10-Q 1 p64600e10-q.txt FORM 10-Q 1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended December 31, 2000 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 No. 2-331855 SENSORY SCIENCE CORPORATION (Exact name of registrant as specified in its charter) Delaware 86-0492122 (State of Incorporation) (IRS E.I.N.) 7835 East McClain Drive, Scottsdale, Arizona 85260 (Address of principal executive offices) (Zip code) (480) 998-3400 (Registrant's telephone number, including area code) 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 [ ] 14,426,970 shares of Common Stock were outstanding as of February 7, 2001. 2 SENSORY SCIENCE CORPORATION INDEX

PAGE NO. -------- Part I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS Consolidated Balance Sheets -- At ~~September~~December 3031, 2000 and March 31, 2000 3 Consolidated Statements of Operations and Comprehensive Income (Loss) ~~Income~~ -- Quarters and ~~Six~~Nine Months Ended ~~September~~December 3031, 2000 and 1999 4-5 Consolidated Statements of Cash Flows -- ~~Six~~Nine Months Ended ~~September~~December 3031, 2000 and 1999 6-7 Notes to ~~the~~ Consolidated Financial Statements 8-10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 11-1415 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ~~12-13~~15 PART II. OTHER INFORMATION ITEM ~~4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 14-15 ITEM~~ 6. EXHIBITS AND REPORTS ON FORM 8-K 15 SIGNATURES 16

THIS QUARTERLY REPORT ON FORM 10-Q CONTAINS "FORWARD LOOKING STATEMENTS" WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED AND SECTION 21E OF THE SECURITIES AND EXCHANGE ACT OF 1934, AS AMENDED. SUCH STATEMENTS REFER TO FUTURE EVENTS OR INCLUDE TERMS SUCH AS: WE OR THE COMPANY "BELIEVES", "EXPECTS", "INTENDS", "PLANS", AND OTHER USES OF FUTURE TENSES. SEE NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS AND "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" FOR SUCH FORWARD LOOKING STATEMENTS, WHICH INCLUDE STATEMENTS REGARDING THE PROBABILITY OF AND THE BENEFITS OF THE MERGER WITH A SUBSIDIARY OF SONICBLUE, INC. EXPECTATIONS REGARDING, SALES OF THE COMPANY'S PRODUCTS AND THE COMPANY'S REVENUES AND PERFORMANCE, AND EXPECTATIONS REGARDING THE COMPANY'S LIQUIDITY. ALSO SEE "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" ON PAGES 11-15 AND EXHIBIT 99.1 FOR A DISCUSSION OF IMPORTANT FACTORS THAT COULD AFFECT THE VALIDITY OF ANY SUCH FORWARD LOOKING STATEMENTS. 2 3 SENSORY SCIENCE CORPORATION CONSOLIDATED BALANCE SHEETS

~~SEPTEMBER~~DECEMBER 3031, 2000 MARCH 31, 2000 ~~2000~~ ------------ ------------- ASSETS (UNAUDITED) CURRENT ASSETS: Cash and cash equivalents $ 1382,~~281,766~~452 $ 1,218,949 Receivables - less allowance for doubtful accounts of $~~116~~245,000 and $116,000, respectively 1315,~~477~~467,~~930~~069 15,670,572 Inventories 129,~~976~~411,~~019~~077 11,869,163 Prepaid expenses and other assets ~~394~~320,~~247~~557 975,923 Deferred tax asset -- 100,000 Net investment in discontinued operations -- 214,426 ------------ ------------ Total Current Assets 2825,~~129~~581,~~962~~155 30,049,033 ------------ ------------ EQUIPMENT AND LEASEHOLD IMPROVEMENTS: Furniture, fixtures & equipment 1,~~018~~015,~~282~~371 856,787 Leasehold improvements 651,615 420,227 Office equipment 2,~~017~~027,~~555~~562 1,803,319 Tooling 1,~~565~~748,~~623~~537 1,377,523 ------------ ------------ Gross equipment and improvements 5,~~253~~443,~~075~~085 4,457,856 Less accumulated depreciation and amortization (2,~~390~~861,~~323~~056) (1,912,972) ------------ ------------ Equipment and improvements - net 2,~~862~~582,~~752~~029 2,544,884 ------------ ------------ PATENTS, net of amortization ~~129~~125,~~122~~551 136,264 GOODWILL, net of amortization 1,~~080~~065,~~880~~439 1,111,763 MARKET EXCLUSIVITY FEE, net of amortization 1,~~232~~090,~~398~~199 1,516,799 DEFERRED TAX ASSET 570,000 317,500 OTHER ASSETS, net of amortization ~~261~~259,~~576~~316 248,414 ------------ ------------ $ 3431,~~266~~273,~~690~~689 $ 35,924,657 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 1211,~~710~~867,~~460~~843 $ 4,789,152 Accrued expenses 1668,~~031,029~~330 938,866 Other current liabilities ~~776~~760,~~032~~708 957,838 Warranty reserve ~~271~~257,~~262~~744 324,964 Line of credit 1413,~~969~~000,~~979~~094 14,732,513 ------------ ------------ Total Current Liabilities 2926,~~758~~554,~~762~~719 21,743,333 Severance reserve and other liabilities ~~453~~484,~~144~~254 386,713 ------------ ------------ Total Liabilities 3027,~~211~~038,~~906~~973 22,130,046 ------------ ------------ STOCKHOLDERS' EQUITY: Common stock 14,~~422~~427 14,260 Additional paid-in capital 22,~~723~~796,~~832~~932 22,422,587 Unrealized gain on investment, net of tax -- 228,748 Accumulated deficit (18,~~683~~576,~~470~~643) (8,870,984) ------------ ------------ Total Stockholders' Equity 4,~~054~~234,~~784~~716 13,794,611 ------------ ------------ $ 3431,~~266~~273,~~690~~689 $ 35,924,657 ============ ============

