ITEM 1. Business
General
We are a leading provider of innovative, automated traffic enforcement systems and services to state and local governments throughout the United States and also in Canada. We are the only provider of both a fully video-based automated red light enforcement system and a multi-lane, bi-directional scanning light detection and ranging, or LiDAR, speed enforcement system. We also offer a newly developed ViDAR™ (Video Detection and Ranging) speed detection and imaging system as complement to our other products or as a stand-alone speed enforcement system. CrossingGuard, our red light enforcement product, uses our patented image processing technology to predict and record the occurrence of a red light violation, and manages the process of issuing and processing a citation. Poliscan, one of our speed enforcement products, uses technology developed by Vitronic GmbH. We have exclusive distribution rights to Poliscan in North America through February 2010, subject to meeting certain purchase minimums. ViDAR™ uses average speed over distance calculations to detect and record evidence of speeding vehicles. Because ViDAR™ was developed by in-house talent, there are no purchase minimums. By combining CrossingGuard, Poliscan and ViDAR™ with Citation Composer, our proprietary citation preparation and processing software, we are able to provide fully integrated, turnkey red light and speed enforcement solutions.
CrossingGuard is an automated, video-based monitoring system that predicts and records the occurrence of a red light violation. The system includes our patented collision avoidance technology that anticipates expected violations and can be used to extend the red light phase for cross traffic, preventing collisions between violators and vehicles in the cross traffic. CrossingGuard simultaneously records multiple views of the violation sequence, including close-ups of the vehicle and the license plate, and transmits video evidence electronically to the police department, which reviews the violation and approves the issuance of a citation. Our technology captures over 200 images of each red light violation, which combined with our patented synchronized playback capability, enables us to provide a superior evidence package, resulting in a system-wide court challenge rate of 3% and a court dismissal rate of less than 1%.
Poliscan is a fully automated system for photo speed detection and recording. Poliscan is capable of simultaneously capturing multiple vehicles in multiple lanes in bi-directional traffic, a distinct advantage over traditional radar or LiDAR systems limited to one lane, one direction or one car at a time. This laser-based system scans a 45-degree arc 100 times per second, recording the speed, vehicle classification, and distance between vehicles, to create a three-dimensional image of all vehicles in the coverage area. The system uses high-resolution digital cameras for documenting the speeding violation, including pictures of the license plate and an overview picture specifically identifying the speeding vehicle.
Nestor recently announced a new product, ViDAR™ that can help communities enforce posted speed limits. ViDAR™ uses distance over time calculations in combination with video detection and tracking technology to measure and record the scene, license plate and driver images from speeding vehicles. ViDAR™ technology simultaneously tracks multiple vehicles bi-directionally in multiple lanes and is accurate to within 1 mph. ViDAR™ incorporates current digital camera technology and secures evidence of violations in real-time with a time-stamp accurate within 1/100 of a second. Also, because the system is based on video tracking, it is undetectable by radar/laser detectors. A unique feature of the ViDAR™ speed system is its evidence package. In addition to producing digital close-up still images, it is capable of storing and replaying time-stamped, full motion video of the violation. Both speed products can capture driver image with minimal adjustments.
We provide back office citation processing services for CrossingGuard, Poliscan and ViDAR™ systems using our proprietary software solution called Citation Composer. These processing services include obtaining data from the roadside systems, reviewing the data, preparing the citations and evidence packages and tracking final resolution of the citations. One of Citation Composer’s many unique features is its ability to simultaneously replay synchronized videos of a red light violation, allowing for a more complete evidence package.
We generate recurring revenue through contracts with government entities that provide for equipment lease and services on a fixed monthly and/or per citation fee basis. As of December 31, 2006, we were generating revenue from 222 installed CrossingGuard-equipped approaches in 29 municipalities in eight states and one Canadian province, and eleven speed units in five municipalities. As of that date, our active contracts with state and local governments authorized the installation of CrossingGuard at up to an additional 245 approaches and thirteen speed units.
Our Market
Status of the CrossingGuard Market
The market for automated red light enforcement is experiencing significant growth. Based on the Federal Highway Administration’s (FHWA) 2007 assessment that there are approximately 290,000 signalized intersections in the United States, and we estimate that there are over 1 million approaches to signalized intersections in the United States. With over 250 communities with red-light cameras and assuming an average of 10 enforced approaches per community, there are approximately 2,500 or .025% of signalized approaches enforced with red light cameras.
Recent studies have shown that automated red-light enforcement systems are effective in reducing red-light running at enforced intersections. The Insurance Institute for Highway Safety (IIHS) reported that red-light cameras were generally successful, leading to significant decreases in intersection crashes and violations - a 25-30% reduction in intersection injury crashes. Our customers in Germantown, Tennessee, themselves, reported more than a 20% reduction in crashes since the system began and more than a 30% reduction since before the system was put in place. The City of Germantown’s Automated Enforcement System began issuing citations on September 6, 2002.
First-generation red-light camera systems generally relied on in-ground vehicle sensing loops and still photography. This technology is outdated. The preferred technology uses all digital video detection and either all high resolution digital still cameras or a combination of digital still and digital video technology.
The use of automated traffic systems to enforce red light running violations requires specific authority at the state or local government level, either through state enabling or home rule statutes. Attorney General and/or court rulings also affect a state’s ability to allow red light enforcement. Twenty-three states and the District of Columbia currently allow the use of automated traffic light systems, such as CrossingGuard; and several more including Virginia are expected to enter the automated red light market later this year. Four Canadian provinces allow red light and one Canadian province permits red light in just the City of Winnipeg.
U.S. jurisdictions allowing red light enforcement include:
Arizona
California
Colorado
Delaware
Florida
Georgia
Illinois
Iowa
Louisiana
Maryland
Massachusetts
Missouri
New Mexico
New York
North Carolina
Ohio
Oregon
Pennsylvania
Rhode Island
South Dakota
Tennessee
Texas
Washington
Washington, D.C.
Canadian jurisdictions allowing red light enforcement include:
Alberta
British Columbia
Manitoba
Ontario
Saskatchewan
There remains some opposition to these systems, largely based upon concerns regarding compliance with existing state law, individual privacy and due process rights. For example, in Minneapolis, Minnesota last year, a Hennepin County district judge and later the state’s Court of Appeals struck down the city ordinance allowing automated enforcement suggesting the city’s ordinance overstepped state law. Many states and communities have or are considering authorization of automated traffic enforcement but need to address these concerns first.
Status of the Speed Market
The automated speed enforcement market is potentially more significant than the automated red light enforcement market. While already well established in Europe, Asia and Australia, the automated speed enforcement market in the U.S. is positioned to grow significantly as a result of the enormous costs associated with speeding-related crashes. The FHWA reports an average of 117 traffic fatalities each day, 30% of which are under the age of 25. They further report that daily financial losses from such accidents is $630 million.
The need for automated speed enforcement is well documented. The IIHS released information in July 2006 linking high rates of speed to the likelihood of a crash resulting in a serious injury. The report cited “one problem is that speed increases the distance it takes to stop in an emergency, so crash likelihood increases. When a crash does occur, speed worsens its severity by increasing the energy of impact.” The IIHS further reported the number of drivers and the miles traveled have increased faster than the availability of officers to routinely enforce traffic laws. Plus it is hard on congested roads to pull over speeding drivers without creating a hazard. So while police do pay attention to speeders, they cannot keep up.
Similar to automated red light enforcement, the use of automated traffic systems to enforce speed limits requires specific authority at the state or local government level, either through state enabling or home rule statutes. Judicial opinions and rulings have also determined state progress. Currently, ten states, the District of Columbia and two Canadian provinces, with Manitoba limited to just the City of Winnipeg, allow automated speed enforcement. They are:
In addition, many states are moving forward with speed enforcement technology to deliver traditional uniform traffic tickets (UTT) under existing state statute. The UTT market depends upon the interpretation of state law for personal delivery of the citation and witnessing the violation. The active UTT market includes Texas and Massachusetts.
Our Response to the Market
Our automated traffic solutions respond to the traffic enforcement market by creating a strong overall value proposition for our customers. Our response to the UTT speed enforcement market in particular has broadened our appeal. Our ability to capture a full evidence package, including the driver image, and deliver tickets via the postal service has allowed us to become the first company to use speed enforcement technology for delivering traditional uniform traffic tickets (UTT).
We offer complete turnkey solutions for automated traffic enforcement programs. We generally retain ownership of the equipment and bear all of the up-front costs for purchase, installation and maintenance of our systems. We provide the software, data warehousing, processing, printing, mailing, collection, maintenance, and community awareness support for a program. Customers generally provide program management and oversight, approve all citations for issuance, prosecute citations, establish operating and enforcement criteria, and select enforcement locations and times. Our systems increase safety by reducing the number of crashes while enhancing police officer safety and efficiency. Our systems also reduce the demand for emergency resources without significantly increasing our customer’s administrative costs.
Company History
We were founded in 1975, incorporated in 1981, and completed our initial public offering in 1983. During our first 25 years of operations, we developed a number of patented intelligent software solutions for decision and data-mining applications, including financial services, fraud detection and our intelligent traffic-management systems. In January 1997, we organized Nestor Traffic as a wholly-owned subsidiary. In 1999 and 2000, Nestor Traffic raised additional capital through two private placements of its common stock, reducing our ownership to approximately 35%. In 2000, we made the strategic decision to concentrate on our traffic management technologies and we began to dispose of our other product lines. In connection with this restructuring effort, on September 12, 2001, we reacquired 100% ownership of Nestor Traffic through a merger transaction with another subsidiary in which we issued common stock for the Nestor Traffic shares held by outside investors. By 2003, we had exited our financial services, fraud detection and Rail CrossingGuard and TrafficVision business lines, and had refocused our resources on our traffic enforcement systems such as CrossingGuard.
Our transition to traffic management solutions involved a series of licensing arrangements and transfers of technology rights, including a June 11, 1996 licensing agreement and an asset purchase agreement to transfer the development, production and marketing rights of our character recognition products to National Computer Systems. In early 2001, we also entered into two separate source-code licensing agreements for our fraud detection product line. The first of these was a February 1, 2001 non-exclusive license agreement with Applied Communication, Inc., (ACI), whereby we granted ACI the right to integrate and distribute all of our fraud detection products throughout its worldwide sales and support network. ACI paid us $1,100,000 in the first six months of 2001, and was required to make guaranteed minimum royalty payments during the first year in an amount of approximately $500,000. The license requires the payment of a 15% royalty starting on February 1, 2002, but no further guaranteed minimum royalty payments are required. This agreement replaced an earlier license to ACI. We sold the royalty rights to Churchill Lane Associates (CLA) from this license on July 1, 2002. We do not expect to receive future revenue from this license.
Additionally, on May 18, 2001, we entered into a license agreement with Retail Decisions, Inc. (ReD). We granted ReD a perpetual, fully-paid, worldwide license in the field of fraud and money laundering detection and risk management in certain defined industries; and a non-exclusive, perpetual, fully-paid, worldwide license solely for use in the field of use of customer relationship management in certain defined industries. Additionally, we transferred to ReD assets that supported the technology licensed under the license agreement to ReD. ReD paid us $1,800,000 under the license agreement, and for certain marketing and transition services, we paid ReD $968,000 in 2001. No ongoing revenues are expected to be realized from ReD.
The licensing, royalty and other payments we received under these licensing arrangements and other transfers of our property and technology financed our operations during 2001 and 2002 and enabled us to develop our traffic enforcement business.
On January 15, 2003, Silver Star Partners I, LLC (Silver Star) purchased 49 million shares of our pre-reverse stock split common stock (4,900,000 shares on a post-split basis) for $2,376,500. Following the initial Silver Star investment, on April 11, 2003, we effected a one-for-ten reverse stock split of our common stock. On April 16, 2003, Silver Star purchased an additional 4,013,557 post-reverse stock split shares for $1,946,575. William B. Danzell, our President and Chief Executive Officer is the Managing Director of Silver Star. Upon completion of the second sale, Silver Star owned 64% of our outstanding shares of common stock.
On August 31, 2005, we acquired certain assets of Transol USA, one of our competitors, in a foreclosure sale. The assets included contracts to provide automated red light enforcement services in six U.S. cities at an aggregate of 39 red light approaches, of which approximately 26 are fully installed and operating, as well as related equipment, intellectual property, inventory, work in process, accounts receivable and unbilled contract revenue related to Transol's red light enforcement services. We paid $1,760,000 for the acquired assets.
Products and Services
Our products combine sophisticated digital and analog camera technologies with advanced image processing methods to detect and record traffic-related violations. We complement these roadside products with a full suite of back-office processing support services, providing our customers with a complete turnkey solution. Our roadside systems are a combination of Nestor- and/or Vitronic-developed modular hardware components and software that provide monitoring for traffic-data collection, vehicle detection and tracking and enforcement. These roadside systems include: CrossingGuard for red light enforcement, Poliscanspeed and ViDAR™ for mobile speed or fixed speed enforcement. We provide back-office processing and support services across our roadside systems using a proprietary software solution called Citation Composer. These processing and support services include obtaining data from the roadside systems, reviewing the data, preparing the citations and evidence packages and tracking final resolution of the citations. We believe that our strong suite of patents covering our image processing technology provides us with a strategic advantage and enables us to offer a comprehensive traffic enforcement solution.
CrossingGuard Red Light Enforcement
CrossingGuard. Our CrossingGuard system is an automated, video-based monitoring system that predicts and records the occurrence of a red light violation. The system applies high speed image processing and target-tracking technology to real-time video scenes. The products use digital video and still cameras, computers and software to detect red light violators at signalized intersections. Using the captured video frames, our systems apply algorithms to recognize objects as vehicles and predict their motion relative to the stop line. This advanced proprietary technology, which effectively sees and interprets objects captured in video images, is at the core of the CrossingGuard solution.
The CrossingGuard system includes patented collision avoidance technology that anticipates violations and generates a signal that can extend the red light phase for cross traffic. This helps prevent collisions between red light violators and vehicles on the cross streets. Through a system of multiple video cameras set up to monitor and capture violators on a per approach basis, the system simultaneously records the violation sequence, including a view of the vehicle from the front approaching the intersection, a view of the vehicle from the rear entering the intersection, and a close-up of the vehicle and license plate, and transmits video evidence electronically to the police department, which reviews the violation and issues a citation. Our advanced video technology, which combined with our patented synchronized replay capability, enables us to provide a superior evidence package, resulting in a court dismissal rate of less than 1%.
The CrossingGuard system consists of a video camera installed on top of a traffic signal pole or a roadside pole installed by us that is used to track and record the actions of an approaching vehicle. Another camera is positioned to view the signal lights as they change from green to yellow to red and record the vehicle’s actions as the lights change and it enters the intersection, capturing over 200 images of each violation. The views from these two cameras can also be presented in a patented side-by-side synchronized mode to demonstrate the complete view of the violation, including extenuating circumstances, aggressive behavior or other factors. Finally, an enforcement camera is positioned to obtain a close-up image of the vehicle license plate and, where needed, the driver image, based upon vehicle location instructions provided by the tracking camera. A personal computer, which we install in an enclosure by the roadside link through a fiber optic connection, runs the intelligent software and controls camera activity. High-speed communications transmit video and data from the intersection to a designated facility for processing. CrossingGuard is built upon standard PC hardware and software components. This design provides the reliability and performance benefits of improving PC hardware and the ability to upgrade and add functionality as needed. We purchase all electronic and mechanical components from third-party vendors, built in accordance with our specifications, and primarily use local contractors to install the systems.
The primary attributes of CrossingGuard are:
Accurate, real-time interpretation of traffic video images. We apply our high-speed pattern-recognition technologies in real-time processing and video-image interpretation for traffic management, enforcement and safety. Previous industry attempts to provide video-based detection of traffic did not prove effective due to the difficulty of designing robust detection algorithms under a variety of illumination, visibility and traffic conditions, as well as the need to implement such algorithms on cost-effective computing platforms that provide real-time operation. Our image recognition technology is able to interpret video images accurately and respond in a real-time environment at affordable cost. Our Citation Composer software can process red light violations with a patented display of the approaching and receding videos presented side-by side, and can re-play the violation sequence in slow motion or frame-by frame, producing a comprehensive evidence package subject to fewer meritorious challenges than any of our competitors’ systems.
Vehicle trajectory analysis for real-time forecasting. As each frame in a video sequence is interpreted, the individual objects in the scene are identified and located. This information, passed from frame to frame, enables the accurate tracing of vehicles' trajectories. Unlike competitive vision systems, which note changing images in a fixed and static area of the image (so-called virtual loops), our proprietary vehicle-centric technology can use the trajectories to predict vehicle positions. Our CrossingGuard system includes a collision avoidance feature that anticipates violations and generates a signal that can extend the red light phase for cross traffic, which helps prevent collisions between violators and vehicles in the cross traffic accelerating on a green signal. Thus, intersections equipped with CrossingGuard have the potential to become smarter and safer.
Compatibility with industry standard platforms. Our traffic monitoring solutions are built upon dominant industry-standard platforms including Microsoft Windows operating systems, tools and communication components and general "WinTel" hardware specifications. This facilitates integration into a customer's existing computing environment, leverages PC economics to offer a compelling price/performance advantage and lowers product engineering development costs. Additionally, the traffic monitoring systems are designed to support the emerging communications standards being mandated in the traffic industry by the National Transportation Communications for Intelligent Transportation Systems Protocol.
CrossingGuard VIP. We also provide the CrossingGuard Video Intersection Profiling program, a tool that we have developed to help municipalities pre-qualify intersections. Because intersection violation rates can range from an average of a few per day to over 50 per hour, the system helps the municipality develop an estimate of safety issues at a given intersection and the long-term ticket volume by counting and profiling violations for all directions at a particular intersection.
Revenue Generation. The economics of the CrossingGuard product are tied to the number of operating systems in the field and, to an increasingly lesser extent, the number of violations processed by the CrossingGuard systems. Many of our early contracts compensate us on a per ticket paid or issued basis in return for equipment lease, maintenance, citation processing and customer support services. More recent red light contracts compensate us on a monthly fixed fee basis or fixed fee in conjunction with a fee per ticket issued or paid.
As of December 31, 2006, we had installed CrossingGuard at 222 approaches or 29 customers throughout the United States and Canada, and our contracts authorize up to an additional 245 CrossingGuard approaches for installations. Management believes the majority of the authorized approaches under these outstanding and pending contracts will be installed, but no assurances can be given that all approaches under contract will ultimately be installed or that pending contracts will be finalized. Depending upon contract terms and services provided, we realize (a) from $19 to $99 per citation issued or paid or (b) a fixed monthly fee ranging from $2,000 to $7,000 per approach for system delivery, lease, processing services and maintenance.
State statutes providing for automated red light enforcement may impose liability on the driver or the registered owner of a vehicle for a violation. Driver liability statutes require that the driver be identified, from the photographic evidence, and that the citation be issued and sent to the driver. Registered owner statutes require that the vehicle’s owner be identified, through registration records, and that the citation be issued and sent to the driver. As only the license plate is required for identification under a registered owner statute, program operating efficiencies are higher resulting in lower per citation or monthly fees for systems installed in these jurisdictions. Actual results from deployment of CrossingGuard systems are expected to fluctuate depending upon intersection selection and configuration, driver response to installed systems and many other factors.
Poliscanspeed Products
Poliscan Speed. Poliscanspeed, an innovative solution for digital speed detection and recording, is the only multi-lane, bi-directional, scanning LiDAR (light detection and ranging) mobile speed enforcement system in the industry. Unlike traditional photo speed enforcement systems, which use radar or conventional LiDAR, Poliscanspeed utilizes scanning LiDAR technology to simultaneously record and measure several vehicles in parallel lanes, with laser beams per second sweeping a 45 degree arc, creating a real-time 3-dimensional image of the scene. The system records the speed, classification (motorcycle, car or truck) and the distance between every vehicle entering the coverage area. Poliscan uses a high-resolution digital camera for documentation of the speeding offense, including pictures of the license plate, an overview picture which specifically targets the speeding vehicle, as well as the image of the driver where required. Detecting all vehicles in all lanes simultaneously avoids the ambiguity and measuring errors that are more common among our competitors' systems, allowing many more speed offenses to be effectively recorded and prosecuted.
The measuring sensor developed for Poliscanspeed is based on a scanning LiDAR that is mounted in a stationary position and transmits short pulses of light out to a target. The transmitted light is reflected back to the receiver of the LiDAR instrument where it is analyzed. While the LiDAR sensor carries out the measurements with a high repetition rate, a rotating polygonal mirror deflects the transmitted signals, so that the LiDAR sensor covers the full region of interest (a sector of 45 degrees), allowing simultaneous monitoring of multiple lanes. Accordingly, the Poliscanspeed system offers the following competitive advantages:
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High resolution all digital camera solution
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All weather, day and night operations with no visible illumination
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scans per second in the 45 degree scan sector
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Multi-lane, multi-vehicle, bi-directional speed enforcement
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Not restricted to straight roads (only needs 20 meters to operate)
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3D image processing (Scans entire road, all lanes)
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Fully automated, unattended operations
Deployment and Set Up. With outside dimensions of less than 12 inches per side and weighing less than 45 pounds, the PoliScanspeed unit is designed for ease of use and maximum portability. Additionally, its small size allows maximum versatility. Unlike competing systems, which are confined to either a minivan or a portable unit, PoliScanspeed can be deployed in a variety of different ways giving our customers the flexibility to rotate enforcement to areas that have the greatest need. We offer PoliScanspeed in a variety of configurations, including our Mobile Speed Unit, which is a self-contained violation capture and processing center all in one. Other configurations include vehicle mount and tripod mount. Our proven back office integration and citation processing systems, coupled with PoliScan’s advanced technology, provide a fully integrated automated speed enforcement solution.
Deployment of our competitors’ mobile speed enforcement systems can be an involved process, including precisely aiming LiDAR, measuring radar angles for cosine effect, and searching for level stretches of straight roadway. In contrast to conventional measures such as radar, light barriers, and piezo-section, PoliScanspeed does not require a complex installation and calibration of the system at the measurement site. We require only 20 meters of roadway to deploy the PoliScanspeed system, which can be operational in less than five minutes.
Revenue Generation. As of December 31, 2006, we had installed 11 PoliScanspeed units for 5 customers throughout the United States and Canada, and our contracts authorize up to an additional 13 speed units for deployment.
Enforcing only a single lane drastically reduces potential citation rates by 2 or 3 times. Poliscan utilizes the vehicle targeting advantages of LiDAR while covering multiple lanes, gaining the advantages of radar. This technology solution couples the advantages of radar and LiDAR into one unique enforcement system. Because the system covers all vehicles in all lanes, we can issue, in some cases, twice as many speed citations as can our competition on multi-lane or bi-directional roads. Unlike traditional laser systems, which can require up to 90 meters of flat, straight roadway to accurately target a speeding vehicle, our speed unit can track at distances as short as 20 meters. This short-range LiDAR tracking capability is a major competitive advantage, enabling speed enforcement on roads with sharp curves and hills and enabling better image quality regardless of lighting conditions.
ViDAR™ Products
ViDAR™ incorporates the latest in digital camera technology to capture up to 60 frames per second. The ViDAR™ system displays vehicle speeds in real-time. Using a graphic user interface (GUI), the system shows vehicle speeds at key intervals during the event. ViDAR™ records a video clip of every speeding violation for use as evidence and for future verification. The unique system time-stamps video evidence of the violation as it happens ensuring that all data is directly correlated to the evidence collected. The time-stamp is accurate to 1/100 of a second.
