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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
þ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended September 30, 2010
OR
o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from ____ to _____
Commission file number 0-10560
CTI GROUP (HOLDINGS) INC.
(Exact name of registrant as specified in its charter)
DELAWARE | 51-0308583 | |
(State or other jurisdiction of | (I.R.S. Employer | |
incorporation or organization) | Identification No.) |
333 North Alabama Street, Suite 240, Indianapolis, IN 46204
(Address of principal executive offices) (Zip Code)
(Address of principal executive offices) (Zip Code)
(317) 262-4666
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yesþ Noo
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yeso Noo
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filero | Accelerated filero | Non-accelerated filero | Smaller reporting companyþ | |||
(Do not check if a smaller reporting company) |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso Noþ
APPLICABLE ONLY TO CORPORATE ISSUERS:
As of November 9, 2010, the number of shares of Class A common stock, par value $.01 per share, outstanding was 29,178,271. As of November 9, 2010, treasury stock constituted 140,250 shares of Class A common stock.
CTI GROUP (HOLDINGS) INC.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2010
TABLE OF CONTENTS
TABLE OF CONTENTS
ITEM | PAGE | |||||||
NO. | NO. | |||||||
Forward Looking Statements | 4 | |||||||
PART I — Financial Information | ||||||||
1. Financial Statements | ||||||||
Consolidated Balance Sheets at September 30, 2010 (unaudited) and December 31, 2009 | 4 | |||||||
Consolidated Statements of Operations (unaudited) for the nine months ended September 30, 2010 and September 30, 2009 | 5 | |||||||
Consolidated Statements of Operations (unaudited) for the three months ended September 30, 2010 and September 30, 2009 | 6 | |||||||
Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2010 and September 30, 2009 | 7 | |||||||
Notes to Consolidated Financial Statements (unaudited) | 9 | |||||||
2. Management’s Discussion and Analysis of Financial Condition and Results of Operations | 17 | |||||||
3. Quantitative and Qualitative Disclosures about Market Risk | 27 | |||||||
4(T). Controls and Procedures | 28 | |||||||
PART II — Other Information | ||||||||
1. Legal Proceedings | 29 | |||||||
1A. Risk Factors | 29 | |||||||
2. Unregistered Sales of Equity Securities and Use of Proceeds | 29 | |||||||
3. Defaults Upon Senior Securities | 29 | |||||||
4. (Removed and Reserved) | 29 | |||||||
5. Other Information | 29 | |||||||
6. Exhibits | 30 | |||||||
Signatures | 31 | |||||||
EX-31.1 | ||||||||
EX-31.2 | ||||||||
EX-32.1 | ||||||||
EX-32.2 |
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Forward-Looking Statements
This Quarterly Report on Form 10-Q (“Form 10-Q”) contains “forward-looking” statements. Examples of forward-looking statements include, but are not limited to: (a) projections of revenues, capital expenditures, growth, prospects, dividends, capital structure and other financial matters; (b) statements of plans and objectives of the Company or its management or board of directors; (c) statements of future economic performance; (d) statements of assumptions underlying other statements and statements about the Company and its business relating to the future; and (e) any statements using the words “anticipate”, “expect”, “may”, “project”, “intend”, “believe”, or similar expressions.
The Company’s ability to predict projected results or the effect of certain events on the Company’s operating results is inherently uncertain. Therefore, the Company wishes to caution each reader of this Quarterly Report to carefully consider the risk factors stated in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2009 and Quarterly Report on Form 10-Q for the quarter ended June 30, 2010, any or all of which have in the past and could in the future affect the ability of the Company to achieve its anticipated results and could cause actual results to differ materially from those discussed herein, including, but not limited to: effects of current economic crisis, reductions in the borrowing base under the revolving loan facility, ability to renew or obtain replacement loan facility, ability to attract and retain customers to purchase its products, ability to develop or launch new software products, technological advances by third parties and competition, ability to protect the Company’s patented technology, and ability to obtain settlements in connection with its patent enforcement activities. You should not place any undue reliance on any forward-looking statements. The Company disclaims any intent or obligations to update forward-looking statements contained in this Form 10-Q.
References herein to the Company mean CTI Group (Holdings) Inc. and its subsidiaries unless context otherwise requires.
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PART I — FINANCIAL INFORMATION
Item 1. | Financial Statements |
CTI GROUP (HOLDINGS) INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
CONSOLIDATED BALANCE SHEETS
September 30, | ||||||||
2010 | December 31, | |||||||
(unaudited) | 2009 | |||||||
ASSETS | ||||||||
Cash and cash equivalents | $ | 323,333 | $ | 508,836 | ||||
Trade accounts receivable, less allowance for doubtful accounts of $71,444 and $59,199, respectively | 2,825,552 | 2,381,293 | ||||||
Note and settlement receivable — short term | 97,707 | 379,447 | ||||||
Prepaid expenses | 380,294 | 329,720 | ||||||
Deferred financing costs | 15,051 | 71,756 | ||||||
Other current assets | 180,062 | 209,445 | ||||||
Total current assets | 3,821,999 | 3,880,497 | ||||||
Long term settlement receivable — net of current portion | — | 24,623 | ||||||
Property, equipment, and software, net | 2,151,647 | 2,198,376 | ||||||
Intangible assets, net | 3,370,590 | 3,882,209 | ||||||
Goodwill | 4,896,990 | 4,896,990 | ||||||
Other assets | 78,738 | 78,499 | ||||||
Total assets | $ | 14,319,964 | $ | 14,961,194 | ||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||
Accounts payable | $ | 432,178 | $ | 670,402 | ||||
Accrued expenses | 1,090,199 | 1,103,533 | ||||||
Accrued wages and other compensation | 514,448 | 298,852 | ||||||
Income tax payable | 295,582 | 62,057 | ||||||
Deferred income tax liability | 114,603 | 256,461 | ||||||
Note payable | 1,260,000 | 918,027 | ||||||
Deferred revenue | 2,191,188 | 1,991,664 | ||||||
Total current liabilities | 5,898,198 | 5,300,996 | ||||||
Lease incentive — long term | 200,232 | 193,751 | ||||||
Deferred revenue — long term | 275,554 | 127,306 | ||||||
Deferred income tax liability — long term | 833,333 | 802,994 | ||||||
Total liabilities | 7,207,317 | 6,425,047 | ||||||
Commitments and contingencies | ||||||||
Stockholders’ equity | ||||||||
Class A common stock, par value $.01 per share; 47,166,666 shares authorized; 29,178,271 issued and outstanding at September 30, 2010 and at December 31, 2009 | 291,783 | 291,783 | ||||||
Additional paid-in capital | 26,010,919 | 25,968,526 | ||||||
Accumulated deficit | (19,369,437 | ) | (17,970,400 | ) | ||||
Other comprehensive income — foreign currency translation | 371,525 | 438,381 | ||||||
Treasury stock, 140,250 shares at cost | (192,143 | ) | (192,143 | ) | ||||
Total stockholders’ equity | 7,112,647 | 8,536,147 | ||||||
Total liabilities and stockholders’ equity | $ | 14,319,964 | $ | 14,961,194 | ||||
See accompanying notes to consolidated financial statements.
