Module and Segment Reference



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, 2006
 
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 000-17219 
 
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 x  No ¨
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of 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 10,454,019 shares of voting common stock held by non-affiliates was approximately $24,985,000 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 August 31, 2006 was 12,184,727.
 
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).

Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held November 20, 2006 are incorporated by reference into Part III.


 
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INDEX
 
   
PAGE
 
4
     
PART I.
   
ITEM 1.
4
ITEM 1A.
16
ITEM 1B.
21
ITEM 2.
22
ITEM 3.
23
ITEM 4.
24
     
PART II.
   
ITEM 5.
25
 
ITEM 6.
26
ITEM 7.
29
ITEM 7A.
45
ITEM 8.
47
ITEM 9.
47
ITEM 9A.
47
ITEM 9B.
48
     
PART III.
   
ITEM 10.
49
ITEM 11.
49
ITEM 12.
49
ITEM 13.
49
ITEM 14.
49
     
PART IV.
   
ITEM 15.
50
     
 
52

 

 
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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.
 
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.
 
ITEM 1. 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 personal conferencing products to tabletop conferencing phones to professionally installed audio systems. We also manufacture and sell conferencing furniture. Until August 2006, we also sold document and education cameras. 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 communications environment, which saves organizations of all sizes time and money by enabling more effective and efficient communication.
 
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 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 Securities and Exchange Commission (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.
 

 
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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 that we call premium conferencing, and have also taken a leadership role in defining the new personal conferencing space with the introduction of the Chat™ 50. We will continue to develop additional new products as we build on 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:
 
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, including Distributed Echo Cancellation®, 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; similar feedback was also directly responsible for the creation of the Tabletop Controller for the XAP® platform, which began shipping in March 2006.
 
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 and personal audio conferencing technologies, and developing products based on internationally-accepted standards and protocols. 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. In addition, the introduction of our Chat 50 personal speaker phone established ClearOne as a technology leader and innovator in the personal conferencing space, with its unmatched audio quality and multiple usage models.
 
Expand and strengthen sales channels
 
We have made significant efforts to expand and strengthen 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 have directed significant sales efforts toward channel partners who are focused on the tabletop conferencing space. As a result, we have enjoyed a considerable increase in our MAX® conference phone sales. We have also strengthened our presence within the telephony reseller channel, which is best suited to sell our RAV premium conferencing systems and our new MAX IP VoIP conference phones. Also, with the introduction of the Chat 50, we signed up a number of the leading direct marketing resellers (“DMRs”), who are well situated to fulfill broad demand for a high-volume product and also push the Chat 50 into the enterprise space. We have also recently added resources to focus on the audio conferencing opportunities in the federal government market.
 

 
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Broaden our product offerings
 
We believe that we offer the industry’s most complete audio conferencing product line:
 
·  
Professionally installed audio conferencing systems that are used in executive boardrooms, courtrooms, hospitals, and auditoriums
·  
Premium conferencing systems that integrate with video and web conferencing systems
·  
Tabletop conferencing phones used in conference rooms and offices
·  
Personal conferencing devices that enable hands-free audio communications in new ways that have never before been possible
 
We plan to continue to broaden and expand 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 and market developments, we plan to continue to identify partners with expertise in areas strategic to our growth objectives. We will 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. We also dedicate significant resources to providing product training to our channel partners worldwide.
 
Markets and Products
 
Our business is primarily focused on audio conferencing. 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 affiliate 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., a Canada corporation (the “6351352 Canada Inc.”). For additional financial information about our segments, see Note 18 to Consolidated Financial Statements, which are included in this report.
 
Products Overview
 
The performance and reliability of our high-quality audio 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, hospitals, classrooms, and auditoriums, to premium conferencing systems that interface with video and web conferencing systems, to tabletop conference phones used in conference rooms and offices, and to personal conferencing devices. Our audio conferencing products feature our proprietary Distributed Echo Cancellation® and noise cancellation technologies to enhance communication during a conference call by eliminating echo and background noise. Most of our products 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
 
·  
Increasing availability of easy-to-use audio conferencing equipment
·  
Improving voice quality of audio conferencing systems compared to telephone handset speakerphones
·  
Trending expansion of global, regional, and local corporate enterprises
 
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Other factors that we expect to have a significant impact on the demand for audio conferencing systems include:
 
·  
Availability of a wider range of affordable audio conferencing products for small businesses and home offices
·  
Growth of distance learning and corporate training programs
·  
Trend toward deploying greater numbers of teleworkers
·  
Decreases in the amount of travel within most enterprises for routine meetings
·  
Transition to the Internet Protocol (“IP”) network from the traditional public switched telephone network (“PSTN”) and the deployment of Voice over Internet Protocol (“VoIP”) applications
 
We expect these growth factors to be offset by direct competition from high-end telephone handset speakerphones, new and existing 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® product line and Converge 560 and Converge 590 products. The PSR1212 product features similar technologies and is used for sound reinforcement applications.
 
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 an excellent 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.
 
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.
 

 
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At June 2006’s InfoComm trade show, we showcased for the first time our upcoming Converge Pro™ professional conferencing line, the eventual successor to our industry-leading XAP platform. The products were well received by our channel partners and customers and sent the message that we continue to innovate and improve upon a very strong product line. We believe the Converge Pro products will offer the next generation of audio processing technologies and will deliver enhanced management capabilities, simplified configuration, and new flexibility in matching specific conferencing application needs. These products are expected to ship by the end of calendar 2006.
 
In March 2006, Frost and Sullivan, an analyst group that focuses on the conferencing industry, awarded ClearOne their 2006 Product Line Strategy Award. They recognized us for our attention to customer needs, particularly in the professional conferencing space, as we introduced the Converge™ 560 and 590 products, which were strategically positioned between our XAP and RAV products in price and functionality.
 
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 rich-media devices, such as video or web conferencing systems, to deliver enhanced audio performance. RAV is strategically positioned between our professional and tabletop conferencing systems in price and functionality, and fills an important audio conferencing application need for rooms requiring integration of high-end audio quality with web or video conferencing.
 
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 MAXAttach™ Wireless, MAX® Wireless, MAXAttach™, MAX® EX, MAXAttach IP™, and MAX IP™ tabletop conferencing phones. MAX Wireless was 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 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, the phones can be daisy chained together, up to a total of four phones. 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 other VoIP conference phones on the market cannot match.
 
Personal Conferencing Products
 
In April 2006, ClearOne began shipping the Chat 50 personal speaker phone. This revolutionary crossover technology delivers ClearOne’s trademark crystal-clear full-duplex audio performance, and can be used in a variety of applications with a wide number of devices:
 

 
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PCs & Macs
 
VoIP telephony applications such as Skype & Vonage; enterprise softphones, audio for web-based videoconferencing applications; gaming; audio playback
 
Cell phones
 
Connects to the 2.5mm headset jack for hands-free, full-duplex audio conferencing
 
Telephones
 
Connects to the headset jack (certain phone models) for hands-free, full-duplex audio conferencing
 
iPods & MP3 players
 
For full-bandwidth audio playback
 
Desktop video conferencing systems
 
For hands-free, full-duplex audio conferencing
 
Through public relations efforts by ClearOne, the Chat 50 has garnered significant media coverage and won PC Magazine’s Editors’ Choice Award.
 