Most vendors’ “evidence packages” consist of a photograph with either multiple untargeted vehicles at short range, or a single targeted vehicle at some far, distant range-zoomed in by near telescopic length lenses. The ViDAR™ system achieves an indisputable evidence package by taking video of the violating vehicle with embedded vehicle speed-stamps at up to 60 frames per second (fps). Digital still images of the driver image and/or the license plate provide the most conclusive evidence of speeding violations.
Deployment and Set Up. The complete ViDAR™ system is available with all software and hardware for the municipality to issue citations from the speed system in a fixed or mobile configuration.
Revenue generation ViDAR™ is fully commercialized and awaiting the initial pilot program.
Program Management and Processing Services
We offer our CrossingGuard and Poliscan customers a complete package of services and support, which can be customized. These services consist of site planning and equipment installation, user training and support, violation review, citation preparation and processing, account management, toll free hotline support, public education and expert testimony. In addition, we provide direct, remote and online equipment monitoring and maintenance primarily through our field and office personnel and through local contractors as necessary. We also offer fine collection and processing as an optional service for our customers.
We have been able to leverage the infrastructure and technology developed for our CrossingGuard system to support all of our traffic enforcement products. All of our citation processing services utilize our proprietary Citation Composer software, which allows us to retrieve and review images and format pictures and other data for citation processing. Citation Composer supports the necessary interfaces with state departments of motor vehicles, local police departments and court systems to facilitate review and approval of citations, court scheduling, providing evidence packages and tracking payment and resolution of the citations. Our customer service platform supports our entire product line, and enables us to integrate additional products without significant development costs.
Rail CrossingGuard. We developed Rail CrossingGuard, a system to monitor grade-crossing vehicles and train traffic, as well as signalization activity, to provide grade-crossing-integrity measurement, real-time crossing alert capabilities and crossing violation enforcement. This product has the potential to enhance rail-crossing safety by improving signal and crossing gate monitoring, alerting personnel to dangerous crossing situations, and enforcing train and vehicle safety regulations. Rail CrossingGuard may also be integrated with train communications systems to provide a method of alerting trains to dangerous rail crossing conditions.
TrafficVision. TrafficVision is a product that uses video cameras to monitor traffic flow and to send traffic data to a central Traffic Operations Center. Replacing short-life, high-maintenance, road-embedded copper-loop technologies from the 1950's, TrafficVision is a non-intrusive sensor system for traffic management. TrafficVision uses our proprietary high-speed image-processing technology to analyze video content to sense and monitor traffic on highways, roadways and intersections in real-time. TrafficVision recognizes and classifies multiple vehicles continuously so that surveillance and traffic management are based upon detailed, real-time information. TrafficVision is installed at 26 locations in Rhode Island and in the state's centralized Traffic Operations Center in Providence.
Sales, Marketing and Methods of Distribution
We market our products and services to municipalities and governmental traffic management departments. As of December 31, 2006, our nationwide direct sales force consisted of five employees (reduced to two employees in February 2007) and our marketing support group consisted of two employees. In addition, members of senior management are actively involved in sales and marketing. Because our products require technical assistance during the sales and installation processes, our marketing team also accesses our internal staff of program managers and field engineers. Within the last 12 months we have also engaged the services of several consultants and lobbyists to assist with our marketing and sales efforts.
We obtain product inquiries from customer referrals, product mailings, attendance at trade shows, trade press coverage and our Internet site. Most contracts are obtained through competitive proposal processes in response to requests for proposals, or RFPs, issued by municipalities. In some cases, our customers may issue a sole-source contract, avoiding the RFP process. Our sales force actively engages in direct discussions with potential customers to encourage sole-sourcing or the issuance of RFPs that incorporate our products’ features. We also subscribe to multiple services that advise us of relevant RFPs, issued by state and local governments. Purchasing decisions are influenced by the advantages of a particular product, customer references, existing relationships with the jurisdiction, pricing, and in some cases, consultant and lobbyist activities. In 2006, we submitted 56 proposals to state and local governments. As of December 31, 2006, as a result of bids submitted in 2006, we were awarded 5 contracts. No provider has been selected with respect to 17 of the RFPs to which we responded in 2006.
Our marketing and sales plan includes state-specific marketing, comprehensive municipal coverage by our sales team and consultant and lobbyist engagements. Marketing and sales plan to use more mass electronic communication tools to deliver sales materials to passive leads and attend tradeshows in target markets to generate new interest.
Research and Development Activities
The focus of our research and development is on improvements to our products and technologies in order to maintain and increase our products’ competitive advantages as well as customer service and satisfaction. We also consider developing new technologies and products that we believe will complement our traffic enforcement product line.
We have completed development and commercialized three new products:
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Our "All Digital" CrossingGuard system, which enhances image quality (up to 12.4 megabytes), efficiency and reliability while reducing installation costs and supporting infrastructure needs. The All Digital system uses decentralized processing and provides a completely digital Ethernet solution. With internet protocol addressable cameras, it can provide live video for homeland security or other applications;
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Our CrossingGuard Speed system, which can utilize any of three speed detection systems - Ka band radar, single beam traditional LiDAR and Vitronic’s scanning LiDAR. The integration of all known types of non-intrusive speed sensors into our product allows us to deliver a full array of solutions to the customer while maintaining the advantage of full motion digital video; and,
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ViDAR™ utilizing distance over time calculations in combination with video detection and tracking technology to measure and record the scene, license plate and driver images from speeding vehicles.
We have begun development and integration of LPR (License Plate Recognition) capabilities into our CrossingGuard and ViDAR™ product lines. This development will enable our current enforcement products to image-process and identify vehicles by their license plates. We are currently on schedule to have this commercially available in 2007.
We spent $1,383,000, $1,737,000 and $157,000 in the years ended December 31, 2006, 2005 and 2004 respectively, on research and development. The more significant 2006 research and development expenditures are attributable to development of ViDAR™, the CrossingGuard all digital video solution and the US commercialization and back office integration of the PoliScanspeed product. We expect these costs to decrease in 2007.
Patents
We have continually sought and obtained patent protection for our traffic enforcement systems and for our proprietary neural networks, which have as a principal feature rapid learning from a relatively small number of examples, or the application of video techniques in traffic management applications. Our patented neural network exhibits rapid learning and minimizes the internal connections needed for it’s functioning. We believe that these capabilities make our technology uniquely suited to applications that require field trainability or self-modification to adapt to new or changing patterns in the data. Our patents also cover multiple-neural-network systems, which enabled us to develop products that combine high accuracy with high processing speeds.
During 2005, we received one patent relative to the CrossingGuard product line. The patent recognizes the use of a virtual violation line for detecting red light violations. During 2004, we received two patents relative to the CrossingGuard product line. The first patent recognizes the transmission of video as part of the user interface in our CitationComposer software for ticket processing and issuance. The second patent recognizes the invention of a traffic sensor. During 2003, we received two patents relative to the CrossingGuard product line. One of the patents recognizes our method of predicting and recording a red light violation with a video-based system including the use of violation probability scores. The other patent defines a system and method of detecting and filtering non-violations in a traffic light enforcement system employing a video camera to improve the effectiveness of the system.
As of December 31, 2006, we own 14 U.S. patents and 2 foreign patents. We have three US and three foreign patent applications pending. Eight of our U.S. patents, both of our foreign patents and all of our patent applications have relevance to our traffic enforcement business. The foreign patents correspond to one or more of the U.S. patents. Our patents expire at various times from 2007 to 2023. None relevant to our traffic enforcement business expire before 2018.
Competition
We believe that our products are more technologically advanced than competing systems for traffic enforcement. In red light enforcement, our competition generally consists of multiple still image red light camera systems. These systems generally rely on digital still cameras (or older wet film 35mm cameras) that record only a few frames of evidence regarding a violation and detect vehicles through the use of in-ground sensor loops. In-ground sensor loops require digging up the pavement and are generally unresponsive to vehicles moving below twelve miles per hour. For wet film systems, there is the added burden of retrieving, replacing, developing and scanning the film. Most competitors have developed digital still systems and do not promote wet film applications.
CrossingGuard vehicle detection cameras are installed above the ground, on roadside poles or mast arms. This helps avoid some of the logistical problems associated with installing in-ground loop sensors at an intersection. The system’s digital video evidence consists of both front and rear vehicle images. This ensures fairness so that violations are not issued out of context (e.g., if the violation occurred to make way for an emergency vehicle, as part of a funeral procession or to avoid a crash). In case of a dispute, unlike non-video systems, the violation video sequence can be replayed. This perception of fairness makes our video evidence attractive to city councils, law enforcement officials, courts and the general public.
In speed enforcement, competition is generally limited to single-beam LiDAR or indiscriminate radar detection systems.
Our largest competitors in the enforcement market are Affiliated Computer Services, Inc. (ACS), American Traffic Systems, Inc. (ATS) and Redflex Traffic Systems, Inc. Among others are Lasercraft, Traffipax, and Siemens. Although these companies generally use buried loops, digital still cameras and/or wet film systems, single-beam LiDAR or radar, some may pose a competitive threat due to their size, market share, legacy customer relationships, enhanced driver image, additional products offered and/or citation-processing experience.
Most of our competitors have significantly greater financial, marketing and other resources. As a result, they may be able to respond more quickly to new or emerging technologies or to devote greater resources to the development, promotion and sale of their products than we may. Competitive pressures faced by us may materially affect our business, financial condition and results of operations in an adverse way.
Contracts with Governmental Entities
Our agreements are generally service contracts with states or municipalities that in most circumstances may be cancelled by the customer for various reasons. We retain all patent and other proprietary rights from products developed and delivered under government-supported contracts.
Employees
As of December 31, 2006, we had 110 full-time employees, comprising 12 in engineering and product development, 33 in processing and system support, 46 in program management and field services, 7 in sales and marketing and 12 in management, finance and office support. None of our employees are represented by a labor union. We have experienced no work stoppages and management believes our employee relationships are generally good.
ITEM 1A.
ITEM 1A.
Risk Factors
This Annual Report on Form 10-K and other communications made by us contain forward-looking statements, including statements about our growth and future operating results, development of products, sales and intellectual property. For this purpose, any statement that is not a statement of historical fact should be considered a forward-looking statement. We often use the words “believe,” “anticipate,” “plan,” “expect,” “intend,” “will” and similar expressions to help identify forward-looking statements. References to “we,” “us,” and “our” refer to Nestor, Inc. and its subsidiaries.
We cannot assure investors that our assumptions and expectations will prove to have been correct. Important factors could cause our actual results to differ materially from those indicated or implied by forward-looking statements. Such factors that could cause or contribute to such differences include those factors discussed below. We undertake no intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
Risks Related to Our Business
We have a history of losses and expect to incur losses in the future.
We have a history of net losses. For the years ended December 31, 2006, 2005, and 2004, our net losses have been approximately $7,491,000, $6,764,000 and $6,178,000, respectively. As of December 31, 2006 we had an accumulated deficit of $68,479,000. We expect to incur continuing losses for the foreseeable future due to significant marketing, product delivery, engineering and general and administrative expenses, and those losses could be substantial. We will need to generate significantly higher revenue, or reduce costs, to achieve profitability, which we may be unable to do. Even if we do achieve profitability, we may not be able to sustain or increase our profitability in the future.
We have substantial indebtedness.
As a result of the May 2006 offering of secured notes due May 2011, we have substantial indebtedness and we are highly leveraged. As of December 31, 2006, we have total indebtedness of approximately $25,690,000. Our substantial indebtedness may limit our strategic operating flexibility and our capacity to meet competitive pressures and withstand adverse economic conditions. In addition, our secured notes contain restrictive covenants which, among other things, limit our ability to borrow additional funds, sell equity, repay indebtedness, including the secured notes, before maturity or grant security interests on our assets. Under the terms of the secured notes, we will be unable to refinance our existing debt on more favorable terms.
Our substantial indebtedness could have significant adverse consequences, including:
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requiring us to dedicate a substantial portion of the net proceeds of the debt and any cash flow from operations to the payment of interest, and potentially principal, on our indebtedness, thereby reducing the availability of such proceeds and cash flow to fund working capital, capital expenditures or other general corporate purposes.
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increasing our vulnerability to general adverse economic and industry conditions,
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limiting our ability to obtain additional financing to fund future working capital, capital expenditures, research and development and other general corporate requirements;
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limiting our flexibility in planning for, or reacting to, changes in our business and the industry; and
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placing us at a disadvantage compared to our competitors with less debt and competitors that have better access to capital resources.
Furthermore, in order to repay our indebtedness at maturity, if not converted into common stock, including the secured notes, we will need to refinance all or a portion of that indebtedness. There can be no assurance that we will be able to effect any such refinancing on commercially reasonable terms or at all.
Our debt service costs exceed our current operating cash flow.
For the year ended December 31, 2006, and each of our prior fiscal years, we had negative operating cash flow, and we expect to continue to incur negative operating cash flow in future periods. Our ability to make scheduled payments of interest or principal, if any, on our indebtedness, including the secured notes, or to fund planned capital expenditures, will depend on our future performance, which, to some extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. There can be no assurance that future revenue growth will be realized or that our business will generate sufficient cash flow from operations to enable us to service our indebtedness or to fund our other liquidity needs.
If our financial performance doesn’t improve, our interest costs will increase.
The interest rate on our secured notes is subject to a 2% increase if we fail to achieve EBITDA (defined as earnings before interest, taxes, depreciation and amortization, any derivative instrument gain or loss or any employee stock option expense under SFAS 123R, “Share-Based Payment ) of at least $1,250,000 for our fiscal quarter ending June 30, 2007. For the quarter ended December 31, 2006, EBITDA as so calculated was negative $1,370,000. There is no assurance that we will be able to achieve $1,250,000 of EBITDA by the second quarter of fiscal 2007, which would result in a material increase in our fixed interest expense and could adversely affect our results of operations and financial condition.
We have granted a lien on substantially all of our assets.
Our obligations under the secured notes are secured by substantially all of our assets and substantially all of the assets of our principal subsidiaries, except as to contracts we enter into after October 1, 2006 and all assets directly related thereto. Upon an event of default under the secured notes, these lenders could elect to declare all amounts outstanding, together with accrued and unpaid interest thereon, to be immediately due and payable. If we were unable to repay those amounts, such lenders will have a first claim on our assets and the assets of our subsidiaries. If these creditors should attempt to foreclose on their collateral, it is unlikely that there would be any assets remaining after repayment in full of such secured indebtedness and our financial condition and, thus, the value of our common stock, would be materially adversely affected.
We will need additional financing, which may be difficult or impossible to obtain and may restrict our operations and dilute stockholder ownership interest.
At December 31, 2006, we had approximately $25,690,000 million of outstanding debt, at par value. We will need to raise additional funds in the near future to fund our operations, deliver our products, expand or enhance our products and services, finance acquisitions and respond to competitive pressures or perceived opportunities. Because the nature of our operations requires us to bear all the up-front costs of deploying our technology, additional funds will be crucial to our continuing operations. We cannot provide any assurance that additional financing will be available on acceptable terms, or at all. If adequate funds are not available or not available on acceptable terms, our business and results of operations may suffer. We cannot provide any assurance that we can continue as a going concern unless we raise the additional financing.
Our outstanding debt contains restrictive covenants that limit our ability to raise additional funds through debt financings. As a result of these restrictions, any additional debt must be for the sole purpose of financing the design, engineering, installation, construction, configuring, maintenance, or operation or improvement of property or equipment at customer sites pursuant to customer contracts entered into after October 1, 2006 and will not be available to fund general overhead expenses. If we raise additional funds through a debt financing, the terms and conditions of the debt financing may result in further restrictions on our operations or require that we grant a security interest in some or all of the assets related to the customer contracts toward which such financing would be applied. Any debt that we incur would increase our leverage and could exacerbate the negative consequences described above under “- We have substantial indebtedness.”
Additionally, we could be required to seek funds through arrangements with collaborative partners or others that may require us to relinquish rights to certain of our technologies, product candidates or products which we would otherwise pursue on our own.
Our outstanding debt consists of convertible notes which contain anti-dilution provisions which would lower the conversion price if we were to issue equity for a price less than the conversion price. We also have outstanding warrants to purchase our common stock which contain anti-dilution provisions which would lower the exercise price and increase the number of shares issuable upon exercise if we were to issue equity for a price less than the exercise price. If we raise additional funds by issuing equity securities, which would require the consent of our secured Noteholders, further dilution to our then-existing stockholders will result and the terms of the financing may adversely affect the holdings or the rights of such stockholders.
Substantially all of our current revenue is from a single product and related services.
Currently, substantially all of our revenue is from our red light enforcement systems and services. While we have recently begun to deploy the speed enforcement products, there can be no assurance that we will be able to generate significant revenue from this product or that we will be able to develop other sources of revenue. Because our revenue depends substantially on a single product, any decrease in the market share held by CrossingGuard, unless offset by other revenue sources, would have a substantial adverse effect on our business, financial condition and results of operations. If we fail to meet our expectations for the growth in sales of CrossingGuard and Poliscan or if we are not able to expand our speed enforcement business or develop other sources of revenue, we will not be able to generate the significantly higher revenue that we believe we must generate to achieve profitability.
We have limited experience in the speed enforcement market.
We have limited experience in the speed enforcement market. Currently, we are only party to nine speed enforcement contracts, one of which is a pilot program that we expect will run through the end of the current school year, and thereafter be replaced by a longer term program with a vendor selected through an RFP. There can be no assurance that we will obtain additional speed enforcement contracts. Furthermore, since we have only limited experience in deploying the Poliscan automated enforcement system, we cannot assure you that this product will be profitable, new customers will be obtained, or that any revenue from the sale of these systems will be sustainable.
We may not maintain our rights to market Poliscan.
Under our contract with Vitronic, if we fail to generate specific sales volume during each year of the contract beginning with the year ending June 30, 2007, Vitronic can elect to terminate our exclusivity or the entire contract. There can be no assurance that we will meet the performance targets under the contract. Because the growth of our speed business, namely the increased deployment of Poliscan systems, is a key component of our growth strategy, the termination of the Vitronic contract could adversely affect our business and results of operations.
A substantial portion of our debt is subject to redemption at the holder’s option prior to maturity.
The holders of our secured notes have the right to require us to redeem all or any portion of those notes on May 25, 2009, unless our consolidated EBITDA (defined as earnings before interest, taxes, depreciation and amortization, any derivative instrument gain or loss or any employee stock option expense under SFAS 123R, “Share-Based Payment”) for 2008 exceeds $14,000,000. The terms of our secured notes do not permit us to refinance those notes or to borrow to redeem the notes prior to maturity. Thus, our ability to redeem the secured notes if tendered will depend upon our operating performance as well as prevailing economic and market conditions and other factors beyond our control. Failure to redeem properly tendered notes would constitute an event of default, which, if not cured or waived, could have a material adverse effect on our financial condition, and thus, the value of our common stock.
Our financial condition and results of operations may be adversely affected if we are unable to secure and maintain future contracts with government entities.
Contracts with government entities account for essentially all of our revenue. The majority of these contracts may be terminated at any time on short notice with limited penalties. Accordingly, we might fail to derive any revenue from sales to government entities in any given future period. If government entities fail to renew or if they terminate any of these contracts, it would adversely affect our business and results of operations. Our existing contracts typically authorize the installation of our products at a specified number of approaches. As of December 31, 2006, our active contracts with state and local governments authorized the installation of CrossingGuard at up to an additional 245 approaches. In many cases, we cannot proceed with these installations until the sites and related installation plans have been approved by the contracting entities, which can be a lengthy process. In those cases, if government entities fail to approve sites, we will not be able to deliver products and services or generate revenue associated therewith. We cannot assure you that all approaches under contract will ultimately be installed.
We face substantial competition and may not be able to compete successfully.
Many other companies offer products that directly compete with CrossingGuard and our speed products. Many of our current and potential competitors have significantly greater financial, marketing, technical and other competitive resources than we do and may be able to bring new technologies to market before we are able to do so. Some of our competitors may have a competitive advantage because of their size, market share, legacy customer relationships, enhanced driver imaging, additional products offered and/or citation-processing experience. Current and potential competitors may establish cooperative relationships with one another or with third parties to compete more effectively against us. One of our competitors, Affiliated Computer Services, Inc. (ACS), offers state and local governments solutions to a wide variety of data processing issues, has the greatest number of red light camera systems installed, and may have a competitive advantage because of the scope of its relationship with, and the volume of transactions it conducts for, a particular government. It is also possible that new competitors may emerge and acquire market share. Additionally, if we are not successful in protecting our patents, we could lose a competitive advantage. We cannot assure you that we will be able to compete successfully with our competitors. Failure to compete successfully could have a material adverse effect on our business, financial condition and results of operations.
The failure of governments to authorize or maintain automated traffic enforcement may hinder our growth and harm our business.
Currently, 24 states and the District of Columbia either authorize some use of automated red light enforcement or allow municipalities to elect to do so under “home rule” laws, whereby the authority to act in local affairs is transferred from the state to local counties and municipalities through a local home rule charter. It is uncertain at this time which additional states, if any, will allow the use of automated red light enforcement or if there will be other changes in the states that currently allow the practice. If additional states do not authorize the use of automated red light enforcement, our opportunities to generate additional revenue from the sale of CrossingGuard systems and related services will be limited.
Additionally, some states that had previously authorized some use of automated red light enforcement could fail to maintain such authorization. For example, in 2005 the Virginia General Assembly declined to extend authorization for automated red light enforcement beyond the sunset date of June 30, 2005 in the enabling legislation. We had two revenue-producing red light enforcement contracts with municipalities in Virginia. We anticipate no material revenues from the 14 approaches covered by these contracts unless there is a change in Virginia law. It is possible that other states or municipalities could prohibit the use of red light enforcement systems in the future, which could adversely affect our business, financial condition and results of operations.
The market for automated speed enforcement products in the United States is limited. Ten states and the District of Columbia either authorize some use of automated speed enforcement or allow municipalities to elect to do so under “home rule” laws. Some of these states authorize automated speed enforcement only in limited circumstances such as school or work zones. If additional states do not authorize automated speed enforcement, our opportunities to generate additional revenue from the sale of automated speed enforcement systems and related services will be limited.
We could be subject to differing and inconsistent laws and regulations with respect to our products. If that were to happen, we may find it necessary to eliminate, modify or cancel components of our services that could result in additional development costs and the possible loss of revenue. Future legislative changes or other changes in the laws of states authorizing automated red light or speed enforcement in the administration of traffic enforcement programs could have an adverse effect on our business, financial condition and results of operations.
In states in which municipalities or counties are allowed to use automated enforcement under home rule laws, those municipalities or counties must act in accordance with state law in exercising that authority. The failure to act in accordance with state law would subject its automated enforcement program to legal challenge, which, if successful, could invalidate the program. As a result, we could lose our contract with that municipality or county and be required to refund revenue from that program. Currently, our program in Davenport, Iowa is suspended following a district court ruling that Davenport’s ordinance authorizing automated traffic enforcement exceeds the city's home rule authority.
Our products might not achieve market acceptance, which could adversely affect our growth.
The market for our products is still emerging. The rate at which state and local government bodies have accepted automated enforcement programs has varied significantly by locale. We expect to continue to experience variations in the degree to which these programs are accepted. Our ability to grow will depend on the extent to which our potential customers accept our products. This acceptance may be limited by:
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The failure of states to adopt or maintain legislation enabling the use of automated traffic enforcement systems;
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The failure of prospective customers to conclude that our products are valuable and should be used;
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The reluctance of our prospective customers to replace their existing solutions with our products;
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Marketing efforts of our competitors; and
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The emergence of new technologies that could cause our products to be less competitive or obsolete.
Because automated traffic enforcement in the United States is still in an early stage of development, we cannot accurately predict how large the market will become, and we have limited insight into trends that may emerge and affect our business. For example, without knowing how commonplace automated enforcement will become, we may have difficulties in predicting the competitive environment that will develop.
