Management’s Discussion and Analysis
of
Financial Condition and Results of Operations
Cautionary Statement for Purposes of the “Safe Harbor”
Provisions of the Private Securities Litigation Reform Act of 1995
Some of the information in this Quarterly
Report on Form 10-Q contains forward-looking statements that involve substantial risks and uncertainties. You can identify these
statements by forward-looking words such as “may,” “will,” “expect,” “anticipate,”
“believe,” “estimate,” “continue” and similar words. You should read statements that contain
these words carefully because they: (1) discuss our future expectations; (2) contain projections of our future operating results
or financial condition; or (3) state other “forward-looking” information. However, we may not be able to predict future
events accurately. The risk factors listed in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year
ended December 31, 2019, as well as any cautionary language in this Quarterly Report on Form 10-Q, provide examples of risks, uncertainties
and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements.
You should be aware that the occurrence of any of the events described in these risk factors and elsewhere in this Quarterly Report
on Form 10-Q could materially and adversely affect our business.
Summary of Operations
We are primarily engaged in the development
and sale of biometrics products, solutions and services. Our software products are used in government and commercial systems and
applications and fulfill a broad range of functions critical to secure biometric enrollment, authentication, identification and
transactions. Principal government applications of biometrics systems include border control, visa applicant screening, law enforcement,
national defense, intelligence, secure credentialing, access control, and background checks. Principal commercial applications
include: i) user enrollment and authentication used for login to mobile devices, computers, networks, and software programs; ii)
user authentication for financial transactions and purchases (online and in-person); iii) physical access control to buildings;
and iv) identity proofing of prospective employees and customers. We sell our biometrics software products and services globally
through a multifaceted distribution strategy using systems integrators, OEMs, VARs, partners, and directly to end user customers.
We also derive a portion of our revenue from the sale of imaging software licenses to OEMs and systems integrators that incorporate
our software into medical imaging products and medical systems.
Due to the COVID-19 pandemic we have been
unable to: (i) conduct face-to-face meetings with customers and prospective customers, (ii) present in-person demonstrations of
our software solutions, (iii) attend trade shows and conferences which typically generate future sales opportunities or (iv) meet
with prospective strategic partners. We believe that these effects caused by the COVID-19 pandemic adversely impacted our revenue
in the second quarter of 2020 and will likely have an adverse impact on our revenue over the next several quarters.
Summary of Financial Results
We use revenue and results of operations
to summarize financial results as we believe these measurements are the most meaningful way to understand our operating performance.
Revenue and operating loss for the three
months ended June 30, 2020 were $1.9 million and $3.7 million, respectively. These results compared to revenue of $3.0 million
and operating loss of $1.2 million for the three months ended June 30, 2019. Lower revenue in the current three month period was
primarily due to lower license revenue associated with delays caused by the COVID-19 pandemic. Higher operating loss in the current
three month period was primarily due to lower revenue and higher operating expenses including previous investment in sales and
engineering resources driving growth in new product areas and expenses related to turnover of administrative personnel and COVID-19
remote working costs.
Revenue and operating loss for the six
months ended June 30, 2020 were $5.4 million and $5.0 million, respectively. These results compared to revenue of $6.7 million
and operating loss of $1.2 million in the six months ended June 30, 2019. Lower revenue was primarily due to lower services revenue.
Higher operating loss was primarily due to lower revenue and higher operating expenses including previous investment in sales and
engineering resources driving growth in new product areas and expenses related to turnover of administrative personnel and COVID-19
remote working costs.
These and all other financial results are
discussed in more detail in the results of operations section that follows.
Results of Operations
Software licenses. Software
licenses consist of revenue from the sale of biometrics and imaging software products. Sales of software products depend on our
ability to win proposals to supply software for biometrics systems projects either directly to end user customers or indirectly
through channel partners.
Software license revenue decreased 66%
from $1.2 million in the three months ended June 30, 2019 to $0.4 million in the same three month period in 2020. As a percentage
of total revenue, software license revenue decreased from 39% in the second quarter of 2019 to 22% in the current year quarter.
The $0.8 million decrease in software license revenue was due primarily to a decrease in biometrics software license sales to $0.4
million in the second quarter of 2020 versus $1.1 million in the same quarter last year. The dollar decrease was primarily due
to delays in new software procurements caused by the COVID-19 pandemic and lower revenue from the software license agreement we
entered into with a systems integrator in the second quarter of 2018 for a large project with follow-on sales in 2019. We recognized
$0.2 million of software license revenue from this agreement in the second quarter of 2019.