The Chat™ 150 is the next product to join ClearOne’s personal conferencing category. Introduced first at the June 2006 InfoComm trade show, the product offers many of the same connectivity options as the Chat 50, but comes in a larger form factor and features three microphones compared to the single microphone on the Chat 50. The Chat 150 connects to enterprise telephone handsets, PCs, and video conferencing systems. ClearOne believes the primary opportunity for the Chat 150 is in connecting to the enterprise handset. Customers will now have the ability to add a high-quality, full-duplex speaker phone to their handsets, and still retain the full functionality that comes with today’s handsets, including access to company directory, voicemail access, audio bridge functions, etc. The Chat 150 is expected to begin shipping by the end of calendar 2006.
 
Other Products
 
We complement our audio conferencing products with microphones, conferencing-specific furniture, and until August 2006 document and education cameras. Our AccuMic® microphones are designed to improve the audio quality for 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.
 
In August 2006, we completed the sale of our document and educational camera manufacturing and sales operations to a privately-held manufacturer of camera solutions.
 
Marketing and Sales
 
We use a two-tier channel 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, value-added resellers, and end-users.
 

 
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In fiscal 2006, approximately $26.9 million, or 71.5 percent, of our total product sales were generated in the United States and product sales of approximately $10.7 million, or 28.5 percent, were generated outside the United States. Revenue from product customers outside of the United States accounted for approximately 28.5 percent of our total product sales from continuing operations for fiscal 2006, 25.9 percent for fiscal 2005, and 22.7 percent for fiscal 2004. We sell our products in more than 70 countries worldwide. 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 channel partners, strengthening our presence in key growth areas, complying with regional environmental regulatory standards, 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, Dealers, 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 dealers 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 from distributors 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.
 
General Marketing & Public Relations Activities
 
Much of our marketing effort is done in conjunction with our channel partners, who provide leverage for ClearOne in reaching customers and prospective customers worldwide. We also have a highly-focused public relations effort to get editorial coverage on ClearOne’s products in industry and non-industry publications alike. This effort has resulted in significant coverage as we launched the Chat 50, including product reviews in PC Magazine (the Chat 50 also won PC Magazine’s Editors’ Choice Award), Popular Science, BusinessWeek, VAR Business,USA Today, multiple regional newspapers, multiple online articles, and highlights on radio shows such as Bloomberg Radio’s Bootcamp and Into Tomorrow with Dave Graveline.
 
Trade Shows and Industry Forums
 
We regularly attend industry forums and exhibit our products at trade shows, including:
 
·  
InfoComm - the AV industry’s largest trade show. In June 2005, we launched our new brand with the simultaneous release of our new website, product collateral, and InfoComm booth. We received positive attention for this re-branding effort. In June 2006, we again had a strong presence at InfoComm, where we highlighted a significant number of new products, including our new Converge Pro professional conferencing platform, Chat 50, and Chat 150, MAXAttach IP and MAX IP, and the Tabletop Controller for XAP.
 
·  
National Systems Contractors Association (“NSCA”) - this show focuses on the sound reinforcement industry, and we highlight our professional conferencing products.
 
In addition, there are multiple regional and international shows that we attend along with our channel partners. These shows provide exposure for ClearOne’s brand and products to the wide audience of show attendees.
 

 
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Customers
 
We do not believe that any end-user accounted for more than 10 percent of our total revenue during fiscal 2006, 2005, or 2004. In fiscal 2006, product segment revenues included sales to three distributors that represented approximately 56.2 percent of the segment’s revenues. (For additional financial information about our segments or geographic areas, see Note 13 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. 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, 2006, our shipped orders on which we had not recognized revenues were $5.9 million and our backlog of unshipped orders was $382,000.
 
Competition
 
The conferencing products market is characterized by intense competition and rapidly evolving technology. We compete with businesses having substantially greater financial, research and product development, manufacturing, marketing, and other resources. If we are not able to continually design, manufacture, and successfully market 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, gross profit margins, profits, and market share, each of which could have a materially adverse effect on our business.
 
Our competitors vary 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.
 
We believe the principal factors driving sales are channel partnerships; marketing efforts; sales programs; 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 and sound reinforcement markets, our main competitors include Polycom, Biamp Systems, Lectrosonics, Peavey, Shure, and Wide Band Solutions, with several other companies potentially poised to enter the market. 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 uniquely contributed to the professional conferencing space with the introduction of the Audio Perfect (“AP”) product line a number of years ago and continued that tradition with the introduction of the XAP several years later. 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, Aethra, Konftel, LifeSize, Panasonic, and a number of other smaller manufacturers. During the 2005 calendar year, we increased our market share position in the tabletop market to take the number two position worldwide. 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.
 
The new personal conferencing space has seen a number of new entries. Our primary competitors are Polycom, Actiontec, Iogear, mVox, Phoenix, and USRobotics. We believe that our Chat 50 and Chat 150 offer unique and distinct advantages in their superior audio performance and their abilities to connect to multiple devices and to be used in multiple scenarios. The competitive products are primarily USB devices only.
 
Our microphones compete with the products of Audio Technica, Global Media, Harmon Music, Shure, and others. Our conferencing furniture products compete primarily with the products of Accuwood, Comlink, and Video Furniture International.
 

 
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In each of the markets in which we compete, many of our competitors may have access to greater financial, technical, manufacturing, and marketing resources, and as a result they may respond more quickly or effectively to new technologies and changes in customer preferences. No guarantees can be given that we can continue to compete effectively in the markets we serve.
 
Regulatory Environment
 
New regulations regarding the materials used in manufacturing, the process of disposing of electronic equipment, and the efficient use of energy have emerged in the last few years. The first implementations of these regulations have taken place in Europe and have required significant effort from ClearOne to comply. Other countries and U.S. states are currently considering similar regulations, which could require additional resources and effort from ClearOne to comply.
 
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 products 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 design, develop, test and validate them, and re-submitting these re-designed products for multiple country emissions, safety, and telephone line interface compliance testing and approvals. This effort has consumed resources and time on product development, which will continue until the products have been updated. During fiscal 2006, we spent approximately $300,000 or 3.5 percent of our total research and product development expenses on RoHS Directive compliance efforts with additional expenses in operations departments which are necessary to bring these updated products into production.
 
To date, certain of our products have not been re-designed and are therefore not-compliant with these environmental laws and regulations. Accordingly, sales into the European market beginning July 1, 2006 may be negatively impacted and our results of operations could suffer. We anticipate that most of these product re-designs and launches will be completed during the first half of fiscal 2007. Additionally, certain of our products will not be re-designed. Our outsourced manufacturers may hold us responsible for the cost of purchased components that become obsolete as a result of these re-design efforts. To the extent that we cannot manage these potential exposures to our current estimates, our results of operations could be negatively impacted. 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, but also applies to all manufacturers exporting products to the European Union.
 
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 our understanding of 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.
 
The California law regarding efficient use of energy goes into effect in July 2007 and will require re-design of power supplies in order to comply. ClearOne has already begun this effort.
 
Seasonality
 
Our audio conferencing products revenue has historically been strongest during the second and fourth quarters. Our camera product line revenue was 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.
 

 
12


Product Development
 
We are committed to research and product development and view our continued investment in research and product development as a key ingredient to our long-term business success. Our research and product development expenditures were approximately $8.3 million in fiscal 2006, $5.3 million in fiscal 2005, and $4.2 million in fiscal 2004.
 