Our speed products are not certified by the International Association of Chiefs of Police.
Potential customers may require or prefer IACP certification of automated speed enforcement equipment. Were a potential customer to require or prefer IACP certification, we would or could lose that potential customer, which would have a material adverse effect on our business, financial condition and results of operations.
Earnings for future periods may be affected by impairment charges.
Because of the nature of our business, long-lived assets, including intangibles, represent a substantial portion of our assets. The Company evaluates long-lived assets for impairment when events or changes in circumstances indicate, in management’s judgment, that the carrying value of such assets used in operations may not be recoverable. The determination of whether an impairment has occurred is based on management’s estimate of undiscounted future cash flows attributable to the assets as compared to the carrying value of the assets. If an impairment occurs, the amount of the impairment recognized will be determined by estimating the fair value for the assets and we will record a charge against earnings if the carrying value is greater than fair value.
Concerns about privacy rights and negative publicity regarding our industry could slow acceptance of our products.
Various advocacy groups and some politicians have expressed concerns that automated traffic enforcement products infringe individual privacy and due process rights. Such concerns can delay the acceptance of our products and result in legal challenges that impede implementation of our traffic enforcement systems. Our business is more vulnerable to these types of challenges because the automated traffic enforcement industry is emerging. Furthermore, in the event of adverse publicity, whether directed at us or our competitors’ products, due to processing errors or other system failures, the automated traffic enforcement industry could suffer as a whole, which would have a material adverse effect on our business, financial condition and results of operations.
Concentration of our processing operations in one location exposes us to potential business interruption in the event of a natural disaster.
We maintain substantially all of our operations, including a majority of our red light and speed enforcement equipment, at our Providence, Rhode Island headquarters. A disruption of our operations for any reason, including theft, government intervention or a natural disaster such as fire, earthquake, flood or other casualty could cause us to limit or cease our operations, which would have a material adverse effect on our business, financial condition and results of operation. Although we maintain business interruption insurance to cover natural disasters, no assurance can be given that such insurance will continue to be available to us on commercially reasonable terms, if at all, or that such insurance would be sufficient to compensate us for damages resulting from such casualty. In addition, no assurance can be given that an interruption in our operations would not result in permanent loss of significant customers, which would have a material adverse effect on our business, financial condition and results of operation.
Our financial results will depend significantly on our ability to continually develop our products and technologies.
Our financial performance will depend to a significant extent on our ability to successfully develop and enhance our products. We must successfully identify product and service opportunities, and develop and bring our products and technologies to market in a timely manner. The success of our product introductions will depend on several factors, including:
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Proper product definition;
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Timely completion and introduction of enhanced product designs;
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The ability of subcontractors and component manufacturers to effectively design and implement the manufacture of new or enhanced products and technologies;
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The quality of our products and technologies;
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Product and technology performance as compared to competitors' products and technologies;
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Market acceptance of our products; and
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Competitive pricing of products, services and technologies.
We have in the past experienced delays in completing the development or the introduction of new products. Our failure to successfully develop and introduce new or enhanced products and technologies or to achieve market acceptance for such products and technologies may materially harm our business and results of operations.
Fluctuations in our results of operations make it difficult to predict our future performance and may result in volatility in the market price of our common stock.
Our quarterly operating results have fluctuated in the past and may fluctuate significantly in the future. We may incur significant expenses in anticipation of revenue, which may not materialize and we may not be able to reduce spending quickly if our revenue is lower than expected. In addition, our ability to forecast revenue, particularly with respect to our new speed products, is limited. As a result, our operating results are volatile and difficult to predict and you should not rely on the results of one quarter as an indication of future performance. Factors that may cause our operating results to fluctuate include the risks discussed in this section as well as:
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Costs related to customization of our products and services;
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Announcements or introductions of new products and services by our competitors;
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The failure of additional states to adopt or maintain legislation enabling the use of automated traffic enforcement systems;
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Determinations by state and local government bodies to utilize our equipment without the additional processing services we provide;
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Software defects and other product quality problems;
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A shift towards fixed rate, as opposed to per ticket, compensation arrangements for our speed products, which could adversely affect revenues;
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Adjustments in the estimates used to report revenue under contracts that require payment only after our customer has collected the fine;
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The discretionary nature of our customers’ internal evaluation, approval and order processes;
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The varying size, timing and contractual terms of orders for our products and services; and
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The mix of revenue from our products and services.
Our sales cycles vary significantly, making it difficult to plan our expenses and forecast our results.
Our sales cycles typically range from several months to over a year. Accordingly, it is difficult to predict the quarter in which a particular sale will occur and to plan our expenses accordingly. The period between our initial contact with potential customers and the installation of our products, the use of our services and our generation of revenue, if any, varies due to several factors, including:
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The complex nature of our products and services;
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Political or legal challenges to legislation authorizing the use of automated traffic enforcement systems;
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The novelty of automated traffic enforcement in many jurisdictions and a lack of familiarity with automated traffic enforcement systems on the part of legislative, executive and judicial bodies and the public;
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The selection, award and contracting processes at municipalities and other government entities, including protests by other bidders with respect to competitive awards;
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Our customers’ internal evaluation, approval and order processes;
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The site evaluation and analysis process; and
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Our customers' delays in issuing requests for proposals or in awarding contracts because of announcements or planned introductions of new products or services by our competitors.
Any delay or failure to complete installations in a particular quarter could reduce our revenue in that quarter, as well as subsequent quarters over which revenue would likely be recognized. If our installation cycles unexpectedly lengthen in general or for one or more large customers, it would delay our generation of the related revenue. If we were to experience a delay of several weeks or longer on a large customer, it could harm our ability to meet our forecasts for a given quarter.
Our intellectual property might not be protectible, and if we fail to protect and preserve our intellectual property, we may lose an important competitive advantage.
We rely on a combination of copyright, trademark, patent and trade-secret laws, employee and third-party nondisclosure agreements and other arrangements to protect our proprietary rights. Despite these precautions, it may be possible for unauthorized parties to copy our products or obtain and use information that we regard as proprietary to create products that compete against ours. In addition, some of our competitors have been able to offer products with some similar features that do not infringe our patents. For example, during the past 18 months we initiated two patent infringement suits against competitors, Redflex Traffic Systems, Inc. and Transol USA, Inc., both of which have been dismissed without a finding of infringement. The scope of United States patent protection in the software industry is not well defined and will evolve as the United States Patent and Trademark Office grants additional patents. Because some patent applications in the United States are not publicly disclosed until the patent is issued or 18 months after the filing date, applications may exist that would relate to our products and are not publicly accessible. Moreover, a patent search has not been performed in an attempt to identify patents applicable to our business and, even if such a search were conducted, all patents applicable to the business might not be located. If we are unable to protect our proprietary rights, we may lose an important competitive advantage, and our business, financial condition and results of operations could suffer.
We are at risk of claims that our products or services infringe the proprietary rights of others.
Given our ongoing efforts to develop and market new technologies and products, we may from time to time be served with claims from third parties asserting that our products or technologies infringe their intellectual property rights. If, as a result of any claims, we were precluded from using technologies or intellectual property rights, licenses to the disputed third-party technology or intellectual property rights might not be available on reasonable commercial terms, or at all, which could restrict our ability to sell our products and services. We may initiate claims or litigation against third parties for infringement of our proprietary rights or to establish the validity of our proprietary rights. Litigation, either as plaintiff or defendant, could result in significant expense and divert the efforts of our technical and management personnel from productive tasks, whether or not litigation is resolved in our favor. An adverse ruling in any litigation might require us to pay substantial damages, to discontinue our use and sale of infringing products and to expend significant resources in order to develop non-infringing technology or obtain licenses for our infringing technology. A court might also invalidate our patents, trademarks or other proprietary rights. A successful claim against us, coupled with our failure to develop or license a substitute technology, could cause our business, financial condition and results of operations to be materially adversely affected. As the number of software products increase and the functionality of these products further overlaps, we believe that our risk of infringement claims will increase.
If we are unable to safeguard the integrity, security and privacy of our data or our customers' data, our revenue may decline, our business could be disrupted and we may be sued.
We need to preserve and protect our data and our customers' data against loss, corruption and misappropriation caused by system failures and unauthorized access. We could be subject to liability claims by individuals, whose data resides in our databases, for misuse of personal information. These claims could result in costly litigation. A party who is able to circumvent our security measures could misappropriate or destroy proprietary information or cause interruptions in our operations. We may be required to make significant expenditures to protect against systems failures, security breaches or to alleviate problems caused by any failures or breaches. Any failure that causes the loss or corruption of, or unauthorized access to, this data could reduce customer satisfaction, expose us to liability and, if significant, could cause our revenue to decline and our expenses to increase.
We may be subject to product liability claims that could result in costly and time-consuming litigation.
Although our customer contracts typically contain provisions designed to limit our exposure to product liability claims, existing or future laws or unfavorable judicial decisions could negate these limitation of liability provisions. Any product liability claim brought against us, even if unsuccessful, would likely be time-consuming and costly, and potential liabilities could exceed our available insurance coverage, which could have an adverse effect on our financial condition and results of operations.
The failure of our suppliers to deliver components, equipment and materials in sufficient quantities and in a timely manner could adversely affect our business.
Our business employs a wide variety of components, equipment and materials from a limited number of suppliers. To date, we have found that the components, equipment and materials necessary for the development, testing, production and delivery of our products and services have sometimes not been available in the quantities or at the times we have required. Our failure to procure components, equipment and materials in particular quantities or at a particular time may result in delays in meeting our customers’ needs, which could have a negative effect on customer satisfaction and on our business, financial condition and results of operations.
If we lose our key personnel or are unable to attract and retain additional personnel, our operations could be disrupted and our business could be harmed.
We believe that the hiring and retaining of qualified individuals at all levels in our organization will be essential to our ability to sustain and manage growth successfully. Competition for highly qualified technical personnel is intense and we may not be successful in attracting and retaining the necessary personnel, which may limit the rate at which we can develop products and generate sales. We will be particularly dependent on the efforts and abilities of our senior management personnel. The departure of any of our senior management members or other key personnel could harm our business.
We may make acquisitions, which could divert management’s attention, cause ownership dilution to our stockholders and be difficult to integrate.
We may seek to expand our operations through the acquisition of complementary businesses. Our future growth may depend, in part, upon the continued success of our acquisitions. Acquisitions involve many risks, which could have a material adverse effect on our business, financial condition and results of operations, including:
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Acquired businesses may not achieve anticipated revenues, earnings or cash flow;
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Integration of acquired businesses and technologies may not be successful and we may not realize anticipated economic, operational and other benefits in a timely manner, particularly if we acquire a business in a market in which we have limited or no current expertise or with a corporate culture different from ours;
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Potential dilutive effect on our stockholders from the issuance of common stock as consideration for acquisitions;
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Adverse effect on net income from impairment charges related to goodwill and other intangible assets, and other acquisition-related charges, costs and expenses effects on net income;
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Competing with other companies, many of which have greater financial and other resources, to acquire attractive companies, making it more difficult to acquire suitable companies on acceptable terms or at all; and
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Disruption of our existing business, distraction of management, diversion of other resources and difficulty in maintaining our current business standards, controls and procedures.
Risks Related to Our Common Stock
Our common stock price is volatile and may decline in the future.
The market price of our common stock has fluctuated significantly and may be affected by our operating results, changes in our business, changes in the industry in which we conduct business, and general market and economic conditions that are beyond our control. In addition, the stock market in general has recently experienced extreme price and volume fluctuations. These fluctuations have affected stock prices of many companies without regard to their specific operating performance. These market fluctuations may make it difficult for stockholders to sell their shares at a price equal to or above the price at which the shares were purchased. In addition, if our results of operations are below the expectations of market analysts and investors, the market price of our common stock could be adversely affected.
Our board of directors can, without stockholder approval, cause preferred stock to be issued on terms that could adversely affect common stockholders.
Under our certificate of incorporation, our board of directors is authorized to issue up to 10,000,000 shares of preferred stock, of which 180,000 shares are issued and outstanding, and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any further vote or action by our stockholders. If the board causes any additional preferred stock to be issued, the rights of the holders of our common stock could be adversely affected. The board's ability to determine the terms of preferred stock and to cause its issuance, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no current plans to issue additional shares of preferred stock.
Our President and Chief Executive Officer beneficially owns a significant amount of our common stock and, accordingly, exercises significant control over our business and affairs, including the approval of change in control transactions.
As of December 31, 2006, our President and Chief Executive Officer beneficially owns approximately 51.3% of our common stock, which includes shares of common stock held by Silver Star Partners I, LLC (Silver Star), of which he serves as the managing director. Based on the number of shares of common stock outstanding as of February 28, 2007, our President and Chief Executive Officer will be able to exert substantial influence over all matters requiring approval by our stockholders. These matters include the election and removal of directors and any merger, consolidation or sale of all or substantially all of our assets. This concentration of ownership may have the effect of delaying, deferring or preventing a change in control, or impeding a merger, consolidation, takeover or business combination even if the transaction might be beneficial to our stockholders.
In addition, Section 203 of the General Corporation Law of the State of Delaware restricts business combinations with any “interested stockholder” as defined by the statute. The statute may have the effect of delaying, deferring or preventing a change in control of our company.
Provisions of our secured notes and secured note warrants could delay or prevent a change of control
There are provisions in our secured notes and secured note warrants that may discourage, delay or prevent a merger or acquisition because, upon a change of control (as defined in the notes), the holders of the secured notes have the right to redeem some or all of their secured notes and the holders of the secured note warrants will have the right to effectively accelerate the maturity date and demand payment.
We have not paid, and do not intend to pay, dividends and therefore, unless our common stock appreciates in value, our investors may not benefit from holding our common stock.
We have not paid any cash dividends since inception. We intend on retaining any future earnings to support the development and expansion of our business, and, therefore, we do not anticipate paying any cash dividends in the foreseeable future. As a result, our investors will not be able to benefit from owning our common stock unless the market price of our common stock becomes greater than the basis that these investors have in their shares.
We have a significant number of options, warrants and convertible securities outstanding, which if exercised or converted, will have a dilutive effect upon our stockholders. The anti-dilution provisions of some of these securities could magnify that dilutive effect..
As of December 31, 2006, we have issued and outstanding warrants and options to purchase up to approximately 5,879,454 shares of our common stock, preferred stock convertible into 18,000 shares of our common stock and debt convertible into approximately 7,136,111 shares of our common stock.
Furthermore, the documents governing our convertible debt have anti-dilution provisions, pursuant to which the conversion price is reduced if we sell common stock at a price below the conversion price, which is now $3.60 per share. The secured notes provide “full ratchet” anti-dilution protection until May 25, 2009 and “weighted average” anti-dilution protection thereafter. The holders of our 5% notes also have “full ratchet” anti-dilution protection until maturity of the notes. In addition, some of our warrants contain weighted average anti-dilution provisions that would lower the exercise price and increase the number of shares issuable upon exercise if we sell stock at a price below $4.35.
Unlike ordinary anti-dilution provisions, “full ratchet” anti-dilution provisions have the effect of extending a “lowest price guarantee” to the holders of the secured notes and the 5% notes.
If the holders of these securities convert the notes or exercise the options and warrants, we will issue shares of our common stock and such issuances will be dilutive to our stockholders. Because the conversion price of the notes and the exercise price of the warrants may be adjusted from time to time in accordance with the anti-dilution provisions of the notes and the warrants, the number of shares that could actually be issued may be greater than the amount described above. In addition, if such investors or our other stockholders sell substantial amounts of our common stock in the public market during a short period of time, our stock price may decline significantly.
The price of our common stock may decline because a substantial amount of our common stock is available for trading in the public market.
Availability of shares of our common stock could depress the price of our common stock. A substantial amount of common stock is available for trading in the public market. This amount of stock in the market may cause the price of our common stock to decline. In addition, if our stockholders sell substantial amounts of our common stock in the public markets, the market price of our common stock could fall. These sales might also make it more difficult for us to sell equity or equity-related securities at a time and price that we would deem appropriate. We also have issued options, warrants and convertible securities that can be exercised for, or converted to, shares of common stock, many of which would be freely tradable without restrictions or further registration under the Securities Act.
There were approximately 20,386,816 shares of our common stock outstanding as of December 31, 2006, of which approximately 9,329,390 shares were freely tradable without restrictions or further registration under the Securities Act. Silver Star, our majority stockholder, has the right to require us to register under the Securities Act their resale of all 9,836,430 shares of common stock that it owns, as soon as practicable after Silver Star requests that registration, of which 220,589 were registered on our registration statement (File No. 333-133468) that was declared effective on July 14, 2006.
ITEM 2.
ITEM 2. Properties.
In June 2006, we closed our West Coast field offices in San Diego and Placentia, California and relocated to North Hollywood, California. We entered into a five-year lease for 12,500 square feet of office and warehouse space at the new location with a lease payment of approximately $18,750 per month, subject to renewal terms.
In October 2005, we relocated our corporate headquarters from 400 Massasoit Avenue, East Providence, Rhode Island to 42 Oriental Street, Third Floor, Providence, Rhode Island. We entered into a five-year lease for 12,700 square feet of office space and 11,000 square feet of warehouse space at this new location with lease payments of approximately $8,000 per month for the office space, subject to increase for renewal terms. The warehouse space is rent-free until the first anniversary of the lease, after which time annual rent for the warehouse space became $3,000. We are still the lessee of 4,800 square feet of our former corporate headquarters in East Providence. Our obligations under that lease expire on May 31, 2007.
ITEM 3.
ITEM 3. Legal Proceedings.
Two suits have been filed against us and the City of Akron seeking to enjoin the City of Akron speed program and damages. These cases have been consolidated in the U.S. District Court for the Northern District of Ohio. These cases are:
Mendenhall v. The City of Akron, et al., United States District Court, Northern District of Ohio, Eastern Division, No. 5:06CV0139, in which plaintiff filed a complaint and class action for declaratory judgment, injunctive relief and for a money judgment in an unspecified amount against City of Akron and all of its City Council members in their official capacity and us alleging federal and state constitutional violations. The action was filed in the Summit County Court of Common Pleas and was removed to federal court. On February 17, 2006, we and the other defendants filed a joint motion for judgment on the pleadings. Plaintiff filed an opposition to that motion on March 24, 2006. On May 19, 2006, the court ruled that the Akron ordinance permitting photo enforcement of speeding laws was a proper exercise of municipal power under the Ohio Constitution, but deferred ruling on the alleged due process violations pending an opportunity for discovery by the plaintiff, which was completed on October 20, 2006. The plaintiff amended her complaint on August 8, 2006 to include equal protection violations among her federal constitutional claims. We filed an answer to that amended complaint on August 18, 2006. Dispositive motions in the case were due by November 22, 2006.
Sipe, et al. v. Nestor Traffic Systems, Inc., et al., United States District Court, Northern District of Ohio, Eastern Division, No. 5:06CV0139, in which plaintiffs filed a complaint and class action for declaratory judgment, injunctive relief and for a money judgment in an unspecified amount against us, various past and present employees of ours and the City of Akron and alleging fraud, civil conspiracy, common plan to commit fraud, violations of the Consumer Sales Practices Act, nuisance, conversion, invasion of privacy, negligence, and federal constitutional violation. The action was filed in the Summit County Court of Common Pleas and was removed to federal court. On February 17, 2006, we and the other defendants filed a joint motion for judgment on the pleadings. Plaintiff filed an opposition to that motion on March 24, 2006. On May 19, 2006, the court ruled that the Akron ordinance permitting photo enforcement of speeding laws was a proper exercise of municipal power under the Ohio Constitution, but deferred ruling on the alleged due process violations pending an opportunity for discovery by the plaintiff, which was completed on October 20, 2006. Dispositive motions in the case were due by November 22, 2006.
With respect to both of the above cases, the Court certified a question to the Ohio Supreme Court:
Whether a municipality has the power under home rule to enact civil penalties for the offense of violating a traffic signal light or for the offense of speeding, both of which are criminal offenses under the Ohio Revised Code.
On February 7, 2007, the Ohio Supreme Court accepted the case for determination of the question presented.
With respect to the underlying actions, discovery was complete at the time the Court certified the question to the Ohio Supreme Court.
In addition, from time to time, we are involved in legal proceedings arising in the ordinary course of business. Other than litigation, which is immaterial, we do not currently have any pending litigation other than that described above.
ITEM 4.
ITEM 4. Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2006.
PART II
ITEM 5.
ITEM 5. Market for Registrant’s Common Stock, Related Stockholder Matters and Issuer Purchases of Equity Securities.
The Company’s common stock was traded on the Nasdaq Global Market under the symbol “NEST” in 2005 and through November 26, 2006 The Company transferred to the Nasdaq Capital Market at the opening of business on November 27, 2006. The “NEST” trading symbol did not change. The following table reflects the range of the reported high and low last sale prices on the respective Nasdaq Market for the periods indicated:
Holders of Common Stock
At March 26, 2007, the number of holders of record of the issued and outstanding common stock of the Company was 384.
Dividend Policy
The Company has not paid any cash dividends with respect to its common stock since formation and does not expect to pay cash dividends in the foreseeable future.
Securities Authorized for Issuance Under Equity Compensation Plans
Incorporated by reference from the Company's definitive proxy or information statement to be filed with the Securities and Exchange Commission not later than 120 days following the end of the Company’s fiscal year.
ITEM 6.
ITEM 6. Selected Financial Data.
The following is a summary of key financial measurements monitored by management. The financial statements for fiscal years 2004 and 2003 and for the fiscal quarters therein, along with the first three quarters of fiscal 2005, have been restated. You should read the data set forth below in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Result of Operations,” Item 1A, “Risk Factors,” and our consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K.
SELECTED BALANCE SHEET DATA:
(Note: Earnings per share information as previously reported for fiscal year ended December 31, 2002 has been adjusted to a post-reverse split basis.)
We are a capital-intensive business, so in addition to focusing on GAAP measures, we focus on modified EBITDA to measure our results. We calculate this number by first calculating EBITDA, which we define as net income before interest expense, debt restructuring or debt extinguishment costs (if any during the relevant measurement period), provision for income taxes, and depreciation and amortization. Then we exclude derivative instrument income or expense, debt discount expense, share-based compensation expense, and asset impairment charges These measures eliminate the effect of financing transactions that we enter into on an irregular basis based on capital needs and market opportunities, and these measures provide us with a means to track internally generated cash from which we can fund our interest expense and our growth. In comparing modified EBITDA from year to year, we also ignore the effect of what we consider non-recurring events not related to our core business operations to arrive at what we define as modified EBITDA. Because modified EBITDA is a non-GAAP financial measure, we include in the tables below reconciliations of modified EBITDA to the most directly comparable financial measures calculated and presented in accordance with accounting principles generally accepted in the United States.
We present modified EBITDA because we believe it provides useful information regarding our ability to meet our future debt payment requirements, capital expenditures and working capital requirements, and that it provides an overall evaluation of our financial condition. In addition, modified EBITDA is defined in certain financial covenants under our 7% Senior Secured Convertible Notes and may be used to adjust the interest rate on those notes at July 1, 2007 and January 1, 2009 and determine whether the holders of those notes have a redemption right at May 25, 2009.
Modified EBITDA has certain limitations as an analytical tool and should not be used as a substitute for net income, cash flows or other consolidated income or cash flow data prepared in accordance with generally accepted accounting principles in the United States or as a measure of our profitability or our liquidity.
When evaluating modified EBITDA as a performance measure, and excluding the above-noted items, all of which have material limitations, investors should consider, among other factors, the following:
Because modified EBITDA, as defined, excludes some but not all items that affect our net income, modified EBITDA may not be comparable to a similarly titled performance measure presented by other companies.