See Notes to Consolidated Financial Statements 3 4 SENSORY SCIENCE CORPORATION CONSOLIDATED STATEMENT OF OPERATIONS AND COMPREHENSIVE INCOME

(UNAUDITED) QUARTER ENDED ~~SEPTEMBER~~DECEMBER 3031, ------------------------------------- 2000 1999 ------------ ----------- Net sales $ 1824,~~513~~694,~~505~~078 $1920,~~582~~435,~~961~~421 Cost of sales 1719,~~607~~259,~~609~~444 15,~~290~~547,~~966~~848 ------------ ----------- Gross profit ~~905~~5,~~896~~434,634 4,~~291~~887,~~995~~573 ------------ ----------- Costs and expenses: Sales and marketing 32,~~178~~578,~~965~~990 1,~~707~~872,~~766~~874 Research and development ~~770~~797,~~082~~564 1547,~~009,418~~189 General and administrative 1,~~996~~573,~~536~~457 1,~~246~~363,~~374~~206 ------------ ----------- 54,~~945~~950,~~583~~011 3,~~963~~783,~~558~~269 ------------ ----------- Operating ~~(loss)~~ income (5484,~~039,687)~~623 ~~328~~1,~~437~~104,304 Interest and other expenses ~~385~~377,~~317~~793 ~~302~~426,~~713~~657 ------------ ----------- ~~(Loss)~~Income ~~income~~ before income taxes (5106,~~425,004)~~830 25677,~~724~~647 Income ~~tax~~taxes ~~benefit~~ -- --278,000 ------------ ----------- NET ~~(LOSS)~~ INCOME $ (5106,~~425,004)~~830 $ 25399,~~724~~647 ============ =========== NET ~~(LOSS)~~ INCOME PER SHARE - BASIC $ (0.~~38)~~01 $ 0.0003 ============ =========== NET ~~(LOSS)~~ INCOME PER SHARE - DILUTED $ (0.~~38)~~01 $ 0.0003 ============ =========== Weighted average basic shares outstanding 14,~~373~~426,~~867~~970 13,~~784~~893,~~975~~660 Weighted average equivalent shares -- 1374,~~083,673~~179 ------------ ----------- Weighted average diluted shares outstanding 14,~~373~~426,~~867~~970 14,~~868~~267,~~648~~839 ============ =========== NET ~~(LOSS)~~ INCOME $ (5106,~~425,004)~~830 $ 25399,~~724~~647 Other comprehensive income -- ~~Holding gain arising during the quarter, net of tax of $5,000 7,500~~ -- ----------- ----------- COMPREHENSIVE ~~(LOSS)~~ INCOME $ (5106,~~417,504)~~830 $ 25399,~~724~~647 ============ ===========

See Notes to Consolidated Financial Statements. 4 5 SENSORY SCIENCE CORPORATION CONSOLIDATED STATEMENT OF OPERATIONS AND COMPREHENSIVE LOSS

(UNAUDITED) ~~SIX~~NINE MONTHS ENDED ~~SEPTEMBER~~DECEMBER 3031, ---------------------------------------- 2000 1999 ------------ ------------ Net sales $ 2953,~~196~~890,~~601~~679 $ 3354,~~719~~154,~~145~~566 Cost of sales 2746,~~023~~283,~~700~~144 2641,~~436~~984,~~356~~204 ------------ ------------ Gross profit 27,~~172~~607,~~901~~535 712,~~282~~170,~~789~~362 ------------ ------------ Costs and expenses: Sales and marketing 58,~~993~~572,~~972~~962 35,~~283~~155,~~097~~971 Research and development 12,~~519~~316,~~215~~779 12,~~891~~439,~~896~~085 General and administrative 35,~~750~~324,~~605~~062 23,~~234~~598,~~816~~022 ------------ ------------ 1116,~~263~~213,~~792~~803 711,~~409~~193,~~809~~078 ------------ ------------ Operating (loss) income (98,~~090~~606,~~891~~268) ~~(127~~977,~~020)~~284 Interest and other expenses ~~721~~1,~~595~~099,388 ~~561~~988,~~986~~643 ------------ ------------ Loss before income taxes (9,~~812~~705,~~486~~656) (~~689~~11,~~006~~359) Income ~~tax~~taxes ~~benefit~~-- -- ~~(278,000)~~ ------------ ------------ NET LOSS $ (9,~~812~~705,~~486~~656) $ (~~411~~11,~~006~~359) ============ ============ NET LOSS PER SHARE - BASIC $ (0.68) $ (0.0300) ============ ============ NET LOSS PER SHARE - DILUTED $ (0.68) $ (0.0300) ============ ============ Weighted average basic shares outstanding 14,~~342~~370,~~187~~448 13,~~724~~780,~~603~~955 Weighted average equivalent shares -- --816,530 ------------ ------------ Weighted average diluted shares outstanding 14,~~342~~370,~~187~~448 1314,~~724~~597,~~603~~485 ============ ============ NET LOSS $ (9,~~812~~705,~~486~~656) $ (~~411~~11,~~006~~359) Other comprehensive loss - Holding loss arising ~~during the six months, net of tax of $152,500~~ (228,748) -- ------------ ------------ during the nine months, net of tax of $152,500 COMPREHENSIVE LOSS $ (109,~~041~~934,~~234~~404) $ (~~411~~11,~~006~~359) ============ ============

