ITEM 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following is a discussion of our financial condition and results of operations, and should be read in conjunction with our financial statements and the related notes included elsewhere in this Form 10-Q. Certain statements contained in this section are not historical facts, including statements about our strategies and expectations about new and existing products, market demand, acceptance of new and existing products, technologies and opportunities, market and industry segment growth, and return on investments in products and markets. These statements are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”), and we intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in these statutes. You can identify forward-looking statements by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “intends,” “plans” or “anticipates” or the negative of these words and phrases or similar words or phrases that are predictions of or indicate future events or trends and that do not relate solely to historical matters. Such statements involve substantial risks and uncertainties that may cause actual results to differ materially from those indicated by the forward-looking statements. All forward-looking statements in this section are based on information available to us on the date of this document, and we assume no obligation to update such forward looking statements. Readers of this Form 10-Q are strongly encouraged to review the section titled
“Risk Factors”
in our December 31, 2017 Form 10-K.
Overview
Lifeloc Technologies, Inc., a Colorado corporation ("Lifeloc" or the "Company"), is a Colorado-based developer, manufacturer and marketer of portable hand-held and fixed station breathalyzers and related accessories, supplies and education. We design, produce and sell fuel-cell based breath alcohol testing, monitoring and reporting equipment. We compete in all major segments of the portable breath alcohol testing instrument market, including law enforcement, workplace, corrections, original equipment manufacturing ("OEM") and consumer markets. In addition, we offer a line of supplies, accessories, services, and training to support customers' alcohol testing programs. We sell globally through distributors as well as directly to users.
We define our business as providing "near and remote sensing" products and solutions. Today, the majority of our revenues are derived from products and services for alcohol detection and measurement. We remain committed to growing our breath alcohol testing business. In the future, we anticipate the commercialization of new sensing and measurement products that may allow Lifeloc to successfully expand our business into new growth areas where we do not presently compete or where no satisfactory product solutions exist today.
In addition, with the October 2014 purchase of our corporate headquarters and certain adjacent property, we added a new reporting segment focused on the ownership and rental of real property through existing commercial leases.
Lifeloc incorporated in Colorado in December 1983. We filed a registration statement on Form 10 with the Securities and Exchange Commission, which became effective on May 31, 2011. Our fiscal year end is December 31. Our principal executive offices are located at 12441 West 49th Avenue, Unit 4, Wheat Ridge, Colorado 80033-3338. Our telephone number is (303) 431-9500. Our websites are www.lifelocbreathtester.com and www.stsfirst.com. Information contained on our websites does not constitute part of this Form 10-Q.
Principal Products and Services and Methods of Distribution
In 1989, we introduced our first breath alcohol tester, the PBA3000. Our Phoenix® Classic was completed and released for sale in 1998, superseding the PBA3000. In turn, the Phoenix® Classic has been superseded by our FC Series and Workplace Series of portable breath alcohol testers, which are discussed below. Neither the PBA3000 nor the Phoenix® Classic is actively sold today.
In 2001, we completed and released for sale an additional product line, our new FC Series, designed specifically for domestic and international law enforcement and corrections markets. The portable breath alcohol testers comprising our FC Series are currently being sold worldwide, having contributed to our growth since their introduction. The FC Series is designed to meet the needs of domestic and international law enforcement for roadside drink/drive testing and alcohol offender monitoring. The FC Series is approved by the U.S. Department of Transportation ("DOT") as an evidential breath tester, making it suitable for sale to state law enforcement agencies for preliminary roadside breath alcohol testing. The FC Series is routinely updated with firmware, software and component improvements as they become available. It is readily adaptable to the specific requirements and regulations of domestic and international markets.
In 2005 and 2006, we introduced two new models, the EV30 and Phoenix® 6.0 Evidential Breath Tester ("Phoenix® 6.0"), which constitute our Workplace Series of testing devices. Like their predecessor, the Phoenix® Classic, these instruments are also DOT approved. The DOT's specifications support the DOT's workplace alcohol testing programs, including those applicable to workplace alcohol testing for the federally regulated transportation industry. We also sell component parts used in alcohol testing devices, such as mouthpieces used by our breathalyzers, as well as forms and labels used for record keeping, and calibration products for user re-calibration of our devices. We offer optional service agreements on our equipment, re-calibration services, and spare parts, and we sell supporting instrument training and user certification training to our workplace customers.
In 2006, we commenced selling breath alcohol equipment components that we manufacture to other original equipment manufacturers ("OEMs") for inclusion as subassemblies or components in their breath alcohol testing devices.
