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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-K (Mark one) [X] Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended December 31, 2003 or [   ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from  to Commission file number 001-15069 Duraswitch Industries, Inc.  Nevada
    
    88-0308867(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)234 S. Extension Road
    
    85210Mesa, Arizona
    
    (Zip Code)(Address of principal executive offices)
 (480) 586-3300
(Registrants telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par
value $0.001 Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [   ]. Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrants knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K. [   ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [   ] No [X]. The aggregate market value of common stock held by nonaffiliates of the
registrant (6,923,925 shares) based on the closing price of the registrants
common stock as reported on the NASDAQ SmallCap Market on June 30, 2003, which
was the last business day of the registrants most recently completed second
fiscal quarter, was $14,194,046. For purposes of this computation, all
officers, directors, and 10% beneficial owners of the registrant are deemed to
be affiliates. Such determination should not be deemed to be an admission that
such officers, directors, or 10% beneficial owners are, in fact, affiliates of
the registrant. Number of registrants shares of common stock outstanding as of March 15, 2004
was 9,591,673. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrants Proxy Statement for the 2004 Annual Meeting of
Stockholders are incorporated by reference into Part III of this Form 10-K.




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Duraswitch Industries, Inc.
Form 10-K
For the Year Ended December 31, 2003 Table of Contents PagePART IItem 1.
    
    Business
    
    
    3Item 2.
    
    Properties
    
    
    10Item 3.
    
    Legal Proceedings
    
    
    11Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    11PART IIItem 5.
    
    Market for
Registrants Common Equity and Related Stockholder Matters
    
    
    12Item 6.
    
    Selected Financial Data
    
    
    12Item 7.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 7A.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    18Item 8.
    
    Financial Statements and Supplementary Data
    
    
    19Item 9.
    
    Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
    
    
    33Item 9A.
    
    Controls and Procedures
    
    
    33PART IIIItem 10.
    
    Directors and Executive Officers of the Registrant
    
    
    34Item 11.
    
    Executive Compensation
    
    
    34Item 12.
    
    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
    
    
    34Item 13.
    
    Certain Relationships and Related Transactions
    
    
    34Item 14.
    
    Principal Accountant Fees and Services
    
    
    34PART IVItem 15.
    
    Exhibits, Financial Statement Schedules and Reports on Form 8-K
    
    
    35Signatures
    
    
    
    
    36EX-10.1.2EX-10.13EX-21EX-23.1EX-31EX-32
  Statement Regarding Forward-Looking Statements The statements contained in this report onForm 10-Kthat are not purely
historical are forward-looking statements within the meaning of applicable
securities laws. Forward-looking statements include statements regarding our
expectations, anticipations, intentions, beliefs, or strategies
regarding the future. Forward-looking statements also include statements
regarding revenue, margins, and expenses for fiscal 2004 and thereafter;
statements regarding our licensees ability to successfully market and
manufacture products using our technologies; the potential for our technologies
in key markets; anticipated cost savings; our estimation of the benefits
derived from our organizational reductions; our ability to drive high-volume
applications resulting in revenue growth; potential acquisitions or strategic
alliances; and liquidity and anticipated cash needs and availability. All
forward-looking statements included in this report are based on information
available to us as of the filing date of this report, and we assume no
liability to update any such forward-looking statements. Our actual results
could differ materially from the forward-looking statements. Among the factors
that could cause actual results to differ materially are the factors discussed
in Item 1, Business  Risk Factors. 2




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PART I 
 Item 1. Business. Overview We have developed, patented and licensed innovative technologies utilizing
a magnetic-based design for electronic switches. We are currently expanding the
use of these technologies by licensing manufacturers to produce and sell
products using our technologies. We believe these patented technologies allow
us and our licensees to provide innovative solutions to the electronic switch
design challenges faced by original equipment manufacturers, or OEMs, and
component suppliers. We maintain our executive offices at 234 S. Extension Road, Suite 103,
Mesa, Arizona 85210, and our telephone number is (480) 586-3300. Our website is
located at www.duraswitch.com.Through our website, we make available free of
charge our annual report on Form 10-K, our quarterly reports on Form 10-Q, our
current reports on Form 8-K, our proxy statements, and any amendments to those
reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities
Exchange Act of 1934. These reports are available as soon as reasonable
practicable after we electronically file those reports with the Securities and
Exchange Commission. We also post on our website the charters of our Audit,
Compensation, and Nominations and Corporate Governance committees; our Code of
Conduct, and Code of Ethics for the CEO and Senior Financial Officers, and any
amendments or waivers thereto; and any other corporate governance materials
contemplated by SEC or NASDAQ regulations. These documents are also available
in print to any stockholders requesting a copy from our corporate secretary at
our principal executive offices Industry Analysis Electronic switches and Integrated Control Panels, or ICPs, are used in a
wide variety of consumer, industrial and agricultural products, such as
appliances, military equipment, airplanes, automobiles, security systems,
temperature controls, point-of-sale systems, elevators, medical equipment,
computers, gas pumps, beverage dispensers, gaming units, fitness equipment,
consumer electronics and commercial food preparation equipment. History of Electronic Switches.In the last hundred years, two basic
switches have dominated the market for our switch technologies:
electro-mechanical and membrane. In its simplest form, an electronic switch
controls the flow of electric current: press the switch to complete the circuit
and the current flows to operate a microprocessor, which in turn, performs the
desired function. Electro-mechanical switches operate by pushing, turning or
sliding a button, knob or lever to mechanically activate a series of movable
parts that will close or complete a circuit within the switch itself. Although
they offer excellent tactile feedback for the user, electro-mechanical switches
are bulky, mechanically complex and can be difficult to integrate into certain
ICPs. Membrane switches consist of multiple, thin-film layers topped by an
overlay with printed graphics or instructions to operate the device in which
the switch is incorporated. A typical example of a membrane switch is found on
most microwave oven control panels. Without tactile feedback, users may
activate the switch multiple times, which could cause the opposite effect of
what the user intended. To solve the feedback response problem, membrane switch
manufacturers typically have offered a beep sound, light, or status icon on a
display to inform the user when the switch has been activated. However, this
solution increases the cost, complexity and size of the product to which it is
added, thus decreasing the advantages of a membrane switch over an
electro-mechanical switch. The second option to overcome the feedback response problem is to
incorporate a metal, rubber or plastic dome as part of the membrane switch.
When pressed by a user, the center of the dome will invert and contact the
circuit on the membrane layer beneath it. Domed membrane switches are prone to
failure due to material fatigue, are much less reliable than membrane switches
without domes and require inconsistent amounts of force to be activated. These
limitations have frustrated users and increased the cost and design complexity
while decreasing the reliability of the switch. The Duraswitch Competitive Advantage The keys to our technologies are simplicity of design and reliance on
magnetic force, rather than mechanical parts or the elastic properties of
materials, to operate a switch. Based on our experience and available research
in the electronic switch and ICP industries, we believe our technologies offer
several competitive advantages compared to switches and ICPs using traditional
electro-mechanical or membrane switch technologies, including the following: Significantly Greater Durability and Reliability.Our technologies rely on
a magnetic-based design with few moving parts and virtually no stress, fatigue,
or potential breaking points. By eliminating or reducing the mechanical
complexity and precision required by traditional technologies, we believe
switches made with our technologies are 3




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significantly more durable and reliable than traditional
electro-mechanical and membrane switches. From January 1998 to January 2001, we
tested one of our PushGate® pushbutton switches. It exceeded 500 million
activations on an electronic counter. Additionally, multiple samples of new
PushGate switch designs routinely successfully complete durability tests of
between three and 50 million activations. We believe these test results support
our belief in the reliability and durability of products manufactured using our
PushGate technologies. Inherent Feedback Response.Membrane switches and some electro-mechanical
switches require additional cues such as beeps, lights or status icons to
artificially provide feedback to the user which increases the complexity and
total cost of the switch. Our PushGate design consistently produces a
distinctive click each time the user activates our switch and eliminates the
costs associated with additional cues. Ease of Integration in Slim Profile, Environmentally Sealed Design.
Because switches produced using our technologies use a thin, multiple layer
design that incorporates a flexible circuit rather than bulky mechanical parts,
they are easily integrated into flat panel/slim profile products currently
desired by the market. This design also eliminates the need to breach the
surface of the ICP, enabling our ICPs to be easily sealed, cleaned, disinfected
and protected from harsh environmental conditions. Value Engineering Alternative.We believe switches produced using our
technologies offer a better overall value compared to switches using
traditional technologies. The integration attributes of our technologies allow
for a complete value engineering alternative to switch panel designs, which can
allow for cost reductions in various components and manufacturing processes. In
addition, devices using our switches are more durable and reliable than
electro-mechanical switches and are therefore less costly to maintain. Strategy Our objective is to become the leading switch technology licensor in the
electronic switch and ICP industries. In order to achieve this objective, we
intend to implement the following strategies: Maintain and Further Our Patented Technologies Competitive Advantages.We
intend to maintain and further our patented technologies competitive
advantages in order to make our technologies standard in the industry. We
intend to pursue this strategy by aggressively marketing our technologies
advantages and broaden market awareness within our target industries. We are
focusing our sales and marketing efforts on our licensing program and will work
together with licensees and technology partners to develop further these
technologies for specific commercial applications as it makes economic sense. Increase Market Awareness of Duraswitchs Patented Technological
Advantages.We plan to aggressively promote our patented technologies and
design expertise to achieve widespread market awareness of our technologies
advantages. Our promotional efforts will target design engineers and purchasing
managers, whom we believe are the primary decision makers within the switch
purchasing market. These efforts will include increasing exposure in trade
magazines, increasing traffic to our website, participating actively in
vendor-sponsored seminars for design engineers and aggressively promoting our
technologies in the trade media. We believe that promoting our success and our
licensees successes in providing custom-designed solutions for a number of
high-profile companies will further enhance market awareness of our
technologies and their unique competitive advantages. License Switch Manufacturers and OEMs.We plan to continue to offer to
license Duraswitch technologies to switch manufacturers, turnkey manufacturers
and OEMs as a product extension and a market differentiation. We intend to
target manufacturers in countries where we currently have little or no
representation, as well as manufacturers and OEMs who directly manufacture for,
or have key customers in, our target markets. When targeting OEMs, we offer to
license directly, license preferred manufacturers or provide information on
currently licensed manufacturers. We believe this flexible approach and the
simplified requirement of our license agreements, whereby a non-exclusive
licensee pays us per-switch royalties for use of our technologies, reduces
barriers common to traditional licensing models that often require significant
up-front fees to gain access and charge royalties on a percentage-of-sales
basis. Provide Full Service Training, Design Engineering and Marketing Support.
We intend to be a one stop shop for electronic switch solution design
engineering and marketing support for licensees of our technologies. We plan to
provide engineering and sales training at our licensees facilities, quarterly
sales training in various locations across North America and Europe as well as
Web cast training on engineering updates and sales strategies for our
technologies. We believe we add value to our licensees efforts by offering
design reviews for new projects and by offering direct access to online design
manuals. We will continue to expand our lead generation efforts to drive
potential business to our licensees through e-mail and direct marketing
campaigns. We plan to continue to enhance communications of our technology
updates and sales techniques in order to support our licensees. 4




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Form Strategic Technology Alliances.We have strategic technology alliances with the following:  
    
    FLEXcon, a manufacturer of pressure-sensitive films and adhesives;
    
    Three-Five Systems Inc., a leading supplier of display products and systems solutions;
    
    Semtech Corp., a global supplier of firmware for human interface devices;
    
    CTI Electronics Corp., a manufacturer and global distributor of industrial keyboards, joysticks and trackballs;
    
    Durel Corp., the largest supplier of electroluminescent (EL) systems in the world; and
    
    Hanaco Manufacturing Co., a leading source of elastomer rubber overlays for keypads. We believe that technology and marketing alliances not only help expand
our reach, but also help us to source materials for our licensees. We intend to
pursue additional strategic technology alliances with companies offering
complementary technologies to leverage resources and expertise in engineering,
marketing, training and purchasing and to increase the variations and options
that licensees can offer their customers by designing our technologies into
their products. Target Key Industries with Potential for High-Volume Applications.We
intend to continue to market the advantages of our patented technologies to key
high-volume markets including appliance, medical and industrial controls. We
believe that we have developed the technologies that meet the needs of these
industries and can educate OEMs on the benefits of utilizing our technologies
in future designs. In marketing directly to OEMs, we plan to be a source for
design ideas by educating engineers on the benefits our technologies offer. We
promote the solutions our technologies have provided for similar industries. We
will also support our licensees sales efforts through sales calls and
engineering support. Leverage Our Licensing Model with Additional Technologies.Our licensing
model employs a network of manufacturers and technology alliances that sell to
and manufacture products for the electronics industry. We believe these
partnerships can provide an avenue to commercialize additional technologies and
open new mutually-beneficial relationships. We intend to pursue growth
opportunities that expand our portfolio of licensable technologies as it makes
economic sense. Technologies We have a number of switch applications based on our patented
magnetic-based technologies. We have licensed the PushGate®, thiNcoder® and
MagnaMouse to our licensees. Our non-exclusive licensees typically pay
royalties of $0.08 per PushGate, ($0.10 including the licensed component
charge), between $0.25 and $0.75 per thiNcoder, and between $0.25 and $0.75 per
MagnaMouse, depending on volume. Licensees are charged separately for any
licensed components they purchase from us. Current prices for licensed
components range from $0.02 per PushGate to $1.75 per thiNcoder subassembly.
Fees for additional technologies will be determined upon release. The Duraswitch PushGate®.A typical Duraswitch PushGate switch consists of
up to five bonded micro-thin layers of material, which collectively measure
less than 1/10th of an inch. The top layer of the switch is printed with a
graphical overlay that indicates which buttons must be pressed to activate a
desired function, such as the on, defrost and cook buttons on a microwave
oven. Below the top layer is a thin, flexible layer of permanent magnetic
material. Below the magnetic layer is spacer material containing a hole through
which a patented metal disc is pushed. The disc has a small, raised, off-center
button that is pushed by the user through the surface of the switch. A flexible
circuit or printed circuit board (PCB) is located at the bottom of the switch.
When the button is pressed, the disc separates from the magnet and the
underside of the disc completes the circuit by touching the contacts located on
the printed circuit. When the button is released, the magnet pulls the disc
away from the switch contacts into its resting position, and the circuit is
broken. This magnetic-based design produces a consistent tactile feedback
response to the user each time the switch is activated. In 2001, we introduced the PushGate Island construction which reduces the
number of material layers and allows for the switching element of the PushGate
to be fabricated as a freestanding subassembly that can be easily inserted into
a foam layer. The ability to manufacture the PushGate as an Island simplifies
the manufacturing process and reduces cost. In 2002, we introduced a number of unique constructions including the
Large-Key PushGate and High-Impact PushGate incorporating PushGate technology.
Each of these constructions provide distinct advantages in certain
applications. The Duraswitch thiNcoder®.The Duraswitch thiNcoder resembles a typical
volume control knob on a car radio or a selector knob on a washing machine,
except that unlike an electro-mechanical rotary switch, our switch is
integrated on a flex-circuit. The entire assembly can be less than 1/10th of an
inch thick. The Duraswitch thiNcoder consists of a rotary knob containing
embedded magnets all fastened to a flat surface. The top of the surface
displays instructions for the user. The bottom of the surface seals a circular
space below the magnet containing small gold-plated balls. Between the magnets 5




