Aware Inc (AWRE) 2005 Q3 法說會逐字稿

Hello, everyone. Thank you very much for holding, and welcome to the Aware Inc. third-quarter 2005 earnings release conference call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn things over to Robert Weiskopf, Chief Financial Officer. Please go ahead, sir.

Thank you. Welcome to Aware's third-quarter 2005 earnings conference call. I'm Rob Weiskopf, the Company's CFO. With me is Michael Tzannes, Aware's CEO. Thank you for joining us today.

The agenda for the call will be as follows. I will review financial results for the quarter. Next, Michael will talk about the business. And finally, we will take questions. A recording of this call will be available on our website at Aware.com after the call is completed.

First, I would like to point out that various remarks we make about future expectations, plans and prospects of the Company in the DSL market constitute forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various import factors, including those discussed in the section titled Factors That May Affect Future Results in our Annual Report on Form 10-K for the year ended December 31, 2004, which is on file with the SEC.

Turning now to the financial results, third-quarter 2005 revenue was 5.1 million, and EPS was $0.02 per share. Last year in Q3, revenue was 4.6 million and EPS was $0.01 per share.

Product revenue was 2.4 million this quarter, which compares to 0.8 million last quarter and 1 million a year ago. Product revenue this quarter consisted of software sales for biometrics and medical imaging, as well as hardware sales for ADSL tests and diagnostics. The increase in product revenue, both sequentially and for comparable quarters, was attributable to an increase in software revenue.

Contract revenue was 1.9 million this quarter, which compares to 1 million last quarter and 2.6 million a year ago. Contract revenue was up sequentially due to higher license fee revenues from new contracts. Contract revenue was down this quarter versus last year's comparable quarter, primarily due to lower license fee revenues associated with the delivery of licensed technology and engineering services. Royalty revenue was 0.8 million this quarter, which compares to 0.9 million last quarter and 1 million a year ago. For the quarter, Analog Devices and Infineon continued to be top customers.

Q3 spending was 4.8 million, which compares to 4.5 million last quarter and in last year's third quarter. The sequential increase in spending was predominantly due to higher product development costs and higher cost of product sales in the current quarter. Higher spending in this quarter compared to last year's Q3 was primarily due to higher sales and marketing costs and higher product development costs. Interest income was 309,000 for the quarter at a 3.3% annualized interest rate.

Our balance sheet is in excellent shape. Cash and investments were 37.5 million at the end of the quarter. Receivables were 3.6 million at quarter-end, which translates into DSOs of 65 days. Our inventory levels were minimal, and we have no debt. On September ,30 we had 109 full-time employees; 79 of these employees were engineers.

And finally, regarding capital stock, there were approximately 23.2 million shares outstanding at quarter-end.

This completes my financial commentary, and now I would like to turn the call over to Michael.

Thank you, Rob. We're happy with our progress this quarter because it validated that our products and product developments are positioned well in their respective markets. In the licensing business, we continue to see strong demand for our StratiPHY products, which resulted in new contracts for customer chipset developments during the quarter. We expect to see continued success in selling this product line, since we're at the very early stages of transition to ADSL2+ and the very, very early stages of bonded ADSL2+ and VDSL2.

The move to these standards is being driven by requirements of telephone companies to deliver a series of next-generation services, including video and television. Near term, we expect to see contract revenues from the licensing of this technology. Longer term, as ADSL2+ and eventually VDSL2 service deploys, we expect to see a positive impact in our royalty revenues.

VDSL2 is already having a tremendous impact on the DSL industry. With VDSL2, the pool of options open to phone companies is very broad, so that as they deliver fiber deeper in their networks, they can leverage new technologies to achieve higher speeds.

These options today are to use ADSL2+ to get speeds over 20 Mb at around 5000 feet. By using bonded ADSL2+, a phone company can achieve 44 Mb at around 5000 feet. By using VDSL1 in its 8 to 12 MHz modes, phone companies are able to provide faster speeds than ADSL2+ at distances below about 4000 feet.

And then VDSL2, with its 8 to 30 MHz modes of operation, provides faster speeds than VDSL1 at any distance, as well as feature improvements such as impulse noise protection and loop diagnostics.

VDSL2 solutions, because they also are being developed by companies who have traditionally been active participants in ADSL, will support ADSL2+ and legacy ADSL2 technology. Therefore, VDSL2 is being perceived as a solution that encompasses all previous DSL technologies.

The DSL industry is entering its most exciting phase ever, with new deployments driven by new services and standards creating an energy level that we have not seen before. ADSL2+ will be the next step the ADSL world will take. On paper, ADSL2+ is a foregone conclusion. In fact, ADSL2+ has really only rolled out in isolated spots so far.

This isn't unexpected, but with all of the focus on VDSL2 today, one could get the wrong impression that all the work involving the deployment of ADSL2+ is over. In fact, in most cases, it hasn't yet begun. Bonded ADSL2+ is also a next-generation technology that we believe will see significant success.

With StratiPHY3 and StratiPHY-Bonded, Aware has solutions that address new types of deployments that phone companies are planning. These solutions also support legacy ADSL standards and the requisite interoperability that we have gained from being on the front lines in the DSL industry for over a decade. We have simplified a complicated and diverse set of technologies so that it can be easily and cost-effectively integrated into any semiconductor company's products.