In late 2009, Lifeloc released the LifeGuard® Personal Breathalyzer ("LifeGuard®"), a personal alcohol breath tester that incorporates the same fuel-cell technology used in our professional devices. Intended for the global consumer breathalyzer market, LifeGuard® is marketed internationally through global distributors and, until March 2017, was sold directly to consumers in the U.S.
In 2011 and 2012 Lifeloc introduced Bluetooth wireless keyboard and printer communication options for our popular Phoenix® 6.0 along with a series of web based workplace training courses. We believe these two product innovations have been key to our success and leadership in workplace breath testing.
In 2013 Lifeloc expanded our FC Series of professional breath alcohol testers targeted at domestic and international law enforcement and corrections markets with the addition of the FC5 Hornet (the "FC5"). The FC5 is a passive (no mouthpieces required) portable handheld alcohol screening device that competes directly with passive alcohol screeners from our competitors in the education, law enforcement, workplace and corrections markets. In 2013 we also introduced the Sentinel™ zero tolerance alcohol screening station, a fully automated wall mounted screening station for use in safety sensitive industries such as oil and gas and mining. Both devices expand Lifeloc's products for passive alcohol screening.
In the third quarter of 2014 we received approval from DOT for our EASYCAL® automatic calibration station for use with Lifeloc Evidential Breath Testers, and we began shipments of the EASYCAL® to our law enforcement, corrections, workplace and international customers. The EASYCAL® is a first of its kind device that automatically performs breath tester instrument calibration, calibration verification and gas management. As compared to manual instrument calibration, the EASYCAL® reduces the opportunity for human error, saves time and reduces operating costs.
In October 2014 we were awarded a $250,000 grant from the Colorado Office of Economic Development to accelerate development of a breathalyzer that tests for Tetrahydrocannabinol (THC), the principal psychoactive constituent in cannabis. In 2016 the breathalyzer development effort was broadened to include the SpinDx technology as a potential detection method. Terms of the grant required us to submit invoices as work was performed. We received $25,000, $42,396, and $44,523 of grant reimbursements in 2014, 2015 and 2016 respectively. None have been received in 2018 or 2017. The grant completion date was August 31, 2017, at which point $126,793 of grant funds remained unused and are no longer available. Reimbursements received under the grant are included in our Statements of Income as reductions in Research and Development cost. No revenue has been recognized from these grant reimbursements. The SpinDx platform has the potential to revolutionize real-time screening for a panel of high abuse drugs, with the ability to quickly and quantitatively measure very low concentrations of such drugs, including cocaine, methamphetamine and others. We have detected delta-9-THC (the primary psychoactive component of marijuana) down to concentrations of 5 nanograms per milliliter in our laboratory. We remain committed to completing development of a marijuana breathalyzer, utilizing the SpinDx technology developed through our cooperative research and development agreement with Sandia National Laboratory. There is no assurance that this effort to develop a THC breathalyzer will be successful or that significant sales will result from such development if successful.
On October 31, 2014, we purchased the commercial property the Company uses as its corporate headquarters and certain adjacent property in Wheat Ridge, Colorado. The building consists of 22,325 square feet, of which 10,670 are currently leased to three tenants under leases that expire at various times ranging from April 30, 2020 to July 31, 2020. We intend to continue to lease the space we are not occupying, but in the future may elect to expand our own operations into space currently leased to other tenants. Our purchase of the property was partially financed through a term loan in an original principal amount of $1,581,106, secured by a first-priority mortgage on the property. The loan matures in October 2024.
In December 2014, we acquired substantially all of the assets of Superior Training Solutions, Inc. ("STS"), a company that develops and sells online drug and alcohol training and refresher courses. The assets we acquired from STS complement our existing drug and alcohol training courses.
In October 2016 we expanded our Sentinel™ line with the Sentinel™ VA alcohol screening station, a full automated station to control vehicular access to safety critical facilities, such as mines, refineries, power stations and nuclear facilities.
In March 2017 we acquired all of the assets related to the Real-time Alcohol Detection and Recognition product (“R.A.D.A.R.”) from Track Group, Inc. (“TRCK”) for $860,000 in cash. The purchased assets included the R.A.D.A.R. device with cellular reporting for real-time alcohol monitoring, database infrastructure to tabulate and manage subscriber behavior, and biometric methodology and intellectual property to fully automate identity verification. The R.A.D.A.R. device was designed to be part of an offender supervision program as an alternative to incarceration, and it is assigned to offenders as a condition of parole or probation, with random testing throughout the day to demonstrate that they are meeting the conditions of their sentence. We are currently working on improving the manufacturability of R.A.D.A.R. devices and upgrading our base breathalyzer product, both of which we expect to launch before year end.