See Notes to Consolidated Financial Statements. 5 6 SENSORY SCIENCE CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED) ~~SIX~~NINE MONTHS ENDED ~~SEPTEMBER~~DECEMBER 3031, -------------------------------------- 2000 1999 ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $(9,~~812~~705,~~486~~656) $ (~~411~~11,~~006~~359) Adjustments to reconcile net loss to net cash provided (used) by operations: Depreciation and amortization 1,~~079~~528,~~469~~498 ~~666~~1,~~910 Deferred taxes (278~~238,~~000)~~684 Change in operating assets and liabilities: Receivables 2203,~~192,642~~503 (83,~~976~~429,~~424~~251) Inventories (12,~~106~~458,~~856)~~086 ~~416~~(621,~~582~~894) Prepaids and other assets ~~(49~~92,~~574)~~347 (~~451~~84,~~552~~943) Accounts payable 7,~~921~~078,~~308~~691 12,~~488~~940,~~219~~430 Accrued expenses 92(270,~~163~~536) ~~461~~(814,~~338~~390) Other asset and liabilities, net (~~194~~189,~~425~~898) (~~174~~347,~~271~~410) ----------- ----------- Net cash provided by (used) in) operating activities ~~122~~1,~~241~~195,035 (71,~~258~~130,~~204~~133) ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES: Equipment and improvement expenditures (1,~~062~~069,~~811~~908) (1,~~079~~313,~~339~~640) Investment in discontinued operation 214,426 (~~299~~567,~~379~~321) Proceeds from disposal of discontinued operations 830,924 Proceeds from sale of investment 250,088 ----------- ----------- Net cash provided by (used) in) investing activities ~~232~~225,~~627~~530 (1,~~378~~880,~~718~~961) ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from the issuance of common stock ~~301~~306,~~407~~281 6442,~~244~~416 Net (repayments) borrowings under line of credit (~~593~~2,~~458~~563,343) 83,~~559~~622,~~520~~180 ----------- ----------- Net cash (used in) provided by financing activities (~~292~~2,~~051~~257,062) 83,~~623~~664,~~764~~596 ----------- ----------- NET ~~INCREASE~~ (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS ~~62,817~~ (13836,~~158~~497) 653,502 CASH AND CASH EQUIVALENTS, beginning of period 1,218,949 358,038 ----------- ----------- CASH AND CASH EQUIVALENTS, end of period $ 1382,~~281,766~~452 $ ~~344~~1,~~880~~011,540 =========== ===========

See Notes to Consolidated Financial Statements. 6 7 SENSORY SCIENCE CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED) FOR THE ~~SIX~~NINE MONTHS ENDED ~~SEPTEMBER~~DECEMBER 3031, ----------------------------- 2000 1999 -------- --------------------- SUPPLEMENTAL INFORMATION TO CASH FLOW STATEMENT: Cash paid for interest $~~735~~ 1,118,973 $~~576~~ 937,~~412~~644 Cash paid for income taxes $ --16,287 $ 1627,~~300~~787 SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES: Conversion of subordinated debt and accrued interest to common stock $ 236,691

