News Column

COPYTELE INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.

June 16, 2014

GENERAL

As used herein, "we," "us," "our," the "Company", "CopyTele" or "CTI" means CopyTele, Inc. and its wholly-owned subsidiaries, unless otherwise indicated. The primary operations of the Company involve the development, acquisition, licensing, and enforcement of patented technologies that are either owned or controlled by the Company. The Company currently owns or controls 9 patent portfolios including Encrypted Mobile Communication; ePaper® Electrophoretic Display; Internet Telephonic Gateway; J-Channel Window Frame Construction; Key Based Web Conferencing Encryption; Loyalty Conversion Systems; Micro Electro Mechanical Systems Display; Nano Field Emission Display; and VPN Multicast Communications.

As part of our patent assertion activities and in the ordinary course of our business, the Company has initiated and will likely continue to initiate patent infringement lawsuits, and engage in patent infringement litigation. In March of 2013, the Company initiated its sixth patent assertion campaign, bringing the total number of lawsuits since we implemented our patent monetization business model in January of 2013, to 42.

Our primary source of revenue will come from licenses resulting from the unauthorized use of our patented technologies, including the settlement of patent infringement lawsuits. For the fiscal quarter ended April 30, 2014, the Company entered into 5 revenue producing license and/or settlement agreements including agreements with Logitech Inc. in connection with our patented Key Based Web Encryption technology, and HWD Acquisition, Inc., PGT Industries, Inc., MI Window and Doors LLC, and YKK-AP American Inc., in connection with our patented J-Channel Window Frame Construction technology. These licenses resolved lawsuits that were pending against the aforementioned companies.

Since implementing our new business model in January of 2013, the Company has entered into a total of 9 revenue producing license and/or settlement agreements, and 3 of our 6 patent assertion campaigns have generated revenue. As a result of our license/settlement agreements, the Company currently has 33 pending patent infringement lawsuits.

In addition to continuing to mine and monetize our existing patents, our wholly owned subsidiary, CTI Patent Acquisition Corporation, will continue to acquire patents and the exclusive rights to license and enforce patents from third parties. When necessary, we will assist such parties in the further development of their patent portfolios through the filing of additional patent applications.

In April 2013, CopyTele, through its wholly owned subsidiary, CTI Patent Acquisition Corporation, acquired the exclusive rights to license and enforce patent portfolios relating to (i) loyalty awards programs commonly provided by airlines, credit card companies, hotels, retailers, casinos, and others, and (ii) vinyl windows with integrated J-Channels, commonly used in modular buildings, mobile homes, and conventional, new construction.

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In November 2013, CTI Patent Acquisition Corporation acquired 2 patent portfolios in the rapidly expanding area of unified communications relating to (i) the multicast Internet delivery of streaming data, media, and other content, within the confines of specialized virtual private networks, and (ii) the integration of telephonic participation in web-based audio/video conferences by creating a gateway between the Internet and cellular or traditional landline telephones.

Due to arrangements previously entered into by the Company, certain of our patents contain encumbrances which may negatively impact our patent monetization and patent assertion activities. Where we are able, we will take the steps necessary to remove any encumbrances that may inhibit our patent monetization and patent assertion activities.

Patent Monetization and Patent Assertion

Patent monetization is the generation of revenue and proceeds from patents and patented technologies ("Patent Monetization"). Patent assertion is a specialized type of Patent Monetization where a patent owner, or a representative of the patent owner, seeks to prohibit or collect royalties from the unauthorized manufacture, sale, and use of the owner's patented invention ("Patent Assertion"). CTI's business model is Patent Monetization and Patent Assertion.

CTI's Patent Portfolios



Encrypted Mobile Communications

The Encrypted Mobile Communications patent portfolio covers hardware and software used to encrypt cellular phone calls and other mobile communications.

With the increased use of mobile devices, and the increased concerns regarding privacy and the protection of personal information, we believe the demand for secure mobile communications is increasing for both businesses and consumers.

ePaper® Electrophoretic Display

The ePaper® Electrophoretic Display patent portfolio covers core electrophoretic technology that is used in the world's most popular eReader devices such as the Nook® and the Kindle. The ePaper patents cover the underlying chemistry that is used to manufacture both the particles and the suspension, two of the key elements that are fundamental to the generation of the black and white eReader display. CTI's ePaper patents also cover the manufacturing, assembly, and physical structure of the display unit itself, as well as the electronics and internal operation of the device.

