Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Information
This Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the Exchange Act), regarding, among other things, anticipated improvements in operations, the Companys plans, earnings, cash flow and expense estimates, strategies and prospects, both business and financial. All statements other than statements of current or historical fact contained in this report are forward-looking statements. The words believe, expect, anticipate, should, plan, will, may, intend, estimate, potential, continue and similar expressions, as they relate to the Company, are intended to identify, where possible, forward-looking statements.
The Company has based these forward-looking statements largely on its current expectations and projections about future events, financial trends, market opportunities, competition, and the adequacy of the Companys available cash resources, which the Company believes may affect its financial condition, results of operations, business strategy and financial needs. This Form 10-Q also contains forward-looking statements attributed to third parties. All such statements can be affected by inaccurate assumptions, including, without limitation, with respect to risks, uncertainties, anticipated operating efficiencies, new business prospects and the rate of expense increases. In light of these risks, uncertainties and assumptions, the forward-looking statements in this report may not occur and actual results could differ materially from those anticipated or implied in the forward-looking statements. For these reasons, and because of the uncertainty relating to the current financial conditions in todays economic environment and the potential reduction in demand for the Companys products, you should not consider this information to be a guarantee by the Company or any other person that its objectives and plans will be achieved. When you consider these forward-looking statements, you should keep in mind the Risk Factors and other cautionary statements set forth in this Item 2 and elsewhere in this Form 10-Q. The Companys forward-looking statements speak only as of the date made. The Company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
The following Managements Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Condensed Financial Statements and related notes included elsewhere in this report as well as with the Companys audited Financial Statements and Notes thereto included in the Companys Annual Report on Form 10-K for the year ended December 31, 2015 filed with the Securities and Exchange Commission (the SEC) on March 30, 2016 and keeping in mind this cautionary statement regarding forward-looking information.
Results of Operations
The Companys revenues are derived from (i) royalties paid by licensees of the Companys technologies; (ii) fees for the provision of technical services to licensees; and (iii) the direct sale of (a) products incorporating the Companys technologies, such as inks, security paper and pressure sensitive labels, and (b) equipment used to support the application of the Companys technologies, such as ink-jet printing systems. Royalties consist of guaranteed minimum royalties payable by the Companys licensees and/or additional royalties, which typically vary with the licensees sales or production of products incorporating the licensed technology. Technical services, in the form of on-site or telephone consultations by members of the Companys technical staff, may be offered to licensees of the Companys technologies. The consulting fees are billed at agreed upon per diem or hourly rates at the time the services are rendered. Service fees and sales revenues vary directly with the number of units of service or product provided.
The Company recognizes revenue on its lines of business as follows:
a) License fees and royalties are recognized when the license term begins. Upon inception of the license term, revenue is recognized in a manner consistent with the nature of the transaction and the earnings process, which generally is ratably over the license term;
b) Product sales are recognized (i) upon shipment of products; (ii) when the price is fixed or determinable; and (iii) when collectability is reasonably assured; and
c) Fees for technical services are recognized when (i) the service has been rendered; (ii) an arrangement exists; (iii) the price is fixed or determinable based upon a per diem or hourly rate; and (iv) collectability is reasonably assured.
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The Company believes that, as fixed cost reductions beyond those it has achieved in recent years may not be achievable, its operating results are substantially dependent on revenue levels. Because revenues derived from licenses and royalties carry a much higher gross profit margin than other revenues, operating results are also substantially affected by changes in revenue mix.
Both the absolute amounts of the Companys revenues and the mix among the various sources of revenue are subject to substantial fluctuation. The Company has a relatively small number of substantial customers rather than a large number of small customers. Accordingly, changes in the revenue received from a significant customer can have a substantial effect on the Companys total revenue and on its revenue mix and overall financial performance. Such changes may result from a customers product development delays, engineering changes, changes in product marketing strategies and the like. In addition, certain customers have, from time to time, sought to renegotiate certain provisions of their license agreements and, when the Company agrees to revise terms, revenues from the customer may be affected. The addition of a substantial new customer or the loss of a substantial existing customer may also have a substantial effect on the Companys total revenue, revenue mix and operating results.