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and the gold-plated balls are printed electronic circuits, which are
activated through contact with the gold-plated balls. When the user turns the
knob, the magnet within the rotary knob causes the gold-plated balls to rotate
within their circular space. As the balls roll across the flex-circuit
membrane, they close or open the circuit and convey the users instructions to
the device. The design of the Duraswitch thiNcoder also allows for a tactile
feedback response to the user, such that the user can feel each click as the
knob is turned. The thiNcoder can be utilized by the appliance industry and
other industries that require a large number of selector positions. The Duraswitch MagnaMouse.The Duraswitch MagnaMouse is an
omni-directional switch that works by using a disc-shaped actuator held by
magnetic attraction. Pushing on the switch surface or any custom designed key
cap closes the contact and actuates the MagnaMouse. Electrodes are arranged to
produce different outputs when contacted in different locations. The MagnaMouse
allows for the integration of cursor control devices into ultra-thin, durable
control panels. The Duraswitch PushFlex.The Duraswitch PushFlex technology combines a
commonly available magnet sheet and a magnetically receptive actuating layer to
create a unique switch construction. The actuating layer is a slotted flat
configuration that aligns to holes cut in the magnetic layer. Together, these
layers form a web of switches. Customers Our success depends in part on our licensees ability to incorporate our
technologies into OEMs designs and products in key industry segments. As a
result, we have licensed various custom and turnkey switch manufacturers to
produce switches for devices in a wide variety of industries. Some of the key
industries in which our licensees operate include the following: elevator,
beverage dispensing, energy management, test and measurement, medical,
point-of-sale, appliance, vending machine, gaming, recreational marine,
industrial automation, health and fitness, restaurant equipment, gas pump, mass
transit, computer, lighting and sound, aerospace and industrial controls. In May 2000, Duraswitch received $4 million from Delphi Automotive Systems
LLC, in exchange for: (a) Delphis exclusive right to utilize and manufacture
our patented switch technologies for the automotive industry, (b) a warrant to
purchase 225,000 shares of our common stock at $7 per share and (c) an option
to purchase approximately 1.65 million shares of our stock. The license
agreement with Delphi generated licensing revenue of $409,753 or 54% of
licensing revenue and $409,380 or 55% of licensing revenue in 2003 and 2002,
respectively. Licensing revenue from Delphi primarily resulted from the
recognition of deferred licensing revenue which was recorded in 2000. Intellectual Property Our success also depends in part on maintaining and protecting our
proprietary technologies. As a result, we have adopted an intellectual property
protection policy designed to deter and stop infringement. To deter
infringement, we file U.S. and foreign patents for relevant material
technological advances and warn against potential infringement by posting
patent numbers on our products, packaging and published materials. Examples of
these materials include our website, brochures, advertisements and some
technology samples. We have not had to become involved in infringement
litigation to protect our intellectual property, however, we intend to
prosecute litigation against infringers if necessary. In order to protect our trade secrets and other intellectual property, we
also require our employees, contract workers, consultants, advisors and
collaborators to enter into confidentiality agreements, which prohibit the
disclosure of proprietary information to third parties or the use of our
proprietary information for commercial purposes. Our technical and sales
employees also must agree to disclose and assign to us all methods,
improvements, modifications, developments, discoveries and inventions conceived
or developed on the job, using our property, or relating to our business. As of
December 31, 2003, we had $789,184 of capitalized costs related to patents, net
of accumulated amortization. As of December 31, 2003, we held 18 U.S. patents and 19 foreign patents.
We also have patent applications pending in the United States, Mexico, Canada,
France, Great Britain, China, Taiwan, Italy and Germany. We have made further
filings under the Patent Cooperation Treaty, which makes it possible to seek
patent protection for an invention simultaneously in each of a large number of
countries by filing an international patent application. We have registered the following trademarks with the United States Patent
and Trademark Office: Duraswitch®, Duraswitch as a stylized word with a
unique D, The World is Switching®, PushGate®, and thiNcoder®. Research, Development and Commercial Application Engineering We have three people in our research, development and commercial
application engineering department who focus on patenting and adapting our
technologies for commercialization through our licensees. In 2002 and 2001, we
dedicated a 6




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large amount of our resources to research and development and the
protection of our patented technologies. Through those efforts, we believe we
developed a portfolio of patented and patent-pending technologies that meet the
needs of our licensees, their customers and our target markets. In 2003, we
focused our engineering efforts on the commercialization of these technologies
through our licensees. In late 2002, we announced cost-cutting initiatives that included
significant personnel reductions. We made additional reductions in research and
development personnel during 2003 and expect research development expenses to
decrease in 2004 as compared to 2003 levels. During 2003, 2002 and 2001, we
spent $917,610, $2,614,905, and $2,773,221, respectively, on research,
development and commercial application engineering efforts. Sales and Marketing We have three people in the sales and marketing department who focus on
supporting our existing licensees, marketing our technologies to OEMs,
obtaining new licensees and forming technology alliances. In support of our
licensees, we train their internal and independent sales and marketing teams on
Duraswitch technologies. Website: www.duraswitch.com.We believe design engineers and purchasing
managers, the individuals most likely to make the decision to incorporate our
technologies in their products, frequently use the Internet to search for
design solutions. Therefore, our website, www.duraswitch.com, is a key
component of our current direct marketing efforts. Most of our advertising and
promotional materials direct readers to our website. In addition to attracting
potential licensees to our website for information, we use our website to
generate interest in our technologies. Using our website as a promotional tool
is also less expensive than other methods, is interactive and reaches a global
audience. Our website has several features, including the following:  
    
    information about the advantages of our patented technologies,
accompanied by articles published by third parties about our products;
    
    virtual demonstrations of our technologies and products;
    
    technical data to assist design engineers in designing ICPs and
electronic products using Duraswitch components;
    
    e-mail communication links to our design engineers and sales
representatives to facilitate dialogue about how our technologies can be
integrated into customers products;
    
    information on products available through our current licensees
customers; and
    
    benefits and the process for obtaining information about licensing
rights to utilize and manufacture Duraswitch technologies. Licensee Support.Our existing licensees and their sales representatives
are an extension of our marketing effort as they sell our technologies to their
customers. We provide direct support by attending sales calls and with
one-on-one design reviews and conference calls. We also provide generalized
support and training to keep licensees abreast of technology developments,
improvements in processes, and sales tools. To communicate this, we have
created a licensee-only section on our website that includes:  
    
    Click: an e-newsletter highlighting engineering, manufacturing and procurement updates;
    
    The REPort: an e-newsletter with sales tips, licensee success stories, and technology updates;
    
    web cast training: interactive presentation on Duraswitch
technologies given multiple times to accommodate various time zones, and
also archived;
    
    online training manuals: complete design and manufacturing manuals
for our technologies available online to ensure updates and enhancements
are available immediately;
    
    sales presentations, marketing literature, images and logos available
for licensees to download and integrate with their own branded sales
materials;
    
    strategic technology partner contacts for procurement and support for
complementary products that our licensees often use when manufacturing
our technologies. We are also able to negotiate with vendors who provide magnets, adhesives
and other materials used in the manufacture of our technologies to provide our
licensees with preferred pricing. Public Relations.We target technical periodicals for media exposure in an
effort to raise awareness of Duraswitch technologies and our licensing
strategy. Our public relations campaigns have included editorial coverage of
our technologies, co-operative advertising opportunities with licensees and
listings in industry-specific supplier guides. We believe this is a
cost-effective method of capturing the attention of design engineers and OEMs
and educating them on the benefits of our technologies. Articles on our
technologies have been included in numerous trade publications including Design
News, EDN (Electronic Design News), EE Times, ECN (Electronic Component News),
EPN (Electronic Product News),as well as industry-specific publications such
as Appliance Magazine, National Petroleum News, and Elevator World. 7




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Seminars and Trade Shows.We present training seminars about our
technologies at some vendor-sponsored events for product design engineers. At
these seminars, we are able to meet attendees and provide them with information
about our technologies through multi-media presentations, product
demonstrations, brochures and samples. We support the efforts of, and often
partner with, licensees and technology partners to broaden awareness of our
technologies at these events. For example, at electronica 2002, the worlds
largest international summit for the electronics industry held bi-annually in
Germany, Duraswitch technologies were represented in several licensee booths in
addition to our own sales teams attendance. Our sales and marketing team conducts regional training seminars for
licensees and their sales representatives. Over the past year, we held four
regional seminars, training approximately 120 sales representatives that are
associated with our licensees on the advantages of our technologies. Competition We operate in an industry characterized by intense competition. We believe
that our primary competitors are manufacturers of electro-mechanical and dome
membrane switches. Many of these manufacturers have established products, broad
brand and name recognition and significantly greater resources than we do. Our
strategy has not been to compete directly with these manufacturers, but to
offer to license them our switch technologies. If these manufacturers, as
licensees, incorporate our technology into their switches, we will have
converted our competitors into business partners and Duraswitch technology
advocates. While a licensing business model fosters cooperation, switch manufacturers
may not adopt Duraswitchs technologies. In particular, manufacturers may be
reluctant to alter current designs or have other long-standing relationships
that may affect the manufacturers decision to use one technology over another,
even if our technologies offer additional benefits. Employees As of March 15, 2004, we had 14 employees. None of our employees are
covered by collective bargaining agreements and we consider our employee
relations to be good. Risk Factors You should carefully consider the following factors, in addition to those
discussed elsewhere in this report, in evaluation of our company and our
business: We depend on our relationship with Delphi.We enter into license
agreements and other similar contractual relationships under which we license
our technologies. Any termination or breach of our relationship with Delphi,
cessation of operations by Delphi, or non-performance under the license
agreement by Delphi, could have a material adverse effect on our business. Our
license agreement with Delphi requires Delphi to pay us minimum royalty
payments of $12 million during 2004 through 2007. The first $1 million royalty
payment will be earned effective June 30, 2004 and is due July 1, 2004.
Subsequent payments are due as follows: $2 million on July 1, 2005; $3 million
on July 1, 2006; and $6 million on July 1, 2007. Delphi can maintain
exclusivity for the automotive industry through June 30, 2012 by making
additional minimum royalty payments during that period. After June 30, 2012,
either party may convert the agreement to a non-exclusive agreement through
2020. Our technologies may not gain market acceptance.Our success will depend
in part on the commercial acceptance of our patented technologies. To be
accepted, our technologies must meet the expectations of our potential
customers. We market our technologies directly to OEMs, whose products utilize
switches, and to our licensees to encourage them to incorporate our
technologies in the switches they supply to OEMs, focusing on the advantages of
our switches over the electro-mechanical and dome membrane switches. If the
OEMs or our licensees ultimately decide to continue with their existing switch
technologies, our business would be adversely affected. Should we be unable to protect our proprietary technologies, their value
and our competitive position would be significantly impaired.Although we seek
to protect our intellectual property rights through patents, copyrights, trade
secret protection and other measures,  
    
    we may be unable to adequately protect our technologies;
    
    competitors may be able to develop similar or better technologies independently;
    
    any of our pending patent applications may not be issued; or
    
    intellectual property laws may not continue to protect our
intellectual property rights, particularly as we expand 8