See Notes to Consolidated Financial Statements. 7 8 SENSORY SCIENCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A - BASIS OF PREPARATION The consolidated financial statements include Sensory Science Corporation (the "Company" or "we") and its wholly owned subsidiary, California Audio Labs, LLC. This information should be read in conjunction with the financial statements set forth in the Sensory Science Corporation 2000 Annual Report to Stockholders for the fiscal year ended March 31, 2000 ("Fiscal 2000"). See the Capital Resources and Liquidity section of Management's Discussion and Analysis of Financial Condition and Results of Operations for a discussion of liquidity issues. Accounting policies utilized in the preparation of the financial information herein presented are the same as set forth in the Company's annual financial statements except as modified for interim accounting policies which are within the guidelines set forth in Accounting Principles Board Opinion No. 28, "Interim Financial Reporting." The interim consolidated financial statements are unaudited. In the opinion of management, all adjustments, consisting of normal recurring accruals, necessary to present fairly the financial position as of December 31, 2000, the results of operations for the quarters and nine months ended December 31, 2000 and 1999 and cash flows for the nine months ended December 31, 2000 and 1999 have been included. Interim results of operations are not necessarily indicative of the results of operations for the full year. Certain reclassifications have been made to the prior financial statements to conform to the current classifications. NOTE B - RECENT DEVELOPMENTS The Company announced on February 1, 2001 that it had entered into a definitive agreement to merge with a subsidiary of SONICblue, Inc. ("SONICblue") in a stock-for-stock transaction. The Company believes the combination of the two companies will provide the Company with the necessary resources to continue its digital product strategy while strengthening SONICblue's growing digital products portfolio and providing both companies with new marketing and distribution opportunities. SONICblue is a leader in the converging Internet, digital media and consumer device markets, with brands that include Rio(R) digital audio players, HomeFree(TM) home networking solutions, and Diamond(TM) Internet access products. Under the terms of the merger agreement unanimously approved by each company's board of directors, each outstanding share of the Company will be exchanged for 0.0710 shares of SONICblue common stock. This exchange ratio may be subject to adjustment at the consummation of the merger as provided for in the merger agreement. In connection with the merger, SONICblue has agreed, subject to certain conditions, to loan the Company $3 million for up to one year to provide working capital to fund operations. A portion of the funds will be directed to the Company's technology division, iCache, to support the continued development of the Company's media appliance initiative. In addition, in connection with the amounts of the loan to be drawn down from SONICblue, the Company will issue to SONICblue warrants to acquire up to a maximum of 5,357,142 shares of common stock of the Company at a price of $0.56 per share. The merger is structured to be tax-free to the Company's shareholders and will be accounted for as a purchase transaction. The merger agreement is subject to certain closing conditions, including customary consents and regulatory approvals and the approval of the Company's shareholders. The merger transaction is expected to close in approximately four months. Current plans call for the Company to retain its name and operate as a subsidiary of SONICblue at its current location in Scottsdale, Arizona. Working capital of the Company has declined from $8.3 million at the end of fiscal 2000 to a deficit of $1.0 million at the end of December 31, 2000. The Company experienced operating losses during the nine months ended December 31, 2000 due to decreases in unit volumes, increased sales allowances to customers and declining average selling prices on certain key products that has affected the Company's liquidity. While the Company reported a profit of approximately $.1 million during the third fiscal quarter and a 20.8% growth in sales, we were negatively affected during the quarter due to limited working capital, which limited our ability to purchase and sell product. We were able to meet our goal of improving asset management ratios during the quarter, but that did not generate sufficient cash for the Company to operate effectively and to fund necessary marketing, inventory purchase and product development programs, particularly as the Company enters into the seasonally slower sales periods. In connection with the merger, SONICblue has agreed, subject to certain conditions, to loan the Company $3 million for up to one year to provide working capital to fund operations. In addition, management is also continuing to address liquidity issues by obtaining price reductions with contract manufacturers and is reviewing certain strategic relationships and planned expenditures. Although there can be no assurance, the Company believes the merger will be completed. Both of the Company's 8 9 major suppliers have indicated support of the merger. However, if the merger is not completed, the Company will attempt to restructure, with the assistance of its two major suppliers, to support only their distribution needs. The Company believes that both of these suppliers will want to continue to distribute products in the United States and will provide the working capital to the Company necessary to accomplish this objective. Management believes that these actions and plans will provide sufficient working capital for the Company for the next twelve months. During the second quarter of the fiscal year, the Company announced a business reorganization to place more emphasis on sales and marketing initiatives and improve operational efficiency. As part of the reorganization, the Company consolidated its sales force to get closer to the customer, streamlined operations to be more responsive and increase efficiencies and shifted resources to marketing from other areas of our business. The overall corporate reorganization resulted in the reduction in total staff of about one-third, with the most significant reductions applying to manufacturing-related positions. As part of this overall reorganization, the Company incurred a one-time charge of approximately $1.5 million. Approximately $1.3 million of this one-time charge related to inventory and obsolete parts writedowns and the remaining $0.2 million was associated with severance costs. At December 31, 2000, approximately $835,000 of inventory, lease termination and severance reserves remain available for use. Management believes that the remaining reserves will be adequate for these obligations. NOTE C - DISCONTINUED OPERATIONS In fiscal 1999, the Company approved plans to dispose of its security products business to the former management of the business. A legal transfer of the assets occurred during May 2000. The Company has continued involvement in the new company through a seat on its Board of Directors. Cash proceeds from the disposal of this business during May 2000 amounted to $830,924, which represented the debt associated with the security products business. The debt was paid at closing using these proceeds. The disposition of the remaining net assets resulted in a loss of approximately $242,000, which approximated the reserve the Company had established of approximately $289,000. Therefore, the disposition did not have a material impact on the financial position of the Company. NOTE D - PRODUCT MANUFACTURING AND LICENSING The Market Exclusivity Fee of $1.1 million represents the unamortized balance of a $2.3 million fee paid by the Company to Loewe Opta GmbH ("Loewe Opta") for the exclusive right to market and distribute in North America a line of digital direct view televisions specifically developed and manufactured by Loewe Opta for the Company. An amendment to our agreement with Loewe Opta was completed in September 2000, modifying the territory to market and distribute these products to exclude Mexico and Canada. In exchange, we have received pricing concessions on certain models of digital direct view televisions purchased from Loewe Opta. In our opinion, the change in territory has a minimal effect on our marketing and sales strategy for these products. Accordingly, the carrying amount of the market exclusivity fee was not reduced. The Company began amortization of the fee in November 1998 on a straight-line basis over the initial term of the agreement which ended on January 1, 2003. This amendment reduces the initial term by one year and now expires on January 1, 2002. The amortization period has been adjusted accordingly. NOTE E - COMPANY OPERATIONS Beginning with the current fiscal year, sales of the Company's new digital products have constituted a majority of its revenues. For the prior four fiscal years, sales of the Company's Dual-Deck videocassette recorder have constituted substantially all of its revenue. For the nine months ended December 31, 2000, the Company's largest customer represented 20.7% of total revenues and the Company's second largest customer represented 16.7% of revenues. No other customer represented 10% or more of the Company's revenues. Accounts receivable at December 31, 2000 for the Company's largest customer and second largest customer amounted to approximately $2.0 million. NOTE F - RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities." In June 2000, the FASB issued SFAS No. 138, an amendment to SFAS No. 133. The Company will adopt these statements effective April 1, 2001. The statement requires that entities record all derivatives as assets or liabilities, measured at fair value, with the change in fair value recognized in earnings or in other comprehensive income, depending on the use of the derivative and 9 10 whether it qualifies for hedge accounting. We are in the process of evaluating the impact which will result upon adoption of this standard. In December 1999, the Securities and Exchange Commission ("SEC") released Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101"), that summarizes the SEC's views in applying generally accepted accounting principles to revenue recognition in financial statements. The adoption of SAB 101 did not have a material effect on our revenues or revenue recognition policy. NOTE G - SEGMENT INFORMATION We have adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 requires enterprises to report information about operating segments in annual financial statements and selected information about reportable segments in interim financial reports issued to stockholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. We operate in one business segment but track revenue by two product categories. Operating margins are not tracked separately by category. The following represents the revenue by product category for the quarters and nine months ended December 31:

