1.         BUSINESS AND FUNDING 

Description of Business and Basis of Presentation

Our principal operations include the development, production and marketing of thin flat display technologies, including low-voltage phosphor color displays and low-power passive E-Paper® displays, and the development, production and marketing of multi-functional encryption products that provide information security for domestic and international users over several communications media.

The condensed consolidated financial statements are unaudited, and have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial reporting, and with the rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  The information contained herein is as of July 31, 2012 and for the nine and three-month periods ended July 31, 2012 and 2011.  In management’s opinion, all adjustments (consisting only of normal recurring adjustments considered necessary for a fair presentation of the results of operations for such periods) have been included herein.  We are required to make certain estimates, judgments and assumptions that management believes are reasonable based upon the information available.  These estimates and assumptions affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the condensed  consolidated financial statements and the reported amounts of revenue and expenses during the reporting periods.  We have evaluated subsequent events for possible disclosure through the date the condensed consolidated financial statements were issued. 

The condensed consolidated financial statements include the accounts of CopyTele, Inc. and its wholly owned subsidiaries, CopyTele International Ltd. (“CopyTele International”) and CopyTele Marketing Inc. (“CopyTele Marketing”).  CopyTele International and CopyTele Marketing were incorporated in the British Virgin Islands in July 2007 and September 2007, respectively.  CopyTele International was formed for the purpose of holding an investment in global depository receipts of Videocon Industries Limited, an Indian company (“Videocon”).  As of July 31, 2012, CopyTele Marketing was inactive.  All significant intercompany transactions have been eliminated in consolidation.

The results of operations for interim periods presented are not necessarily indicative of the results that may be expected for a full year or any interim period.  Reference is made to the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended October 31, 2011, for more extensive disclosures than contained in these condensed consolidated financial statements.

Unless otherwise indicated, all references in this Form 10-Q to “dollars” or “$” refer to U.S. dollars.

Funding and Management’s Plans

We are in the process of evaluating our complete patent portfolio to identify potential opportunities and maximize the return on investment from our intellectual property. We are also reassessing all of our business relationships and development programs to identify our most promising prospects and, in order to achieve cost savings, eliminate those we consider less productive.

Since our inception, we have met our liquidity and capital expenditure needs primarily through the proceeds from sales of common stock in our initial public offering and in private placements, upon exercise of warrants issued in connection with the private placements and our initial public offering, and upon the exercise of stock options.  In addition, we have generated limited cash flows from sales of our encryption products and from license fees from Videocon related to our display technology pursuant to the Videocon License Agreement (as defined below).  In May 2011, we entered into the AUO License Agreements (as defined below) with AU Optronics Corp., a Taiwanese company (“AUO”), and in June 2011 we received an initial license fee from AUO.

During the nine months ended July 31, 2012, our cash used in operating activities was approximately $2,178,000.  This resulted from payments to suppliers, employees and consultants of approximately $2,186,000, which was offset by cash of approximately $5,000 received from collections of accounts receivable related to sales of encryption products and approximately $3,000 of interest received on certificates of deposit.  Our cash provided by investing activities during the nine months ended July 31, 2012 was approximately $1,297,000, which resulted from approximately $2,499,000 received upon the sale or maturities of short-term investments consisting of certificates of deposit and U.S. government securities, offset by purchases of short-term investments consisting of certificates of deposit of $1,200,000 and the purchase of equipment for approximately $2,000.  Our cash provided by financing activities during the nine months ended July 31, 2012 was approximately $208,000, which resulted from cash received upon the exercise of stock options.  As a result, our cash, cash equivalents, and investments in certificates of deposit and U.S. government securities at July 31, 2012 decreased by approximately $1,971,000 to approximately $1,052,000 from approximately $3,023,000 at October 31, 2011.  