This winning combination of simplifying complicated technology and making it available under an attractive business model is why we're so optimistic about our future prospects. This value proposition is why we continue to add customers and development projects. We also continue to improve our products offering with the development of analog front-end technology.

Turning now to our biometrics products, sales were up this quarter in our NISTPack product, which is targeted at enrollment stations for fingerprint systems used in background checks. We have a mature product and set of technologies that are widely used in this market, especially for fingerprint systems. The use of these systems, also known as AFIS, is being driven by expanded domestic use of background checks, as well as by adoption of these systems internationally. We directly benefit from this growth through increased sales of our biometrics products.

The primary driver in the biometrics industry is the demand for improved security solutions to combat the threat of terrorism, both domestically and internationally. Biometrics technology plays a central role in these solutions. According to IBG, the biometrics market will grow at a five-year compounded average growth rate of about 40%.

And expanded use of fingerprint systems is also something that we're seeing as a characteristic in this market. These systems are traditionally, as I said earlier, used for background checks. These systems, as I said earlier, known as AFIS, are both being used in the domestic arena more broadly, as well as internationally. And we are a direct beneficiary of that expansion with existing products.

Another characteristic that we're seeing in the biometrics market is international legislation that's creating new biometrics opportunities and new biometric applications. One of these is the e-passport initiative; another is the US-VISIT program; and we're also seeing the personal identity verification, which is essentially a biometric-enabled federal employee smartcard for the United States government. There are standards bodies addressing these applications, which are helping accelerate the availability of these solutions.

We have products that are addressing the e-passport, as well as the personal identity verification market, and we expect to benefit as the use of these new biometric applications grows.

Another driver for growth in the biometrics market is the use of biometrics other than fingerprints. This is true in some of the applications I mentioned earlier, where facial images are going to be used. This is also an opportunity that Aware is targeting with new product developments.

I'd like to turn now for a few minutes to the DSL test and service assurance market. This is that portion of the DSL industry that deals with provisioning, delivering and maintaining DSL service. This industry is not new, but it's also going through some significant changes, driven by new DSL standards and new subscriber services.

Aware brings many years of DSL technology expertise to our tested diagnostics products. Our leadership position in the implementation of solutions that support new standards, most notably ADSL2+ and VDSL2, have put us in a position to benefit as the landscape changes in this marketplace.

We see new services affecting the test and diagnostics market in two primary ways -- the need or opportunity to add value associated with new services, and the need to support new standards that will be deployed for these new services. The test market, according to Frost & Sullivan, will grow at a five-year compounded annual growth rate of about 14%.

Most of this market is addressed today via remote automated test equipment, known as testheads, as well as via handheld testers. We're developing hardware and software products to address both of these segments of the market, and expect to see revenues grow as new services and standards take hold in the industry.

Turning now to guidance for the fourth quarter of 2005, we expect revenues to be in the 4 to $6 million range. Most importantly, we're very confident that over the long term, our products are well-positioned in markets that are growing in ways that favor us.

Our expenses are expected to be in the 5 to $5.5 million range. The increase is primarily associated with increased research and development spending, including salaries and outside service expenses associated with our StratiPHY chip developments.

Given the range of revenues and expenses, we hope to be able to show a modest profit. However, that is not as important, in our opinion, as seeing progress in our product developments and attracting new customers so that we can capitalize over the longer term on the opportunities that the markets we are addressing present. This is what will deliver significant shareholder value, and this is our primary goal.

To summarize, in each of the markets we are addressing, there are significant changes underway. DSL is moving to standards where we have a leadership position, and there is growth in the biometrics industry in the use of fingerprint systems where we have a leadership position. In a nutshell, our existing products and new product developments are aimed at the growth portions of changing markets, and this make us very optimistic about the future.

With that, we will open up the call for questions. I do have a few more announcements about conferences we will be attending, which I will get to after we get through some questions.

(OPERATOR INSTRUCTIONS) Stanley Cohen, Atrium Advisers.

A couple of quick questions on the test and diagnostics business. Before we get to some long-term points, just the calling code (ph) obviously, the sales were very low. Yet Tollgrade, a customer of yours, had a good quarter in ADSL testing. Some of the DSLAM guys -- Zone just recorded -- and I think they used boards from your customers. Why are revenues a little bit better right now in that segment of the business?

I don't know the specific details of what Tollgrade or Zone sold, and what the potential lag between -- whether these are products we sold to them in the distant past or not. Those are all possibilities. So I don't know the direct details of it.

But there's nothing particularly wrong with the current business right now; it's just a matter of --

What's really -- the position the current business has right now is that it's addressing primarily new deployments associated with and around ADSL2+, and eventually, even further in the future, around VDSL2. So the products that we're having the most traction with in the customer base and the potential customer base are things that are addressing new primarily deployments. So that puts them in the future, not necessarily in the distant future, but in the future.

I understand. Also, in the past, we talked about adding basically to the business model for the test and diagnostics. In addition to selling to the board guys, who then sell to the equipment DSLAM guys, you're interested in going after the actual DSLAM vendors, integrate the product into theirs. Have you won any design wins in that area, or what stage are we in?

