<PAGE> 1
U. S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
(Mark One)
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For quarterly period ended August 31, 1999
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
For the transition period from _____________ to _______________
Commission File Number 0-22182
PATRIOT SCIENTIFIC CORPORATION
(Exact name of small business issuer as specified in its charter)
Delaware 84-1070278
(State or other jurisdiction of (I.R.S. Empl. Ident. No.)
incorporation or organization)
10989 Via Frontera, San Diego, California 92127
(Address of principal executive offices)
(858) 674-5000
(Issuer's telephone number)
Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 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 [ ]
State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date:
Common Stock, $.00001 par value 40,381,120
- ------------------------------- ----------
(Class) (Outstanding at October 9, 1999)
Transitional Small Business Disclosure Format (check one): YES [ ] NO [X]
<PAGE> 2
PATRIOT SCIENTIFIC CORPORATION
INDEX
<TABLE>
<CAPTION>
Page
<S> <C>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Consolidated Balance Sheets as of August 31, 1999 (unaudited)
and May 31, 1999 3
Consolidated Statements of Operations for the three
months ended August 31, 1999 and 1998 (unaudited) 4
Consolidated Statements of Cash Flows for the three months ended
August 31, 1999 and 1998 (unaudited) 5
Notes to Consolidated Financial Statements 6-11
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 12
PART II. OTHER INFORMATION 17
Item 1. Legal Proceedings 17
Item 2. Changes in Securities *
Item 3. Defaults upon Senior Securities *
Item 4. Submission of Matters to a Vote of Security Holders *
Item 5. Other Information *
Item 6. Exhibits and Reports on Form 8-K 17
SIGNATURES 17
</TABLE>
* No information provided due to inapplicability of the item.
2
<PAGE> 3
PART I- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
PATRIOT SCIENTIFIC CORPORATION
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
August 31, May 31,
1999 1999
------------ ------------
(Unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 28,880 $ 35,813
Accounts receivable, net of allowance
of $22,000 for uncollectible accounts 89,637 85,362
Retained receivable due from factor (Note 1) 13,395 --
Inventories (Note 3) 242,231 249,833
Prepaid expenses 107,811 135,198
------------ ------------
Total current assets 481,954 506,206
Property and equipment, net 411,214 448,764
Patents and trademarks, net 169,197 190,057
------------ ------------
$ 1,062,365 $ 1,145,027
============ ============
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities:
Notes payable (Note 4) $ 402,645 $ 355,274
Related party notes payable (Note 4) 175,000 175,000
Accounts payable 1,237,671 1,196,553
Accrued liabilities 151,731 140,083
Accrued past due payroll taxes (Note 1) 305,016 182,996
Capital lease obligations 782 1,355
------------ ------------
Total current liabilities 2,272,845 2,051,261
Contingency (Note 9)
Common stock subject to rescission (Note 5) 191,182 75,000
Stockholders' deficit (Note 6):
Preferred stock, $.00001 par value; 5,000,000 shares
authorized; none outstanding -- --
Common Stock, $.00001 par value; 60,000,000 shares
authorized; issued and outstanding 39,583,915 and 39,563,915 396 396
Additional paid-in capital 23,207,799 22,879,449
Accumulated deficit (24,609,857) (23,861,079)
------------ ------------
Total stockholders' deficit (1,401,662) (981,234)
------------ ------------
$ 1,062,365 $ 1,145,027
============ ============
</TABLE>
See accompanying summary of accounting policies and notes to consolidated
financial statements.
3
<PAGE> 4
Patriot Scientific Corporation
Consolidated Statements of Operations
(Unaudited)
<TABLE>
<CAPTION>
Three months Ended
August 31,
-------------------------------
1999 1998
------------ ------------
<S> <C> <C>
Net sales $ 199,024 $ 605,592
Cost of sales 126,610 379,478
------------ ------------
Gross profit 72,414 226,114
Operating expenses:
Research and development 433,400 701,992
Selling, general and
administrative 345,714 627,771
------------ ------------
779,114 1,329,763
------------ ------------
Operating loss (706,700) (1,103,649)
------------ ------------
Other income (expenses):
Gain on sale of technology 250,000 --
Interest income 98 3,589
Interest expense (26,355) (869)
Non-cash interest expense
related to notes payable
(Notes 4 and 7) (265,821) (147,946)
------------ ------------
(42,078) (145,226)
------------ ------------
Net loss $ (748,778) $ (1,248,875)
============ ============
Basic and diluted loss
per common share $ (0.02) $ (0.03)
============ ============
Weighted average number of
common shares outstanding
during the period (Note 1) 39,575,872 35,830,756
============ ============
</TABLE>
See accompanying summary of accounting policies and notes to consolidated
financial statements.
4
<PAGE> 5
PATRIOT SCIENTIFIC CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
<TABLE>
<CAPTION>
Three Months Ended August 31,
-----------------------------
1999 1998
----------- -----------
<S> <C> <C>
Increase (Decrease) in Cash and Cash Equivalents
Operating activities:
Net loss $ (748,778) $(1,248,875)
Adjustments to reconcile net loss
to cash used in operating activities:
Amortization and depreciation 90,077 104,453
Non-cash interest expense related to
convertible notes -- 147,946
Non-cash interest expense related to warrants 265,821 --
Amortization of debt issuance costs -- 23,000
Non-cash compensation expense -- 225,000
Changes in:
Accounts receivable (17,670) 114,157
Inventories 7,602 43,561
Prepaid and other assets 27,387 (209,011)
Accounts payable and accrued expenses 188,468 519,854
----------- -----------
Net cash used in operating activities (187,093) (279,915)
----------- -----------
Investing activities -
Purchase of property, equipment and patents (31,667) (163,312)
Financing activities:
Proceeds from issuance of short term notes payable 205,000 --
Principal payments on notes payable and
long-term debt (573) (528)
Proceeds from issuance of common stock
and exercise of options 7,400 5,931
----------- -----------
Net cash provided by financing activities 211,827 5,403
----------- -----------
Net decrease in cash and cash equivalents (6,933) (437,824)
Cash and cash equivalents, beginning of period 35,813 602,456
----------- -----------
Cash and cash equivalents, end of period $ 28,880 $ 164,632
=========== ===========
Supplemental Disclosure of Cash Flow Information:
Notes and accrued interest exchanged for
common stock $ 116,182 $ 165,116
Cash payments for interest 1,403 69
Unamortized debt discount 225,355 --
----------- -----------
</TABLE>
See accompanying summary of accounting policies and
notes to consolidated financial statements.