Our core competencies in research and product 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. We also have in-house expertise in wireless technologies, VoIP, and software and network application development. We 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 also have an agreement with an offshore manufacturer for the manufacture of other product lines. We manufactured our furniture product line in our manufacturing facility located in Champlin, Minnesota until July 28, 2006 at which time we closed the manufacturing facility and outsourced the manufacturing of furniture to two manufacturers.
 
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 definitive 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, and which TPM 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;
·  
RoHS-compliant manufacturing facilities;
·  
Scalability 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 1A.
 

 
13


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 agreements and processes 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 required to assign to us any proprietary information, inventions, or other technology created during the term of their employment with us. However, these precautions may not be sufficient to protect us from misappropriation or infringement of our intellectual property.
 
We currently have several patents that are issued, pending, or applied for 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, Converge, Chat, and others.
 
Employees
 
 
Employees of as
 
June 30, 2006
June 30, 2005
June 30, 2004
Sales, marketing, and
     
customer support
44
45
51
Product development
49
43
41
Operations support
17
20
40
Administration
17
18
29
Conferencing services
-
-
76
OM Video
-
-
27
Total
127
126
264

As of June 30, 2006, we had 127 employees, 123 of whom were employed on a full-time basis, with 44 in sales, marketing, and customer support; 49 in product development; 17 in operations support; and 17 in administration, including finance. Of these employees, 102 were located in our Salt Lake City office, 19 in other U.S. locations, 4 in the United Kingdom and 2 in Asia. None of our employees are subject to a collective bargaining agreement and we believe our relationship with our employees is good. We occasionally hire contractors with specific technology skill sets to meet project timelines.
 
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. (“Burk”). During fiscal 2004, we sold our U.S. audiovisual integration services business to M:Space, Inc. (“M.Space”). During fiscal 2005, we sold our conferencing services segment to Premiere and we sold our Canadian audiovisual integration services business to 6351352 Canada Inc. Each disposition is summarized below and is discussed in detail in the footnotes to the June 30, 2006 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, 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 $1.3 million for fiscal 2006, $187,000 for fiscal 2005, and $93,000 for fiscal 2004.
 

 
14


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.
 
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 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 fiscal 2004.
 
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 together with the $30,000 in related interest income 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 $1.0 million in fiscal 2006 and $17.4 million in fiscal 2005.
 
Sale of OM Video - Canadian Audiovisual Integration Services. On March 4, 2005, we sold all of the issued and outstanding stock of ClearOne Communications of Canada, Inc. (“ClearOne Canada”) to 6351352 Canada Inc. 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 new owners of OM Video had settled an action brought by the former employer of certain of OM Video’s new 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 at the end of fiscal 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 (as collection was not reasonably assured). The Company realized a pre-tax gain on the sale of $350,000 for fiscal 2006 and $295,000 for fiscal 2005. Through December 31, 2005, all payments had been received and $854,000 of the promissory note remained outstanding; however, 6351352 Canada Inc. failed to make any subsequent, required payments under the note receivable until June 30, 2006, when we received a payment of $50,000. The note receivable is in default and we are currently considering our collection options.
 

 
15


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, 2006 consolidated financial statements and related notes.
 
Risks Relating to Our Business
 
We face intense competition in all 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 product 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, gross 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 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 gross profit and results of operations will be adversely affected. Higher inventory levels or stock shortages may also result from difficulties in estimating customer demand.
 
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
 
New regulations regarding the materials used in manufacturing, the process of disposing of electronic equipment, and the efficient use of energy have emerged in the last few years. The first implementations of these regulations have taken place in Europe and have required significant effort from ClearOne to comply. Other countries and U.S. states are currently considering similar regulations, which could require additional resources and effort from ClearOne to comply.
 

 
16


The European Parliament has published 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 products 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 design, develop, test, and validate them, and re-submitting these re-designed products for multiple country emissions, safety, and telephone line interface compliance testing and approvals. This effort has consumed resources and time that would otherwise have been spent on new product development, which will continue until the products have been updated.
 
To date, certain of our products have not been re-designed and are therefore not-compliant with these environmental laws and regulations. Accordingly, sales into the European market beginning July 1, 2006 may be negatively impacted and our results of operations could suffer. We anticipate that most of these product re-designs and launches will be completed during the first half of fiscal 2007. Additionally, certain of our products will not be re-designed. Our outsourced manufacturers may hold us responsible for the cost of purchased components that become obsolete as a result of these re-design efforts. To the extent that we cannot manage these potential exposures to our current estimates, our results of operations could be negatively impacted. 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, but also applies to many manufacturers exporting products to the European Union.
 
The European Parliament has also published 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 our understanding of 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.
 
The California law regarding efficient use of energy goes into effect in July 2007 and will require re-design of power supplies in order to comply. ClearOne has already begun this effort.
 
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 circuitry and 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;
·  
obtaining prototype products at anticipated cost levels;
·  
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, or may be met by unanticipated new competitive products, 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 and results of operations could be negatively 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.
 

 
17


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.
 
Reporting of channel inventory by certain distributors.
 
We defer recognition of revenue from product sales to distributors until the return privilege has expired, which approximates when product is sold-through to customers of our distributors. We evaluate, at each quarter-end, the inventory in the channel through information provided by certain of our distributors. We use this information along with our judgment and estimates to determine the amount of inventory in the entire channel, for all customers and for all inventory items, and the appropriate revenue and cost of goods sold associated with those channel products. We cannot guarantee that the third party data, as reported, or that our assumptions and judgments regarding total channel inventory revenue and cost of goods sold will be accurate.
 
We depend on an outsourced manufacturing strategy.
 
In August 2005, we entered into a manufacturing agreement with a 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 many of our products. We also have an agreement with an offshore manufacturer for the manufacture of other product lines. Additionally, in July 2006, we outsourced the manufacturing of our furniture product lines to two manufacturers. If these manufacturers experience difficulties in obtaining sufficient supplies of components, component prices significantly exceed anticipated costs, an interruption in their operations, or otherwise suffer capacity constraints, we would experience a delay in shipping these products which would have a negative impact on our revenues. Should there be any disruption in services due to natural disaster, economic or political difficulties, quarantines, transportation restrictions, acts of terror, 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. 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. Currently, we have no second source of manufacturing for substantially all of our products.
 
The cost of delivered product from our contract manufacturers is a direct function of their ability to buy components at a competitive price and to realize efficiencies and economies of scale within their overall business structure. If they are unsuccessful in driving efficient cost models, our delivered costs could rise, affecting our profitability and ability to compete. In addition, if the contract manufacturers are unable to achieve greater operational efficiencies, delivery schedules for new product development and current product delivery could be negatively impacted.
 
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.
 

 
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, patents pending, 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 the resulting 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 28.5 percent of our total product sales from continuing operations for fiscal 2006, 25.9 percent for fiscal 2005, and 22.7 percent for fiscal 2004. 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;
·  
unique environmental regulations;
·  
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, transportation, or other restrictions associated with infectious diseases.

Our revenues in the international market are generally 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. generally accepted accounting principles (“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 do not undertake hedging activities that protect us against such risks.
 

 
19


We may not be able to hire and retain qualified key and highly-skilled technical employees, which could affect our ability to compete effectively and may cause our revenue and profitability to decline.
 