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our licensing in foreign countries where the local laws do not provide a
strong protection of intellectual properties or recognize international
treaties. Claims that we infringe third-party intellectual property rights could
result in significant expenses or restrictions on our ability to license
technology.In recent years, there has been significant litigation in the
United States involving patents and other intellectual property rights. From
time to time, third parties may assert patent, copyright, trademark and other
intellectual property claims against technologies used in our business. Any
such claims, with or without merit, could be time-consuming to defend, would
result in costly litigation and divert the efforts of our personnel. Claims of
intellectual property infringement might require us to enter into costly
royalty or license agreements. Additionally, we might be unable to obtain
royalty or license agreements on terms acceptable to us. A successful claim of
patent or other intellectual property infringement against us could have a
material adverse affect on our business. We are not currently involved in any
litigation to protect our technologies from infringement or to defend against
claims of infringement. Acquisitions could divert managements time and attention, dilute the
voting power of existing shareholders, and have a material adverse effect on
our business.As part of our growth strategy, we may acquire complementary
businesses and assets. Acquisitions that we may make in the future could result
in the diversion of time and personnel from our business. We also may issue
shares of common stock or other securities in connection with acquisitions,
which could result in the dilution of the voting power of existing stockholders
and could dilute earnings per share. Any acquisitions would be accompanied by
other risks commonly encountered in such transactions, including the following:  
    
    difficulties integrating the operations and personnel of acquired companies;
    
    additional financial resources required to fund the operations of acquired companies;
    
    potential disruption of our business;
    
    our ability to maximize our financial and strategic position by the
incorporation of acquired technology or businesses with our product
offerings;
    
    difficulty of maintaining uniform standards, controls, procedures, and policies;
    
    potential loss of key employees of acquired companies;
    
    impairment of employee and customer relationships as a result of changes in management;
    
    significant expenditures to consummate acquisitions; and
    
    difficulties in meeting applicable regulatory requirements. Our quarterly revenue and operating results may fluctuate.Our results may
fluctuate from those in prior quarters and will continue to do so due to a
variety of factors. These factors include:  
    
    establishment, growth or loss of licensee relationships;
    
    timing of introductions, production and sales cycles of new products
by our licensees incorporating our technologies, which is at the
discretion of our licensees and their customers; and
    
    market acceptance of our technologies. Our stock price may be volatile.The stock market has experienced extreme
volatility that often has been unrelated or disproportionate to the performance
of particular companies. These market fluctuations may cause our stock price to
decrease regardless of our performance. The market price of our common stock
has been, and in the future could be, significantly affected by factors such
as, but not limited to:  
    
    actual or anticipated fluctuations in operating results;
    
    announcements of our technologies or our competitors technologies,
new licensees or other business developments;
    
    sales or the perception in the market of possible sales by insiders
or others which could have a disproportionate effect on our stock price
due to our typically low trading volume. The stock market has experienced significant price and volume fluctuations
that have particularly affected the market prices of the stocks of technology
companies. Recently, the market price of our common stock, like that of many
technology companies, has experienced significant fluctuations. For instance,
from August 26, 1999, the date we became a reporting company, to March 15,
2004, the price of our common stock ranged from $0.56 to $17.92 per share. On
March 15, 2004, the last reported sale price of our common stock was $2.29. The market price of our common stock has been, and is likely to continue
to be, significantly affected by expectations of analysts and investors.
Reports and statements of analysts do not necessarily reflect our views. We depend on our management team.Our future success will be largely
dependent on the efforts of key management personnel. The loss of one or more
of these key employees could have a material adverse effect on our business. We
depend upon the services of Robert J. Brilon, our Chief Executive Officer,
President, and Chief Financial 9




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Officer and Anthony J. Van Zeeland, our Chief Technology Officer. Mr.
Brilon has extensive experience in the formation, financing and management of
entrepreneurial companies. Mr. Van Zeeland has over 30 years experience in the
switch industry. We have employment agreements with Mr. Brilon
for a term that expires April 30, 2005 and with Mr. Van
Zeeland for a term that expires December 31, 2007. We may have difficulty protecting our intellectual property rights
overseas.The laws of some foreign countries do not protect proprietary rights
to as great an extent as do the laws of the United States, and many U.S.
companies have encountered substantial infringement problems in some foreign
countries. Because some of our products are sold and a portion of our business
is conducted overseas, our exposure to intellectual property risks may be
higher. Rights to acquire shares of common stock could result in dilution to other
holders of common stock.As of December 31, 2003, we had options to purchase
1,042,440 shares of common stock outstanding under our stock option plans at a
weighted average exercise price of $9.02 per share. We have filed registration
statements under the securities laws to register the common stock to be issued
under our stock option plans. As a result, shares issued under these plans will
be freely tradable without restriction unless acquired by affiliates of our
company, who will be subject to the volume and other limitations of Rule 144.
At December 31, 2003, there were outstanding warrants to purchase 425,000
shares of common stock at a weighted average exercise price of $7.59 per share.
These warrants expire in 2004 if they are not exercised. The existence of such
stock options and warrants could adversely affect the terms on which we can
obtain additional financing, and the option and warrant holders can be expected
to purchase shares at a time when we, in all likelihood, would be able to
obtain additional capital by offering shares of common stock on terms more
favorable to us than those provided by such options and warrants. We have a history of operating losses and expect to incur losses in the
immediate future.We have had substantial losses since our inception and we
expect to incur additional losses as we expand our licensing business. We
expect to commit substantial resources to the establishment and support of new
licensee relationships. We are unable to accurately estimate future revenue based upon historical
performance and we cannot assure you if and when we will become profitable. Risks related to rapidly changing technology.Our results of operations
will depend in part on successful management of the challenges of rapidly
changing technology and evolving industry standards characteristic of the
market for switch technology. These challenges include predicting the nature
and timing of technological changes and the direction of evolving industry
standards and identifying, developing and successfully marketing new
technologies as they emerge. We work with our licensees and OEMs to design
solutions specific to their needs and the needs of their customers. Our growing international business activities subject us to risks that
could reduce the demand for our products and increase our operating expense.In
2003, net revenue from international licensees represented 23% of our total net
revenue. We have been expanding our licensing business with international
licensees and expect that net revenue from international licensees will
increase. To date, all of our licensing revenue and substantially all of our
costs have been denominated in U.S. dollars. We expect that net revenue and
substantially all of our costs will continue to be denominated in U.S. dollars
for the foreseeable future. We could be significantly affected by other risks
associated with international activities, including the following:  
    
    different technology standards and design requirements;
    
    longer payment cycles for and greater difficulties collecting accounts receivable;
    
    fluctuations in currency exchange rates;
    
    nationalization, expropriation and limitations on repatriation of cash;
    
    social, economic, banking and political risks;
    
    taxation;
    
    changes in U.S. laws and policies affecting trade, foreign investment and loans; and
    
    changes in enforcement of laws protecting intellectual property. 
 Item 2. Properties. Our principal administrative and design facilities are located in Mesa,
Arizona, where we presently lease 7,006 square feet of office space in a
building located at 234 South Extension Road. Our lease terminates on December
31, 2005, subject to our option to extend the term for three additional
one-year periods. We believe our current facilities will be sufficient for our
operational purposes for the foreseeable future and any additional facilities
needed thereafter will be available on commercially reasonable terms. 10




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Item 3. Legal Proceedings. From time to time we may be subject to claims and litigation incident to
our business. As of March 15, 2004, we were not a party to any material legal
proceedings. 
 Item 4. Submission of Matters to a Vote of Security Holders. None. 11




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PART II 
 Item 5. Market for Registrants Common Equity and Related Stockholder Matters. Market Information Our common stock has been listed on the NASDAQ SmallCap Market under the
symbol DSWT since December 20, 2002 and was listed on the NASDAQ National
Market System from October 11, 2000 to December 19, 2002. Between August 26,
1999 and October 10, 2000, our common stock was traded on the American Stock
Exchange under the symbol DRA. The following table sets forth high and low
sale prices of the common stock for each calendar quarter indicated as reported
on the NASDAQ National Market or NASDAQ SmallCap Market, as applicable. High
    
    LowFiscal Year Ended December 31, 2004First Quarter (through March 15, 2004)
    
    $
    2.75
    
    
    $
    1.60Fiscal Year Ended December 31, 2003First Quarter
    
    $
    1.30
    
    
    $
    0.67Second Quarter
    
    
    3.00
    
    
    
    0.50Third Quarter
    
    
    2.21
    
    
    
    1.25Fourth Quarter
    
    
    2.20
    
    
    
    1.45Fiscal Year Ended December 31, 2002First Quarter
    
    $
    9.20
    
    
    $
    7.00Second Quarter
    
    
    8.02
    
    
    
    4.93Third Quarter
    
    
    7.41
    
    
    
    2.40Fourth Quarter
    
    
    2.53
    
    
    
    0.89
 Dividends We have never declared any cash dividends on our common stock since we
currently intend to retain any future earnings to finance future growth. We do
not intend to declare any dividends on our common stock in the foreseeable
future. Holders As of March 15, 2004, there were approximately 300 holders of record of
our common stock. We believe that our common stock is held by more than 2,000
beneficial holders. 
 Item 6. Selected Financial Data. Year Ended December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999(In thousands, except per share data)Consolidated Statement of Operations Data (1)Licensing revenue
    
    $
    760
    
    
    $
    747
    
    
    $
    835
    
    
    $
    533
    
    
    $
    Product revenue
    
    
    
    
    
    
    25
    
    
    
    150
    
    
    
    1,786
    
    
    
    1,674Total net revenue
    
    
    760
    
    
    
    772
    
    
    
    985
    
    
    
    2,319
    
    
    
    1,674Gross profit (loss)
    
    
    657
    
    
    
    616
    
    
    
    728
    
    
    
    264
    
    
    
    (355
    )Net loss
    
    
    (2,551
    )
    
    
    (4,706
    )
    
    
    (5,390
    )
    
    
    (4,110
    )
    
    
    (3,475
    )Net loss per common share, basic and diluted
    
    $
    (0.27
    )
    
    $
    (0.49
    )
    
    $
    (0.57
    )
    
    $
    (0.49
    )
    
    $
    (0.58
    )Weighted average common shares outstanding, basic and diluted
    
    
    9,591
    
    
    
    9,532
    
    
    
    9,443
    
    
    
    8,436
    
    
    
    6,034
 (1) No cash dividends were declared or paid in any year presented. 12




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December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999(In thousands)Consolidated Balance Sheet DataCash and cash equivalents
    
    $
    4,257
    
    
    $
    7,037
    
    
    $
    12,016
    
    
    $
    16,446
    
    
    $
    5,885Total assets
    
    
    6,243
    
    
    
    9,502
    
    
    
    14,816
    
    
    
    19,098
    
    
    
    8,238Long-term debt, net of current portion
    
    
    
    
    
    
    8
    
    
    
    26
    
    
    
    44
    
    
    
    125Total stockholders equity
    
    $
    4,373
    
    
    $
    6,857
    
    
    $
    11,532
    
    
    $
    15,749
    
    
    $
    6,871
 
 Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations. The following discussion should be read in conjunction with our audited
consolidated financial statements and associated notes appearing elsewhere in
this report. Overview We have developed, patented and licensed innovative technologies utilizing
a magnetic-based design for electronic switches. We are currently expanding the
use of these technologies by licensing manufacturers to produce and sell
products using our technologies. We believe these patented and patent-pending
technologies allow us and our licensees to provide innovative solutions to the
design challenges faced by OEMs and component suppliers. During 2000, we started to implement our business model of licensing our
technologies rather than manufacturing switches ourselves. We completed this
transition in June 2001 and expect substantially all of our future revenues to
come from our licensing efforts. As of March 15, 2004, we had 29 licensees,
foreign and domestic. Because the revenue generated from licensing switch
technologies is lower than the revenue from manufacturing the same number of
switches, we expected our net revenue to decrease during our transition to
licensing. Concurrently, our gross profit as a percentage of revenue increased
because the cost of goods sold associated with licensing is much lower than
with manufacturing. We anticipate that licensing revenue will fluctuate from period to period.
It will be difficult for us to predict the timing and magnitude of such
revenue, as it depends on the licensees ability to market, produce and ship
products that incorporate our technologies. We believe that the amount of
licensing revenue for any period is not necessarily indicative of results for
any future period. Our research, development and commercial application engineering expenses
are comprised mainly of personnel and occupancy costs. Our selling, general and
administrative expenses are comprised mainly of personnel costs, depreciation,
and occupancy costs. During the second quarter of 2001, we completed the transition to a
licensing business model away from switch manufacturing and, as a result, the
relationship between net revenue, cost of goods sold, and operating expenses
reflected in our financial information may not represent future expected
financial relationships. Application of Critical Accounting Policies We have identified the policies below as critical to our business
operations and the understanding of our results of operations. The impact and
any associated risks related to these policies on our business operations are
discussed throughout Managements Discussion and Analysis of Financial
Condition and Results of Operations when such policies affect our reported or
expected financial results. In the ordinary course of business, we have made a number of estimates and
assumptions relating to the reporting of results of operations and financial
condition in the preparation of our financial statements in conformity with
accounting principles generally accepted in the United States. We base our
estimates on historical experience and on various other assumptions that we
believe are reasonable under the circumstances. The results form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results could differ
significantly from those estimates under different assumptions and conditions.
We believe that the following discussion addresses our most critical accounting
policies, which are those that are most important to the portrayal of our
financial condition and results of operations and require our most difficult,
subjective, and complex judgments, often as a result of the need to make
estimates about the effect of matters that are inherently uncertain. Revenue Recognition.We enter into licensing agreements with our
customers. Our licensing strategy incorporates a simplified requirement whereby
the licensee purchases licensed components from us. The purchase price of the
licensed components includes the royalty fee. When the components are shipped,
we recognize licensing revenue and licensing cost 13




