Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This report on Form 10-Q includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements in this report, other than statements of historical fact, are forward-looking statements for purposes of these provisions, including any projections of earnings, revenues or other financial items, any statements of the plans and objectives of management for future operations, any statements concerning proposed new products or services, any statements regarding future economic conditions or performance, and any statements of assumptions underlying any of the foregoing. All forward-looking statements included in this report are made as of the date hereof and are based on information available to us as of such date. We assume no obligation to update any forward-looking statement. In some cases, forward-looking statements can be identified by the use of terminology such as “may,” “will,” “expects,” “plans,” “anticipates,” “intends,” “believes,” “estimates,” “potential,” or “continue,” or the negative thereof or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements contained herein are based upon reasonable assumptions at the time made, there can be no assurance that any such expectations or any forward-looking statement will prove to be correct. Our actual results will vary, and may vary materially, from those projected or assumed in the forward-looking statements. Future financial condition and results of operations, as well as any forward-looking statements, are subject to inherent risks and uncertainties, many of which we cannot predict with accuracy and some of which we might not anticipate, including, without limitation, product recalls and product liability claims; infringement of our technology or assertion that our technology infringes the rights of other parties; termination of supplier relationships, or failure of suppliers to perform; inability to successfully manage growth; delays in obtaining regulatory approvals or the failure to maintain such approvals; concentration of our revenue among a few customers, products or procedures; development of new products and technology that could render our products obsolete; market acceptance of new products; introduction of products in a timely fashion; price and product competition, availability of labor and materials, cost increases, and fluctuations in and obsolescence of inventory; volatility of the market price of our common stock; foreign currency fluctuations; changes in key personnel; work stoppage or transportation risks; integration of business acquisitions; and other factors referred to in our reports filed with the SEC, including our Annual Report on Form 10-K for the year ended December 31, 2017. All subsequent forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. Additional factors that may have a direct bearing on our operating results are discussed in Part I, Item 1A “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2017.
BUSINESS OVERVIEW
ClearOne is a global market leader enabling conferencing, collaboration, and network streaming solutions. The performance and simplicity of our advanced, comprehensive solutions offer unprecedented levels of functionality, reliability and scalability.
We derive most of our revenue from professional audio conferencing products by promoting our products in the professional audio-visual channel. We have extended our total addressable market from installed audio conferencing market to adjacent complementary markets – microphones, video collaboration and networked audio and video streaming. We have achieved this through strategic technological acquisitions as well as by internal product development.
In June 2018, at our industry’s largest trade show in North America, we introduced new audio products including significant additions to our CONVERGE® 2 audio conferencing platform, ceiling microphone array product line, and wireless microphone systems in the newly FCC allocated 537-563 MHz range. We also introduced new video solutions including economical new SKUs to our VIEW® AV Networking platform and a second-generation video cloud solution, COLLABORATE® Space. During the six months ended June 30, 2018 seven more patents related to video synchronization, speech technology, integrated microphone array and ceiling or wall tile, echo cancellation with beamforming microphone array, audio distribution over local area networks, and USB to Bluetooth audio bridging were issued to us. While focusing on strategic innovation that we believe will strengthen our competitive position, and accelerated product development, we have also planned and initiated a company-wide cost cutting programs. We also continued our vigorous litigation efforts to stop infringement of two of our strategic patents.
Overall revenue declined in the three and six months ended June 30, 2018 when compared to the three months and six months ended June 30, 2017, with declines seen in all product categories. Our gross profit margin decreased to 47% during the three months ended June 30, 2018 from 59% for the three months ended June 30, 2017. Gross profit margin decreased primarily due to an increase in inventory obsolescence costs, a decline in licensing revenues and due to reduced overhead absorption into inventory as we continue to reduce our net spend on inventory. Our gross profit margin decreased to 52% during the six months ended June 30, 2018 from 58% for the six months ended June 30, 2017. Gross profit margin decrease was primarily due to an increase in inventory obsolescence costs, a decline in licensing revenues and due to reduced overhead absorption into inventory. The proportion of overhead costs absorbed into inventory has declined due to a sharp decline in our inventory purchasing activity causing increased amounts of overhead costs to be expensed.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Industry conditions
We operate in a very dynamic and highly competitive industry which is dominated on the one hand by a few players with respect to certain products like traditional video conferencing appliances while on the other influenced heavily by a fragmented reseller market consisting of numerous regional and local players. The industry is also characterized by the influx of venture capitalist funded start-ups and private companies keen to win market share even at the expense of mounting financial losses.