We depend on our ability to hire and retain qualified key and highly-skilled employees to manage, research and develop, market, and service new and existing products. Competition for such key and highly-skilled employees is intense, and we may not be successful in attracting or retaining such personnel. 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. In addition, provisions of the Sarbanes-Oxley Act of 2002 and related rules of the SEC impose heightened personal liability on some of our key employees. The threat of such liability could make it more difficult to identify, hire and retain qualified key and highly-skilled employees. We have relied on our ability to grant stock options as a means of recruiting and retaining key employees. Recent accounting regulations requiring the expensing of stock options will impair our future ability to provide these incentives without incurring associated compensation costs. 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, results of operations, financial position, or liquidity.
 
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.
 
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 position.
 
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 disease and terrorist attacks. 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.
 

 
20


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-gross profit 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;
·  
success in meeting targeted availability dates for new or redesigned products;
·  
the ability to profitably and efficiently manage our supplies of products and key components;
·  
the ability to maintain profitable relationships with our customers;
·  
the ability to maintain an appropriate cost structure;
·  
quarterly variations in our results of operations;
·  
general consumer confidence or general market conditions or market conditions specific to technology industries;
·  
domestic and international economic conditions;
·  
the adoption of the new accounting standard, SFAS No. 123R, “Share-Based Payments,” which requires us to record compensation expense for certain options issued 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.

We have previously identified material weaknesses in our internal controls.
 
Although we have committed considerable resources to date to the reviews and remedies over our disclosure and financial reporting internal controls, it will take time and additional expenditures to completely remediate any material weakness in our internal controls. We are always at risk that any future failure of our own internal controls or the internal control at any of our outsourced manufacturers or service providers could result in additional reported material weaknesses. Any future failures of our internal controls could have a material impact on our market capitalization, results of operations, or financial position, or have other adverse consequences.
 
Our directors and officers own 19.0 percent of the Company and may exert significant influence over us.
 
Our officers and directors together have beneficial ownership of approximately 19.0 percent of our common stock (including options that are currently exercisable or exercisable within 60 days of August 31, 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.
 

 
21


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, 2006
     
Salt Lake City, UT
Company headquarters
39,760
Continuing
October 2006
Salt Lake City, UT
Manufacturing facility
12,000
Previously subleased
October 2006
Champlin, MN
Furniture manufacturing
17,520
Continuing
September 2007
Berkshire,
       
United Kingdom
Sales office
250
Continuing
90 days notice
         
Future Leases
       
Salt Lake City, UT
Company headquarters
36,279
Beginning November 2006
December 2013
         
Terminated Leases, i.e., per contract terms, sale of entity, or through early termination
 
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 product 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 until May 2006, as discussed below. We believe the facility will be reasonably adequate to meet our needs through October 2006; however, we are moving our Company headquarters in late calendar 2006. Additionally, we are pursuing a warehousing location as replacement for our current warehouse at our current company headquarters. 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 paid rent in the amount of $11,040 per month through May 31, 2006 when the 90-day termination clause was exercised.
 
Our conference furniture manufacturing and warehousing operations have been conducted from a facility totaling 17,520 square feet located in Champlin, Minnesota until July 28, 2006, when we closed the manufacturing facility. The lease agreement expires in September 2007. We are currently negotiating an early buyout of the lease.
 
Our wholly owned United Kingdom subsidiary, ClearOne Communications Limited UK, rents an office in Berkshire, 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.
 

 
22


On June 5, 2006, we entered into a new 86-month lease for our principal administrative, sales, marketing, customer support, and research and product development facility which will house our headquarters in Salt Lake City, Utah. Under the terms of the new lease we will occupy a 36,279 square-foot facility which will commence in November 2006. We believe the facility will be adequate to meet our needs for the current fiscal year and beyond.
 
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 August 15, 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 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 that was filed on January 15, 2003 with regard to alleged improper revenue recognition practices and the shareholders’ class action that was filed on June 30, 2003 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.
 

 
23


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 filed on January 15, 2003, the shareholders’ class action filed on June 30, 2003, 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, 2006. 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”).
 
U.S. Attorney’s Investigation. On January 28, 2003, the Company was 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 that was filed on January 15, 2003. 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.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
No matters were submitted to a vote of our security holders during fiscal 2006.
 

 
24


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 their enforcement of a policy to block all non-current public filers and due to our failure to file current public information. On August 28, 2006, the Company’s shares began trading on the Over-the-Counter Bulletin Board under the trading symbol CLRO.OB. 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.
 
   
2006
 
2005
 
   
High
 
Low
 
High
 
Low
 
                   
First Quarter
 
$
4.10
 
$
2.20
 
$
5.70
 
$
3.50
 
Second Quarter
   
2.50
   
1.95
   
4.80
   
3.55
 
Third Quarter
   
3.60
   
2.25
   
4.30
   
3.00
 
Fourth Quarter
   
4.25
   
3.50
   
3.65
   
2.25
 

On August 31, 2006, the high and low sales prices for our common stock on the Over-the-Counter Bulletin Board were $3.35 and $3.10, respectively.
 
Shareholders
 
As of August 31, 2006, there were 12,184,727 shares of our common stock issued and outstanding and held by approximately 604 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, product development, and our stock buy-back program.
 
Securities Authorized for Issuance under Equity Compensation Plans
 
We currently have one equity compensation plan, our 1998 Stock Option Plan (the “1998 Plan”), which provides for the grant of stock options to employees, directors and consultants. As of June 30, 2006, there were 1,237,920 options outstanding under the 1998 Plan with 959,956 options available for grant in the future. During the time the Company failed to remain current in its filing of periodic reports with the SEC, employees, executive officers, and directors were not allowed to exercise options under the 1998 Plan. The Company became current with its required SEC filings on June 28, 2006.
 

 
25


The following table sets forth information as of June 30, 2006 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
1,237,920
$6.12
959,956
Equity compensation
     
plans not approved by
     
security holders
-
-
-
Total
1,237,920
$6.12
959,956
 
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 shareholders’ class action 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, 2006, ClearOne did not purchase any of its equity securities.
 
Stock Buy-Back Program. On August 31, 2006, the Company announced that its Board of Directors had approved a stock buy-back program to purchase up $2,000,000 of the Company’s common stock over the next 12 months on the open market. All repurchased shares will be immediately retired. The stock buy-back program will expire in August 2007.
 
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, 2006, 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 intend to reinstate this program in October 2006, as the Company became current with its required filing of periodic reports with the SEC on June 28, 2006.
 
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, 2006, 2005, 2004, 2003, and 2002. 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.
 