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of goods sold. In some cases where no licensed components are supplied, we
are paid a royalty per switch manufactured by the licensee and we recognize
revenue in the period the switch is manufactured. In the case of the Delphi
minimum royalty payments, we recognize revenue as it is earned: either as
Delphi sells products incorporating our technologies; or in the event that the
royalties earned on the sale of Delphi products is less than the minimum
royalty payment, we recognize the difference between royalties previously
recognized and the minimum royalty payment as revenue on June 30 of each
applicable year. Some of our licensees have prepaid royalties to us pursuant to their
license agreements. These prepayments are recorded as deferred revenue. This
deferred revenue is recognized as licensing revenue when earned under the
licensing agreement. If a licensee purchases a licensed component from us, the
royalty is earned when the licensed component is shipped. If the licensee is
directly manufacturing our switches without purchasing licensed components from
us, we consider the royalty earned when the switch is manufactured. In the case
of our exclusive license agreement with Delphi, the up-front payment is
nonrefundable and the portion of the $4.0 million payment allocated to deferred
revenue is being amortized over the initial seven-year term of the agreement.
(See Note 7 of our Notes to Consolidated Financial Statements.) Inventory Valuation.Our inventory is primarily comprised of licensed
components, which are sold to licensees. We state inventories at the lower of
cost or market value, determined using the first-in, first-out method. Our
policy is to write down our inventory for estimated obsolescence or
unmarketable inventory to the extent the cost exceeds the estimated market
value. We base the estimate on our assumptions about future demand and market
conditions. If actual market conditions are less favorable than those assumed
in our estimates, additional inventory write-downs might be required. We
reflect any write-down of inventory in the period in which the facts giving
rise to the inventory write-down become known to us. Impairment or Disposal of Long-Lived Assets.We review our long-lived
assets and identifiable intangibles for impairment whenever events or changes
in circumstances indicate that the carrying amount of the asset may not be
recoverable. Additionally, goodwill is reviewed on an annual basis. Our
intangible assets are primarily our patents and the goodwill associated with
the acquisition of Aztec Industries. If such assets were considered to be
impaired, the impairment to be recognized would be measured by the amount by
which the carrying amount of the assets exceeds the fair market value of the
assets. We evaluate the recoverability of property and equipment and intangibles
(excluding goodwill) not held for sale by comparing the carrying amount of the
asset or group of assets against the estimated undiscounted future net cash
flows expected to result from the use of the asset or group of assets. If the
undiscounted estimated cash flows are less than the carrying value of the asset
or group of assets being reviewed, an impairment loss would be recorded. The
loss would be measured based on the estimated fair value of the asset or group
of assets compared to its carrying value. The estimated fair value would be
based on the best information available under the circumstances, including
prices for similar assets and the results of valuation techniques, including
the present value of expected future cash flows using a discount rate
commensurate with the risks involved. We evaluate goodwill for impairment by comparing the estimated fair value
of our company, which is the only reporting unit, with the carrying value,
including goodwill. The estimated fair value is based on the best information
available under the circumstances, including quoted market prices in stock
markets, valuation techniques based on earnings, or independent valuations. If
the fair value of our company exceeds the carrying amount, goodwill is not
considered to be impaired. If the carrying amount of our company exceeds our
fair value, the fair value of the goodwill is calculated, and the excess of the
carrying value of the goodwill over its fair value is recorded as an impairment
loss. To determine the fair value of goodwill, our fair value is allocated to
all of our assets and liabilities, and any excess of fair value of our company
over the fair value of our assets and liabilities is the estimated fair value
of goodwill. Results of Operations for the Year Ended December 31, 2003 Compared to the Year
Ended December 31, 2002 Net Revenue.We recorded net revenue of $759,912 for the year ended
December 31, 2003, compared to $772,169 for the year ended December 31, 2002, a
decrease of $12,257. The decrease is due to the expected decrease in product
revenue as a result of the completion of our transition from manufacturing to
licensing switch technologies. Licensing revenue was $759,912 and $747,494 for the years ended December
31, 2003 and 2002, respectively, an increase of $12,418 or 2%. Our licensing
revenue is primarily comprised of the recognition of revenue resulting from the
recognition of deferred revenue from our license agreement with Delphi and
per-switch revenue from non-exclusive licensees who manufacture switches
incorporating our technologies. The per-switch revenue includes royalties and
revenue from the sale of licensed components. 14




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To date, the majority of non-exclusive licensing revenue has been related
to our PushGate pushbutton technology. The number of unit sales of
royalty-bearing PushGates has fluctuated during the last three years from
approximately 1.8 million in 2001, to 2.8 million in 2002 to 2.3 million in
2003. The increase in units from 2001 to 2002 was primarily related to a sale
of one million units to one licensee. The decrease from 2002 to 2003 was
primarily due to the 2002 sale of one million units to one licensee not being
replicated in 2003 and was offset by increased unit sales to other licensees. Our license agreement with Delphi generated licensing revenue of $409,753
or 54% of our licensing revenue and total net revenue for the year ended
December 31, 2003 and $409,380 or 55% of our licensing revenue and 53% of our
total net revenue for the year ended December 31, 2002. Licensing revenue from
Delphi primarily resulted from the recognition of deferred licensing revenue,
which was recorded in 2000. Delphis license agreement also includes minimum
royalty payments of $12 million during 2004 through 2007. The first minimum
royalty payment of $1 million will be earned effective June 30, 2004 and is due
July 1, 2004. The remaining installments are due as follows: $2 million July 1,
2005; $3 million July 1, 2006; and $6 million due July 1, 2007. Product revenue was $0 and $24,675 for the years ended December 31, 2003
and 2002, respectively, a decrease of $24,675. The decrease reflects our
transition to a technology licensing company. The $24,675 of product revenue
for the year ended December 31, 2002 was related to fees received for
engineering services we had provided to a customer in prior periods that were
in dispute. We do not expect to have any significant product revenue in the
future. Cost of Goods Sold.Total cost of goods sold and licensing cost of goods
sold was $103,304 for the year ended December 31, 2003, compared to $156,406
for the year ended December 31, 2002, a decrease of $53,102. The decrease in
cost of goods sold and increase in gross profit as a percentage of revenue to
86% in 2003 from 80% in 2002 was primarily due to a 2002 charge to licensing
cost of goods sold related to earlier versions of licensed components that will
no longer be promoted and will only be considered as an alternative to our
current licensed component inventories in limited circumstances. There was no
comparable charge in 2003. We anticipate that our gross profit as a percentage
of revenue will fluctuate in future periods as we experience changes in the
percentage of revenue generated from sales of licensed components, royalties
from licensees who manufacture products utilizing our technologies without
purchasing licensed components from us and the recognition of deferred revenue
from our licensing agreement with Delphi. Selling, General and Administrative Expenses.Selling, general and
administrative expenses were $2,299,750 for 2003, compared to $2,857,609 for
2002, a decrease of $557,859. The decrease in selling, general and
administrative expenses was primarily related to personnel reductions. We
expect 2004 general and administrative expenses to decrease as we significantly
reduced our ongoing occupancy costs on January 1, 2004 when we entered into a
new long-term building lease, saving approximately $200,000 annually.
Additionally in 2004, we will see the full-year effect of our 2003 personnel
reductions. As revenue increases, additional commission expense will be
incurred including a 5% commission on cash received from Delphi related to
their license agreement. Research, Development and Commercial Application Engineering.Research,
development and commercial application engineering expenses were $917,610 for
2003, compared to $2,614,905 for 2002, a decrease of $1,697,295. The decrease
was primarily attributable to costs related to decreased research and
development personnel. In 2001, we added personnel and increased our modeling
and testing capabilities, resulting in increased costs. As we entered 2002, we
began to reduce these expenses primarily by reducing research and development
personnel. In 2002 and 2003, research and development expenses decreased each
quarter from the preceding quarter. We anticipate that 2004 research,
development and commercial application engineering expenses will decrease due
to reductions in occupancy costs, personnel, and depreciation. In October 2002, we announced cost-cutting initiatives that included
significant reductions in research and development personnel focused on new
technologies. In 2003, we continued the cost cutting initiatives and made
further personnel reductions. As part of our reduced research and development
activities, we entered into a new employment agreement with our co-founder and
Chief Technology Officer. The new agreement reduced his salary and time
commitment to Duraswitch by 50%. We have created a portfolio of patented and
patent-pending technologies, which are available through our licensees. The
efforts of our remaining personnel will continue to be directed at
commercializing our technologies as opposed to also focusing on the creation of
new technologies. They will continue to support our licensees in their efforts
to commercialize our existing patented and patent-pending technologies. Loss from Operations.As a result of the decreases in selling, general and
administrative expenses and research, development and commercial application
engineering expenses, loss from operations decreased to $2,560,752 for the year
ended December 31, 2003, compared to $4,856,751 for the year ended December 31,
2002, a decrease of $2,295,999. Other Income-Net.Other income-net was $10,191 for 2003 compared to
$150,699 for 2002, a decrease of $140,508. The decrease in other income-net is
due to the decrease in investment income as a result of lower interest rates 15




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and lower average cash balances and to the $43,073 loss recorded for the
disposal of fixed assets. Net Loss.The decrease of $2,155,491 or 46% in the net loss to $2,550,561
for the year ended December 31, 2003 from $4,706,052 for the year ended
December 31, 2002 was primarily a result of decreased selling, general and
administrative expenses and decreased research and development expenses. Results of Operations for the Year Ended December 31, 2002 Compared to the Year
Ended December 31, 2001 Net Revenue.We recorded net revenue of $772,169 for the year ended
December 31, 2002, compared to $985,312 for the year ended December 31, 2001, a
decrease of $213,143. The decrease is due primarily to the expected decrease in
product revenue as a result of the completion of our transition from
manufacturing to licensing switch technologies and decreased licensing revenue
resulting from a decrease in per-switch royalties and a decrease in the
per-design review revenue. Licensing revenue was $747,494 and $835,541 for the years ended December
31, 2002 and 2001, respectively, a decrease of $88,047 or 11%. Our licensing
revenue is primarily comprised of the recognition of revenue resulting from the
recognition of deferred revenue from our license agreement with Delphi and
per-switch revenue from non-exclusive licensees who manufacture switches
incorporating our technologies. The per-switch revenue includes royalties and
revenue from the sale of licensed components. To date, the majority of non-exclusive licensing revenue has been related
to our PushGate pushbutton technology. The number of unit sales of
royalty-bearing PushGates has increased during the last three years from
approximately one million in 2000, 1.8 million in 2001, to 2.8 million in 2002.
Revenue has not tracked this increase because the average revenue earned per
PushGate during 2002 was just over $0.10, the low end of the $0.10-0.30 range,
compared to average per-PushGate revenue of $0.17 in 2001. The increase in the
quantity of licensed components sold was primarily related to a sale of one
million units to one licensee. The decrease in the per-switch royalties
resulted from volume discounts. Licensing revenue was also impacted by a
decrease in fees related to the review of customer designs. The primary reason
for the decrease in design review fees was a reduction of the amount billed
per-design review. At the same time, we experienced an increase in the number
of design reviews. As contemplated in our license agreements, we have lowered
these fees as our licensees have gained experience and become more proficient
with our technologies as well as to remove barriers to commercial acceptance. Our license agreement with Delphi generated licensing revenue of $409,380
or 55% of our licensing revenue and 53% of our total net revenue for the year
ended December 31, 2002 and $411,362 or 49% of our licensing revenue and 42% of
our total net revenue for the year ended December 31, 2001. Licensing revenue
from Delphi primarily resulted from the recognition of deferred licensing
revenue which was recorded in 2000. Product revenue was $24,675 and $149,771 for the years ended December 31,
2002 and 2001, respectively, a decrease of $125,096. The decrease reflects our
transition to a technology licensing company. The $24,675 of product revenue
for the year ended December 31, 2002 was related to fees received for
engineering services we had provided to a customer in prior periods that were
in dispute. We do not expect to have any significant product revenue in the
future. Cost of Goods Sold.Cost of goods sold was $156,406 for the year ended
December 31, 2002, compared to $256,838 for the year ended December 31, 2001, a
decrease of $100,432. The decrease in cost of goods sold and the increase in
gross profit as a percentage of revenue to 80% in 2002 from 74% in 2001
reflects our transition from the low-margin business of manufacturing switch
panels to the high-margin business of licensing. We anticipate that our gross
profit as a percentage of revenue will fluctuate in future periods as we
experience changes in the percentage of revenue generated from sales of
licensed components, royalties from licensees who manufacture products
utilizing our technologies without purchasing licensed components from us and
the recognition of deferred revenue from our licensing agreement with Delphi. Licensing cost of sales for 2002 was $156,406 compared to $100,540 in
2001, an increase of $55,866. The increase in licensing cost of goods sold for
the year ended December 31, 2002 was primarily due to a $73,171 charge to
licensing cost of goods sold related to earlier versions of licensed components
that will no longer be promoted and will only be considered as an alternative
to our current licensed component inventories in limited circumstances. This
increase was offset by a 34% reduction in our per-unit cost of licensed
components and decreased sales of other materials with low gross margins. Product cost of goods sold was $0 in 2002 compared to $156,298 in 2001, a
decrease of $156,298. The decrease in product cost of goods sold was due to the
completion of our transition to a licensing business model from a product-based
model. 16