It's a continued area of interest. To the extent that testing becomes integrated in DSLAMs and there are some aspects of testing that appear to be very close to the kinds of functionality that a DSLAM would be able to deliver, that's an area where think we have some value to offer. We don't have any specific things to announce at this point, but it's an area we've been involved in and we think there's some opportunities there.

Regarding the licensing and royalty portion of the business, you said you had some new contracts in the quarter. Is that new customers or just new contracts with existing customers?

We're not at this point distinguishing whether they're new customers or existing customers. The important thing to us is -- these are for some of the new standards. One of them is a VDSL2 contract, so it's another customer who's going to be participating in that market. To date, we had just Infineon addressing that market.

So the way we look at this is transition to ADSL2+ and VDSL2 are underway. Certainly the ADSL2+ is the first thing that is going to hit the market in any significant way. The more customer chip sets that we can have going after the central office and the customer premise side of the wire, the more likely we are to see the market share that we're really hoping to see as this market materializes.

Okay, but these are in addition to the two yet unannounced customers you previously spoke about?

These are new projects.

New projects, in addition to what you previously mentioned but didn't announce the names of.

That's correct.

Finally, in the -- what do you call it again? -- the biometric business, was there anything in particular in the quarter that made it so strong that was an aberration (technical difficulty) fundamentally, the business is picking up?

Well, it was a large order associated with fingerprint systems. It's a business we've been in for a long time. It's not necessarily something we expect to see each quarter, but it's based on a mature product that we've been selling into a very mature channel for a number of years.

And we think it's part of a larger trend, which I tried to talk about a little bit, of an increased use of these kinds of systems, both in the United States as well as internationally, and an increase also in the use of these things, not only for government and criminal applications, but also for civil applications.

And if you go dig into some of the IBG numbers, some of the fastest-growing markets are still around fingerprint systems, in particular, when they get applied to civil applications. So we don't think of it as an aberration at all. We think we have a mature product that's addressing a growth segment of a very vibrant market.

What was that acronym you mentioned, IBG?

I think they're the International Biometrics Group. It's a research (multiple speakers) that publishes market information.

Congratulations. Thanks a lot.

Lilly Wu, TGRA Capital.

I had a few questions on the various businesses. On the biometrics software sales, I think I have less understanding of exactly how that business model or revenue model works. Is that traditional enterprise software, which is licensed? Is it -- when you mentioned enrollment stations, are they software packages per station? Is there maintenance and service revenue associated with it?

Yes. So there are -- it's traditional enterprise software, vertically oriented software packages, and there are maintenance programs associated with them.

Okay. And it's the typical proportion where, say, it's something like 10, 15% of (multiple speakers)

Correct. You mean from a partitioning of the revenue perspective, yes.

And when they taken over the enrollment stations, they pay the license fee and then the maintenance is recurrent.

Right.

Okay, but the license fee is a one-time --

The license fee is per station, yes. So as we see more of these stations being deployed or used for capturing fingerprints as part of an overall background check, we sell more of these licenses. These licenses are in support of these stations. These stations are also known as live scan devices.

Okay. Were -- the contracts in the third quarter, were they to the private sector or to the federal government, or -- what kind of customers were they?

You know, the customer base -- I don't think we want to get into specifically what happened in the third quarter. The customer base for these products, which, as I mentioned earlier, we've had for some time and of course we continue to improve over time, are biometrics companies who are in the AFIS business or in the live scan business, as well as system integrators who will take devices and pull systems together themselves.

Okay, so not necessarily directly to the ultimate end user.

No, Usually not to the end user. Usually to OEMs, either live scan companies or other biometrics suppliers, or system integrator companies.

Okay. And are those sales in the U.S., or are they international?

Sometimes they're in the U.S., but actually, I think it's fair to say that traditionally, they've primarily been in the U.S., and we are increasingly seeing international sales or sales that are ending up in international spots. We may still be selling them to a U.S. entity, but the end application is an international application.

The facial recognition package that you referred to earlier -- is that under development, or an existing product?

It's under development. We have an area of leverage there from the products that we already have in development, which are fingerprint-based. So we can leverage a lot of what we've done in that area. We're participating in a number of standards that are taking place to address these new biometrics. But most of those products are under development.

And do we have an expected timeline or timeframe of when that would be a software package that's ready for market?

We've announced several new products in the last year. We announced an e-passport product called ICAOPack, and we announced a personal identity verification product called PIVSuite. So we will announce those when they're available. I can't say at this point when that will be.

Okay. All right. Moving on here, in terms of the R&D, you have been spending around 2.5 million per quarter the last couple of quarters. Just to give us an idea, I mean, you have basically three businesses that you're reporting from -- the ADSL2 chips, the test units, as well as biometric software. How is your R&D split up between the three?

We don't really distinguish it at this point. I mean, it's a pool of engineers that there are -- there's a lot of -- there's some overlap between the development, certainly between DSL licensing and the test and diagnostics. There's a lot of overlap. Less so between the biometrics and medical imaging. But there's some overlap there as well. The majority of the R&D is focused on DSL licensing, just because that's a larger suite of products and activity that has traditionally been a larger revenue generator for us.