5
<PAGE> 6
PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. BASIS OF PRESENTATION
The consolidated financial statements of Patriot Scientific Corporation ("the
Company") presented herein have been prepared pursuant to the rules of the
Securities and Exchange Commission for quarterly reports on Form 10-QSB and do
not include all of the information and footnotes required by generally accepted
accounting principles. These statements should be read in conjunction with the
Company's audited financial statements and notes thereto for the year ended May
31, 1999.
In the opinion of management, the interim financial statements reflect all
adjustments of a normal recurring nature necessary for a fair statement of the
results for interim periods. Operating results for the three month period are
not necessarily indicative of the results that may be expected for the year.
LOSS PER SHARE
The Company has implemented Standard of Financial Accounting Standards ("SFAS")
No. 128, "Earnings per Share." Under SFAS No. 128, basic loss per share is
calculated as loss available to common stockholders divided by the weighted
average number of common shares outstanding. Diluted loss per share is
calculated as net loss divided by the diluted weighted average number of common
shares. The diluted weighted average number of common shares is calculated using
the treasury stock method for common stock issuable pursuant to outstanding
stock options, common stock warrants, and debt convertible into common stock.
Common stock options and warrants of 1,452,253 and 206,201 and debt convertible
into none and 992,177 common shares of stock were not included in diluted loss
per share for the periods ended August 31, 1999 and 1998, respectively, as the
effect was antidilutive due to the Company recording losses in each of those
periods.
In addition, for the quarter ended August 31, 1998, 2,000,000 shares of common
stock in escrow as of August 31, 1998 were not considered outstanding for
diluted loss per share because theses shares were subject to an earnout
agreement which had not yet been met.
Options and warrants to purchase 2,750,691 shares of common stock at exercise
prices ranging from $0.50 to $2.30 per share were outstanding at August 31, 1999
but were not included in the computation of diluted loss per share because the
exercise prices were greater than the average market price of the common shares.
Options and warrants to purchase 4,654,291 shares of common stock at exercise
prices ranging from $0.585 to $7.50 per share were outstanding at August 31,
1998 but were not included in the computation of diluted loss per share because
the exercise prices were greater than the average market price of the common
shares.
SALE OF ACCOUNTS RECEIVABLE
The Company has adopted SFAS No. 125, "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities" ("SFAS 125"). SFAS 125
provides consistent standards for distinguishing transfers of financial assets
that are sales from transfers that are secured borrowings. A factoring line
established by the Company with a bank enables the Company to sell selected
accounts receivable invoices to the bank with full recourse against the Company.
These transactions qualify for a sale of assets since (1) the Company has
transferred all of its right, title and interest in the selected accounts
receivable invoices to the bank, (2) the bank may pledge, sell or transfer the
selected accounts receivable invoices, and (3) the Company has no effective
control over the selected accounts receivable invoices since it may not redeem
the invoices sold previous to the invoices being greater than 90 days past due.
Under SFAS 125, after a transfer of financial assets, an entity recognizes the
financial and servicing assets it controls and the liabilities it has incurred,
derecognizes financial assets when control has been surrendered, and
derecognizes liabilities when extinguished. During the first quarter of fiscal
2000, the Company sold approximately $119,000 of its accounts receivable to a
bank under a factoring agreement for approximately $95,000. Pursuant to the
provisions of SFAS 125, the Company reflected the transactions as sales of
assets and established an accounts receivable from the bank for the retained
amount less the costs of the transaction and less any anticipated future loss in
6
<PAGE> 7
PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
the value of the retained asset. The retained amount is equal to 20% of the
total accounts receivable invoice sold to the bank less 1% of the total invoice
as an administrative fee and 1.75% per month of the total outstanding accounts
receivable invoices as a finance fee. The estimated future loss reserve for each
receivable included in the estimated value of the retained asset is based on the
payment history of the accounts receivable customer. As of August 31, 1999, the
retained amount less the liability for fees and anticipated losses was $13,395.
MANAGEMENT'S PLAN
At August 31, 1999, the Company had a working capital deficit of $1,790,891,
cash and cash equivalents of $28,880, and was delinquent to the Internal Revenue
Service for approximately $264,000 and various states for $41,000 in past due
payroll taxes. The Company has funded its operations primarily through the
issuance of securities and debt financings.
The Company's current cash requirements to sustain its operations for the next
twelve months are estimated to be $1,600,000. The Company expects that these
requirements will be provided by:
Internally:
- - sales of accounts receivables under a factoring agreement established with
its bank, and
- - sales of licenses and/or intellectual property, and
Externally:
- - previous to the receipt of funds from draws under the investment agreement
as discussed in Note 8 or during periods in which draw limitations restrict
the amount of funds available under the investment agreement, short-term
debt instruments with individual and institutional investors, and
- - during periods in which draws under the investment agreement support the
Company's cash requirements, draws against the investment agreement.
If the Company does not receive the initial draw against the investment
agreement by the end of October 1999, then debt financings will be necessary to
continue to meet its cash requirements. The puts under the investment agreement
are subject to common stock trading volume limitations and registration of the
securities. The registration statement went effective October 5, 1999. The
Company anticipates the initial put under the investment agreement will take
place during October 1999.