2000 1999 --------------------------- ------------------------ $ % $ % ---------- ----- ---------- ----- QUARTERS ENDED ~~SEPTEMBER~~DECEMBER 3031: Dual-Deck VCR's 96,~~195~~516,~~230~~916 4926.74 1716,~~713~~972,~~877~~916 9083.51 New Digital Products 918,~~318~~177,~~275~~162 5073.36 13,~~869~~462,~~084~~505 916.59 ---------- ----- ---------- ----- Total 1824,~~513~~694,~~505~~078 100.0 1920,~~582~~435,~~961~~421 100.0 ========== ===== ========== ===== ~~SIX~~NINE MONTHS ENDED ~~SEPTEMBER~~DECEMBER 3031: Dual-Deck VCR's 1723,~~418~~935,~~255~~171 5944.74 2946,~~622~~595,~~986~~902 8786.90 New Digital Products 1129,~~778~~955,~~346~~508 4055.36 47,~~096~~558,~~159~~664 1214.10 ---------- ----- ---------- ----- Total 2953,~~196~~890,~~601~~679 100.0 3354,~~719~~154,~~145~~566 100.0 ========== ===== ========== =====

Our assets are all located in the United States and all sales were to customers in the United States and Canada. 10 11 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RECENT DEVELOPMENTS: The Company announced on February 1, 2001 that it had entered into a definitive agreement to merge with a subsidiary of SONICblue, Inc. ("SONICblue") in a stock-for-stock transaction. The Company believes the combination of the two companies will provide the Company with the necessary resources to continue its digital product strategy while strengthening SONICblue's growing digital products portfolio and providing both companies with new marketing and distribution opportunities. SONICblue is a leader in the converging Internet, digital media and consumer device markets, with brands that include Rio(R) digital audio players, HomeFree(TM) home networking solutions, and Diamond(TM) Internet access products. Under the terms of the merger agreement unanimously approved by each company's board of directors, each outstanding share of the Company will be exchanged for 0.0710 shares of SONICblue common stock. This exchange ratio may be subject to adjustment at the consummation of the merger as provided for in the merger agreement. In connection with the merger, SONICblue has agreed, subject to certain conditions, to loan the Company $3 million for up to one year to provide working capital to fund operations. A portion of the funds will be directed to the Company's technology division, iCache, to support the continued development of the Company's media appliance initiative. In addition, in connection with the amounts of the loan to be drawn down from SONICblue, the Company will issue to SONICblue warrants to acquire up to a maximum of 5,357,142 shares of common stock of the Company at a price of $0.56 per share. The merger is structured to be tax-free to the Company's shareholders and will be accounted for as a purchase transaction. The merger agreement is subject to certain closing conditions, including customary consents and regulatory approvals and the approval of the Company's shareholders. The merger transaction is expected to close in approximately four months. Current plans call for the Company to retain its name and operate as a subsidiary of SONICblue at its current location in Scottsdale, Arizona. Working capital of the Company has declined from $8.3 million at the end of fiscal 2000 to a deficit of $1.0 million at the end of December 31, 2000. The Company experienced operating losses during the nine months ended December 31, 2000 due to decreases in unit volumes, increased sales allowances to customers and declining average selling prices on certain key products that has affected the Company's liquidity. While the Company reported a profit of approximately $.1 million during the third fiscal quarter and a 20.8% growth in sales, we were negatively affected during the quarter due to limited working capital, which limited our ability to purchase and sell product. We were able to meet our goal of improving asset management ratios during the quarter, but that did not generate sufficient cash for the Company to operate effectively and to fund necessary marketing, inventory purchase and product development programs, particularly as the Company enters into the seasonally slower sales periods. In connection with the merger, SONICblue has agreed, subject to certain conditions, to loan the Company $3 million for up to one year to provide working capital to fund operations. In addition, management is also continuing to address liquidity issues by obtaining price reductions with contract manufacturers and is reviewing certain strategic relationships and planned expenditures. Although there can be no assurance, the Company believes the merger will be completed. Both of the Company's major suppliers have indicated support of the merger. However, if the merger is not completed, the Company will attempt to restructure, with the assistance of its two major suppliers, to support only their distribution needs. The Company believes that both of these suppliers will want to continue to distribute products in the United States and will provide the working capital to the Company necessary to accomplish this objective. Management believes that these actions and plans will provide sufficient working capital for the Company for the next twelve months. During the second quarter of the fiscal year, the Company announced a business reorganization to place more emphasis on sales and marketing initiatives and improve operational efficiency. As part of the reorganization, the Company consolidated its sales force to get closer to the customer, streamlined operations to be more responsive and increase efficiencies and shifted resources to marketing from other areas of our business. The overall corporate reorganization resulted in the reduction in total staff of about one-third, with the most significant reductions applying to manufacturing-related positions. As part of this overall reorganization, the Company incurred a one-time charge of approximately $1.5 million. Approximately $1.3 million of this one-time charge related to inventory and obsolete parts writedowns and the remaining $0.2 million was associated with severance costs. At December 31, 2000, approximately $835,000 of inventory, lease termination and severance reserves remain available for use. Management believes that the remaining reserves will be adequate for