Okay.

But in the last several years, we've increased the amount of R&D that we put into the biometrics and medical imaging, because we've seen the potential for these kinds of opportunities that we're actually seeing materialize now.

So we also have a medical imaging product that I did not talk about too much today, but we'll probably have an opportunity to talk about some other time, which is based on JPEG2000 technology that we've developed. And so one of the objectives over the last several years has been to improve our product offerings in the biometrics and medical imaging areas, and we're starting to see some of the fruit of that, and that's very satisfying to us.

And the increase in operating expense that you gave in the guidance. You mentioned that a good portion of that will go into R&D. And again, is there -- is that to serve all the businesses, or (multiple speakers)

Yes. It really is. It's pretty much across the board. Part of it is for outside services or product development expenses, we'll sometimes call them, which have to do with the actual StratiPHY chip development specifically. So those of course are not associated with the biometrics business, but more associated with the other two products. But a good percentage of it is just R&D growth. We've added some people, we've increased salaries in the recent months, so there's a lot of it is just resource and research and development associated expense.

Great. And on the ADSL side, the royalty that we see, is that fair to say it's still pretty much all legacy ADSL chip sales?

It's mostly, for sure. I mean, there's some ADSL2+ areas of deployment. France has been one area that has been very aggressive in deploying ADSL2+ and actually deploying IP TV over that technology for the delivery of TV service to its consumer base.

But when you look at really the world as a whole, ADSL deployments are still primarily being served by legacy ADSL. And that transition is underway. We think it's not only we, but I think the entire industry believes, understands, knows that this is going to transition to ADSL2+. But that hasn't happened yet, which isn't surprising. It's a very normal sort of development cycle for phone companies and equipment suppliers to transition from one technology to another.

And I fully understand that the royalty for you is a lagged recognition, because basically your customers sell the chips and then after their quarter closes, you recognize royalty on it the quarter thereafter.

That's correct.

So, but even with the lag, I was wondering how you see, say, ADI or Infineon's ADSL2 chip sales going at this time. I noted that the --

I think their ADSL2+ and ADSL2 products are doing very well. At some point, it would be nice if we had enough visibility into what's going on in the market to be able to say this percentage of the ADSL2+ market is being captured by Aware customers. I think they're doing very well in those portions of the market that are deploying ADSL2+.

And I think that that is a lot of the -- so if all they had on the market today were regular ADSL products, you would see royalties going down more than they've gone down in the last year, just because ADSL is being transitioned out all over the world. I think with that transition, you're seeing price pressure and a number of other things that could come with that sort of thing.

That business is being supplemented at both Analog Devices and Infineon by ADSL2+ products, which I think are being met with a significant amount of success, and we expect that continue as the rollouts to more ADSL2+ take place and as VDSL2 -- now, what's going to happen with VDSL2 is probably similar to what happened with ADSL2+ in the last year or two, which is you will see some concentrated pockets of deployments in the near term, but it won't be for quite some time, our guess is at least until 2007, before you see a broad rollout of VDSL2 service.

Broadcom had announced just a few days ago at their results that they expect their ADSL2 chips -- modem chips to triple in number by the fourth quarter. And they see strong demand within the Asian market in terms of installation, as well as increasing Europe. Of course, they didn't give a number base, so tripling could mean nothing to three. But in that regard, it seemed like there was distinct and measurable traction on their side. Is that something similar on your side?

I don't think we have the visibility through our customers for that kind of preciseness. The overall trend in the market is certainly pointing to that kind of opportunity, and we wouldn't at all be surprised if we saw our customers having that kind of improved traction in those markets. But Broadcom could be looking at one pocket of deployment that is rapidly growing, and it may not be something that everyone in the industry is experiencing at that point in time.

Ted Moreau, The Cardinal Group.

I want to get back to this VDSL2, VDSL1 and even the bonded ADSL. And you have answered part of the question in that you've indicated VDSL2 might ramp in '07. But am I right in this, that if you're able to reduce the distances for this kind of bandwidth, that these fiber built-outs for the carriers, would -- if they can not have to get as, let's say, as close to the customer, it seems like it would reduce the cost of these deployments as VDSL2 and bonded ADSL would roll out. And wouldn't this be a significant ramp with the fiber to the node initiatives, and maybe Verizon might change their fiber to the home plan?

I think you're right. I think that this suite of technologies, ADSL2+ enabling a certain speed at -- a certain speed at a certain distance, and then as you go to bonded, you really double that speed at the same distance, so it's a significant improvement. And then VDSL as you get closer.

I think you can't look at a general solution for every phone company. Each phone company in each geographic region sort of has sets of requirements and needs that are particular to them. I think the main sort of benefit that VDSL2 has brought to the industry is it plugs a hole that sort of used to exist, and that is as I get closer, what do I do?

In many cases, phone companies say I don't want to get closer; I don't need to get closer. 25 Mb is plenty. But others say I really want to be able to deliver 100, and now with VDSL2, I think they have an answer, if they want to go to that point.