Total employee compensation expense for the nine-month periods ended July 31, 2012 and 2011 was approximately $1,939,000 and $2,836,000, respectively, and for the three-month periods ended July 31, 2012 and 2011 was approximately $595,000 and $1,094,000, respectively.  During the nine-months ended July 31, 2012 and 2011, a significant portion of employee compensation consisted of the issuance of stock and stock options to employees in lieu of cash compensation.  We recorded stock-based compensation expense, related to stock awards granted to employees, for the nine-month periods ended July 31, 2012 and 2011 of approximately $861,000 and $1,313,000, respectively, and the three-month periods ended July 31, 2012 and 2011 of approximately $337,000 and $353,000, respectively.  We recorded stock-based compensation expense, related to stock options granted to employees and directors, for the nine-month periods ended July 31, 2012 and 2011 of approximately $111,000 and $643,000 respectively, and for the three-month periods ended July 31, 2012 and 2011 of approximately $-0- and $334,000, respectively.

In February 2011, we sold 7,000,000 unregistered shares of our common stock in a private placement at a price of $0.1786 per share, for proceeds of $1,250,000, of which 3,360,000 shares were sold to our former and current Chairmen and Chief Executive Officers, our Chief Financial Officer and director, and the two other directors of the Company.  In conjunction with the sale of the common stock, we issued warrants to purchase 7,000,000 unregistered shares of our common stock.  Each warrant grants the holder the right to purchase one share of our common stock (or 7,000,000 shares of common stock in the aggregate) at the purchase price of $0.1786 per share on or before February 8, 2016.  The warrants were valued at $0.0756 per share using a Black-Scholes pricing model, adjusted for the estimated impact on fair value of the restrictions relating to the warrants.

In September 2012, we received aggregate gross proceeds of $750,000 from the issuance of 8% convertible debentures due September 12, 2016, of which $300,000 was received from our current Chairman and Chief Executive Officer and one other director of the Company.  The debentures pay interest quarterly and are convertible into shares of our common stock at a conversion price of $0.092 per share on or before September 12, 2016.  The debentures beneficial conversion feature will result in the recording of a material expense during the fourth quarter of fiscal 2012.  We may prepay the debentures at any time without penalty upon 30 days prior notice.

Based on information presently available, we do not believe that our existing cash, cash equivalents, and investments in certificates of deposit, together with cash flows from expected sales of our encryption products and revenue relating to our display technologies, and other potential sources of cash flows or necessary expense reductions including employee compensation, will be sufficient to enable us to continue our marketing, production, and research and development activities for 12 months from the end of this reporting period.  Accordingly, there is substantial doubt about our ability to continue as a going concern.  If current cash on hand and cash that may be generated from operations are insufficient to satisfy our liquidity requirements, we may seek to sell our investment securities or other financial assets or our debt or additional 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 revenues in the future (through sales, license fees and royalties, or otherwise) to satisfy our liquidity requirements or sustain future operations, that our production capabilities will be adequate, that other products will not be produced by other companies that will render our products obsolete, or that other sources of funding, such as sales of equity or debt, would be available, if needed, on favorable terms or at all.  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.  We currently have no arrangements with respect to additional financing. 

Subsequent to July 31, 2012, management discontinued compensating employees and consultants through the issuance of stock and does not presently anticipate instituting this practice in the future.  Management intends to continue issuing stock options to provide incentives which will attract, retain and motivate highly competent persons as officers, key employees and non-employee directors of, and consultants to, the Company.

AU Optronics Corp.

In May 2011, we entered into an Exclusive License Agreement (the “EPD License Agreement”) with AUO.  Under the EPD License Agreement, we provided AUO with an exclusive, non-transferable, worldwide license of our E-Paper^® display patents and technology (the “EPD Licensed Technology”), for AUO (or an AUO subsidiary) to produce, market and sell products containing the EPD Licensed Technology, with the right to sublicense the technology to third parties.  The EPD License Agreement provides for joint development with AUO, with an objective to achieve mass production.  We retained the non-exclusive right to use the EPD Licensed Technology in a non-competitive manner.