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##### Table of Contents



Selling, General and Administrative Expenses.Selling, general and
administrative expenses were $2,857,609 for 2002, compared to $3,899,652 for
2001, a decrease of $1,042,043. Selling, general and administrative expenses in
2001 included a charge of $397,431 related to costs associated with the
resignation of our former Chief Executive Officer. No such charge was recorded
in 2002. The remainder of the decrease in selling, general and administrative
expenses was primarily related to reductions in executive and support
personnel. Research, Development and Commercial Application Engineering.Research,
development and commercial application engineering expenses were $2,614,905 for
2002, compared to $2,773,221 for 2001, a decrease of $158,316. The decrease was
primarily attributable to costs related to decreased research and development
personnel. During 2001, research and development expenses increased every
quarter as we ramped up our research and development activities to expand our
technology portfolio and develop various adaptations of our core technologies.
We added personnel and increased our modeling and testing capabilities,
resulting in increased costs. As we entered 2002, we began to reduce these
expenses primarily by reducing research and development personnel. In 2002,
research and development expenses decreased each quarter from the preceding
quarter. Loss from Operations.As a result of the decreases in selling, general and
administrative expenses and research, development and commercial application
engineering expenses, loss from operations decreased to $4,856,751 for the year
ended December 31, 2002, compared to $5,944,399 for the year ended December 31,
2001, a decreased loss of $1,087,648. Other Income-Net.Other income-net was $150,699 for 2002, compared to
$554,245 for 2001, a decrease of $403,546. The decrease in other income-net is
due to the decrease in investment income as a result of lower interest rates
and lower average cash balances. Net Loss.The decrease of $684,102 or 13% in the net loss to $4,706,052
for the year ended December 31, 2002 from $5,390,154 for the year ended
December 31, 2001 was primarily a result of decreased selling, general and
administrative expenses and decreased research and development expenses, which
were offset by the reduction in investment income. Liquidity and Capital Resources We had cash and cash equivalents of $4,256,978 on December 31, 2003.
During the past three years, we have experienced decreases in our cash and cash
equivalents primarily as a result of cash used in operations offset by the
proceeds from the stock sales related to the exercise of employee stock
options. Net cash used in operating activities during the year ended December 31,
2003 was $2,791,532. Cash used in operating activities consisted primarily of
the net loss, a decrease in deferred licensing revenue, and a decrease in
accrued salaries and benefits that were all partially offset by depreciation
and amortization. Net cash provided by investing activities during the year ended December
31, 2003 was $3,438. Our net cash provided by investing activities consisted
primarily of proceeds from the sale of equipment that had been used for
research and development and for manufacturing marketing pieces. The sale
proceeds were partially offset by investments in patents. Net cash provided by financing activities during the year ended December
31, 2003 was $8,113, consisting primarily of net proceeds from the sale of
stock related to the exercise of employee stock options, which was partially
offset by principal payments on capital lease obligations. Our license agreement with Delphi requires Delphi to pay us minimum
royalty payments totaling $12 million during 2004 through 2007. The first $1
million minimum royalty payment is earned effective June 30, 2004 and is due on
July 1, 2004. Subsequent payments are due as follows: $2 million on July 1,
2005; $3 million on July 1, 2006; and $6 million on July 1, 2007. Delphi can
maintain exclusivity for the automotive industry through June 30, 2012 by
making additional minimum annual royalty payments during that period. After
June 30, 2012, either party may convert the agreement to a non-exclusive
agreement through 2020. At December 31, 2003, we had approximately $20.3 million in net operating
loss carryforwards available for federal and state income tax purposes. We have
not recognized any benefit from these operating loss carryforwards, which
expire in 2011 through 2023. We have employment agreements with our executive officers. These
agreements call for a base salary and bonuses. These agreements also provide
for salary and benefits in the event of separation. Effective December 31,
2001, 17




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##### Table of Contents



our former Chief Executive Officer resigned his position. His employment
agreement provided for salary and benefits in the event of termination or
resignation. As such, we recorded a charge of $397,431 during the year ended
December 31, 2001 to be paid over an 18-month period. At December 31, 2003 the
entire amount had been paid. We have experienced significant operating losses since our inception.
During 2002 and 2003 we reduced our personnel to 14 employees from 72 at
December 31, 2001. We entered into a new lease agreement on January 1, 2004 and
significantly reduced our occupancy costs as we reduced our lease commitment
from 33,650 square feet to 7,006 square feet. As a result of these factors and
other cost cutting initiatives we anticipate that our cash and working capital
requirements will decrease in 2004 from 2003 historical levels. However, our
capital expenditures and working capital requirements could increase depending
on our operating results and other adjustments to our operating plan as may be

needed to respond to competition or unexpected events. We believe that our cash on hand will be sufficient to meet our
anticipated cash needs for working capital and capital expenditures for at
least 12 months. We continually evaluate our working capital needs and we may
seek to obtain additional working capital through debt or equity offerings.
There can be no assurance that additional funds will be available on acceptable
terms. In the event that additional funds are not available on acceptable
terms, we could be required to reduce the scope of or cease operations. The following table sets forth our contractual obligations and commitments
as of December 31, 2003: Payments Due by PeriodLess thanContractual obligations
    
    1 year
    
    
    
    
    
    1-3 years
    
    
    
    
    
    Thereafter
    
    TotalCapital lease obligations (including interest)
    
    $
    8,766
    
    
    
    
    
    
    $
    
    
    
    
    
    
    
    $
    
    
    
    $
    8,766Operating leases
    
    
    43,609
    
    
    
    
    
    
    
    44,529
    
    
    
    
    
    
    
    
    
    
    
    88,138Purchase order obligations
    
    
    41,555
    
    
    
    (1
    )
    
    
    93,500
    
    
    
    (2
    )
    
    
    
    
    
    
    135,055Total contractual cash obligations
    
    $
    93,930
    
    
    
    
    
    
    $
    138,029
    
    
    
    
    
    
    $
    
    
    
    $
    231,959
  (1)
    
    Represents open commitments to acquire licensed components within the
next twelve months.(2)
    
    Represents the cost of tooling for volume production of PushGate Island
magnets which is being built to our specifications. Commitment will be
reduced by each component part which is sold by the vendor. 
 Item 7A. Quantitative and Qualitative Disclosures About Market Risk. Market risk is the potential loss arising from adverse changes in market
rates and prices, such as foreign currency exchange and interest rates. We do
not use derivative financial instruments to manage these risks and do not hold
or issue financial instruments for trading purposes. We are currently exposed to credit risk on credit extended to our
licensees. Based on the credit worthiness of our licensee base and the relative
size of these financial instruments, we believe the risk associated with these
instruments will not have a material adverse affect on our business, financial
position, results of operations or cash flows. Additionally, we are exposed to some market risk through interest rates
related to our investment of cash and cash equivalents of approximately $4
million. The risk is not considered material and we manage such risk by
evaluating the best investment rates available for short-term high-quality
investments. Presently, all of our receivables and substantially all of our payments
are denominated in U.S. dollars and, consequently, we believe we have no
foreign currency exchange rate risk. However, in the future, we may enter into
agreements in foreign currencies that may subject us to foreign exchange rate
risk. There can be no assurance that our future efforts to reduce foreign
exchange risk will be successful. 18




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##### Table of Contents



Item 8. Financial Statements and Supplementary Data. INDEPENDENT AUDITORS REPORT Board of Directors
Duraswitch Industries, Inc.
Mesa, Arizona We have audited the accompanying consolidated balance sheets of Duraswitch
Industries, Inc. and subsidiaries (the Company) as of December 31, 2003 and
2002, and the related consolidated statements of operations, stockholders
equity, and cash flows for each of the three years in the period ended December
31, 2003. These financial statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes 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, such consolidated financial statements present fairly, in all
material respects, the financial position of Duraswitch Industries, Inc. and
subsidiaries at December 31, 2003 and 2002, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 2003 in conformity with accounting principles generally accepted in the
United States of America. DELOITTE & TOUCHE LLP
Phoenix, Arizona March 11, 2004 19




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##### Table of Contents



DURASWITCH INDUSTRIES, INC. CONSOLIDATED BALANCE SHEETSDECEMBER 31, 2003 AND 2002 2003
    
    2002ASSETSCURRENT ASSETS:Cash and cash equivalents
    
    $
    4,256,978
    
    
    $
    7,036,959Accounts receivable (net of allowance for doubtful accounts
of $12,000 in 2003 and 2002)
    
    
    49,763
    
    
    
    11,191Inventory  Net (Note 4)
    
    
    171,522
    
    
    
    192,915Prepaid expenses and other current assets
    
    
    113,434
    
    
    
    168,121Total current assets
    
    
    4,591,697
    
    
    
    7,409,186PROPERTY AND EQUIPMENT  Net (Notes 5 and 8)
    
    
    314,712
    
    
    
    786,506GOODWILL  Net
    
    
    443,874
    
    
    
    443,874PATENTS  Net (Note 6)
    
    
    789,184
    
    
    
    743,447OTHER ASSETS
    
    
    103,837
    
    
    
    119,116TOTAL
    
    $
    6,243,304
    
    
    $
    9,502,129LIABILITIES AND STOCKHOLDERS EQUITYCURRENT LIABILITIES:Accounts payable
    
    $
    73,452
    
    
    $
    23,933Accrued salaries and benefits
    
    
    162,817
    
    
    
    500,413Other accrued expenses and other current liabilities
    
    
    164,469
    
    
    
    231,973Deferred licensing revenue (Note 7)
    
    
    471,033
    
    
    
    460,803Current portion of capital leases payable (Note 8)
    
    
    8,213
    
    
    
    18,110Total current liabilities
    
    
    879,984
    
    
    
    1,235,232LONG-TERM LIABILITIES:Capital leases payable (Note 8)
    
    
    
    
    
    
    8,213Other non-current liabilities
    
    
    29,687
    
    
    
    36,750Deferred
licensing revenue - long-term (Note 7)
    
    
    960,638
    
    
    
    1,364,601Total long-term liabilities
    
    
    990,325
    
    
    
    1,409,564Total liabilities
    
    
    1,870,309
    
    
    
    2,644,796COMMITMENTS AND CONTINGENCIES (Notes 3 and 14)STOCKHOLDERS EQUITY (Notes 9 and 10):Preferred stock, no par value, 10,000,000 shares authorized,
no shares issued and outstanding in 2003 and 2002
    
    
    
    
    
    
    Common stock, $.001 par value, 40,000,000 shares authorized in
2003 and 2002, 9,591,673 and 9,534,195 shares issued and
outstanding in 2003 and 2002, respectively
    
    
    9,592
    
    
    
    9,534Additional paid-in capital
    
    
    27,383,479
    
    
    
    27,317,314Accumulated deficit
    
    
    (23,020,076
    )
    
    
    (20,469,515
    )Total stockholders equity
    
    
    4,372,995
    
    
    
    6,857,333TOTAL
    
    $
    6,243,304
    
    
    $
    9,502,129
 See notes to consolidated financial statements. 20




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##### Table of Contents



DURASWITCH INDUSTRIES, INC. CONSOLIDATED STATEMENTS OF OPERATIONSYEARS ENDED DECEMBER 31, 2003, 2002 AND 2001 2003
    
    2002
    
    2001NET REVENUE (Note 3):Licensing (Note 7)
    
    $
    759,912
    
    
    $
    747,494
    
    
    $
    835,541Product
    
    
    
    
    
    
    24,675
    
    
    
    149,771Total net revenue
    
    
    759,912
    
    
    
    772,169
    
    
    
    985,312COST OF GOODS SOLD:Licensing
    
    
    103,304
    
    
    
    156,406
    
    
    
    100,540Product
    
    
    
    
    
    
    
    
    
    

    156,298Total cost of goods sold
    
    
    103,304
    
    
    
    156,406
    
    
    
    256,838Gross profit
    
    
    656,608
    
    
    
    615,763
    
    
    
    728,474OPERATING EXPENSES:Selling, general and administrative
    
    
    2,299,750
    
    
    
    2,857,609
    
    
    
    3,899,652Research, development and commercial
application engineering
    
    
    917,610
    
    
    
    2,614,905
    
    
    
    2,773,221Total operating expenses
    
    
    3,217,360
    
    
    
    5,472,514
    
    
    
    6,672,873LOSS FROM OPERATIONS
    
    
    (2,560,752
    )
    
    
    (4,856,751
    )
    
    
    (5,944,399
    )OTHER INCOME  Net
    
    
    10,191
    
    
    
    150,699
    
    
    
    554,245NET LOSS
    
    $
    (2,550,561
    )
    
    $
    (4,706,052
    )
    
    $
    (5,390,154
    )NET LOSS PER COMMON SHARE, BASIC AND DILUTED
    
    $
    (0.27
    )
    
    $
    (0.49
    )
    
    $
    (0.57
    )WEIGHTED AVERAGE SHARES OUTSTANDING,
BASIC AND DILUTED
    
    
    9,591,090
    
    
    
    9,532,463
    
    
    
    9,443,313
 See notes to consolidated financial statements. 21




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DURASWITCH INDUSTRIES, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITYYEARS ENDED DECEMBER 31, 2003, 2002 AND 2001 AdditionalCommon Stock
    
    Paid-in
    
    AccumulatedShares
    
    Amount
    
    Capital
    
    Deficit
    
    TotalBALANCE, DECEMBER 31, 2000
    
    
    9,266,696
    
    
    $
    9,267
    
    
    $
    26,112,732
    
    
    $
    (10,373,309
    )
    
    $
    15,748,690Employee stock options exercised
    
    
    261,999
    
    
    
    262
    
    
    
    1,172,738
    
    
    
    
    
    
    
    1,173,000Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,390,154
    )
    
    
    (5,390,154
    )BALANCE, DECEMBER 31, 2001
    
    
    9,528,695
    
    
    
    9,529
    
    
    
    27,285,470
    
    
    
    (15,763,463
    )
    
    
    11,531,536Employee stock options exercised
    
    
    5,500
    
    
    
    5
    
    
    
    31,844
    
    
    
    
    
    
    
    31,849Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,706,052
    )
    
    
    (4,706,052
    )BALANCE, DECEMBER 31, 2002
    
    
    9,534,195
    
    
    
    9,534
    
    
    
    27,317,314
    
    
    
    (20,469,515
    )
    
    
    6,857,333Employee stock options exercised
    
    
    22,696
    
    
    
    23
    
    
    
    26,200
    
    
    
    
    
    
    
    26,223Issuance of stock for services
    
    
    34,782
    
    
    
    35
    
    
    
    39,965
    
    
    
    
    
    
    
    40,000Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,550,561
    )
    
    
    (2,550,561
    )BALANCE, DECEMBER 31, 2003
    
    
    9,591,673
    
    
    $
    9,592
    
    
    $
    27,383,479
    
    
    $
    (23,020,076
    )
    