Internet Telephonic Gateway



The internet telephonic gateway patent portfolio covers the integration of telephonic participation in web-based audio/video conferences by creating a gateway between the Internet, and cellular or traditional landline telephones. The end result is that participants can join and participate in online, audio/video conferences via a cellular or conventional telephone. This internet telephonic gateway technology is commonly used for web based audio/video events with broad based audience participation such as earnings calls, webinars, and virtual town hall meetings.

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J-Channel Window Frame Construction

The J-Channel Window Frame Construction patent portfolio covers vinyl windows with an integrated frame, known in the industry as a "J-Channel". Such windows are commonly used in modular buildings, mobile homes, and conventional, new home construction, resulting in easier and faster window installation.

Key Based Web Conferencing Encryption

The Key Based Web Conferencing Encryption patent portfolio covers the generation and management of encryption keys. This type of encryption technology is commonly used to encrypt web-based conferencing, email for regulatory compliance purposes, and personal information such as contracts.

Loyalty Conversion Systems

The Loyalty Conversion System patent portfolio covers coalition loyalty awards programs commonly provided by airlines, credit card companies, hotels, retailers, casinos, and others. The portfolio covers the electronic conversion of non-negotiable, loyalty awards points into negotiable funds used to purchase goods and services from third parties, as well as covering the electronic conversions of awards points into points and awards provided by other loyalty program providers.

Micro Electro Mechanical Systems Display

The Micro Electro Mechanical Systems Display patent portfolio covers vanadium dioxide coated pixels that electrically modulate light at extremely high speeds to form an image, as well as the use of electrostatic force to move pixel sized membranes that create a color image. These are emerging, low voltage, display technologies with numerous potential commercial applications.

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Table of Contents Nano Field Emission Display



The Nano Field Emission Display patent portfolio covers a new type of flat panel display consisting of low voltage color phosphors, specially coated carbon nanotubes, nano materials to generate secondary electrons, and ionized noble gas, resulting in a bright, sharp, high contrast color image. This emerging technology could result in a flat panel display utilizing less power, with better picture quality and lower manufacturing costs than is currently found in the flat panel display industry.

VPN Multicast Communications



The VPN Multicast Communications patent portfolio covers the multicast, internet delivery of streaming data, media, and other content to large numbers of recipients, within the confines of specialized virtual private networks ("VPN's). Multicasting is a commonly used content delivery protocol that enables several recipients to simultaneous receive content from a single internet transmission, greatly reducing Internet bandwidth costs. When combined with specialized VPN's, the content and communications are protected from unwanted disclosure and piracy. Applications for these live, VPN multicast communications include videoconferences, online training and e-learning classes, internet television, web-based corporate events and strategy sessions, and other live transmissions of sensitive or protected content.

RESULTS OF OPERATIONS



Six months ended April 30, 2014 compared to the six months ended April 30, 2013

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Revenue from Patent Assertion Activities

For the six months ended April 30, 2014, we recorded revenue of $1,105,000, from 5 license agreements issued from our Key Based Web Conferencing Encryption and J-Channel Window Frame Construction patent portfolios. The license agreements provided for one-time, non-recurring, lump sum payments in exchange for a non-exclusive retroactive and future license, or covenant not to sue.

Accordingly, the earning process from these licenses was complete and 100% of the revenue was recognized upon execution of the license agreements. There was no revenue in the six months ended April 30, 2013.

The Company currently owns or controls 9 patent portfolios. Since implementing our new business model in January of 2013, the Company has initiated 42 lawsuits in connection with 6 of our patent portfolios. As of April 30, 2014, 9 license agreements have been issued and the Company has 33 active lawsuits over 6 patent portfolios. Our primary source of revenue will come from licenses resulting from the unauthorized use of our patented technologies, including the settlement of patent infringement lawsuits

Inventor Royalties and Contingent Legal Fees

Inventor royalties and contingent legal fees of approximately $465,000 during the six months ended April 30, 2014 are attributable to our patent assertion activities initiated during fiscal 2013, and are expensed in the period that the related revenues are recognized. Inventor royalties and contingent legal fees, as a percentage of revenue from patent assertion activities, will vary between fiscal periods since the economic terms of patent agreements and contingent legal fee arrangements vary across the patent portfolios owned or controlled by our operating subsidiaries. We did not incur any inventor royalties or contingent legal fees during the six months ended April 30, 2013, as we recognized no revenues during this period.