In May 2011, we also entered into another license agreement (the “Nano Display License Agreement” and together with the EPD License Agreement, the “AUO License Agreements”) with AUO.  Under the Nano Display License Agreement, we provided AUO with a non-exclusive, non-transferable, worldwide license of our Nano Display (as defined below) patents and technology (the “Nano Display Licensed Technology”), for AUO (or an AUO subsidiary) to produce, market and sell products containing the Nano Display Licensed Technology, with the right to consent to the granting of licenses of the Nano Display Licensed Technology to third parties.  The Nano Display License Agreement provides for joint development with AUO, with an objective to achieve mass production.  We are presently reassessing this joint development effort.

Under the AUO License Agreements, AUO has agreed to pay CopyTele an aggregate license fee of up to $10 million, of which $3 million was paid by AUO in June 2011 and the remaining $7 million is payable upon completion of certain conditions for the respective technologies, in each case subject to a 20% foreign withholding tax. Accordingly, in June 2011 we received a payment from AUO, net of the withholding tax, of $2.4 million.  As of July 31, 2012, we are working with AUO and cannot presently estimate when or if we will receive the remaining $7 million in licensing fees.  In addition, the AUO License Agreements also provide for the basis for royalty payments by AUO to CopyTele.  

 Related Party Transactions with Videocon Industries Limited

In November 2007, we entered into a Technology License Agreement (as amended in May 2008, the “Videocon License Agreement”) with Videocon.  In April 2008, the Indian Government approved the Videocon License Agreement.  Under the Videocon License Agreement, we provided Videocon with a non-transferable, worldwide license of our technology for thin, flat, low voltage phosphor Nano Display (the “Videocon Licensed Technology”), for Videocon (or a Videocon Group company) to produce and market products, including TVs, incorporating displays utilizing the Videocon Licensed Technology.  With the approval and support of Videocon, we entered into the AUO License Agreements for AUO to utilize their production facilities to produce our display technologies, including the Videocon Licensed Technology, for their own products and potentially for Videocon products.  Additional licenses of the Videocon Licensed Technology to third parties require the joint agreement of CopyTele, Videocon, and AUO.

Under the terms of the Videocon License Agreement, we were scheduled to receive a license fee of $11 million from Videocon, payable in installments over a 27 month period and an agreed upon royalty from Videocon based on display sales by Videocon (which royalty will decrease if and when a specified sales level and time period are reached and may increase under other certain circumstances as a result of significant improvements in the Videocon Licensed Technology).  As of July 31, 2012, we have received aggregate license fee payments from Videocon of $3.2 million.  The initial installment commenced in May 2008 however certain license fee payments had been subsequently deferred in light of our joint decision to jointly develop improved versions of our Nano Display technology.  However, the aggregate amount of the payments did not change and Videocon’s obligation to make such payments continues to be subject to CopyTele’s limited performance requirements and is not dependent on any specific performance standards which must be met by completion or delivery of prototypes of CopyTele’s products in the development stage.  No such license fee payments were received from Videocon during the nine-month periods ended July 31, 2012 and 2011 and we cannot presently estimate future payment dates for license fee payments from Videocon. The deferral of the license fee payments is no longer in effect and we are in discussion with Videocon concerning payment of the balance of the license fees; however, we cannot give any estimate as to the outcome of these discussions.  We are not presently involved in development efforts with Videocon.

Under the Videocon License Agreement we retained the right to produce and market products utilizing the Videocon Licensed Technology.  We also continue to have the right to utilize Volga-Svet Ltd., a Russian corporation (“Volga”), in which we have a 19.9% ownership interest and with whom we have been working with for more than fourteen years, to produce and market products utilizing the Videocon Licensed Technology. 

