Lattice Incorporated and Subsidiaries
Notes to Condensed Consolidated Financial Statements
September 30, 2010 (Unaudited)
Note 1 - Organization and summary of significant accounting policies
a) Organization
Lattice Incorporated (the “Company”) was incorporated in the State of Delaware May 1973 and commenced operations in July 1977. The Company began as a provider of specialized solutions to the telecom industry. Throughout its history Lattice has adapted to the changes in this industry by reinventing itself to be more responsive and open to the dynamic pace of change experienced in the broader converged communications industry of today. Currently Lattice provides advanced solutions for several vertical markets. The greatest change in operations is in the shift from being a component manufacturer to a solution provider focused on developing applications through software on its core platform technology. To further its strategy of becoming a solutions provider, the Company acquired a majority interest in “SMEI” in February 2005. In September 2006 the Company purchased all of the issued and outstanding shares of the common stock of Ricciardi Technologies Inc. (“RTI”). RTI was founded in 1992 and provides software consulting and development services for the command and control of biological sensors and other Department of Defense requirements to United States federal governmental agencies either directly or through prime contractors of such governmental agencies. RTI’s proprietary products include SensorView, which provides clients with the capability to command, control and monitor multiple distributed chemical, biological, nuclear, explosive and hazardous material sensors. With the SMEI and the RTI acquisitions, approximately 71% of the Company’s revenues are derived from solution services. In December 2009 we ch anged RTI’s name to Lattice Government Services Inc. In January 2007, we changed our name from Science Dynamics Corporation to Lattice Incorporated.
b) Basis of Presentation going concern
At September 30, 2010 the Company has a working capital deficiency of $1,108,100 including non-cash derivative liabilities of $148,383. For the three months ended September 30, 2010, the Company had a loss from operations of $137,796 of which $318,155 was from non-cash items. For the nine months ended September 30, 2010, the reported loss from operations was $442,853. For the nine months, non-cash expenses included in the reported loss of $442,853 totaled $954,466 inclusive of $560,641 in amortization of intangibles and depreciation and $393,825 from share-based compensation. During the second quarter of 2 010, the Company obtained $1,250,000 of long-term financing to repay short-term obligations. The Company’s working capital deficiency in conjunction with the Company’s history of operating losses raises doubt regarding the Company’s ability to continue as a going concern. The Company’s ability to continue as a going concern is highly dependent upon management’s ability to increase operating cashflows, maintain continued availability on its line of credit and the ability to obtain alternative financing to fund capital requirements and/or debt repayments coming due in the next twelve months. The accompanying financial statements do not include any adjustments that may result from the outcome of this uncertainty.
c) Interim Condensed Consolidated Financial Statements
The condensed consolidated financial statements as of September 30, 2010 and for the three and nine months ended September 30, 2010 are unaudited. In the opinion of management, such condensed consolidated financial statements include all adjustments (consisting of normal recurring accruals) necessary for the fair representation of the consolidated financial position and the consolidated results of operations. The consolidated results of operations for the periods presented are not necessarily indicative of the results to be expected for the full year. The interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year end December 31, 2009 appearing in Form 10K filed on April 15, 2010.
d) Principles of consolidation
The consolidated financial statements included the accounts of the Company and all of its subsidiaries in which a controlling interest is maintained. All significant inter-company accounts and transactions have been eliminated in consolidation. For those consolidated subsidiaries where Company ownership is less than 100%, the outside stockholders’ interests are shown as minority interests. Investments in affiliates over which the Company has significant influence but not a controlling interest are carried on the equity basis.
e) Use of estimates
The preparation of these financial statements in accordance with accounting principles generally accepted in the United States (US GAAP) requires management to make estimates and assumptions that affect the reported amounts in the financial statements and accompanying notes. These estimates form the basis for judgments made about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates and judgments are based on historical experience and on various other assumptions that the Company believes are reasonable under the circumstances. However, future events are subject to change and the best estimates and judgments ro utinely require adjustment. US GAAP requires estimates and judgments in several areas, including those related to impairment of goodwill and equity investments, revenue recognition, recoverability of inventory and receivables, the useful lives long lived assets such as property and equipment, the future realization of deferred income tax benefits and the recording of various accruals. The ultimate outcome and actual results could differ from the estimates and assumptions used.