Revenues for the third quarter of 2016 were $543,700 compared to $236,400 in the third quarter of 2015, an increase of $307,300, or approximately 130%. Licenses, royalties and fees increased by $93,600, or approximately 122%, to $170,300 in the third quarter of 2016 from $76,700 in the third quarter of 2015. The increase in licenses, royalties and fees is due primarily to higher quarterly licensing revenues from an existing licensee in the entertainment and toy products market who signed a new four-year license late in the second quarter of 2015 along with higher royalties from certain licensees, including one new licensee. There can be no assurances that the marketing and product development activities of the Companys licensees or other businesses in the entertainment and toy products market will produce sustained increases in revenues for the Company, nor can the timing of any potential revenue increases be predicted, particularly given the uncertain economic conditions being experienced worldwide.
Product and other sales increased by $213,700, or approximately 134%, to $373,400 in the third quarter of 2016 from $159,700 in the third quarter of 2015. Sales of ink increased in the third quarter of 2016 compared to the third quarter of 2015 due primarily to a significant volume of ink shipped in the third quarter of 2016 to a new third party authorized printer used by one of the Companys major licensees in the entertainment and toy products market offset in part by lower ink shipments to the Companys licensees in the retail receipt and document fraud market. In the third quarter of 2016, the Company derived revenues of approximately $490,100 from its licensees and their authorized printers in the entertainment and toy products market compared to revenues of approximately $181,400 in the third quarter of 2015.
For the first nine months of 2016, revenues were $1,029,900, representing an increase of $288,400, or approximately 39% higher than revenues of $741,500 in the first nine months of 2015. Licenses, royalties and fees of $381,800 in the first nine months of 2016 were $148,200, or approximately 63%, higher than licenses, royalties and fees of $233,600 in the first nine months of 2015. The increase in licenses, royalties and fees in the first nine months of 2016 compared to the first nine months of 2015 is due primarily to higher licensing revenues from existing licensees in the entertainment and toy products market.
Product and other sales increased by $140,200, or approximately 28%, to $648,100 in the first nine months of 2016 from $507,900 in the first nine months of 2015. Sales of ink increased in the first nine months of 2016 compared to the first nine months of 2015 due primarily to a higher volume of ink shipped to the third party authorized printers used by two of the Companys major licensees in the entertainment and toy products market offset in part by lower ink shipments to the Companys licensees in the retail receipt and document fraud market. The Company derived revenues of approximately $883,800 from licensees and their authorized printers in the entertainment and toy products market in the first nine months of 2016 compared to revenues of approximately $603,800 in the first nine months of 2015.
The Companys gross profit increased to $350,300 in the third quarter of 2016, or approximately 64% of revenues, from $154,100 in the third quarter of 2015, or approximately 65% of revenues. Licenses, royalties and fees have historically carried a higher gross profit than product and other sales. Such other sales generally consist of supplies or other manufactured products which incorporate the Companys technologies or equipment used to support the application of its technologies. These items (except for inks which are manufactured by the Company) are generally purchased from third-party vendors and resold to the end-user or licensee and carry a lower gross profit than licenses, royalties and fees. The higher gross profit in the third quarter of 2016 compared to the third quarter of 2015 results primarily from higher gross revenues from licenses, royalties and fees and from product and other sales in the third quarter of 2016 compared to the third quarter of 2015.
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For the first nine months of 2016, gross profit was $681,700, or approximately 66% of revenues, compared to $473,400, or approximately 64% of revenues, in the first nine months of 2015. The higher gross profit in the first nine months of 2016 compared to the first nine months of 2015 results from the same positive factors as the increase in the third quarter of 2016 compared to the third quarter of 2015.