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CTI GROUP (HOLDINGS) INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
Nine months ended | ||||||||
September 30, | ||||||||
2010 | 2009 | |||||||
Revenues: | ||||||||
Software sales, service fee and license fee revenue | $ | 10,824,098 | $ | 11,660,097 | ||||
Patent license fee and enforcement revenues | 40,500 | — | ||||||
10,864,598 | 11,660,097 | |||||||
Cost and Expenses: | ||||||||
Cost of products and services, excluding depreciation and amortization | 3,558,107 | 3,273,946 | ||||||
Patent license fee and enforcement cost | 7,450 | 812,892 | ||||||
Selling, general and administration | 5,542,584 | 5,723,105 | ||||||
Research and development | 1,798,569 | 1,994,163 | ||||||
Depreciation and amortization | 1,231,223 | 1,146,724 | ||||||
Loss from operations | (1,273,335 | ) | (1,290,733 | ) | ||||
Other expense | ||||||||
Interest expense, net of interest income of $23,012 and $61,627, respectively | 72,998 | 70,256 | ||||||
Other expense / (income) | 51 | (1,201 | ) | |||||
Total other expense | 73,049 | 69,055 | ||||||
Loss before income taxes | (1,346,384 | ) | (1,359,788 | ) | ||||
Tax expense | 52,654 | 168,450 | ||||||
Net loss | (1,399,038 | ) | (1,528,238 | ) | ||||
Other comprehensive income / (loss) | ||||||||
Foreign currency translation adjustment | (66,855 | ) | (7,724 | ) | ||||
Comprehensive loss | $ | (1,465,893 | ) | $ | (1,535,962 | ) | ||
Basic and diluted net loss per common share | $ | (0.05 | ) | $ | (0.05 | ) | ||
Basic and diluted weighted average common shares outstanding | 29,038,021 | 29,038,021 |
See accompanying notes to consolidated financial statements
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CTI GROUP (HOLDINGS) INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
Three months ended | ||||||||
September 30, | ||||||||
2010 | 2009 | |||||||
Revenues: | ||||||||
Software sales, service fee and license fee revenue | $ | 3,346,509 | $ | 3,571,487 | ||||
Patent license fee and enforcement revenues | — | — | ||||||
3,346,509 | 3,571,487 | |||||||
Cost and Expenses: | ||||||||
Cost of products and services, excluding depreciation and amortization | 1,212,783 | 875,038 | ||||||
Patent license fee and enforcement cost | (3,153 | ) | 128,739 | |||||
Selling, general and administration | 1,800,264 | 1,802,220 | ||||||
Research and development | 571,982 | 582,851 | ||||||
Depreciation and amortization | 435,113 | 392,773 | ||||||
Loss from operations | (670,480 | ) | (210,134 | ) | ||||
Other expense | ||||||||
Interest expense, net of interest income of $3,068 and $10,495, respectively | 31,349 | 27,458 | ||||||
Other expense | — | 298 | ||||||
Total other expense | 31,349 | 27,756 | ||||||
Loss before income taxes | (701,829 | ) | (237,890 | ) | ||||
Tax expense | 26,559 | 99,659 | ||||||
Net loss | (728,388 | ) | (337,549 | ) | ||||
Other comprehensive income / (loss) | ||||||||
Foreign currency translation adjustment | (210,582 | ) | 17,233 | |||||
Comprehensive loss | $ | (938,970 | ) | $ | (320,316 | ) | ||
Basic and diluted net loss per common share | $ | (0.03 | ) | $ | (0.01 | ) | ||
Basic and diluted weighted average common shares outstanding | 29,038,021 | 29,038,021 |
See accompanying notes to consolidated financial statements
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CTI GROUP (HOLDINGS) INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Nine months ended | ||||||||
September 30, | ||||||||
2010 | 2009 | |||||||
Cash flows from operating activities: | ||||||||
Net loss | $ | (1,399,038 | ) | $ | (1,528,238 | ) | ||
Adjustments to reconcile net loss to net cash used in operating activities: | ||||||||
Depreciation and amortization | 1,231,223 | 1,146,724 | ||||||
Provision for doubtful accounts | 29,500 | 27,830 | ||||||
Deferred income taxes | (88,904 | ) | (250,850 | ) | ||||
Amortization of deferred financing fees | 56,705 | 82,771 | ||||||
Non-cash interest charge | 2,006 | 2,006 | ||||||
Recognition of rent incentive benefit | 46,117 | 25,138 | ||||||
Stock option grant expense | 40,387 | 85,144 | ||||||
Loss on disposal of property and equipment | 53 | 275 | ||||||
Changes in operating assets and liabilities: | ||||||||
Trade receivables | (516,985 | ) | 106,707 | |||||
Note and settlement receivables | 306,362 | 289,904 | ||||||
Prepaid expenses | (53,971 | ) | (117,714 | ) | ||||
Income taxes | 235,567 | 153,539 | ||||||
Other assets | 31,574 | (91,087 | ) | |||||
Accounts payable | (231,822 | ) | 331,400 | |||||
Accrued expenses | (36,795 | ) | (149,418 | ) | ||||
Accrued wages and other compensation | 218,330 | (53,291 | ) | |||||
Deferred revenue | 391,963 | 664,222 | ||||||
Cash provided by operating activities | 262,272 | 725,062 | ||||||
Cash flows used in investing activities: | ||||||||
Additions to property, equipment, and software | (786,932 | ) | (923,197 | ) | ||||
Cash used in investing activities | (786,932 | ) | (923,197 | ) | ||||
Cash flows provided by financing activities: | ||||||||
Borrowings under credit agreements | 3,031,000 | 3,714,000 | ||||||
Repayments under credit agreements | (2,689,027 | ) | (3,353,000 | ) | ||||
Cash provided by financing activities | 341,973 | 361,000 | ||||||
Effect of foreign currency exchange rates on cash and cash equivalents | (2,816 | ) | 109,699 | |||||
Increase / (decrease) in cash and cash equivalents | (185,503 | ) | 272,564 | |||||
Cash and cash equivalents, beginning of period | 508,836 | 341,936 | ||||||
Cash and cash equivalents, end of period | $ | 323,333 | $ | 614,500 | ||||
See accompanying notes to consolidated financial statements.
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CTI GROUP (HOLDINGS) INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
NOTE 1: Business and Basis of Presentation
CTI Group (Holdings) Inc. and subsidiaries (the “Company” or “CTI”) design, develop, market and support billing and data management software and services. The Company operates in four business segments: Electronic Invoice Management, Telemanagement, Voice Over Internet Protocol and Patent Enforcement Activities. The majority of the Company’s business is in Europe and North America.
The Company was originally incorporated in Pennsylvania in 1968 and reincorporated in the State of Delaware in 1988, pursuant to a merger of CTI into a wholly owned subsidiary formed as a Delaware corporation. In November 1995, the Company changed its name to CTI Group (Holdings) Inc.
The Company is comprised of the following business segments: Electronic Invoice Management (“EIM”), Telemanagement (“Telemanagement”), Voice over Internet Protocol (“VoIP”) and Patent Enforcement Activities (“Patent Enforcement”). EIM designs, develops and provides services and software tools that enable telecommunication service providers to better meet the needs of their enterprise customers. EIM software and services are provided and sold directly to telecommunication service providers who then market and distribute such software to their enterprise customers. Using the Company’s software and services, telecommunication service providers are able to electronically invoice their enterprise customers in a form and format that enables the enterprise customers to improve their ability to analyze, allocate and manage their telecommunications expenses while driving internal efficiencies into their invoice receipt, validation, approval and payment workflow processes. Telemanagement designs, develops and provides software and services used by enterprise, governmental and institutional end users to manage their telecommunications service and equipment usage. VoIP designs, develops and provides software and services that enable managed and hosted customers of service providers to analyze voice, video, and data usage, record and monitor communications, and perform administration and back office functions such as cost allocation or client bill back. These applications are commonly available in the market as enterprise-grade products. Customers typically purchase the VoIP products when upgrading or acquiring a new enterprise communications platform. Patent Enforcement involves the licensing, protection, enforcement and defense of the Company’s intellectual property and rights.
The accompanying consolidated financial statements have been prepared by the Company without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”), and reflect all adjustments which, in the opinion of management, are necessary for a fair statement of the results for the interim periods presented. All such adjustments are of a normal recurring nature.
Certain information in footnote disclosures, normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States of America, has been condensed or omitted pursuant to the rules and regulations of the SEC, although the Company believes the disclosures are adequate to make the information presented not misleading. These financial statements should be read in conjunction with the consolidated financial statements for the years ended December 31, 2009 and 2008 and the notes thereto included in the Company’s Form 10-K filed with the SEC.
The Company follows accounting standards set by the Financial Accounting Standards Board (“FASB”). The FASB establishes accounting principles generally accepted in the United States (“GAAP”). Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants, which the Company is required to follow.
The Company realizes patent license fee and enforcement revenues. These revenues are realized once the Company has received a signed settlement or judgment and the collection of the receivable is deemed probable. The Company recognized $40,500 and $0 in revenues associated with patent license fee and enforcement activities in the nine months ended September 30, 2010 and September 30, 2009, respectively.
Amortization expense of developed software amounted to $559,127 and $420,128 for the nine months ended September 30, 2010 and 2009, respectively. Amortization expense of developed software amounted to $251,553 and $119,360 for the three months ended September 30, 2010 and 2009, respectively. Amortization expense of developed software, which relates to cost of sales, was presented as depreciation and amortization expense.
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NOTE 2:Supplemental Schedule of Non-Cash Investing and Financing Activities
The Company paid $27,468 and $29,381 in interest related to the Company’s notes payable for the nine months ended September 30, 2010 and 2009, respectively.
The Company paid approximately $4,200 and $131,039 during the nine months ended September 30, 2010 and 2009, respectively, for prior year tax payments and approximately $17,000 and $0 for current year tax estimates for the nine months ended September 30, 2010 and 2009, respectively. The Company received income tax refunds of approximately $124,914 and $0 during the nine months ended September 30, 2010 and 2009, respectively, for prior year tax payments.
NOTE 3: Fair Value of Financial Instruments
The carrying amounts of cash and cash equivalents, accounts receivable, notes receivable, deferred finance costs, prepaid expenses and other assets, accounts payable, and other accruals approximate their fair values because of their nature and expected duration. The fair value of the revolving credit facility and note payable is equal to its carrying value due to the variable nature of its interest rate.
NOTE 4: Debt Obligations and Liquidity
The Company has available a revolving loan facility with PNC Bank (“PNC”), formerly known as National City Bank, equal to the lesser of (a) $3,000,000, (b) the sum of 80% of eligible domestic trade accounts receivable and 90% of eligible, insured foreign trade accounts receivable or (c) four times the sum of earnings before interest, taxes, depreciation and amortization for the trailing twelve month period. Outstanding borrowings under the revolving loan bear interest at LIBOR plus 2.50% payable monthly which amounted to 2.76% as of September 30, 2010. The Company also must pay an unused revolving loan commitment fee of 0.25% of the average daily amount by which the revolving loan commitment exceeds the outstanding principal amount. The amount paid on the unused revolving loan commitment fee amounted to $3,677 and $1,026 for the nine and three months ended September 30, 2010, respectively. The revolving loan expires on December 30, 2010. All borrowings are collateralized by substantially all assets of the Company. The outstanding balance on the revolving loan was $1,260,000 at September 30, 2010. Available for borrowing under the revolving loan on September 30, 2010 was $706,023. The carrying amount of receivables that served as collateral for borrowings totaled $1,966,023 at September 30, 2010.