The table below is a reconciliation of modified EBITDA to net loss for the years ended December 31, 2006, 2005 and 2004:
ITEM 7.
ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Our management’s discussion and analysis of our financial condition and results of our operations contains forward-looking statements, including statements about our growth and future operating results, development of products, sales and intellectual property. For this purpose, any statement that is not a statement of historical fact should be considered a forward-looking statement. We often used the words “believe,” “anticipate,” “plan,” “expect,” “intend,” “may,” “will” and similar expressions to help identify forward-looking statements.
Actual results may differ from those indicated by such forward-looking statements as a result of various important factors, including, without limitation, those factors discussed in this annual report under the heading “Risk Factors.”
The following discussion and analysis gives effect to the restatement described in Note 3 in the Notes to the Consolidated Financial Statements. For this reason, the data in this section may not be comparable to discussions and data in previously filed annual and quarterly reports.
Executive Summary
We are a leading provider of innovative, automated traffic enforcement systems and services to state and local governments throughout the United States and Canada. We are the only provider of both a fully video-based automated red light enforcement system and a multi-lane, bi-directional scanning light detection and ranging, or LiDAR, speed enforcement system. We also offer a newly developed ViDAR™ speed detection and imaging system as complement to our other products or as a stand-alone speed enforcement system. CrossingGuard, our red light enforcement product, uses our patented image processing technology to predict and record the occurrence of a red light violation, and manages the process of issuing and processing a citation. Poliscan, one of our speed enforcement products, uses technology developed by Vitronic GmbH. We have exclusive distribution rights to Poliscan in North America through February 2010, subject to meeting certain purchase minimums. ViDAR™ uses average speed over distance calculations to detect and record evidence of speeding vehicles. Because ViDAR™ was developed by in-house talent, there are no purchase minimums. By combining CrossingGuard, Poliscan and ViDAR™ with Citation Composer, our proprietary citation preparation and processing software, we are able to provide fully integrated, turnkey red light and speed enforcement solutions.
We generate recurring revenue through contracts that provide for equipment leasing and services on a fixed and/or per citation fee basis. Essentially all of our revenue prior to September 30, 2005 was generated through contracts for our CrossingGuard red light system as explained below. Beginning in the fourth quarter of 2005, we started generating revenue from our PoliScanspeed system. The economics of products and services are tied to the number of operating systems in the field and the number of violations processed by such systems. Customer pricing entails fixed monthly fees, variable per ticket fee pricing structures, or a combination of both. Because fixed fees are based upon the expected level of violations over the contract term, the shift to monthly fixed fee contracts may result in a more stable revenue stream for those installations. Many of our initial red light and speed contracts, however, compensate us on a per ticket paid or issued basis in return for both equipment lease and maintenance and citation processing and customer support services. Depending on the terms of each contract, we realize from $19 to $99 per citation issued or paid and/or fixed monthly fees ranging from $2,000 to $7,000 per approach for system delivery and processing services.
State statutes providing for automated enforcement may impose liability on either the driver or the registered owner of a vehicle for a violation. Driver liability statutes require that the driver be identified, from the photographic evidence, and that the citation be issued and sent to the driver. Registered owner statutes require that the vehicle’s owner be identified, through registration records, and that the citation be issued and sent to the registered owner. Because only the license plate is required for identification under a registered owner statute, program operating efficiencies are much higher, resulting in lower per citation costs and monthly fees for CrossingGuard systems installed in these jurisdictions. Of the twenty-four jurisdictions that currently allow for automated red light enforcement programs, five require that a driver be identified; the other states limit identification to the vehicle license plate and impose liability on the registered owner. Driver identification states are generally in the western part of the US, and include California, Arizona, Oregon, Utah, and Colorado.
Almost all of our contracts provide for the lease of equipment and the services as a bundled, turnkey program over three to five years. The equipment leases are generally classified as operating leases under FAS 13 “Accounting for Leases” and the revenues are realized along with service revenues as services are delivered to a customer over the life of the contract. One contract with Delaware DOT provided for a monthly lease of the roadside equipment, and we transferred this lease to GE Municipal Services for the face value of the roadside equipment, or $80,000 per approach. In accordance with FAS 13, this lease qualified as a sales-type financing lease and we recognized the value received from the leased equipment, and expensed the associated costs of the system in the same period. We delivered 11 and 20 systems to Delaware DOT in 2004 and 2005, respectively, and have completed deliveries of units under the current contract terms.
Our existing CrossingGuard contracts with government entities typically authorize the installation of systems at a specified number of approaches. As of December 31, 2006, our existing active contracts authorized the installation of our CrossingGuard product at up to an additional 245 approaches. Management believes the majority of the authorized approaches under existing active contracts will be installed, but no assurances can be given that all approaches under contract will ultimately be installed due to factors including locating qualifying intersections, budget or personnel considerations, etc.
The following table provides summary information regarding our active CrossingGuard contracts.
On October 26, 2005, we deployed the first of four approved Poliscan systems in the City of Akron, Ohio. We receive fees from $19 per ticket paid to 40% of the ticket fine paid under the existing speed agreements with our customers. We expect that a majority of any future speed enforcement contracts will compensate us on a per ticket paid basis in return for both equipment lease and citation processing and customer support services. We anticipate that we will generally receive fees from $19 to $35 per ticket under future speed enforcement contracts depending on factors including number of units ordered, length of contract, service levels provided, state statutes, and competition.
Our quarterly operating results have fluctuated in the past and may fluctuate significantly in the future. We may incur significant expenses in anticipation of revenue, which may not materialize and we may not be able to reduce spending quickly if our revenue is lower than expected. In addition, our ability to forecast revenue, particularly with respect to our new speed products, is limited. As a result, our operating results are volatile and difficult to predict and you should not rely on the results of one quarter as an indication of future performance. Factors that may cause our operating results to fluctuate include costs related to customization of our products and services; announcements or introductions of new products and services by our competitors; the failure of additional states to adopt or maintain legislation enabling the use of automated traffic enforcement systems; determinations by state and local government bodies to utilize our equipment without the additional processing services we provide; equipment defects and other product quality problems; a shift towards fixed rate, as opposed to per ticket, compensation arrangements for our speed products, which could adversely affect revenues; the discretionary nature of our customers’ internal evaluation, approval and order processes; the varying size, timing and contractual terms of orders for our products and services; and the mix of revenue from our products and services.
During our first 25 years of operations, we developed a number of patented intelligent software solutions for decision and data-mining applications, including financial services, fraud detection and intelligent traffic-management systems. In 2000, we made the strategic decision to concentrate on our traffic management technologies and began to dispose of our other product lines. By 2003, we had exited our financial services, fraud detection and Rail CrossingGuard and TrafficVision business lines, and had refocused our resources on our traffic safety and enforcement systems such as CrossingGuard, our current primary source of revenue. This transition involved a series of licensing arrangements and transfers of our rights. In early 2001, we also entered into two separate source-code licensing agreements for our fraud detection product line appointing Applied Communications, Inc., or ACI, and Retail Decisions, Inc., or ReD, as co-exclusive resellers in the transaction processing industry. Royalty revenues from ACI continued through June 2002 when the royalty stream was assigned to Churchill Lane Associates, or CLA. We do not expect to receive future revenues from this license. Additionally, we transferred to ReD certain of our assets that supported the technology licensed under our license to ReD. No ongoing revenues are expected to be realized from ReD. The licensing, royalty and other payments we received under these licensing arrangements and other transfers of our property and technology financed our operations during 2001 and 2002 and enabled us to develop our traffic enforcement business.
On August 31, 2005, we acquired certain assets of Transol USA, one of our competitors, in a foreclosure sale. The assets included contracts to provide automated red light enforcement services in six U.S. cities at an aggregate of 39 red light approaches, as well as related equipment, intellectual property, inventory, work in process, accounts receivable and unbilled contract revenue related to Transol’s red light enforcement services. We paid $1.8 million for the acquired assets. We funded the acquisition of the acquired assets with internal working capital.
Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require us to make estimates and assumptions. For more information, see Note 2 to the audited financial statements included elsewhere in this report. We believe that of our significant accounting policies, the following may involve a higher degree of judgment and complexity.
Revenue Recognition
In accordance with Staff Accounting Bulletin 104 - Revenue Recognition in Financial Statements (“SAB 104”), revenue is generally recognized and earned when all of the following criteria are satisfied: (a) persuasive evidence of sales arrangements exist, (b) delivery has occurred, (c) the sales price is fixed or determinable, and (d) collectability is reasonably assured. In those cases where all four criteria are not met, we defer recognition of revenue until the period these criteria are satisfied.
The majority of our revenue is derived from three types of customer arrangements:
a.
We provide hardware and equipment, and related third party embedded software (“roadside systems”). The third party embedded software is considered incidental to the system as a whole. In these arrangements, we typically sell or lease the system as a stand alone roadside system and account for it either as a direct sale, in one instance as a sales type lease, as it met the criteria of a sales type lease in Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (FAS) No. 13 - Accounting for Leases, or in most other cases as an operating lease accounted for on a monthly basis. For each arrangement, usually upon delivery for the sales type lease or monthly for operating type leases, revenue is recognized as there exists evidence that an arrangement exists, the system is delivered, the price is fixed or determinable, and collectability is reasonably assured in accordance with SAB 104;
b.
We provide services, which typically include citation processing, back office and hosting services. Software is more than incidental to the services as a whole, but 1) is used by us to capture and internally process the violations and 2) customers do not have the right to and do not take possession of our detection and tracking, or our citation processing and back office software. For these services, we typically recognize revenue on a fixed monthly fee or a per citation fee basis. Revenue usually commences for these service arrangements, upon the first month after inception of operations, as there exists evidence that an arrangement exists, services have been rendered or delivered (citations and other services are delivered), the price is fixed or determinable, and collectability is reasonably assured; and
c.
For two current customers who want to process their own citations, we lease them our detection and tracking and citation processing and back office software and provide monthly customer support on the software. For this arrangement, we recognize revenue in accordance with Statement of Position 97 -2 Software Revenue Recognition. Although all software deliverables are complete in the initial month of operations, and the monthly customer support is the only undelivered element, we recognize revenue on a monthly basis as the citations are issued or paid.
Some contracts include penalty provisions relating to timely performance and delivery of systems and services by us. Penalties are charged to operations in the period the penalty is determinable, if incurred.
Unbilled contract revenue
Unbilled contract revenue represents revenue earned by us in advance of being billable under customer contract terms. Under the terms of some current contracts, we cannot bill the municipality until the court has collected the citation fine. Through September 30, 2005, management recorded unbilled contract revenue in these situations at a net amount, based upon a historical pattern of collections by the courts for the municipalities. The pattern of collections on these citations was periodically reviewed and updated by management.
Based upon review of this policy during discussions with the Securities and Exchange examining division, management decided to defer recognition of income on these contracts until the municipality has collected the applicable citation to which we are entitled to a portion. Management implemented this change in the fourth quarter of 2005 and recorded a cumulative adjustment to reflect the change including a reduction of lease and service revenue and unbilled contract revenues of $149,000.
Allowance for Doubtful Accounts
The allowance for doubtful accounts is evaluated on a regular basis and adjusted based on management’s best estimate of probable losses inherent in receivables, based on historical experience. Receivables are considered to be past due if they have not been paid by the payment due dates. Debts are written off against the allowance when deemed to be uncollectible. Subsequent recoveries, if any, are credited to the allowance when received.
Inventory Obsolescence
We evaluate our inventory for excess and obsolescence on a quarterly basis. In preparing our evaluation, we look at the expected demand for our products for the next three to twelve months in order to determine whether or not such equipment to be installed requires a change in the inventory reserve in order to record the inventory at net realizable value. After discussions with the senior management team, a reserve is established so that inventory is appropriately stated at the lower of cost or net realizable value.
Capitalization of Internal Buildout Costs
The Company's CrossingGuard red light enforcement business requires us to install our technology in the communities that we serve. To do this, the Company deploys internal resources to design, help install, and configure its software and equipment in those communities (i.e. buildout). Buildout costs are defined as directly related payroll, fringe, and related travel and entertainment expense. Those buildout costs are capitalizable as part of the cost of the system deployed under contract in a community we serve and depreciated over the life of the contract. The Company accumulates the amount of those internal buildout costs incurred on a quarterly basis and capitalizes them. Internal buildout costs capitalized in 2006 were approximately $598,000, and no costs were capitalized in 2005 and 2004, as most buildout costs were out sourced in prior years.
Share-Based Compensation
In the first quarter of 2006, we adopted Statement of Financial Accounting Standards No. 123(R) "Share-Based Payments" ("SFAS 123(R)"), which required all share-based payments to employees to be recognized in our financial statements at their fair value. We have continued to use the Black-Scholes option pricing model to determine fair value of options under SFAS 123(R) and have elected to use the modified-prospective transition method, in which prior period financial statements will not be restated but disclosure of the pro forma net loss calculation will be included in the footnotes to the financial statements for periods prior to fiscal 2006 and the adoption of SFAS123(R).
The calculation of stock-based compensation requires the use of a valuation model and related assumptions. The use of the Black-Scholes option pricing model requires the use of subjective assumptions including an estimate of the volatility of our stock, the expected life of our share-based instruments, the expected forfeitures of share-based instruments, the expected dividend rate on our common stock, and the risk free interest rates that can materially affect our fair value estimate of our share-based instruments. Changes in these estimates and assumptions could materially impact the calculation of stock-based compensation.
Derivative Instruments
In connection with the sale of debt or equity instruments, we may sell options or warrants to purchase our common stock. In certain circumstances, these options or warrants may be classified as derivative liabilities, rather than as equity. Additionally, the debt or equity instruments may contain embedded derivative instruments, such as variable conversion options, which in certain circumstances may be required to be bifurcated from the host instrument and accounted for separately as a derivative instrument liability.
The identification of, and accounting for, derivative instruments is complex. Derivative instrument liabilities are re-valued at the end of each reporting period, with changes in fair value of the derivative liability recorded as charges or credits to income in the period in which the changes occur. For options, warrants and bifurcated conversion options that are accounted for as derivative instrument liabilities, we determine the fair value of these instruments using the Black-Sholes option pricing model, binomial stock price probability trees, or other valuation techniques, sometimes with the assistance of a certified valuation expert. These models require assumptions related to the remaining term of the instruments and risk-free rates of return, our current common stock price and expected dividend yield, and the expected volatility of our common stock price based on not only the history of our stock price but also the experience of other entities considered comparable to us. The identification of, and accounting for, derivative instruments and the assumptions used to value them can significantly affect our financial statements.
Long-Term Asset Impairment
In assessing the recoverability of our long-term assets, management must make assumptions regarding estimated future cash flows, contract renewal options and other factors to determine its fair value. If these estimates change in the future, we may be required to record impairment charges that were not previously recorded. During the year ended December 31, 2006, the Company recorded impairment charges of $2,366,000 primarily related to its Transol red light contracts.
Deferred Taxes
We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance. In the event we determine that we would be able to realize our deferred tax assets in excess of their net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made.
Concentrations of credit risk
Our financial instruments that are exposed to concentrations of credit risk consist primarily of cash and cash equivalents, marketable equity securities and trade accounts receivable. We place our cash and temporary cash investments with high credit quality financial institutions. At times such investments may be in excess of the FDIC limit. However, senior management continually reviews the financial stability of these financial institutions. We routinely assess the financial strength of our customers, most of which are municipalities, and, as a result, believe that our trade accounts receivable credit risk exposure is limited. We do not require collateral from our customers.
Liquidity and Capital Resources
Cash Position and Working Capital
We had cash, cash equivalents and marketable securities totaling $3,010,000 at December 31, 2006 compared with $1,280,000 at December 31, 2005. At December 31, 2006, we had working capital of $3,433,000 compared with a working capital deficit of $2,097,000 at December 31, 2005. Our net worth at December 31, 2006 was $5,502,000 compared with $5,407,000 at December 31, 2005.
The $1,730,000 increase in cash is primarily due to: (i) our private stock placement on January 31, 2006 that raised $4,822,000, net of expenses, and (ii) proceeds of $26,397,000, net of expenses, received from our placement of $28,550,000 in 7% Senior Secured Convertible Notes on May 25, 2006 reduced by the repayment of existing debt of $10,850,000 and the return of $5,710,000 to the 7% Noteholders upon their exercise of their right to put back 20% of the debt to the Company at the end of the year. These net proceeds were offset by (iii) cash used in our operations in the year of $6,324,000, and (iv) investments in capitalized systems of $6,270,000 which are expected to generate revenue in future periods.
The increase in net worth was primarily the result of the private stock placement discussed above offset by our twelve month net loss of $3,818,000 excluding stock compensation charges of $2,506,000. We continue to seek additional sources of equity and debt financing to fund operations and to position ourselves to capitalize on new market and growth opportunities; however, there can be no assurance that the funds will be available on terms acceptable to us, if at all.
Historically, we have raised capital by/through a series of privately placed debt and equity transactions. See notes 7 and 10 to the consolidated financial statements.
On January 31, 2006, the Company sold 1,237,811 shares of its common stock to fifteen accredited investors at $4.42 per share raising $4,822,000, net of expenses and issued warrants to purchase 371,339 shares of its common stock exercisable at $4.91 per share expiring on January 31, 2009. The Company used $1,250,000 of the proceeds to immediately retire the Heil Secured Promissory Note. Among the purchasers was Silver Star Partners, an affiliate of the Company, which purchased 220,589 shares and a warrant to purchase an additional 66,176 shares.
On May 24, 2006, the Company entered into a Securities Purchase Agreement with several institutional and accredited investors to sell $28,550,000 of units consisting of five-year, 7% senior secured convertible promissory notes, convertible into shares of the Company’s common stock, and five-year warrants to purchase 1,982,639 shares of common stock, in a private placement pursuant to Regulation D under the Securities Act of 1933. The transaction was closed on May 25, 2006.
On March 30, 2007, the Company entered into a Note Purchase Agreement, which will be effective as of April 1, 2007, pursuant to which accredited investors (some of whom are affiliates of the Company) agreed to purchase $1.5 million of the Company’s Variable Rate Senior Notes due May 25, 2011 (the “Speed Notes”), which Speed Notes are secured by a first priority security interest in all of the Company’s assets which are directly and exclusively used for the implementation and performance of existing (entered into after October 1, 2006) and future contracts for fixed and mobile automated speed enforcement units.
Speed Note holders will receive interest payments equal to (a) $5.00 per paid citation issued with the Equipment (for “as issued” contracts), (b) $6.00 per paid citation (for “as paid” contracts) and (c) 17% of amounts collected (for “fixed fee” contracts), subject to a minimum return of 10% per annum, payable quarterly in arrears. Payments will be made based upon citations issued from 16 speed units per $1.5 million in aggregate outstanding principal on all Notes. Once the Company has entered into contracts for the operation of 16 speed units, the Company may, but is not obligated to, sell an additional $1.5 million of Speed Notes.
The Speed Notes will mature on May 25, 2011, at which time the Company will pay all unpaid principal together with all accrued but unpaid interest. The Company may at any time redeem the Speed Notes at 110% of face value plus accumulated but unpaid interest.
The proceeds from the Speed Notes will be used, either prospectively or retrospectively, to fund the purchase price or cost of design, engineering, installation, construction, configuring, maintenance, or operation or improvement of property or equipment used in contracts signed after October 1, 2006 at a customer site, including without limitation, costs of site analysis and preparation.
The foregoing is a summary only of the Note Purchase Agreement and the Speed Notes. This summary is qualified in its entirety by reference to the actual Note Purchase Agreement (with the form of Speed Note attached thereto) in its entirety attached to this Annual Report as Exhibit 10.81.
We continue to seek additional sources of equity and debt financing to fund system installations and to position ourselves to capitalize on new market and growth opportunities; however, there can be no assurance that the funds will be available on terms acceptable to us, if at all.
Commitments, Contractual Obligations and Off-Balance Sheet Arrangements
The following table summarizes the Company’s contractual obligations at December 31, 2006, and the effect such obligations are expected to have on its cash flow in future periods:
(1) Primarily facility lease obligations in Providence, RI and Los Angeles, CA.
As of December 31, 2006, we have no off balance sheet arrangements.
For the twelve months ended December 31, 2006, we invested $6,270,000 in capitalized systems and no system costs were expensed under a sales-type lease for Delaware approaches compared to $3,562,000 invested in capitalized systems and $1,253,000 Delaware system costs expensed in the same period last year. Management expects that NTS will make substantial future commitments for systems related to our CrossingGuard contracts.
Results of Operations
The following table sets forth selected operating results, including as a percentage of revenue, for the periods indicated:
Analysis of the Years Ended December 31, 2006 and December 31,
Revenue
During the year ended December 31, 2006, revenue increased $318,000, or 4%, to $8,087,000 from $7,769,000 in the comparable period in 2005. The increase in overall revenue was primarily the result of a 35% increase in lease and service fees offset by no product sales in 2006.
Lease and service fee revenues totaled $8,079,000 in 2006, as compared with $5,975,000 in 2005, an increase of $2,104,000, or 35%, primarily due to additional revenue generating approaches. For the 2006 year, our Red light business began the year with 171 revenue generating approaches and ended with 222 revenue generating approaches. During the 2006 year, we installed 51 revenue generating approaches and did not decommission any. In 2005, we started the year with 111 revenue generating approaches, installed 51 revenue generating approaches, had 26 installed approaches decommissioned and acquired 35 approaches on August 31 from Transol USA. The 26 decommissioned approaches resulted from: (i) on June 30, 2005 14 approaches in Falls Church and Vienna, Virginia were turned off due to the expiration of the enabling law in Virginia, and (ii) the conclusion of a contract with one customer with 12 approaches. Additionally, average monthly revenue generated from approaches installed in 2005 and before, decreased in 2006 as violation rates declined, which typically occurs due to modified driver behavior.
There were no direct product sales or product sales recognized from sales-type leases for CrossingGuard roadside systems in 2006 as compared to $1,600,000 in the period. Prior year direct product sales were with one customer for $158,000 and product sales recognized from sales-type leases were primarily attributable to twenty Delaware approaches being completed and funded (under sales-type leasing) during the year. These product sales are unique and are one-time, non-recurring in nature. Residual royalty streams from two customers relating to technology licenses to IBM and NCS accounted for product royalty revenues of $7,000 and $36,000 in 2006 and 2005, respectively.
Cost of Sales
For the year ended December 31, 2006, cost of sales totaled $6,313,000, an increase of $581,000, or 10%, compared to $5,732,000 in 2005. The increase in cost of sales is primarily due to increased amortization of capitalized systems and associated direct processing and support costs for more revenue-generating red-light approaches and speed units. The twelve months of 2006 also includes higher costs related to our Transol contracts, which we acquired in September 2005 as well as indirect costs for our Poliscan speed business which is not yet profitable. These increases in costs are partially offset by the decline in product cost of sales as a result of no one-time, nonrecurring sales in 2006.
Gross Profit
For the year ended December 31, 2006, gross profit declined $263,000, or 13%, to $1,774,000 from $2,037,000 in 2005, while gross margin decreased by four percentage points to 22% for the year ended December 31, 2006 from 26% for the year ended December 31, 2005. The decline in gross profit is primarily attributable to a higher mix of lower margin sales-type leases in 2006 versus 2005, particularly related to our acquired Transol contracts and initial investment in our speed business.