Previously, the Company had anticipated receiving funds from a kiosk order that
the Company's customer had with the Mexican Department of Tourism. On several
occasions product shipments had been rescheduled pending the receipt of those
funds. The Company's customer has notified it that the kiosks will no longer be
purchased by the Mexican Department of Tourism and that the customer is trying
to find an alternative purchaser. There can be no assurance that an alternative
purchaser for the kiosks can be found by the Company's customer.
The Company anticipates that it may require additional equipment, fabrication,
components and supplies during the next twelve months to continue development of
its technologies. Product introductions such as those currently underway for
communication products and the PSC1000 may require significant inventory,
product launch, marketing personnel and other expenditures that the Company can
not currently estimate. Further, if expanded development is commenced or new
generations of microprocessors are accelerated beyond the Company's current
plans, additional expenditures, that it can not currently estimate, may be
required. It is possible therefore, that higher levels of expenditures may be
required than are currently contemplated resulting from changes in development
plans or as required to support new developments or commercialization activities
or otherwise.
There can be no assurance that any funds required during the next twelve months
or thereafter can be generated from operations or, if such required funds are
not internally generated, that funds will be available from external sources
7
<PAGE> 8
PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
such as debt or equity financings or other potential sources. The lack of
additional capital could force the Company to substantially curtail or cease
operations and would, therefore, have a material adverse effect on its business.
Further, there can be no assurance that any such required funds, if available,
will be available on attractive terms or that they will not have a significantly
dilutive effect on the Company's existing shareholders.
2. RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board (the "FASB") issued SFAS
No. 133, "Accounting for Derivative Instruments and Hedging Activities" which
requires companies to record derivatives on the balance sheet as assets or
liabilities, measured at fair market value. Gains or losses resulting from
changes in the values of those derivatives would be accounted for depending on
the use of the derivative and whether it qualifies for hedge accounting. The key
criterion for hedge accounting is that the hedging relationship must be highly
effective in achieving offsetting changes in fair value or cash flows. SFAS No.
133 is effective for fiscal periods beginning after June 15, 2000. Management
believes the adoption of this statement will have no material impact on the
Company's financial statements.
3. INVENTORIES
Inventories are stated at cost (determined primarily by the weighted average
cost method which approximates cost on a first-in, first-out basis) not in
excess of market value.
Inventories at August 31, 1999 and May 31, 1999, consist of the following:
<TABLE>
<CAPTION>
August 31, 1999 May 31, 1999
--------------- ------------
<S> <C> <C>
Component parts $ 443,949 $ 449,582
Work in process 93,262 93,262
Finished goods 121,020 122,989
--------- ---------
658,231 665,833
Reserve for obsolescence (416,000) (416,000)
--------- ---------
$ 242,231 $ 249,833
========= =========
</TABLE>
4. NOTES PAYABLE
As of August 31, 1999, the Company has short term loans aggregating $803,000
with a group of individual investors, one of which is a major shareholder in the
Company. Of this amount, $205,000 was issued during the first fiscal quarter of
2000. The original terms of the loans are typically for four months with
interest rates of 10% and maturity dates ranging from September 8, 1999 to
January 15, 2000.
In addition to the interest accruing on the loans, warrants exercisable for
three years, for an aggregate of 3,178,122 common shares of the Company were
issued to investors at exercise prices ranging from $.25 to $.50 which was equal
to the market price of the common stock on the date of the issuances. During the
three months ended August 31, 1999, warrants to purchase 538,342 common shares
of the Company were issued related to the $205,000 short term loans placed
during the first quarter and warrants to purchase 961,318 common shares of the
Company were issued to the individual investors to extend the due dates of their
short term loans. These warrants were valued using the Black-Scholes model and a
value of $596,176 was reflected as a discount to the debt and is being amortized
over the life of the debt. In the first fiscal quarter of 2000, $265,821 of the
debt discount has been amortized and reflected as non-cash interest expense. The
short term notes have been discounted to reflect the valuation of the warrants
as follows:
8
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PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
<TABLE>
<CAPTION>
Interest
Amount Rate Due Dates
-------- -------- --------------------
<S> <C> <C> <C>
Notes due to a related party $175,000 10% October 22, 1999 to
January 15, 2000
Notes due to individuals 628,000 10% September 8, 1999 to
December 30, 1999
--------
803,000
Less unamortized debt discount
related to valuation of warrants 225,355
--------
$577,645
========
</TABLE>
5. COMMON STOCK SUBJECT TO RECISION
In April 1999, the Company sold 400,000 shares of its common stock to two
individuals for an aggregated amount of $75,000 and in June 1999, the Company
issued 397,205 shares of its common stock to an institutional investor upon the
conversion of a short term note plus accrued interest in the amount of $116,182.
These sales occurred after the filing of a registration statement for the public
resale of shares sold under the investment agreement; and, therefore, the
Company may have violated Section 5 of the Securities Act of 1933 as described
in Note 8. As the shares may have been sold in violation of Section 5, the
investors, at their option, may have the right, for a one year period after the
purchase of the common stock, to rescind their purchases of common stock.
Therefore, at August 31, 1999, these shares of common stock are reported
separately from stockholders' deficit in the accompanying consolidated balance
sheet. At the conclusion of the recision period, these shares will be
reclassified to stockholders' equity (deficit).
6. STOCKHOLDERS' EQUITY
The following table summarizes equity transactions during the three months ended
August 31, 1999:
<TABLE>
<CAPTION>
Common
Shares Dollars
----------- -----------
<S> <C> <C>
Balance June 1, 1999 39,563,915 $22,879,845
Exercise of stock options 20,000 7,400
Non-cash interest expense related to issuances of warrants
recorded to additional paid-in capital (Note 4) -- 320,950
----------- -----------
Balance August 31, 1999 39,583,915 $23,208,195
=========== ===========
</TABLE>
A total of 5,000,000 shares of the Company's common stock was issued as a
contingent cost of the Company's acquisition of its ShBoom technology in 1994.