As described in the strategy section of
our Form 10-K for the year ended December 31, 2019, our market strategy is to continue to focus on our legacy government biometrics
markets and expand into new commercial biometrics markets. We are unable to predict future revenue from commercial markets as these
are emerging markets.
Software license revenue decreased 13%
from $2.7 million in the six months ended June 30, 2019 to $2.4 million in the same six month period in 2020. As a percentage of
total revenue, software license revenue increased from 40% in the first six months of 2019 to 44% in the current year six month
period. The $0.3 million decrease in software license revenue was primarily due to a $352,000 decrease in biometrics software license
sales. The dollar decrease was primarily due to aforementioned delays in new software procurements caused by the COVID-19 pandemic
and lower revenue from the aforementioned software license agreement we entered into with a systems integrator in 2018. We recognized
$0.4 million of software license revenue from this agreement in the six months ended June 30, 2019. This was partially offset by
higher software license sales to other customers.
Software maintenance. Software
maintenance consists of revenue from the sale of software maintenance contracts. Software maintenance contracts entitle customers
to receive software support and software updates, if and when they become available, during the term of the contract.
Software maintenance revenue increased
5% from $1.3 million in the three months ended June 30, 2019 to $1.4 million in the same three month period in 2020. As a percentage
of total revenue, software maintenance revenue increased from 44% in the second quarter of 2019 to 73% in the current year quarter.
Software maintenance revenue increased
2% from $2.68 million in the six months ended June 30, 2019 to $2.74 million in the same six month period in 2020. As a percentage
of total revenue, software maintenance revenue increased from 40% for the first six month of 2019 to 51% in the current year six
month period.
For the three and six month periods ended
June 30, 2020, the slight dollar increase in software maintenance revenue was primarily due to slightly higher retention of maintenance
renewals in those periods.
Services. Services
consist of fees we charge to perform software development, integration, installation, and customization services. Similar to software
license revenue, services revenue depends on our ability to win biometrics systems projects either directly with end user customers
or in conjunction with channel partners. Services revenue will fluctuate when we commence new projects and/or when we complete
projects that were started in previous periods.
Services revenue decreased from $0.5 million
in the three months ended June 30, 2019 to $0.1 million in the same three month period in 2020. As a percentage of total revenue,
services revenue decreased from 17% in the second quarter of 2019 to 5% in the current year quarter.
For the three month period ended June 30,
2020, the dollar decrease in services revenue was primarily due to lower services revenue in the current year quarter related to
the software license agreement we entered into with a systems integrator in the second quarter of 2018 for a large project. This
decrease was partially offset by higher services revenue from other service customers.
Services revenue decreased 59% from $1.3
million in the six months ended June 30, 2019 to $0.3 million in the same six month period in 2020. As a percentage of total revenue,
services revenue decreased from 20% in the first six months of 2019 to 5% in the corresponding period of 2020.
For the six month period ended June 30,
2020, the dollar decrease in services revenue was primarily due to lower services revenue related to the software license agreement
we entered into with a systems integrator in the second quarter of 2018 for a large project, and lower service revenue from other
direct to government customers. The remaining value of the services revenue on this project was $0.1 million as of June 30, 2020
and we expect requests for additional support services on this project related to the impact of COVID-19 delays.
Cost of services. Cost of
services consists of engineering costs to perform customer services projects. Such costs primarily include: i) engineering salaries,
stock-based compensation, fringe benefits, and facilities; and ii) engineering consultants and contractors.
Cost of services decreased from $0.3 million
in the three months ended June 30, 2019 to $0.2 million in the same three month period in 2020. Cost of services as a percentage
of services increased from 64% in the second quarter of 2019 to 166% in the current year quarter, which means that gross margins
decreased from 36% to a negative 66%. The decrease in cost of services expense was primarily due to lower service revenue in the
second quarter of 2020 resulting from fewer active contracts with services. The decrease in the gross margin was primarily due
to timing of costs compared to the recognition of revenue on a project with a customer in Canada.
Cost of services decreased 50% from $0.8
million in the six months ended June 30, 2019 to $0.3 million in the same six month period in 2020. Cost of services as a percentage
of services increased from 62% in the first six months of 2019 to 116% in the corresponding period of 2020, which means that gross
margins decreased from 38% to a negative 16%. The decrease in cost of services expense was primarily due to lower service revenue
in the six months ended June 30, 2020 resulting from fewer active contracts with services during this period. The decrease in the
gross margin was primarily due to the aforementioned timing of costs compared to the recognition of revenue on a project with a
customer in Canada.
Research and development expense.