 
26


SELECTED CONSOLIDATED FINANCIAL DATA
(in thousands of dollars, except per share data)
 
   
Years Ended June 30,
 
   
2006
 
2005
 
2004
 
2003
 
2002
 
                       
Operating results:
                     
Revenue
 
$
37,632
 
$
31,645
 
$
27,966
 
$
28,566
 
$
26,253
 
Costs and expenses:
                               
Cost of goods sold
   
19,284
   
14,951
   
16,379
   
18,115
   
13,884
 
Marketing and selling
   
7,866
   
9,070
   
8,497
   
7,070
   
7,010
 
Research and product development
   
8,299
   
5,305
   
4,237
   
3,281
   
3,810
 
General and administrative
   
5,108
   
5,489
   
6,767
   
5,915
   
4,376
 
Settlement in shareholders' class action
   
(1,205
)
 
(2,046
)
 
4,080
   
7,325
   
-
 
Impairment losses
   
-
   
180
   
-
   
5,102
   
7,115
 
Restructuring charge
   
-
   
110
   
-
   
-
   
-
 
Operating loss
   
(1,720
)
 
(1,414
)
 
(11,994
)
 
(18,242
)
 
(9,942
)
Other income (expense), net
   
1,016
   
318
   
(261
)
 
48
   
288
 
Loss from continuing operations before income taxes
   
(704
)
 
(1,096
)
 
(12,255
)
 
(18,194
)
 
(9,654
)
Benefit (provision) for income taxes
   
870
   
3,248
   
736
   
1,352
   
173
 
Income (loss) from continuing operations
   
166
   
2,152
   
(11,519
)
 
(16,842
)
 
(9,481
)
Income (loss) from discontinued operations
   
1,930
   
13,923
   
1,632
   
(19,130
)
 
2,820
 
Net income (loss)
 
$
2,096
 
$
16,075
 
$
(9,887
)
$
(35,972
)
$
(6,661
)
                                 
Earnings (loss) per common share:
                               
Basic earnings (loss) from continuing operations
 
$
0.02
 
$
0.19
 
$
(1.04
)
$
(1.50
)
$
(0.99
)
Diluted earnings (loss) from continuing operations
 
$
0.01
 
$
0.17
 
$
(1.04
)
$
(1.50
)
$
(0.99
)
Basic earnings (loss) from discontinued operations
 
$
0.16
 
$
1.25
 
$
0.15
 
$
(1.71
)
$
0.30
 
Diluted earnings (loss) from discontinued operations
 
$
0.16
 
$
1.13
 
$
0.15
 
$
(1.71
)
$
0.30
 
Basic earnings (loss)
 
$
0.18
 
$
1.44
 
$
(0.89
)
$
(3.21
)
$
(0.69
)
Diluted earnings (loss)
 
$
0.17
 
$
1.30
 
$
(0.89
)
$
(3.21
)
$
(0.69
)
Weighted average shares outstanding:
                               
Basic
   
11,957,756
   
11,177,406
   
11,057,896
   
11,183,339
   
9,588,118
 
Diluted
   
12,206,618
   
12,332,106
   
11,057,896
   
11,183,339
   
9,588,118
 
                                 
 
As of June 30,
     
2006
   
2005
   
2004
   
2003
   
2002
 
                                 
Financial data:
                               
Current assets
 
$
39,589
 
$
34,879
 
$
27,202
 
$
29,365
 
$
52,304
 
Property, plant and equipment, net
   
1,647
   
2,805
   
4,027
   
4,320
   
4,678
 
Total assets
   
41,405
   
38,021
   
32,156
   
35,276
   
63,876
 
Long-term debt, net of current maturities
   
-
   
-
   
240
   
931
   
-
 
Capital leases, net of current maturities
   
-
   
-
   
2
   
9
   
41
 
Total shareholders' equity
   
30,412
   
24,911
   
9,006
   
18,743
   
53,892
 

 

 
27


Quarterly Financial Data (Unaudited)
 
The following table is a summary of unaudited quarterly financial information for the years ended June 30, 2006, 2005 and 2004.
 
   
Fiscal 2006 Quarters Ended
     
   
(in thousands of dollars, except per share data)
     
   
Sept. 30
 
Dec. 31
 
Mar. 31
 
June 30
 
Total
 
Revenue
 
$
9,527
 
$
9,675
 
$
8,700
 
$
9,730
 
$
37,632
 
Cost of goods sold
   
(4,645
)
 
(4,943
)
 
(4,625
)
 
(5,071
)
 
(19,284
)
Marketing and selling
   
(1,812
)
 
(1,810
)
 
(1,920
)
 
(2,324
)
 
(7,866
)
Research and product development
   
(1,799
)
 
(1,778
)
 
(2,201
)
 
(2,521
)
 
(8,299
)
General and administrative
   
(1,771
)
 
(1,457
)
 
(1,060
)
 
(820
)
 
(5,108
)
Settlement in shareholders' class action
   
1,205
   
-
   
-
   
-
   
1,205
 
Other income (expense), net
   
166
   
191
   
237
   
422
   
1,016
 
(Loss) income from continuing operations before income taxes
   
871
   
(122
)
 
(869
)
 
(584
)
 
(704
)
Benefit (provision) for income taxes
   
178
   
109
   
763
   
(180
)
 
870
 
(Loss) income from continuing operations
   
1,049
   
(13
)
 
(106
)
 
(764
)
 
166
 
Income from discontinued operations
   
938
   
94
   
646
   
252
   
1,930
 
Net income
 
$
1,987
 
$
81
 
$
540
 
$
(512
)
$
2,096
 
                                 
Basic income (loss) earnings per common share:
                               
Continuing operations
 
$
0.09
 
$
-
 
$
(0.01
)
$
(0.06
)
$
0.02
 
Discontinued operations
   
0.08
   
0.01
   
0.05
   
0.02
   
0.16
 
Basic income (loss) earnings per common share
 
$
0.18
 
$
0.01
 
$
0.04
 
$
(0.04
)
$
0.18
 
Diluted income (loss) earnings per common share:
                               
Continuing operations
 
$
0.09
 
$
-
 
$
(0.01
)
$
(0.06
)
$
0.01
 
Discontinued operations
   
0.08
   
0.01
   
0.05
   
0.02
   
0.16
 
Diluted income (loss) earnings per common share
 
$
0.16
 
$
0.01
 
$
0.04
 
$
(0.04
)
$
0.17
 

 
   
Fiscal 2005 Quarters Ended
     
   
(in thousands of dollars, except per share data)
     
   
Sept. 30
 
Dec. 31
 
Mar. 31
 
June 30
 
Total
 
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
)
Research and product development
   
(1,105
)
 
(1,282
)
 
(1,423
)
 
(1,495
)
 
(5,305
)
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
 
Impairment losses
   
-
   
-
   
-
   
(180
)
 
(180
)
Restructuring charge
   
-
   
-
   
-
   
(110
)
 
(110
)
Other income (expense), net
   
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
 

 

 
28



 
   
Fiscal 2004 Quarters Ended
     
   
(in thousands of dollars, except per share data)
     
   
Sept. 30
 
Dec. 31
 
Mar. 31
 
June 30
 
Total
 
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
)
Research and product development
   
(925
)
 
(829
)
 
(1,112
)
 
(1,371
)
 
(4,237
)
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
)
Other income (expense), net
   
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
)

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, 2006 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 1A 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 the 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 is product revenue, primarily from product sales to distributors, dealers, and end-users. Product revenue is recognized when (i) the products are shipped and any right of return expires, (ii) persuasive evidence of an arrangement exists, (iii) the price is fixed and determinable, and (iv) collection is reasonably assured.
 

 
29


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) rather than when the product is initially shipped to a distributor. We evaluate, at each quarter-end, the inventory in the channel through information provided by certain of our distributors. The level of inventory in the channel will fluctuate up or down, each quarter, based upon our distributors’ individual operations. Accordingly, each quarter-end revenue deferral is calculated and recorded based upon the underlying, estimated channel inventory at quarter-end. 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.  The amounts of deferred cost of goods sold were included in consigned inventory. The following table details the amount of deferred revenue, cost of goods sold, and gross profit at each quarter end for the 24-month period ended June 30, 2006 (in thousands).
 