As such, when the escrowed shares were earned, they were charged to compensation
costs. The terms of the escrow arrangement provided for an earnout formula of
500,000 shares for each $500,000 of revenues earned by the Company during the
period from June 1, 1994 through May 31, 1999. At May 31, 1999, 1,500,000
contingent shares not earned were returned to the Company and canceled.
During the quarter ended August 31, 1998, 500,000 shares were earned as a result
of the arrangement and $225,000 was charged to compensation costs in that
quarter. At August 31, 1999, 1,500,000 additional shares remain in escrow that
have been earned and charged to compensation costs but have not been released
pending the outcome of a lawsuit between the Company, nanoTronics and the Fish
Family Trust as discussed in Note 9. On the resolution of the lawsuit, the
remaining shares held in escrow will either be released to the Falk Family
Trust, used either partially or in their entirety as a means of settling the
lawsuit, or be returned to the Company.
At August 31, 1999, the Company had 165,000 options outstanding pursuant to its
1992 ISO Stock Option Plan exercisable at prices ranging from $0.50 to $2.30 per
share expiring beginning 2000 through 2001. The Company had
9
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PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
481,753 options outstanding pursuant to its 1992 NSO Stock Option Plan
exercisable at prices ranging from $0.18 to $2.28 per share expiring beginning
2000 through 2002. The Company also had 3,025,691 options outstanding pursuant
to its 1996 Stock Option Plan exercisable at $0.36 to $2.30 per share expiring
beginning in 1999 through 2004. Some of the options outstanding under these
plans are not presently exercisable and are subject to meeting vesting criteria.
At August 31, 1999, the Company had warrants outstanding exercisable into
3,640,722 common shares at exercise prices ranging from $0.25 to $1.25 per share
expiring beginning in 2000 through 2004.
7. 5% CONVERTIBLE TERM DEBENTURES
In 1997, the Company issued to a limited number of investors for cash an
aggregate of $3,000,000 of unsecured 5% Convertible Term Debentures
("Debentures") and Stock Purchase Warrants ("Warrants") with a right to purchase
an aggregate 917,600 shares of common stock, par value $.00001 per share, at
exercise prices ranging initially from $1.50 to $1.69125 per share which were
subsequently reduced to from $0.36 to $0.4375 per share.
As of May 31, 1999, the Debentures had been fully converted into 6,069,345
common shares of the Company. In addition, as of May 31, 1999, the investors had
exercised warrants to purchase 555,000 common shares of the Company.
Convertible debt instruments which were convertible at a discount to market were
accounted for by treating such discount as additional interest expense. The
Company computed the amount of the discount based on the difference between the
conversion price and fair value of the underlying common stock on the dates the
Debentures were issued. During the quarter ended August 31, 1999, $147,946 was
expensed under the caption "Non-cash interest expense."
8. INVESTMENT AGREEMENT
In February 1999, the Company entered into an investment agreement with Swartz
Private Equity LLC ("Swartz"). The investment agreement entitles the Company, at
the Company's option, to issue and sell its common stock for up to an aggregate
of $5 million from time to time during a three-year period through February 24,
2002, subject to certain conditions including (1) an effective registration
statement must be on file with the SEC registering the resale of the common
shares, and (2) a limitation on the number of common shares which can be sold to
Swartz within a 30 day time period based on the trading volume of the stock,
among others. Swartz may purchase the common stock from the Company at a
discount ranging from 10% to 20% depending on the price of the common stock. In
addition to the common stock purchased, Swartz will receive warrants to purchase
an additional 15% of the common stock equal to 110% of the market price on the
last day of the purchasing period, subject to further semi-annual adjustments if
the price of the common stock goes down.
In July 1999, the Company amended and restated the investment agreement with
Swartz to eliminate the discretion of Swartz as to the timing of its purchase of
the Company's common stock. The amended and restated investment agreement
requires Swartz, after the Company puts shares of common stock to it, to
purchase the Company's common stock on the twentieth day following the put. The
previous agreement enabled Swartz, in its sole discretion, to purchase the
Company's common stock at any time during a twenty day period following the
Company's put to it.
The registration statement went effective on October 5, 1999 and the Company
anticipates to initiate puts against the investment agreement during October
1999.
In April 1999, the Company sold shares of common stock to two individuals in the
accumulated amount of $75,000 and in June 1999 the Company issued shares to an
institutional investor upon conversion of a short term note in the amount of
$116,182. These sales occurred after the filing of a registration statement by
the Company and, therefore, by making these sales the Company may have violated
Section 5 of the Securities Act of 1933. In July 1999, the Company amended and
restated the investment agreement with Swartz to eliminate the discretion of
Swartz as to the timing of its purchase of the Company's common stock. By
entering into the amended and restated investment
10
<PAGE> 11
PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
agreement, the Company completed its sale of common stock to Swartz. Since this
private sale to Swartz occurred after the Company filed its registration
statement, the Company may have sold securities to Swartz in violation of
Section 5 of the Securities Act of 1933, and each placement of shares with
Swartz in the future under the investment agreement may be a separate violation
of Section 5. Consequently, the two individual investors, the institutional
investor and Swartz may have the right to rescind these purchases of common
stock for a one year period after the purchase of the common stock. In addition,
the Company and certain officers and directors of the Company may be subject to
civil and criminal penalties for potential violation of either or both Section 5
of the Securities Act of 1933 and applicable state law as a result of these
sales. Management believes that the possibility of damages related to these
potential violations of Section 5 of the Securities Act of 1933 is remote and
that such potential violations will have no material impact on the Company's
financial statements. See Note 5 for further discussion.