Research and development expense consists of costs for: i) engineering personnel, including salaries, stock-based compensation,
fringe benefits, and facilities; ii) engineering consultants and contractors, and iii) other engineering expenses such as supplies,
equipment depreciation, dues and memberships and travel. Engineering costs incurred to develop our technology and products are
classified as research and development expense. As described in the cost of services section, engineering costs incurred to provide
engineering services for customer projects are classified as cost of services, and are not included in research and development
expense.
The classification of total engineering
costs to research and development expense and cost of services was (in thousands):
|
|
Three Months Ended
June 30,
|
|
|
Six Months Ended
June 30,
|
|
|
|
2020
|
|
|
2019
|
|
|
2020
|
|
|
2019
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Research and development expense
|
|
$
|
2,422
|
|
|
$
|
2,091
|
|
|
$
|
4,694
|
|
|
$
|
3,851
|
|
Cost of services
|
|
|
164
|
|
|
|
321
|
|
|
|
334
|
|
|
|
839
|
|
Total engineering costs
|
|
$
|
2,586
|
|
|
$
|
2,412
|
|
|
$
|
5,028
|
|
|
$
|
4,690
|
|
Research and development expense increased
16% from $2.1 million in the three months ended June 30, 2019 to $2.4 million in 2020. As a percentage of total revenue, research
and development expense increased from 69% in 2019 to 128% in 2020.
Research and development expense increased
from $3.9 million in the six months ended June 30, 2019 to $4.7 million in the same six month period in 2020. As a percentage of
total revenue, research and development expense increased from 57% in the first six months of 2019 to 87% in the corresponding
period of 2020.
As the table immediately above indicates,
total engineering costs in the second quarter of 2020 increased by $0.2 million compared to the same period last year. Total engineering
costs increased by $0.3 million for the six months ended June 30, 2020 as compared to the same period last year. For both the three
and six month periods, the spending increase was primarily due to higher employee costs due to increased headcount. This increase
was partially offset by a decrease in spending on third-party development costs. Lower spending on third-party development costs
was primarily due to a decrease in spending with a third-party software development vendor that has been providing services since
2016.
We anticipate that we will continue to
focus our future research and development activities on enhancing our existing products and developing new products with our growing
internal resources.
Selling and marketing expense.
Selling and marketing expense primarily consists of costs for: i) sales and marketing personnel, including salaries, sales commissions,
stock-based compensation, fringe benefits, travel, and facilities; and ii) advertising and promotion expenses.
Sales and marketing expense increased 30%
from $0.9 million in the three months ended June 30, 2019 to $1.2 million in the same three month period of 2020. As a percentage
of total revenue, sales and marketing expense increased from 30% in the second quarter of 2019 to 62% in the corresponding period
in 2020. The dollar increase in sales and marketing expense was primarily due to higher employee costs due to increased headcount.
Sales and marketing expense increased 42%
from $1.7 million in the six months ended June 30, 2019 to $2.5 million in the same six month period of 2020. As a percentage of
total revenue, sales and marketing expense increased from 26% in the first six months of 2019 to 46% in the corresponding period
in 2020. The dollar increase in sales and marketing expense was primarily due to higher employee costs due to increased headcount.
General and administrative expense.
General and administrative expense consists primarily of costs for: i) officers, directors and administrative personnel,
including salaries, bonuses, director compensation, stock-based compensation, fringe benefits, and facilities; ii) professional
fees, including legal and audit fees; iii) public company expenses; and iv) other administrative expenses, such as insurance costs
and bad debt provisions.
General and administrative expense increased
109% from $0.9 million in the three months ended June 30, 2019 to $1.8 million in the same three month period in 2020. As a percentage
of total revenue, general and administrative expense increased from 29% in the second quarter of 2019 to 97% in the corresponding
period in 2020. The increase in general and administrative expense was primarily due to costs related to the COVID-19 pandemic
and a turnover of over 50% of our administrative personnel. Costs included $0.3 million of severance expense, $0.1 million of recruiting
and other employee transition expenses, $0.1 million of legal fees, $0.1 million of bad debt expense, and $0.1 million computer
hardware and software related to remote working.
General and administrative expense increased
86% from $1.6 million in the six months ended June 30, 2019 to $3.0 million in the same six month period in 2020. As a percentage
of total revenue, general and administrative expense increased from 24% in the first six months of 2019 to 55% in the corresponding
period in 2020. The increase in general and administrative expense was primarily due to costs related to the COVID-19 pandemic
and turnover of over 50% of our administrative personnel. Costs included $0.7 million of severance and transition expense, $0.2
million of legal fees, $0.1 million of bad debt expense and $0.2 million computer hardware and software related to remote working.