Litigation and Licensing Expenses

Litigation and licensing expenses increased by approximately $97,000 to approximately $104,000 in the six months ended April 30 2014, from approximately $7,000 in the comparable period year period. Litigation and licensing expenses, which are attributable to our patent assertion activities initiated during fiscal 2013 and the AUO/E Ink Lawsuit, are expensed in the period incurred.

Amortization of Patents



Amortization of patents of approximately $152,000 in the six months ended April 30, 2014 is related to patent portfolios acquired in the first quarter of fiscal 2014. We did not incur any patent amortization expense during the six months ended April 30, 2013.

Marketing, General and Administrative Expenses

Marketing, general and administrative expenses decreased by approximately $213,000 to approximately $3,704,000 in the six months ended April 30, 2014, from approximately $3,917,000 in the comparable prior-year period. The decrease in marketing, general and administrative expenses was principally due to a decrease in legal and accounting fees of approximately $458,000, a decrease in rent expense of approximately $242,000 and a decrease in shareholder relations expense of approximately $156,000, offset by an increase in employee compensation, excluding stock option expense, of approximately $271,000 which was primarily attributable to employee bonuses, a bonus paid to the Company's strategic advisor and a director of the Company of $100,000 and an increase in stock option expense for this strategic advisor and director of the Company of approximately $461,000.

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Legal and accounting fees in 2013 included nonrecurring costs related to the Company's restructuring, which commenced in the fourth quarter of the fiscal year 2012. The decrease in rent expenses reflects the reduction in facilities requirements as a result of the Company's restructuring. Marketing, general and administrative expense for the six months ended April 30, 2014 and 2013 includes approximately $1,877,000 and $1,455,000, respectively, of non-cash stock option compensation expense.

Change in Value of Derivative Liability

Change in value of derivative liability was a loss of approximately $2,311,000 in the six months ended April 30, 2014 compared to a gain of $210,000 in the comparable prior year period. The derivative liability represents the bifurcated conversion features of the January 2013 Convertible Debentures and the November 2013 Convertible Debenture. An increase in the price of our common stock results in an increase in derivative liability and a loss from change in value of derivative liability. See Note 2 to the condensed consolidated financial statements for additional information.

Loss on Extinguishment of Debt

During the six months ended April 30, 2014, holders of $1,240,000 of the Convertible Debentures due January 2015 converted their holdings into 8,267,080 shares of Common Stock and holders of $200,000 of principal of Convertible Debentures due January 2015 consented to prepayment of obligations to them. In connection with these conversions and prepayments, the Company recorded a loss on extinguishment of debt of approximately $483,000 in the six months ended April 30, 2014, compared to $-0- in the comparable prior year period. See Note 2 to the condensed consolidated financial statements for additional information.

Interest Expense



Interest expense decreased by approximately $57,000 to approximately $801,000 in the six months ended April 30, 2014 from approximately $858,000 in the prior year period. Interest expense in the six months ended April 30, 2014 and 2013 includes approximately $447,000 and $103,000, respectively, of amortization of debt discount on convertible debentures, approximately $186,000 and $-0-, respectively, of amortized interest on our patent acquisition obligation and approximately $99,000 and $-0-, respectively, of accrued interest on the November 2013 convertible debentures. During the six months ended April 30, 2013, the convertible debentures due September 2016 were converted into shares of common stock. The conversion of these debentures resulted in a charge to interest expense of approximately $717,000 during the six months ended April 30, 2013. There was no charge to interest expense related to the conversion of debentures in the current fiscal period.

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Table of Contents Dividend Income



Dividend income of approximately $48,000 received in the six months ended April 30, 2014 was related to the Videocon GDR's. There was no dividend income received in the six months ended April 30, 2013.

Interest Income



Interest income increased to approximately $3,000 in the six months ended April 30, 2014 compared to approximately $-0- in the six months ended April 30, 2013 due to the increased amount of short term investments during the current period.

Three months ended April 30, 2014 compared with three months ended April 30, 2013

Revenue from Patent Assertion Activities

For the three months ended April 30, 2014, we recorded revenue of $1,105,000, from 5 license agreements issued from our Key Based Web Conferencing Encryption and J-Channel Window Frame Construction patent portfolios. The license agreements provided for one-time, non-recurring, lump sum payments in exchange for a non-exclusive retroactive and future license, or covenant not to sue.

