Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward Looking Statements
This Quarterly Report on Form 10-Q, including, without limitation, the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains 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”). Such forward-looking statements are generally accompanied by words such as “estimate,” “expect,” “believe,” “should,” “would,” “could,” “anticipate,” “may” or other words that convey uncertainty of future events or outcomes. These statements relate to future events or to our future financial performance, and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance, or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. Factors that may cause actual results to differ materially from current expectations, which we describe in more detail elsewhere in this Quarterly Report on Form 10-Q, as well as in our 2018 Annual Report on Form 10-K, filed March 28, 2019, in Item 1A “Risk Factors” include, but are not limited to:
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insufficient cash to operate our business and inability to meet our liquidity requirements;
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loss of revenues due to the failure of our newer products to achieve market acceptance;
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our need to increase current revenue levels in order to achieve sustainable profitability;
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concentration of our revenues from U.S. government entities or commercial customers and the possibility of loss of one of these customers and the unique risks associated with government customers;
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our dependence on sales made through indirect channels;
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our dependence on equity or debt financing provided primarily by our Chief Executive Officer under the CEO Note in order to meet our cash flow requirements;
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the adverse effect that payment of accrued dividends on our preferred stock would have on our cash resources and the substantial dilution upon the conversion or redemption of our preferred stock;
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the consequences of our inability to pay scheduled dividends on shares of our preferred stock;
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the potentially detrimental impact that the conversion of preferred stock would have on the price of our common stock;
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the ability of our preferred stockholders to hinder additional financing; and
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the influence that our management and larger stockholders have over actions taken by the Company.
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If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary significantly from what we projected. These forward-looking statements and other statements made elsewhere in this report are made in reliance on the Private Securities Litigation Reform Act of 1995. Any forward-looking statement you read in this Quarterly Report on Form 10-Q or our Annual Report on Form 10-K reflects our current views with respect to future events and is subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategy and liquidity. We assume no obligation to publicly update or revise these forward-looking statements for any reason, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future. The section below entitled “Factors That May Affect Future Results of Operations” sets forth and incorporates by reference certain factors that could cause actual future results of the Company to differ materially from these statements.
Results of Operations
The following table sets forth, for the periods indicated, certain financial data as a percentage of net revenues. The period-to-period comparison of financial results is not necessarily indicative of future results.
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Three Months Ended
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March
3
1
, 20
1
9
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March 31
, 20
1
8
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Total revenue
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100.0
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%
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100.0
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%
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Total cost of revenue
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40.2
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37.6
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Gross profit
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59.8
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62.4
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Operating expenses:
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Sales and marketing
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12.9
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18.3
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Research and development
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5.7
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13.4
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General and administrative
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10.4
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13.1
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Operating income
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30.8
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17.6
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Interest expense, net
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(1.1
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(2.3
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)
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Income before income tax provision
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29.7
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15.3
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Income tax provision
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—
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—
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Net income
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29.7
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%
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15.3
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%
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Preferred stock dividends accrued
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(1.1
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(1.6
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Net income attributable to common stockholders
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28.6
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%
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13.7
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%
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Three Months Ended
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March 31, 201
9
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March 31, 201
8
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Domestic revenues
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100.0
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%
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100.0
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%
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Export revenues
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—
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—
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Net revenues
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100.0
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%
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100.0
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%
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Net Revenues
. Product revenues increased for the quarter ended March 31, 2019 to $3.2 million, compared to $2.3 million for the quarter ended March 31, 2018. TraceCop revenues increased to $3.1 million for the quarter ended March 31, 2019, compared to $2.2 million for the quarter ended March 31, 2018. Savant revenues remained constant at $0.1 million for the quarter ended March 31, 2019 and 2018. Substantially all of our revenue for the quarters ended March 31, 2019 and 2018 were derived from TraceCop/Savant sales.
Concentration of Revenues
. Revenues from sales to various U.S. government entities totaled $2.8 million, or 86.4% of revenues, for the quarter ended March 31, 2019, compared to $1.8 million, or 79.6% of revenues, for the same period in 2018. Although we expect our concentration of revenues to vary among customers in future periods depending upon the timing of certain sales, we anticipate that sales to government customers will continue to account for a significant portion of our revenues in future periods. Sales to the government present risks in addition to those involved in sales to commercial customers which could adversely affect our revenues, including, without limitation, potential disruption to appropriation and spending patterns and the government’s reservation of the right to cancel contracts and purchase orders for its convenience. Although we do not anticipate that any of our revenues with government customers will be renegotiated, a large number of cancelled or renegotiated government orders could have a material adverse effect on our financial results. Currently, we are not aware of any proposed cancellation or renegotiation of any of our existing arrangements with government entities and, historically, government entities have not cancelled or renegotiated orders which had a material adverse effect on our business. There was one individual commercial customer in the first quarter of 2019 attributable for 11.1% of total revenue compared to 19.0% of total revenue to one individual commercial customer for the same period in 2018.
Gross Profit
. Gross profit was $1.9 million or 59.8% of net revenues for the quarter ended March 31, 2019, compared to $1.4 million or 62.4% of net revenues for the quarter ended March 31, 2018. Gross profit on product revenues for the quarter ended March 31, 2019, remained at 59.8% compared to 62.4% for the quarter ended March 31, 2018, mainly due to TraceCop/Savant product mix. Gross profit as a percentage of net revenues is impacted by several factors, including shifts in product mix, changes in channels of distribution, revenue volume, pricing strategies, and fluctuations in revenues of integrated third-party products.
Sales and Marketing
. Sales and marketing expenses remained constant at $0.4 million for the quarter ended March 31, 2019 and 2018. Sales and marketing expenses may vary in the future. We believe that these costs may increase through the end of 2019 if we achieve anticipated increases in revenue.