f) Share-based payments
On January 1, 2006, the Company adopted the fair value recognition provisions of Financial Accounting Standards Board Accounting Standards Condification 718-10, Accounting for Share-based payments, to account for compensation costs under its stock option plans and other share-based arrangements. ASC 718 requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. For purposes of estimating fair value of stock options, we use the Black-Scholes-Merton valuation technique. At Sept ember 30, 2010, there was approximately $305,883 of total unrecognized compensation cost related to unvested share-based compensation awards granted. The $305,883 will be charged to operations over the weighted average remaining service period. For the three months and nine months ended September 30, 2010 share-based compensation was $131,275 and $393,825 respectively. This compared to $125,631 and $382,541 in the prior year periods.
g) Reclassifications
Certain items have been reclassified in the accompanying consolidated Financial Statements and Notes for prior periods to be comparable with the classification for the period ended September 30, 2010. The reclassification had no effect on previously reported Net income.
Certain prior period amounts have been reclassified to conform to the current presentation. Such reclassifications were limited to the statement of Operations presentation and did not impact the Net Income (Loss). Specially, the Company reclassified revenues from “Revenue – Technology Services and Revenue – Technology Products to “Revenue”, with prior periods updated to conform to this presentation.
h) Revenue Recognition
Revenues related to collect and prepaid calling services generated by the communication services segment are recognized during the period in which the calls are made. In addition, during the same period, the Company records the related telecommunication costs for validating, transmitting, billing and collection, and line and long distance charges, along with commissions payable to the facilities and allowances for uncollectible calls, based on historical experience.
Government claims: Unapproved claims relate to contracts where costs have exceeded the customer’s funded value of the task ordered on our cost reimbursement type contract vehicles. The unapproved claims are considered to be probable of collection and have been recognized as revenue. Unapproved claims included as a component of our Accounts Receivable totaled approximately $1,525,000 and $1,245,000 as of September 30, 2010 and December 31, 2009, respectively. Consistent with industry practice, we classify assets and liabilities related to these claims as current, even though some of these amounts are not expected to be realized within one year.
Additional revenue recognition policies are stated in our 10K filed April 15, 2010.
i) Segment Reporting
FASB ASC 280-10-50, “Disclosure about Segments of an Enterprise and Related Information” requires use of the “management approach” model for segment reporting. The management approach model is based on the way a company’s management organizes segments within the company for making operating decisions and assessing performance. Reportable segments are based on products and services, geography, legal structure, management structure, or any other manner in which management disaggregates a company. The Company operates in two segments for the nine months ended September 30, 2010. Prior to 2010 the company ope rated in one segment.
j) Recent accounting pronouncements
In January 2010, the FASB issued ASU 2010-06, Improving Disclosures about Fair Value Measurements. ASU 2010-06 amends ASC Topic 820 to require additional disclosures regarding fair value measurements. One of the areas concerned is related to the inclusion of information about purchases, sales, issuances and settlements in the reconciliation of recurring Level 3 measurements. Such disclosure requirements will be effective for annual reporting periods beginning after December 15, 2010 and for interim periods within those fiscal years. As ASU 2010-06 only requires enhanced disclosures, the Company does not expect that the adoption of this update will have a m aterial effect on its consolidated financial statements.