Additional Areas of Interest
Consistent with our business goal of providing "near and remote sensing" products and solutions, our acquisition strategy involves purchasing companies, development resources and assets that are aligned with our areas of interest and that can further aid in our entering additional markets. We expect to actively research and engage in the acquisition of resources that can expedite our entrance into new markets or strengthen our position in existing ones.
Results of Operations
For the three months ended September 30, 2018 compared to the three months ended September 30, 2017
.
Net sales.
Our product sales for the quarter ended September 30, 2018 were $1,985,520, an increase of 2% from $1,944,734 for the quarter ended September 30, 2017. This increase is primarily attributable to an increase in demand. When royalties of $46,417 and rental income of $23,822 are included, total revenues of $2,055,759 increased by $55,080, or 3%, for the quarter ended September 30, 2018 when compared to the same quarter a year ago.
Gross profit.
Total gross profit for the three months ended September 30, 2018 of $944,692 represented an increase of $62,216, or 7%, from total gross profit of $882,476 for the same period a year earlier, primarily as a result of a difference in mix of products sold. Cost of product sales increased to $1,093,964 in Q3 of 2018 from $1,076,228 in Q3 of 2017, or 2%, primarily as a result of increased labor and materials required for the increased sales volume. Gross profit margin on products was 45% in Q3 of 2018, compared to 45% in Q3 of 2017.
Research and development expenses.
Research and development expenses were relatively unchanged at $249,092 for the quarter ended September 30, 2018 vs. $242,005 in the same quarter a year ago.
Sales and marketing expenses.
Sales and marketing expenses of $331,505 for the quarter ended September 30, 2018 decreased from the $367,101 for the quarter ended September 30, 2017, with the decrease of $35,596 attributable primarily to decreased compensation expense.
General and administrative expenses.
General and administrative expenses of $271,172 for the quarter ended September 30, 2018 were relatively unchanged from the $268,667 spent in the same quarter a year ago.
Other income (expense).
Other income consisted of interest income of $7,676 in the quarter ended September 30, 2018 vs. $1,036 in the same quarter a year ago, primarily as the result of increased yields available on cash. Interest expense of $14,957 in the current quarter was relatively unchanged from $15,261 in the same period a year ago.
Net income.
We realized net income of $58,164 for the quarter ended September 30, 2018 compared to net income of $190 for the quarter ended September 30, 2017. This increase of $57,974 was primarily the result of the changes in gross profit discussed above, offset in part by an increase in income taxes of $37,190.
For the Nine Months Ended September 30, 2018 compared to the Nine Months Ended September 30, 2017
.
Net sales.
Our product sales for the nine months ended September 30, 2018 were $6,121,553, an increase of 7% from $5,706,328 for the same period a year ago. This increase is primarily attributable to an increase in demand. When royalties of $207,840 and rental income of $57,524 are included, total revenues of $6,386,917 reflect an increase of $355,387, or 6%, for the nine months ended September 30, 2018 when compared to the same nine months a year ago.
Gross profit.
Total gross profit for the nine months ended September 30, 2018 of $2,940,325 represented an increase of 3% from total gross profit of $2,860,081 for the nine months a year earlier, primarily as a result of increased sales volume, partially offset by lower royalties in 2018. Cost of product sales increased from $3,101,840 in the nine months ended September 30, 2017 to $3,386,406 in the same period in 2018, or 9%, primarily as a result of increased labor and materials required for the increased sales volume, together with increased depreciation resulting from the purchase of production equipment and software. Gross profit margin on products decreased from 46% in the nine months ended September 30, 2017 to 45% in the nine months ended September 30, 2018.
Research and development expenses.
Research and development expenses were $840,647 for the nine months ended September 30, 2018, representing an increase of 22% over the $690,198 in the same period a year ago. This increase resulted primarily from increased compensation expense and from higher payments to outside vendors in connection with the work needed to upgrade and re-launch R.A.D.A.R.
Sales and marketing expenses.
Sales and marketing expenses of $997,563 for the nine months ended September 30, 2018 decreased $76,656 from the $1,074,219 in the same nine months ended September 30, 2017, or 7%, mostly as the result of decreased compensation.
General and administrative expenses.