   
Deferred Revenue
 
Deferred Cost of Goods Sold
 
Deferred Gross Profit
 
               
June 30, 2006
 
$
5,871
 
$
2,817
 
$
3,054
 
March 31, 2006
   
5,355
   
2,443
   
2,912
 
December 31, 2005
   
4,936
   
2,199
   
2,737
 
September 30, 2005
   
4,848
   
2,373
   
2,475
 
June 30, 2005
   
5,055
   
2,297
   
2,758
 
March 31, 2005
   
5,456
   
2,321
   
3,135
 
December 31, 2004
   
4,742
   
1,765
   
2,977
 
September 30, 2004
   
5,617
   
1,920
   
3,697
 
June 30, 2004
   
6,107
   
2,381
   
3,726
 

We offer rebates and market development funds to certain of our distributors, dealers/resellers, and end-users based upon volume of product purchased by them. 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 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.


 
30


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.
 
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.
 
Impairment of Long-Lived Assets
 
We assess the impairment of long-lived assets, such as property and equipment and definite-lived intangibles subject to amortization, annually or whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset or asset group to estimated future undiscounted net cash flows of the related asset or group of assets over their remaining lives. If the carrying amount of an asset exceeds its estimated future undiscounted cash flows, an impairment charge is recognized for the amount by which the carrying amount exceeds the estimated fair value of the asset. Impairment of long-lived assets is assessed at the lowest levels for which there are identifiable cash flows that are independent of other groups of assets. The impairment of long-lived assets requires judgments and estimates. If circumstances change, such estimates could also change. Assets held for sale are reported at the lower of the carrying amount or fair value, less the estimated costs to sell.
 
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. The reversal of a previously established valuation allowance results in a benefit for income taxes.
 
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.
 

 
31


Share-Based Payment
 
Prior to June 30, 2005 and as permitted under the original Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” we accounted for our share-based payments following the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” as interpreted. Accordingly, no share-based compensation expense had been reflected in our statements of operations for unmodified option grants since (1) the exercise price equaled the market value of the underlying common stock on the grant date and (2) the related number of shares to be granted upon exercise of the stock option was fixed on the grant date.
 
In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, “Share-Based Payment.” SFAS No. 123R is a revision of SFAS No. 123. SFAS No. 123R establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. Primarily, SFAS No. 123R focuses on accounting for transactions in which an entity obtains employee services in share-based payment transactions. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments.
 
Under SFAS No. 123R, we measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the awards - the requisite service period (usually the vesting period). No compensation cost is recognized for equity instruments for which employees do not render the requisite service. Therefore, if an employee does not ultimately render the requisite service, the costs associated with the unvested options will not be recognized, cumulatively.
 
Effective July 1, 2005, we adopted SFAS No. 123R and its fair value recognition provisions using the modified prospective transition method. Under this transition method, stock-based compensation cost recognized after July 1, 2005 includes the straight-line basis compensation cost for (a) all share-based payments granted prior to July 1, 2005, but not yet vested, based on the grant date fair values used for the pro-forma disclosures under the original SFAS No. 123 and (b) all share-based payments granted or modified on or after July 1, 2005, in accordance with the provisions of SFAS No. 123R.
 
Under SFAS No. 123R, we recognize compensation cost net of an anticipated forfeiture rate and recognize the associated compensation cost for those awards expected to vest on a straight-line basis over the requisite service period. We use judgment in determining the fair value of the share-based payments on the date of grant using an option-pricing model with assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the risk-free interest rate of the awards, the expected life of the awards, the expected volatility over the term of the awards, the expected dividends of the awards, and an estimate of the amount of awards that are expected to be forfeited. If assumptions change in the application of SFAS No. 123R in future periods, the stock-based compensation cost ultimately recorded under SFAS No. 123R may differ significantly from what was recorded in the current period.
 
SEASONALITY
 
Our audio conferencing products revenue has historically been strongest during our second and fourth quarters. Our camera product line revenue was 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.
 
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.
 

 
32


DISCUSSION OF OPERATIONS
 
Results of Operations
 
The following table sets forth certain items from our consolidated statements of operations (in thousands of dollars) for the fiscal years ended June 30, 2006, 2005, and 2004, together with the percentage of total revenue which each such item represents:

   
Year Ended June 30,
 
   
(in thousands of dollars)
 
   
2006
 
2005
 
2004
 
       
% of
Revenue
     
% of
Revenue
     
% of
Revenue
 
                           
Revenue
 
$
37,632
   
100.0%
 
$
31,645
   
100.0%
 
$
27,966
   
100.0%
 
Cost of goods sold
   
19,284
   
51.2%
 
 
14,951
   
47.2%
 
 
16,379
   
58.6%
 
Gross profit
   
18,348
   
48.8%
 
 
16,694
   
52.8%
 
 
11,587
   
41.4%
 
Operating expenses (benefit):
                                     
Marketing and selling
   
7,866
   
20.9%
 
 
9,070
   
28.7%
 
 
8,497
   
30.4%
 
Research and product development
   
8,299
   
22.1%
 
 
5,305
   
16.8%
 
 
4,237
   
15.2%
 
General and administrative
   
5,108
   
13.6%
 
 
5,489
   
17.3%
 
 
6,767
   
24.2%
 
Settlement in shareholders' class action
   
(1,205
)
 
-3.2%
 
 
(2,046
)
 
-6.5%
 
 
4,080
   
14.6%
 
Impairment losses
   
-
   
0.0%
 
 
180
   
0.6%
 
 
-
   
0.0%
 
Restructuring charge
   
-
   
0.0%
 
 
110
   
0.3%
 
 
-
   
0.0%
 
Total operating expenses
   
20,068
   
53.3%
 
 
18,108
   
57.2%
 
 
23,581
   
84.3%
 
Operating loss
   
(1,720
)
 
-4.6%
 
 
(1,414
)
 
-4.5%
 
 
(11,994
)
 
-42.9%
 
Other income (expense), net
   
1,016
   
2.7%
 
 
318
   
1.0%
 
 
(261
)
 
-0.9%
 
Loss from continuing operations before income taxes
   
(704
)
 
-1.9%
 
 
(1,096
)
 
-3.5%
 
 
(12,255
)
 
-43.8%
 
Benefit for income taxes
   
870
   
2.3%
 
 
3,248
   
10.3%
 
 
736
   
2.6%
 
Income (loss) from continuing operations
   
166
   
0.4%
 
 
2,152
   
6.8%
 
 
(11,519
)
 
-41.2%
 
Income from discontinued operations, net of tax
   
1,930
   
5.1%
 
 
13,923
   
44.0%
 
 
1,632
   
5.8%
 
Net income (loss)
 
$
2,096
   
5.6%
 
$
16,075
   
50.8%
 
$
(9,887
)
 
-35.4%
 

Our revenue increased 34.6 percent over the three-year period from $28.0 million in fiscal 2004 to $37.6 million in fiscal 2006. During the fiscal year ended June 30, 2006, we introduced several new products, including the Converge™ 560/590 and Tabletop Controller for XAP in our professional conferencing product line and the expansion of our MAX tabletop audio conferencing products with the Max IP and MaxAttach IP. During the fiscal year ended June 30, 2005, we introduced several new products, including the RAV in our premium conferencing product line and the expansion of our MAX® tabletop audio conferencing product line with the MaxAttach. During the fiscal year ended June 30, 2004, we introduced several new products, including the XAP Net Control Interface in our professional conferencing product line, the AccuMic PC for Personal Computers in our personal conferencing product line, the Max Wireless and Max EX in our tabletop conferencing product line, the Ceiling DocCam II in our camera product line, and the Titan Plasma Cart in our furniture product line. For the fiscal year ended June 30, 2006 our settlement in shareholders’ class action expense (benefit) decreased $841,000 from the same period in fiscal 2005 due to a quarterly mark-to-market adjustment of the liability associated with our December 2003 settlement agreement, while research and development expense for the fiscal year ended June 30, 2006 increased primarily due to salaries and benefit-related costs, including compensation cost related to SFAS No. 123R, over the same period in fiscal 2005. Our marketing and selling costs decreased during the fiscal year ended June 30, 2006 over the same period in fiscal 2005 primarily due to the cost savings associated with reduced other marketing expenses and the closing of our Germany sales office. Our loss from continuing operations before income taxes decreased approximately $392,000 for the fiscal year ended June 30, 2006 over the same period in fiscal 2005.
 