9. CONTINGENCY
In October 1998, the Company was sued in the District Court for Travis County,
Texas by the Fish Family Trust, a co-inventor of the original ShBoom technology.
The suit also named as defendants nanoTronics and Gloria Felcyn on behalf of the
Falk Trust. The suit sought a judgment for damages, a rescission of the
Technology Transfer Agreement and a restoration of the technology to the
co-inventor. The Company had the suit removed to the United States District
Court for the Western District of Texas, Austin Division, and requested the
Federal District Court to dismiss the suit based on lack of minimum contacts
with Texas or, in the alternative, to transfer the case to the Southern District
of California. In January 1999, the Federal District Court dismissed the suit
for lack of subject matter and personal jurisdiction. The Fish Family Trust then
refiled the suit in the Superior Court of San Diego County, California seeking
remedies similar to the Federal District Court dismissed action. In March 1999,
the Company joined with nanoTronics and Gloria Felcyn and filed its response and
cross-complaint against the Fish Family Trust. The suit is scheduled for trial
in December 1999. The Company and the other defendants intend to vigorously
contest the plaintiff's allegations. It is reasonably possible that the outcome
of these matters may result in a material liability for the Company. Management
does not believe, at this stage of the case, that it is possible to estimate the
outcome of the litigation or a range of reasonably possible losses that might
result from the suit.
11
<PAGE> 12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
THE FOLLOWING DISCUSSION INCLUDES FORWARD-LOOKING STATEMENTS WITH RESPECT TO THE
COMPANY'S FUTURE FINANCIAL PERFORMANCE. ACTUAL RESULTS MAY DIFFER MATERIALLY
FROM THOSE CURRENTLY ANTICIPATED AND FROM HISTORICAL RESULTS DEPENDING UPON A
VARIETY OF FACTORS, INCLUDING THOSE DESCRIBED BELOW UNDER THE SUB-HEADING,
"FUTURE PERFORMANCE AND RISK FACTORS." SEE ALSO THE COMPANY'S ANNUAL REPORT ON
FORM 10-KSB FOR THE YEAR ENDED MAY 31, 1999.
The Company's results of operations have been and may continue to be
subject to significant variations. The results for a particular period may vary
due to a number of factors. These include:
- the overall state of the semiconductor and communications
segments of the economy,
- the development status of and demand for its products,
- economic conditions in its markets,
- the timing of orders,
- the timing of expenditures in anticipation of future sales,
- the mix of products sold by the Company,
- the introduction of new products,
- product enhancements by the Company or its competitors, and
- pricing and other competitive conditions.
RESULTS OF OPERATIONS FOR THE FIRST QUARTERS ENDED AUGUST 31, 1999 AND 1998
Net sales. Total net sales for the first fiscal quarter ended August 31,
1999 decreased 67.1% to $199,024 from $605,592 for the corresponding period of
the previous fiscal year. Of this decrease, $250,000 was due to a reduction in
follow-on shipments for the Company's matured communication products several of
which are approaching the end of their life cycles. Development and sales of new
communications products have not achieved a level to replace the maturing
products. The Company anticipates this trend in communication product revenue to
continue since many of the communication products are approaching the end of
their life cycles and its efforts are being focused on the microprocessor
product line. In addition, during the first fiscal quarter of 1998 the Company
recognized sales of $155,000 related to the non-recurring engineering efforts on
the kiosk application.
Cost of sales. Cost of sales as a percentage of net sales increased to
63.6% in the first fiscal quarter ended August 31, 1999 compared to 62.7% for
the corresponding period of the previous fiscal year.
Research and development expenses decreased 38.3% from $701,992 for the
first fiscal quarter ended August 31, 1998 to $433,400 for the first fiscal
quarter ended August 31, 1999. This decrease was due primarily to a reduction in
costs related to porting an operating system to the PSC1000 microprocessor and a
reduction in licensed software support and update fees.
Selling, general and administrative expenses decreased 44.9% to $345,714
for the first fiscal quarter ended August 31, 1999 compared to $627,771 for the
first fiscal quarter ended August 31, 1998. This decrease was due primarily to
no compensation costs related to the earnout from escrowed shares during the
first fiscal quarter ended August 31, 1999 compared to compensation costs of
$225,000 for the corresponding period of the previous fiscal year, a reduction
in personnel costs for the first quarter ended August 31, 1999 and a reduction
in expenses related to financings.
Other income (expense) decreased by 71.1% to ($42,078) for the first
fiscal quarter ended August 31, 1999 compared to ($145,226) for the
corresponding period of the previous fiscal year. This decrease resulted
primarily from the sale of its gas plasma antenna technology for $250,000 during
the first fiscal quarter ended August 31, 1999 offset by the recognition in the
first fiscal quarter ended August 31, 1999 of $265,821 of non-cash interest
related to
12
<PAGE> 13
the amortization of the debt discount as discussed in Note 4 compared to
$147,946 of non-cash interest related to the discount on convertible term
debentures for the corresponding period of the previous fiscal year.
LIQUIDITY AND CAPITAL RESOURCES
At August 31, 1999, the Company had a working capital deficit of
$1,790,891, cash and cash equivalents of $28,880, and was delinquent to the
Internal Revenue Service for approximately $264,000 and various states for
$41,000 in past due payroll taxes. The Company has funded its operations
primarily through the issuance of securities and debt financings. Cash and cash
equivalents decreased $6,933 during the first fiscal quarter of 2000. The net
cash used in operating activities was $187,093, additions to property and
equipment were $31,667, and funds generated from debt and equity financings were
$211,827. During the first fiscal quarter of 2000, accounts receivable increased
$17,670. Accounts payable and accrued expenses increased $188,468 as a result of
a slow down in payments due to the cash and cash equivalent reduction.