So I think I agree with you. I think that the reason there's sort of a rebirth in the DSL industry is that you have a suite of technologies that can be used for almost any imaginable deployment scenario. And what exactly BellSouth or Horizon or SBC are going to do, we know what they say they're going to do. SBC says they're going to use bonded ADSL2+ for exactly the reason you said, they don't have to get as close if they do that, and therefore it's cheaper.

SBC plans on using VDSL, and Verizon is currently talking about fiber to the home, although I've heard some discussions or rumors about the fiber to basements of buildings and then VDSL-type service inside those buildings. So I think at the end of the day, the phone company looks at it as a suite of services they need to deliver, and now they have a suite of technologies that they can use to deliver that, and it really opens up a very good set of options for them.

Tell me, VDSL1, which you said could deliver -- I forgot what bandwidth you indicated, but it was within 4000 feet or less, right?

Yes. VDSL1 is sort of the pre-VDSL2 version of very high-speed DSL, and --

So is that 20 megabits, though, or--?

No, it's higher data rates than that, but its disadvantage is that it doesn't have the reach of VDSL2, because VDSL2 will really go out to 8 or 9000 feet. And the other thing that's probably the most important is that most VDSL2 suppliers are also going to support ADSL2 in their solutions, and that's not necessarily true in VDSL1.

So I think the sort of soundbite is if you're deploying VDSL sort of yesterday, then you use VDSL1. But if you're really planning on deploying it tomorrow, you should look at VDSL2, because it's a better technology; it's got support for ADSL2 in almost all real-world implementations; it's got better features; it's the latest and greatest of the highest speed DSL technology there is.

It seems to me, though, if I just looked at the timing of the carrier buildouts, that '07 is about when they're going to really get going. And why get going any sooner, and why wait for VDSL2? It would make fiber to the node a pretty easy infrastructure to implement, because I don't have to -- I can use that copper connection now with pretty good bandwidth from a pretty strong -- from almost a mile and a half.

Again, I don't think you can generalize and say that about all phone companies around the world. I mean, I think there are some who are much more aggressive at wanting to deliver higher speeds. I think in the U.S., what you're saying may be right, but again, we don't really know the pressure and the deployment -- the real deployment scenario that we're going to see at either SBC or BellSouth just yet.

They've laid out sort of where they want to go, and even Verizon was just talking about 3 million homes a year here, which no one -- which is going to be a little too slow. So it hardly gets them going. Do you get -- in terms of aside of your knowledge from the industry, do you get feedback from the carriers, or are you mostly working with your chip guys and they give you the feedback on their plans? I mean, how directly do you work with what the telephone companies might want to be doing?

With some phone companies, we work pretty closely. At this point, it's mostly with those guys who are really pushing the envelope on these new standards.

Is it mostly the independents?

No. At this point, it's mostly international guys, although we do work directly with the independents as well, and that's really more for sort of the new service challenges that they might be seeing and some of the test and diagnostics offerings that we have. But in the United States, there are folks at the phone companies who we talk to and try to understand their challenges and try to understand what kind of technology improvements might be able to improve the deployment scenario they're facing.

Hasan Karim (ph), Pacific Edge Investment Management.

Good quarter. I just had a few questions, and I'm not sure if you've covered them already since I joined the called a little late. Firstly, did you have any 10% customers in the quarter?

We didn't announce it one way or another.

But it will be in the Q, most likely?

It will be in the K. I think at this point, we announce 10% customers at the end of the year and not necessarily on a quarterly basis. But we said that Infineon and Analog Devices were large customers. But I don't think we talked about whether they were 10% or not.

And then I think in the past conference call that you had mentioned you had in terms of DSL customers or licensees four announced customers and two unannounced customers. Is that correct?

Right.

Us that changed?

Well, we have some new customers that we haven't announced as well. So, yes, it's changed. We had some new developments that we are under contract for this quarter. And I think the best way to answer that is that we're going to start trying to track how many different chipset developments we have going on for the different technologies. So we've about six customers developing chipsets for the ADSL2+ market. With this quarter's new contracts, we now have two customers developing chipsets for the VDSL2 market. Some of these customers are still unannounced, and as you've probably heard us say before, we typically will disclose who they are when they have products available.

Okay. But would it be fair to assume that customers who license ADSL2+ or ADSL would most likely also license VDSL products as well, or have been licensing or are going to license VDSL products?

It would make sense, we think, for that transition to happen -- for that evolution, I guess, of technology licensing to happen.

And have you seen your large customers transition to VDSL2+, either from a licensing or product development perspective?

Certainly Infineon, who’s one of our largest, started as an ADSL licensee and is one of our largest VDSL2 licensees.

Okay. And it would make sense that the other one would do the same.

We think so, yes.

Regarding the OpEx guidance that you gave, does that include cost of goods sold? Is that what's included in OpEx as well?

It is, yes. And the cost of goods sold really is -- the only significant thing that's variable there is hardware sales, which are around the custom diagnostics product. So there's part of that range is dependent on how much hardware is actually sold in the quarter. Part of it is dependent on how many outside services we pay for in the quarter associated with chip developments. That's why there's a range.

Okay. And then I guess in terms of -- on a going-forward basis, do you tend to recognize revenue on a percentage of completion method, or is it just upfront licensing? How does revenue recognition work there?

