 and 2004, we have fully reserved against our net deferred tax assets.
 

38


Income (loss) from discontinued operations, net of tax. Income (loss) from discontinued operations, net of tax, includes our Canadian audiovisual integration services business which was sold on March 4, 2005, our conferencing services segment which was sold on July 1, 2004, our U.S. audiovisual integration services business which was sold on May 6, 2004, and payments received on our note receivable and commissions related to the sale of our remote control product line to Burk Technology in April 2001. The income from discontinued operations was $13.9 million in fiscal 2005, an increase of $12.3 million or 753.1 percent, from $1.6 million in fiscal 2004.

OM Video audiovisual integration services business revenue was $3.8 million in fiscal 2005, a decrease of $2.1 million, from revenue of $5.9 million in fiscal 2004 due to revenue in fiscal 2005 being generated over an eight-month period versus a twelve-month period in fiscal 2004. OM Video services income, net of tax, was $401,000 for fiscal 2005, an increase of $184,000, from income, net of tax, of $217,000 in fiscal 2004. The increase was mostly due to a $227,000 post-tax gain on the sale of OM Video being partially offset by decrease from post-tax income of $43,000 in fiscal 2005 over fiscal 2004. (see Discontinued Operations below.)

Conferencing services business revenue was $0 in fiscal 2005, a decrease of $15.6 million, from revenue of $15.6 million in fiscal 2004 due to the sale of conferencing services on the first day of fiscal 2005. (see Discontinued Operations below). Conferencing services income, net of tax, was $13.4 million for fiscal 2005, an increase of $11.6 million, from income, net of tax, of $1.8 million in fiscal 2004. The income, net of tax, in fiscal 2005 included the gain on disposal of discontinued operations, while the income, net of tax, in fiscal 2004 included income from discontinued operations.

U.S. audiovisual integration services business revenue was $0 in fiscal 2005, a decrease of $3.6 million, from revenue of $3.6 million in fiscal 2004. Since this segment was sold in May 2004, U.S. audiovisual integration services business loss, net of tax, was $0 in fiscal 2005, a decrease of $399,000, from a loss, net of tax, of ($399,000) in fiscal 2004. There was no activity related to our U.S. audiovisual integration services business in fiscal 2005. (see Discontinued Operations below.)

We realized a gain, net of tax, on the Burk sale of $144,000 for fiscal 2005, an increase of $86,000, from a gain, net of tax, of $58,000 in fiscal 2004. The increase was due to quarterly payments from Burk on the promissory note.

Fiscal Year Ended June 30, 2004 (“Fiscal 2004”)
Compared to Fiscal Year Ended June 30, 2003 (“Fiscal 2003”)
 
Revenue
 
For the fiscal years ended June 30, 2004 and 2003, revenues by business segment were as follows:

   
Year Ended June 30,
 
   
(in thousands)
 
   
2004
 
2003
 
       
% of Revenue
     
% of Revenue
 
Product
 
$
27,836
   
99.5%
 
$
27,512
   
96.3%
 
Business services
   
130
   
0.5%
 
 
1,054
   
3.7%
 
Total
 
$
27,966
   
100.0%
 
$
28,566
   
100.0%
 

Product. Product revenue increased $324,000, or 1.2 percent, in fiscal 2004 compared to fiscal 2003. The increase in revenue was primarily due to introducing new product lines, which include the MAX and XAP® products. During the fiscal year ended June 30, 2004, we recognized $5.2 million in revenues and $1.7 million in cost of goods sold that were deferred in prior periods since cash had not been collected as of the end of the fiscal year ended June 30, 2003.  As of June 30, 2004, we deferred $6.2 million in revenues and $2.4 million in cost of goods sold related to invoices sold where return rights had not lapsed.
 

39


The following table relates to individual unit shipments to our distributors for certain of our product lines for the fiscal years ended June 30, 2004 and 2003 and due to our current revenue recognition policy will not tie directly to recognized revenues:
 
 
Year Ended June 30,
 
(by individual unit)
 
2004
2003
Professional audio conferencing
10,576
7,166
Premium and tabletop conferencing
9,813
-

 
Business Services. Business services revenue decreased $924,000, or 87.7 percent, in fiscal 2004 compared to fiscal 2003. During fiscal 2003, we recognized revenue due to the sale of a software license associated with our telephone interface products to Comrex with a value of $1.1 million while we recognized $130,000 in fiscal 2004.
 