The Company had an acquisition loan of $500,000 with PNC (the “Acquisition Loan”). The Acquisition Loan was repaid and expired on December 21, 2009. All borrowings under the Acquisition Loan were collateralized by substantially all assets of the Company. Borrowings under the Acquisition Loan bore interest at LIBOR plus 2.00% payable monthly. The outstanding balances on the Acquisition Loan were $0 and $500,000 at September 30, 2010 and September 30, 2009, respectively.
The revolving loan facility (the “Loan Agreement”) is and the Acquisition Loan (the “Loan Agreements”) was secured by a guarantee from a wholly-owned subsidiary of Fairford Holdings Limited, a British Virgin Islands company (“Fairford”). As of September 30, 2010, Fairford beneficially owned 63.7% of the Company’s outstanding Class A common stock. Mr. Osseiran, the majority holder of the Company’s Class A common stock and director of the Company, is a director of Fairford and a grantor and sole beneficiary of a revocable trust which is the sole stockholder of Fairford. Mr. Dahl, a director of the Company, is the director of Fairford.
The Loan Agreement contains certain financial covenants and restrictions on indebtedness, encumbrances, investments, business combinations, and other related items. As of September 30, 2010, the Company believes it was in compliance with all covenants. The more significant covenants under the Loan Agreements, include that, without PNC’s prior written consent, the Company shall not, and shall not permit any of its subsidiaries to: (i) incur or have outstanding any indebtedness in excess of $20,000 individually or $100,000 in the aggregate; (ii) dispose of all, or any part, of business or assets; (iii) make any acquisitions, or (iv) issue any additional shares of stock or other securities and the Company shall not issue more than 10% of the Company’s capital stock pursuant to its stock option plan on a fully-diluted basis.
As of September 30, 2010, the Company had negative working capital of $2,076,199 and stockholders’ equity of $7,112,647. Included in current liabilities was deferred revenue of $2,191,188, which reflects revenue to be recognized in future periods. Therefore, the cash requirements associated with the deferred revenue are expected to be less than the recorded liability.
The Company believes that the primary sources of liquidity over the next twelve months will be cash on hand,
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anticipated increased cash generated from future operating activities, and from contemplated financing transactions, whether from issuing additional long-term debt or from shareholder advances, as well as from borrowings available under the line of credit, will be sufficient to support its operations. If the Company is unable to enter into a new credit facility or raise funds through the sale of debt or equity by December 30, 2010, the Company will seek additional funds from Fairford. There can be no assurance, however, that Fairford will provide additional funding to the Company. If the Company is unable to raise funds through these financing transactions it would have a material adverse effect on the Company’s operations, financial condition, results of operations and its ability to continue as a going concern. If the Company is unable to complete a financing, obtain a new credit facility or received additional funds from Fairford by December 30, 2010, the Company will be unable to meet its debt obligations to PNC. If the Company is unable to pay its obligations to PNC when they become due, the Company may be forced to restrict its operations and PNC has the right, among other things, to declare an event of default which would enable PNC to foreclose on the Company’s assets securing the Loan Agreement.
In October 2010, in order to supplement the Company’s liquidity, Fairford advanced to the Company $500,000. Subsequent to the advancement, the Company issued to Fairford a demand note, in the aggregate principal amount of $500,000 bearing interest at LIBOR plus 4%. The demand note has no term and is due on demand. The Company intends to seek a replacement revolving loan facility. If the Company is not successful in obtaining a replacement revolving loan facility, it will seek additional funds from Fairford. There can be no assurance that Fairford will provide additional funding to the Company, if needed, or that the Company will be successful in obtaining a replacement revolving loan facility.
NOTE 5: New Accounting Pronouncements
FASB ASU No. 2009-13 — Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements - a consensus of the FASB Emerging Issues Task Force applies to multiple-deliverable revenue arrangements that are currently within the scope of Topic 605-25. This ASU also provides principles and application guidance on whether multiple deliverables exist, how the arrangement should be separated, and the consideration allocated, requires an entity to allocate revenue in an arrangement using estimated selling prices of deliverables if a vendor does not have vendor-specific objective evidence or third-party evidence of selling price, eliminates the use of the residual method and requires an entity to allocate revenue using the relative selling price method. The consensus significantly expands the disclosure requirements for multiple-deliverable revenue arrangements. This ASU should be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with earlier application permitted. Alternatively, an entity can elect to adopt this ASU on a retrospective basis. The Company has not yet determined the effect of the adoption of this ASU on the Company’s results of operations or financial position.
FASB ASU No. 2009-14 — Software (Topic 985): Certain Revenue Arrangements That Include Software Elements — a consensus of the FASB Emerging Issues Task Force was issued concurrently with ASU No. 2009-13 and focuses on determining which arrangements are within the scope of the software revenue guidance in Topic 985 and which are subject to the guidance in ASU No. 2009-13. This ASU removes tangible products from the scope of the software revenue guidance and provides guidance on determining whether software deliverables in an arrangement that includes a tangible product are within the scope of the software revenue model or the guidance in revenue arrangements with multiple deliverables model, ASU No. 2009-13. Generally, if the software contained in or part of the arrangement with the tangible product is essential to the tangible product’s functionality, then the software is excluded from the software revenue guidance. The ASU also provides factors to consider in evaluating whether the software was essential to the tangible product or not. The disclosure requirements, effective date, and transition methods for this ASU are the same as those for ASU No. 2009-13. An entity must adopt both ASUs in the same period using the same transition method. The Company has not yet determined the effect of the adoption of this ASU on the Company’s results of operations or financial position.
NOTE 6: Basic and Diluted Net Income Per Common Share
Basic earnings per share amounts are computed by dividing reported earnings available to common stockholders by the weighted average shares outstanding for the period. Diluted earnings per share amounts are computed by dividing reported earnings available to common stockholders by weighted average common shares outstanding for the period giving effect to securities considered to be potentially dilutive common shares such as stock options.
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For the Three Months Ended | For the Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2010 | 2009 | 2010 | 2009 | |||||||||||||
Net loss | $ | (728,388 | ) | $ | (337,549 | ) | $ | (1,399,038 | ) | $ | (1,528,238 | ) | ||||
Weighted average shares of common stock outstanding used to compute basic earnings per share | 29,038,021 | 29,038,021 | 29,038,021 | 29,038,021 | ||||||||||||
Additional common shares to be issued assuming exercise of stock options and stock warrants | — | — | — | — | ||||||||||||
Weighted average shares of common and common equivalent stock outstanding used to compute diluted earnings per share | 29,038,021 | 29,038,021 | 29,038,021 | 29,038,021 | ||||||||||||
Basic: | ||||||||||||||||
Net loss per share | $ | (0.03 | ) | $ | (0.01 | ) | $ | (0.05 | ) | $ | (0.05 | ) | ||||
Weighted average common shares outstanding | 29,038,021 | 29,038,021 | 29,038,021 | 29,038,021 | ||||||||||||
Diluted: | ||||||||||||||||
Net loss per share | $ | (0.03 | ) | $ | (0.01 | ) | $ | (0.05 | ) | $ | (0.05 | ) | ||||
Weighted average common and common equivalent shares outstanding | 29,038,021 | 29,038,021 | 29,038,021 | 29,038,021 | ||||||||||||
There were no additional common shares to be issued, assuming exercise of stock options and stock warrants, since all options and warrants had an exercise price higher than the average stock price for the three and nine months ended September 30, 2010. For the nine months and three months ended September 30, 2009, outstanding stock options were excluded from weighted average shares of common and common equivalent shares outstanding due to their anti-dilutive effect as a result of the Company’s net loss. Additional common shares to be issued, assuming exercise of stock options for the nine and three months ended September 30, 2009, would have been 178,511 and 248,039, respectively.
NOTE 7: Stock Based Compensation
The Company’s Amended and Restated Stock Option and Restricted Stock Plan (the “Plan”) provides for the issuance of incentive and nonqualified stock options to purchase, and restricted stock grants of, shares of the Company’s Class A common stock. Individuals eligible for participation in the Plan include designated officers and other employees (including employees who also serve as directors), non-employee directors, independent contractors and consultants who perform services for the Company. The terms of each grant under the Plan are determined by the Board of Directors, or a committee of the board administering the Plan, in accordance with the terms of the Plan. Outstanding stock options become immediately exercisable upon a change of control of the Company as in accordance with the terms of the Plan. Stock options granted under the Plan typically become exercisable over a one to five year period. Generally, the options have various vesting periods, which include immediate and term vesting periods.
On December 8, 2005, the Company’s stockholders approved the CTI Group (Holdings) Inc. Stock Incentive Plan (the “Stock Incentive Plan”). The Stock Incentive Plan replaced the Plan. No new grants will be granted under the Plan. Grants that were made under the Plan prior to stockholders’ approval of the Stock Incentive Plan will continue to be administered under the Plan.
The Stock Incentive Plan is administered by the Compensation Committee of the board of directors. Under the Stock Incentive Plan, the Compensation Committee is authorized to grant awards to non-employee directors, executive officers and other employees of, and consultants and advisors to, the Company or any of its subsidiaries and to determine the number and types of such awards and the terms, conditions, vesting and other limitations applicable to each such award. In addition, the Compensation Committee has the power to interpret the Stock Incentive Plan and to adopt such rules and regulations as it considers necessary or appropriate for purposes of administering the Stock Incentive Plan.
The following types of awards or any combination of them may be granted under the Stock Incentive Plan: (i) incentive stock options, (ii) non-qualified stock options, (iii) stock grants, and (iv) performance awards.