The Company's current cash requirements to sustain its operations for
the next twelve months through August 2000 are estimated to be $1,600,000.
Management of the Company expects that these requirements will be provided by:
Internally:
- - sales of accounts receivables under a factoring agreement established with
its bank, and
- - sales of licenses and/or intellectual property, and
Externally:
- - previous to the receipt of funds from draws under the investment agreement
as discussed in Note 8 or during periods in which draw limitations restrict
the amount of funds available under the investment agreement, short-term
debt instruments with individual and institutional investors, and
- - during periods in which draws under the investment agreement support the
Company's cash requirements, draws against the investment agreement.
In February 1999, the Company entered into an investment agreement with
Swartz. The investment agreement entitles the Company, at its option, to issue
and sell its common stock for up to an aggregate of $5 million from time to time
during a three-year period through February 24, 2002, subject to certain
conditions including (1) an effective registration statement must be on file
with the SEC registering the resale of the common shares, and (2) a limitation
on the number of common shares which can be sold to Swartz within a 30 day time
period based on the trading volume of the stock, among other factors. Swartz may
purchase the common stock from the Company at a discount ranging from 10% to 20%
depending on the price of the common stock. In addition to the common stock
purchased, Swartz will receive warrants to purchase an additional 15% of the
common stock equal to 110% of the market price on the last day of the purchasing
period, subject to further semi-annual adjustments if the price of the common
stock goes down. In July 1999, the Company amended and restated the investment
agreement with Swartz to eliminate the discretion of Swartz as to the timing of
its purchase of its common stock. The amended and restated investment agreement
requires Swartz, after the Company put shares of common stock to it, to purchase
its common stock on the twentieth day following the put. The previous agreement
enabled Swartz, in its sole discretion, to purchase the Company's common stock
at any time during a twenty day period following the Company's put to it.
If the Company does not receive the initial draw against the investment
agreement by the end of October 1999, then debt or equity financings will be
necessary to continue to meet its cash requirements. The puts under the
investment agreement are subject to common stock trading volume limitations and
registration of the securities. The registration statement went effective
October 5, 1999 and the Company anticipates to initiate puts against the
investment agreement during October 1999.
Previously, the Company had anticipated to receive funds from a kiosk
order that the Company's customer had with the Mexican Department of Tourism. On
several occasions product shipments had been rescheduled pending the receipt of
those funds. The Company's customer has notified it that the kiosks will no
longer be purchased by the
13
<PAGE> 14
Mexican Department of Tourism and that the customer is trying to find an
alternative purchaser. There can be no assurance that an alternative purchaser
for the kiosks can be found by the Company's customer. The Company is
negotiating with its customer to rescind exclusivity for kiosk sales, thereby
allowing the Company to pursue other sales opportunities for the kiosk product.
In addition, the Company sold the gas plasma antenna technology for an
up-front fee of $250,000 in August 1999, has a $500,000 factoring agreement with
its bank and has renegotiated and extended the scheduled maturity dates for
short-term notes. Management of the Company believes that additional financing
could be obtained if the $5,000,000 financing is not completed. However, no
assurance can be given that it will, in fact, be able to obtain additional
financing or that the terms of such financing will be favorable to the Company.
The Company anticipates that it may require additional equipment,
fabrication, components and supplies during the next twelve months to continue
development of its technologies. Product introductions such as those currently
underway for communication products and the PSC1000 may require significant
inventory, product launch, marketing personnel and other expenditures that the
Company can not currently estimate. Further, if expanded development is
commenced or new generations of microprocessors are accelerated beyond its
current plans, additional expenditures, that the Company can not currently
estimate, may be required. It is possible therefore, that higher levels of
expenditures may be required than the Company currently contemplates resulting
from changes in development plans or as required to support new developments or
commercialization activities or otherwise.
Based on the current fiscal year's rate of cash operating expenditures
and current plans, the Company anticipates a need for additional cash to meet
its requirements for the next twelve months. There can be no assurance that any
funds required during the next twelve months or thereafter can be generated from
operations or, if such required funds are not internally generated, that funds
will be available from external sources such as debt or equity financings or
other potential sources. The lack of additional capital could force the Company
to substantially curtail or cease operations and would, therefore, have a
material adverse effect on its business. Further, there can be no assurance that
any such required funds, if available, will be available on attractive terms or
that they will not have a significantly dilutive effect on its existing
shareholders.
POTENTIAL VIOLATION OF SECTION 5 OF THE SECURITIES ACT
In April 1999, the Company sold shares of common stock to two
individuals in the aggregated amount of $75,000 and in June the Company issued
shares to an institutional investor upon conversion of a short term note in the
amount of $116,182. These sales occurred after the filing of a registration
statement for the public resale of shares sold under the investment agreement;
and, therefore, by making these sales the Company may have violated Section 5 of
the Securities Act. In July 1999, the Company amended and restated the
investment agreement with Swartz to eliminate the discretion of Swartz as to the
timing of its purchase of its common stock. The amended and restated investment
agreement requires Swartz, after the Company puts shares of common stock to it,
to purchase its common stock on the twentieth day following the put. The
previous agreement enabled Swartz, in its sole discretion, to purchase the
Company's common stock at any time during a twenty day period following the
Company's put to it. By entering into the amended and restated investment
agreement, the Company completed its sale of common stock to Swartz. Since this
private sale to Swartz occurred after the Company filed its registration
statement, the Company may have sold securities to Swartz in violation of
Section 5 of the Securities Act and each placement of shares with Swartz in the
future under this investment agreement may be a separate violation of Section 5.