Total Revenue. Total revenue decreased $600,000, or 2.1 percent, in fiscal 2004 compared to fiscal 2003. The overall decrease in revenue during fiscal 2004 was primarily attributable to a one-time sale of $1.1 million of software license in our business services segment during fiscal 2003, partially offset by an increase in product revenue. Product revenue from sales outside of the United States accounted for 22.7 percent of total revenue for fiscal 2004 and 32.3 percent of total revenue for fiscal 2003.
 
Costs of Goods Sold and Gross Profit
 
Costs of goods sold (“COGS”) from the product segment includes expenses associated with finished goods purchased from outsourced manufacturers, the manufacture of our products, including material and direct labor, our manufacturing and operations organization, tooling amortization, warranty expense, freight expense, royalty payments, and the allocation of overhead expenses.
 
   
Year Ended June 30,
 
   
(in thousands)
 
   
2004
 
2003
 
       
% of Revenue
     
% of Revenue
 
Cost of goods sold
                         
Product
 
$
16,379
   
58.6%
 
$
18,115
   
63.4%
 
Business services
   
-
   
0.0%
 
 
-
   
0.0%
 
Total
 
$
16,379
   
58.6%
 
$
18,115
   
63.4%
 
                           
Gross profit
                         
Product
 
$
11,457
   
41.0%
 
$
9,397
   
32.9%
 
Business services
   
130
   
0.4%
 
 
1,054
   
3.7%
 
Total
 
$
11,587
   
41.4%
 
$
10,451
   
36.6%
 

COGS decreased by approximately $1.7 million, or 9.6 percent, to $16.4 million in fiscal 2004 compared with $18.1 million in fiscal 2003. The decrease in COGS from fiscal 2003 to fiscal 2004 was primarily attributable to a $1.6 million decrease in standard COGS due to higher product revenue and sales mix, partially offset by a $521,000 increase in our obsolete inventory write-offs.
 
During the fiscal year ended June 30, 2004, there was a $643,000 favorable impact on net COGS due to change in deferrals of product revenue related to cash collection during fiscal 2003 to the deferrals of COGS related to the deferral of product revenue where return rights had not lapsed as of the end of the fiscal year ended June 30, 2004.
 
Our gross profit from continuing operations was 41.4 percent in fiscal 2004 compared to 36.6 percent in fiscal 2003. The increase in gross profit was impacted by reduced material costs and improvements in inventory accuracy, cost cutting, and efficiencies.
 

40


Operating Expenses
 
Our operating expenses were $23.6 million in fiscal 2004, a decrease of $5.1 million, or 17.8 percent, from $28.7 million in fiscal 2003. The decrease in operating expenses from fiscal 2003 to fiscal 2004 is primarily related to a decrease in impairment losses and SEC investigation and subsequent litigation-related expenses partially offset by increased marketing and selling and research and product development expenses. The following is a more detailed discussion of expenses related to marketing and selling, general and administrative, settlement in shareholders’ class action, research and product development, and impairment losses.
 
Marketing and selling expenses. Marketing and selling expenses include selling, customer service, and marketing expenses such as employee-related costs, allocations of overhead expenses, trade shows, and other advertising and selling expenses. Total marketing and selling expenses increased $1.4 million, or 20.2 percent, to $8.5 million in fiscal 2004 compared with fiscal 2003 expenses of $7.1 million. As a percentage of revenues, marketing and selling expenses were 30.4 percent in fiscal 2004 and 24.7 percent in fiscal 2003. The increase in marketing and selling expenses from fiscal 2003 to fiscal 2004 was primarily attributable to an increase in our United Kingdom sales operations, as well as an increase in U.S. employee-related expenses due to an increase of nine employees in the marketing and sales departments at the end of fiscal 2004 over fiscal 2003.
 
General and administrative expenses. G&A expenses include employee-related costs, professional service fees, allocations of overhead expenses, litigation costs, including costs associated with the SEC investigation and subsequent litigation, and corporate administrative costs, including finance and human resources. Total G&A expenses increased $852,000, or 14.4 percent, to $6.8 million in fiscal 2004 compared with fiscal 2003 expenses of $5.9 million. As a percentage of revenues, G&A expenses were 24.2 percent in fiscal 2004 and 20.7 percent in fiscal 2003.

   
Year Ended June 30,
 
   
(in thousands)
 
   
2004
 
2003
 
Total G&A before discontinued operations
 
$
9,703
 
$
9,798
 
               
OM Video G&A
   
(1,113
)
 
(1,270
)
Conferencing services G&A
   
(1,036
)
 
(972
)
U.S. business services G&A
   
(787
)
 
(1,641
)
Total G&A from continuing operations
 
$
6,767
 
$
5,915
 
               
Professional fees (SEC investigation and subsequent litigation)
 
$
936
 
$
1,844