We talk about in detail what our revenue recognition policies are in the K. Typically, we don't recognize 100% completion. Our projects are milestone-based, so as milestones are achieved, we recognize the revenue associated with those milestones.

To the extent that a contract has more than one service being delivered from Aware, you bundle those things together and sort of recognize it radically over the duration of the contract. But most of our projects are recognized on a milestone basis, so we deliver technology, the customer accepts the technology, the revenue is recognized. Royalties are recognized in a quarter lag from the report, and usually payment by our customer of those royalties.

And then on the royalty side, there was a decent downtick this quarter year on year and quarter on quarter. Could you just explain that?

I think I talked about it already. I mean, I think what you're seeing there is the effect of the transition that's taking place from ADSL to ADSL2+. The exposure that we have in the ADSL market has generally been declining over the last five years, where our two primary customers there, Analog Devices and Infineon, have not been gaining share, certainly, for the last couple of years, and there's been a number of other suppliers who are out actively going after that market.

The important part of the ADSL market in our opinion is the new market, the ADSL2+ market. And in that market, we think our customers, the ones I mentioned as well as a number of new ones, are very well-positioned to gain share. And it's the gaining of the share that is the most important sort of metric for us going forward.

And our indications at this point are that those areas that are deploying 2+, our customers have a good position in, that our new products that are being developed by those customers as well as others are going to be very well-positioned into the ADSL2+ market. And now you have a VDSL2 market, which is probably still further away in the future, but we certainly think we've got a good solid product offering from Aware, but also offerings from our customers that will address that market.

And then I guess with the customers that you have and haven't announced, based on their announced deployment schedules, when do you expect royalties to bottom out, considering the transition is -- well, starting to happen, it sounds like.

I don't think we expect them to bottom out. I see. So when do they -- it's hard to know. I think as I said earlier, we're seeing some of the downturn or the reduction in sales by our customers in ADSL being picked up by ADSL2+, but I think ADSL2+ commands a little bit of a premium in the market over traditional ADSL. But it hasn't been significant enough yet to overcome the older products going down. We expect that it's going to go in the right direction as 2+ really starts rolling out.

With the distinction between contract revenues and product sales, should I consider product sales in the biometric category, or with contract revenues, traditional DSL licensing business?

That's right. Also in product sales, however, are our test and diagnostics hardware products, and software products, for that matter. So we also sell software products in that industry. So products include the biometrics and the test and diagnostics business, and contract revenues are almost all DSL licensing. Sometimes there's test and diagnostics revenue there as well, but it's usually small.

I guess on the biometrics side, there are a lot of small companies deploying products, but there are a concentrated number of larger companies than plan products, I guess. Could you talk about when a biometric or a live scan manufacturer purchases your product as opposed to developing their own internal software image product?

I guess that's really their decision. I think the presence we have in the industry is one that we've had for a number of years. We have a very mature product in this area. We were involved in the very early days in some of the standards that are the underpinnings of the technology that goes into these solutions. We've done a very good job making sure that we add features around the products that are requisite as the systems get more sophisticated.

In terms of sort of experience in the industry, you develop just like you do in DSL sort of an interoperability capability and the ability to interoperate with a number of the systems that a fingerprint system has to interact with. And that's something that we've gained experience and expertise in over the years.

So it's a value that we deliver to our customers, and there's nothing exclusive about the relationships, and there's no prohibition from either existing customers or new customers doing it themselves. But it's a fairly well-established value that we deliver to the industry, and we have a long list of very happy customers.

Finally, what was your deferred revenue for the quarter?

This quarter, I don't think we had any. Right, Rob? Minimal. $105,000.

Is that mostly maintenance revenue, or what is that?

That's correct.

Ken Luskin, Intrinsic Value Asset Management.

Congratulations on a great quarter. Back in the black. Can we talk about -- you mentioned last conference call the pipeline a little bit. Can you touch on that?

Yes. Continues to look very strong. I think the real pull for contracts right now is around two technologies, VDSL2 and bonded ADSL2+. Both of these are almost certainly going to be big deals in the deployment of next-generation systems. So we see a number of customers interested in licensing that. We have very strong product offerings in both of those. I haven't tallied up sort of the size of the opportunity. I think I did that last time. I can --

You mentioned 15 million.

Yes, I remember mentioning 15 million. I haven't added it up this time. We could make it a -- we're going to have one of those investor question things; I can try and answer it on an e-mail in the next few days.

Good. But it doesn't look like you've written into it very much.

It's still very strong, for all the right reasons. We have a great product and it's at the right time in the market.

Excellent. In France, Thomson seems to be the primary seller on the CPE side, and I know that Infineon is supplying Alcatel on the DSLAM side. So there's a very good chance that we start seeing some significant royalties come into this quarter. Is that a fair statement?

I think there's a good chance we see it. I don't know the specifics of what you're saying. I think (multiple speakers)

I'm saying that Thomson seems to be rolling out a lot of -- they've made public statements about the amount of devices that they're rolling out on a weekly basis -- it's 45, 50,000, or something like that.