As the variable component of cost of revenues related to licenses, royalties and fees is a low percentage of these revenues and the fixed component is not substantial, period to period changes in revenues from licenses, royalties and fees can significantly affect both the gross profit from licenses, royalties and fees as well as overall gross profit. Primarily due to higher revenues from licenses, royalties and fees in the third quarter of 2016 compared to the third quarter of 2015, the gross profit from licenses, royalties and fees increased to approximately 79% of revenues in the third quarter of 2016 from approximately 75% of revenues in the third quarter of 2015. The gross profit from licenses, royalties and fees was approximately 81% in the first nine months of 2016 compared to approximately 74% in first nine months of 2015 resulting from the same factors as the third quarter of 2016 compared to the third quarter of 2015.
The gross profit, expressed as a percentage of revenues, of product and other sales is dependent on both the overall sales volumes of product and other sales and on the mix of the specific goods produced and/or sold. The gross profit from product and other sales decreased to approximately 58% of revenues in the third quarter of 2016 compared to approximately 60% of revenues in the third quarter of 2015. This decrease in the gross profit, expressed as a percentage of revenues was due primarily to a change in mix of products sold during the third quarter of 2016 compared to the third quarter of 2015. For the first nine months of 2016, the gross profit, expressed as a percentage of revenues, decreased to approximately 58% of revenues from product and other sales compared to approximately 59% of revenues from product and other sales in the first nine months of 2015.
Research and development expenses of $33,700 in the third quarter of 2016 and $103,700 in the first nine months of 2016 were comparable to $31,300 in the third quarter of 2015 and $95,300 in the first nine months of 2015.
Sales and marketing expenses increased to $72,800 in the third quarter of 2016 from $49,100 in the third quarter of 2015 and to $176,700 in the first nine months of 2016 from $154,300 in the first nine months of 2015. This increase is due primarily to higher commission expense on the higher level of sales in the third quarter and first nine months of 2016 compared to the third quarter and first nine months of 2015.
General and administrative expenses decreased in the third quarter and first nine months of 2016 to $69,900 and $224,200, respectively, from $101,600 and $253,000 in the third quarter and first nine months of 2015, respectively, due primarily to lower legal and audit expenses incurred in the third quarter and first nine months of 2016 compared to the third quarter and first nine months of 2015. In the third quarter of 2015, the Company incurred significant expenses related to the filing of the comprehensive annual report on Form 10-K and the first and second quarter 2015 Form 10-Qs that were filed during the third quarter of 2015. These expenses included legal and audit fees in the third quarter and first nine months of 2015 as well as expenses related to the electronic filing of the documents.
Other income (expenses) in the third quarter and first nine months of 2016 and 2015 included interest on unsecured loans from three individuals and on convertible debentures held by ten investors. Other income (expenses) decreased to $3,300 in the third quarter of 2016 from $21,900 in the third quarter of 2015 and to $10,100 in the first nine months of 2016 from $32,200 in the first nine months of 2015. This decrease is due primarily to lower interest expense on the lower level of unsecured loans and convertible debentures and lower accretion of interest in the third quarter and first nine months of 2016 compared to the third quarter and first nine months of 2015.
The net income of $170,600 in the third quarter of 2016 compared to the net loss of $49,800 in the third quarter of 2015 resulted primarily from a higher gross profit on a higher level of revenues in the third quarter of 2016 compared to the third quarter of 2015 along with lower operating expenses, interest expense and accretion of interest in the third quarter of 2016 compared to the third quarter of 2015. The net income of $167,000 in the first nine months of 2016 compared to the net loss of $61,400 in the first nine months of 2015 resulted primarily from a higher gross profit on a higher level of revenues, lower interest expense and lower accretion of interest in the first nine months of 2016 compared to the first nine months of 2015 offset in part by higher operating expenses in the first nine months of 2016 compared to the first nine months of 2015.
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Plan of Operation, Liquidity and Capital Resources
During the first nine months of 2016, the Companys cash increased to $37,100 at September 30, 2016 from $11,400 at December 31, 2015. During the first nine months of 2016, the Company generated $40,600 from its operating activities, used $1,400 for capital equipment and repaid $13,500 to an individual lender.