Note 2- Segment reporting
Management views its business as two reportable segments: Government Services and Communication Services. The Company evaluates performance based on profit or loss before intercompany charges.
| | | September 30, | | | Nine Months Ended | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | | | | | | | | | | | | |
| Revenues: | | | | | | | | | | | | |
| Goverment Services | | $ | 2,206,321 | | | $ | 3,632,911 | | | $ | 7,637,274 | | | $ | 11,000,359 | |
| Communication Serivices | | | 916,549 | | | | 289,153 | | | | 2,600,347 | | | | 896,288 | |
| Total Consolidated Revenues | | $ | 3,122,870 | | | $ | 3,922,064 | | | $ | 10,237,621 | | | $ | 11,896,647 | |
| | | | | | | | | | | | | | | | | |
| Gross Profit: | | | | | | | | | | | | | | | | |
| Government Services | | $ | 924,438 | | | $ | 1,087,578 | | | $ | 3,028,680 | | | $ | 3,237,071 | |
| Communication Serivices | | | 370,077 | | | | 169,753 | | | | 845,966 | | | | 553,833 | |
| Total Consolidated | | $ | 1,294,515 | | | $ | 1,257,331 | | | $ | 3,874,646 | | | $ | 3,790,904 | |
| | | | | | | | | | | | | | | | | |
| | | September 30, 2010 | | | December 31, 2009 | | | | | | | | | |
| Total Assets: | | | | | | | | | | | | | | | | |
| Government Services | | $ | 7,287,745 | | | $ | 8,270,589 | | | | | | | | | |
| Communication Services | | | 2,177,308 | | | | 560,980 | | | | | | | | | |
| Total Consolidated Assets | | $ | 9,465,053 | | | $ | 8,831,569 | | | | | | | | | |
Note 3 - Notes payable
Notes payable consists of the following as of September 30, 2010 and December 31, 2009:
| | | September 30, 2010 | | | December 31, 2009 | |
| | | | | | | |
| Bank line-of-credit (a) | | $ | 171,105 | | | $ | 838,231 | |
| Note Payable – (b) | | | 531,000 | | | | 562,500 | |
| Notes payable to Stockholders/director (c) | | | 170,345 | | | | 197,180 | |
| Capital lease payable (d) | | | 69,656 | | | | 94,297 | |
| Note Payable – I Wistar Morris (e) | | | 1,250,000 | | | | - | |
| Total notes payable | | | 2,192,106 | | | | 1,692,208 | |
| Less current maturities | | | (932,153 | ) | | | (1,503,742 | ) |
| Long-term debt | | $ | 1,259,953 | | | $ | 188,466 | |
(a) Bank line-of-credit
On July 17, 2009, the Company and its wholly-owned subsidiary, Lattice Government Services (formally “RTI”), entered into a Financing and Security Agreement (the “Action Agreement”) with Action Capital Corporation (“Action Capital”).
Pursuant to the terms of the Action Agreement, Action Capital agreed to provide the Company with advances of up to 90% of the net amount of certain acceptable account receivables of the Company (the “Acceptable Accounts”). The maximum amount eligible to be advanced to the Company by Action Capital under the Action Agreement is $3,000,000. The Company will pay Action Capital interest on the advances outstanding under the Action Agreement equal to the prime rate of Wachovia Bank, N.A. in effect on the last business day of the prior month plus 1%. In addition, the Company will pay a monthly fee to Action Capital equal to 0.75% of the total outstanding balance at the end of each month.
In addition, pursuant to the Action Agreement, the Company granted Action Capital a security interest in certain assets of the Company including all, accounts receivable, contract rights, rebates and books and records pertaining to the foregoing (the “Action Lien”). On June 11, 2010, Action Capital and I. Wistar Morris entered into an agreement under which $1,250,000 of the collateral otherwise securing advances covered by the Action Agreement are subordinated to a new security interest securing an additional loan from Morris.
The outstanding balance owed on the line at September 30, 2010 and December 31, 2009 was $171,105 and $838,231 respectively.
(b) Note payable
In February 2010 (“effective date”) the former RTI shareholders assigned their interest in the note to a third party, at which time the Company amended the terms of the note to pay interest only and extend the maturity for 18 months with a balloon payment August 19, 2012. The holder has a call option on the principal balance of $531,000 which includes $31,000 in deferred financing fees after twelve months from the effective date upon written notification 45 days in advance. The balance at September 30, 2010 and December 31, 2009 was $531,000 and $562,500 respectively.
