Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Information
This report on Form 10-Q contains, and our officers and representatives may from time to time make, "forward-looking statements" within the meaning of the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by words such as: "anticipate," "intend," "plan," "goal," "seek," "believe," "project," "estimate," "expect," "strategy," "future," "likely," "may," "should," "will" and similar references to future periods. Examples of forward-looking statements include, among others, statements we make
regarding
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Expected operating results, such as revenue growth and earnings
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Anticipated levels of capital expenditures for fiscal year 2017 and beyond
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Current or future volatility in market conditions
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Our belief that we have sufficient liquidity to fund our business operations during the next twelve months
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Strategy for customer retention, growth, product development, market position, financial results and reserves
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Strategy for risk management
Forward-looking statements are neither historical facts nor assurances of future performance. Instead, they are based only on our current beliefs, expectations and assumptions regarding the future of our business, future plans and strategies, projections, anticipated events and trends, the economy and other future conditions. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict and many of which are outside of our control. Our actual results and financial condition may differ materially from those indicated in the forward-looking statements. Therefore, you should not rely on any of these forward-looking statements. Important factors that could cause our actual results and financial condition to differ materially from those indicated in the forward-looking statements include, among others, the following:
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The extent to which we are successful in gaining new long-term relationships with customers or retaining significant existing customers and the level of service failures that could lead customers to use competitors' services.
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Our ability to improve our current credit rating with our vendors and the impact on our raw materials and other costs and competitive position of doing so.
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The impact of losing our intellectual property protections or the loss in value of our intellectual property.
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Changes in customer demand.
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The adequacy of our cash flow and earnings and other conditions which may affect our ability to timely service our debt obligations.
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The occurrence of hostilities, political instability or catastrophic events.
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Such other factors as discussed throughout Part I, Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations in this report, and throughout Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations and in Part I, Item 1A. Risk Factors of our Annual Report on Form 10-K for the year ended December 31, 2016.
Any forward-looking statement made by us in this report is based only on information currently available to us and speaks only as of the date on which it is made. We undertake no obligation to publicly update any forward-looking statement, whether written or oral, that may be made from time to time, whether as a result of new information, future developments or otherwise.
The following discussion and analysis should be read in conjunction with our Condensed financial statements, included herewith. This discussion should not be construed to imply that the results discussed herein will necessarily continue into the future, or that any conclusion reached herein will necessarily be indicative of actual operating results in the future. Such discussion represents only the best present assessment of our management. This information should also be read in conjunction with our audited historical financial statements which are included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016, filed with the Securities and Exchange Commission on March 30, 2017.
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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.
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 2017 were $402,400 compared to $543,700 in the third quarter of 2016, a decrease of $141,300, or approximately 26%. Licenses, royalties and fees increased by $7,900, or approximately 5%, to $178,200 in the third quarter of 2017 from $170,300 in the third quarter of 2016. The increase in licenses, royalties and fees is due primarily to higher licensing revenue received from four licensees including one licensee added in the second half of 2016. 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 decreased by $149,200, or approximately 40%, to $224,200 in the third quarter of 2017 from $373,400 in the third quarter of 2016. Sales of ink decreased in the third quarter of 2017 compared to the third quarter of 2016 due primarily to a decrease in the volume of ink shipped in the third quarter of 2017 to a third party authorized printer used by one of the Companys major licensees in the entertainment and toy products market compared to the third quarter of 2016, along with lower ink shipments to the Companys licensees in the retail receipt and document fraud market. This new printer was appointed late in the second quarter of 2016 and, at that time, placed a significant amount of ink orders that were shipped in the third quarter of 2016. In 2017, this printers orders and shipments were more equally balanced between the second and third quarters. In the third quarter of 2017, the Company derived revenues of approximately
$344,900 from its licensees and their authorized printers in the entertainment and toy products market compared to revenues of approximately $490,100 in the third quarter of 2016.