During the first nine months of 2016, the Companys revenues increased primarily as a result of significant sales of ink to a new authorized printer of one of the Companys licensees in the entertainment and toy products market and higher license fees from a licensee in the entertainment and toy products market offset in part by lower sales of ink to an existing authorized printer for certain licensees in the entertainment and toy products market. The Companys operating expenses increased nominally in the first nine months of 2016 compared to operating expenses in the first nine months of 2015. As a result of these factors, the Company recorded a net profit in the first nine months of 2016 compared to a net loss in the first nine months of 2015. The Company had positive operating cash flow of $40,600 during the first nine months of 2016. At September 30, 2016, the Company had negative working capital of $287,900 and a stockholders deficiency of $271,100. For the full year of 2015, the Company had a net loss of $18,000 and had positive operating cash flow of $41,800. At December 31, 2015, the Company had negative working capital of $364,000 and a $438,100 stockholders deficiency.
Through September 30, 2016, the Company repaid $53,000 of $63,000 of short-term loans that had been outstanding at January 1, 2015. In 2015, the Company repaid $10,000 of convertible debentures and extended the maturity dates of $95,000 of convertible debentures from the third quarter of 2015 to the third quarter of 2017. Borrowings and sales of common stock in years prior to January 1, 2015 have allowed the Company to remain in operation through the current date. There can be no assurances that the Company will be able to secure sufficient additional funding through investments or borrowings that will allow the Company to fund losses that it presently believes may be experienced in the future. The Company believes that without additional investment, it may be forced to cease operations at an undetermined date in the future.
The Companys plan of operation for the twelve months beginning with the date of this quarterly report consists of concentrating available human and financial resources to continue to capitalize on the specific business relationships the Company has developed in the entertainment and toy products market including two licensees with a significant presence in the entertainment and toy products market that have been marketing products incorporating the Companys technologies since 2012. These two licensees in the entertainment and toy products market are well-known and highly regarded participants in this market. The Company believes that these two licensees will continue to expand their offerings incorporating the Companys technologies currently being marketed and will introduce new products incorporating available technologies covered by the license agreements that are not currently being marketed by them. The Company plans to continue developing applications for these licensees while expanding its licensee base in the entertainment and toy market. The Company has additional licensees marketing or developing products incorporating the Companys technologies in certain niche markets of the overall entertainment and toy products market. In late 2015, the Company added a licensee who the Company believes will market products incorporating the Companys available technologies in certain international markets in late 2016 or early 2017. The Company maintains its presence in the retail loss prevention market and believes that revenue growth in this market could be achieved through increased security ink sales to its licensees in this market. The Company will continue to adjust its production and technical staff as necessary. The Company will also, subject to available financial resources, invest in capital equipment needed to support potential growth in ink production requirements beyond its current capacity. Additionally, the Company will pursue opportunities to market its current technologies in specific security and non-security markets. There can be no assurances that these efforts will enable the Company to generate additional revenues and positive cash flow.
The Company has received and continues to seek additional capital, in the form of debt, equity or both, to support its working capital requirements. There can be no assurances that the Company will be successful in raising additional capital, or that such additional capital, if obtained, will enable the Company to generate additional revenues and positive cash flow.
The Company generates a significant portion of its total revenues from licensees in the entertainment and toy products market. These licensees generally sell their products through retail outlets. During the year, such sales may be adversely affected by changes in consumer spending that may occur as a result of an uncertain economic environment. As a result, the Companys revenues, results of operations and liquidity may be negatively impacted as they were in previous years.
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Risk Factors
The Companys operating results, financial condition and stock price are subject to certain risks, some of which are beyond the Companys control. These risks could cause actual operating and financial results to differ materially from those expressed in the Companys forward-looking statements, including the risks described below and the risks identified in other documents which are filed and furnished with the SEC including the Companys Annual Report on Form 10-K for the year ended December 31, 2015 that was filed with the SEC on March 30, 2016:
Limited Interim Historical Information.