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The maximum number of shares of Class A common stock with respect to which awards may be granted or measured to any individual participant under the Stock Incentive Plan during each of the Company’s fiscal years will not exceed 1,500,000 shares of Class A common stock, subject to certain adjustments.
The aggregate number of shares of Class A common stock that are reserved for awards, including shares of Class A common stock underlying stock options, to be granted under the Stock Incentive Plan is 6,000,000 shares, subject to adjustments for stock splits, recapitalizations and other specified events. Such shares may be treasury shares or authorized but unissued shares. As of September 30, 2010, there were 1,585,468 awards available for grant under the Stock Incentive Plan. If any outstanding award is cancelled, forfeited, or surrendered to the Company, shares of Class A common stock allocable to such award may again be available for awards under the Stock Incentive Plan. Incentive stock options may be granted only to participants who are executive officers and other employees of the Company or any of its subsidiaries on the day of the grant, and non-qualified stock options may be granted to any participant in the Stock Incentive Plan. No stock option granted under the Stock Incentive Plan will be exercisable later than ten years after the date it is granted.
At September 30, 2010, there were options to purchase 5,860,782 shares of Class A common stock outstanding consisting of 5,610,782 Plan and Stock Incentive Plan options and 250,000 outside plan stock options. There were exercisable options to purchase an aggregate of 4,494,112 shares of Class A common stock under the Plan and Stock Incentive Plan and options to purchase 250,000 shares of Class A common stock that were outside plan stock options as of September 30, 2010.
Information with respect to options is as follows:
Exercise | ||||||||||||
Price Range | Weighted Average | |||||||||||
Options Shares | Per Share | Exercise Price | ||||||||||
Outstanding, January 1, 2010 | 5,892,782 | $ | 0.08 – $0.49 | $ | 0.27 | |||||||
Granted | — | — | — | |||||||||
Exercised | — | — | — | |||||||||
Cancelled | 32,000 | $ | 0.21 – $0.34 | $ | 0.24 | |||||||
Outstanding, September 30, 2010 | 5,860,782 | $ | 0.08 – $0.49 | $ | 0.27 | |||||||
The following table summarizes options exercisable at September 30, 2010:
Exercise Price Range | Weighted Average | Aggregate Intrinsic | Weighted Remaining | |||||||||||||||||
Option Shares | Per Share | Exercise Price | Value | Contractual Term | ||||||||||||||||
September 30, 2010 | 4,744,112 | $ | 0.08 - $0.49 | $ | 0.31 | — | 5.69 years |
The following table summarizes non-vested options:
Option Shares | ||||
January 1, 2010 | 2,133,340 | |||
Granted | — | |||
Cancelled | — | |||
Vested | (1,016,670 | ) | ||
September 30, 2010 | 1,116,670 | |||
The fair value of each option award is estimated on the date of grant using a closed-form option valuation model (Black-Scholes-Merton formula) that uses the assumptions noted in the following table:
2009 | ||||
Risk-free interest rate | 1.76 | % | ||
Dividend yield | 0.00 | % | ||
Volatility factor | 157.43 | % | ||
Expected lives | 5 years |
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The fair value of each option award is estimated on the date of grant using a closed-form option valuation model (Black-Scholes-Merton formula) that uses the assumptions noted in the following table. Because closed-form valuation models incorporate ranges of assumptions for inputs, those ranges are disclosed. Expected volatilities are based on implied volatilities from historical volatility of the Company’s stock. The Company uses historical data to estimate option exercise and employee termination within the valuation model; separate groups of employees that have similar historical exercise behavior are considered separately for valuation purposes. The expected term of options granted is derived from general practices used by other companies in the software industry and estimates by the Company of the period of time that options granted are expected to be outstanding. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.
On February 16, 2007, the Company and Fairford Holdings Scandinavia AB (“Fairford Scandinavia”), a wholly-owned subsidiary of Fairford, entered into the Securities Purchase Agreement (the “Agreement”), dated February 16, 2007. Pursuant to the Agreement, on February 16, 2007, the Company issued to Fairford Scandinavia a Class A common stock Purchase Warrant (the “Original Warrant”) to purchase shares of Class A Common Stock of the Company in consideration for securing the issuance of a $2.6 million letter of credit (the “Letter of Credit”) from SEB bank to National City Bank. Due to National City Bank’s receipt of the Letter of Credit, the Company was able to obtain the Acquisition Loan at a favorable cash-backed interest rate. Effective April 14, 2008, the Company entered into the Securities Purchase Agreement with Fairford Scandinavia and issued an additional warrant to Fairford Scandinavia to purchase shares of Class A common stock based on the interest rate savings (the “Additional Warrant”).
Pursuant to the Original Warrant, Fairford Scandinavia is entitled to purchase 419,495 shares of Class A common stock at the exercise price of $0.34 per share, subject to adjustments as described in the Original Warrant, at any time prior to the 10th anniversary of the date of issuance. Pursuant to the Additional Warrant, Fairford Scandinavia is entitled to purchase 620,675 shares of Class A common stock at the exercise price of $0.22 per share, subject to adjustments as described in the Additional Warrant, at any time prior to the 10th anniversary of the date of issuance. On December 31, 2009, Fairford Scandinavia sold all of its owned Class A shares, or 355,099 shares to Fairford for SEK 2.80362 ($0.39) per share. As of September 30, 2010, Fairford beneficially owned 63.7% of the Company’s outstanding Class A common stock and Fairford Scandinavia owned warrants to purchase 1,040,170 shares of the Company’s Class A common stock. Mr. Osseiran, the majority holder of the Company’s Class A common stock and a director of the Company, is a director of Fairford, the President of Fairford Scandinavia and a grantor and sole beneficiary of a revocable trust which is the sole stockholder of Fairford. Mr. Dahl, a director of the Company, is a director of Fairford and the Chairman of Fairford Scandinavia. The Original Warrant and Additional Warrant vested immediately upon grant.
Included within selling, general and administrative expense for the three months ended September 30, 2010 and September 30, 2009 was $9,388 and $27,313, respectively, of stock-based compensation. Included within selling, general and administrative expense for the nine months ended September 30, 2010 and September 30, 2009 was $40,387 and $85,144, respectively, of stock-based compensation. Stock-based compensation expenses are recorded in the Corporate Allocation segment as these amounts are not included in internal measures of segment operating performance.
NOTE 8: Indemnification to Customers
The Company’s agreements with customers generally require the Company to indemnify the customer against claims that the Company’s software infringes third party patent, copyright, trademark or other proprietary rights. Such indemnification obligations are generally limited in a variety of industry-standard provisions including our right to replace the infringing product. As of September 30, 2010, the Company did not experience any material losses related to these indemnification obligations and no material claims with respect thereto were outstanding. The Company does not expect significant claims related to these indemnification obligations, and consequently, the Company has not established any related accruals.
NOTE 9: Contingencies
The Company is, from time to time, subject to claims and administrative proceedings in the ordinary course of business that are unrelated to Patent Enforcement.
NOTE 10: Income Taxes
The Company records a valuation allowance against its net deferred tax asset to the extent management believes, it is more likely than not, that the asset will not be realized. As of September 30, 2010, the Company’s valuation allowance related only to net deferred tax assets in the United States.
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The Company recognizes a tax position as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. As of September 30, 2010 and December 31, 2009, the Company had $79,530 and $65,908 of unrecognized tax benefits, respectively, all of which would favorably affect the Company’s effective tax rate if recognized. The Company and its subsidiaries are subject to U.S. federal and state income taxes as well as foreign income tax in the United Kingdom. The Company does not expect the total amount of unrecognized tax benefits to significantly increase in the next twelve months.
The Company recognizes interest and/or penalties related to income tax matters in income tax expense. The Company had amounts accrued for interest and penalties as of September 30, 2010.
For the nine months ended September 30, 2010 and September 30, 2009, the Company had $52,654 and $168,450, respectively, of income tax expense and for the three months ended September 30, 2010 and September 30, 2009, the Company had $26,559 and $99,659 of income tax expense, respectively. The income tax benefit and expense are primarily related to the United Kingdom operations.
NOTE 11: Segment Information
The Company has four reportable segments, EIM, Telemanagement, VoIP, and Patent Enforcement. These segments are managed separately because the services provided by each segment require different technology and marketing strategies.
Electronic Invoice Management:EIM designs, develops and provides electronic invoice presentment and analysis software that enables internet-based customer self-care for wireline, wireless and convergent providers of telecommunications services. EIM software and services are used primarily by telecommunications services providers to enhance their customer relationships while reducing the providers operational expenses related to paper-based invoice delivery and customer support relating to billing inquiries. The Company provided these services primarily through facilities located in Indianapolis, Indiana and Blackburn, United Kingdom.
Telemanagement:Through its operations in the United Kingdom and Indianapolis and the utilization of the Proteus® products, the Company offers telemanagement software and services for end users to manage their usage of multi-media communications services and equipment.
Voice Over Internet Protocol:VoIP designs, develops and provides software and services that enable managed and hosted customers of service providers to analyze voice, video, and data usage, record and monitor communications, and perform administration and back office functions such as cost allocation or client bill back. These applications are commonly available in the market as enterprise-grade products. Customers typically purchase these products when upgrading or acquiring a new enterprise communications platform.
Patent Enforcement:Patent Enforcement involves the licensing, protection, enforcement and defense of the Company’s intellectual property and rights.