    $
    4,372,995
 See notes to consolidated financial statements. 22




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##### Table of Contents



DURASWITCH INDUSTRIES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWSYEARS ENDED DECEMBER 31, 2003, 2002 AND 2001 2003
    
    2002
    
    2001CASH FLOWS FROM OPERATING ACTIVITIES:Net loss
    
    $
    (2,550,561
    )
    
    $
    (4,706,052
    )
    
    $
    (5,390,154
    )Adjustments to reconcile net loss to net cash used in
operating activities:Depreciation and amortization
    
    
    421,779
    
    
    
    410,976
    
    
    
    418,546Issuance of stock for services
    
    
    40,000
    
    
    
    
    
    
    
    Loss on disposal of equipment
    
    
    8,932
    
    
    
    7,205
    
    
    
    2,552Reserve for inventory obsolescense
    
    
    22,000
    
    
    
    125,000
    
    
    
    12,700Bad debt expense
    
    
    
    
    
    
    11,000
    
    
    
    Changes in operating assets and liabilities:Accounts receivable
    
    
    (38,572
    )
    
    
    79,743
    
    
    
    122,485Inventory
    
    
    (607
    )
    
    
    (41,996
    )
    
    
    (37,636
    )Prepaid expenses and other current assets
    
    
    61,874
    
    
    
    18,537
    
    
    
    4,338Accounts payable
    
    
    49,519
    
    
    
    (60,879
    )
    
    
    32,343Accrued salaries and benefits
    
    
    (337,596
    )
    
    
    (75,325
    )
    
    
    254,089Other accrued expenses and other current liabilities
    
    
    (67,504
    )
    
    
    65,061
    
    
    
    (57,377
    )Other non-current liabilities
    
    
    (7,063
    )
    
    
    (144,490
    )
    
    
    181,240Deferred licensing revenue
    
    
    (393,733
    )
    
    
    (406,727
    )
    
    
    (429,111
    )Net cash used in operating activities
    
    
    (2,791,532
    )
    
    
    (4,717,947
    )
    
    
    (4,885,985
    )CASH FLOWS FROM INVESTING ACTIVITIES:Increase in patents
    
    
    (90,255
    )
    
    
    (192,803
    )
    
    
    (283,464
    )Decrease in other assets
    
    
    
    
    
    
    7,914
    
    
    
    14,838Repayment of advance to employee
    
    
    
    
    
    
    
    
    
    
    40,000Proceeds from sale of equipment
    
    
    137,230
    
    
    
    
    
    
    
    7,000Purchases of property and equipment
    
    
    (43,537
    )
    
    
    (91,027
    )
    
    
    (448,488
    )Net cash provided by (used in) investing activities
    
    
    3,438
    
    
    
    (275,916
    )
    
    
    (670,114
    )CASH FLOWS FROM FINANCING ACTIVITIES:Net proceeds from sale of stock
    
    
    26,223
    
    
    
    31,849
    
    
    
    1,173,000Principal payments on capital leases
    
    
    (18,110
    )
    
    
    (17,457
    )
    
    
    (46,035
    )Net cash provided by financing activities
    
    
    8,113
    
    
    
    14,392
    
    
    
    1,126,965DECREASE IN CASH AND CASH EQUIVALENTS
    
    
    (2,779,981
    )
    
    
    (4,979,471
    )
    
    
    (4,429,134
    )CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR
    
    
    7,036,959
    
    
    
    12,016,430
    
    
    
    16,445,564CASH AND CASH EQUIVALENTS, END OF YEAR
    
    $
    4,256,978
    
    
    $
    7,036,959
    
    
    $
    12,016,430SUPPLEMENTAL DISCLOSURE OF CASH FLOW
INFORMATION  Cash paid for interest
    
    $
    2,714
    
    
    $
    5,413
    
    
    $
    12,169
 See notes to consolidated financial statements. 23




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##### Table of Contents



DURASWITCH INDUSTRIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  1.
    
    NATURE OF BUSINESS Duraswitch Industries, Inc. (the Company) develops, patents and
licenses electronic switch technologies used to operate or control
products in a wide variety of commercial and consumer applications. The
Company has built domestic and foreign patent protection for its
technologies and is entering into license agreements with switch
manufacturers and OEMs worldwide to achieve widespread distribution of its
technologies. During 2000, the Company started to implement its business
model of licensing its technologies rather than manufacturing switches.
The Company has completed this transition and expects almost all of its
future revenue to come from its licensing efforts. Licensing royalties are
earned on a per switch basis. The Company has experienced significant operating losses since its
inception. The Company raised net proceeds of approximately $8.2 million
from its public offering in August 1999. In May 2000, the Company received
$4.0 million from Delphi Automotive Systems LLC, (Delphi), for the
exclusive right to utilize and manufacture the Companys patented switch
technologies for the automotive industry, a warrant to purchase
225,000 shares of stock and a short-term option to purchase approximately 1.65
million shares of common stock. In June 2000, Delphi exercised its option
to purchase approximately 1.65 million shares of the Companys common
stock at $7 per share, representing approximately 18% of the Companys
outstanding shares, for approximately $11.5 million in cash. The Company believes that it will be able to meet its presently
projected cash and working capital requirements for at least the next 12
months. The timing and amounts of cash used will depend on many factors,
including the Companys ability to increase revenue, control expenditures
and become profitable.  2.
    
    SUMMARY OF SIGNIFICANT ACCOUNTING PRINCIPLES The consolidated financial statements include the accounts of the
Company and its wholly owned subsidiaries. The consolidated financial
statements are prepared in accordance with accounting principles generally
accepted in the United States of America. The following paragraphs
summarize the significant accounting policies followed by the Company in
the preparation of its financial statements. Principles of Consolidation.All material intercompany balances and
transactions have been eliminated in consolidation. Cash Equivalents.The Company considers all highly liquid debt
instruments purchased with maturities of three months or less to be cash
equivalents. Inventory.Inventory is carried at the lower of cost, determined
using the FIFO (first-in, first-out) method, or market. The Company
writes down its inventory for estimated obsolescence or unmarketable
inventory to the extent the cost exceeds the estimated market value. The
Company bases the estimate on its assumptions about future demand and
market conditions. If actual market conditions are less favorable than
those assumed in its estimates, additional inventory write-downs might be
required. The Company reflects any write-down of inventory in the period
in which the facts giving rise to the inventory write-down become known to
it. Property and Equipment.Depreciation is computed using the
straight-line method over the useful lives of the related assets as
follows: Computer software
    
    3 yearsComputer equipment
    
    5 yearsOther machinery and equipment
    
    5 yearsOffice furniture and fixtures
    
    7 years
 Leasehold improvements are amortized over the lesser of their
estimated useful life or the term of the lease. Patents.Patents are reported at cost, net of accumulated
amortization, and are amortized using the straight-line method over the
estimated life of twenty years. 24




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##### Table of Contents



Goodwill.In June 2001, the Financial Accounting Standards Board
(FASB) issued SFAS No. 141, Business Combinations, and SFAS No. 142,
Goodwill and Other Intangibles. SFAS No. 141 requires the purchase method
of accounting for business combinations initiated after June 30, 2001,
eliminates the pooling-of-interests method of accounting for business
combinations, and identifies criteria for the establishment of
identifiable intangible assets separate from goodwill resulting from a
business combination. SFAS No. 142 requires companies to cease amortizing
goodwill. SFAS No. 142 also establishes a new method of testing goodwill
and other intangibles for impairment on an annual basis or on an interim
basis if an event occurs or circumstances change that would reduce the
fair value of a reporting unit below its carrying value. The standard
became effective for the Company beginning January 1, 2002. The adoption
of these standards did not have a material effect on the Companys
financial position or results of operations. Total goodwill amortization
for the year ended December 31, 2001 was $72,946. Accordingly, the net
loss for the year ended December 31, 2001, assuming non-amortization of
goodwill, would have been $5,317,208. Net loss per share, basic and
diluted, would have been $0.56 for the year ended December 31, 2001. Revenue Recognition.The Company enters into licensing agreements
with its customers. The Companys licensing strategy incorporates a
simplified requirement whereby the licensee purchases defined licensed
components from the Company. The licensed component revenue includes the
royalty for the rights to manufacture, assemble and sell patented
Duraswitch technologies. In some cases, where no components are supplied,
the Company is paid a royalty per switch manufactured and we recognize
revenue in the period the switch is manufactured. The Companys
non-exclusive licensees typically pay royalties of $0.08 per PushGate
($0.10 including the licensed component cost) and between $0.25 and $0.75
per thiNcoder, and between $0.25 and $0.75 per MagnaMouse, depending on
volume. The terms of some of its license agreements require prepayment of
royalties to the Company. The prepayments are recorded as deferred revenue
and licensing revenue is recognized when the royalties are earned under
the licensing agreements. Royalties are considered earned when the
licensee purchases component parts from the Company or, when component
parts are not supplied by the Company, royalties are considered earned
when the licensee manufactures a switch utilizing Duraswitch technologies.
In the case of the Delphi minimum royalty payments, we recognize revenue
as it is earned: either as Delphi sells products incorporating our
technologies; or in the event that the royalties earned on the sale of
Delphi products are less than the minimum royalty payment, we recognize
the difference between royalties previously recognized and the minimum
royalty payment as revenue on June 30 of each applicable year. The
deferred revenue received from Delphi in 2000 is being amortized over the
initial seven-year term of the exclusive license agreement ending June 30,
2007. Stock-Based Compensation.At December 31, 2003, the Company has three
stock-based employee compensation plans, which are described more fully in
Note 10. SFAS No. 123, Accounting for Stock-Based Compensationencourages,
but does not require, companies to record as compensation expense, over
the vesting period, the fair value of all stock-based awards on the date
of grant. The Company has chosen to account for these plans using the
intrinsic value method of accounting prescribed by APB Opinion No. 25,
Accounting for Stock Issued to Employees,and related interpretations. No
stock-based employee compensation cost is reflected in net income, as all
options granted under those plans had an exercise price equal to the
market value of the underlying common stock on the date of grant. The fair
value of all stock option grants is estimated on the date of grant in
accordance with SFAS No. 123 using the Black-Scholes option pricing model
with the following assumptions: an expected risk-free interest rate of 2.4
percent, 2.9 percent, and 4.0 percent for options granted in 2003, 2002
and 2001, respectively, an expected life of three years, an expected
volatility rate of 80 percent, 69 percent and 56 percent for options
granted in 2003, 2002 and 2001, respectively, and an expected dividend
rate of zero percent. The following table illustrates the effect on net
income and earnings per share if the Company had applied the fair value
recognition provisions of SFAS No. 123 to stock-based employee
compensation: Year Ended December 31,2003
    
    2002
    
    2001Net loss, as reported
    
    $
    (2,550,561
    )
    
    $
    (4,706,052
    )
    
    $
    (5,390,154
    )Less: Total stock-based
employee expense determined
under fair value based method
for all awards, net of
related tax effects
    
    
    (234,265
    )
    
    
    (350,212
    )
    
    
    (634,663
    )Pro forma net loss
    
    $
    (2,784,826
    )
    
    $
    (5,056,264
    )
    
    $
    (6,024,817
    )Loss per share:Basic and diluted, as reported
    
    $
    (0.27
    )
    
    $
    (0.49
    )
    
    $
    (0.57
    )Basic and diluted, pro forma
    
    $
    (0.29
    )
    
    $
    (0.53
    )
    
    $
    (0.64
    )
 Income Taxes.Deferred taxes are provided on temporary differences
between the tax basis of assets and liabilities for financial reporting
purposes and income tax purposes. The valuation allowance reduces deferred
tax assets to an amount that represents the Companys best estimate of the
amount of such deferred tax assets that, more likely than not, will be
realized. 25




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##### Table of Contents



Loss Per Common Share.Basic loss per share is computed by dividing
the loss attributable to the stockholders by the weighted average number
of common shares outstanding during the period. Diluted loss per share is
computed using the weighted average number of shares of common stock
outstanding plus the effect of any stock options or warrants if they are
dilutive. All stock options and warrants were anti-dilutive in 2003, 2002
and 2001. Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed
of.The Company reviews its long-lived assets and identifiable intangibles
for impairment whenever events or changes in circumstances indicate that
the carrying amount of the asset may not be recoverable. If such assets
were considered to be impaired, the impairment to be recognized would be
measured by the amount by which the carrying amount of the assets exceeds
the fair market value of the assets. Assets to be disposed of are reported
at the lower of the carrying amount or fair value less costs to sell. The Company evaluates the recoverability of property and equipment
and intangibles not held for sale by comparing the carrying amount of the
asset or group of assets against the estimated undiscounted future net
cash flows expected to result from the use of the asset or group of
assets. Goodwill from acquisitions related to a group of assets being
evaluated for impairment is included in the evaluation. If the
undiscounted estimated cash flows are less than the carrying value of the
asset or group of assets being reviewed, an impairment loss would be
recorded. The loss would be measured based on the estimated fair value of
the asset or group of assets compared to cost. The estimated fair value
would be based on the best information available under the circumstances,
including prices for similar assets and the results of valuation
techniques, including the present value of expected future cash flows
using a discount rate commensurate with the risks involved. New Accounting Pronouncements.In November 2002, the FASB issued FASB
Interpretation No. 45 (FIN 45), Guarantors Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness
of Others. This Interpretation addresses the disclosures to be made by a
guarantor in its financial statements and its obligations under
guarantees. The Interpretation also clarifies the requirements related to
the recognition of a liability by the guarantor at the inception of a
guarantee. Per the Interpretation, initial recognition of a liability will
be applied only on a prospective basis to guarantees issued or modified
after December 31, 2002. The Company adopted FIN 45 as of January 1, 2003,
and there was no impact on our financial position or results of
operations. Effective December 31, 2003, the Company adopted FASB Interpretation
No. 46 (FIN 46) (revised December 2003) Consolidation of Variable
Interest Entities, an Interpretation of ARB No. 51(FIN 46R). FIN 46R
replaced FIN 46 and clarified the application of Accounting Research
Bulletin No. 51, Consolidated Financial Statements, to certain entities in
which equity investors do not have the characteristics of a controlling
financial interest or do not have sufficient equity at risk for the entity
to finance its activities without additional subordinated financial
support. The Company did not have any variable interest entities as of
December 31, 2003, and the consolidation requirements of FIN 46R will
apply immediately to all variable interest entities created after December
31, 2003. Adoption of FIN 46R had no impact on the Companys consolidated
financial statements. Effective June 1, 2003, the Company adopted SFAS No. 150, Accounting
for Certain Financial Instruments with Characteristics of Both Liabilities
and Equity. SFAS No. 150 establishes standards for how an issuer
classifies and measures certain financial instruments with characteristics
of both liabilities and equity. It requires that an issuer classify a
financial instrument that is within its scope as a liability (or an asset
in some circumstances). Many of those instruments were previously
classified as equity. SFAS No. 150 is effective for financial instruments
entered into or modified after May 31, 2003. The company did not have any
such instruments outstanding at December 31, 2003. The adoption of SFAS
No. 150 had no impact on the Companys consolidated financial statements. Fair Value of Financial Instruments.The carrying values of cash and
cash equivalents, accounts receivable and accounts payable approximate
fair values due to the short-term maturities of these instruments. The
fair value of notes payable and capital leases approximate the carrying
value of these instruments because the terms are similar to those in the
marketplace under which they could be replaced. Use of Estimates.The preparation of financial statements in
conformity with accounting principles generally accepted in the United
States of America necessarily requires the Company 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 revenue and expenses
during the reporting period. Actual results could differ from those
estimates.  3.
    