(c) Notes payable Director
The Company has a term note payable with a director of the Company totaling $170,345 and $197,180 at September 30, 2010 and December 31, 2009, respectively. The note bears interest at 21.5% per annum In February 2010 the Company renegotiated the terms of the note as follows:
Monthly principal payments:
$6,000 from February 1, 2010 to July 1, 2010
$9,869 from August 1, 2010 to December 1, 2010
$10,368 from January 1, 2011 to July 1, 2011
Balance due of $85,011 August 1, 2011
(d) Capital Lease Payable
On June 16, 2009 Lattice entered an equipment lease financing agreement with Royal Bank America Leasing to purchase approximately $130,000 in equipment for our communication services. The terms of which included monthly payments of $5,196 per month over 32 months and a $1.00 buy-out at end of the lease term. As of September 30, 2010 and December 31, 2009, the outstanding balance was $69,656 and $94,297 respectively.
(e) Note Payable – I. Wistar Morris
On June 11, 2010 Lattice closed on a Note Payable with I. Wistar Morris for $1,250,000. The proceeds to the Company were $1,100,000. The note matures June 30, 2012 and payment of principal will be due at that time in the lump sum value of $1,250,000 including interest. Until maturity, Lattice is required to make quarterly interest payments (calculated in arrears) at 12% stated interest with the first quarter interest payment of $37,500 due September 30, 2010 and $37,500 due each quarter end thereafter until the final payment comes due June 30, 2012 totaling $1,287,500 including the final interest payment. The note is secured by certain rece ivables totaling $1,250,000. Concurrent with the note, an intercreditor agreement was signed between Action Capital and I. Wistar Morris where Action has agreed to subordinate the ACTION Lien on certain government contracts, task orders and accounts receivable totaling $1,250,000. As of the date of this filing, the Company is current with all interest payments.
Note 4 - Derivative financial instruments
The balance sheet caption derivative liabilities consist of Warrants, issued in connection with the 2005 Laurus Financing Arrangement, and the 2006 Omnibus Amendment and Waiver Agreement with Laurus. These derivative financial instruments are indexed to an aggregate of 1,548,333 and 4,313,465 shares of the Company’s common stock as of September 30, 2010 and December 31, 2009 and are carried at fair value. The balance at September 30, 2010 and December 31, 2009 was $148,383 and $161,570 respectively.
Note 5 - Major Customers and Concentrations
Our government service segment’s primary “end-user” customer is the U.S. Department of Defense (DoD) which accounted for approximately 75% and 93% of our total revenues for nine months ended September 30, 2010 and September 30, 2009 respectively. For the three months ended September 30, 2010 and 2009 they accounted for 71% and 93% of our total revenue. Accounts receivable for these contracts at September 30, 2010 and December 31, 2009 was $2,921,308 and $3,335,667 respectively.
Included in the government segment are two contract vehicles with the Navy Space and Navel Warfare Command (SPAWAR) in San Diego that account for 61% and 81% of its revenues in the nine months ended September 30, 2010 and 2009 respectively and 66% and 80% of its revenues in the three months ended September 30, 2010 and 2009 respectively. Accounts receivable for these contracts at September 30, 2010 and 2009 was $1,973,305 and $2,727,418 respectively. Any disruption in funding or renewals of these contract vehicles would have a material adverse effect on our business, results of operations, and cash flow.
Note 6 – Commitments and Contingencies
From time to time, lawsuits are threatened or filed against us in the ordinary course of business. Such lawsuits typically involve claims from customers, former or current employees, and vendors related to issues common to our industry. A number of such claims may exist at any given time. Although there can be no assurance as to the ultimate disposition of these matters, it is our management’s opinion, based upon the information available at this time, that the expected outcome of these matters, individually and in the aggregate, will not have a material adverse effect on the results of operations, liquidity or financial condition of our company.
In August 2010 the Company extended its Herdon VA lease until October 31, 2011 at an average monthly rent of $14,755.