Consequently, the two individual investors, the institutional investor and
Swartz may have the right to rescind these purchases of common stock for one
year after the purchase of the common stock. In addition, Patriot and certain
officers and directors of Patriot may be subject to civil and criminal penalties
for potential violation of either or both Section 5 of the Securities Act and
applicable state law as a result of these sales. Management believes that the
possibility of damages related to these potential violations of the Securities
Act is remote and that such potential violations will have no material impact on
its financial statements. See Note 8 to the Consolidated Financial Statements.
NEW ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivative Instruments and Hedging Activities" which requires companies to
record derivatives on the balance sheet as assets or liabilities, measured at
fair market value. Gains or
14
<PAGE> 15
losses resulting from changes in the values of those derivatives would be
accounted for depending on the use of the derivative and whether it qualifies
for hedge accounting. The key criterion for hedge accounting is that the hedging
relationship must be highly effective in achieving offsetting changes in fair
value or cash flows. SFAS No. 133 is effective for fiscal periods beginning
after June 15, 2000. The Company believes the adoption of this statement will
have no material impact on its financial statements.
YEAR 2000 COMPLIANCE
Many existing computer programs use only two digits to identify a year
in the date field, with the result that data referring to the year 2000 and
subsequent years may be misinterpreted by these programs. If present in the
computer applications of a company or third parties (such as customers,
financial institutions, and suppliers) and not corrected, this problem may cause
computer applications to fail or to create erroneous results and could cause a
disruption in operations and have an adverse effect on a company's business and
results of operations.
The Company has adopted a formal plan to evaluate its readiness for the
Year 2000 and to address any deficiencies. The plan encompasses:
- information technology (IT) systems,
- non-IT systems,
- its products, and
- systems of third parties, including distributors and key
suppliers.
INFORMATION TECHNOLOGY. The principal computer systems that the Company
used for financial accounting, manufacturing, inventory control, purchasing,
sales administration, engineering, and other business functions were not Year
2000 compliant. The Company purchased a replacement system in July 1999 that was
fully functional as of October 1, 1999. The cost of this new system was
approximately $30,000.
NON-IT SYSTEMS. The Company has completed an evaluation of telephone
systems, manufacturing equipment, facility heating and cooling systems, and
other non-IT systems for Year 2000 readiness and is taking remedial action as
necessary.
ITS PRODUCTS. The Company have completed a series of tests, utilizing
industry standards, of the electronics systems of its products, including those
product lines no longer being manufactured but remaining in use at customer
sites. Its review has determined that the products should continue to operate
according to specifications after December 31, 1999.
KEY VENDORS AND SUPPLIERS. The Company has completed a survey of its key
vendors and suppliers to assess their plans for bringing any non-compliant
systems into Year 2000 compliance.
Other than the replacement computer system discussed above,
substantially all of the effort to evaluate its Year 2000 readiness has been
made using internal personnel, and therefore incremental expenses have been less
than $50,000. The Company has not incurred any material expenses in connection
with its evaluation of non-IT systems and does not expect material expense in
the future, although the implementation related to non-IT systems is not yet
complete. The Company has not incurred any material expenses to date in
connection with the evaluation of its products and the status of its vendors and
suppliers with respect to Year 2000 issues. The Company does not anticipate
material expenses in the future.
The Company's Year 2000 readiness plan, as well as its consideration of
contingency plans, are ongoing and will continue to evolve as new information
becomes available. At the present time, the Company believes that it is
difficult to identify the cause of the most reasonably likely worst case Year
2000 scenario. The Company has not yet adopted any formal contingency plans and
will determine the need for such plans as part of its ongoing assessment of
vendors and suppliers, products, and internal business systems. Due to the
complexity and pervasiveness of the Year 2000 issue, and in particular the
uncertainty regarding the Year 2000 compliance programs of third parties, no
assurances can be given that the Year 2000 problem will not have material
adverse effects on its business or its results from operations.
15
<PAGE> 16
FUTURE PERFORMANCE AND RISK FACTORS
THIS REPORT CONTAINS A NUMBER OF FORWARD-LOOKING STATEMENTS WHICH REFLECTS THE
COMPANY'S CURRENT VIEWS WITH RESPECT TO FUTURE EVENTS AND FINANCIAL PERFORMANCE.
THE COMPANY'S FUTURE BUSINESS, OPERATING RESULTS AND FINANCIAL CONDITION ARE
SUBJECT TO VARIOUS RISKS AND UNCERTAINTIES, INCLUDING THOSE SUMMARIZED BELOW.
READERS ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON FORWARD-LOOKING STATEMENTS
CONTAINED HEREIN, WHICH SPEAK ONLY AS OF THE DATE HEREOF. THE COMPANY UNDERTAKES
NO OBLIGATION TO PUBLICLY REVISE THESE FORWARD-LOOKING STATEMENTS, TO REFLECT
EVENTS OR CIRCUMSTANCES THAT MAY ARISE AFTER THE DATE OF THIS REPORT.
Since the business combination with Metacomp, effective December 1996,
the Company has segregated its operations into microprocessor, communication,
and radar/antenna product lines. However, synergistic technical and other
resources can and will be deployed across all three lines.
Product revenues have been primarily from communication products. The
communication products are specifically designed to fill both the high speed
data as well as the video conferencing requirements of the Internet.
The microprocessor continues to be the Company's primary development
focus. The Company has completed development of a 0.35 micron version of the
PSC1000 which has resulted in increased processing speed and performance. In
addition, the Company is running the Sun Microsystems's Java OS on the PSC1000.
The PSC1000 executes Java very efficiently, and is the price/performance leader
in the Java processor marketplace. This enhancement is expected to increase
potential market opportunities in areas such as TV set top boxes, smart phones,
PDAs, network computers, and other Internet related products.
The Company sold its gas plasma antenna technology in August 1999.
The Company is focusing its sales efforts on original equipment
manufacturers, system integrators, and Internet service providers for both the
microprocessor and communication products.