Reconciling items for operating income (loss) in the table below represent corporate expenses and depreciation all of which are in the United States.
The accounting policies for segment reporting are the same as those described in Note 1 of the Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.
Summarized financial information concerning the Company’s reportable segments for the nine months and three months ended September 30, 2010 and 2009 is shown in the following tables.
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For Nine Months Ended September 30, 2010 | ||||||||||||||||||||||||
Electronic | ||||||||||||||||||||||||
Invoice Management | Telemanagement | VoIP | Patent Enforcement | Corporate Allocation | Consolidated | |||||||||||||||||||
Revenues | $ | 6,860,275 | $ | 3,475,198 | $ | 488,625 | $ | 40,500 | $ | — | $ | 10,864,598 | ||||||||||||
Gross profit/(loss) (Revenues less cost of products and patent license cost, excluding depreciation and amortization) | 5,342,442 | 1,901,443 | 22,106 | 33,050 | — | 7,299,041 | ||||||||||||||||||
Depreciation and Amortization | 795,780 | 12,768 | 404,528 | 353 | 17,794 | 1,231,223 | ||||||||||||||||||
1,021,170 | 399,025 | (1,885,984 | ) | 32,697 | (840,243 | ) | (1,273,355 | ) | ||||||||||||||||
Long-lived assets | 9,595,997 | 62,192 | 829,411 | — | 10,365 | 10,497,965 |
For Nine Months Ended September 30, 2009 | ||||||||||||||||||||||||
Electronic | ||||||||||||||||||||||||
Invoice Management | Telemanagement | VoIP | Patent Enforcement | Corporate Allocation | Consolidated | |||||||||||||||||||
Revenues | $ | 7,880,830 | $ | 3,406,935 | $ | 372,332 | $ | — | $ | — | $ | 11,660,097 | ||||||||||||
Gross profit/(loss) (Revenues less cost of products and patent license cost, excluding depreciation and amortization) | 6,597,480 | 1,673,844 | 114,827 | (812,892 | ) | — | 7,573,259 | |||||||||||||||||
Depreciation and Amortization | 715,982 | 27,898 | 362,588 | 13,944 | 26,312 | 1,146,724 | ||||||||||||||||||
Income (loss) from operations | 2,474,397 | (74,409 | ) | (2,037,060 | ) | (826,836 | ) | (826,825 | ) | (1,290,733 | ) | |||||||||||||
Long-lived assets | 10,029,491 | 31,715 | 1,071,362 | 96,997 | 56,818 | 11,286,383 |
For Three Months Ended September 30, 2010 | ||||||||||||||||||||||||
Electronic | ||||||||||||||||||||||||
Invoice Management | Telemanagement | VoIP | Patent Enforcement | Corporate Allocation | Consolidated | |||||||||||||||||||
Revenues | $ | 2,091,285 | $ | 1,084,493 | $ | 170,731 | — | — | $ | 3,346,509 | ||||||||||||||
Gross profit/(loss) (Revenues less cost of products and patent license cost, excluding depreciation and amortization) | 1,538,844 | 603,079 | (8,197 | ) | 3,153 | — | 2,136,879 | |||||||||||||||||
Depreciation and Amortization | 299,216 | 4,380 | 128,105 | — | 3,412 | 435,113 | ||||||||||||||||||
Income (loss) from operations | 179,145 | 137,189 | (667,219 | ) | 3,153 | (322,748 | ) | (670,480 | ) | |||||||||||||||
Long-lived assets | 9,595,997 | 62,192 | 829,411 | — | 10,365 | 10,497,965 |
For Three Months Ended September 30, 2009 | ||||||||||||||||||||||||
Electronic | ||||||||||||||||||||||||
Invoice Management | Telemanagement | VoIP | Patent Enforcement | Corporate Allocation | Consolidated | |||||||||||||||||||
Revenues | $ | 2,216,164 | $ | 1,243,348 | $ | 111,975 | — | — | $ | 3,571,487 | ||||||||||||||
Gross profit/(loss) (Revenues less cost of products and patent license cost, excluding depreciation and amortization) | 2,048,740 | 647,491 | 218 | (128,739 | ) | — | 2,567,710 | |||||||||||||||||
Depreciation and Amortization | 245,984 | 9,711 | 125,858 | 2,449 | 8,771 | 392,773 | ||||||||||||||||||
Income (loss) from operations | 765,303 | 74,685 | (675,480 | ) | (131,188 | ) | (243,454 | ) | (210,134 | ) | ||||||||||||||
Long-lived assets | 10,029,491 | 31,715 | 1,071,362 | 96,997 | 56,818 | 11,286,383 |
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The following table presents net revenues by geographic location.
For Nine Months Ended September 30, 2010 | ||||||||||||
United States | United Kingdom | Consolidated | ||||||||||
Revenues | $ | 3,275,401 | $ | 7,589,197 | $ | 10,864,598 | ||||||
Gross profit (Revenues less cost of products and patent license cost, excluding depreciation and amortization) | 2,309,225 | 4,989,816 | 7,299,041 | |||||||||
Depreciation and Amortization | 483,057 | 748,166 | 1,231,223 | |||||||||
Loss from operations | (950,634 | ) | (322,721 | ) | (1,273,355 | ) | ||||||
Long-lived assets | 9,336,499 | 1,161,466 | 10,497,965 | |||||||||
For Nine Months Ended September 30, 2009 | ||||||||||||
United States | United Kingdom | Consolidated | ||||||||||
Revenues | $ | 3,266,908 | $ | 8,393,189 | $ | 11,660,097 | ||||||
Gross profit (Revenues less cost of products and patent license cost, excluding depreciation and amortization) | 1,710,690 | 5,862,569 | 7,573,259 | |||||||||
Depreciation and Amortization | 499,511 | 647,213 | 1,146,724 | |||||||||
Income (loss) from operations | (1,791,970 | ) | 501,237 | (1,290,733 | ) | |||||||
Long-lived assets | 10,491,941 | 794,442 | 11,286,383 | |||||||||
For Three Months Ended September, 2010 | ||||||||||||
United States | United Kingdom | Consolidated | ||||||||||
Revenues | $ | 1,004,419 | $ | 2,342,090 | $ | 3,346,509 | ||||||
Gross profit (Revenues less cost of products and patent license cost, excluding depreciation and amortization) | 645,494 | 1,491,385 | 2,136,879 | |||||||||
Depreciation and Amortization | 148,738 | 286,375 | 435,113 | |||||||||
Loss from operations | (522,432 | ) | (148,048 | ) | (670,480 | ) | ||||||
Long-lived assets | 9,336,499 | 1,161,466 | 10,497,965 | |||||||||
For Three Months Ended September 30, 2009 | ||||||||||||
United States | United Kingdom | Consolidated | ||||||||||
Revenues | $ | 1,007,316 | $ | 2,564,171 | $ | 3,571,487 | ||||||
Gross profit (Revenues less cost of products and patent license cost, excluding depreciation and amortization) | 606,526 | 1,961,184 | 2,567,710 | |||||||||
Depreciation and Amortization | 168,229 | 224,544 | 392,773 | |||||||||
Income (loss) from operations | (455,611 | ) | 245,477 | (210,134 | ) | |||||||
Long-lived assets | 10,491,941 | 794,442 | 11,286,383 |
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Overview
The Company is comprised of four business segments: Electronic Invoice Management (“EIM”), Telemanagment (“Telemanagement”), Voice Over Internet Protocol (“VoIP”) and Patent Enforcement Activities (“Patent Enforcement”). EIM designs, develops and provides services and software tools that enable telecommunication service providers to better meet the needs of their enterprise customers. EIM software and services are provided and sold directly to telecommunication service providers who then market and distribute such software to their enterprise customers. Using the Company’s software and services, telecommunication service providers are able to electronically invoice their enterprise customers in a form and format that enables the enterprise customers to improve their ability to analyze, allocate and manage telecommunications expenses while driving internal efficiencies into their invoice receipt, validation, approval and payment workflow processes. Telemanagement designs, develops and provides software and services used by enterprise, governmental and institutional end users to manage their telecommunications service and equipment usage. VoIP designs, develops and provides software and services that enable managed and hosted customers of service providers to analyze voice, video, and data usage, record and monitor communications, and perform administration and back office functions such as cost allocation or client bill back. These applications are commonly available in the market as enterprise-grade products. Customers typically purchase the VoIP products when upgrading or acquiring a new enterprise communications platform. Patent Enforcement involves the licensing, protection, enforcement and defense of the Company’s intellectual property and rights.
The Company generates its revenues and cash from several sources: software sales, license fees, processing fees, implementation fees, training and consulting services, and enforcement revenues.
The Company’s software products and services are subject to changing technology and evolving customer needs which require the Company to continually invest in research and development in order to respond to such demands. The limited financial resources available to the Company require the Company to concentrate on those business segments and product lines which provide the greatest returns on investment. The EIM segment, as compared to the other business segments, provides the predominant share of income from operations and cash flow from operations. The majority of Telemanagement segment revenues are derived from its United Kingdom operations.