General and administrative expenses of $864,629 for the nine months ended September 30, 2018 were relatively unchanged from the $858,987 spent in the same nine months a year ago.
Other income (expense).
Other income consisted of interest income of $14,113 in the nine months ended September 30, 2018 vs. $4,682 in the same period a year ago, primarily as the result of increased yields available on cash. Interest expense of $47,045 in the current 9 months was relatively unchanged from $45,572 in the same period a year ago.
Net income.
We realized net income of $147,493 for the nine months ended September 30, 2018 which was relatively unchanged when compared to net income of $146,051 for the same nine months ended September 30, 2017.
Trends and Uncertainties That May Affect Future Results
Revenues in the third quarter of 2018 were modestly higher compared to revenues in 2017. We expect our quarter-to-quarter revenue fluctuations to continue, due to the unpredictable timing of large orders from customers and the size of those orders in relation to total revenues. Going forward, we intend to focus our development efforts on products we believe offer the best prospects to increase our intermediate and near-term revenues.
Our 2018 operating plan is focused on growing sales, increasing gross profits, and increasing research and development efforts on new products for long term growth. We cannot predict with certainty the expected sales, gross profit, net income or loss, or usage of cash and cash equivalents for 2018. However, we believe that cash resources and borrowing capacity will be sufficient to fund our operations for the next twelve months under our current operating plan. If we are unable to manage the business operations in line with our budget expectations, it could have a material adverse effect on business viability, financial position, results of operations and cash flows. Further, if we are not successful in sustaining profitability and remaining at least cash flow break-even, additional capital may be required to maintain ongoing operations.
Liquidity and Capital Resources
We compete in a highly technical, very competitive and, in most cases, price driven alcohol testing marketplace, where products can take years to develop and introduce to distributors and end users. Furthermore, manufacturing, marketing and distribution activities are regulated by the FDA, the DOT, and other regulatory bodies that, while intended to enhance the ultimate quality and functionality of products produced, can contribute to the cost and time needed to maintain existing products and develop and introduce new products.
We have traditionally funded working capital needs through product sales and close management of working capital components of our business. Historically, we have also received cash from private offerings of our common stock, warrants to purchase shares of our common stock, and notes. In our earlier years, we incurred quarter to quarter operating losses to develop current product applications, utilizing a number of proprietary and patent-pending technologies. Although we have been profitable during the last several years, we expect that operating losses could well occur in the future. Should that situation arise, we may not be able to obtain working capital funds necessary in the time frame needed and at satisfactory terms or at all.
On October 31, 2014, we purchased the commercial property we use as our corporate headquarters and certain adjacent property in Wheat Ridge, Colorado for a total purchase price of $1,949,139, of which we paid $368,033 in cash and financed the remaining $1,581,106 through a 10-year term loan from Bank of America bearing interest at 4.45% per annum (amended to 4% per annum in 2016), secured by a first-priority security interest in the property we acquired with the loan. In connection with the term loan, we arranged for a one-year $250,000 line of credit (increased to $500,000 in 2016, and again to $750,000 in 2017) from Bank of America secured by all assets of the Company. The line of credit bears interest at a rate calculated at the LIBOR daily floating rate plus 2.5%. At September 30, 2018 this credit facility had not been used.
Equipment expenditures during the nine months ended September 30, 2018 were $378,567, consisting primarily of an enterprise planning software package for materials management, customer relations management and e-commerce, compared to $139,736 in the same period a year ago. Expense related to patent applications was $6,648 in the first nine months of 2018 versus $17,217 in the same period in 2017.
In March 2017 we acquired the R.A.D.A.R. assets from TRCK for $860,000 cash. The purchased assets included handheld hardware device technology (the “Device”) which is designed to measure breath alcohol content of the user and software technology designed to allow the Device to be configured and to capture and manage the data being returned from the Device. It also included patents and patent applications and production equipment. The R.A.D.A.R. device was designed to be part of an offender supervision program as an alternative to incarceration. R.A.D.A.R. devices are assigned to offenders as a condition of parole or probation, with random testing throughout the day to demonstrate that they are meeting the conditions of their sentence. We are currently working on improving the manufacturability of R.A.D.A.R. devices and upgrading our base breathalyzer product, both of which we expect to launch before year end.
As of September 30, 2018, cash was $2,657,328, accounts receivable were $724,221 and current liabilities were $732,029 resulting in a net liquid asset amount of $2,649,520. We believe that the introduction of several new products during the last several years, along with new and on-going customer relationships, will continue to generate sufficient revenues to maintain profitability. If these revenues are not achieved on a timely basis, we may be required to implement cost reduction measures, as necessary.