Accordingly, the earning process from these licenses was complete and 100% of the revenue was recognized upon execution of the license agreements. There was no revenue in the three months ended April 30, 2013.

Inventor Royalties and Contingent Legal Fees

Inventor royalties and contingent legal fees of approximately $465,000 during the three months ended April 30, 2014 are attributable to our patent assertion activities initiated during fiscal 2013, and are expensed in the period that the related revenues are recognized. Inventor royalties and contingent legal fees, as a percentage of revenue from patent assertion activities, will vary between fiscal periods since the economic terms of patent agreements and contingent legal fee arrangements vary across the patent portfolios owned or controlled by our operating subsidiaries. We did not incur any inventor royalties or contingent legal fees during the three months ended April 30, 2013, as we recognized no revenues during this period.

Litigation and Licensing Expenses

Litigation and licensing expenses increased by approximately $64,000 to approximately $71,000 in the three months ended April 30 2014, from approximately $7,000 in the comparable period year period. Litigation and licensing expenses, which are attributable to our patent assertion activities initiated during fiscal 2013 and the AUO/E Ink Lawsuit, are expensed in the period incurred.

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Table of Contents Amortization of Patents



Amortization of patents of approximately $81,000 in the three months ended April 30, 2014 is related to patent portfolios acquired in the first quarter of fiscal 2014. We did not incur any patent amortization expense during the three months ended April 30, 2013.

Marketing, General and Administrative Expenses

Marketing, general and administrative expenses decreased by approximately $1,000 to approximately $1,843,000 in the three months ended April 30, 2014, from approximately $1,844,000 in the comparable prior-year period. The decrease in marketing, general and administrative expenses was principally due to a decrease in legal and accounting fees of approximately $147,000 and a decrease in shareholder relations expense of approximately $206,000, offset by an increase in stock option expense for the Company's strategic advisor and a director of the Company of $447,000. Marketing, general and administrative expense for the three months ended April 30, 2014 and 2013 includes approximately $1,156,000 and $741,000, respectively, of non-cash stock option expense.

Change in Value of Derivative Liability

Change in value of derivative liability was a loss of approximately $991,000 in the three months ended April 30, 2014 compared to a gain of $210,000 in the comparable prior year period. The derivative liability represents the bifurcated conversion features of the January 2013 Convertible Debentures and the November 2013 Convertible Debenture. An increase in the price of our common stock or the conversion of debentures into shares of our common stock results in an increase in derivative liability and a loss from change in value of derivative liability. See Note 2 to the condensed consolidated financial statements for additional information.

Loss on Extinguishment of Debt

During the three months ended April 30, 2014 holders of $1,240,000 of the Convertible Debentures due January 2015 converted their holdings into 8,267,080 shares of Common Stock and holders of $200,000 of principal of Convertible Debentures due January 2015 consented to prepayment of obligations to them. In connection with these conversions and prepayments the Company recorded a loss on extinguishment of debt of approximately $483,000 in the three months ended April 30, 2014 compared to $-0- in the comparable prior year period. See Note 2 to the condensed consolidated financial statements for additional information.

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Table of Contents Interest Expense



Interest expense decreased by approximately $413,000 to approximately $422,000 in the three months ended April 30, 2014 from approximately $835,000 in the prior year period. Interest expense in the three months ended April 30, 2014 and 2013 includes approximately $229,000 and $83,000, respectively, of amortization of debt discount on convertible debentures, approximately $100,000 and $-0-, respectively, of amortized interest on our patent acquisition obligation and approximately $53,000 and $-0-, respectively, of accrued interest on the November 2013 convertible debentures. During the three months ended April 30, 2013, the convertible debentures due September 2016 were converted into shares of common stock.The conversion of these debentures resulted in a charge to interest expense of approximately $717,000 during the three months ended April 30, 2013. There was no charge to interest expense related to the conversion of debentures in the current fiscal period.

Interest Income



Interest income increased to approximately $2,000 in the three months ended April 30, 2014 compared to approximately $-0- in the three months ended April 30, 2013 due to the increased amount of short term investments during the current period.

LIQUIDITY AND CAPITAL RESOURCES

Our primary sources of liquidity are cash, cash equivalents and short term investments on hand generated from our operating activities and proceeds from previous financing.