The Company reported revenue in the EIM segment of $6.9 million and $7.9 million for the nine months ended September 30, 2010 and 2009, respectively, and $2.1 million and $2.2 million for the three months ended September 30, 2010 and 2009, respectively. For the Telemanagement segment, the Company recorded revenues of $3.5 million and $3.4 million for the nine months ended September 30, 2010 and 2009, respectively, and $1.1 million and $1.2 million for the three months ended September 30, 2010 and 2009, respectively. The Patent Enforcement segment recorded revenue of $40,500 and $0 for the nine months ended September 30, 2010 and 2009 and no revenue for the three months ended September 30, 2010 and 2009. The VoIP segment recorded revenue of approximately $489,000 and $372,000 for the nine months ended September 30, 2010 and 2009, respectively, and $171,000 and $112,000 for the three months ended September 30, 2010 and 2009, respectively.
The Company believes that as voice and data services continue to commoditize, service providers will seek alternative business models to replace revenue lost as a result of pricing pressures. One such business model is the delivery of managed or hosted voice and video services.
Traditionally, organizations that required advanced voice and video services would purchase enabling communications hardware and software, operate and maintain this equipment, and depreciate the associated capital expense over time. This approach had two major disadvantages for such organizations. The first being that organizations would experience significant capital and operational expenditures related to acquiring these advanced services. The second being that the capabilities of the acquired equipment would not materially improve as voice and video service technology evolved.
Service providers recognized these challenges and began, as part of their next generation network (“NGN”) strategies, to deliver managed and hosted service offerings that do not require the customer to purchase expensive equipment up-front and virtually eliminate the operational expenditures associated with managing and maintaining an enterprise-grade communications network. Service providers incrementally improve revenue by enabling competitive voice and video features while reducing costs by delivering these services on high-capacity, low-cost NGNs.
Due to the profitability and average revenue per user advantage possible by delivering such managed and hosted service offerings, providers not only look at acquiring new customers but converting legacy customers onto the NGN platform. The Company believes that this conversion process is significant. Many legacy features and functions are not available on NGN platforms, primarily due to the immaturity of the service delivery model.
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The Company’s VoIP applications will help eliminate customer resistance to conversion to next generation platforms, while creating new revenue opportunities for service providers through the delivery of compelling value added services. In 2007, the Company marketed two applications, emPulse, a web-based communications traffic analysis solution, and SmartRecord® IP, which enable service providers to selectively intercept communications on behalf of their hosted and managed service customers. These applications also enable managed and hosted service customers of service providers to analyze voice, video, and data usage, record and monitor communications, and perform administration and back office functions such as cost allocation or client bill back. These applications were released as enterprise-grade products. The Company anticipates that customers will purchase these products when upgrading or acquiring a new enterprise communications platform. The Company has taken the business benefits of these enterprise-grade applications and has delivered provider-grade managed and hosted service applications, enabling service providers to create a new recurring revenue stream, while ensuring that enterprise customers have the tools necessary and relevant to their particular line of business or vertical. The Company’s future success in the VoIP segment is directly related to the successful market penetration of emPulse and SmartRecord® IP.
Financial Condition
In the nine months ended September 30, 2010, the stockholders’ equity decreased $1,423,500 from $8,536,147 as of December 31, 2009 to $7,112,647 as of September 30, 2010 primarily as a result of the nine months ended September 30, 2010 net loss of $1,399,038. The Company realized a decrease in net current assets (current assets less current liabilities) of approximately $655,700 which was primarily attributable to the increases in short-term notes payable, accrued wages and other compensation and deferred revenue as of September 30, 2010.
At September 30, 2010, cash and cash equivalents were $323,333 compared to $508,836 at December 31, 2009, and such decrease was primarily attributable to cash provided by operating and financing activities offset by cash used in investing activities. Cash provided by operating activities in the nine months ended September 30, 2010 amounted to $262,272 which was primarily related to the net operating loss of $1,399,038 being offset by depreciation and amortization of $1,231,223. Cash provided by financing activities related to net borrowings of $341,973 under the Company’s revolving loan facility during the nine months ended September 30, 2010. Cash utilized in investing activities of $786,932 related to additions to property, equipment and software. The Company generates approximately 70% of its revenues from operations in the United Kingdom where the functional currency, the UK pound, has deteriorated by 2.2% in relation to the US dollar during the nine month period ended September 30, 2010.
As disclosed elsewhere herein, the Company’s revolving loan facility with PNC Bank expires on December 30, 2010 and any amounts then outstanding will be due and payable. As of September 30, 2010, there was $1,260,000 outstanding under the revolving loan facility.
In October 2010, in order to supplement the Company’s liquidity, Fairford Holdings Ltd. (“Fairford”) advanced to the Company $500,000. Subsequent to the advancement, the Company issued to Fairford a demand note in the aggregate principal amount of $500,000 bearing interest at LIBOR plus 4%. The demand note has no term and is due on demand. As of September 30, 2010, Fairford beneficially owned 63.7% of the Company’s outstanding Class A common stock. Fairford Holdings Scandinavia AB (“Fairford Scandinavia”), a wholly-owned subsidiary of Fairford, owns stock warrants to purchase 1,040,170 shares of the Company’s Class A common stock. Mr. Osseiran, the majority holder of the Company’s Class A common stock and a director of the Company, is a director of Fairford, the President of Fairford Scandinavia and a grantor and sole beneficiary of a revocable trust which is the sole stockholder of Fairford. Mr. Dahl, a director of the Company, is a director of Fairford and the Chairman of Fairford Scandinavia
The $500,000 advance from Fairford, created a technical default regarding the loan covenant on limitation on additional indebtedness under the revolving line of credit agreement. The bank granted a waiver of the technical default of the loan covenants created by the advance from Fairford. Furthermore, in connection with the waiver, the bank reduced the maximum available under the revolving line of credit from $3,000,000 to $2,000,000.
The Company will not have sufficient cash to repay amounts due under the revolving loan facility absent an equity or debt financing or entering into a new credit facility with another financial institution or another financing transaction, which is sufficient to repay the amount outstanding to PNC. The Company is exploring a variety of alternative financing options, including a new credit facility to replace the facility currently provided by PNC and the sale of debt or equity. If the Company is unable to enter into a new credit facility or raise funds through the sale of debt or equity by December 30, 2010, the Company will seek additional funds from Fairford. There can be no assurance, however, that Fairford will provide additional funding to the Company.
There can be no assurances that the Company will be able to complete an equity or debt financing, enter into a new credit facility with sufficient capacity on terms that are favorable to the Company or at all. The Company’s failure to complete a new financing, enter into a new credit facility on unfavorable terms to the Company or receive funds from Fairford would have a material adverse effect on the Company’s operations, financial condition, results of operations and its ability to continue as a going concern. If the Company is unable to complete a financing, obtain a new credit facility or received additional funds from Fairford by December 30, 2010, the Company will be unable to meet its debt obligations to PNC. If the Company is unable to pay its obligations to PNC when they become due, the Company may be forced to restrict its operations and PNC has the right, among other things, to declare an event of default which would enable PNC to foreclose on the Company’s assets securing the Loan Agreement (as defined below).
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We are seeking to increase profitability, cash flow and liquidity. Management’s plans include securing new customers, reducing overhead costs and seeking a more competitive capital structure. Although we continue to pursue these plans, there is no assurance that we will be successful in generating such profitable operations.
Results of Operations(Nine Months Ended September 30, 2010 Compared to Nine Months Ended September 30, 2009)
Revenues
Revenues from operations for the nine months ended September 30, 2010 decreased $795,499, or 6.8%, to $10,864,598 as compared to $11,660,097 for the nine months ended September 30, 2009. Revenues derived from the UK operations represent 69.9% and 72.0% of total revenues for the nine months ended September 30, 2010 and 2009, respectively. The decrease in UK revenues is primarily related to the focus on non-billable professional services in 2010 in order to retain revenue into future periods. The US revenues increased by $8,493, or 0.3%, to $3,275,401 for the nine months ended September 30, 2010 compared to $3,266,908 for the nine months ended September 30, 2009. The Company earns a substantial portion of its revenue from a single EIM customer. This customer represented 16.9% of the total revenues for the nine months ended September 30, 2010 and 18.9% for the nine months ended September 30, 2009. The Company believes that the portion of revenue from the single largest EIM customer will continue to decline due to the erosion of the customer’s customer base.
Cost of Products and Services Excluding Depreciation and Amortization
Cost of products and services, excluding depreciation and amortization, for the nine months ended September 30, 2010, increased $284,161, or 8.7%, to $3,558,107 as compared to $3,273,946 for the nine months ended September 30, 2009. The increase was primarily related to costs associated with professional services work. The cost of products and services, excluding depreciation and amortization, was 32.9% of revenue for the nine months ended September 30, 2010 as compared to 28.1% of revenue for the nine months ended September 30, 2009. The increase in percentage is related to the decrease in revenue along with the increased cost in non-billable professional services work associated with retaining current customers.
Patent License Fee and Enforcement Cost
Patent license fee and enforcement cost for the nine months ended September 30, 2010 decreased by $805,442, or 99.1%, to $7,450 as compared to $812,892 for the nine months ended September 30, 2009. The decrease was primarily due to decreased professional fees associated with additional cost absorption of certain out-of-pocket expenses by the Company’s attorneys in connection with certain patent enforcement activities.
Selling, General and Administrative Costs
Selling, general and administrative expenses for the nine months ended September 30, 2010 decreased $180,521, or 3.2%, to $5,542,584 compared to $5,723,105 for the nine months ended September 30, 2009. The decrease in Selling, general and administrative expenses was primarily due to decreased selling costs related to a decrease in revenue.