Operating Expenses
Total operating expenses amounted to $15,676,000 in 2006, an increase of $4,362,000, or 39%, over total operating expenses of $11,314,000 in 2005. The increase is primarily due to (1) the recording of a $2,366,000 nonrecurring non-cash impairment charge in the year relating to our long lived assets mostly associated with our Transol contracts acquired in 2005, and (2) the adoption of FAS123R in 2006 by recording a $2,506,000 non-cash stock compensation charge, offset by (3) steps taken to reduce costs including the reduction in salaries to most employees by 10% during the year including management under employment contract, and terminating nine employees in the first quarter and 27 in the fourth quarter. The severance cost of these actions was $66,000 and is primarily included in operating expense during the year.
In March 2006, the Company took steps to reduce costs including the reduction in salaries to most employees by 10% including management under employment contract, and terminated nine employees. The severance cost of this action was $102,000 and primarily affected our operating expenses. In November 2006, we instituted additional operational cost reductions in an internal reorganization intended to focus the company's operations on program delivery and support and reduce current operating expense levels. The reorganization resulted in the reduction of 27 employees, or approximately 20% of the workforce, which is expected to result in an annual payroll reduction of over $1.5 million. The cost savings of the actions taken in the fourth quarter of 2006 actions are not expected to begin to affect our financial results until the first quarter of 2007.
Engineering and operations expenses totaled $4,373,000 in the year ended December 31, 2006, an increase of $323,000, or 8%, compared to $4,050,000 in 2005. Excluding the $290,000 stock compensation charge recorded in 2006, the increase in costs related to supporting our increased install base partially offset by the impact of the March 2006 cost reduction program.
Research and development expenses totaled $1,383,000 in the year ended December 31, 2006, a decline of $354,000 compared with $1,737,000 in the comparable year of 2005. Excluding the $119,000 stock compensation charge recorded in 2006, research and development expenses declined $473,000. The transition of our red light technology from analog to digital as well as the commercialization of our mobile speed enforcement technology was substantially completed in 2006 resulting in a decline in R&D costs in the latter half of the year. We expect research and development costs to continue to decline in 2007.
Selling and marketing expenses totaled $2,180,000 in the year ended December 31, 2006, an increase of $123,000, or 6%, compared with $2,057,000 in 2005. Excluding the $79,000 stock compensation charge recorded in 2006, sales and marketing costs were relatively flat with the prior year.
General and administrative expenses totaled $5,374,000 for the year ended December 31, 2006, an increase of $1,904,000, or 55%, compared with $3,470,000 in 2005. Excluding the $1,992,000 stock compensation charge recorded in 2006, general and administrative expenses declined slightly primarily due to the reduction in legal expenses associated with the conclusion of a patent infringement case in June 2005.
We assess potential impairment of our long-lived assets on an annual basis or more frequently as events or circumstances indicate that an asset may be impaired. Our long-lived assets are primarily capitalized systems, property and equipment, and our identifiable intangibles such as goodwill and customer contracts. We determine such impairment by measuring the estimated undiscounted future cash flow generated by the assets, comparing the result to the asset carrying value and adjust the asset to the lower of its carrying value or fair value and charging current operations for the measured impairment. The determination of the asset fair value is subject to significant judgment. In the second quarter of 2006, the Company recorded a $175,000 impairment charge relating to two of our red-light contracts. In the fourth quarter of 2006, the Company recorded a $2,191,000 impairment charge primarily relating to long-lived assets associated with underperforming contracts we acquired from Transol, Inc. in 2005. These impairment charges had no impact on our operating covenants associated with our debt agreements.
Derivative instrument income (expense)
Derivative instrument income for the year ended December 31, 2006 totaled $16,940,000 as compared to income of $7,780,000 for the year ended December 31, 2005.
The changes were attributable to changes in the fair market value of embedded derivatives issued with our convertible debt. The fair value of the derivatives will fluctuate based on: our stock price at particular points in time, the debt conversion price, the volatility of our stock price over a period of time, changes in the value of the risk free interest rate, and the remaining time to maturity of the outstanding debt.
The major factors contributing to the change for the year ended 2006 was due to the decline in the fair market value of our derivative instrument liabilities relating to our convertible debt due to the passage of time and a decline in our stock price.
Debt discount expense
Debt discount expense for the year ended December 31, 2006 totaled $8,664,000 as compared to an expense of $4,054,000 for the year ended December 31, 2005.
The increase in year ending December 31, 2006 is primarily due to higher debt discounts associated with the sale of our 7% Senior Secured Convertible Notes, and higher debt discounts on the extension of our 5% Senior Convertible Notes in May 2006. These debt discounts are established at the time a derivative is bifurcated from the host debt agreement at issuance and amortized over the life of the note.
Loss on Debt Refinancing
During December 2005, the company retired a Laurus convertible note issued in May in the face amount of $6,000,000 which resulted in a loss on retirement of $509,000 related to the write-off of the discount applied to the note for the value of the warrants originally issued with the note. The note was retired in conjunction with the issuance of a new, non-convertible note to Laurus with a face value of $6,000,000.
Other Expense - Net
Other expense, net totaled $1,865,000 in the year ended December 31, 2006, an increase of $1,161,000, or 65%, compared with other expense, net of $704,000 in 2005. The increase is primarily attributable to higher levels of interest expense on the new 7% Senior Secured Convertible Notes.
Net Loss
For the year ended December 31, 2006, we incurred a net loss of $7,491,000, or $0.37 per share, an increase of $727,000, compared with a net loss of $6,764,000, or $0.36 per share, in 2005. The increase in net loss was primarily due to (1) the recording of a $2,366,000 nonrecurring non-cash impairment charge in the year relating to our long lived assets mostly associated with our Transol contracts acquired in 2005, (2) the adoption of FAS123R in 2006 by recording a $2,506,000 non-cash stock compensation charge, (3) $4,610,000 higher debt discount amortization, (5) $1,161,000 higher other expense, primarily interest, offset by (4) $9,160,000 of higher derivative instrument income in the year.
The increase in net loss per share was primarily due to the increase in our net loss discussed above, partially offset by the increase in outstanding shares. During the year ended December 31, 2006, there were 20,277,770 basic and diluted weighted average shares outstanding compared with 18,826,966 for the year ended 2005.
Analysis of the Years Ended December 31, 2005 and December 31,
Revenue
During the year ended December 31, 2005, revenue increased $1,734,000, or 29%, to $7,769,000 from $6,035,000 in the comparable period in 2004. The increase in overall revenue was primarily the result of an increase in lease and service fees and product sales.
Lease and service fee revenues totaled $5,975,000 in 2005, as compared with $5,118,000 in 2004, an increase of $857,000, or 17%, primarily due to additional revenue generating approaches. For the 2005 year, we began the year with 111 revenue generating approaches and ended with 171 revenue generating approaches. During the 2005 year we installed 51 revenue generating approaches, had 26 installed approaches decommissioned, and acquired 35 approaches on August 31 from Transol USA. The 26 decommissioned approaches resulted from: (i) on June 30, 2005 14 approaches in Falls Church and Vienna, Virginia were turned off due to the expiration of the enabling law in Virginia, and (ii) the conclusion of a contract with one customer with 12 approaches. In 2004, we started the year with 88 revenue generating approaches, installed 23 approaches, and ended the year with 111 revenue generating approaches. Additionally, average monthly revenue generated from approaches installed in 2004 and before, decreased in 2005 as violation rates declined, which typically occurs due to modified driver behavior.
Product sales recognized from sales-type leases for CrossingGuard roadside systems, totaled $1,600,000 in the 2005 period, compared with $880,000 in the 2004 period, an increase of $720,000 or 82%. This primarily represents delivery of 20 roadside systems in the 2005 year, compared to delivery of 11 roadside systems in the 2004 year. Additionally, we recognized $158,000 in direct product sales of our CrossingGuard roadside systems in 2005, while in the 2004 period we did not have direct product sales. Residual royalty streams from two customers relating to technology licenses to IBM and NCS accounted for product royalty revenues of $36,000 and $37,000 in 2005 and 2004, respectively.
Cost of Sales
For the year ended December 31, 2005, cost of sales totaled $5,732,000, an increase of $1,800,000, or 46%, compared to $3,932,000 in 2004. The increase in cost of sales is primarily due to the cost of 9 more roadside systems installed under sales-type leases ($1,253,000 in 2005 as compared to $607,000 in 2004), increased amortization of more installed capitalized systems, other direct processing and support costs due to the increase in citation volumes processed, accelerated amortization of capitalized systems in the amount of $201,000 due to the red light enforcement law expiring in Virginia, and because we also recorded a $330,000 charge in 2005 to reserve for obsolete and excess inventory relating to the conversion and upgrade of certain installations from old to new technology to improve violation capture capability.
Gross Profit
For the year ended December 31, 2005, gross profit declined $66,000, or 3%, to $2,037,000 from $2,103,000 in 2004, while gross margin decreased by 9 percentage points to 26% for the year ended December 31, 2005 from 35% for the year ended December 31, 2004. The decline in gross profit is primarily attributable to a higher mix of lower margin sales-type leases in 2005 versus 2004, the $201,000 of accelerated depreciation due to the shutdown of our Virginia customers as a result of the expiration of the red light enforcement law, and the $330,000 of additional excess and obsolete inventory costs related to the conversion and upgrade of certain installations from old to new technology to improve violation capture capability.
Operating Expenses
Total operating expenses amounted to $11,315,000 in 2005, an increase of $4,565,000, or 68%, over total operating expenses of $6,750,000 in 2004. The increase is primarily due to increased engineering and operating expenses from growth in installed CrossingGuard systems and the development of our speed enforcement program, along with increased investments in our sales and marketing efforts.
Engineering and operations expenses totaled $4,050,000 in the year ended December 31, 2005, an increase of $586,000, or 17%, compared to $3,465,000 in 2004. The increase in engineering and operations expenses are primarily attributable to increased personnel and related field support costs driven by our increased installed base as well as an increase in design and engineering consultant expenses.
Research and development expenses totaled $1,737,000 in the year ended December 31, 2005, an increase of $1,579,000 compared with $157,000 in the comparable year of 2004. The increase in research and development expenses primarily resulted from increased spending in salary and related personnel costs and development consultants attributable to projects advancing our CrossingGuard product technology and development and commercialization of our mobile speed enforcement system.
Selling and marketing expenses totaled $2,057,000 in the year ended December 31, 2005, an increase of $1,183,000, or 135%, compared with $874,000 in 2004. Selling and marketing expenses increases in 2005 are primarily attributable to a larger sales force and support personnel with related increases in sales commissions and travel expenses, as well as due to the strategic use of consultants and marketing activities during the year.
General and administrative expenses totaled $3,470,000 for the year ended December 31, 2005, an increase of $1,216,000, or 54%, compared with $2,254,000 in 2004. The increase in general and administrative expenses for the year ended December 31, 2005 compared to 2004 is primarily related to (i) an increase in payroll and related costs, (ii) an increase in accounting and related costs, (iii) an increase in legal expenses for the prosecution of patent infringement cases, which were concluded in June 2005, (iv) an increase in financing fees due to note conversions and a new financing arrangement, and (v) increased costs associated with shareholder communication and meetings.
Gain on Debt Extinguishment
During the year ended December 31, 2004, obligations to Electronic Data Systems, or EDS, under a lease payable and obligations to Laurus under a convertible note originally issued in July 2003 were fully satisfied, resulting in a net gain of $508,000. An early payment on the lease payable resulted in a gain of $681,000, which was partially offset by a prepayment penalty of $173,000 incurred in the repayment of the convertible note.
Loss on Debt Refinancing
During December 2005, the company retired a Laurus convertible note issued in May in the face amount of $6,000,000 which resulted in a loss on retirement of $509,000 related to the write-off of the discount applied to the note for the value of the warrants originally issued with the note. The note was retired in conjunction with the issuance of a new, non-convertible note to Laurus with a face value of $6,000,000.
Other Expense - Net
Other expense, net totaled $704,000 in the year ended December 31, 2005, an increase of $370,000, or 111%, compared with other expense, net of $334,000 in 2004. In the year ended December 31, 2005, we incurred increased interest expense as a result of higher debt levels, which was partially offset by earnings on investments.
Derivative instrument income (expense)
Derivative instrument income for the year ended December 31, 2005 totaled $7,780,000 as compared to a loss of $1,341,000 for the year ended December 31, 2004.
The changes were attributable to changes in the fair market value of embedded derivatives issued with our convertible debt. The fair value of the derivatives will fluctuate based on: our stock price at particular points in time, the debt conversion price, the volatility of our stock price over a period of time, changes in the value of the risk free interest rate, and the remaining time to maturity of the outstanding debt.
The major factors contributing to the change for the year ended 2005 was due to the decline in the fair market value of our derivative instrument liabilities relating to our convertible debt due to the passage of time and a decline in our stock price.
Debt discount expense
Debt discount expense for the year ended December 31, 2005 totaled $4,054,000 as compared to an expense of $364,000 for the year ended December 31, 2004.
The increase in year ending December 31, 2005 is primarily due to higher debt discounts associated with higher nonconventional convertible debt levels. These debt discounts are established at the time a derivative is bifurcated from the host debt agreement at issuance and amortized over the life of the note.
Net Loss
For the year ended December 31, 2005, we incurred a net loss of $6,764,000, or $0.36 per share, an increase of $586,000, compared with a net loss of $6,178,000, or $0.34 per share, in 2004. The increase in the net loss was a result of (i) substantial investment in operating activities during 2005 of $7,782,000 to improve the CrossingGuard technologies, introduce and integrate the Poliscanspeed technology, deliver the increased revenues, and to support overall expansion of the companies business; (ii) additional financing and interest costs, related to our debt and financing arrangements, and; (iii) offset by the change in fair market value of the embedded derivatives in our senior convertible notes.
The increase in net loss per share was primarily due to the increase in our net loss discussed above, partially offset by the increase in outstanding shares. During the year ended December 31, 2005, there were 18,826,966 basic and diluted weighted average shares outstanding compared with 18,223,609 for the year ended 2004.
ITEM 7A.
ITEM 7A. Quantitative and Qualitative Disclosure about Market Risk
The following discussion of our market risk includes forward looking statements that involve risk and uncertainty. Actual results could differ materially from those projected in the forward looking statements. Market risk represents risk of changes in value of a financial instrument caused by fluctuations in interest rates, foreign exchange rates and equity and bond prices.
Interest Rates
Our marketable securities, an insured municipal bond fund, valued at $58,000 at December 31, 2006, are exposed to market risk due to changes in U.S. interest rates. The primary objective of our investment activities is the preservation of principal while maximizing investment income. Our exposure to this market risk is moderately high in the short-term. During the year ended December 31, 2006, we had an unrealized gain of $8,000 on securities held at December 31, 2006. The securities are classified as “trading securities” and accordingly are reported at fair value with unrealized gains and losses included in other expense, net.
We have senior convertible notes with interest fixed at 5% and 7% through maturity, subject to certain financial performance targets. If the financial performance target for the second quarter of 2007 is not achieved, the interest rate on our 7% senior secured convertible note will increase from 7% to 9% beginning in the third fiscal quarter of 2007. Management assesses the exposure to market risk for these obligations as minimal.
ITEM 8.
ITEM 8. Financial Statements and Supplementary Data
The following consolidated financial statements and the related notes thereto of NESTOR, Inc. and the Report of Independent Registered Public Accounting Firm are filed as a part of this annual report on form 10-K:
CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006
NESTOR, INC.
CONTENTS
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Nestor, Inc.
Providence, Rhode Island
We have audited the accompanying consolidated balance sheets of Nestor, Inc. as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2006. Our audit also included the financial statement schedule for the years ended as listed in the index at Item 15(a)(2). These consolidated financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Nestor, Inc. as of December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
The accompanying consolidated financial statements have been prepared assuming that Nestor, Inc. will continue as a going concern. As disclosed in the consolidated financial statements, Nestor, Inc. has an accumulated deficit at December 31, 2006 and has suffered substantial net losses in recent years, which raise substantial doubt about Nestor, Inc.’s ability to continue as a going concern. Management's plans in regard to these matters are disclosed in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ Carlin, Charron, & Rosen, LLP.
Westborough, Massachusetts
March 30,
NESTOR, INC.
Consolidated Balance Sheets
In Thousands, Except Share And Per Share Information
NESTOR, INC.
Consolidated Statements of Operations
In Thousands, Except Share And Per Share Information
NESTOR, INC.
Consolidated Statements of Stockholders’ Equity
For the Years Ended December 31, 2006, 2005 and 2004
In Thousands, Except Share And Per Share Information
See Notes to the Consolidated Financial Statements.
NESTOR, INC.
Consolidated Statements of Cash Flows
In Thousands, Except Share And Per Share Information
Significant non-cash transactions are further described in Notes 7, 8, and 11.
See Notes to the Consolidated Financial Statements.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share And Per Share Information
Note 1 -
Nature of operations
A.
Organization
Nestor, Inc. was organized on March 21, 1983 in Delaware to acquire and develop certain patent rights and know-how, which we acquired from our predecessor, Nestor Associates, a limited partnership. Our wholly-owned operating subsidiary, Nestor Traffic Systems, Inc. (“NTS”) was formed on January 1, 1997. CrossingGuard, Inc., a wholly owned subsidiary of NTS, was formed July 18, 2003 in connection with a financing. The consolidated financials statements include the accounts of Nestor, Inc. and our wholly-owned subsidiary. All intercompany transactions and balances have been eliminated. Our principal office is located in Providence, RI.
We are a leading provider of innovative, automated traffic enforcement systems and services to state and local governments throughout the United States and Canada. We are the only provider of both a fully video-based automated red light enforcement system and a multi-lane, bi-directional scanning light detection and ranging, or LiDAR, speed enforcement system. We also offer a newly developed ViDAR™ speed detection and imaging system as complement to our other products or as a stand-alone speed enforcement system. CrossingGuard, our red light enforcement product, uses our patented image processing technology to predict and record the occurrence of a red light violation, and manages the process of issuing and processing a citation. Poliscan, one of our speed enforcement products, uses technology developed by Vitronic GmbH. We have exclusive distribution rights to Poliscan in North America through February 2010, subject to meeting certain purchase minimums. ViDAR™ uses average speed over distance calculations to detect and record evidence of speeding vehicles. Because ViDAR™ was developed by in-house talent, there are no purchase minimums. By combining CrossingGuard, Poliscan and ViDAR™ with Citation Composer, our proprietary citation preparation and processing software, we are able to provide fully integrated, turnkey red light and speed enforcement solutions.
B.
Liquidity and management’s plans
The accompanying consolidated financial statements have been prepared assuming we will continue as a going concern, which contemplates continuity of operations, realization of assets and the satisfaction of liabilities and commitments in the normal course of business. We have incurred significant losses since inception and have an accumulated deficit of $68,479 through December 31, 2006. These circumstances raise substantial doubt about our ability to continue as a going concern. Our consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded assets or the amounts and classification of liabilities that might be necessary in the event we cannot continue in existence.
Management believes that given its liquidity at December 31, 2006, its current levels of cash being used by operations, and capital requirements necessary to deliver on current contracts with municipalities, we will be required to raise additional capital in the near term. Even if we obtain the capital desired, there can be no assurance that our operations will be profitable in the future, that our product development and marketing efforts will be successful, or that the additional capital will be available on terms acceptable to us, if at all.
Note 2 -
Summary of significant accounting policies:
A.
Cash equivalents
The Company considers all highly liquid debt instruments purchased with an original maturity of 90 days or less to be cash equivalents.
B.
Marketable securities
The Company’s marketable securities consist of investments in closed-end insured municipal bond funds. The securities are classified as “trading securities” and accordingly are reported at fair value with unrealized gains and losses included in other income (expense).
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
C.
Accounts receivable
Accounts receivable represents balances due from customers, net of $227 and $164 reserve for doubtful accounts at December 31, 2006 and 2005. In determining the need for an allowance, objective evidence that a single receivable is uncollectible as well as a historical pattern of collections of accounts receivable that indicate that the entire face amount of a portfolio of accounts receivable may not be collected is considered at each balance sheet date.
D.
Unbilled contract revenue
Unbilled contract revenue represented revenue earned by the Company in advance of being billable under customer contract terms. Under the terms of some current contracts, the Company cannot bill the municipality until the court has collected the citation fine. Management recorded unbilled contract revenue in these situations at a net amount, based upon a historical pattern of collections by the courts for the municipalities. In 2005, The Company discontinued this practice and records revenue when the citation has been paid.
E.
Inventory
Inventory is valued at the lower of cost or market, with cost determined by the first-in, first-out basis and consists mostly of equipment to be installed as capitalized system costs. The December 31, 2006 and 2005 inventory balances are presented net of a $542 and $540, respectively, inventory reserve.
F.
Property and equipment & depreciation and amortization
Property and equipment are recorded at cost. Depreciation and amortization are calculated using the straight-line method at rates sufficient to write off the cost of the assets over their estimated useful lives.
G.
Goodwill
Goodwill represents the excess of cost over the fair value of net assets acquired. Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets,” requires that goodwill be tested for impairment at least annually and whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Goodwill is reviewed for impairment using the Company’s quoted stock price as a measurement of the Company’s fair value of assets, including goodwill, and liabilities. Any resulting goodwill impairment will be charged to operations.
H.
Product and patent development costs
The costs of development of the Company’s software - which consist primarily of labor and outside consulting, and are an inherent cost of the Company’s business - and costs of research and development are expensed until technological feasibility has been established for the product. Thereafter, all software production costs are capitalized and subsequently reported at the lower of unamortized cost or net realizable value. Capitalized costs are amortized on a straight-line basis over the estimated economic life of the product. The Company currently has no costs eligible for capitalization under the American Institute of Certified Public Accountants Statement of Position 98-1.
Patent-development costs are expensed or capitalized, as appropriate. Amortization of capitalized costs is on a straight-line basis over the shorter of the estimated economic life, or statutory life, of the patent.
I.
Revenue recognition
In accordance with Staff Accounting Bulletin 104 - Revenue Recognition in Financial Statements (“SAB 104”), revenue is generally recognized and earned when all of the following criteria are satisfied: (a) persuasive evidence of sales arrangements exist, (b) delivery has occurred, (c) the sales price is fixed or determinable, and (d) collectability is reasonably assured. In those cases where all four criteria are not met, we defer recognition of revenue until the period these criteria are satisfied.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
The majority of our revenue is derived from three types of customer arrangements:
a)
We provide hardware and equipment, and related third party embedded software (“roadside systems”). The third party embedded software is considered incidental to the system as a whole. In these arrangements, we typically sell or lease the system as a stand alone roadside system and account for it either as a direct sale, in one instance as a sales type lease, as it met the criteria of a sales type lease in Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (FAS) No. 13 - Accounting for Leases, or in most other cases as an operating lease accounted for on a monthly basis. For each arrangement, usually upon delivery for the sales type lease or monthly for operating type leases, revenue is recognized as there exists evidence that an arrangement exists, the system is delivered, the price is fixed or determinable, and collectability is reasonably assured in accordance with SAB 104;
b)
We provide services, which typically include citation processing, back office and hosting services. Software is more than incidental to the services as a whole, but 1) is used by us to capture and internally process the violations and 2) customers do not have the right to and do not take possession of our detection and tracking, or our citation processing and back office software. For these services, we typically recognize revenue on a fixed monthly fee or a per citation fee basis. Revenue usually commences for these service arrangements, upon the first month after inception of operations, as there exists evidence that an arrangement exists, services have been rendered or delivered (citations and other services are delivered), the price is fixed or determinable, and collectability is reasonably assured; and
c)
For two current customers who want to process their own citations, we lease them our detection and tracking and citation processing and back office software and provide monthly customer support on the software. For these arrangements, we recognize revenue in accordance with Statement of Position 97 -2 Software Revenue Recognition. Although all software deliverables are complete in the initial month of operations, and the monthly customer support is the only undelivered element, we recognize revenue on a monthly basis as the citations are issued.