In September 2015, the Company filed a comprehensive annual report on Form 10-K for the fiscal years ended December 31, 2012, 2013 and 2014. The Form 10-K contains summarized quarterly financial information for each of the quarters ended June 30 and September 30, 2012 and for each of the quarters ended March 31, June 30 and September 30, 2013 and 2014. As the complete periodic filings for those periods have not been filed, certain financial information, disclosures and discussions normally contained in a Form 10-Q were not included in the Form 10-K. The omission of the information that would have been contained in these periodic filings leaves current and prospective investors, customers, employees and others without this source of information about the Companys business achievements and prospects and may negatively impact the Companys business opportunities and its ability to raise capital. There can be no assurances that the Company will be able to remain current with its required SEC filing obligations in the future.
Access to Capital.
The Company anticipates that it may need to raise capital in the future to fund its historical and new business operations. Negative or uncertain global economic conditions would make it more difficult for the Company to raise capital. If the Company is unable to secure capital, if needed, in the future, in the form debt, equity or both, it may be forced to cease operations. There can be no assurances that, if required, the Company will be successful in obtaining additional investment in sufficient amounts to fund its ongoing business operations.
Dependency on Major Customers.
The Company is dependent on its licensees to develop new products and markets that will generate increases in its licensing and product revenues. The inability of the Companys licensees to maintain at least current levels of sales of products utilizing the Companys technologies would adversely affect the Companys operating results and cash flow. To the extent that the Companys licensees are affected by negative economic conditions, the Companys revenues would also be negatively impacted. The Company derives a significant percentage of its revenues through licensing relationships with two major customers. Revenues obtained directly from these two licensees and indirectly, through the licensees third party authorized printers, equaled approximately 87% and 81% of the Companys revenues in the third quarter and first nine months of 2016, respectively, and approximately 73% of the Companys revenues in 2015. Receivables from these two licensees and their third party authorized printers were approximately 87% and 58% of the Companys net accounts receivable at September 30, 2016 and December 31, 2015, respectively. The Company has a license agreement containing guaranteed minimum royalties expiring in 2019 with one of these two licensees and a license with the second that expires in 2017. Products incorporating the Companys technologies that are sold by these two licensees have certain dissimilar characteristics and are marketed generally through distinctly different channels of distribution. These two licensees are well-known and highly regarded participants in the entertainment and toy products market. The agreements with both licensees contain renewal options but there can be no assurances that the licenses will be renewed or that they will be renewed at the same or more favorable terms beyond their current termination dates, nor can there be any assurances that the relationships with these two licensees will generate increased revenues for the Company in the future.
Possible Inability to Develop New Business
. Management of the Company believes that any significant improvement in the Companys cash flow must result from increases in revenues from traditional sources and from new revenue sources. The Company raised cash through additional capital investment and loans from investors in 2012, 2013 and 2014. The Company also benefited from limiting increases in its operating expenses and reducing its operating expenses when possible. The Companys ability to develop new revenues may depend on the extent of its marketing activities and its research and development activities, both of which are limited. There are no assurances that the resources that the Company can devote to marketing and to research and development will be sufficient to increase its revenues to levels that will enable it to maintain positive operating cash flow in the future.
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Inability to Obtain Raw Materials and Products for Resale.
The Companys adverse financial condition in the past has required it to significantly defer payments due to (i) vendors who supply raw materials and other components of the lines of inks marketed by the Company, (ii) providers of professional and other services and (iii) certain employees to whom salary and sales commissions are owed. As a result, the Company is required to pay cash in advance of shipment to certain of its suppliers. The inability to obtain materials on a timely basis and the possibility that certain vendors may permanently discontinue supplying the Company with needed products and services threaten to result in delayed shipments to customers and further impact the Companys ability to service its customers, thereby adversely affecting the Companys relationships with its customers and licensees. There can be no assurances that the Company will be able to maintain its vendor relationships in an acceptable manner.