Research and Development Expense
Research and development expense for the nine months ended September 30, 2010 decreased $195,594, or 9.8%, to $1,798,569 as compared to $1,994,163 for the nine months ended September 30, 2009. The decrease was primarily due to an increase in research and development being allocated to cost of sales in the nine months ended September 30, 2010. Research and development costs that were capitalized during the nine months ended September 30, 2010 and September 30, 2009 amounted to $521,002 and $747,960, respectively. Research and development costs allocated to cost of goods sold during the nine months ended September 30, 2010 and September 30, 2009 amounted to $910,123 and $268,032, respectively.
Depreciation and Amortization
Depreciation and amortization for the nine months ended September 30, 2010 increased $84,499, or 7.4%, to $1,231,223 from $1,146,724 in the nine months ended September 30, 2009. The increase was primarily associated with amortization of developed software. Amortization expense of developed software amounted to $559,127 and $420,128 for the nine months ended September 30, 2010 and 2009, respectively. Amortization expense of developed software, which relates to cost of sales, was presented as depreciation and amortization expense.
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Other Income and Expense
Net interest expense increased $2,742, or 3.9%, to $72,998 for the nine months ended September 30, 2010 compared to $70,256 for the nine months ended September 30, 2009.
The Company realized a loss on disposal of equipment of $51 for the nine months ended September 30, 2010 and an income from disposal of equipment of $1,201 for the nine months ended September 30, 2009.
Taxes
The tax expense for the nine months ended September 30, 2010 and September 30, 2009 of $52,654 and $168,450, respectively, was due to the pre-tax loss in the United Kingdom of $327,650 for the nine months ended September 30, 2010 and a pretax income of $493,720 for the nine months ended September 30, 2009.
The Company records a valuation allowance against its net deferred tax asset to the extent management believes that it is more likely than not that the asset will not be realized. As of September 30, 2010, the Company’s valuation allowance related only to the net deferred tax assets in the United States.
Net Loss
Net loss decreased $129,200 to $1,399,038 for the nine months ended September 30, 2010 compared to a net loss of $1,528,238 for the nine months ended September 30, 2009. The decrease in net loss was primarily associated with lower patent enforcement costs and higher patent enforcement revenues.
Results of Operations(Three Months Ended September 30, 2010 Compared to Three Months Ended September 30, 2009)
Revenues
Revenues from operations for the three months ended September 30, 2010 decreased $224,978, or 6.3%, to $3,346,509 as compared to $3,571,487 for the three months ended September 30, 2009. Revenues derived from the UK operations represented 70.0% and 71.8% of total revenues for the three months ended September 30, 2010 and 2009, respectively. The decrease in UK revenues was primarily related to the focus on non-billable professional services in 2010 in order to retain revenue into future periods. The US revenues decreased by $2,897, or 0.3%, to $1,004,419 for the three months ended September 30, 2010 compared to $1,007,316 for the three months ended September 30, 2009. The Company earns a substantial portion of its revenue from a single EIM customer. This customer represented 17.6% of the total revenues for the three months ended September 30, 2010 and 20.0% for the three months ended September 30, 2009. The Company believes that the portion of revenue from the single largest EIM customer will continue to decline due to the erosion of the customer’s customer base.
Cost of Products and Services Excluding Depreciation and Amortization
Cost of products and services, excluding depreciation and amortization, for the three months ended September 30, 2010, increased $337,745, or 38.6%, to $1,212,783 as compared to $875,038 for the three months ended September 30, 2009. The increase was primarily related to an increase in professional services cost. The cost of products and services, excluding depreciation and amortization, was 36.2% of revenue for the three months ended September 30, 2010 as compared to 24.5% of revenue for the three months ended September 30, 2009. The increase in percentage is related to the decrease in revenue along with the increased cost in non-billable professional services work associated with retaining current customers.
Patent License Fee and Enforcement Cost
Patent license fee and enforcement cost for the three months ended September 30, 2010 decreased by $131,892, or 102.4%, to a credit of $3,153 as compared to $128,739 for the three months ended September 30, 2009. The decrease was primarily due to additional cost absorption of certain out-of-pocket expenses by the Company’s attorneys in connection with certain patent enforcement activities and change to the respective estimated legal accrual.
Selling, General and Administrative Costs
Selling, general and administrative expenses for the three months ended September 30, 2010 decreased $1,956, or 0.1%, to $1,800,264 compared to $1,802,220 for the three months ended September 30, 2009.
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Research and Development Expense
Research and development expense for the three months ended September 30, 2010 decreased $10,869, or 1.9%, to $571,982 as compared to $582,851 for the three months ended September 30, 2009. Research and development costs that were capitalized during the three months ended September 30, 2010 and September 30, 2009 amounted to $80,495 and $428,987, respectively. Research and development costs allocated to cost of goods sold during the three months ended September 30, 2010 and September 30, 2009 amounted to $422,835 and $(29,500), respectively.
Depreciation and Amortization
Depreciation and amortization for the three months ended September 30, 2010 increased $42,340, or 10.8%, to $435,113 from $392,773 in the three months ended September 30, 2009. The increase was primarily associated with depreciation and amortization of fixed assets acquired and software capitalized in 2009.
Amortization expense of developed software amounted to $251,553 and $119,360 for the three months ended September 30, 2010 and 2009, respectively. Amortization expense of developed software, which relates to cost of sales, was presented as depreciation and amortization expense.
Other Income and Expense
Interest expense increased $3,891, or 14.2%, to $31,349 for the three months ended September 30, 2010 compared to $27,458 for the three months ended September 30, 2009. The increase in net interest expense was primarily associated with a decrease in interest income on notes receivable held by the Company as they near maturity.
The Company realized a loss on disposal of equipment of $298 for the three months ended September 30, 2009.
Taxes
The Company records a valuation allowance against its net deferred tax asset to the extent management believes that it is more likely than not that the asset will not be realized. As of September 30, 2010, the Company’s valuation allowance related to the net deferred tax assets in the United States.
The tax expense for the three months ended September 30, 2010 and September 30, 2009 of $26,559 and $99,659, respectively, was due to the pre-tax income in the United Kingdom of $153,355 and $242,244, respectively.
Net Loss
Net loss increased $390,839 to $728,388 for the three months ended September 30, 2010 compared to a net loss of $337,549 for the three months ended September 30, 2009. The increase in net loss was primarily associated with the decreased revenues and capitalized research and development expense.
Liquidity and Capital Resources
Historically, the Company’s principal needs for funds have been for operating activities (including costs of products and services, patent enforcement activities, selling, general and administrative expenses, research and development, and working capital needs) and capital expenditures, including software development. Cash flows from operations and existing cash and cash equivalents have been adequate to meet the Company’s business objectives. Cash and cash equivalents, decreased $185,503 to $323,333 as of September 30, 2010 compared to $508,836 as of December 31, 2009.The decrease in cash, cash equivalents, and short-term investments during the nine months ended September 30, 2010 was predominately related cash spent on property, equipment, and software of $786,932 partially off-set by cash flows provided by operations of $262,272 along with cash provided by financing activities of $341,973. The effect of foreign currency exchange rates on cash and cash equivalents was a loss of $2,816.
Cash is generated from (or utilized in) the income/(loss) from operations for each segment (see Note 11 to the Consolidated Financial Statements (unaudited) of Part I, Item 1 of this Form 10-Q). The EIM, Telemanagement, VoIP, and Patent Enforcement segments represented income / (loss) from operations for the nine months ended September 30, 2010 of $1,021,170, $399,025, $(1,885,984) and $32,697, respectively. The Corporate Allocation expense generated an operating loss of $(840,243) for the nine months ended September 30, 2010. The United States location generated a loss from operations for the nine months ended September 30, 2010 of $(950,634) which was primarily associated with losses generated in the VoIP segment and the Corporate Allocations expense. The United Kingdom location generated a loss from operations for the same period of $(322,721). For the nine months ended September 30, 2009 the EIM, Telemanagement, VoIP, and Patent Enforcement segments represented income / (loss) from operations
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of $2,474,397, $(74,409), $(2,037,060) and $(826,836), respectively. The Corporate Allocation expense generated an operating loss of $(826,825) for the nine months ended September 30, 2009. The United States location generated a loss from operations for the nine months ended September 30, 2009 of $(1,791,970) which was primarily associated with corporate expenses and a loss from the VoIP segment. The United Kingdom location generated income from operations for the same period of $501,237.
The Company has available a revolving loan facility with PNC Bank (“PNC”), formerly known as National City Bank, equal to the lesser of (a) $3,000,000, (b) the sum of 80% of eligible domestic trade accounts receivable and 90% of eligible, insured foreign trade accounts receivable or (c) four times the sum of earnings before interest, taxes, depreciation and amortization for the trailing twelve month period. Outstanding borrowings under the revolving loan bear interest at LIBOR plus 2.50% payable monthly which amounted to 2.76% as of September 30, 2010. The Company also must pay an unused revolving loan commitment fee of 0.25% of the average daily amount by which the revolving loan commitment exceeds the outstanding principal amount. The amount paid on the unused revolving loan commitment fee amounted to $3,677 and $1,026 for the nine and three months ended September 30, 2010, respectively. The revolving loan expires on December 30, 2010. All borrowings are collateralized by substantially all assets of the Company. The outstanding balance on the revolving loan was $1,260,000 at September 30, 2010. Available for borrowing under the revolving loan on September 30, 2010 was $706,023. The carrying amount of receivables that served as collateral for borrowings totaled $1,966,023 at September 30, 2010.