these obligations. RESULTS OF OPERATIONS 11 12 QUARTER ENDED DECEMBER 31, 2000 COMPARED WITH THE QUARTER ENDED DECEMBER 31, 1999: Net sales increased $4.3 million, or 20.8%, to $24.7 million during the quarter ended December 31, 2000 from $20.4 million during the quarter ended December 31, 1999. The increase in sales was primarily due to gross revenues of the new VCR/DVD combination product and a doubling of gross unit sales of digital televisions. Partially offsetting these improvements was an approximate 50% decrease in gross revenues and 42% decrease in units in the Dual-Deck VCR ("DDVCR") business. We expect that VCR/DVD product sales will account for approximately 50% of revenues in the quarter ended March 31, 2001. Other new products' gross revenues were down approximately 22% from the prior year's levels, primarily due to lower sales prices of RaveMP portable internet media players. Gross profit was approximately $5.4 million and $4.9 million for the quarters ended December 31, 2000 and December 31, 1999, respectively. Gross profit as a percentage of sales for the quarter ended December 31, 2000 was 22.0%, down from last year's levels of approximately 23.9%. The primary factor contributing to the decline in gross margins is a 19.3% decline in the average selling price of the DDVCR and to a lesser extent a 37.1% decline in the average selling price of digital televisions due to the higher mix of older 480p line of products. The digital television average selling price is expected to increase as the Company increases shipments of the new 1080i line or high definition compatible products. We anticipate that gross margins for the DDVCR business will continue to decline. Sales and marketing expense was approximately $2.6 million for the quarter ended December 31, 2000, down approximately $0.6 million in the second quarter, but up approximately $0.7 million from prior year levels. The increase in sales and marketing expense from last year's levels was primarily due to increased promotional costs for market development funds paid to customers. As a percentage of net sales, sales and marketing expense was 10.4% for the quarter ended December 31, 2000 compared to 9.2% for the quarter ended December 31, 1999. Research and development expense for the quarter ended December 31, 2000, although essentially flat with the second quarter of the fiscal year, increased from last year's levels by about $0.3 million for the same period due primarily to the Company's iCache initiatives. As a percentage of net sales, research and development expense was 3.2% for the quarter ended December 31, 2000 compared to 2.7% for the quarter ended December 31, 1999. General and administrative expense was up approximately $0.2 million from the prior year to $1.6 million due primarily to bad debt expense associated with the bankruptcy filing of a customer. General and administrative expense as a percentage of net sales was 6.4% for the quarter ended December 31, 2000 compared to 6.7% for the quarter ended December 31, 1999. Because of the above, the Company recorded operating income of $0.5 million for the quarter ended December 31, 2000 compared to $1.1 million for last year. We recorded net interest and other expense of approximately $0.4 million for each of the quarters ended December 31, 2000 and 1999. NINE MONTHS ENDED DECEMBER 31, 2000 COMPARED WITH NINE MONTHS ENDED DECEMBER 31, 1999: Net sales decreased approximately $0.3 million, or 0.5%, to $53.9 million during the nine months ended December 31, 2000 from $54.2 million during the nine months ended December 31, 1999. The decrease in sales was primarily due to a decline in gross revenues of DDVCRs by approximately 45% from the prior year's levels due to a 33.2% decrease in unit volumes and an 18.4% decline in average selling price. Nearly offsetting this decrease in the DDVCR business were sales of the new VCR/DVD combination product that began shipping to customers during September 2000. We expect the selling price of our DDVCR product line will continue to be under pressure, however we are continuing to work with our suppliers to obtain more favorable pricing and terms. We expect the VCR/DVD combination product sales will account for approximately 50% of revenues in the quarter ended March 31, 2001. Other new products' gross revenues were essentially unchanged from the prior year. We believe recent retail price moves in connection with lower negotiated purchase prices and the introduction of the new 1080i model may improve revenues from digital televisions. Gross profit was approximately $7.6 million and $12.2 million for the nine months ended December 31, 2000 and December 31, 1999, respectively. Gross profit as a percentage of sales for the nine months ended December 31, 2000 was 14.1%, down from last year's level of approximately 22.5%. The nine months ended December 31, 2000 includes a one-time charge of approximately $1.3 million relating to inventory writedowns of one model of our digital television, 12 13 certain internet media players and obsolete parts. Without this one-time charge, gross margins for the nine months ended December 31, 2000 would have been 16.6% of sales, down significantly from last year's levels. The primary factor contributing to the decline in gross margins is an 18.4% decline in the average selling price of the DDVCR and to a lesser extent a 26% decline in the average selling prices of digital televisions. We anticipate that future gross margins for the DDVCR business will continue to decline. Partially offsetting these declines was the strong average selling price of our new VCR/DVD combination product. Sales and marketing expense was approximately $8.6 million for the nine months ended December 31, 2000, up $3.4 million from the prior year. The increase in sales and marketing expense was primarily due to increased promotional costs for market development funds paid to customers and increased costs of consumer rebate programs. As a percentage of sales, sales and marketing expense was 15.9% for the nine months ended December 31, 2000 compared to 9.5% for the nine months ended December 31, 1999. Research and development expense for the nine months ended December 31, 2000 was down approximately $0.1 million from last year's levels due