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For the first nine months of 2017, revenues were $1,103,400, representing an increase of $73,500, or approximately 7% higher than revenues of $1,029,900 in the first nine months of 2016. Licenses, royalties and fees of $468,900 in the first nine months of 2017 were $87,100, or approximately 23%, higher than licenses, royalties and fees of $381,800 in the first nine months of 2016. The increase in licenses, royalties and fees is due primarily to higher licensing revenue received from four licensees including one licensee added in the second half of 2016.
Product and other sales decreased by $13,600, or approximately 2%, to $634,500 in the first nine months of 2017 from $648,100 in the first nine months of 2016. Sales of ink decreased in the first nine months of 2017 compared to the first nine months of 2016 due primarily to lower ink shipments to the Companys licensees in the retail receipt and document fraud market. The Company derived revenues of approximately $932,600 from licensees and their authorized printers in the entertainment and toy products market in the first nine months of 2017 compared to revenues of approximately $883,800 in the first nine months of 2016.
The Companys gross profit decreased to $296,800 in the third quarter of 2017, or approximately 74% of revenues, from $350,300 in the third quarter of 2016, or approximately 64% 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 lower gross profit in the third quarter of 2017 compared to the third quarter of 2016 results primarily from lower gross revenues from product and other sales offset in part by higher gross revenues from licenses, royalties and fees in the third quarter of 2017 compared to the third quarter of 2016.
For the first nine months of 2017, gross profit was $783,700, or approximately 71% of revenues, compared to $681,700, or approximately 66% of revenues, in the first nine months of 2016. The higher gross profit in the first nine months of 2017 compared to the first nine months of 2016 results from higher gross revenues from licenses, royalties and fees along with a higher gross profit from product and other sales in the first nine months of 2017 compared to the first nine months of 2016 resulting from a favorable mix of products sold in the first nine months of 2017 compared to the first nine months of 2016.
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 2017 compared to the third quarter of 2016, the gross profit from licenses, royalties and fees increased to approximately 87% of revenues in the third quarter of 2017 from approximately 79% of revenues in the third quarter of 2016. The gross profit from licenses, royalties and fees was approximately 85% in the first nine months of 2017 compared to approximately 81% in first nine months of 2017 resulting from the same factors as the third quarter of 2017 compared to the third quarter of 2016.
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 increased to approximately 63% of revenues in the third quarter of 2017 compared to approximately 58% of revenues in the third quarter of 2016. This increase 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 2017 compared to the third quarter of 2016. For the first nine months of 2017, the gross profit, expressed as a percentage of revenues, increased to approximately 61% of revenues from product and other sales compared to approximately 58% of revenues from product and other sales in the first nine months of 2016 resulting from the same factors as the third quarter of 2017 compared to the third quarter of 2016.
Research and development expenses of $36,300 in the third quarter of 2017 and $109,200 in the first nine months of 2017 were comparable to $33,700 in the third quarter of 2016 and $103,700 in the first nine months of 2016.
Sales and marketing expenses decreased to $67,200 in the third quarter of 2017 from $72,800 in the third quarter of 2016 due primarily to lower commission expense on the lower level of sales in the third quarter of 2017 compared to the third quarter of 2016. Sales and marketing expenses increased to $187,900 in the first nine months of 2017 compared to $176,700 the first nine months of 2016 due primarily to higher commission expense on the higher level of sales in the first nine months of 2017 compared to the first nine months of 2016.
General and administrative expenses increased in the third quarter and first nine months of 2017 to $80,400 and $240,000, respectively, from $69,900 and $224,200 in the third quarter and first nine months of 2016, respectively, due primarily to higher employment costs, insurance expenses and fees offset in part by lower legal expenses in the third quarter and first nine months of 2017 compared to the third quarter and first nine months of 2016.
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Other income (expenses) in the third quarter and first nine months of 2017 and 2016 included interest on unsecured loans from two individuals and on convertible debentures held by nine investors. Also included in other income (expenses) is accretion of debt discounts in the first nine months of 2017 related to the extension of the maturity dates of $33,300 of convertible debentures. Other income (expenses) decreased to $3,100 in the third quarter of 2017 from $3,300 in the third quarter of 2016. Other income (expenses) increased to $22,400 in the first nine months of 2017 from $10,100 in the first nine months 2016. This increase is due primarily to accretion of debt discounts in the first nine months of 2017 related to the extension of the maturity dates of $33,300 of convertible debentures in the first quarter of 2017.
The net income of $109,800 in the third quarter of 2017 compared to the net income of $170,600 in the third quarter of 2016 resulted primarily from a lower gross profit on a lower level of revenues in the third quarter of 2017 compared to the third quarter of 2016 along with higher operating expenses in the third quarter of 2017 compared to the third quarter of 2016. The net income of $224,200 in the first nine months of 2017 compared to the net income of $167,000 in the first nine months of 2016 resulted primarily from a higher gross profit on a higher level of revenues in the first nine months of 2017 compared to the first nine months of 2016 offset in part by higher operating expenses and accretion of debt discounts in the first nine months of 2017 compared to the first nine months of 2016.
Plan of Operation, Liquidity and Capital Resources
During the first nine months of 2017, the Companys cash increased to $362,800 at September 30, 2017 from $199,100 at December 31, 2016. During the first nine months of 2017, the Company generated $178,600 from its operating activities, used $4,900 for capital equipment and repaid $10,000 to an individual lender.
During the first nine months of 2017, the Companys revenues increased approximately 7% primarily as a result of higher licensing and royalty revenues from new and existing licensees. The Companys first nine months of 2017 total overhead expenses increased compared to the 2016 first nine months total overhead expenses and the Companys interest expense increased related to accretion of interest in the first nine months of 2017 compared to the first nine months of 2016. As a result of these factors, the Company recorded a higher net profit in the first nine months of 2017 compared to the first nine months of 2016. The Company had positive operating cash flow of $178,600 during the first nine months of 2017. At September 30, 2017, the Company had positive working capital of $43,300 and stockholders equity of $57,800. For the full year of 2016, the Company had net income of $258,500 and had positive operating cash flow of $202,600. At December 31, 2016, the Company had negative working capital of $194,600 and a $179,600 stockholders deficiency.
Through September 30, 2017, the Company repaid all $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, in 2017, extended the maturity dates of $33,300 of convertible debentures from 2016 to 2018 and extended the maturity dates of $95,000 of convertible debentures from the third quarter of 2017 to the third quarter of 2018. Borrowings and sales of common stock in years prior to January 1, 2015 have allowed the Company to remain in operation through 2016. 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 if the Company is unable to maintain revenue levels and profits consistent with 2016 and the first nine months of 2017. The Company believes that without additional investment, it may then 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 along with a licensee added in 2015 who has been marketing products incorporating the Companys available technologies in certain international markets since 2016. These licensees in the entertainment and toy products market are well known and highly regarded participants in this market. The Company believes that the licensees that the Company has developed in the entertainment and toy products market will 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 geographic and niche markets of the overall entertainment and toy products market. The Company maintains its presence in the retail loss prevention, anti-counterfeiting and anti-diversion markets and believes that revenue growth in these markets can 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.
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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.
Recently Adopted Accounting Pronouncements
As of September 30, 2017 and for the period then ended, there were no recently adopted accounting pronouncements that had a material effect on the Companys financial statements.
Recently Issued Accounting Pronouncements Not Yet Adopted
In May 2014, the FASB issued ASU No. 2014-09,
Revenue from Contracts with Customers (Topic 606)
. The core principle of the guidance is that an entity should recognize 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. This guidance will supersede current revenue recognition guidance which is effective for the Company on January 1, 2018. Under the new standard, the Company may be required to recognize revenue from license fees at the point in time when the license is granted as opposed to the recognition as earned over the license term which has been our historical practice. The Company has not determined the method to be used in applying the amendments in this standard.
Off-Balance Sheet Arrangements
The Company does not have any off-balance sheet arrangements.