The following is a discussion of our results of operations for our fiscal years ended June 30, 2006, 2005, and 2004. All items are discussed on a consolidated basis. 
 

 
33


Fiscal Year Ended June 30, 2006 (“Fiscal 2006”)
Compared to Fiscal Year Ended June 30, 2005 (“Fiscal 2005”)
 
Revenue
 
Our revenues were $37.6 million for the fiscal year ended June 30, 2006 compared to revenues of $31.6 million for the fiscal year ended June 30, 2005. Total revenues increased $6.0 million, or 18.9 percent, for fiscal 2006 compared to fiscal 2005. The increase in revenue was mostly due to continued growth in premium and tabletop conferencing products sales of approximately $3.6 million, professional audio conferencing products sales of approximately $2.2 million, and net sales in other product lines of approximately $175,000.
 
We evaluate, at each quarter-end, the inventory in the channel through information provided by certain of our distributors.  The level of inventory in the channel will fluctuate up or down, each quarter, based upon our distributors’ individual operations.  Accordingly, each quarter-end revenue deferral is calculated and recorded based upon the underlying, estimated channel inventory at quarter-end.  During the fiscal years ended June 30, 2006 and 2005, the net change in deferred revenue based on the net movement of inventory in the channel was a net (deferral) of ($816,000) and a net recognition $1.1 million in revenue, respectively. Approximately $700,000 of the net (deferral) during fiscal 2006 related to the Company’s customers affected by the RoHS Directive ordering additional product during the fourth quarter of 2006 in anticipation of an inability to get product after June 30, 2006 until the Company’s product lines become compliant with the RoHS Directive.
 
The following table indicates the number of individual unit shipments to our distributors for certain of our product lines for the fiscal years ended June 30, 2006 and 2005. Due to our current revenue recognition policy, the figures do not tie directly to recognized revenues because revenues are recognized when the return rights lapse rather than at the time of shipment.
 
 
Year Ended June 30,
 
(by individual unit)
 
2006
2005
Professional audio conferencing
13,212
10,786
Premium and tabletop conferencing
25,283
11,782

Total revenues from sales outside of the United States accounted for 28.5 percent of total revenue for fiscal 2006 and 25.9 percent of total revenue for fiscal 2005.
 
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, property and equipment depreciation, warranty expense, freight expense, royalty payments, and the allocation of overhead expenses.
 
The following table shows our COGS and gross profit together with each item’s amount as a percentage of total revenue:
 
   
Year Ended June 30,
 
   
(in thousands of dollars)
 
   
2006
 
2005
 
       
% of
Revenue
     
% of
Revenue
 
                   
Cost of goods sold
 
$
19,284
   
51.2%
 
$
14,951
   
47.2%
 
                           
Gross profit
 
$
18,348
   
48.8%
 
$
16,694
   
52.8%
 

 
34


COGS increased by approximately $4.3 million, or 29.0 percent, to $19.3 million for the fiscal year ended June 30, 2006 compared with $15.0 million for the fiscal year ended June 30, 2005. The increase in COGS from fiscal 2005 to fiscal 2006 was primarily attributable to the mix and magnitude of the $6.0 million or 18.9 percent increase in total revenue partially offset by an incremental deferral of $604,000 more during fiscal 2006 versus fiscal 2005 in the deferred COGS where return rights had not lapsed. We had a $431,000 increase in our write-off of product inventory.
 
COGS for the fiscal years ended June 30, 2006 and 2005, includes $520,000 and ($84,000) in net increases (decreases) related to the deferral of product revenue from the respective deferral at June 30, 2005 and 2004 because return rights had not lapsed. Approximately $300,000 of the net increase during 2006 related to the Company’s customers affected by the RoHS Directive ordering additional product during the fourth quarter of 2006 in anticipation of an inability to get product after June 30, 2006 until the Company’s product lines become compliant with the RoHS Directive.
 
Our gross profit from continuing operations was $18.3 million, or 48.8 percent of revenue, for the fiscal year ended June 30, 2006 compared to $16.7 million, or 52.8 percent of revenue, for the fiscal year ended June 30, 2005. The increase in gross profit of $1.7 million, or 9.9 percent, is mostly due to the $6.0 million, or 18.9 percent, increase in revenue mix from sales of premium and tabletop conferencing products and professional conferencing products partially offset by the change in deferred gross profit where return rights had not lapsed. Deferred gross profit changed from a net increase in recognized gross profit of $968,000 during fiscal 2005 compared to a net (reduction) in recognized gross profit of ($296,000) during fiscal 2006. The change in gross profit was also negatively impacted by reduced prices on certain end-of-life products and the $431,000 increase in product inventory write-offs. During the past eight quarters, the gross profit percentage has ranged from a high of 55.8 percent in the three months ended June 30, 2005 to a low of 43.7 percent for the three months ended September 30, 2004. We believe quarterly fluctuations will continue to occur based upon actual product mix.
 
Operating Expenses
 
Our operating expenses were $20.1 million for the fiscal year ended June 30, 2006, an increase of $2.0 million, or 10.8 percent, from $18.1 million for the fiscal year ended June 30, 2005. The increase in operating expenses is primarily related to increased research and product development expenses, the reduced benefit related to the settlement in the shareholders’ class action, and the introduction of compensation cost related to SFAS No. 123R, partially offset by decreased spending in marketing and selling. The following is a more detailed discussion of expenses related to marketing and selling, research and product development, general and administrative, and settlement in shareholders’ class action.
 
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 decreased $1.2 million, or 13.3 percent, to $7.9 million for the fiscal year ended June 30, 2006 compared with the fiscal year ended June 30, 2005 expenses of $9.1 million. As a percentage of revenues, marketing and selling expenses were 20.9 percent for fiscal 2006 and 28.7 percent for fiscal 2005. The decrease in marketing and selling expenses from fiscal 2005 to fiscal 2006 was primarily attributable to a decrease of approximately $820,000 of other marketing and selling expenses and a decrease in our international sales offices of approximately $580,000 partially offset by an increase in employee related expenses of $100,000 and the addition of SFAS No. 123R compensation cost of $99,000.
 