But Thomson doesn't necessarily use only products licensed from Aware. Having said that, also, Alcatel doesn't necessarily only use chipsets from Infineon.

So I think the general -- the thing I am most comfortable answering, because a lot of the questions are trying to get at this -- I think the general trend is still very positive towards our gaining share in the ADSL2+ and also now as VDSL2 starts gaining traction in the market. I'm still hesitant to say it's going to happen next quarter or the quarter after that. It's not that I know one way or another, I just have -- we've been in this industry long enough to know that things sometimes take a little longer than you think. And it's not as critical as when the market materializes, but we are in a really good spot.

It's not a question of if; it's a question of when. But we know (multiple speakers) we know what's happening, and so (multiple speakers)

I certainly agree that the sooner the better.

I don't blame you; you're not in control of it. So you just have to wait and see until it really rolls in, basically.

Right.

Good. So now the -- great to see that the biometrics business looks like what we've been talking about here for quite some time is starting to happen there. So it's a big order; it's lumpy business to a certain extent. But it looks like that is now kind of arcing upward.

We don't think it's an aberration. I guess somebody used that word earlier. We think it's part of a general trend in that industry. We've invested a lot in new products there. We're seeing a lot of traction in the market for fingerprint systems in places other than sort of their traditional use, and even in the places where they're traditionally used, we're seeing increased use.

So it's one of the fastest-growing markets, actually, we're looking at. It's certainly growing faster than the overall ADSL chipset market. And I think we've got a good position in it.

In the ideal situation, we're looking at three sets of product, the test and diagnostics, the DSL licensing and the biometrics products, all being very profitable, successful products. And I think that's a very real possibility. And I tried to talk today on the call about some of the changes we're seeing in all those industries that we think are really beneficial to us. They're growth-oriented, and I think we've positioned ourselves to really capitalize on those transitions and changes that we're seeing.

Wonderful. Can we just move into VDSL. There's a lot of fluff out there, I would call it, from people who have VDSL1 and seem to be claiming they have VDSL2. And, you know, what is your sense of who has what? You guys definitely have it, and Infineon has it. Do you have any sense of who has anything else?

I think there are several companies that developed solutions prior to the VDSL2 standard. And it's very natural for them to have a transition required to go to the new standard. And I think that's what you'll see in some of the solutions that are out there.

In many cases, these existing VDSL1 chipsets will support certain modes of operation, perhaps, that are VDSL2, similar to VDSL2. But I think it's fair to say that Infineon is probably the only chipset that supports all the modes of VDSL2 standard. And I think that's important, because I think getting all the way up to 30 MHz and getting up to 17 MHz, which are some of the modes that VDSL2 supports, are important capabilities that the phone companies, when they look at this suite of options that they have to address, need to have at their fingertips. So I think that puts Infineon in a very strong position. So I think that's --

And the diagnostics part of the VDSL2 are there such that there's not in the VDSL1, so that phone companies -- and that's a real expense for phone companies, is servicing --

There's a number of features. There's a number of features that VDSL2 has that VDSL1 doesn't. There's a performance enhancement that VDSL2 brings over VDSL1. And there's this sort of de facto ADSL2+ backward functionality that VDSL2 solutions are bringing to the market.

I think anyone who's contemplating deploying a VDSL-based service is going to use VDSL2 because it's the better technology. I think anyone who's already deployed something inevitably had to or had no choice but to deploy VDSL1. And I think that's just the way -- that's what you have.

I don't think the industry expected VDSL2 to emerge as rapidly as it did. I don't think even we expected it to have the sort of enormous positive impact it had on the industry. And I think if you were a telephone company a year ago, thinking about deploying a VDSL-based service, even though you heard VDSL2 was coming, you probably figured it was a couple years away. And in fact it wasn't; it was much sooner than that. So you went ahead and did something with VDSL1, but now you have to worry about it not being the best technology you could use.

And this accounts for all the pipeline of all these folks who are now realizing that this is actually happening, and going, how do I get my hands on it, and that's (multiple speakers)

Pipeline to us.

Right.

Yes. The bar -- when VDSL2 showed up, the bar was raised another -- I don't know, a bunch. It wasn't just ADSL2+ that had to be developed and integrated and optimized; all of a sudden here came a new standard, and it's a very complicated standard with lots of different modes of operation. And it almost immediately became a requirement.

So I think that a lot of the reason that people are interested in licensing is because there's an opportunity staring them in the face and doing it themselves isn't an extremely viable option. I also think that the business model, and I've talked about this a lot, is a very compelling one. And I think technology is important, but being able to deliver a product that's easy to use, which we do in StratiPHY, and presenting a business model that's attractive to the customer and attractive to us is what really brings it all to a sort of a win-win situation.

Yes. People like Centillium, who I asked on their conference call were they a licensor of you, gave a cryptic answer that they could not disclose it at this point in time because for competitive reasons. But, yes. Anyway, so I know you can't disclose it either, obviously. But it would sound like from what they said, that they've come to you for that. Guys like Ikanos that have VDSL1, they need to figure out how to have ADSL2+ to incorporate that to even get to VDSL2, right?