The Company has experienced in the past and may experience in the future
many of the problems, delays and expenses encountered by any business in the
early stages of development, some of which are beyond the Company's control. The
Company has limited operating history, has incurred significant cumulated
losses, has only recently commenced marketing and sales of its products and has
not achieved a profitable level of operations. There can be no assurance of
future profitability. The Company may require additional funds in the future for
operations or to exploit its technologies. There can be no assurance that any
funds required during the next twelve months or thereafter can be generated from
operations or that such required funds will be available from the aforementioned
or other potential sources. The lack of additional capital could force the
Company to substantially curtail or cease operations and would therefore have a
material adverse effect on the Company's business. Further there can be no
assurance that any such required funds, if available, will be available on
attractive terms or that they will not have a significantly dilutive effect on
existing shareholders of the Company. The Company's technologies are in various
stages of development. The Company's CyberShark(TM) digital modem and certain
communication products have been developed to the point of production of
marketable product and the PSC1000 is in the first stages of production. There
can be no assurance that any of the technologies in development can be completed
to commercial exploitation due to the inherent risks of new technology
development limitations on financing, competition, obsolescence, loss of key
technical personnel and other factors. The Company's development projects are
high risk in nature, where unanticipated technical obstacles can arise at any
time and result in lengthy and costly delays or result in determination that
further development is unfeasible. There can be no assurance that the
technologies, if completed, will achieve market acceptance sufficient to sustain
the Company or achieve profitable operations.
The Company relies primarily on patents to protect its intellectual
property rights. There can be no assurance that patents held by the Company will
not be challenged and invalidated, that patents will issue from any of the
Company's pending applications or that any claims allowed from existing or
pending patents will be sufficient in scope or strength or be issued in all
countries where the Company's products can be sold to provide meaningful
protection or commercial advantage to the Company. Competitors may also be able
to design around the Company's patents.
16
<PAGE> 17
The Company acquired its ShBoom technology pursuant to a chain of
agreements and there is uncertainty regarding royalty payments, if any, and
indemnification from prior parties. The Company does not believe it is obligated
to pay any royalties on aspects of the ShBoom technology specified in prior
agreements between nanoTronics Corporation and previous inventors. The Company
believes, should there be royalties due to previous inventors, that the
obligation is that of nanoTronics. The Company could become subject to
unindemnified claims relating to any failure by nanoTronics to pay such
royalties, if due. Also the Company could become liable for up to $1,250,000 to
nanoTronics under certain indemnification provisions.
The Company's common shares are traded on the OTC Bulletin Board, are
thinly traded and are subject to special regulations imposed on "penny stocks."
The Company's shares may experience significant price and volume volatility,
increasing the risk of ownership to investors.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In October 1998, the Company was sued in the District Court for Travis
County, Texas by the Fish Family Trust, a co-inventor of the original ShBoom
technology. The suit also named as defendants nanoTronics and Gloria Felcyn on
behalf of the Falk Trust. The suit sought a judgment for damages, a rescission
of the Technology Transfer Agreement and a restoration of the technology to the
co-inventor. The Company had the suit removed to the United States District
Court for the Western District of Texas, Austin Division, and requested the
Federal District Court to dismiss the suit based on lack of minimum contacts
with Texas or, in the alternative, to transfer the case to the Southern District
of California. In January 1999, the Federal District Court dismissed the suit
for lack of subject matter and personal jurisdiction. The Fish Family Trust then
refiled the suit in the Superior Court of San Diego County, California seeking
remedies similar to the Federal District Court dismissed action. In March 1999,
the Company joined with nanoTronics and Gloria Felcyn and filed its response and
cross-complaint against the Fish Family Trust. The suit is scheduled for trial
in December 1999. The Company and the other defendants intend to vigorously
contest the plaintiff's allegations. It is reasonably possible that the outcome
of these matters may result in a material liability for the Company. Management
does not believe, at this stage of the case, that it is possible to estimate the
outcome of the litigation or a range of reasonably possible losses that might
result from the suit.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits - NONE
(b) Reports on Form 8-K - The Company filed a Report on Form 8-K on August 30,
1999.
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
PATRIOT SCIENTIFIC CORPORATION
Date: October 14, 1999 By: /s/ LOWELL W. GIFFHORN
---------------------------------
Chief Financial Officer
(Principal Financial and
Accounting Officer and duly
authorized to sign on behalf
of the Registrant)
17
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM UNAUDITED
INTERIM STATEMENTS FOR THE THREE MONTHS ENDED AUGUST 31, 1999 AND IS QUALIFIED
IN ITS ENTIRETY BY REFERENCE TO SUCH QUARTERLY REPORT ON FORM 10QSB FOR THE
QUARTERLY PERIOD ENDED AUGUST 31, 1999.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> MAY-31-2000
<PERIOD-START> JUN-01-1999
<PERIOD-END> AUG-31-1999
<CASH> 28,880
<SECURITIES> 0
<RECEIVABLES> 103,032
<ALLOWANCES> 0
<INVENTORY> 242,231
<CURRENT-ASSETS> 481,954
<PP&E> 1,890,447
<DEPRECIATION> 1,479,233
<TOTAL-ASSETS> 1,062,365
<CURRENT-LIABILITIES> 2,272,845
<BONDS> 0
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<OTHER-SE> 23,207,799
<TOTAL-LIABILITY-AND-EQUITY> 1,062,365
<SALES> 199,024
<TOTAL-REVENUES> 199,024
<CGS> 126,610
<TOTAL-COSTS> 126,610
<OTHER-EXPENSES> 779,114
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 292,078
<INCOME-PRETAX> (748,778)
<INCOME-TAX> 0
<INCOME-CONTINUING> (748,778)
<DISCONTINUED> 0
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<EPS-BASIC> (0.02)
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