Uneven Pattern of Quarterly and Annual Operating Results
. The Companys revenues, which are derived primarily from licensing, royalties and sales of products incorporating its technologies, are difficult to forecast; such forecasting difficulty is due to, among other reasons, the long sales cycle of the Companys technologies, the potential for customer delay or deferral of implementation of the Companys technologies, the size and timing of inception of individual license agreements, the success of the Companys licensees and strategic partners in exploiting the market for the licensed products, modifications of customer budgets, and uneven patterns of royalty revenue and product orders. As the Companys revenue base is not substantial, delays in finalizing license contracts, implementing the technology to initiate the revenue stream and ordering decisions of customers can have a material adverse effect on the Companys quarterly and annual revenue expectations. As the Companys operating expenses are substantially fixed, income expectations will be subject to a similar adverse outcome. As licensees for the entertainment and toy products markets are added, the predictability of the Companys revenue stream may be further impacted.
Volatility of Stock Price
. The market price for the Companys common stock has historically experienced significant fluctuations and may continue to do so. From inception, with the exception of 2007, 2013 and 2014, the Company has operated at a loss and has not produced revenue levels traditionally associated with publicly-traded companies. The Companys common stock is not listed on a national or regional securities exchange and, consequently, the Company receives limited publicity regarding its business achievements and prospects. Additionally, securities analysts and traders do not extensively follow the Companys stock and its stock is thinly traded. The Companys market price may be affected by announcements of new relationships or modifications to existing relationships. The stock prices of many developing public companies, particularly those with small capitalizations, have experienced wide fluctuations not necessarily related to operating performance. Such fluctuations may adversely affect the market price of the Companys common stock.
Intellectual Property.
The Company relies on a combination of protections as may be available under applicable domestic, foreign or international patent, trademark and trade secret laws. The Company also relies on confidentiality, non-analysis and licensing agreements to establish and protect its rights in its proprietary technologies. While the Company attempts to protect these rights, its technologies may be compromised through reverse engineering, independent invention or other means. In addition, the Companys ability to enforce its intellectual property rights through appropriate legal action has been and will continue to be limited by its adverse liquidity. There can be no assurances that the Company will be able to protect the basis of its technologies from discovery by third parties or to preclude third parties from conducting activities that infringe on the Companys rights. The Companys adverse liquidity situation also impacts its ability to obtain patent protection on its intellectual property and to maintain protection on previously issued patents. There can be no assurances that the Company will be able to continue to prosecute new patents and maintain issued patents. As a result, the Companys customer and licensee relationships could be adversely affected, and the value of the Companys technologies and intellectual property (including their value upon liquidation) could be substantially diminished.
Economic Conditions
. The Companys revenue is susceptible to changes in general economic conditions. The Companys sales, liquidity and overall results of operations may be negatively affected by decreasing consumer confidence, slowdowns in consumer spending or other downturns in the U.S. economy as a whole or in any geographic markets from which the Company derives revenue. In addition, these factors may result in decreased customer and licensee demand for the Companys products and may negatively impact the Companys ability to develop new customers and licensees. Due to uncertainties surrounding the worldwide economy, the Company is unable to predict the effect of such conditions on its customers and licensees. Consequently, the Company cannot predict the scope or magnitude of the negative effect resulting from ongoing global financial uncertainties or economic slowdowns.
Recently Adopted Accounting Pronouncements
As of September 30, 2016 and for the period then ended, there were no recently adopted accounting pronouncements that had a material effect on the Companys financial statements.
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Recently Issued Accounting Pronouncements Not Yet Adopted
In August 2014, the FASB issued ASU 2014-15,
Presentation of Financial Statements Going Concern (Subtopic 205-40), Disclosure of Uncertainties about an Entitys Ability to Continue as a Going Concern.
The amendments in this Update provide guidance about managements responsibility to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entitys ability to continue as a going concern within one year after the date that the financial statements are issued and to provide related footnote disclosures. Substantial doubt about an entitys ability to continue as a going concern exists when relevant conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued. The amendments in this Update are effective for the annual period ending after December 15, 2016, and for annual periods and interim periods thereafter. Early application is permitted. Management is assessing the impact of the adoption to the financial statements.
Off-Balance Sheet Arrangements
The Company does not have any off-balance sheet arrangements.