Some contracts include penalty provisions relating to timely performance and delivery of systems and services by us. Penalties are charged to operations in the period the penalty is determinable.
J.
Deferred Revenue
In some cases, a customer may pay the Company an upfront, non-refundable mobilization fee for the Company to install our technology in addition to fees on a per ticket basis over the life of a contract. The Company records the non-refundable mobilization fee as deferred revenue and amortizes it over the life of the contract. Deferred revenue for December 31, 2006 and 2005 was $712 and $103, respectively.
K.
Shipping and handling costs
Shipping and handling costs are capitalized if a material part of a leased system or included in engineering and operations.
L.
Research and development
Research and development costs associated with the Company’s products consist principally of payroll and related costs, facilities costs and the cost of prototype components.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
M.
Impairment of long lived assets
We assess potential impairment of our long-lived assets on an annual basis or more frequently as events or circumstances indicate that an asset may be impaired. Our long-lived assets are primarily capitalized systems, property and equipment, and our identifiable intangibles such as goodwill and customer contracts. We determine such impairment by measuring the estimated undiscounted future cash flow generated by the assets, comparing the result to the asset carrying value and adjust the asset to the lower of its carrying value or fair value and charging current operations for the measured impairment. The determination of the asset fair value is subject to significant judgment. In the second quarter of 2006, the Company recorded a $175 impairment charge relating to two of our red-light contracts. In the fourth quarter of 2006, the Company recorded a $2,191 impairment charge of which $1,737 related to long-lived assets associated with the contracts we acquired from Transol, Inc. in 2005. The components of the $2,366 charge taken in 2006 were $1,364 to capitalized systems, $893 to customer contracts, and $109 to accrued liabilities. No impairment charges were taken in 2005.
N.
Income taxes
The Company accounts for income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and the tax bases of assets and liabilities, and are measured using enacted tax rates and tax laws that will be in effect when the differences are expected to reverse. The primary component of the deferred tax asset, which is fully reserved, is net operating loss carry forwards.
Although the Company reports consolidated results and balances for financial reporting purposes, the individual companies file separate tax returns. Due to operating losses throughout the reporting periods, no provision for income tax has been made.
O.
Earnings (loss) per share and common stock
The Company reports its earnings (loss) per share (“EPS”) in accordance with the provisions of Statement of Financial Accounting Standards No. 128, Earnings Per Share (“SFAS 128”). Basic EPS is calculated by dividing the net income (loss) by the weighted average number of common shares outstanding for the period, without consideration for common stock equivalents. Diluted EPS is computed giving effect to common stock equivalents and other dilutive securities, unless the computation results in anti-dilution. Diluted per share computations are not presented since the effect would be anti-dilutive.
P.
Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Q.
Concentrations of credit risk
The Company’s financial instruments that are exposed to concentrations of credit risk consist primarily of cash and cash equivalents, marketable equity securities and trade accounts receivable. The Company places its cash and temporary cash investments with high credit quality institutions. At times such investments may be in excess of the FDIC limit. However, senior management continually reviews the financial stability of these financial institutions. The Company’s marketable equity securities (primarily cash reserves and an insured municipal bond fund) are exposed to market risk due to changes in U.S. interest rates and fluctuations in foreign currency exchange rates. The securities are classified as “trading securities” and accordingly are reported at fair value with unrealized gains and losses included in other income (expense). The Company routinely assesses the financial strength of its customers, most of which are municipalities, and, as a result, believes that its trade accounts receivable credit risk exposure is limited. The Company does not require collateral from its customers.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
Two customers accounted for 32%, 51% and 40% of the Company’s total revenues in fiscal 2006, 2005 and 2004, respectively. Three customers accounted for 52% of net accounts receivable at December 31, 2006, and two customers accounted for 51% of net accounts receivable at December 31, 2005.
R.
Stock option plans
Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R) (“SFAS 123(R)”), “Share-Based Payment,” which establishes accounting for equity instruments exchanged for employee services. Under the provisions of SFAS 123(R), share-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period of the equity grant). Prior to January 1, 2006, the Company accounted for share-based compensation to employees in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company also followed the disclosure requirements of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-based Compensation (“SFAS 123”). The Company elected to adopt the modified prospective transition method as provided by SFAS 123(R) and, accordingly, financial statement amounts for the prior periods presented in this Form 10-Q have not been restated to reflect the fair value method of expensing share-based compensation. Under this application, we are required to record compensation cost for all share-based payments granted after the date of adoption based on the grant date fair value estimated in accordance with the provisions of SFAS 123R and for the unvested portion of all share-based payments previously granted that remain outstanding which were based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. The majority of our share-based compensation arrangements vest over either a four or five year graded vesting schedule. The Company expenses its share-based compensation under the ratable method, which treats each vesting tranche as if it were an individual grant.
Prior to 2006, the Company accounted for stock option awards granted to officers, directors and employees (collectively “employees”) under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Under APB 25, no stock-based employee compensation cost is reflected in net income, as all options granted to employees under these plans have been granted at no less than fair market value on the date of grant. The Company applied the disclosure only provision of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-based Compensation” (“SFAS 123”) and SFAS No. 148, “Accounting for Stock-based Compensation-Transition and Disclosure (“SFAS 148”) for such employee stock option awards. The Company accounted for stock option awards granted to consultants under the fair value recognition provisions of SFAS 123. Under this method, options were valued using the Black-Scholes option pricing model, and the calculated option value is recorded as an expense in the financial statements.
S.
Asset retirement obligations
The Company’s fixed red light and speed enforcement systems are installed at traffic intersections under three to five year customer contracts. At the end of many contracts, the Company is required to remove all aboveground structures and restore the site. As required by SFAS No. 143, the Company records an obligation for the cost to remove its systems, and remediate the site, if contractually required.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
Upon installation, a liability for the asset retirement obligation is initially recorded at its present value . Over time, the liability is accreted to its present value each period. Upon settlement of the liability, a gain or loss is recorded. A reconciliation of the net carrying value of the asset retirement obligations (ARO) is as follows:
T.
Deferred Rent
The Company accounts for escalating rental payments on a straight-line basis over the term of the lease. The balance of deferred rent at December 31, 2006 is $49 and is included in accrued liabilities in the balance sheet.
U.
Derivative Instruments
In connection with the sale of debt or equity instruments, the Company may sell options or warrants to purchase our common stock. In certain circumstances, these options or warrants may be classified as derivative liabilities, rather than as equity. Additionally, the debt or equity instruments may contain embedded derivative instruments, such as variable conversion options, which in certain circumstances may be required to be bifurcated from the host instrument and accounted for separately as a derivative instrument liability.
The identification of, and accounting for, derivative instruments is complex. Derivative instrument liabilities are re-valued at the end of each reporting period, with changes in fair value of the derivative liability recorded as charges or credits to income in the period in which the changes occur. For options, warrants and bifurcated conversion options that are accounted for as derivative instrument liabilities, we determine the fair value of these instruments using the Black-Sholes option pricing model, binomial stock price probability trees, or other valuation techniques, sometimes with the assistance of a certified valuation expert. These models require assumptions related to the remaining term of the instruments and risk-free rates of return, our current common stock price and expected dividend yield, and the expected volatility of our common stock price based on not only the history of our stock price but also the experience of other entities considered comparable to us. The identification of, and accounting for, derivative instruments and the assumptions used to value them can significantly affect our financial statements.
V.
Advertising
The Company charges advertising costs to operations as incurred. For the years ended December 31, 2006 and 2005, the Company’s advertising expense was $114 and $135, respectively.
W.
Reclassification
Certain prior year balances have been reclassified to conform to the current year presentation. These reclassifications had no effect on the net loss as previously reported.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
Note 3 -
Restatement of Consolidated Financial Statements:
The Company has restated its Consolidated Financial Statements for fiscal 2003 and 2004 as well as the first three interim periods of fiscal 2005 in order to bifurcate embedded derivative instruments within the Company’s debt and account for them separately as derivative instrument liabilities. The following provides a more detailed discussion of the restatement along with a comparison of the amounts previously reported in the Consolidated Balance Sheet for December 31, 2004, and Statements of Operations in the Company’s Annual Report on Form 10-K for fiscal 2004 and 2003.
As previously reported in our Current Report on Form 8-K filed with the Securities and Exchange Commission on December 5, 2005, the Company had been in extensive discussions with the Staff of the Securities and Exchange Commission concerning the proper accounting treatment regarding certain of its convertible debt in current and previously reported financial results. As a result of these discussions, the Company’s 2005 quarterly and 2004 and 2003 fiscal year financial statements are restated to bifurcate embedded derivative instruments within the Company’s debt and account for them separately as derivative instrument liabilities.
More specifically, the Securities and Exchange Commission ("SEC") raised questions with regard to our convertible term notes suggesting that we consider EITF 00-19 "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock" to evaluate whether there were any embedded derivative instruments and if so, whether they should be accounted for as an equity or liability classification.
As a result, the Company reviewed its initial accounting for its (1) First Laurus Convertible Note dated July 31, 2003, (2) Second Laurus Convertible Note dated January 14, 2004, (3) Third Laurus Convertible Note dated May 16, 2005, and (4) Senior Convertible Notes dated November 5, 2004 (See Notes 7 and 8). During the review, the Company identified that EITF 00-19 should be applied to evaluate whether any embedded derivative instruments qualify as equity instruments or as liabilities. As a result, certain embedded derivatives were identified that met the conditions set forth under paragraph 12 of SFAS No. 133. These embedded derivative instruments have been evaluated using EITF 00-19 paragraphs 12 to and determined that these instruments would not be classified as components of stockholders equity. The instruments have been deemed liabilities, and as such, are subject to SFAS 133 and will be recorded at fair value.
Features within the debt noted above that have been evaluated and determined to require such treatment include:
·
The principal conversion options.
·
The monthly payments conversion options.
·
The interest rate adjustment provisions.
Management believes the scope and process of its internal review of previously reported financial information was sufficient to identify issues of a material nature that could affect our Consolidated Financial Statements and all dates and periods presented herein have been restated to fairly present the results of our operations.
For the quarterly impact of the restatement see Note 19.
The foregoing restatement adjustments did not affect the Company’s reported cash and cash equivalents balance during these reported periods.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
Impact of the Financial Statement Adjustments on the Consolidated Statements of Operations
The following table presents the impact of the financial statement adjustments on the Company’s previously reported consolidated statements of operations for the fiscal years ended December 31, 2004:
Note 4 -
Capitalized system costs:
Equipment, installation, and in some cases interest costs related to operating lease contracts are capitalized and, after acceptance by the municipality (customer), are depreciated over the term of the contract, generally either three or five years, less an applicable residual value. There was no interest capitalized in fiscal years 2006 and 2005. Revenues realized from these agreements, generally in the form of per-citation or monthly fees, are expected to be adequate to cover the capitalized and future costs related to these agreements. Many leases contain minimum payment requirements, which currently aggregate to $6,982 in 2007, $5,581 in 2008 and $2,065 in 2009, $1,212 in 2010 and $75 in 2011. Management expects that these annual amounts could increase and extend to future years, as additional intersections are installed or decrease based on cost-neutral contract adjustment provisions.
In 2006, an impairment charge of $1,364 was recorded and none for 2005. See Note 2 for further details.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
Note 5 -
Property and equipment - net:
Depreciation and amortization expense of $475 and $325 on the above assets was recorded for the years ended December 31, 2006 and 2005, respectively.
In and 2005, the Company disposed of no equipment.
Note 6 -
Goodwill and other intangible assets, net:
Under SFAS 142, the Company tests goodwill for impairment on an annual basis, or whenever indicators of impairment are identified. Management considers the Company’s quoted stock price to be the best indicator of fair value for purposes of performing these analyses.
Other intangible assets were comprised of the following as of December 31, 2006:
For fiscal 2006, amortization expense related to identified intangible assets was $321, which was included in cost of sales and $893 included in impairment charge for long lived assets.
The following is the estimated future amortization expense related to other intangible assets as of December 31:
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
Note 7 -
Long Term Obligations:
The Company considers its long-term convertible notes payable, long term notes payable, and derivative financial instruments, which are described in Footnotes 7 and 8, to be its long-term financial obligations.
Long-term financial obligations consisted of the following at December 31:
Aggregate maturities of long-term obligations for the years ending after December 31, are as follows:
7% Senior Secured Convertible Notes
On May 24, 2006, Nestor, Inc. (the “Company”) entered into a Securities Purchase Agreement (the “Agreement”) with several institutional and accredited investors to sell $28.55 million of Units consisting of five-year, 7% senior secured convertible promissory notes (the “Secured Notes”), convertible into shares of the Company’s common stock (the “common stock”), and five-year warrants to purchase 1,982,639 shares of common stock (the “Warrants”), in a private placement pursuant to Regulation D under the Securities Act of 1933 (the “Transaction”). The Transaction was closed on May 25, 2006.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
The Secured Notes, which rank pari passu with the Company’s existing, 5% Senior Convertible Notes (the “5% Notes”), are secured by a first priority security interest in all corporate assets, except contracts entered into by the Company after October 1, 2006 and all assets related thereto and all proceeds thereof. Interest is payable quarterly in arrears, and an amount equal to two years’ interest on the Secured Notes is secured by an irrevocable letter of credit. In order to obtain the irrevocable letter of credit from a bank, the Company needed to establish a restricted cash account as collateral. The letter of credit expires once drawn down, but no later than May 25, 2008; and the bank fee is one and one-quarter percent on the open balance, annually. The interest rate is subject to adjustment for certain changes in the Company’s consolidated EBITDA (defined as earnings before interest, taxes, depreciation and amortization, any derivative instrument gain or loss or any employee stock option expense under SFAS 123R, “Share-Based Payment”), as follows: (a) if consolidated EBITDA as reported on the Company’s Quarterly Report on Form 10-Q (“Form 10-Q”) for the fiscal quarter ending June 30, 2007 is less than $1.25 million, the interest rate will increase to 9%, effective July 1, 2007; (b) if consolidated EBITDA as reported on the Form 10-Q for the fiscal quarter ending June 30, 2007 is greater than $2.5 million, the interest rate will decrease to 5%, effective July 1, 2007; and (c) if consolidated EBITDA for the year ended December 31, 2008 as reported on the Company’s Annual Report on Form 10-K (the “Form 10-K”) for that period is greater than $14.0 million, the interest rate currently in effect at that time will decrease by 2%, effective January 1, 2009. In no event will the interest rate be less than 5%. In the event of default on the Secured Notes, the interest rate will be 13.5% during the period of default.
All outstanding principal and interest on the Secured Notes is due on May 25, 2011. The principal of the Secured Notes is convertible into the Company’s common stock at a conversion price of $3.60 per share. The conversion price is subject to full ratchet anti-dilution protection for any equity issuances within three years and standard weighted-average anti-dilution protection thereafter in addition to other customary adjustment events.
The Secured Notes contain restrictive covenants, which, among other things, restrict the Company’s ability to incur additional indebtedness, repay indebtedness including the secured notes before maturity, grant security interests on its assets or make distributions on or repurchase its common stock.
The holders of the Secured Notes had the right to require the Company to redeem up to 20% of the outstanding principal by written notice to the Company at least five trading days prior to December 29, 2006. In addition, the holders have the right to require the Company to redeem all or any portion of the outstanding balance of the Secured Notes on May 25, 2009, provided that this right will be forfeited if, among other things, the Company’s consolidated EBITDA for the twelve-month period ended December 31, 2008 as reported on the Form 10-K exceeds $14.0 million. The Secured Note holders also have the right to redeem some or all of their Secured Notes in the event of a change of control of the Company or an event of default under the Notes. On December 29, 2006, the Secured Noteholders exercised their right to require the Company to redeem 20% of the outstanding principal, or $5,710.
If, prior to May 25, 2009, a holder elects to convert its Secured Notes into shares of the Company’s common stock, or in the event of a “Mandatory Conversion” (defined below) by the Company, such Secured Note holder will receive a “make-whole” payment in cash equal to 21% of the face value of the Secured Notes so converted, less any interest paid. Beginning on May 25, 2008, if the average closing bid price of the common stock exceeds 165% of the conversion price for any 20 trading days during a 30 consecutive trading day period, the Company can force conversion of the Secured Notes (a “Mandatory Conversion”), subject to certain notice and other requirements. The number of shares of common stock issuable to all Secured Note holders in such Mandatory Conversion cannot exceed the total daily trading volume of the common stock for the 20 consecutive trading days immediately preceding the conversion date. Furthermore, the Company can require a Mandatory Conversion only once in any 60 consecutive trading-day period.
Under the Agreement, the Company has agreed that until 180 days following the effective date of the Registration Statement covering the shares issuable upon conversion of the Secured Notes and exercise of the Warrants, it will not, directly or indirectly, offer, sell grant any option to purchase, or otherwise dispose of (or announce any offer, sale, grant or any option to purchase or other disposition of) any of its or its subsidiaries' equity or equity equivalent securities, including any debt, preferred stock or other instrument or security that is convertible into or exchangeable or exercisable for shares of its common stock without the prior written approval of the holders of at least 75% of the aggregate principal amount of the Secured Notes. In addition, until the first anniversary of the effective date of such Registration Statement, and provided that at least 30% of the principal face amount of the Secured Notes remain outstanding, holders of the Secured Note have the right to purchase up to 30% of any equity or equity-linked financings, subject to certain conditions. Furthermore, if at any time the Company grants, issues or sells any options, convertible securities or rights to purchase stock, warrants, securities or other property pro rata to the record holders of any class of its common stock, each holder will be entitled to acquire, upon the terms applicable to such purchase rights, the aggregate purchase rights a holder could have acquired if the holder had held the number of shares of common stock acquirable upon complete conversion of such holder’s Secured Note.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
The Warrants are exercisable at $4.35, subject to standard weighted average anti-dilution protection for the life of the Warrants, and expire on May 25, 2011. In the event of a change of control, unless the closing sale price of the common stock on the first trading day immediately following the public announcement of the change of control exceeds $6.00 per share, the Warrant holder may require the Company to purchase all or any portion of a Warrant (the “redeemed portion”) for cash at a price equal to the value of the redeemed portion of the Warrant determined using the Black-Scholes option pricing model. The Warrants also contain a “cashless exercise” provision.
The Company used the net proceeds from the sale of the Units (after expenses and placement agent fees) to repay the outstanding principal and interest, totaling $5.67 million, of a non-convertible promissory note dated December 28, 2005 issued to Laurus Master Fund, Ltd., the outstanding principal and interest, totaling $1.27 million, of a secured promissory note dated August 30, 2005 issued to Foundation Partners I, LLC, and $2.42 million was used to repurchase approximately $2.35 million principal amount of the Company’s 5% Notes at a price of 102.5% of face amount plus accrued interest. The remaining funds will be used for capital expenditures, including the installation of automated traffic enforcement systems pursuant to existing contracts, for general corporate purposes and working capital.
In connection with the Transaction, the Company and the holders of the 5% Notes entered into a Written Consent and Waiver and Amendment to Note Agreement (the “5% Noteholder Agreement”) pursuant to which the holders of the 5% Notes consented to the Company granting a security interest in its assets to the holders of the Secured Notes and waiving their right to redeem the balance of their 5% Notes. In addition, the 5% Note holders agreed to extend the maturity of the $2.85 million remaining 5% Notes from October 31, 2007 to May 25, 2009, and received warrants to purchase an aggregate 163,793 shares of common stock at an exercise price of $4.35 (the “5% Warrants”). The 5% Warrants expire on May 25, 2009. The 5% Notes contain full-ratchet anti-dilution protection. As a result of the Transaction, the remaining 5% Notes are now convertible into shares of common stock at a conversion price of $3.60 per share.
In connection with the Transaction, we entered into a registration rights agreement with the holders of the Secured Notes, pursuant to which the Company agreed to file a Registration Statement on Form S-3 registering for resale a number of common shares sufficient to allow for full conversion of the Secured Notes and exercise of the Warrants. The Registration Statement was filed on July 14, 2006. Penalties are imposed on the Company if the registration statement is not declared effective by the SEC within 60 days of filing (or 90 days if subject to SEC review) up to a maximum of 10% of the purchase price of the Secured Notes. In addition, the Company is obligated to register for resale shares of common stock issuable upon exercise of the 5% Warrants issued to the 5% Note holders. The Registration Statement was declared effective by the SEC on September 14, 2006.
The Company was required by the terms of the Transaction documents to seek stockholder approval of the Transaction (as required by NASDAQ Rule 4350(i)) and stockholder approval of an amendment to its certificate of incorporation increasing the number of shares of authorized common stock sufficient to allow for conversion in full of the Secured Notes and exercise in full of the Warrants. No conversions or exercises into common stock was effected by the Company to the extent that such issuance would exceed 19.99% of the currently outstanding common stock, until such approvals were obtained. The Company obtained such approval on July 6, 2006, the date of the Annual Meeting of Stockholders. In connection with the Transaction, the Company entered into Voting Agreements with stockholders who hold, in the aggregate, 10,351,048 shares, or 50.83%, of the outstanding common stock of the Company, pursuant to which they have agreed to vote in favor of the Transaction and the increase in the number of shares of authorized common stock.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
Cowen & Co. LLC (“Cowen”) acted as exclusive placement agent for the offering and was paid $1,484,600 at closing. In addition, the Company reimbursed Cowen for its out-of-pocket expenses and issued Cowen Warrants to purchase 198,264 shares of common stock at an exercise price of $3.60 and 49,566 shares of common stock at an exercise price of $4.35, which Warrants generally have the same terms as the Warrants issued to the Secured Note holders in the Transaction.
Fourth Laurus Note:
On December 28, 2005, Laurus issued a new non-convertible note to the Company in the face amount of $6,000. The note was used to retire the unamortized portion of the May 2005 Laurus convertible note discussed above (having a remaining principal balance of $5,273 on December 28, 2005), plus unpaid interest on the closing date. The Company received a net cash balance of $603 on the closing. In consideration of repaying the note and eliminating conversion rights, prepayment penalty rights, registration rights, and other rights under the third Laurus convertible note, the Company issued 203,774 shares of common stock to Laurus with a market value of $1,078 at the date of close, and recorded the transaction as a discount to the non-convertible note and a credit to Additional Paid in Capital. The principal amount of the Note was repayable at rates commencing in April 2006 of $181 per month through the end of the Note term in December 2008. The Note bore interest at the coupon rate of the prime rate plus 2.00% and was subject to a floor interest rate of 7.00%. The Note contained certain non-financial operating covenants.
The Company also entered into a registration rights agreement covering the common stock issued to Laurus with this non-convertible note, and the Warrants from the May 2005 Laurus Note. The agreement required the Company to use its best efforts to file for registration of the shares within 120 days after closing of the transaction, and obtaining an effective registration within 180 days. No specific damages are provided for in the agreement in the event a registration statement is not filed or effective within the proposed time periods.
This Note was paid in full with proceeds received from the 7% Senior Secured Convertible Notes.
Heil Secured Promissory Note:
On October 26, 2005, we gave a secured promissory note to Edward F. Heil in the principal amount of $1,250 with a maturity date of October 25, 2006. The note bore interest at the rate of one percent (1.00%) per month until the note was paid in full. The due date of the principal and all accrued interest could be accelerated if we default on the note. The note could be prepaid in full or in part on the last calendar day of any month during the term. The note was secured by ten mobile speed enforcement units including all associated speed detection systems and all rights to operate said systems. If Mr. Heil foreclosed on the units, we would provide citation processing services for Mr. Heil with respect to violation data generated by the units at commercially reasonable prices and Mr. Heil would have all rights and licenses necessary to so operate the units for their intended uses. If we were unable to provide Mr. Heil with citation processing services, then Mr. Heil may obtain such services from any person or entity, including our competitors. In connection with the loan that the secured promissory note evidences, we paid an origination fee of $25, and we agreed to pay Mr. Heil’s legal fees, related to the loan. We amortized the origination fee and any legal fees over the note term.