Research and product development expenses. Research and product development expenses include research and development, product management, 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 $3.0 million, or 56.4 percent, to $8.3 million for the fiscal year ended June 30, 2006 compared with the fiscal year ended June 30, 2005 expenses of $5.3 million. As a percentage of revenues, research and product development expenses were 22.1 percent for fiscal 2006 and 16.8 percent for fiscal 2005. The increase in product development expenses from the levels for fiscal 2005 to the levels for fiscal 2006 was due to ongoing research and product development efforts, expenditures related to bringing the Company’s product offerings into compliance with the RoHS Directive, and the addition of SFAS No. 123R compensation cost of $203,000.
 

 
35


General and administrative expenses. 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 $381,000, or 6.9 percent, to $5.1 million for the fiscal year ended June 30, 2006 compared with the fiscal year ended June 30, 2005 expenses of $5.5 million. As a percentage of revenues, G&A expenses were 13.6 percent for fiscal 2006 and 17.3 percent for fiscal 2005. A summary of our general and administrative expenses are as follows:
 
   
Year Ended June 30,
 
   
(in thousands of dollars)
 
   
2006
 
2005
 
           
Total G&A before discontinued operations
 
$
5,108
 
$
5,742
 
OM Video G&A
   
-
   
(253
)
Total G&A from continuing operations
 
$
5,108
 
$
5,489
 
               
Professional fees (SEC investigation and subsequent litigation)
 
$
493
 
$
997
 
Professional fees (Other)
   
1,797
   
1,993
 
Compensation cost related to SFAS No. 123R
   
756
   
-
 
Severance payments to executives
   
93
   
-
 
Other general and administrative expense
   
1,969
   
2,499
 
Total G&A from continuing operations
 
$
5,108
 
$
5,489
 

We attribute the decrease in G&A as a percentage of revenues to 13.6 percent for fiscal 2006 from 17.3 percent for fiscal 2005 mostly due to a $530,000 decrease in other general and administrative expense, a $504,000 decrease in SEC investigation and subsequent litigation related professional fees, and $196,000 decrease in other professional fees, including accounting and audit fees, partially offset by the addition of SFAS No. 123R compensation cost of $756,000 and an increase of $93,000 in severance payments to executives.
 
Settlement in shareholders’ class action expense (benefit). We attribute the decrease in benefit for settlement in shareholders’ class action expense as a percentage of revenue to (3.2) percent for the fiscal year ended June 30, 2006 from (6.5) percent for the fiscal year ended June 30, 2005 to the 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 adjustment of the stock to reflect the current liability amount associated with the 1.2 million shares was based upon the closing price of the Company’s common stock at the end of each quarter through the date the shares were issued on September 29, 2005. Accordingly, we will no longer recognize any expense (benefit) associated with these stock price fluctuations.
 
Operating loss. For the fiscal year ended June 30, 2006, our operating loss increased $306,000, or 21.6 percent, to ($1.7 million) on revenue of $37.6 million, from an operating loss of ($1.4 million) on revenue of $31.6 million for the fiscal year ended June 30, 2005. As discussed above, the factors mostly affecting this increase in operating loss were an increase in research and product development expenses of $3.0 million and a decrease in settlement in shareholders’ class action benefit of $841,000 partially offset by an increase in gross margin profit of $1.7 million, a decrease in marketing and selling expenses of $1.2 million, and a decrease in general and administrative expenses of $381,000. Additionally, the decrease in impairment losses and restructuring charge of $290,000 was related to our decision to outsource our Salt Lake City manufacturing operations during fiscal 2005.
 
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 $1.0 million for the fiscal year ended June 30, 2006, an increase of $698,000, or 219.5 percent, from income of $318,000 for the fiscal year ended June 30, 2005. The increase in other income for fiscal 2006 over the same period in fiscal 2005 was primarily due to an increase in interest income associated with our marketable securities and a decrease in interest expense related to our Oracle system-related note payable.
 

 
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Loss from continuing operations before income taxes. Loss from continuing operations decreased $392,000, or 35.8 percent to ($704,000) for the fiscal year ended June 30, 2006 compared with the fiscal year ended June 30, 2005 loss from continuing operations of ($1.1 million). As a percentage of revenues, loss from continuing operations was (1.9) percent for fiscal 2006 and (3.5) percent for fiscal 2005. We attribute the change in loss from continuing operations to the results of operations described above.
 
Benefit for income taxes. Benefit for income taxes from continuing operations was $870,000 for the fiscal year ended June 30, 2006 and $3.2 million for the fiscal year ended June 30, 2005. The decrease in the benefit is mostly due to the income from discontinued operations during fiscal 2005 being larger than the similar income in fiscal 2006. The Company was able to partially decrease a portion of the valuation allowance against deferred tax assets based upon this income from discontinued operations. Given the Company’s history of consecutive years of losses from continuing operations, we followed the guidance of SFAS No. 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, 2006 and 2005, we have fully reserved against our net deferred tax assets.
 
Income from discontinued operations, net of tax. Income from discontinued operations, net of tax, includes the gain on the sale of our conferencing services business and the funds from the Indemnity Escrow account from Premiere related to the sale of our conferencing services business which was sold on July 1, 2004; income from discontinued operations related to our Canadian audiovisual integration business (“OM Video”); the gain on the March 4, 2005 sale of OM Video; payments on our note receivable related to the sale of OM Video; and payments on our note receivable related to the sale to Burk. The total income from discontinued operations was $1.9 million for the fiscal year ended June 30, 2006, a decrease of $12.0 million or 86.1 percent, from $13.9 million for the fiscal year ended June 30, 2005.
 
We received funds from the Indemnity Escrow account from Premiere, net of tax, of $729,000 for fiscal 2006 while we realized a gain, net of tax, on the sale of $13.4 million for fiscal 2005.
 
We received payments on our OM Video note receivable, net of tax, of $248,000 for fiscal 2006 while OM Video services income, net of tax, was $174,000 for fiscal 2005 and a gain on the sale of OM Video, net of tax, was $227,000 for the same period in fiscal 2005. OM Video audiovisual integration services business revenue was $3.8 million for fiscal 2005.
 
On August 22, 2005 we entered into a Mutual Release and Waiver 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. We realized a gain, net of tax, of $953,000 for fiscal 2006. We received payment on our Burk note receivable, net of tax, of $144,000 for fiscal 2005.
 
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 of dollars)
 
   
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%
 


 
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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.
 
We evaluate, at each quarter-end, the inventory in the channel through information provided by certain of our distributors.  The level of inventory in the channel will fluctuate up or down, each quarter, based upon our distributors’ individual operations.  Accordingly, each quarter-end revenue deferral is calculated and recorded based upon the underlying, estimated channel inventory at quarter-end.  During the fiscal year ended June 30, 2005, the net change in deferred revenue based on the net movement of inventory in the channel was a net recognition of $1.1 million.
 
The following table indicates the number of individual unit shipments to our distributors for certain of our product lines for the fiscal years ended June 30, 2005 and 2004. Due to our current revenue recognition policy, the figures do not tie directly to recognized revenues because revenues are recognized when the return rights lapse rather than at the time of shipment.
 
 
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.
 
Costs of Goods Sold and Gross Profit
 
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, property and equipment depreciation, warranty expense, freight expense, royalty payments, and the allocation of overhead expenses.
 

 
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The following table shows our COGS and gross profit together with each item’s amount as a percentage of total revenue:
 
   
Year Ended June 30,
 
   
(in thousands of dollars)
 
   
2005
 
2004
 
       
% of
Revenue
     
% of
Revenue
 
Cost of goods sold
                 
Product
 
$
14,951
   
47.2%
 
$
16,379