At the same time we entered into the Videocon License Agreement in November 2007, we also entered into a Share Subscription Agreement (the “Share Subscription Agreement”) with Mars Overseas Limited, an affiliate of Videocon (“Mars Overseas”).  Under the Share Subscription Agreement, Mars Overseas purchased 20,000,000 unregistered shares of our common stock (the “CopyTele Shares”) from us for an aggregate purchase price of $16,200,000.  Also in November 2007, our wholly-owned subsidiary, CopyTele International, entered into a GDR Purchase Agreement with Global EPC Ventures Limited (“Global”), for CopyTele International to purchase from Global 1,495,845 global depository receipts of Videocon (the “Videocon GDRs”) for an aggregate purchase price of $16,200,000. 

For the purpose of effecting a lock up of the Videocon GDRs and CopyTele Shares (collectively, the “Securities”) for a period of seven years, and therefore restricting both parties from selling or transferring the Securities during such period, CopyTele International and Mars Overseas entered into two Loan and Pledge Agreements in November 2007.  The Videocon GDRs are to be held as security for a loan in the principal amount of $5,000,000 from Mars Overseas to CopyTele International, and the CopyTele Shares are similarly held as security for a loan in the principal amount of $5,000,000 from CopyTele International to Mars Overseas.  The loans are for a period of seven years, do not bear interest, and prepayment of the loans will not release the lien on the Securities prior to the end of the seven year period.  The loan agreements provide for customary events of default, which may result in forfeiture of the Securities by the defaulting party, and also provide for the transfer to the respective parties, free and clear of any encumbrances under the agreements, any dividends, distributions, rights or other proceeds or benefits in respect of the Securities.  The loan receivable from Mars Overseas is classified as a contra-equity under shareholders’ equity in the accompanying condensed consolidated balance sheet; because the loan receivable is secured by the CopyTele Shares and the Share Subscription Agreement and Loan and Pledge Agreement were entered into concurrently.

Revenue Recognition

Revenues from sales are recorded when all four of the following criteria are met: (i) persuasive evidence of an arrangement exists; (ii) delivery has occurred and title has transferred or services have been rendered; (iii) our price to the buyer is fixed or determinable; and (iv) collectibility is reasonably assured.

We have assessed the revenue guidance of ASC 605-25 to determine whether multiple deliverables in our arrangements with AUO represent separate units of accounting.  Under the AUO License Agreements, we received initial license fees of $3 million and could receive up to an additional $7 million in license fees upon completion of certain conditions for the respective technologies.  We have determined that the transfer of the licensed patents and technology and the effort involved in completion of the conditions for the respective technologies represent a single unit of accounting for each technology.  Accordingly, using a proportional performance method, during the third quarter of fiscal year 2011 we began recognizing the $3 million initial license fees over the estimated periods that we expect to complete the conditions for the respective technologies and have not recognized any portion of the $7 million as either deferred revenue or revenue as it is considered contingent revenue.  Upon completion of the various conditions for the respective technologies, the additional license fees of $7 million will be recognized over the respective performance periods, limiting the revenue recognized on a cumulative basis to the aggregate license fee payments received from AUO.  At each reporting period we assess the progress in completing these efforts and recognize license fee revenue over the remaining estimated period that we expect to complete the conditions for the respective technologies.  On this basis, we reassessed the performance period during the third quarter of fiscal year 2012 and, accordingly, revenue recognition for certain technology has been suspended. This technology represents approximately 39% of the non-refundable deferred revenue on our condensed consolidated balance sheet as of July 31, 2012.  Such revenue will be recognized upon our determination of the appropriate performance period.  This is reflected in the recognized license fee revenue from AUO for the nine-month and three-month periods ended July 31, 2012 of approximately $940,000 and $247,000, respectively and $426,000 for the nine and three-month periods ended July 31, 2011.  License fee payments received from AUO which are in excess of the amounts recognized as revenue (approximately $1,187,000 as of July 31, 2012) are recorded as non-refundable deferred revenue on the accompanying condensed consolidated balance sheet.  The AUO License Agreements also provide for the basis for royalty payments on future production, if any, by AUO to CopyTele, which we have determined represent separate units of accounting.  We have not recognized any royalty income under the AUO License Agreements.