Note 7 -Exchange of Series A Preferred Stock for cancellation of Series A Warrants
On February 1, 2010, we received cash proceeds of $250,000 from Barron Partners L.P. in exchange for the issuance of 1,400,011 shares of Series A Convertible Preferred Stock (“Series A Preferred”) and the return and cancellation of 1,955,132 shares of Series A warrants which were originally issued in conjunction with the September 19, 2006 Barron financing. The exchange was effective February 19, 2010.
The Series A warrants did not meet all the conditions of Accounting Standards Codification (“ASC”) 815 Derivatives and Hedging for equity classification so they had been recorded as derivative liabilities since inception. The fair value of the Series A warrants on the transaction date was determined to be $87,785 using the Black-Scholes option pricing model. Significant assumptions used in the Black Scholes model as of the date of the exchange included a strike price of $0.283; a historical volatility factor of 181% based upon forward terms of instruments; a remaining term of 1.58 years ; and a risk free rate of 0.95%.
The Series A Preferred was designated on August 28, 2006. The Series A Preferred has a par value of $0.01 and as of the date of the exchange, each share of preferred stock is convertible into 3.5714 shares of the Company’s common stock and would be automatically converted into common stock upon a change in control liquidation, at an amount equal to $.575 per share. The conversion price is subject to anti-dilution protection for (i) traditional capital restructurings, such as splits, stock dividends and reorganizations and (ii) sales or issuances of common shares or contracts to which common shares are indexed at less than the stated conve rsion prices. Holders of the Company’s Series A Preferred are not entitled to dividends and the Holder has no voting rights.
In considering the application of ASC 815, we identified those specific terms and features embedded in the contract that possess the characteristics of derivative financial instruments. Those features included the conversion option and buy-in and non-delivery puts. In evaluating the respective classification of these embedded derivatives, we were required to determine whether the host contract (the Series A Preferred) was more akin to a debt or equity instrument in regards to the risks. This determination is subjective. However, in complying with the guidance provided in ASC 815 we concluded, based upon the preponderance and weight of all terms, conditions and f eatures of the host contracts, that the Series A Preferred was more akin to an equity instrument for purposes of considering the clear and close relation of the embedded feature to the host contract. Based upon this conclusion, we further concluded that (i) embedded features did not require derivative liability classification and (ii) certain Non-delivery and Buy-in puts which require the Company to make-whole the investor for market fluctuation losses in the event of non-delivery of conversion shares meet the requisite criteria of a derivative financial instrument and should be bifurcated. Since share delivery is in the Company’s option and they have enough authorized shares to settle their share-settleable debt, it was determined that the value of these puts was deminimus.
The fair value of the Series A Preferred on the date of the exchange was determined to be $467,840 by considering both (i) the fair value based upon the common stock equivalent value, plus the fair value of enhancements, such as the anti-dilution protection and (ii) the liquidation value. Since the fair value of the Series A Preferred was greater than the carrying value of the warrants and the cash paid, we are required to record a loss on extinguishment in accordance with ASC 470 Modifications and Extinguishments for the difference. This exchange resulted in a loss on extinguishment of $130,055.
Note 8 - Purchase of intellectual property
On January 4, 2010 the Company entered into a Patent Licensing agreement supporting its communication services products. In conjunction with the agreement the Company agreed to pay $1,300,000 as follows; $50,000 on the first of each month starting on January 1, 2010 and ending June 1, 2010 and a lump sum payment due of $1,000,000 on June 30, 2010. The $1,300,000 was paid in full pursuant to the licensing agreement as of June 30, 2010. The 1,300,000 was accounted for as intangible property and is being amortized over 120 months. Accordingly $32,500 and 97,500 of amortization expense was included as a component of the co mmunication segment cost of sales for the three and nine months ended September 30, 2010.
Note 9 - Subsequent Events
Pursuant to Financial Accounting Standards Board Accounting Standards Codification 855-10, we have evaluated all events or transactions that occurred from October 1, 2010 through the filing with the SEC. We did not have any material recognizable subsequent events during this period.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