I think in many applications they do. There are going to be areas and Ikanos sales chips into those areas today that are just VDSL deployments. And there's no ADSL2 or 2+ or possibly even VDSL2 requirement. I think those will be the minority or they will die out.

I think what's really going to happen is some combination of ADSL2+ and maybe some of the modes of VDSL2 or potentially all the modes of VDSL2 will be supported in pieces of equipment, because they deliver a solution to the phone companies that is really easy for them to use. They don't have to worry about exactly how far customer X or Y is. If they're that far, they do ADSL2+. If they're further, they use regular VDSL2. If they're close, they use VDSL2. It all sort of becomes a service offering and not a technology story.

Guys like Infineon, who are extremely adept at selling carrier access products at low prices, can go in there and undercut people like Ikanos with something they can sell -- look, we can sell you more chips at lower prices.

Infineon is certainly a big powerful chip guy, and they've been in this industry. They've actually been in the VDSL industry as a CLAM (ph), which was another VDSL1 technology, supplier, and they I think at some point had some 90%-plus of that market. So they certainly know how to sell into that industry very well.

And having said that, I think you're looking at a situation where VDSL2 has effectively made the pie larger. And this is certainly a way to look at it in an everyone-can-benefit way. And I think that's true because I think phone companies look at, again, this suite of technologies and figure that some combination of these things are going to work. Obviously, they have all the pressure of having to deliver services that either enable them to stay in business, or enable them to take more money off the table. And I think you're going to see a larger than previously perceived overall VDSL market. I believe the VDSL market was perceived as a pretty niche-y market a year or two ago, and it now looks like it's going to be pretty mainstream.

Wonderful. It looks like your business has really started to uptick here. But your guidance at 4.4 to 6, you've been about guiding from 3 to 5. So you've definitely upticked this for the first time in about a year of guidance or more. So you guys -- it sounds like you feel like you're starting to lift off.

Yes. We feel we're well-positioned with a number of different products. There's a lot of people working really hard, and we're really excited about a lot of the opportunities we see, and I can't say that nothing can go wrong. But right now, it looks like a lot of things are going right.

Just wonderful, thank you.

Stanley Cohen, Atrium Advisers.

Are any of your new chip design wins from people other than merchant -- semiconductor manufacturers? Are systems manufactures integrating StratiPHY into some proprietary chips?

Are system manufacturers --

Are they -- not using you yet. Are they looking to use you to design their own chips with VDSL2 or VDSL2 as a core?

I think answer to that is no. I don't know if both of these customers -- and actually, if I were to try to answer the question about all of our customers, whether they're all merchant, as you call it -- but most of them are semiconductor companies. They are not systems companies deciding to develop a chipset. I'm not sure what you mean.

You've spoken in the past that some of your designs are coming from nontraditional type of customers. So instead of designing a stand-alone ADSL2 chip or VDSL2 chip, are designing -- combining with network platforms or something else.

That's almost all of the designs. So pretty much every customer integrates our technology with something of their own. And on the CPE side, it's network processing or some other consumer electronics or broadband capability.

I mean, that wasn't the way the market was in the ADSL market. The market --

Okay, now I understand. I think what you're going to see in the ADSL2+ and beyond market is you'll see some sort of ADSL modem, which are going to be very simple almost connectivity devices or interface devices, but the majority of ADSL CPE boxes will be integrating ADSL2+ and VDSL2 with something else.

In fact, if you look at -- I was looking at some of the Infonetics research data recently, and they're forecasting that a lot of the gateway market in ADSL2 is actually growing faster than they thought. And by gateway, they mean something that integrates ADSL with something else. So I think the combo ADSL plus other things market is probably more likely to grow faster when compared to the just pure ADSL modem, simple modem device market. Almost all of our customers are integrating our ADSL technology, StratiPHY -- our StratiPHY product, whether it's StratiPHY2+ or StratiPHY-Bonded or StratiPHY3, with at the very least a network processor.

So as this market emerges, some of your customers theoretically should have an advantage over the incumbent within the -- the Broadcoms and the Conexants who are selling very discrete solutions.

I think the Broadcoms and the Conexants are also selling integrated solutions. They may also be selling discrete solutions as well. But I don't think I can take a whack at Broadcom and say they don't have good network boosting (ph) technology.

What the heck, come on. Take a whack.

(multiple speakers) -- don't have the ability to integrate their DSL with network processing. That would probably not be a true statement.

Thanks a lot.

Thanks for your participation in the question-and-answer session. I will turn things back over our speakers for any additional or closing remarks.

A couple of opportunities to meet with us if you're in these areas. We're going to be at the Merriman Curhan Ford conference, which is in New York on Tuesday. If you're interested in seeing us there, you can let us know, if you don't know how to get in touch with the folks at Merriman yourselves, and we can try and put you in touch with people there.

Also, we will be at the AEA conference in San Diego the week after next, where we will be presenting and talking about Aware for a good, solid day, and hope that we get a chance to see as many people as possible. And also, we're going to again invite questions from investors to be e-mailed to investorquestions@aware.com, and we will tally up the questions and post answers to those sometime next week.

Thank you very much. Look forward to talking to you next quarter.

Thank you again for participating in the Aware Inc. conference call. You may now disconnect.