Based on currently available information, the Company believes that its existing cash, cash equivalents, short-term investments and accounts receivable, and expected cash flows from patent licensing and enforcement, and other potential sources of cash flows will be sufficient to enable it to continue our patent licensing and enforcement activities for at least 12 months. However, our projections of future cash needs and cash flows may differ from actual results. If current cash on hand and cash that may be generated from the Stock Purchase Agreement and from patent licensing and enforcement activities are insufficient to satisfy our liquidity requirements, we may seek to sell equity securities or obtain loans from various financial institutions where possible. The sale of additional equity securities or convertible debt could result in dilution to our shareholders. We can give no assurance that we will generate sufficient cash flows in the future (through licensing and enforcement of patents, or otherwise) to satisfy our liquidity requirements or sustain future operations, or that other sources of funding, such as sales of equity or debt, would be available, if needed, on favorable terms or at all. We can also give no assurance that we will have sufficient funds to repay our outstanding indebtedness. If we cannot obtain such funding if needed or if we cannot sufficiently reduce operating expenses, we would need to curtail or cease some or all of our operations. Curtailing or ceasing some of our operations could jeopardize our future strategic initiatives and business plans.

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During the six months ended April 30, 2014, cash used in operating activities was approximately $1,680,000. Cash used in investing activities during the six months ended April 30, 2014 was $2,051,000, which resulted from the purchase of certificates of deposit totaling $2,700,000 which was partially offset by the sale of certificates of deposit totaling $650,000. Our cash provided by financing activities during the six months ended April 30, 2014 was approximately $3,451,000, which resulted from the sale of convertible debentures in a private placement for $3,500,000 and the proceeds from exercise of warrants to purchase common stock of approximately $150,000, offset by the payment to redeem convertible debentures of $200,000. As a result, our cash, cash equivalents, and short-term investments at April 30, 2014 increased approximately $1,770,000 to approximately $2,668,000 from approximately $898,000 at the end of fiscal year 2013.

The majority of accounts receivable at April 30, 2014 of approximately $828,000 are scheduled to be collected in the third quarter of fiscal 2014. The majority of royalties and contingent legal fees payable at April 30, 2014 of approximately $483,000 are scheduled to be paid in the third quarter of fiscal 2014.

In April 2013, the Company entered into a common stock purchase agreement (the "Stock Purchase Agreement") with Aspire Capital, which provides that Aspire Capital is committed to purchase up to an aggregate of $10 million of shares of the Company's common stock over the two-year term of the agreement. In order to sell shares under the Stock Purchase Agreement, the Company was required to have a registration statement covering the shares issued to Aspire Capital declared effective by the Securities and Exchange Commission (the "SEC"). Such registration statement was declared effective by the SEC in June 2013 and a post-effective amendment was declared effective by the SEC in February 2014. Under the Stock Purchase Agreement there are two ways that the Company can elect to sell shares of common stock to Aspire Capital. On any business day the Company can select: (1) through a regular purchase of up to 200,000 shares (but not to exceed $200,000) at a known price based on the market price of the Company's common stock prior to the time of each sale, and (2) through a volume-weighted average price, or VWAP, purchase of a number of shares up to 30% of the volume traded on the purchase date at a price equal to the lesser of (i) the closing sale price on the purchase date or (ii) 95% of the VWAP for such purchase date. The Company can only require a VWAP purchase if the closing sale price for our Common Stock on the notice day for the VWAP purchase is higher than $0.50. The number of shares covered by and the timing of, each purchase notice are determined by the Company at its sole discretion. The Company cannot execute any sales under the Stock Purchase Agreement when the closing for our common stock is less than $0.15. Aspire Capital has no right to require any sales from us, but is obligated to make purchases as directed in accordance with the Stock Purchase Agreement. During fiscal year 2013 the Company sold 5,380,000 shares of our common stock to Aspire Capital for approximately $1,092,000. No shares of our common stock were sold to Aspire Capital during the six months ended April 30, 2014.

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The following table presents our expected cash requirements for contractual obligations outstanding as of April 30, 2014:

Payments Due by Period Less than 1-3 3-5 After Contractual Obligations 1 year years years 5 years Total Non-cancelable Operating Leases $ 87,000 $ - $ - $ - $ 87,000 Convertible Debentures due 2016 - 3,500,000 - - 3,500,000 Patent acquisition obligation - - 3,036,745 - 3,036,745 Secured Loan Obligation to Mars Overseas Limited (1) 5,000,000 - - - 5,000,000 Total Contractual Cash Obligations $5,087,000$3,500,000$3,036,745 $ - $11,623,745



(1) The secured loan obligation to Mars Overseas Limited (an affiliate of Videocon) is solely a liability of our wholly owned subsidiary, CopyTele International Ltd., without recourse to CopyTele, Inc., and is secured by CopyTele International Ltd.'s investment in Videocon GDRs. Accordingly, if the loan obligation is not paid when due, the Videocon GDRs with a market value as of April 30, 2014 of approximately $3,977,000 would be surrendered to Mars Overseas Limited.

Critical Accounting Policies



The Company's condensed consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. In preparing these financial statements, we make assumptions, judgments and estimates that can have a significant impact on amounts reported in our consolidated financial statements. We base our assumptions, judgments and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. On a regular basis, we evaluate our assumptions, judgments and estimates and make changes accordingly.

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We believe that, of the significant accounting policies discussed in Note 2 to our consolidated financial statements in our Annual Report on Form 10-K for the fiscal year ended October 31, 2013, the following accounting policies require our most difficult, subjective or complex judgments:

†† Revenue Recognition;

†† Investment Securities;

† Stock-Based Compensation; and

† Convertible Debentures Revenue Recognition



Revenue is recognized when (i) persuasive evidence of an arrangement exists, (ii) all obligations have been substantially performed pursuant to the terms of the arrangement, (iii) amounts are fixed or determinable, and (iv) the collectability of amounts is reasonably assured.

In general, patent revenue arrangements provide for the payment of contractually determined fees in consideration for the grant of certain intellectual property rights for patented technologies owned or controlled by our operating subsidiaries. These rights typically include some combination of the following: (i) the grant of a non-exclusive, retroactive and future license to manufacture and/or sell products covered by patented technologies owned or controlled by our operating subsidiaries, (ii) a covenant-not-to-sue, (iii) the release of the licensee from certain claims, and (iv) the dismissal of any pending litigation. The intellectual property rights granted are perpetual in nature, extending until the expiration of the related patents. Pursuant to the terms of these agreements, our operating subsidiaries have no further obligation with respect to the grant of the non-exclusive retroactive and future licenses, covenants-not-to-sue, releases, and other deliverables, including no express or implied obligation on our operating subsidiaries' part to maintain or upgrade the technology, or provide future support or services. Generally, the agreements provide for the grant of the licenses, covenants-not-to-sue, releases, and other significant deliverables upon execution of the agreement. As such, the earnings process is complete and revenue is recognized upon the execution of the agreement, when collectability is reasonably assured, and when all other revenue recognition criteria have been met.

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Table of Contents Investment Securities



We classify our investment securities as available-for-sale. Available-for-sale securities are recorded at fair value. Unrealized gains and losses, net of the related tax effect, on available-for-sale securities are excluded from earnings and are reported as a component of accumulated other comprehensive income (loss) until realized. Realized gains and losses from the sale of available-for-sale securities are determined on a specific identification basis. Dividend and interest income are recognized when earned.

We monitor the value of our investments for indicators of impairment, including changes in market conditions and the operating results of the underlying investment that may result in the inability to recover the carrying value of the investment. In evaluating our investment in Videocon GDR's at October 31, 2013, we determined that based on both the duration and continuing magnitude of the market price decline compared to the carrying cost basis of approximately $5,382,000, and the uncertainty of its recovery we recorded a write-down of the investment of approximately of $1,185,000 and established a new cost basis of approximately $4,197,000. During the six months ended April 30, 2014, we recorded an unrealized loss on our investment of approximately $220,000.

Stock-Based Compensation

We account for stock options granted to employees and directors using the accounting guidance in ASC 718. We recognize compensation expense for stock option awards over the requisite or implied service period of the grant. We recorded stock-based compensation expense, related to stock options granted to employees and directors, of approximately $989,000 and $1,028,000 during the six months ended April 30, 2014 and 2013, respectively, and approximately $524,000 and approximately $555,000 during the three months ended April 30, 2014 and 2013, respectively. We account for stock options granted to consultants using the accounting guidance under ASC 505-50. We recognized stock-based compensation expense for stock options granted to non-employee consultants during the six months ended April 30, 2014 and 2013, of approximately $888,000 and $427,000, respectively, and for the three months ended April 30, 2014 and 2013 of approximately $633,000 and approximately $185,000, respectively.