Research and Development
. Research and development expenses decreased to $0.2 million for the quarter ended March 31, 2019, compared to $0.3 million for the quarter ended March 31, 2018. The decrease in research and development expense was due to labor expense shifted to direct labor costs on existing projects. Research and development costs are expensed in the period in which they are incurred. Research and development expenses may vary in the future; however, we believe that these costs will remain relatively constant through the end of 2019, although expenses may be increased if we achieve anticipated increases in revenue.
General and Administrative
. General and administrative expenses remained constant at $0.3 million for the quarters ended March 31, 2019 and 2018. It is expected that general and administrative expenses will remain relatively constant throughout the remainder of 2019, although expenses may be increased if we achieve anticipated increases in revenue.
Interest
. Net interest expense decreased to $35 thousand for the quarter ended March 31, 2019 compared to $53 thousand interest expense for the same period in 2018, due to the Company paying down $1.0 million of debt during the quarter ended March 31, 2019. Net interest expense may vary in the future based on our level of borrowing, which will be affected by our cash flow, operating income (loss) and capital expenditures.
Liquidity and Capital Resources
Our principal source of liquidity at March 31, 2019, was approximately $1.0 million of cash and cash equivalents. At March 31, 2019, we had working capital of $0.6 million compared to a $0.3 million deficiency at March 31, 2018.
Net cash provided by operations for the three months ended March 31, 2019 was $787 thousand due primarily to a net income of $947 thousand and the following sources of cash and non-cash items: a $475 thousand decrease in accounts receivable, a $246 thousand decrease in operating lease right-of-use assets, $39 thousand in depreciation expense, $6 thousand in penalties and waived penalties on dividends, and $4 thousand in stock-based compensation. This was partially offset by a $529 thousand decrease in deferred revenue, a $307 thousand decrease in accounts payable and accrued expenses, and a $94 thousand increase in prepaid expenses and other assets. Net cash used in operations for the three months ended March 31, 2018, was $206 thousand due the following uses of cash: $330 thousand decrease in deferred revenue, a $282 thousand increase in accounts receivable, and a $92 thousand increase in prepaid expenses and other assets. This was partially offset by a net income of $346 thousand and the following sources of cash and non-cash items: a $87 thousand increase in accounts payable and accrued expenses, $15 thousand decrease in Inventories, $5 thousand in stock-based compensation, $33 thousand in depreciation expense, and $12 thousand in penalties and waived penalties on dividends. Future fluctuations in inventory balances, accounts receivable and accounts payable will be dependent upon several factors, including, but not limited to, quarterly sales volumes and timing of invoicing, and the accuracy of our forecasts of product demand and component requirements.
Net cash used by investing activities for the nine months ended March 31, 2019, was $96 thousand for net purchases of property and equipment, compared to net cash used in investing activities for the three months ended March 31, 2018, was $37 thousand for net purchases of property and equipment.
Net cash used by financing activities in 2019 was $1.4 million with payments to the CEO Note of $1.0 million, payments for preferred stock dividends of $597 thousand, and payment on principal of finance right-of-use leases of $15 thousand. This was directly offset by the following provisions of cash: proceeds from exercise of stock options of $220 thousand. Net cash provided by financing activities for the three months ended March 31, 2018, was $152 thousand resulting from proceeds of $100 thousand from an officer’s loan and $70 thousand on the exercise of stock options. This was offset by a provision of cash for $18 thousand payment on the principal of finance right-of-use leases.
At March 31, 2019, the Company did not have any material commitments for capital expenditures.
During the three months ended March 31, 2019, the Company funded its operations through the use of cash and cash equivalents.
As of March 31, 2019, we had cash and cash equivalents of approximately $951,000, down from approximately $1,652,000 as of December 31, 2018. We generated net income of $947,000 for the quarter ended March 31, 2019 compared to a net income of $346,000 for the quarter ended March 31, 2018. As of March 31, 2019, in addition to cash and cash equivalents of $951,000, we had $1.9 million of funding available from a promissory note to borrow up to $2.7 million from G. Ward Paxton, the Company’s Chief Executive Officer. We are obligated to make payments of accrued dividends on all our outstanding shares of preferred stock that will reduce our available cash resources. Based on projections of growth in revenue and net income in the coming quarters, and the borrowings available previously mentioned, we believe that we will have sufficient cash resources to finance our operations and expected capital expenditures for the next twelve months. We expect to fund our operations through anticipated Company profits and borrowings from the Company’s CEO, and possibly additional investments of private equity and debt, which, if we are able to obtain, will have the effect of diluting our existing common stockholders, perhaps significantly. Any equity or debt financings, if available at all, may be on terms which are not favorable to us and, in the case of equity financings, may result in dilution to our stockholders. If our operations do not generate positive cash flow in the upcoming year, or if we are not able to obtain additional debt or equity financing on terms and conditions acceptable to us, if at all, we may be unable to implement our business plan, fund our liquidity needs or even continue our operations.
We may explore the possible acquisitions of businesses, products and technologies that are complementary to our existing business. We are continuing to identify and prioritize additional security technologies, which we may wish to develop, either internally or through the licensing, or acquisition of products from third parties. While we may engage from time to time in discussions with respect to potential acquisitions, there can be no assurances that any such acquisitions will be made or that we will be able to successfully integrate any acquired business. In order to finance such acquisitions and working capital it may be necessary for us to raise additional funds through public or private financings. Any equity or debt financings, if available at all, may be on terms, which are not favorable to us and, in the case of equity financings, may result in dilution to our stockholders.