    CONCENTRATIONS The Company maintained its cash and cash equivalents in three
financial institutions at December 31, 2003. At December 31, 2003, the
Company maintained cash and cash equivalents at financial institutions in
excess of federal depository insurance. 26




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##### Table of Contents



In 2003, Delphi represented 54 percent of net revenue. In 2002,
Delphi represented 53 percent of net revenue and Memtron Technologies Inc.
and Xymox Technologies Inc. each represented 11 percent of net revenue. In
2001, Delphi represented 42 percent of net revenue and Siemens Cerberus
product revenue represented 11 percent of net revenue. Net revenue from
Delphi resulted primarily from recognition of deferred licensing revenue
which was recorded in 2000.  4.
    
    INVENTORY The Companys inventory is primarily comprised of licensed components
and other raw materials. The licensed components are sold to licensees and
the other materials are primarily used for research and development
projects and marketing samples. The sale of licensed components and other
materials to licensees is recognized as licensing revenue and the cost of
the components and other materials sold to licensees is recorded as
licensing cost of goods sold when the components and other materials are
shipped to the licensee. Other raw materials are primarily used to produce
research and development pieces and marketing samples, which are expensed
when used. Inventory consists of the following at December 31: 2003
    
    2002Raw materials:Licensed components
    
    $
    247,607
    
    
    $
    230,585Other materials
    
    
    21,415
    
    
    
    100,630Less reserve for obsolete inventory
    
    
    (97,500
    )
    
    
    (138,300
    )Inventory - net
    
    $
    171,522
    
    
    $
    192,915
 The Company recorded charges of $22,000, $125,000 and $12,700 to
increase the reserve for obsolete inventory in 2003, 2002 and 2001,
respectively.  5.
    
    PROPERTY AND EQUIPMENT Property and equipment consists of the following at December 31: 2003
    
    2002Computer equipment and software
    
    $
    439,614
    
    
    $
    611,490Other machinery and equipment
    
    
    325,236
    
    
    
    720,077Leasehold improvements
    
    
    138,073
    
    
    
    305,276Office furniture and fixtures
    
    
    73,669
    
    
    
    122,209Total
    
    
    976,592
    
    
    
    1,759,052Less accumulated depreciation
    
    
    (661,880
    )
    
    
    (972,546
    )Property and
equipment - net
    
    $
    314,712
    
    
    $
    786,506
 Depreciation expense for property and equipment was $353,833,
$349,919 and $289,483 for the years ended December 31, 2003, 2002, and
2001, respectively. During the second quarter of 2003, the Company began outsourcing the
manufacture of research and development pieces and marketing samples and
further reduced its research and development activities. As a result,
equipment which had previously been utilized in these activities was
offered for sale to our licensees and on our website. During 2003 we
recorded an impairment loss of $21,194 and a gain on the sale of Assets
Held for Sale of $55,335. Both the impairment loss and the gain have been
included in selling, general and administrative expenses. At December 31,
2003, the net carrying value of the remaining equipment that is classified
as Assets Held for Sale is $15,336.  6.
    
    PATENTS Amortization expense for patents was $44,518, $37,628 and $32,673 for
the years ended December 31, 2003, 2002 and 2001, respectively. The
estimated amortization expense for existing patents is $46,825 for each of
the next five years. 27




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##### Table of Contents



The gross carrying amount and accumulated amortization of patents are
as follows: 2003
    
    2002Patents
    
    $
    975,052
    
    
    $
    884,797Accumulated amortization
    
    
    (185,868
    )
    
    
    (141,350
    )Patents - net
    
    $
    789,184
    
    
    $
    743,447
  7.
    
    DEFERRED LICENSING REVENUE In April 2000, the Company entered into a license agreement with
Delphi that gives Delphi the exclusive right to utilize and manufacture
the Companys patented switch technologies for the automotive industry. In
connection with the license agreement, the Company also issued a warrant
to Delphi to purchase 225,000 shares of common stock at $7.00 per share
and a short-term option to purchase 1,651,846 shares of common stock at
$7.00 per share. In exchange, Delphi paid the Company a nonrefundable
payment of $4.0 million and agreed to pay a royalty fee for each switch
sold by Delphi. The term of the exclusive license agreement is seven
years. The agreement also requires Delphi to make minimum royalty payments
totaling $12 million during the initial seven-year term ending June 30,
2007. The first payment of $1 million is due on July 1, 2004. Subsequent
payments are as follows: $2 million on July 1, 2005; $3 million on July 1,
2006; and $6 million on July 1, 2007. Delphi can maintain exclusivity for
the automotive industry through June 30, 2012 by making additional minimum
annual royalty payments during that period. After June 30, 2012, either
party may convert the agreement to a non-exclusive agreement through 2020. The estimated fair value of the warrant and the option was
$1,134,338, as determined using the Black-Scholes valuation model. The
remaining value of the nonrefundable payment totaling $2,865,662 was
recorded as deferred revenue and is being amortized over the initial
seven-year term of the exclusive license agreement. The licensing agreement with Delphi generated licensing revenue of
$409,753 and $409,380 for the years ended December 31, 2003 and 2002,
respectively, which primarily resulted from the revenue recognition of
deferred licensing revenue which was recorded in 2000.  8.
    
    CAPITAL LEASES The Company has capital leases for property and equipment with a
gross value of $34,800 and a net book value of $8,120 at December 31,
2003. The amortization of fixed assets acquired with capital leases is
included in depreciation expense. At December 31, 2003, the present values
of future minimum capital lease payments are as follows: 2004 payments
    
    $
    8,766Less interest at 13.29%
    
    
    553Present value of minimum capital lease obligations
    
    
    8,213Less current portion of capital lease obligations
    
    
    8,213Long-term portion of capital lease obligations
    
    $
    
  9.
    
    STOCKHOLDERS EQUITY Common Stock.In 2003, we issued 34,782 shares at a value of $40,000
in exchange for consulting services. Preferred Stock.As of December 31, 2003, no preferred stock is
outstanding. The Companys Board of Directors is authorized, subject to
any limitations prescribed by Nevada law, but without further action by
the stockholders, to provide for the issuance of serial preferred stock in
one or more series; to establish from time to time the number of shares to
be included in these series; to fix the designations, powers, preferences,
and rights of the shares of each such series and any qualifications,
limitations, or restrictions thereof; and to increase or decrease the
number of shares of any such series, but not below the number of shares of
such series then outstanding, without any further vote or action by the
stockholders. The Board of Directors may authorize and issue serial
preferred stock with voting or conversion rights that could adversely
affect the voting power or other rights of the holders of common stock. Warrants.On November 20, 1998, pursuant to a consulting agreement
and prior to becoming an employee of the Company, our current Chief
Executive Officer was granted a warrant to purchase 47,059 shares of
non-registered common stock at an exercise price of $3.19. These warrants
expired on November 20, 2003. 28




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##### Table of Contents



In connection with the public offering that closed in September 1999,
the underwriter was granted warrants to purchase 200,000 shares of common
stock at an exercise price of $8.25 per share. If not exercised, these
warrants will expire on August 26, 2004. On April 20, 2000, the Company sold a warrant to Delphi to purchase
225,000 shares of common stock at an exercise price of $7.00 per share. If
not exercised, this warrant will expire on April 20, 2004 (Note 7). A summary of changes in outstanding warrants is as follows: Warrants
    
    Price RangeBalance, January 1, 2001
    
    
    472,059
    
    
    $
    3.19-$8.25Issued
    
    
    Exercised
    
    
    Balance, December 31, 2001
    
    
    472,059
    
    
    $
    3.19-$8.25Issued
    
    
    Exercised
    
    
    Balance, December 31, 2002
    
    
    472,059
    
    
    $
    3.19-$8.25Issued
    
    
    Exercised
    
    
    Expired
    
    
    (47,059
    )
    
    $
    3.19Balance, December 31, 2003
    
    
    425,000
    
    
    $
    7.00-$8.25
  10.
    
    STOCK OPTION PLANS Effective May 1, 1997, the Board of Directors approved a stock option
plan (the 1997 Option Plan). This plan provides for the granting of
incentive and nonqualified stock options to officers, directors and
employees of the Company. The plan also provides for the granting of
nonqualified stock options to any director, consultant or other individual
whose participation the Board of Directors determines to be in the best
interest of the Company. The number of shares authorized for options under
the 1997 Option Plan is 823,535. The Companys 1999 Stock Option Plan (the 1999 Option Plan) was
adopted by the Companys Board of Directors and was ratified by the
stockholders on March 8, 1999. The number of shares of common stock
authorized subject to options under the 1999 Option Plan is 235,294 shares. The Companys 2000 Stock Option Plan (the 2000 Option Plan) was
adopted by the Companys Board of Directors and was ratified by the
stockholders on June 19, 2000 and was amended on May 20, 2002. The number
of shares of common stock authorized subject to options under the 2000
Option Plan is 500,000 shares. The total number of shares available for grant under all three plans
is 59,803 at December 31, 2003. The Company accounts for the fair value of the options issued to
non-employees in accordance with SFAS No. 123, Accounting for Stock-Based
Compensation. The Company did not record compensation cost during 2003,
2002 and 2001 as no options were granted to non-employees other than to
directors during that time period. As permitted by SFAS No. 123, the Company has elected to continue to
measure cost for its stock-based compensation plans with employees and
directors using the intrinsic value method of accounting prescribed by APB
Opinion No. 25, Accounting for Stock Issued to Employees. Accordingly, no
compensation cost has been recognized, as the option prices are equal to
or greater than fair market value of the stock on the grant dates. Options granted under all plans expire up to ten years from the date
of grant. Options that expire or terminate prior to exercise are added to
the shares available for future grants. 29




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##### Table of Contents



A summary of changes in stock options is as follows: WeightedAverageOption
    
    ExerciseShares
    
    PriceBalance, January 1, 2001
    
    
    973,792
    
    
    $
    10.13Granted
    
    
    131,100
    
    
    $
    10.55Exercised
    
    
    (261,999
    )
    
    $
    4.50Expired or terminated
    
    
    (31,194
    )
    
    $
    15.62Balance, December 31, 2001
    
    
    811,699
    
    
    $
    10.13Granted
    
    
    301,400
    
    
    $
    3.39Exercised
    
    
    (5,500
    )
    
    $
    6.14Expired or terminated
    
    
    (34,900
    )
    
    $
    7.35Balance, December 31, 2002
    
    
    1,072,699
    
    
    $
    9.61Granted
    
    
    156,500
    
    
    $
    1.86Exercised
    
    
    (22,696
    )
    
    $
    1.16Expired or terminated
    
    
    (164,063
    )
    
    $
    7.19Balance, December 31, 2003
    
    
    1,042,440
    
    
    $
    9.02
 2003
    
    2002
    
    2001Exercisable at the end of the year
    
    
    990,940
    
    
    
    1,029,633
    
    
    
    786,699Weighted average fair value of options
granted during the year
    
    $
    0.99
    
    
    $
    1.52
    
    
    $
    4.29
 A summary of options outstanding and exercisable as of December 31,
2003 is as follows: Options Outstanding
    
    Options ExercisableWeightedAverage
    
    Weighted
    
    
    
    
    
    WeightedRemaining
    
    Average
    
    
    
    
    
    AverageOptions
    
    Contractual
    
    Exercise
    
    Options
    
    ExerciseRange of Exercise Price
    
    Outstanding
    
    Life
    
    Price
    
    Exercisable
    
    Price$
    0.81
    
    
    -
    
    
    $
    1.06
    
    
    
    172,800
    
    
    
    8.9
    
    
    $
    1.04
    
    
    
    172,800
    
    
    $
    1.04$
    1.83
    
    
    -
    
    
    $
    3.38
    
    
    
    161,700
    
    
    
    9.4
    
    
    $
    2.14
    
    
    
    110,200
    
    
    $
    3.14$
    6.00
    
    
    -
    
    
    $
    10.85
    
    
    
    460,172
    
    
    
    6.3
    
    
    $
    7.48
    
    
    
    460,172
    
    
    $
    7.48$
    13.01
    
    
    -
    
    
    $
    22.31
    
    
    
    247,768
    
    
    
    4.0
    
    
    $
    21.92
    
    
    
    247,768
    
    
    $
    21.92$
    0.81
    
    
    -
    
    
    $
    22.31
    
    
    
    1,042,440
    
    
    
    6.7
    
    
    $
    9.02
    
    
    
    990,940
    
    
    $
    9.48
   30




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##### Table of Contents



11.
    