The Heil Secured Promissory Note was paid in full in January 2006 from the proceeds of the private placement of the company’s common stock. Mr. Heil invested $1,250 in the equity transaction.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
Foundation Partners Secured Promissory Note:
On August 30, 2005 we gave a secured promissory note to Foundation Partners I, LLC in the principal amount of $1,250 with a maturity date of August 29, 2006. The note bore interest at the rate of 10% per year. Interest was payable monthly and the principal was payable in full on the maturity date. The due date of the principal and all accrued interest could be accelerated if we defaulted on the note. The note could be prepaid in full or in part on the last calendar day of any month during the term. The note was secured by ten mobile speed enforcement units including all associated speed detection systems and all rights to operate said systems. If Foundation Partners foreclosed on the units, we would provide citation processing services for Foundation Partners with respect to violation data generated by the units at commercially reasonable prices and Foundation Partners would have all rights and licenses necessary to so operate the units for their intended uses. If we were unable to provide Foundation Partners with citation processing services, then Foundation Partners may obtain such services from any person or entity, including our competitors, and Foundation Partners would have all rights and licenses necessary to so operate the units for their intended uses. The managing member of Foundation Partners is Danzell Investment Management, Ltd. William B. Danzell is the President and sole stockholder of Danzell Investment Management, Ltd. and the Chief Executive Officer, President, and a director of Nestor. In connection with the loan that the secured promissory note evidences, we paid an origination fee of $25, of which $13 was paid to Foundation Partners and $13 was paid to Danzell Investment Management, Ltd. We amortized the origination fee over the term of the note.
This Note was paid in full in May 2006 from the proceeds received from the 7% Senior Secured Convertible Notes.
Third Laurus Convertible Note:
On May 16, 2005, we entered into a Securities Purchase Agreement ("the Agreement") with Laurus Master Fund, Ltd. ("Laurus"). Pursuant to the Agreement, we issued to Laurus a convertible Note ("the Note") in the principal amount of $6,000 (which was fully paid on December 28, 2005). The Note was convertible into our common stock at the option of Laurus at a fixed conversion price of $5.82 per share. The Note bore interest at the coupon rate of the prime rate plus 4.00% and was subject to a floor interest rate of 6.00%. The Agreement provided for a reduction in the interest rate to the prime rate plus 2.00% in months during which the price of our common stock exceeded the fixed conversion price of $5.82 for five consecutive trading days, and additional reductions of 2.00% for every 25% increase in the price of our common stock above the fixed conversion price of $5.82 (an increase of $1.46), subject to a minimum coupon rate of 0.00%. The Note originally matured on May 16, 2008. The principal amount of the Note was repayable at rates commencing in September 2005 of $181 per month through the end of the Note term in December 2006. Such amounts could have been paid (at the company’s option) (i) in cash with a 3% premium on principal paid plus unpaid interest, or (ii) in shares of common stock, assuming the shares were registered under the Securities Act of 1933 and no default under the Note existed, or (iii) in a combination of the above. If paid in common stock, the number of shares issued should have equaled the total amount due, divided by $5.82. If the average closing price of the common stock for the ten consecutive days prior to a repayment date was equal to or greater than $5.82, we could have required the holder to convert into common stock an amount of principal, accrued interest and fees due under the Note equal to a maximum of 25% of the aggregate dollar trading volume of the common stock for the 20 consecutive trading days prior to a notice of conversion. The Note restricted our ability to make repayment in our common stock at the fixed conversion price, if the then current market price was below 120% of the fixed conversion price (or $6.98). The Note could have been redeemed at any time by us in cash by paying the holder 115% of the principal amount, plus accrued interest. The holder of the Note could have required us to convert all or a portion of the Note, together with interest and fees thereon, at any time. The number of shares to be issued should have equaled the total amount to be converted, divided by $5.82. The conversion price of the secured convertible notes could have been adjusted if we paid a stock dividend, or subdivided, or combined outstanding shares of common stock into a greater or lesser number of shares.
The net proceeds from the Note could only be used for the design, engineering, construction, installation and maintenance of certain of our traffic enforcement systems.
We filed a registration statement for the shares of common stock into which the Note may be converted and for the shares underlying the warrant issued as part of the Agreement (see below). The Agreement requires that the registration statement be declared effective by September 16, 2005. We were obligated to pay Laurus damages because the registration statement was not declared effective by its due date. Under the Agreement, Laurus was entitled to liquidated damages in an amount equal to 1% of the outstanding principal amount for each 30 consecutive days after September 16, 2005 during which the Registration Statement is not effective, prorated daily. The Agreement and related registration rights obligation was satisfied on December 28, 2005 as described below and any registration rights liquidated damages were waived.
The Note was collateralized by a security interest in the proceeds of our existing CrossingGuard contracts except for our Delaware contract.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
In connection with the financing, Laurus was paid a fee of $234 and had approximately $47 of its expenses reimbursed. Laurus received five year warrants to purchase 100,000 shares of our common stock. The exercise prices of the warrants are as follows: $6.69 per share for the purchase of up to 60,000 shares; $7.28 per share for the purchase of an additional 23,000 shares; and $8.43 per share for the purchase of an additional 17,000 shares. The warrants expire on May 16, 2010.
The Black-Scholes value of the warrants issued in connection with this financing totaled approximately $419 and is recorded as additional paid-in capital and a corresponding discount (reduction) to the note payable. The warrant’s entire discount was written off to interest expense in 2005 due to the underlying note being refinanced on December 28, 2005.
After taking into consideration the value of the warrants, we ascribed $38 as a beneficial conversion value and recorded the amount as additional paid-in capital and a corresponding discount to the note payable. This beneficial conversion feature was written off to interest expense in 2005 due to the underlying note being refinanced on December 28, 2005.
This Note was paid in full with proceeds received from the Fourth Laurus Note.
5% Senior Convertible Notes
In November 2004, the Company completed the sale of $6,000 aggregate principal amount of its 5% Senior Convertible Notes due October 31, 2007 (the "Senior Convertible Notes") in a private placement. The Company received $5,555 of note proceeds after $445 of placement fees and related expenses. The Senior Convertible Notes are convertible into Nestor common stock at the option of the investors at $5.82 per share and accrue interest at 5% per year. The Company must make quarterly interest-only payments until the Senior Convertible Notes are either paid in full or are converted into common stock. At the option of the holders, all amounts due may be accelerated upon certain events of default, including failures to pay principal or interest when due, breach of covenants that remain uncured after notice, bankruptcy of the Company or certain similar events and defaults under other material credit arrangements. The Notes contain certain non-financial operating covenants.
The Company may, at its option, redeem the Senior Convertible Notes in whole or in part, at a redemption price of 105% before November 1, 2005, 102.5% before November 1, 2006, and 101% thereafter, plus unpaid interest, upon 30 to 60 days prior written notice. The Company is obligated to offer to repurchase the Senior Convertible Notes at
the then-current redemption price in the event of a change in control of the Company or upon the occurrence certain financing events, as defined. In connection with the Senior Convertible Notes, the Company issued a warrant to a placement agent for the purchase of 60,000 shares of common stock at $5.21 per share exercisable through October 31, 2009.
The Securities and Exchange Commission declared the Registration Statement on Form S-2 (SEC File No. 333-121015) for the resale of these shares effective on January 28, 2005. Pursuant to the terms of the warrant, the Company has agreed to include the resale of the shares of the Company's common stock underlying the warrant in future registration statements upon the request of such holder.
During February 2005, two noteholders converted an aggregate $600 note face value into 103,092 shares of Nestor stock at $5.82 per share. During May 2005, one note holder converted an aggregate $200 note face value into 34,364 shares of Nestor stock at $5.82 per share. Any unamortized deferred financing costs associated with the converted notes was expensed upon conversion.
In January 2006, the Company issued additional common stock at a price of $4.20 per share. In accordance with anti-dilution rights contained in the SMH notes, the conversion price of the outstanding notes decreased from $5.82 to $4.20 on the date of the January transaction.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
In May 2006, in connection with the 7% Senior Secured Convertible Notes, $2,350 was repaid at a price of 102.5% of face value plus accrued interest. In connection with the Transaction, the Company and the holders of the 5% Notes entered into a Written Consent and Waiver and Amendment to Note Agreement (the “5% Noteholder Agreement”) pursuant to which the holders of the 5% Notes consented to the Company granting a security interest in its assets to the holders of the Secured Notes and waiving their right to redeem the balance of their 5% Notes. In addition, the 5% Note holders agreed to extend the maturity of the $2.85 million remaining 5% Notes from October 31, 2007 to May 25, 2009, and received warrants to purchase an aggregate 163,793 shares of common stock at an exercise price of $4.35 (the “5% Warrants”). The 5% Warrants expire on May 25, 2009. The 5% Notes contain full-ratchet anti-dilution protection. As a result of the Transaction, the remaining 5% Notes are now convertible into shares of common stock at a conversion price of $3.60 per share.
Second Laurus Convertible Note:
On January 14, 2004, the Company entered into a second securities purchase agreement with Laurus. Pursuant to that agreement, the Company issued to Laurus a new secured convertible note in the principal amount of $1,500 that bore interest at the prime rate plus 1.25% (subject to a floor of 5.25% per year) and matured on January 14, 2006. The principal amount of the Note was repayable at rates commencing in May 2004 of $15 per month and gradually increasing to $105 per month in September 2006 through the end of the Note term. Such amounts may be paid (at the company’s option) (i) in cash with a 3% premium on principal paid plus unpaid interest, or (ii) in shares of common stock, assuming the shares are registered under the Securities Act of 1933 and no default under the Note exists, or (iii) in a combination of the above. If paid in common stock, the number of shares issued shall equal the total amount due, divided by $3.50. If the average closing price of the common stock for the ten consecutive days prior to a repayment date is equal to or greater than $4.20, we may require the holder to convert into common stock an amount of principal, accrued interest and fees due under the Note equal to a maximum of 25% of the aggregate dollar trading volume of the common stock for the 20 consecutive trading days prior to a notice of conversion. The Note restricts our ability to make repayment in our common stock at the fixed conversion price, if the then current market price is below 120% of the fixed conversion price (or $4.20). The Note may be redeemed at any time by us in cash by paying the holder 115% of the principal amount, plus accrued interest. The holder of the Note may require us to convert all or a portion of the Note, together with interest and fees thereon, at any time. The number of shares to be issued shall equal the total amount to be converted, divided by $3.50. The conversion price of the secured convertible notes may be adjusted if we pay a stock dividend, or subdivide or combine outstanding shares of common stock into a greater or lesser number of shares. In conjunction with this transaction, Sage received a fee of $60 and an affiliate of Laurus received a management fee of $45 and reimbursement of certain expenses. The first lien, security interest and pledge of CrossingGuard, Inc. stock from the first Laurus Note continued to this second note.
During September 2004, Laurus converted $60 due on this note into 17,143 shares of Nestor common stock at $3.50 per share. Laurus subsequently converted their remaining $1,245 note balance into 355,714 shares of Nestor common stock during the period October to November 3, 2004.
First Laurus Convertible Note:
On July 31, 2003, the Company entered into a Securities Purchase Agreement ("the Agreement") with Laurus Master Fund, Ltd. ("Laurus"). Pursuant to the Agreement, the Company issued to Laurus a Secured Convertible Note ("Note") in the principal amount of $2,000 that bore interest at the prime rate plus 1.25% (subject to a floor of 5.25%) and maturing on July 31, 2005. The principal amount of the Note was repayable at rates commencing in December 2003 of $20 per month and gradually increasing to $140 per month in April 2005 through the end of the Note. Such amounts may be paid (at the company’s option) (i) in cash with a 3% premium on principal paid plus unpaid interest, or (ii) in shares of common stock, assuming the shares are registered under the Securities Act of 1933 and no default under the Note exists, or (iii) in a combination of the above. If paid in common stock, the number of shares issued shall equal the total amount due, divided by $1.55. If the average closing price of the common stock for the ten consecutive days prior to a repayment date is equal to or greater than $1.86, we may require the holder to convert into common stock an amount of principal, accrued interest and fees due under the Note equal to a maximum of 25% of the aggregate dollar trading volume of the common stock for the 20 consecutive trading days prior to a notice of conversion. The Note restricts our ability to make repayment in our common stock at the fixed conversion price, if the then current market price is below 120% of the fixed conversion price (or $1.86). The Note may be redeemed at any time by us in cash by paying the holder 115% of the principal amount, plus accrued interest. The holder of the Note may require us to convert all or a portion of the Note, together with interest and fees thereon, at any time. The number of shares to be issued shall equal the total amount to be converted, divided by $1.55. The conversion price of the secured convertible notes may be adjusted if we pay a stock dividend, or subdivide or combine outstanding shares of common stock into a greater or lesser number of shares.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
The note was collateralized by a first lien on all available CrossingGuard, Inc. assets. Laurus had a general security interest in four customer contracts assigned by NTS to CrossingGuard, Inc. and NTS had pledged the common stock of CrossingGuard, Inc. In connection with financing, Laurus was paid a fee of $80, had certain of its expenses reimbursed and received a warrant to purchase 140,000 shares of the Company's common stock. The warrant exercise price was as follows: $1.78 per share for the purchase of up to 83,000 shares; $1.94 per share for the purchase of an additional 33,000 shares; and $2.25 per share for the purchase of an additional 24,000 shares. These warrants were exercised on a cashless basis during the quarter-ended September 30, 2004, resulting in the Company issuing 76,466 shares of its common stock at a conversion price of $4.18 per share.
Also in connection with financing, Management Services Group/Sage Investments, Inc. (“Sage”) was paid a fee of $80 and received $4 per month for nine months for continuing consultation. Sage received warrants to purchase 14,000 shares of Company stock as follows: $1.78 per share for the purchase of up to 8,300 shares; $1.94 per share for the purchase of an additional 3,300 shares; and $2.25 per share for the purchase of an additional 2,400 shares. During the period June through August 2004, Sage exercised 11,720 of these warrants on a cashless basis, resulting in the Company issuing 5,953 shares of stock at conversion prices of $3.54 to $4.46 per share. The warrant expiration date is July 31, 2008.
The Black-Scholes values of the warrants issued in connection with this financing totaled $144 (Laurus) and $14 (Sage) and were recorded as additional paid-in capital. The Laurus warrant value was recorded as a discount on the note payable. During the quarter ended September 30, 2003, the Company amortized $12 of the discount as interest expense. As the Note was satisfied on January 14, 2004, the remaining unamortized discount of $114, deferred interest of $55 and deferred financing fees of $131 had negligible continuing value and were consequently written off to interest expense (discount and deferred interest) and financing fees, respectively, at December 31, 2003.
During November and December 2003, Laurus converted $85 of the Note into 55,000 shares of Nestor common stock at $1.55 per share. On January 14, 2004, the Company satisfied its remaining payment obligations on the Note by issuing 492,904 shares of its common stock to Laurus at the fixed conversion price of $1.55 per share and redeeming the remaining $1,151 note balance by a “payment” of $1,341, which included accrued interest and a $173 prepayment penalty. This “payment” was netted against the proceeds from the Second Laurus Convertible Note (see below), resulting in $98 net cash proceeds to the Company.
Embedded Derivatives and Debt Discounts
The senior convertible notes and the convertible notes payable included a variety of conversion options, variable interest rate features, events of default, and certain variable liquidated damage clauses, that may be considered embedded derivative financial instruments.
The accounting treatment of the derivatives require that the Company record the derivatives at their relative fair value as of the inception date of the agreement, and at fair value as of each subsequent balance sheet date. Any change in fair value is recorded as derivative instrument expense at each reporting date, which is a non-operating, non-cash income or expense.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
Over the life of the senior convertible notes and the convertible notes payable, the Company recorded the following type of embedded derivative financial instruments:
·
Principal’s Conversion Options
·
Monthly Payment Conversion Options
·
Interest Rate Adjustment provisions
As of December 31, 2006 and 2005, respectively, these derivatives were valued at $4,971 and $1,419. The principal's conversion option on the senior convertible note was valued using the Binomial Option Pricing Model with the following assumptions: dividend yield of 0%, annual volatility of 60%; and risk free interest rate of 4.79% as of December 31, 2006.
As of December 31, 2006 and 2005, the derivatives as well as warrants were recorded as discounts to the Notes and are being amortized over the expected term of the debt. At December 31, 2006, the unamortized discount on the Notes was $16,207 and $4,628 for 2006 and 2005, respectively.
Note 8 -
Transol Asset Purchase:
On August 31, 2005, we entered into a purchase and sale agreement with Transol Holdings Pty Limited, Transol PTY Limited, Transol Corporation Limited and Alleasing Finance Australia Limited pursuant to which we purchased certain assets of Transol and its Australian and US subsidiaries related to Transol’s red light enforcement business, including assets leased by Transol USA Inc., Transol Holding’s indirect U.S. subsidiary, from Alleasing. Alleasing held a security interest in all of the assets of Transol USA and sold us the acquired assets in a foreclosure sale. Transol was one of our competitors in the automated traffic enforcement business. The transaction was closed from escrow with final adjustments on January 16, 2006.
The assets purchased, as adjusted, included:
·
Contracts to provide automated red light enforcement services in six US cities at an aggregate of 39 approaches, of which 35 were fully installed and operating.
·
Equipment located at the contracted approaches used for providing automated red light enforcement services.
·
Transol’s intellectual property, including one U.S., one Australian and one international patent application (each related to the technology underlying their red light enforcement services, the Transol website, computer source code for Transol’s products and services and all other “technical know how,” except that relating to Transol’s automated driver’s licensing testing business).
·
Inventory, work in process, accounts receivable and unbilled contract revenue related to Transol’s red light enforcement services.
·
The goodwill of the Transol business, except that relating to the automated driver’s licensing testing business.
Under the agreement, the sellers were obligated to terminate the “Transol Group” trade name registration.
The purchase price we paid into escrow for the acquired assets is $2,000, subject to reduction for any liens on the assets we acquired and subject to reduction if any of the assigned contracts that are terminated before January 16, 2006 by the cities because of their assignment to us or that are terminated by January 16, 2006 pursuant to termination for convenience rights that cities may have under the contracts. The price reduction for any contracts so terminated will be $50 per installed approach and up to $20 per uninstalled approach. In addition, we would receive a price reduction of up to $20 for each unapproved approach for which we do not receive municipal authorization by January 15, 2006 to go forward and for which we did not receive a price reduction because of a contract termination. The final payment from escrow was $1,760.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
We also entered into a Transition Services Agreement with Transol USA pursuant to which we were able to use their Tempe, AZ warehouse until October 31, 2005 and their Phoenix, AZ office until December 31, 2005, as well as the services of some of their employees and consultants until December 31, 2005. We paid Transol USA’s direct costs for the services that we receive under the Transition Services Agreement. As of December 31, 2005, we had converted all but one of the existing installations to our back office processing environment. We do not intend to use the Transol name following the transition period.
The combined purchase price of the acquisition was allocated on a fair value basis as follows:
The value of contracts, net of amortization and impairment charges, at December 31, 2006 and 2005 was $11 and $1,225, respectively and was recorded in other assets.
Note 9 -
Leases payable:
On June 28, 2001, NTS executed a Master Lease Purchase Agreement with Electronic Data Systems Corporation (“EDS”), later amended on January 10, 2003, whereby EDS provided lease financing to support installation of the NTS CrossingGuard product to municipalities under leasing terms. NTS received $3,183 in advances, which were collateralized by equipment delivered under leased CrossingGuard systems. During 2003, the Company recorded $164 of EDS interest expense.
On January 26, 2004, the Company satisfied its remaining obligations to EDS by making a payment of $2,179. This transaction resulted in the Company recording a gain on early extinguishment of debt of $681 in January 2004.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
Note 10 -
Common and preferred stock:
Private Stock Placement
On January 31, 2006, the Company sold 1,237,811 shares of its common stock to fifteen accredited investors at $4.42 per share raising $4,822, net of expenses and issued warrants to purchase 371,339 shares of its common stock exercisable at $4.91 per share expiring on January 31, 2009. The Company used $1,250 of the proceeds to immediately retire the Heil Secured Promissory Note. Among the purchasers was Silver Star Partners, an affiliate of the Company, which purchased 220,589 shares and a warrant to purchase an additional 66,176 shares and Kuekenhof Equity Fund, L.P. an affiliate of the Company, which purchased 56,561 shares and a warrant to purchase an additional 16,968 shares.
Private Placement and Silver Star Note Conversion:
The Company sold 2,843,000 shares of its common stock to accredited investors in private placements conducted during December 2003 (1,596,560 shares), and January 2004 (1,246,440 shares). The shares were sold at $3.00 per share, with net proceeds to Nestor (after $682 of expenses of the offering) of $2.76 per share totaling $7,847 ($3,440 in January 2004). The Securities and Exchange Commission declared the Registration Statement on Form S-2 (SEC File No. 333-112359) for the resale of these shares effective on April 23, 2004. The Company has continuing obligations in connection with the registration of the resale of the shares offered, including causing the registration statement filed to remain continuously effective for two years or, if earlier, until the sale of shares covered by the registration statement is complete and indemnifying the holders from liabilities it may incur resulting from any untrue statement or omission of a material fact in the registration statement and related documents and from other liabilities related to the registration.
On December 31, 2003, after the initial closing of the private placement above, the Company exercised its right to convert the Silver Star Note and accrued interest (see Note 7 ) by issuing 676,384 shares of Nestor common stock at $3.00 per share.
Although the proceeds from the initial closing above were received in December 2003 and the Silver Star note conversion was effective December 31, 2003, the associated stock certificates were not issued until January 2004. As such, these 2,272,944 shares are classified as “Stock Pending Issuance” on the balance sheet at December 31, 2003.
Laurus Note Conversions:
As more fully described in Note 7, Laurus elected to convert $85 of their first note into 55,000 shares of Nestor common stock in 2003. In January 2004, Laurus further converted $764 of the note into 492,904 shares of Nestor common stock. Both conversions were priced at $1.55 per share. During the period September through November 3, 2004, Laurus converted $1,305 due on its second note into 372,857 shares of Nestor common stock at $3.50 per share.
As more fully described in Note 7, the Company issued 203,774 shares of common stock to Laurus on December 28, 2005 in exchange for Laurus agreeing to retire the unpaid portion of the May 2005 convertible debt and interest amounting to $5,320 in exchange for a non-convertible three year Note for $6,000 and cash of $680. The market value of the common shares issued to Laurus on December 28, 2005 were $1,080 and will be recorded as a discount to the new note, and amortized over the three year life of the Note, unless paid earlier.
One-for-Ten Reverse Stock Split:
The Company filed a certificate of amendment to its certificate of incorporation on April 11, 2003, causing a one-for-ten reverse stock split of the outstanding shares of the Company common stock effective on that date. The Company’s common stock began trading on a post reverse split basis on April 21, 2003 under the new trading symbol “NESO” (previously “NEST”). These financials reflect common stock and loss per share on a post-split basis. On July 1, 2005, the Company’s common stock began trading on the NASDAQ Global Market® under the trading symbol NEST. The Company moved to the NASDAQ Capital Market on November 27, 2006.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
Preferred Stock:
Series B Convertible Preferred Stock is convertible into Common Stock of the Company at any time on a share-for-share basis. Series B Convertible Preferred Stock has the same rights with respect to voting and dividends as the Common Stock, except that each share of Series B Convertible Preferred Stock has the right to receive $1.00 in liquidation before any distribution is made to holders of the Common Stock. The liquidation value of Series B Preferred was $180 at December 31, and 2005.