primarily to lower travel and design costs. As a percentage of sales, research and development expense was 4.2% for the nine months ended December 31, 2000 compared to 4.5% for the nine months ended December 31, 1999. General and administrative expense was up approximately $1.7 million from the prior year to $5.3 million due primarily to higher expenses associated with our information system infrastructure, overall salary costs and consulting expenditures. General and administrative expense for the nine months ended December 31, 2000 includes severance costs for staff reductions amounting to approximately $0.2 million. During the second quarter, we announced staff reductions that we expect will reduce payroll cost on an annual basis. General and administrative expense as a percentage of revenues, excluding the severance charges, was 9.6% for the nine months ended December 31, 2000 compared to 6.6% for the nine months ended December 31, 1999. Due to the above factors, the Company recorded an operating loss of $8.6 million for the nine months ended December 31, 2000 compared to operating income of $1.0 million for the nine months ended December 31, 1999. We recorded net interest and other expense of $1.1 million for the nine months ended December 31, 2000, up approximately $0.1 million from last year due to additional borrowings under our line of credit. SEASONALITY The Company's product lines compete within the consumer electronics industry, which generally experiences seasonal peaks in sales from September through January, covering the holiday selling season. The Company expects to continue to exhibit seasonal peaks of its sales in line with industry experience. FUTURE RESULTS Our expectations for results of operations and other forward - looking statements contained in this quarterly report on Form 10-Q, in particular statements concerning expected future revenues and expenses, expectations regarding the probability of and the benefits of the merger and expectations regarding the Company's liquidity, involve a number of risks and uncertainties. Some of the factors that could cause actual results to differ materially from those expected are provided in Exhibit 99.1 and the following: business conditions and general economic conditions; competitive factors, such as pricing and marketing efforts of rival companies; the willingness of suppliers to provide more favorable terms; timing of product introductions and consumer acceptance of new products; ability of contract manufacturers to meet product price objectives and delivery schedules; legislative, regulatory and industry initiatives that may affect planned or actual product features and marketing methods; the failure to consummate the pending merger transaction; and the pace and success of product research and development and acquisition initiatives. CAPITAL RESOURCES AND LIQUIDITY Net cash provided by operating activities was $1.2 million for the nine months ended December 31, 2000, representing an increase of $2.3 million as compared with the nine months ended December 31, 2000. The most significant factors comprising the net cash provided by operating activities for the nine months ended December 31, 2000 was a decrease in inventory levels due to the seasonality of our business, control of inventory purchases and changes in trade payables due to improved terms and an increase in the credit line with a major supplier of products sold by the Company. 13 14 The Company funds its cash requirements through a combination of cash flow from operations, a credit line from a major supplier and loans under a line of credit with Congress Financial Corporation. During the fiscal year, the Company's sales seasonality generally requires incremental working capital for investment primarily in inventories and receivables. The Company's primary source of funds for the nine months ended December 31, 2000 was the line of credit. The financing agreement with Congress Financial was first entered into in October 1992 and was last amended during June 2000. The maximum line of credit is $30.0 million, limited by a borrowing base determined by specific inventory and receivable balances. Interest is charged at prime plus 1/2%. The line is collateralized by all assets of the Company. The unused and available line of credit at December 31, 2000 was approximately $1.1 million. The Company's ability to purchase products sold in the marketplace to meet customer demand has been severely limited by the lack of availability of funds under the line of credit. The Company expects that the lack of funds under this line of credit will continue and may negatively affect the Company's results. The Company announced on February 1, 2001 that it had entered into a definitive agreement to merge with a subsidiary of SONICblue, Inc. ("SONICblue") in a stock-for-stock transaction. The Company believes the combination of the two companies will provide the Company with the necessary resources to continue its digital product strategy while strengthening SONICblue's growing digital products portfolio and providing both companies with new marketing and distribution opportunities. SONICblue is a leader in the converging Internet, digital media and consumer device markets, with brands that include Rio(R) digital audio players, HomeFree(TM) home networking solutions, and Diamond(TM) Internet access products. Under the terms of the merger agreement unanimously approved by each company's board of directors, each outstanding share of the Company will be exchanged for 0.0710 shares of SONICblue common stock. This exchange ratio may be subject to adjustment at the consummation of the merger as provided for in the merger agreement. In connection with the merger, SONICblue has agreed, subject to certain conditions, to loan the Company $3 million for up to one year to provide working capital to fund operations. A portion of the funds will be directed to the Company's technology division, iCache, to support the continued development of the Company's media appliance initiative. In addition, in connection with the amounts of the loan to be drawn down from SONICblue, the Company will issue to SONICblue warrants to acquire up to a maximum of 5,357,142 shares of common stock of the Company at a price of $0.56 per