    INCOME TAXES Net deferred tax assets consist of the following at December 31: 2003
    
    2002Deferred tax assets:Operating loss carryforwards
    
    $
    8,102,140
    
    
    $
    7,944,706Capitalized research and development
    
    
    1,167,109
    
    
    
    Research and development credits
    
    
    723,601
    
    
    
    370,349Deferred licensing revenue
    
    
    572,668
    
    
    
    730,162Other
    
    
    150,295
    
    
    
    305,497Total
    
    
    10,715,813
    
    
    
    9,350,714Less valuation allowance
    
    
    (10,340,742
    )
    
    
    (8,970,556
    )Total
    
    
    375,071
    
    
    
    380,158Deferred tax liabilities:Patents
    
    
    (314,474

    )
    
    
    (326,183
    )Other
    
    
    (60,597
    )
    
    
    (53,975
    )Total
    
    $
    
    
    
    $
    
 During the years ended December 31, 2003, 2002 and 2001, the Company
increased the valuation allowance by $1,370,186, $1,993,272, and
$3,437,316, respectively, against deferred tax assets. The increase in the
valuation allowance recorded in 2003, 2002 and 2001 includes $6,146,
$3,463, and $1,121,965, respectively, for net operating loss carryforwards
related to stock compensation. The benefit of the utilization of these net
operating loss carryforwards would be recorded as a credit to additional
paid-in capital. The valuation allowance reduces deferred tax assets to an
amount that represents managements best estimate of the amount of such
deferred tax assets that, more likely than not, will be realized.
Realization of the deferred tax assets is dependent upon generating
sufficient future taxable income in the period that temporary differences
and carryforwards are expected to be available to reduce taxable income. The Companys net operating loss carryforwards of approximately $20.3
million for federal and state income tax purposes expire in 2011 through
2023. The income tax provision differs from the amount of income tax
determined by applying the U.S. federal income tax rate to pretax income
for 2003, 2002 and 2001 due to the following: 2003
    
    2002
    
    2001Benefit calculated at statutory rate
    
    $
    867,191
    
    
    $
    1,600,057
    
    
    $
    1,832,652Increase (decrease) in income resulting from:State income taxes, net
    
    
    153,034
    
    
    
    282,363
    
    
    
    323,409Permanent differences
    
    
    343,815
    
    
    
    107,389
    
    
    
    159,290Valuation allowance
    
    
    (1,364,040

    )
    
    
    (1,989,809
    )
    
    
    (2,315,351
    )Total
    
    $
    
    
    
    $
    
    
    
    $
    
  12.
    
    SELECTED QUARTERLY FINANCIAL DATA (Unaudited) The following table presents unaudited operating results for each
quarter within the two most recent years. The Company believes that all
necessary adjustments, consisting only of normal recurring adjustments,
have been included in the amounts stated below to present fairly the
following quarterly results when read in conjunction with the financial
statements included elsewhere in this report. Results of operations for
any particular quarter are not necessarily indicative of results of
operations for a full fiscal year: 31




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##### Table of Contents



2003 - Quarter Ended,December 31
    
    September 30
    
    June 30
    
    March 31Licensing revenue
    
    $
    246,777
    
    
    $
    192,863
    
    
    $
    161,245
    
    
    $
    159,027Total net revenue
    
    
    246,777
    
    
    
    192,863
    
    
    
    161,245
    
    
    
    159,027Gross profit
    
    
    204,923
    
    
    
    161,989
    
    
    
    147,722
    
    
    
    141,974Net loss
    
    
    (528,898
    )
    
    
    (475,794
    )
    
    
    (821,042
    )
    
    
    (724,827
    )Net loss per common share,
basic and diluted (1)
    
    $
    (0.06
    )
    
    $
    (0.05
    )
    
    $
    (0.09
    )
    
    $
    (0.08
    )
 2002 - Quarter Ended,December 31
    
    September 30
    
    June 30
    
    March 31Licensing revenue
    
    $
    174,986
    
    
    $
    150,164
    
    
    $
    237,412
    
    
    $
    184,932Product revenue
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    24,675Total net revenue
    
    
    174,986
    
    
    
    150,164
    
    
    
    237,412
    
    
    
    209,607Gross profit
    
    
    85,074
    
    
    
    140,916
    
    
    
    196,190
    
    
    
    193,583Net loss
    
    
    (1,155,968
    )
    
    
    (1,060,925
    )
    
    
    (1,196,346
    )
    
    
    (1,292,813
    )Net loss per common share,
basic and diluted (1)
    
    $
    (0.12
    )
    
    $
    (0.11
    )
    
    $
    (0.13
    )
    
    $
    (0.14
    )
  (1)
    
    Earnings per share are computed independently for each quarter and the full year based upon
respective average shares outstanding. Therefore, the sum of the quarterly net earnings per share
may not equal the annual amounts reported.  13.
    
    SEGMENT REPORTING The Company operates and reports internally as one segment and
substantially all of its assets are located in the United States. Revenue
by geographic area is determined based upon the location of the licensee
or customer. The U.S. is the only country with net revenue in excess of
10% of total net revenue. Net revenue by geographic region for the years
ended December 31, 2003, 2002, and 2001 is as follows: 2003
    
    2002
    
    2001U.S.
    
    $
    586,176
    
    
    $
    678,021
    
    
    $
    876,077Europe
    
    
    106,577
    
    
    
    86,201
    
    
    
    32,175Other
    
    
    67,159
    
    
    
    7,947
    
    
    
    77,060Total
    
    $
    759,912
    
    
    $
    772,169
    
    
    $
    985,312
  14.
    
    COMMITMENTS Management Services Agreement.The Company has a management services
agreement with a company owned and operated by the founders, two major
stockholders. This management agreement requires the Company to pay a
management service fee equal to 1.1 percent of the invoiced sales price
for all Company-patented technology component switches and integrated
switch panels sold by the Company. Also, the Company has agreed to pay an
equivalent percentage of any license or sublicense fees received from the
patented technologies. This agreement remains in effect until the
expiration of the last patent, which may be issued on the switch
technologies. During 2003, 2002 and 2001, the Company paid approximately
$3,100, $5,100 and $9,200, respectively, under this agreement. Employment Agreements.The Company has employment agreements with its
executive officers. These agreements call for a base salary and bonuses.
These agreements also provide for salary and benefits in the event of
separation. Effective December 31, 2001, the former Chief Executive Officer
resigned his position. His employment agreement provided for salary and
benefits in the event of termination or resignation. As such, the Company
recorded a charge of $397,431 for the year ended December 31, 2001 to be
paid over an 18-month period. At December 31, 2003, $0 remained to be
paid. Lease Agreements.Rent expense for the periods ended December 31,
2003, 2002 and 2001 approximated $199,000 each year. Rent payments in 2003
were approximately $222,000. Future minimum rental payments are $43,609 in
2004, $44,529 in 2005, and $0 thereafter. 32




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##### Table of Contents



Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. None. 
 Item 9A. Controls and Procedures. We have evaluated, with the participation of our Chief Executive
Officer and Chief Financial Officer, the effectiveness of our disclosure
controls and procedures as of December 31, 2003. Based on this evaluation,
our Chief Executive Officer and Chief Financial Officer has concluded that
our disclosure controls and procedures are effective to ensure that we
record, process, summarize, and report information required to be
disclosed by us in our annual reports filed under the Securities Exchange
Act within the time periods specified by the Securities and Exchange
Commissions rules and forms. During the period covered by this report,
there have not been any changes in our internal controls over financial
reporting that have materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting. 33




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##### Table of Contents



Part III 
 Item 10. Directors and Executive Officers of the Registrant. The information required by this Item is incorporated herein by
reference to the definitive Proxy Statement to be filed pursuant to
Regulation 14A of the Exchange Act for our 2004 Annual Meeting of
Stockholders. 
 Item 11. Executive Compensation. The information required by this Item is incorporated herein by
reference to the definitive Proxy Statement to be filed pursuant to
Regulation 14A of the Exchange Act for our 2004 Annual Meeting of
Stockholders. 
 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. The information required by this Item is incorporated herein by
reference to the definitive Proxy Statement to be filed pursuant to
Regulation 14A of the Exchange Act for our 2004 Annual Meeting of
Stockholders. 
 Item 13. Certain Relationships and Related Transactions. The information required by this Item is incorporated herein by
reference to the definitive Proxy Statement to be filed pursuant to
Regulation 14A of the Exchange Act for our 2004 Annual Meeting of
Stockholders. 
 Item 14. Principal Accountant Fees and Services. The information required by this Item is incorporated herein by
reference to the definitive Proxy Statement to be filed pursuant to
Regulation 14A of the Exchange Act for our 2004 Annual Meeting of
Stockholders. 34




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##### Table of Contents



PART IV 
 Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K.  (a)
    
    Exhibits.See attached exhibit list.(b)
    
    Reports onForm 8-K.On October 30, 2003, we filed a current report on Form 8-K
reporting our third quarter 2003 financial results.(d)
    
    Financial Statement Schedules.None. 35




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##### Table of Contents



SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Exchange
Act, the registrant has caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized. Date: March 26, 2004
    
    DURASWITCH INDUSTRIES, INC./s/ Robert J. BrilonRobert J. BrilonChairman of the Board, President, Chief
Executive Officer, Chief Financial Officer,
Secretary and Treasurer
 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 capacity and on the dates indicated. Date: March 26, 2004
    
    By:
    
    /s/ Robert J. BrilonRobert J. Brilon,
Chairman of the Board, President, Chief
Executive Officer, Chief Financial Officer,
Secretary and Treasurer(Principal Executive, Financial
and
Accounting Officer)Date: March 26, 2004
    
    By:
    
    /s/ Anthony J. Van ZeelandAnthony J. Van Zeeland,Director, Chief Technology OfficerDate: March 26, 2004
    
    By:
    
    /s/ Michael A. Van ZeelandMichael A. Van Zeeland,DirectorDate: March 26, 2004
    
    By:
    
    /s/ John W. HailJohn W. Hail,DirectorDate: March 26, 2004
    
    By:
    
    /s/ William E. PeelleWilliam E. Peelle,Director
 36




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##### Table of Contents



Exhibit Index Exhibit No.
    
    Description of Exhibit3.1
    
    Amended and Restated Articles of Incorporation (1)3.2
    
    Amended and Restated Bylaws (2)4.1
    
    Specimen Common Stock Certificate (1)10.1
    
    Employment and Separation Agreement
dated November 20, 1998 by and between Duraswitch Industries,
Inc. and Robert J. Brilon (1)10.1.1
    
    Addendum #1 to Employment and
Separation Agreement dated November 20, 1998 by and between
Duraswitch Industries Inc. and Robert J. Brilon (3)10.1.2
    
    Addendum #2 to Employment and
Separation Agreement dated November 20, 1998 by and between
Duraswitch Industries Inc. and Robert J. Brilon10.2
    
    1997 Stock Option Plan (1)10.3
    
    1999 Stock Option Plan (1)10.4
    
    Form of Representatives Warrants (1)10.5
    
    2000 Stock Option Plan (4)10.6
    
    2000 Stock Option Plan Amendment (5)10.7
    
    Management Services Agreement dated May 1, 1997 by and between Total Switch, Inc. and VanDun, LLC (1)10.8
    
    Agreement for Assignment of Present and Future Inventions in
Certain Subject Matter dated May 1, 1997 by and between Total Switch,
Inc. and Anthony J. Van Zeeland (1)10.9*
    
    Licensing Agreement between Delphi Automotive Systems LLC and
Duraswitch Industries, Inc. dated April 20, 2000 (6)10.10
    
    Shareholders Agreement dated June 19, 2000 among Duraswitch
Industries, Inc., Delphi Automotive Systems Corporation, and the
Primary Shareholders named therein (7)10.11
    
    Employment Agreement dated
July 1, 2003 by and between Duraswitch Industries, Inc. and Anthony J. Van Zeeland (8)10.13
    
    Standard sublease dated November 1, 2003 by and between 234 South Extension, L.L.C. and Duraswitch Industries, Inc.21
    
    List of Subsidiaries23.1
    
    Consent of Deloitte & Touche LLP31
    
    Certification of Chief Executive Officer and Chief Financial
Officer pursuant to Rule 13a-14(a) and Rule 15d  14(a), promulgated
under the Securities Exchange Act of 1934, as amended32
    
    Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
    (1)
    
    Incorporated by reference to the registrants Form SB-2 as filed on
August 26, 1999(2)
    
    Incorporated by reference to the registrants Form 10-KSB as filed on
March 30, 2001(3)
    
    Incorporated by reference to the registrants
Form 10-KSB as filed
on March 30, 2000(4)
    
    Incorporated by reference to the registrants Proxy Statement as filed
on May 12, 2000(5)
    
    Incorporated by reference to the registrants Form 10-K as filed on
March 23, 2002(6)
    
    Incorporated by reference to the registrants Form 8-K as filed on
April 26, 2000(7)
    
    Incorporated by reference to the registrants Form 10-K as filed on
March 25, 2003(8)
    
    Incorporated by reference to the registrants Form 10-Q as filed on
August 5, 2003   * Certain information in this exhibit has been omitted and filed
separately with the Securities and Exchange Commission. Confidential
treatment has been requested with respect to the omitted portions. 37