Note 11 -
Options and warrants:
On April 1, 1984, the Company adopted an Incentive Stock Option Plan, which authorized the grant of options for up to 245,000 shares (post-reverse split) of the Company’s common stock. This plan terminated April 1, 2004.
On May 6, 1997, the Company adopted the 1997 Stock Option Plan under which the Board of Directors granted incentive or non-qualified stock options to employees, directors and consultants to purchase shares of the Company’s common stock at a price equal to the market price of the stock at the date of grant. In June 2001, the 1997 Stock Option Plan was amended to increase the aggregate number of options authorized to 500,000 shares (post-reverse split) of the Company’s common stock. Options vest over four years and are exercisable for up to ten years from the date of grant, although most options currently outstanding expire eight years from the date of grant. The options are not transferable except by will or domestic relations order. No further grants may be made under this Plan pursuant to the adoption of the 2004 Stock Incentive Plan.
On June 24, 2004, the Company adopted the 2004 Stock Incentive Plan, which provides for the grant of awards to employees, officers and directors. Subject to adjustments for changes in the Company’s common stock and other events, the stock plan is authorized to grant up to 4,500,000 shares, either in the form of options to purchase Nestor common stock or as restricted stock awards. The Board of Directors will determine the award amount, price usually equal to the market price of the stock on the date of the grant, vesting provisions and expiration period (not to exceed ten years) in each applicable agreement. The awards are not transferable except by will or domestic relations order.
Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R) (“SFAS 123(R)”), “Share-Based Payment,” which establishes accounting for equity instruments exchanged for employee services. Under the provisions of SFAS 123(R), share-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period of the equity grant). Prior to January 1, 2006, the Company accounted for share-based compensation to employees in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company also followed the disclosure requirements of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-based Compensation (“SFAS 123”). The Company elected to adopt the modified prospective transition method as provided by SFAS 123(R) and, accordingly, financial statement amounts for the prior periods presented in this Form 10-Q have not been restated to reflect the fair value method of expensing share-based compensation. Under this application, we are required to record compensation cost for all share-based payments granted after the date of adoption based on the grant date fair value estimated in accordance with the provisions of SFAS 123R and for the unvested portion of all share-based payments previously granted that remain outstanding which were based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. The majority of our share-based compensation arrangements vest over either a four or five year graded vesting schedule. The Company expenses its share-based compensation under the ratable method, which treats each vesting tranche as if it were an individual grant.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
The following table presents share-based compensation expenses for continuing operations included in the Company’s consolidated statements of operations:
The Company estimates the fair value of stock options using the Black-Scholes valuation model. Key input assumptions used to estimate the fair value of stock options include the exercise price of the award, the expected option term, the expected volatility of the Company’s stock over the option’s expected term, the risk-free interest rate over the option’s expected term, and the Company’s expected annual dividend yield. The Company believes that the valuation technique and the approach utilized to develop the underlying assumptions are appropriate in calculating the fair values of the Company’s stock options granted in the twelve months ended December 31, 2006. Estimates of fair value are not intended to predict actual future events of the value ultimately realized by persons who receive equity awards.
The fair value of each option grant was estimated on the grant date using the Black-Scholes option-pricing model with the following assumptions:
(1)
The option life was determined using the simplified method for estimating expected option life, which qualify as “plain-vanilla” options.
(2)
The stock volatility for each grant is determined based on the review of the experience of the weighted average of historical weekly price changes of the Company’s common stock over the expected option term.
(3)
The risk-free interest rate for periods equal to the expected term of the share option is based on the U. S. Treasury yield curve in effect at the time of grant.
(4)
The Company has not paid a dividend historically nor plans to declare a dividend in the near future.
The Company did not recognize compensation expense for employee stock option grants for the years ended December 31, 2005 and 2004, when the exercise price of the Company’s employee stock options equaled the market price of the underlying stock on the date of grant.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
The Company had previously adopted the provisions of SFAS 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure” through disclosure only. The following table illustrates the effects on net income and earnings per share for the years ended December 31, 2005 and 2004 as if the Company had applied the fair value recognition provisions of SFAS 123 to share-based employee awards:
The fair value of each option grant was estimated on the grant date using the Black-Scholes option pricing model with the following assumptions:
During the year ended December 31, 2006, there were $6 intrinsic value of options exercised (i.e. the difference between the market price and the price paid by the employee to exercise the options) and $3 of cash was received from the exercise of options.
The total grant date fair value of stock options that vested during the year ended December 31, 2006 was approximately $2,314 with a weighted average remaining contractual term of 6.5 years.
As of December 31, 2006, there was $3,554 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Company’s stock option plans. That cost is expected to be recognized over a weighted-average period of 1.6 years. The Company amortizes stock-based compensation on the straight-line method.
The Company did not realize any actual tax benefit for tax deductions from option exercise of the share-based payment arrangements for the year ended December 31, 2006.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
The following table presents the activity of the Company’s Stock Option Plans for the years ended December 31, 2006, 2005 and 2004 on post-reverse split basis.
The following table presents weighted average price and life information about significant option groups outstanding at December 31, 2006:
Warrants
The Company, at the discretion of the Board of Directors, has granted warrants from time to time, generally in conjunction with the sale of equities. The Company issued 60,000 warrants in connection with the private placement in November 2004, and 100,000 warrants in connection with the private placement in May 2005. In 2006, the Company issued 371,339 warrants in connection with the January Private Stock Placement and 2,394,262 warrants in connection with the May 2006 Private Debt Placement.
The following table presents warrants outstanding after adjusting to a post-reverse split basis:
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
The warrants outstanding as of December 31, 2006 are currently exercisable and expire at various dates through May, 2011. The outstanding warrants entitle the owner to purchase one share of common stock for each warrant, at prices ranging from $3.60 to $8.43 per share.
During the year ended June 30, 1996, the exercise price of 100,000 warrants issued in the prior year was reduced from $15.00 to $6.50 (post-reverse split). The Company recorded, on a prorated basis, the $850 cumulative expense over the life of the warrants through August 1, 2004. Accordingly, the Company recognized expenses totaling $62, $106 and $106 in 2004, 2003 and 2002. During the quarter ended September 30, 2004, all warrants with an expiration date of August 1, were exercised on a cashless basis. This resulted in Company issuing 136,292 shares of its common stock at conversion prices from $3.98 to $4.28 per share in exchange for 269,856 warrants with exercise prices from $.49 to $2.65 per share. The Company also reclassified $850 related to these warrants and $375 related to other expired warrants from warrants to additional paid-in capital on the balance sheet.
In 2004, Laurus Master Fund, Ltd. exercised their 140,000 warrants with exercise prices from $1.78 to $2.25 per share on a cashless basis, resulting in the Company issuing 76,466 shares of its common stock at a conversion price of $4.18 per share. Sage also exercised 11,720 warrants on a cashless basis, resulting in the issuance of 5,953 shares of Nestor stock at conversion prices of $3.54 to $4.46 per share.
In addition, NTS Investors, LLC (the “Group”) received a warrant right in January 2001 to acquire up to 298,071 additional shares of common stock exercisable at the same price at which the then outstanding warrants of Nestor, Inc. were exercisable, but only in the event the then outstanding warrants were exercised, so as to maintain their initial ownership interest percentage. This warrant right decreased by 125,000 shares on March 1, 2002 with the expiration of TSAI’s warrant on that date. The Group exercised 124,952 warrants on a cashless basis during 2004 at prices of $3.98 to $ 4.63 per share, resulting in 59,898 shares of Nestor stock being issued. Warrants outstanding at December 31, 2005 includes 18,331 warrants belonging to the Group. In addition, the Group received a warrant to acquire 100,0000 shares of the Company’s common stock at $12.80 per share for three years as dilution protection against both the Company’s and NTS’s converted employee stock options outstanding at closing. This warrant expired on September 12, 2004. All such remaining warrants expired in January 2006.
Note 12 -
Segment and geographic information:
Operating segments are identified as components of an enterprise about which separate discrete financial information is available to the chief operating decision maker, or decision-making group, in assessing performance and allocating resources. The Company’s decision-making group, its executive team, views the Company’s operations and manages its business principally as one segment. Therefore, the financial information presented in these financial statements represents all the material financial information related to the Company’s principal operating segment. The Company principally operates in the United States where its long lived assets are located.
Note -
Master lease assignment:
The State of Delaware Department of Transportation (DelDOT) executed a Master Lease Agreement with NTS in February 2004 whereby lease financing for equipment installed under this CrossingGuard contract would be financed under lease terms offered by GE Capital Public Finance, Inc. (“GE”). Under this sales-type lease agreement, NTS received $1,600 in 2005 from GE and $880 in 2004 from GE on behalf of DelDOT pursuant to its Assignment and Security Agreement with GE. NTS retains a first priority interest in the equipment and assigned its interest in the DelDOT lease and right to receive rental payments thereunder to GE. As a matter of convenience, NTS monthly billings to DelDOT include their GE repayment of principal and interest, which NTS then remits to GE on their behalf.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
Note 14 -
Other expense - net:
Other expense as reflected in the consolidated statements of operations consists of the following:
Note 15 -
Income taxes:
During 2006 and 2005, the Company recorded deferred tax assets primarily for the benefit of net operating losses in the amount of $5,053 and $4,054 respectively. The cumulative amount of these assets, which is $26,576 and $21,523 at December 31, 2006 and 2005, respectively, is fully reserved. Due to the Company’s history of operating losses, management has concluded that realization of the benefit is not likely.
The Company has available at December 31, 2005, $62,110 and $36,619 of net operating loss carryforwards for federal and state purposes, respectively. Approximately $13,318 and $2,670 of these federal and state net operating loss carryforwards were acquired as part of the merger with NTS. These loss carryforwards may be applied against future taxable income and began to expire in 2005.
The Company’s effective income tax rate differs from the statutory federal income tax rate for the years ended December 31, 2006, 2005, and 2004 as follows:
Pursuant to Section 382 of the Internal Revenue Code, annual use of the tax loss carryforwards may be limited if there is a change in ownership. This limitation applies to the losses incurred by Nestor, Inc., as well as to the losses incurred by NTS. The use of state net operating losses may be limited in the future due to the apportionment of net operating losses among different states and varying net operating loss utilization requirements by state. The Company has not determined the effect of these limitations.
Note 16 -
Related party transactions:
On January 1, 1999, Nestor, Inc. entered into an exclusive license with NTS through the expiration date of the underlying patents protecting the technologies used in NTS’s products. The license provides for royalties, as defined, to be paid to Nestor, Inc. that are eliminated in consolidation.
See Note 7 and Note 10for transactions with Silver Star, Foundation Partners I, LLC and Kuekenhof Equity Fund L.P.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
Note 17 -
Commitments and contingencies:
The following table summarizes the Company’s non-cancelable operating lease obligations at December 31, 2006:
(1) Primarily facility lease obligations in Providence, RI and North Hollywood, CA.
As of December 31, 2006, we have no off balance sheet arrangements.
Rental expense was approximately $330, $394, and $224 during 2006, 2005, and 2004, respectively.
NTS entered into an operating lease dated June 21, 2000 for office and warehouse facilities in East Providence, Rhode Island. This lease provides for monthly rentals of $10 through July 2003 and then increased to $10 monthly through July 2005. Rent payments for this lease was $127 in 2003, $139 in 2004, and $120 for 2005. Space was leased adjacent to this facility in July 2004, for additional office and warehouse facilities. This lease provides for monthly rentals of $5 through May 2005 then increases two hundred dollars monthly in each of the two following years. Rent expense for this lease was $40 in 2004 and $50 for 2005. The Company relocated to new office and warehouse space in September 2005, and has recorded a reserve for lease termination costs related to the July 2004 adjacent space in the amount of $145 as of December 31, 2006 and 2005.
In September 2005, the company entered into a new office lease in Providence, RI, which calls for monthly lease payments ranging from $8 to $11 through September 2010.
In June 2006, the Company entered into an operating lease for office and warehouse facilities in North Hollywood, California. The lease calls for monthly rent of $19 through the lease term expiration in June 2011.
On October 13, 2004, the Board of Directors approved employment agreements for the Company’s Chief Executive Officer and Chief Operating Officer (now the CFO effective January 2006) through December 31, 2007. The agreements automatically renew for a two-year period unless the Company elects not to renew. The agreements provide for a base salary of not less than $250 (CEO)/$200 (COO) and annual performance-based bonuses to be determined by the Company’s Compensation Committee. See Form 8-K dated October 13, 2004 for further information. On March 25, 2005, the COO’s position changed to Executive Vice President of Nestor, Inc., and on January 5, 2006 his position was expanded to include the CFO responsibilities. On March 6, 2006, these employment agreements were amended to reduce the minimum salary to $225 (CEO) and $180 (CFO).
Further, in March 2005 the Board of Directors approved employment agreements for a new Chief Operating Officer and a Vice President and General Counsel of Nestor, Inc. through December 31, 2008. The agreements automatically renew for one year unless the Company elects not to renew. The agreements provide for a base salary of not less than $175 (COO)/$165 (Counsel) and the COO is entitled to receive performance-based cash and option bonuses, as defined. On March 6, 2006, these employment agreements were amended to reduce the minimum salary to $158 (COO) and $149 (General Counsel). In February 2007, the General Counsel resigned from the Company.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
In February 2007, the Board of Directors approved employment agreements for a new Vice President and General Council and its Vice President, Corporate Controller, and Chief Accounting Officer through December 31, 2008. The agreements automatically renew for one year unless the Company elects not to renew. The agreements provide for a base salary of not less then $149 (General Counsel) and $125 (CAO).
Note 18 -
Litigation:
Two suits have been filed against us and the City of Akron seeking to enjoin the City of Akron speed program and damages. These cases have been consolidated in the U.S. District Court for the Northern District of Ohio. These cases are:
Mendenhall v. The City of Akron, et al., United States District Court, Northern District of Ohio, Eastern Division, No. 5:06CV0139, in which plaintiff filed a complaint and class action for declaratory judgment, injunctive relief and for a money judgment in an unspecified amount against City of Akron and all of its City Council members in their official capacity and us alleging federal and state constitutional violations. The action was filed in the Summit County Court of Common Pleas and was removed to federal court. On February 17, 2006, we and the other defendants filed a joint motion for judgment on the pleadings. Plaintiff filed an opposition to that motion on March 24, 2006. On May 19, 2006, the court ruled that the Akron ordinance permitting photo enforcement of speeding laws was a proper exercise of municipal power under the Ohio Constitution, but deferred ruling on the alleged due process violations pending an opportunity for discovery by the plaintiff, which was completed on October 20, 2006. The plaintiff amended her complaint on August 8, 2006 to include equal protection violations among her federal constitutional claims. We filed an answer to that amended complaint on August 18, 2006. Dispositive motions in the case were due by November 22, 2006.
Sipe, et al. v. Nestor Traffic Systems, Inc., et al., United States District Court, Northern District of Ohio, Eastern Division, No. 5:06CV0139, in which plaintiffs filed a complaint and class action for declaratory judgment, injunctive relief and for a money judgment in an unspecified amount against us, various past and present employees of ours and the City of Akron and alleging fraud, civil conspiracy, common plan to commit fraud, violations of the Consumer Sales Practices Act, nuisance, conversion, invasion of privacy, negligence, and federal constitutional violation. The action was filed in the Summit County Court of Common Pleas and was removed to federal court. On February 17, 2006, we and the other defendants filed a joint motion for judgment on the pleadings. Plaintiff filed an opposition to that motion on March 24, 2006. On May 19, 2006, the court ruled that the Akron ordinance permitting photo enforcement of speeding laws was a proper exercise of municipal power under the Ohio Constitution, but deferred ruling on the alleged due process violations pending an opportunity for discovery by the plaintiff, which was completed on October 20, 2006. Dispositive motions in the case were due by November 22, 2006.
With respect to both of the above cases, the Court certified a question to the Ohio Supreme Court:
Whether a municipality has the power under home rule to enact civil penalties for the offense of violating a traffic signal light or for the offense of speeding, both of which are criminal offenses under the Ohio Revised Code.
On February 7, 2007, the Ohio Supreme Court accepted the case for determination of the question presented.
With respect to the underlying actions, discovery was complete at the time the Court certified the question to the Ohio Supreme Court.
In addition, from time to time, we are involved in legal proceedings arising in the ordinary course of business. Other than litigation, which is immaterial, we do not currently have any pending litigation other than that described above.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
Note
Quarterly financial information (unaudited):
As described in Note 3 “Restatement of Consolidated Financial Statements” the quarterly information for the first three quarters for the fiscal year ended December 31, 2005 have been restated. The effects of this restatement are reflected below.
NESTOR, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
In Thousands, Except Share and Per Share Information
Note
Recent accounting pronouncements:
In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48,“Accounting for Uncertainty in Income Taxes” (“FIN 48”), which is an interpretation of FASB Statement 109,“Accounting for Income Taxes.” FIN 48 requires managements to perform a two-step evaluation of all tax positions, ensuring that these tax return positions meet the “more-likely than not” recognition threshold and can be measured with sufficient precision to determine the benefit recognized in the financial statements. These evaluations provide management with a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements certain tax positions that the Company has taken or expects to take on income tax returns. FIN 48 is effective for the Company’s fiscal year beginning January 1, 2007. The Company does not believe the adoption of FIN 48 will have a material impact on its financial position or results of operations.
In September 2005 the FASB issued a Proposed Statement of Financial Accounting standards which amends FASB Statement No. 128, “Earnings per Share”. The proposed statement is intended to clarify guidance on the computation of earnings per share for certain items such as mandatorily convertible instruments, the treasury stock method, and contingently issuable shares. The Company has evaluated the proposed statement as presently drafted and has determined that, if adopted in its current form, it would not have a significant impact on the computation of earnings per share.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”). SAB 108 addresses how the effects of prior year uncorrected misstatements should be considered when quantifying misstatements in current year financial statements. SAB 108 requires companies to quantify misstatements using a balance sheet and income statement approach and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. When the effect of initial adoption is material, companies will record the effect as a cumulative effect adjustment to beginning of year retained earnings. The provisions of SAB 108 are effective for the Company’s interim reporting period beginning January 1, 2007. The Company does not believe the adoption of SAB 108 will have a material impact on its financial position or results of operations.
In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements” (“SFAS 157”). SFAS 157 prescribes a single definition of fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. SFAS 157 is effective for the Company’s interim reporting period beginning January 1, 2008. The Company is still evaluating the impact of this pronouncement.
Note
Subsequent Event:
On March 30, 2007, the Company entered into a Note Purchase Agreement, which will be effective as of April 1, 2007, pursuant to which accredited investors (some of whom are affiliates of the Company) agreed to purchase $1.5 million of the Company’s Variable Rate Senior Notes due May 25, 2011 (the “Speed Notes”), which Speed Notes are secured by a first priority security interest in all of the Company’s assets which are directly and exclusively used for the implementation and performance of existing (entered into after October 1, 2006) and future contracts for fixed and mobile automated speed enforcement units.
Speed Note holders will receive interest payments equal to (a) $5.00 per paid citation issued with the Equipment (for “as issued” contracts), (b) $6.00 per paid citation (for “as paid” contracts) and (c) 17% of amounts collected (for “fixed fee” contracts), subject to a minimum return of 10% per annum, payable quarterly in arrears. Payments will be made based upon citations issued from 16 speed units per $1.5 million in aggregate outstanding principal on all Notes. Once the Company has entered into contracts for the operation of 16 speed units, the Company may, but is not obligated to, sell an additional $1.5 million of Speed Notes.
The Speed Notes will mature on May 25, 2011, at which time the Company will pay all unpaid principal together with all accrued but unpaid interest. The Company may at any time redeem the Speed Notes at 110% of face value plus accumulated but unpaid interest.
The proceeds from the Speed Notes will be used, either prospectively or retrospectively, to fund the purchase price or cost of design, engineering, installation, construction, configuring, maintenance, or operation or improvement of property or equipment used in contracts signed after October 1, 2006 at a customer site, including without limitation, costs of site analysis and preparation.
ITEM 9.
ITEM 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
ITEM 9A.
ITEM 9A.
Controls and Procedures.
We maintain disclosure controls and procedures, as defined in Exchange Act Rule 13a-15(e) and 15d-15(e), that are designed to ensure that information required to be disclosed in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding the required disclosures. Our disclosure controls and procedures are designed to provide reasonable assurance that their objectives are met.
The management of Nestor, Inc., including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2006.
Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that as of December 31, 2006, our disclosure controls and procedures were effective, in that they provide reasonable assurance (i) that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) that information required to be disclosed in reports that we file or submit under the Exchange Act is accumulated and communicated to our management including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.
No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the quarter ended December 31, 2006 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting
We will be required by the Sarbanes-Oxley Act to include an assessment of our internal control over financial reporting in our Annual Report on Form 10-K beginning with our filing for our fiscal year ending December 31, 2007.
ITEM 9B.
ITEM 9B.
Other Information.
None.
ITEM 10.
ITEM 10.
Directors and Executive Officers of the Registrant.
Incorporated by reference from the Company's definitive proxy or information statement to be filed with the Securities and Exchange Commission not later than 120 days following the end of the Company’s fiscal year.
The Company has adopted a written code of ethics that applies to all employees, including but not limited to, its principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. A copy of Nestor’s code of ethics is available without charge by writing to: Nestor, Inc., 42 Oriental Street, Providence, Rhode Island 02908, Attention: Nigel P. Hebborn.
ITEM 11.
ITEM 11.
Executive Compensation.
Incorporated by reference from the Company's definitive proxy or information statement to be filed with the Securities and Exchange Commission not later than 120 days following the end of the Company’s fiscal year.
ITEM 12.
ITEM 12.
Security Ownership of Certain Beneficial Owners and Management.
Incorporated by reference from the Company's definitive proxy or information statement to be filed with the Securities and Exchange Commission not later than 120 days following the end of the Company’s fiscal year.
ITEM 13.
ITEM 13.
Certain Relationships and Related Transactions.
Incorporated by reference from the Company's definitive proxy or information statement to be filed with the Securities and Exchange Commission not later than 120 days following the end of the Company’s fiscal year.
ITEM 14.
ITEM 14.
Principal Accounting Fees and Services.
Incorporated by reference from the Company's definitive proxy or information statement to be filed with the Securities and Exchange Commission not later than 120 days following the end of the Company’s fiscal year.
PART IV
ITEM 15.
ITEM 15.
Exhibits, Financial Statement Schedules.
(a) The following documents are filed as part of this report:
(1)
The financial statements of the Company and accompanying notes, as set forth in the contents to the financial statements annexed hereto, are included in
Part II, Item 8.
(2)
Consolidated Financial Statement Schedule: Valuation and Qualifying Accounts and
Reserves. All other schedules are omitted because such information is not applicable.
(3)
Exhibits numbered in accordance with Item 601 of Regulation S-K and filed herewith.
See Exhibit Index.
(b) See Exhibit Index.
PART IV
ITEM 15(a)(2)
NESTOR, Inc.
Consolidated Financial Statement Schedule
Valuation and Qualifying Accounts and Reserves
(In Thousands)
For Years ended December 31, 2006, 2005, 2004
Accounts receivable allowance for doubtful accounts:
Inventory allowance for obsolescence:
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused the report to be signed on its behalf by the undersigned, thereunto duly authorized.
NESTOR, INC.
(Registrant)
/s/ William B. Danzell
William B. Danzell, Chief Executive Officer
/s/ Nigel P. Hebborn
Nigel P. Hebborn, Chief Financial Officer
Date: March 30, 2007
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
INDEX OF EXHIBITS