We generally provide a standard one-year warranty on materials and workmanship to our customers. We provide for estimated warranty costs at the time product revenue is recognized. Warranty costs are included as a component of cost of goods sold in the accompanying statements of income. For the quarter ended September 30, 2018 and for the quarter ended September 30, 2017, warranty costs were not deemed significant.
Critical Accounting Policies and Estimates
Our financial statements and accompanying notes have been prepared in accordance with United States generally accepted accounting principles applied on a consistent basis. The preparation of financial statements in conformity with United States generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods.
We regularly evaluate the accounting policies and estimates that we use to prepare our financial statements. In general, management's estimates are based on historical experience, on information from third party professionals, and on various other assumptions that are believed to be reasonable under the facts and circumstances. Actual results could differ from those estimates made by management.
Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, sales and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, inventories, sales returns, warranty, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our financial statements.
We have concluded that we have two operating segments, including our primary business which is as a developer, manufacturer and marketer of portable hand-held breathalyzers and related accessories, supplies and education, and a second segment consisting of renting portions of our building to existing tenants.
We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances would be required, which would increase our expenses during the periods in which any such allowances were made. The amount recorded as a provision for bad debts in each period is based upon our assessment of the likelihood that we will be paid on our outstanding receivables, based on customer-specific as well as general considerations. To the extent that our estimates prove to be too high, and we ultimately collect a receivable previously determined to be impaired, we may record a reversal of the provision in the period of such determination.
We reduce inventory for estimated obsolete or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. Any write-downs of inventory would reduce our reported net income during the period in which such write-downs were applied.
Property and equipment are stated at cost, with depreciation computed over the estimated useful lives of the assets, generally five years (three years for software and technology licenses). We use the double declining method of depreciation for property and equipment, and the straight line method for software and technology licenses. We purchased all of the assets of STS, an online education company, in 2014, which consisted of training courses that are amortized over 15 years using the straight line method. In October 2014, we purchased our building. A majority of the cost of the building is depreciated over 39 years using the straight line method. In addition, based on the results of a third party analysis, a portion of the cost was allocated to components integral to the building. Such components are depreciated over 5 and 15 years, using the double declining method and the straight line method respectively. Maintenance and repairs are expensed as incurred and major additions, replacements and improvements are capitalized.
In March 2018 we acquired the R.A.D.A.R. assets from TRCK, which consisted of production equipment and of hardware device technology (the “Devices”) that are depreciated over 5 years using the double declining balance method when placed in service. With the R.A.D.A.R. assets, we also purchased software designed to measure breath alcohol content of the user and software technology designed to allow the Devices to be configured and to capture and manage the data being returned from the Device, as well as 6 issued U.S. patents and 16 domestic and international patent applications. This software and the patents and patent applications will be amortized over 15 years using the straight line method.
Revenue from product sales and supplies is generally recorded when we ship the product and title has passed to the customer, provided that we have evidence of a customer arrangement and can conclude that collection is probable. The prices at which we sell our products are fixed and determinable at the time we accept a customer's order. We recognize revenue from sales to stocking distributors when there is no right of return, other than for normal warranty claims, and generally have no ongoing obligations related to product sales, except for normal warranty.
Training and certification revenues are recognized at the time the training and certification occurs. Data recording revenue is recognized based on each day’s usage of enrolled devices.
Revenues arising from extended warranty contracts are booked as sales over their life on a straight-line basis. We are providing for customer financing and leasing, which we recognize as revenue over the applicable lease term. Occasionally, we rent used equipment to customers, and in those cases, we recognize the revenues as they are earned over the life of the contract. Revenues from rental of equipment and extended service plans are recognized over the life of the contracts.
Royalty income is recognized in accordance with agreed upon terms, when performance obligations are satisfied, the amount is fixed or determinable and collectability is reasonably assured.
Rental income from space leased to our tenants is recognized in the month in which it is due.
On occasion we receive customer deposits for future product orders. Customer deposits are initially recorded as a liability and recognized as revenue when the product is shipped and title has passed to the customer.
Stock-based compensation is presented in accordance with the guidance of Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 718, Compensation — Stock Compensation ("ASC 718"). Under the provisions of ASC 718, companies are required to estimate the fair value of share-based payment awards made to employees and directors including employee stock options based on estimated fair values on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our statement of operations.
Off-Balance Sheet Arrangements
We currently 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 condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.