Patent related income. We
entered into an arrangement with an unaffiliated third party in 2010 under which we assigned certain patents in return for royalties
on proceeds from patent monetization efforts by the third party. The third party has engaged in various patent monetization activities,
including enforcement, litigation and licensing. In the three and six months ended June 30, 2020, there was no revenue from this
arrangement. For three and six months ended June 30, 2019, revenue was $0 and $49,000 respectively from this arrangement. We continue
to have a contractual relationship with this third party. However, we are unable to predict how much more income we might receive
from this arrangement, if any, because we do not know whether any patent monetization efforts by the third party will be successful.
Interest income. Interest
income decreased 93% from $0.3 million in the three months ended June 30, 2019 to $19,000 in the same three month period in 2020.
Interest income decreased 70% from $0.6 million in the six months ended June 30, 2019 to $0.2 million in the same six month period
in 2020. For the three and six month periods, the decrease in interest income was primarily due to lower interest rates within
our money market accounts as a result of the financial markets response to the COVID-19 pandemic. We expect these lower interest
rates to continue for the foreseeable future.
Income taxes. Income
tax benefit was $0.5 million and $0.7 million for the three and six months ended June 30, 2020, respectively. Income tax expense
for the three and six month periods ended June 30, 2020 were based on the U.S. statutory rate of 21%, increased by state income
taxes, and reduced by permanent adjustments and research tax credits.
The Coronavirus Aid, Relief and Economic
Security Act (CARES Act) was signed into law on March 27, 2020. The Act contained specific relief and stimulus measures including
allowing net operating losses originating in 2018 through 2020 to be carried back five years to offset taxable income in the carryback
period.
Separately, the enactment of the Tax Cut
and Jobs Act in 2017 allowed taxpayers to claim a refund for alternative minimum tax credits over a period of years. The CARES
Act enacted during the first quarter allows for the entire amount of the credit to be refunded in 2020.
We have reviewed the impact of the CARES
Act enactment on the income tax provision and have determined that, as a result of the net operating loss carryback provision,
we can obtain a tax benefit if we were to carry back the forecasted 2020 net operating loss to the five year carryback period.
The carryback of the estimated loss would
result in a refundable alternative minimum tax credit of approximately $1.2 million and an increase in research credit carryforwards
previously utilized. The alternative minimum tax credit can be refunded in the future, if we decide to carry back the loss reported
on the filed 2020 tax return instead of electing to carry the loss forward. Due to the recent loss history and continued uncertainty
surrounding our future projections of income, we will benefit from the current year loss to the extent of the available tax refund
and will maintain a full valuation allowance on all other deferred tax assets, including any increase in research credit carryforward
resulting from a potential carryback.
As of the end of the period, we have not
made a determination on whether to elect to carry forward the 2020 operating loss, however, the alternative minimum tax refund
potential on carryback represents a minimum tax benefit we can obtain from the estimated 2020 loss. We can realize a tax benefit
to the extent of the carryback refund potential as it is considered a source of income against which to utilize the 2020 estimated
loss.
The total estimated benefit of the alternative
minimum tax refund of $1.2 million is included in our projection of our annual effective rate and results in a year to date benefit
of approximately $0.7 million as of June 30, 2020. We recorded the year to date tax benefit as a long term tax receivable.
Liquidity and Capital Resources
At June 30, 2020, we had cash and cash
equivalents of $45.0 million, which represented a decrease of $2.8 million from December 31, 2019. The decrease in cash and cash
equivalents was primarily due to the following factors:
Cash used in operations was $1.9 million
in the first six months of 2020. Cash used in operations was primarily the result of $4.2 million of net loss that was partially
offset by $1.6 million of changes in assets and liabilities, and the add back of $0.6 million of non-cash items primarily for depreciation,
amortization and stock-based compensation.
Cash used in investing activities was $0.4
million in the first six months of 2020. This cash usage consisted of purchases of property and equipment primarily for software
development.
Cash used in financing activities was $0.5
million in the first six months of 2020. Financing activity cash usage was the primarily the result of $0.5 million used to buy
back stock under our stock repurchase program and $0.1 million used to pay income taxes for employees who surrendered shares in
connection with stock grants.
While we cannot assure you that we will
not require additional financing, or that such financing will be available to us, we believe that our cash and cash equivalents
will be sufficient to fund our operations for at least the next twelve months.
Recently Adopted Accounting Pronouncements
See Note 1 to our Consolidated Financial Statements in Item
1.
ITEM 4:
Controls and Procedures
Under the supervision and with the participation
of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our
disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report.
Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls
and procedures are effective.
There were no changes in our internal control
over financial reporting during the quarter ended June 30, 2020 that have materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting.