ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
Management's Discussion and Analysis of Financial Condition and Results of Operations discusses the Company's consolidated financial statements for the periods indicated, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and 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 period. On an on-going basis, management evaluates its estimates and judgments, including those related to revenue recognition, bad debts, product warranties, inventories, long lived and intangible assets, income taxes and contingencies and litigation. Management bases its estimates and judgments on historical experience and on various other factors including general market conditions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. Results for the periods reported herein are not necessarily indicative of results that may be expected in future periods.
Overview
The Company is a global producer of video management systems and system components for use in security, surveillance, safety and communication applications by a broad group of end users worldwide. The Company’s product line consists of various elements of a video system, including DVR's, NVR's, video encoders, decoders, servers and related video management software, data storage units, analog, digital and HD megapixel fixed and robotic cameras, virtual and analog matrix video switchers and controls, and system peripherals.
The Company sells video surveillance system components in a highly competitive worldwide marketplace principally to authorized security distributors, dealers and system integrators. Such dealers and integrators typically resell and install the Company’s products directly to end users, among other services. The Company’s sales are principally project based and are largely dependent upon winning projects, construction activities and the timing of funding. Sales will vary from period to period depending upon many factors including seasonal and geographic trends in construction activities and the timing of deliveries due to changes in
project schedules and funding. The Company usually does not have a large backlog as its customer orders are typically deliverable within three months or often upon receipt of order.
The Company competes in a market of rapid technology shifts which enhance the performance capability of security systems. As a result, the Company spends a significant amount on new product development. In the fiscal years ended September 30, 2016 and 2015, the Company incurred $5.2 million and $5.1 million of engineering and development expense or 15% and 11% of net sales, respectively. The Company’s expenditures for product development are substantially less than its major competitors. The ongoing market shift to intelligent software solutions will continue to burden the Company’s development resources and increase ongoing annual expense for product development. Further, the Company’s sales effort requires a high level of customer service and technical support for its products. The Company routinely considers various strategic options that may augment or supplement its present product offerings and technology platforms.
The Company has a foreign sales and distribution subsidiary in Europe that conducts certain of its business in British pounds and Euros that represented approximately 23% of the Company’s consolidated sales for the fiscal year ended September 30, 2016. It also has an Israel based engineering and development subsidiary that incurs a majority of its operating expenses in Shekels that represented approximately 14% of the Company’s operating expenses for fiscal 2016. Changes in these local foreign currency exchange rates could have a direct impact on the Company's reported financial position and results.
Results of Operations
Three Months Ended
June 30, 2017
Compared with
June 30, 2016
Net sales for the quarter ended June 30, 2017 decreased by $2.1 million (23%) to $7.4 million compared with $9.5 million in the year ago period. Sales in the Americas decreased $958,000 (14%) to $6.0 million compared with $7.0 million in the year ago period, while Europe, Middle East and Africa (EMEA) sales decreased $1.2 million (46%) to $1.4 million compared with $2.6 million in the year ago period. Order intake for the quarter ended June 30, 2017 decreased by $2.0 million (22%) to $6.9 million compared with $8.9 million in the year ago period. Americas order intake decreased by $276,000 (5%) to $5.6 million compared with $5.9 million in the year ago period, while EMEA order intake decreased $1.7 million (57%) to $1.3 million compared with $3.0 million in the year ago period. The backlog of unfilled orders was $1.3 million at June 30, 2017 compared with $1.7 million at September 30, 2016. The Company's sales and order intake levels continued to be negatively impacted by its reliance on an uncompetitive legacy core product offering. While the Company launched an initial version of its new Valerus video management system platform in January 2017, its market impact will not be realized until Valerus gains acceptance in the marketplace. Recently launched system enhancements along with scheduled new camera line product launches during the remainder of fiscal 2017 are expected to improve the Company's market competitiveness, although no assurance can be given in that regard.
Gross profit margins were 38.5% for the quarter ended June 30, 2017 compared with 40.0% in the year ago period.
Operating expenses for the third quarter of fiscal 2017 decreased $504,000 to $4.1 million compared with $4.6 million for the year ago period. Selling, general and administrative (SG&A) expenses for the current quarter decreased $446,000 to $2.9 million compared with $3.3 million in the year ago period. Such decreases included the effects of planned staff and other cost reduction initiatives necessitated by lower revenue expectations. Engineering and development expenses decreased $58,000 to $1.2 million for the current quarter compared with $1.3 million for the year ago period as the Company continued investing in its new video management system platform.
The Company incurred an operating loss of $1.3 million for the third quarter of fiscal 2017 compared with an operating loss of $818,000 in the year ago period.
Interest expense increased to $120,000 for the third quarter of fiscal 2017 compared with $25,000 in the year ago period as a result of increased borrowings under the Company's revolving credit agreement and non-cash amortization charges relating to the warrant granted to the Company's lender.
The Company provides for a valuation allowance against its deferred tax assets due to the uncertainty of future realization and, thus, no tax benefit has been recognized on reported pretax losses for both periods (see Note 9: Income Taxes).
As a result of the foregoing, the Company reported a net loss of $1.4 million for the third quarter of fiscal 2017 compared with a net loss of $843,000 in the year ago period.
Results of Operations
Nine Months Ended
June 30, 2017
Compared with
June 30, 2016
Net sales for the nine months ended June 30, 2017 decreased by $8.4 million (30%) to $20.0 million compared with $28.4 million in the year ago period. Sales in the Americas decreased $5.5 million (25%) to $16.2 million compared with $21.7 million in the year ago period, while Europe, Middle East and Africa (EMEA) sales decreased $2.9 million (43%) to $3.8 million compared with $6.7 million in the year ago period. Order intake for the nine months ended June 30, 2017 decreased by $8.4 million (30%) to $19.5 million compared with $27.9 million in the year ago period. Americas order intake decreased by $5.1 million (24%) to $16.0 million compared with $21.1 million in the year ago period, while EMEA order intake decreased $3.3 million (48%) to $3.5 million compared with $6.8 million in the year ago period. The Company's sales and order intake levels continued to be negatively impacted by its reliance on an uncompetitive legacy core product offering. While the Company launched an initial version of its new Valerus video management system platform in January 2017, its market impact will not be realized until Valerus gains acceptance in the marketplace. Recently launched system enhancements along with scheduled new camera line product launches during the remainder of fiscal 2017 are expected to improve the Company's market competitiveness, although no assurance can be given in that regard.
Gross profit margins were 38.3% for the nine months ended June 30, 2017 compared with 37.7% in the year ago period. The year ago period margins included $150,000 (0.5%) of additional inventory provisions relating to the rework and transitioning of the Company's IQinVision camera line to a new contract manufacturing partner.
Operating expenses for the nine months ended June 30, 2017 decreased $8.9 million to $12.0 million compared with $21.0 million for the year ago period. In the year ago period, the Company charged off its entire $6.0 million goodwill carrying value. Selling, general and administrative (SG&A) expenses for the current year period decreased $2.6 million to $8.4 million compared with $11.0 million in the year ago period. Such decreases included the effects of planned staff and other cost reduction initiatives necessitated by lower revenue expectations. Engineering and development expenses decreased $286,000 to $3.7 million for the current year period compared with $4.0 million for the year ago period as the Company continued investing in its new video management system platform.
The Company incurred an operating loss of $4.4 million for the nine months ended June 30, 2017 compared with an operating loss of $10.2 million in the year ago period.
The Company recorded a gain on the sale of its United Kingdom based operating facility of $785,000 in the first nine months of fiscal 2016.
The Company incurred interest expense of $232,000 for the nine months ended June 30, 2017 compared with $25,000 in the year ago period as a result of increased borrowings under the Company's revolving credit agreement and non-cash amortization charges relating to the warrant granted to the Company's lender.
The Company provides for a valuation allowance against its deferred tax assets due to the uncertainty of future realization and, thus, no tax benefit has been recognized on reported pretax losses for both periods (see Note 9: Income Taxes).
As a result of the foregoing, the Company reported a net loss of $4.6 million for the nine months ended June 30, 2017 compared with a net loss of $9.5 million in the year ago period.
Liquidity and Capital Resources
Net cash used in operating activities was $2.1 million for the first nine months of fiscal 2017. Net losses of $4.1 million for the period, exclusive of non-cash charges, were offset in part by cash generated from a $1.2 million decrease in accounts receivable, a $192,000 decrease in inventories and a $444,000 increase in trade and accrued liabilities. Net cash used in investing activities was $131,000 for the first nine months of fiscal 2017 consisting principally of capital expenditures. Net cash provided by financing activities was $2.0 million for the first nine months of fiscal 2017 consisting of increased revolving credit borrowings. As a result of the foregoing, cash (exclusive of marketable securities) increased by $45,000 for the first nine months of fiscal 2017 after the effect of exchange rate changes on the cash position of the Company.
The Company continues to incur operating losses due to decreased revenue levels and ongoing strategic investments. Since 2012, the Company has made a significant investment in the development of a completely new, and strategically critical, video management system (VMS). The first release of this product offering was launched in January 2017 and is ultimately expected to significantly enhance the Company’s market competitiveness. The funding of this major development effort has contributed to the ongoing operating losses and depletion of cash reserves. The Company has also encountered issues with certain of its camera
offerings that have negatively impacted its revenues during the last twelve months. Although these issues have been substantially resolved, their market impact has lingered into fiscal 2017. In response, the Company phased in material operating expense reductions over the course of the past several years and will consider further cost cutting measures throughout the remainder of the fiscal year. However, the Company intends to continue funding the development of its new VMS platform and rebuilding its market channels.
At June 30, 2017, the Company had $2.0 million of cash reserves and a maximum of $2.3 million of borrowings available under the Credit Agreement described below, which is subject in part to a borrowing-base formula. Cash losses over the past several years have been financed in part by the sale of the Company’s two principal operating facilities and ongoing management of working capital levels. During fiscal 2016, the Company entered into a Credit Agreement that was subsequently amended and restated in August 2016 and April 2017. This Agreement currently consists of two credit lines totaling $6 million that mature in April 2019 (see Note 12 - Credit Agreement). The Company expects to continue to draw on its credit facility to finance its near term working capital needs.
In addition, the Company is currently seeking additional funding sources to finance its aggressive product development roadmap and growth initiatives over the upcoming twelve month period. In this regard, on July 27, 2017, the Company entered into an Investment Agreement with NIL Funding Corporation (“NIL”) whereby NIL has agreed to purchase shares of the Company’s common stock in connection with a contemplated rights offering of common stock to the Company’s shareholders. The aggregate commitment by NIL is equal to the lesser of $3.0 million, or $5.0 million minus the aggregate gross proceeds of the rights offering.
On August 7, 2017, the Company filed its registration statement on Form S-1 with the Securities and Exchange Commission in connection with the contemplated rights offering to sell up to 9.3 million shares of common stock at a discounted price per share. The rights offering by the Company would be launched only following the effectiveness of the registration statement relating to the offering, and will be made only by means of a prospectus.
Since there are no guarantees that such plans will be successful and that the Company will have sufficient available cash to sustain its operations through the next twelve month period, there is substantial doubt about the Company's ability to continue as a going concern.
Off-Balance Sheet Arrangements
The Company does not have any off-balance sheet transactions, arrangements or obligations (including contingent obligations) that have, or are reasonably likely to have, a material effect on the Company’s financial condition, results of operations, liquidity, capital expenditures or capital resources.
Critical Accounting Policies
The Company's significant accounting policies are fully described in Note 1 to the Company's consolidated financial statements included in its
September 30, 2016
Annual Report on Form 10-K. Management believes the following critical accounting policies, among others, affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.
Revenue is generally recognized when products are sold and title is passed to the customer. Advance service billings are deferred and recognized as revenues on a pro rata basis over the term of the service agreement. Pursuant to Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 605-25-05, the Company evaluates multiple-element revenue arrangements for separate units of accounting, and follows appropriate revenue recognition policies for each separate unit. Elements are considered separate units of accounting provided that (i) the delivered item has stand-alone value to the customer, (ii) there is objective and reliable evidence of the fair value of the undelivered item, and (iii) if a general right of return exists relative to the delivered item, delivery or performance of the undelivered item is considered probable and substantially within the control of the Company. As applied to the Company, under arrangements involving the sale of product and the provision of services, product sales are recognized as revenue when the products are sold and title is passed to the customer, and service revenue is recognized as services are performed.
For products that include software and for separate licenses of the Company’s software products, the Company recognizes revenue in accordance with the provisions of FASB Accounting Standards Update (ASU) 2009-13, “Revenue Recognition (Topic 605) - Multiple-Deliverable Revenue Arrangements” (ASU 2009-13). ASU 2009-13 provides revenue recognition guidance for establishing separate units of accounting in a multiple element arrangement and requires the allocation of arrangement consideration to each deliverable in the arrangement based on the fair value of the elements. The fair value for each deliverable is based on vendor-specific objective evidence ("VSOE") if available, third-party evidence ("TPE") if VSOE is not available, or
best estimate of selling price ("BESP") if neither VSOE nor TPE is available. BESP must be determined in a manner that is consistent with that used to determine the price to sell the specific elements on a standalone basis.
The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of its customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
The Company provides for the estimated cost of product warranties at the time revenue is recognized. While the Company engages in product quality programs and processes, including monitoring and evaluating the quality of its component suppliers, its warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. Should actual product failure rates, material usage or service delivery costs differ from its estimates, revisions to the estimated warranty liability may be required.
The Company writes down its inventory for estimated obsolescence and slow moving inventory equal to the difference between the carrying cost of inventory and the estimated net realizable market value based upon assumptions about future demand and market conditions. Technology changes and market conditions may render some of the Company’s products obsolete and additional inventory write-downs may be required. If actual future demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required.
The Company evaluates the establishment of technological feasibility of its software in accordance with ASC 985 ("Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed"). The Company has determined that technological feasibility for its new products is reached shortly before products are released for field testing. Costs incurred after technological feasibility has been established have not been material and are expensed as incurred.
The Company assesses the recoverability of the carrying value of its long-lived and intangible assets whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. The Company evaluates the recoverability of such assets based upon the expectations of undiscounted cash flows from such assets. If the sum of the expected future undiscounted cash flows were less than the carrying amount of the asset, a loss would be recognized for the difference between the fair value and the carrying amount. Since the Company's merger with IQinVision, it has essentially redesigned its acquired camera line. Thus, the Company determined that its technology asset was fully impaired and, as a result, recorded an impairment charge of $2.0 million at September 30, 2016.
The Company's ability to recover the reported amounts of deferred income tax assets is dependent upon its ability to generate sufficient taxable income during the periods over which net temporary tax differences become deductible. The Company provides for a valuation allowance against all deferred tax assets due to the uncertainty of future realization. The Company plans to provide a full valuation allowance against its deferred tax assets until such time that it can achieve a sustained level of profitability or other positive evidence arises that would demonstrate an ability to recover such assets.
The Company accrues liabilities for identified tax contingencies that result from positions that are being challenged or could be challenged by tax authorities. The Company believes that its accrual for tax liabilities is adequate for all open years, based on Management’s assessment of many factors, including its interpretations of the tax law and judgments about potential actions by tax authorities. However, it is possible that the ultimate resolution of any tax audit may be materially greater or lower than the amount accrued.
Accounting for restructuring activities, as compared to regular operating cost management activities, requires an evaluation of formally committed and approved plans. Restructuring activities have comparatively greater strategic significance and materiality and may involve exit activities, whereas regular cost containment activities are more tactical in nature and are rarely characterized by formal and integrated action plans or exiting a particular product, facility or service.
The Company is subject to proceedings, lawsuits and other claims related to labor, product and other matters. The Company assesses the likelihood of an adverse judgment or outcomes for these matters, as well as the range of potential losses. A determination of the reserves required, if any, is made after careful analysis. The required reserves may change in the future due to new developments.
Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995
Statements in this Report on Form 10-Q that are not strictly historical facts including, without limitation, statements included under the “Management’s Discussion and Analysis” caption, are “forward-looking” statements within the meaning of 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, that should be considered as subject to the many risks and uncertainties that exist in the Company's operations and business environment. The forward-looking statements are based on current expectations and involve a number of known and unknown risks and uncertainties that could cause the actual results, performance and/or achievements of the Company to differ materially from any future results, performance or achievements, express or implied, by the forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, and that in light of the significant uncertainties inherent in forward-looking statements, the inclusion of such statements should not be regarded as a representation by the Company or any other person that the objectives or plans of the Company will be achieved. The Company assumes no obligation to publicly update or revise its forward-looking statements or to advise of changes in the assumptions and factors on which they are based.