Economic conditions, challenges and risks
The audio-visual products market is characterized by intense competition and rapidly evolving technology. Our competitors vary within each product category. The adoption of Beamforming Microphone Array 2, along with Converge Pro 2, our new platform for professional audio conferencing, remains challenged in large part because of our competitors’ product offering that directly infringes our strategic patents. The patent infringement also has had a material adverse effect on our revenue from ClearOne’s other products like wireless microphones, ceiling microphones and video products.
Our revenues in the near term may be materially adversely affected by the resignation of a large US distributor in June 2018.
Our strength in professional audio visual space is largely due to our industry leading conferencing technologies and the full suite of professional microphone products, especially Beamforming Microphone Arrays. Despite our strong leadership position in the professional audio communications products market, we face challenges to revenue growth due to the infringement of our patents by competitors, the limited size of the market and pricing pressures from new competitors attracted to the commercial market.
During 2018, revenue from our video products has generally shown lesser decline than revenue from audio conferencing products. However, this is not an identifiable trend given the continuing change in the competitive landscape and also the uncertainty relating to revenue from our core product set due to patent infringement and ensuing litigation. We face intense competition in this market from well-established market leaders as well as emerging players rich with marketing funds. We expect our strategy of combining Spontania, our cloud-based video conferencing product, Collaborate, our appliance-based media collaboration product and our high-end audio conferencing technology to distinguish us from our competitors' product offerings.
We derive a large portion of our revenue (about 48%) from international operations and expect this trend to continue in the future. Most of our revenue from outside the U.S. is billed in US Dollars and is not exposed to any significant currency risk.
A detailed discussion of our results of operations follows below.
Results of Operations for the three
and six
months ended
June 30
, 2018
The following table sets forth certain items from our unaudited condensed consolidated statements of operations (dollars in thousands) for the three and six months ended June 30, 2018 (“2018-Q2”) ("2018-H1") and 2017 (“2017-Q2”) ("2017-H1"), respectively, together with the percentage of total revenue which each such item represents:
|
|
Three months ended June 30,
|
|
|
Six months ended June 30,
|
|
|
|
2018
|
|
|
2017
|
|
|
Percentage
Change
2018 vs.
2017
|
|
|
2018
|
|
|
2017
|
|
|
Percentage
Change
2018 vs.
2017
|
|
Revenue
|
|
$
|
6,971
|
|
|
$
|
10,311
|
|
|
|
(32
|
)%
|
|
$
|
14,260
|
|
|
|
21,989
|
|
|
|
(35
|
)%
|
Cost of goods sold
|
|
|
3,721
|
|
|
|
4,242
|
|
|
|
(12
|
)%
|
|
|
6,911
|
|
|
|
9,242
|
|
|
|
(25
|
)%
|
Gross profit
|
|
|
3,250
|
|
|
|
6,069
|
|
|
|
(46
|
)%
|
|
|
7,349
|
|
|
|
12,747
|
|
|
|
(42
|
)%
|
Sales and marketing
|
|
|
2,760
|
|
|
|
2,646
|
|
|
|
4
|
%
|
|
|
5,628
|
|
|
|
5,387
|
|
|
|
4
|
%
|
Research and product development
|
|
|
1,920
|
|
|
|
2,322
|
|
|
|
(17
|
)%
|
|
|
3,976
|
|
|
|
4,679
|
|
|
|
(15
|
)%
|
General and administrative
|
|
|
1,542
|
|
|
|
2,210
|
|
|
|
(30
|
)%
|
|
|
3,159
|
|
|
|
4,316
|
|
|
|
(27
|
)%
|
Operating loss
|
|
|
(2,972
|
)
|
|
|
(1,109
|
)
|
|
|
(168
|
)%
|
|
|
(5,414
|
)
|
|
|
(1,635
|
)
|
|
|
(231
|
)%
|
Other income
|
|
|
49
|
|
|
|
84
|
|
|
|
(42
|
)%
|
|
|
73
|
|
|
|
186
|
|
|
|
(61
|
)%
|
Loss before income taxes
|
|
|
(2,923
|
)
|
|
|
(1,025
|
)
|
|
|
(185
|
)%
|
|
|
(5,341
|
)
|
|
|
(1,449
|
)
|
|
|
(269
|
)%
|
Provision for (benefit from) income taxes
|
|
|
(760
|
)
|
|
|
(205
|
)
|
|
|
(271
|
)%
|
|
|
(1,332
|
)
|
|
|
(161
|
)
|
|
|
(727
|
)%
|
Net loss
|
|
$
|
(2,163
|
)
|
|
$
|
(820
|
)
|
|
|
(164
|
)%
|
|
$
|
(4,009
|
)
|
|
$
|
(1,288
|
)
|
|
|
(211
|
)%
|
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Revenue
Our revenue decreased by $3.3 million, or 32%, to $7.0 million in 2018-Q2 compared to $10.3 million in 2017-Q2. All product categories witnessed revenue declines with revenue declines of 35%, 15% and 30% for professional audio conferencing, unified communication end points and video products, respectively. The decline in revenue from professional audio conferencing products was mostly due to slower adoption of our Converge Pro 2 platform, largely caused by our competitors’ product offering that we believe directly infringes our strategic patents and due to a decline in licensing revenue. The share of professional audio communications products (which includes microphone products but not premium products) in our product mix declined from 73% in 2017-Q2 to 70% in 2018-Q2. Share of video products revenue during 2018-Q2 remained the same at 16% compared to 2017-Q2 and share of UC end points revenue increased from 11% in 2017-Q2 to 14% in 2018-Q2. During 2018-Q2, revenue declined across all regions except China and Latin America. The revenue declines for Asia Pacific including Middle East, Europe and Africa, and Americas were 16%, 10% and 41%, respectively.
Costs of Goods Sold and Gross Profit
Cost of goods sold (“COGS”) includes expenses associated with finished goods purchased from outsourced manufacturers, the manufacture of our products (including material and direct labor), our manufacturing and operations organization, property and equipment depreciation, warranty expense, freight expense, royalty payments, and the allocation of overhead expenses.
Our gross profit for 2018-Q2 was approximately $3.3 million or 47% compared to approximately $6.1 million, or 59%, for 2017-Q2. Gross margin for 2018-Q2 declined due to an increase in inventory obsolescence costs, a decline in licensing revenues and reduced overhead absorption into inventory. The proportion of overheads absorbed into inventory has declined due to a sharp decline in our inventory purchasing activity causing increased amounts of overheads to be expensed as against being carried with our inventory. Even though the total overhead spending has not increased, the combination of lower revenues and lower absorption has caused gross margin as a percentage of revenue to decline.
Our gross profit for 2018-H1 was approximately $7.3 million or 52% compared to approximately $12.7 million, or 58%, for 2017-H1. Gross margin for 2018-H1 declined due to increased inventory obsolescence costs, a decline in licensing revenues and due to lower absorption of overheads into inventory.
Our profitability in the near-term continues to depend significantly on our revenues from professional audio conferencing products. We hold long-term inventory and if we are unable to sell our long-term inventory, our profitability might be affected by inventory write-offs and price mark-downs. Our long-term inventory includes approximately $2.7 million of wireless microphones related finished goods and assemblies, $2.7 million of Converge Pro 2 products and about $1.1 million of raw materials that will be used for manufacturing professional audio conferencing products. Any business changes that are adverse to these product lines could potentially impact our ability to sell these long-term inventory in addition to our current inventory.
Operating Expenses
Operating expenses include sales and marketing (“S&M”) expenses, research and product development (“R&D”) expenses and general and administrative (“G&A”) expenses. Total operating expenses were $6.2 million for 2018-Q2 compared to $7.2 million for 2017-Q2. Total operating expenses for 2018-H1 were $12.8 million compared to $14.4 million for 2017-H1. The following contains a more detailed discussion of expenses related to sales and marketing, research and product development, general and administrative, and other items.
Sales and Marketing
- S&M expenses include selling, customer service, and marketing expenses such as employee-related costs, allocations of overhead expenses, trade shows, and other advertising and selling expenses.
S&M expenses for 2018-Q2 increased to $2.8 million from $2.6 million for 2017-Q2. The increase was mainly due to an increase in employee related costs partially offset by a decline in tradeshow related expenses. S&M expenses for 2018-H1 increased to $5.6 million from $5.4 million for 2017-H1. The increase was mainly due to an increase in employee related costs including commissions and an increase in marketing expenses.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Research and Product Development
- R&D expenses include research and development, product line management, engineering services, and test and application expenses, including employee related costs, outside services, expensed materials, depreciation, and an allocation of overhead expenses.
R&D expenses were approximately $1.9 million for 2018-Q2, as compared to $2.3 million for 2017-Q2. The decrease was primarily due to reductions in project related expenses and employee costs related to salaries and benefits. R&D expenses were approximately $4.0 million for 2018-H1, as compared to $4.7 million for 2017-H1. The decrease was primarily due to reductions in project related expenses and employee costs related to salaries and benefits.
General and Administrative
- G&A expenses include employee-related costs, professional service fees, allocations of overhead expenses, litigation costs, and corporate administrative costs, including costs related to finance and human resources.
G&A expenses decreased approximately 30% to $1.5 million for 2018-Q2 compared with approximately $2.2 million in 2017-Q2. The reduction was primarily due to the decrease in legal costs and employee costs related to salaries and benefits. Legal expenses in 2018-Q2 reduced mostly because of capitalization of legal costs related to our defense of strategic patents from infringement amounting to $1.1 million. No legal expenses were capitalized in 2017-Q2.
G&A expenses in 2018-H1 was $3.2 million compared to $4.3 million in 2017-H1. The decline of approximately 27% was primarily due to the decrease in legal costs and employee costs related to salaries and benefits. Legal expenses in 2018-H1 reduced mostly because of capitalization of legal costs related to our defense of strategic patents from infringement amounting to $2.4 million. No legal expenses were capitalized in 2017-H1.
Other income (expense), net
Other income (expense), net, includes interest income, interest expense, and foreign currency changes.
Other income reduced in 2018-Q2 and 2018-H1 due to reduction in interest income caused by decline in the investment holdings and due to higher realized losses on liquidated investments.
Provision for income taxes
During the six months ended June 30, 2018, we accrued income taxes at the forecasted effective tax benefit rate of 26.8% as compared to the forecasted effective tax rate of 127% used during the six months ended June 30, 2017. The 100.2% decrease in the forecasted effective tax rate was primarily due to the reduction in U.S. federal corporate tax rates as a result of the enactment of the Tax Cuts and Jobs Act and losses in certain foreign jurisdictions which cannot be benefited, which had a greater impact on the effective rate in 2017 due to differences in forecasted income as compared to 2018. In addition, a discrete tax expense of $64 thousand is primarily attributable to changes in income tax reserves related to an income tax audit in Hong Kong.
LIQUIDITY AND CAPITAL RESOURCES
As of June 30, 2018, our cash and cash equivalents were approximately $4.1 compared to $5.6 million as of December 31, 2017. Our working capital was $23.2 million and $23.3 million as of June 30, 2018 and December 31, 2017, respectively.
Net cash used in operating activities was approximately $1.9 million for the six months ended June 30, 2018, a decrease of cash used of approximately $2.8 million from $4.7 million of cash used in operating activities in the six months ended June 30, 2018. The decrease in cash used was primarily due to an increase in cash inflows due to change in operating assets and liabilities of $6.1 million partially offset by an increase in net loss by $2.7 million and decrease in non-cash charges of $0.6 million.
Net cash provided by investing activities was $1.1 million for the six months ended June 30, 2018 compared to net cash flows provided by investing activities of $49 thousand during the six months ended June 30, 2018, an increase in cash provided of $1.1 million. The increase was primarily due to an increase in proceeds from marketable securities net of purchases of approximately $3.1 million, partially offset by $2.4 million in capitalization of patent defense costs.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Capitalization of patent defense costs
. We capitalize external legal costs incurred in the defense of our patents when we believe that a significant, discernible increase in value will result from the defense and a successful outcome of the legal action is probable. When we capitalize patent defense costs we amortize the costs over the remaining estimated useful life of the patent, which is 15 to 17 years. During the six months ended June 30, 2018 we spent $2.4 million of legal costs related to the defense of our patents and capitalized the entire amount.
Net cash used in financing activities was approximately $0.7 million during the six months ended June 30, 2018, which consisted of cash outflows of $0.1 million on repurchase and cancellation of stock and $0.6 million for dividend payments. Net cash used in financing activities was approximately $4.2 million during the six months ended June 30, 2017, which consisted of cash outflows of $3.2 million on repurchase and cancellation of stock and stock options and $1.1 million for dividend payments.
We are currently pursuing all available legal remedies to defend our strategic patents from infringement. We have already incurred approximately $6.2 million from 2016 through June 30, 2018 towards this litigation and may be required to incur more to continue to enforce our patents. We have been actively engaged in preserving cash by suspending our dividend program, allowing the share repurchase program to expire and implementing company-wide cost reduction measures. In addition, we expect to generate additional cash as our inventory levels are brought down to historical levels. We also believe, although there can be no assurance, that the measures taken by us will yield higher revenues in the future. We believe all of these and effective management of working capital will provide the liquidity needed to meet our short-term and long-term operating requirements and finance our growth plans. We also believe that our strong portfolio of intellectual property and our solid brand equity in the market will enable us to raise additional capital if and when needed to meet our short and long-term financing needs, although there can be no assurance that we would be able to do so on terms that are acceptable to us or at all. In addition to capital expenditures, we may use cash in the near future for selective infusions of technology, sales and marketing, infrastructure, and other investments to fuel our growth.
At June 30, 2018, we had open purchase orders related to our electronics manufacturing service providers of approximately $2.0 million, primarily related to inventory purchases.
At June 30, 2018, we had inventory totaling $22.7 million, of which non-current inventory accounted for $8.4 million. This compares to total inventories of $24.7 million and non-current inventory of $8.7 million as of December 31, 2017. Our non-current inventory includes approximately $2.7 million of wireless microphones related finished goods and assemblies, $2.7 million of Converge Pro 2 products and about $1.1 million of raw materials that will be used for manufacturing professional audio conferencing products. Any business changes that are adverse to these product lines could potentially impact our ability to sell these long-term inventory in addition to our current inventory.
OFF-BALANCE SHEET ARRANGEMENTS
We have no off-balance-sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial conditions, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources, results of operations or liquidity.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our discussion and analysis of our results of operations and financial position are based upon our unaudited consolidated financial statements included under Item 1 of this Form 10-Q, which have been prepared in conformity with accounting principles generally accepted in the United States. We review the accounting policies used in reporting our financial results on a regular basis. We believe certain of our accounting policies are critical to understanding our financial position and results of operations. Except with respect to our revenue recognition practices included in Note 1. “Business Description, Basis of Presentation and Significant Accounting Policies” under Item 1 of this Form 10-Q, there have been no changes to the critical accounting policies as explained in our 2017 Form 10-K.
RECENT ACCOUNTING PRONOUNCEMENTS
For a discussion of recent accounting pronouncements, see Note 3: “Recent Accounting Pronouncements” in the notes to our unaudited consolidated financial statements included under Item 1 of this Form 10-Q.