Determining the appropriate fair value model and calculating the fair value of stock-based awards requires judgment, including estimating stock price volatility, forfeiture rates and expected term. If factors change and we employ different assumptions in the application of ASC 718 and ASC 505-50 in future periods, the compensation expense that we record may differ significantly from what we have recorded in the current period. See Note 3 to the condensed consolidated financial statements for additional information.

Convertible Instruments



The Company accounts for hybrid contracts that feature conversion options in accordance with applicable generally accepted accounting principles ("GAAP").

ASC 815 "Derivatives and Hedging Activities," ("ASC 815") requires companies to bifurcate conversion options from their host instruments and account for them as free standing derivative financial instruments according to certain criteria. The criteria includes circumstances in which (a) the economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract, (b) the hybrid instrument that embodies both the embedded derivative instrument and the host contract is not re-measured at fair value under otherwise applicable generally accepted accounting principles with changes in fair value reported in earnings as they occur and (c) a separate instrument with the same terms as the embedded derivative instrument would be considered a derivative instrument.

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Conversion options that contain variable settlement features such as provisions to adjust the conversion price upon subsequent issuances of equity or equity linked securities at exercise prices more favorable than that featured in the hybrid contract generally result in their bifurcation from the host instrument.

The Company accounts for convertible instruments, when the Company has determined that the embedded conversion options should not be bifurcated from their host instruments, in accordance with ASC 470-20 "Debt with Conversion and Other Options" ("ASC 470-20"). Under ASC 470-20 the Company records, when necessary, discounts to convertible notes for the intrinsic value of conversion options embedded in debt instruments based upon the differences between the fair value of the underlying common stock at the commitment date of the note transaction and the effective conversion price embedded in the note. The Company accounts for convertible instruments (when the Company has determined that the embedded conversion options should be bifurcated from their host instruments) in accordance with ASC 815. Under ASC 815, a portion of the proceeds received upon the issuance of the hybrid contract are allocated to the fair value of the derivative. The derivative is subsequently marked to market at each reporting date based on current fair value, with the changes in fair value reported in results of operations.

EFFECT OF RECENTLY ISSUED PRONOUNCEMENTS

In July 2013, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update 2013-11 ("ASU 2013-11") which requires the netting of unrecognized tax benefits against a deferred tax asset for a loss or other carry forward that would apply in settlement of the uncertain tax positions. Under the new standard, unrecognized tax benefits will be netted against all available same-jurisdiction loss or other tax carry forwards that would be utilized, rather than only against carry forwards that are created by the unrecognized tax benefits. ASC 2013-11 is effective for fiscal years and interim periods within those fiscal years beginning on or after December 15, 2013. The adoption of ASC 213-11 on November 1, 2014 is not expected to have a material effect on our consolidated financial statements.

In May 2014, the FASB issued Accounting Standards Update 2014-09 ("ASU 2014-09"), "Revenue from Contracts with Customers". The amendments in ASU 2014-9 create Topic 606, Revenue from Contracts with Customers, and supersede the revenue recognition requirements in Topic 605, Revenue Recognition, including most industry-specific revenue recognition guidance. In addition, the amendments supersede the cost guidance in Subtopic 605-35, Revenue Recognition-Construction-Type and Production-Type Contracts, and create new Subtopic 340-40, Other Assets and Deferred Costs-Contracts with Customers. In summary, the core principle of Topic 606 is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASC 2014-09 is effective for fiscal years and interim periods within those fiscal years beginning on or after December 15, 2016. The adoption of ASC 213-11 on November 1, 2017 is not expected to have a material effect on our consolidated financial statements.

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Table of Contents FORWARD-LOOKING STATEMENTS



Information included in this Quarterly Report on Form 10-Q (this "Report") contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Forward-looking statements are not statements of historical facts, but rather reflect our current expectations concerning future events and results. We generally use the words "believes," "expects," "intends," "plans," "anticipates," "likely," "will" and similar expressions to identify forward-looking statements. Such forward-looking statements, including those concerning our expectations, involve risks, uncertainties and other factors, some of which are beyond our control, which may cause our actual results, performance or achievements, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. These risks, uncertainties and factors include, but are not limited to, those factors set forth in our Annual Report on Form 10-K for the fiscal year ended October 31, 2013 and the condensed consolidated financial statements included in this Report. Except as required by applicable law, including the securities laws of the United States, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. You are cautioned not to unduly rely on such forward-looking statements when evaluating the information presented in this Report.


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