share. The merger is structured to be tax-free to the Company's shareholders and will be accounted for as a purchase transaction. The merger agreement is subject to certain closing conditions, including customary consents and regulatory approvals and the approval of the Company's shareholders. The merger transaction is expected to close in approximately four months. Current plans call for the Company to retain its name and operate as a subsidiary of SONICblue at its current location in Scottsdale, Arizona. Working capital of the Company has declined from $8.3 million at the end of fiscal 2000 to a deficit of $1.0 million at the end of December 31, 2000. The Company experienced operating losses during the nine months ended December 31, 2000 due to decreases in unit volumes, increased sales allowances to customers and declining average selling prices on certain key products that has affected the Company's liquidity. While the Company reported a profit of approximately $.1 million during the third fiscal quarter and a 20.8% growth in sales, we were negatively affected during the quarter due to limited working capital, which limited our ability to purchase and sell product. We were able to meet our goal of improving asset management ratios during the quarter, but that did not generate sufficient cash for the Company to operate effectively and to fund necessary marketing, inventory purchase and product development programs, particularly as the Company enters into the seasonally slower sales periods. In connection with the merger, SONICblue has agreed, subject to certain conditions, to loan the Company $3 million for up to one year to provide working capital to fund operations. In addition, management is also continuing to address liquidity issues by obtaining price reductions with contract manufacturers and is reviewing certain strategic relationships and planned expenditures. Although there can be no assurance, the Company believes the merger will be completed. Both of the Company's major suppliers have indicated support of the merger. However, if the merger is not completed, the Company will attempt to restructure, with the assistance of its two major suppliers, to support only their distribution needs. The Company believes that both of these suppliers will want to continue to distribute products in the United States and will provide the working capital to the Company necessary to accomplish this objective. Management believes that these actions and plans will provide sufficient working capital for the Company for the next twelve months. During the second quarter of the fiscal year, the Company announced a business reorganization to place more emphasis on sales and marketing initiatives and improve operational efficiency. As part of the reorganization, the Company consolidated its sales force to get closer to the customer, streamlined operations to be more responsive and increase efficiencies and shifted resources to marketing from other areas of our business. The overall corporate reorganization resulted in the reduction in total staff of about one-third, with the most significant reductions applying to 14 15 manufacturing-related positions. As part of this overall reorganization, the Company incurred a one-time charge of approximately $1.5 million. Approximately $1.3 million of this one-time charge related to inventory and obsolete parts writedowns and the remaining $0.2 million was associated with severance costs. At December 31, 2000, approximately $835,000 of inventory, lease termination and severance reserves remain available for use. Management believes that the remaining reserves will be adequate for these obligations. INFLATION Inflation has had no material effect on the Company's operations or financial condition. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company does not utilize market risk sensitive instruments. The Company believes that moderate interest rate increases will not have a material adverse impact on its results of operations or financial position in the foreseeable future. PART II. OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (A) Exhibits 3.1 Certificate of Incorporation of the Company. Incorporated by reference to Exhibit 3-A of the Company's S-1 Registration Statement No. 33-17277. 3.2 Amendment to Certificate of Incorporation. Incorporated by reference to the Company's Form 8-K filing dated March 2, 1999. 3.3 Bylaws of the Company. Incorporated by reference to Exhibit 4-B to the Company's S-2 Registration Statement No. 33-38445. 10.40 Agreement and Plan of Merger among Sensory Science Corporation, Phoenix Acquisition Corp., and SONICblue Incorporated dated January 31, 2001. Filed Herewith. 10.41 Credit Agreement by and between Sensory Science Corporation and SONICblue Incorporated dated February 1, 2001. Filed Herewith. 10.42 Form of Common Stock Purchase Warrant Agreement between Sensory Science Corporation and SONICblue Incorporated dated January 31, 2001. Filed Herewith. 99.1 Safe Harbor Compliance Statement for Forward-Looking Statements (B) Reports on Form 8-K. There were no reports filed on Form 8-K during the quarter ended December 31, 2000. 15 16 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SENSORY SCIENCE CORPORATION (Registrant) Date: February 14, 2001 By /s/ Roger B. Hackett ---------------------------------------- Roger B. Hackett Chairman of the Board, Chief Executive Officer, President and Chief Operating Officer Date: February 14, 2001 By /s/ Thomas E. Linnen ---------------------------------------- Thomas E. Linnen Executive Vice President (principal financial and accounting officer) 16

Nominee Votes For Votes Withheld --------------------- ---------- -------------- Thomas F. Hartley, Jr 12,030,079 777,466 Carmine F. Adimando 12,040,979 766,566

Votes For Abstentions Votes Against Broker Non-votes --------- ----------- ------------- ---------------- 2,994,560 272,558 1,340,176 8,200,251

Votes For Abstentions Votes Against Broker Non-votes --------- ----------- ------------- ---------------- 2,867,579 296,506 1,443,209 8,200,251

Votes For Abstentions Votes Against Broker Non-votes --------- ----------- ------------- ----------------- 2,709,723 148,809 1,748,762 8,200,251

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