The Company had an acquisition loan of $500,000 with PNC (the “Acquisition Loan”). The Acquisition Loan was repaid and expired on December 21, 2009. All borrowings under the Acquisition Loan were collateralized by substantially all assets of the Company. Borrowings under the Acquisition Loan bore interest at LIBOR plus 2.00% payable monthly. The outstanding balances on the Acquisition Loan were $0 and $500,000 at September 30, 2010 and September 30, 2009, respectively.
The revolving loan facility (the “Loan Agreement”) is and the Acquisition Loan (the “Loan Agreements”) was secured by a guarantee from a wholly-owned subsidiary of Fairford Holdings Limited, a British Virgin Islands company (“Fairford”). As of September 30, 2010, Fairford beneficially owned 63.7% of the Company’s outstanding Class A common stock. Mr. Osseiran, the majority holder of the Company’s Class A common stock and director of the Company, is a director of Fairford and a grantor and sole beneficiary of a revocable trust which is the sole stockholder of Fairford. Mr. Dahl, a director of the Company, is the director of Fairford.
The Loan Agreement contains certain financial covenants and restrictions on indebtedness, encumbrances, investments, business combinations, and other related items. As of September 30, 2010, the Company believes it was in compliance with all covenants. The more significant covenants under the Loan Agreements, include that, without PNC’s prior written consent, the Company shall not, and shall not permit any of its subsidiaries to: (i) incur or have outstanding any indebtedness in excess of $20,000 individually or $100,000 in the aggregate; (ii) dispose of all, or any part, of business or assets; (iii) make any acquisitions, or (iv) issue any additional shares of stock or other securities and the Company shall not issue more than 10% of the Company’s capital stock pursuant to its stock option plan on a fully-diluted basis.
The Company derives a substantial portion of its revenues from a single EIM customer. This single customer generated approximately $1.8 million and $2.2 in the nine months ended September 30, 2010 and September 30, 2009, respectively (16.9% of revenue for the nine months ended September 30, 2010 and 18.9% or revenue for the nine months ended September 30, 2009). This customer’s contract includes an automatic annual renewal provision; however, the contract can be terminated at any time by either party with four months advanced notice. The Company experienced significant decreases in the processing for this customer and anticipates additional decreased processing revenue. The loss of this customer would have a substantial negative impact on the Company’s financial condition and results of operations.
The Company’s primary sources of liquidity over the next twelve months will be cash on hand, anticipated increased cash generated from future operating activities and the cash available to the Company under the revolving loan facility.
The Company expects to continue to require funds to meet debt service obligations, capital expenditures and other non-operating expenses. The Company’s future capital requirements will depend on many factors, including revenue growth, expansion of service offerings and business strategy. The Company believes that expected future earnings from operations, available funds, together with existing revolving credit facility, will be adequate to satisfy its planned operations for the next 12 months. There can be no assurances that the Company will be successful in generating increased cash from future operating activities. If the Company is not successful in generating increased cash from operating activities, it would need to undertake, amongst other measures, cost containment and cost cutting activities, extend or seek a new revolving loan agreement or seek other additional capital resources.
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In October 2010, in order to supplement the Company’s liquidity, Fairford advanced to the Company $500,000. Subsequent to the advancement, the Company issued to Fairford a demand note, in the aggregate principal amount of $500,000 bearing interest at LIBOR plus 4%. The demand note has no term and is due on demand. The Company intends to seek a replacement revolving loan facility. If the Company is not successful in obtaining a replacement revolving loan facility, it will seek additional funds from Fairford. There can be no assurance that Fairford will provide additional funding to the Company, if needed, or that the Company will be successful in obtaining a replacement revolving loan facility.
Off-Balance Sheet Arrangements
The Company has no material off-balance sheet arrangements.
Critical Accounting Policies and Estimates
The discussion and analysis of the Company’s financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to revenue recognition, bad debts, depreciation and amortization, investments, income taxes, capitalized software, goodwill, restructuring costs, accrued compensation, contingencies and litigation. The Company bases its 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.
The Company believes the following critical accounting policies affect the more significant judgments and estimates used in the preparation of the consolidated financial statements. For the description of other critical accounting policies used by the Company, see Item 8. “Financial Statements and Supplementary Date — Notes to Consolidated Financial Statements — Note 1” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.
Income Taxes.The Company is required to estimate its income taxes. This process involves estimating the Company’s actual current tax obligations together with assessing differences resulting from different treatment of items for tax and accounting purposes which result in deferred income tax assets and liabilities.
The Company accounts for income taxes using the liability method. Under the liability method, a deferred tax asset or liability is determined based on the difference between the financial statement and tax bases of assets and liabilities, as measured by the enacted tax rates assumed to be in effect when these differences are expected to reverse.
The Company’s deferred tax assets are assessed for each reporting period as to whether it is more likely than not that they will be recovered from future taxable income, including assumptions regarding on-going tax planning strategies. To the extent the Company believes that recovery is uncertain, the Company has established a valuation allowance for assets not expected to be recovered. Changes to the valuation allowance are included as an expense or benefit within the tax provision in the statement of operations. As of September 30, 2010, the Company’s valuation allowance related only to net deferred tax assets in the United States. As a result, the Company’s tax expense relates to the UK operations and the Company does not anticipate recording significant tax charges or benefits related to operating gains or losses for the Company’s US operations.
The Company recognizes a tax position as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax of the state of Indiana and foreign income tax in the United Kingdom. The Company does not expect the total amount of unrecognized tax benefits to significantly increase in the next twelve months.
The Company recognizes interest and/or penalties related to income tax matters in income tax expense. The Company did not have any amounts accrued for interest and penalties at September 30, 2010.
The Company’s tax filings are subject periodically to regulatory review and audit.
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Research and Development and Software Development Costs.Research and development costs are charged to operations as incurred. Software Development Costs are considered for capitalization when technological feasibility is established. The Company bases its determination of when technological feasibility is established based on the development team’s determination that the Company has completed all planning, designing, coding and testing activities that are necessary to establish that the product can be produced to meet its design specifications including, functions, features, and technical performance requirements.
Goodwill and Intangible Assets.The Company considers the goodwill and related intangible assets related to CTI Billing Solutions Limited to be the premium the Company paid for CTI Billing Solutions Limited. For accounting purposes, these assets are maintained at the corporate level and the Company considers the functional currency with respect to these assets the U.S. dollar.
Goodwill is tested for impairment on an annual basis and between annual tests in certain circumstances, and written down when impaired. There were no impairments in 2010 and 2009. Purchased intangible assets other than goodwill are amortized over their useful lives unless these lives are determined to be indefinite. Purchased intangible assets are carried at cost, less accumulated amortization. Amortization is computed over the estimated useful lives of the respective assets, generally 3-15 years. Intangible assets consist of patents, purchased technology, trademarks and trade names, and customer lists.
The Company has allocated goodwill and a significant component of its intangible assets to CTI Billing Solutions Limited, as that entity is considered a separate reporting unit. The Company performed its annual impairment analysis on goodwill as of October 1, 2009, to coincide with the calendar date set in past years for this analysis. The Company’s analysis considered the projected cash flows of the reporting unit and gave consideration to appropriate factors in determining a discount rate to be applied to these cash flows. The Company engaged the same outside firm as was used in past years to assist in this analysis. The Company is satisfied as to the qualifications and independence of this firm with respect to their ability to assist in this analysis. The results of this analysis indicated that there was no Step One impairment as of the date of our annual impairment determination.
The Company’s Class A common stock dropped significantly in the fourth quarter of 2008 and has remained at low levels. As of November 9, 2010, the Company’s Class A common stock closed at $0.08 per share and the “market cap” for the Company’s stock was approximately $0.9 million which was well below the Company’s reported book value at September 30, 2010 of approximately $7.1 million.
Because of the Company’s continued low “market cap”, the Company reviewed the assumptions utilized in the impairment determination and again found that there existed no impairment. The Company’s operations of the business unit are primarily based on recurring revenues and have not experienced an adverse change in anticipated performance considered in the impairment analysis. The business units operating performance subsequent to the goodwill impairment analysis has exceeded anticipated performance through the most recent period that information is available.
The Company recognizes that the market for our stock is significantly below our book value which the Company attributes to a number of factors including very limited trading in the Company’s Class A common stock; a significant portion of the Company’s Class A common stock (approximately 64%) is beneficially owned by a majority stockholder, an overall “flight to quality” by investors in which many “penny stocks” such as CTI’s have been significantly downgraded in terms of pricing and an overall lack of public awareness of its operations. While the Company cannot quantify the impacts of these factors in terms of how they impact the difference between book value and our stock’s “market cap” The Company does not believe that the market in its Class A common stock is sufficiently sophisticated to make a proper determination of the value of the Company’s Class A common stock such that it should drive the Company to reach a conclusion that impairment of its goodwill has occurred when the Company believes that generally accepted valuation techniques using its most recent assessments as to the future performance of our business indicate that it is not impaired. The Company will continue in the future to be aware of the market cap in our assessment of its goodwill and may more frequently update its analysis of goodwill impairment in light of this situation. The Company believes the year-end analysis is sufficiently current and no formal analysis has been performed at September 30, 2010. If the Company assesses market condition changes in our business, it may be required to reflect goodwill impairment in the future.
Long-Lived Assets.The Company reviews the recoverability of the carrying value of its long-lived assets on an annual basis. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. When such events occur, the Company compares the carrying amount of the assets to the undiscounted expected future cash flows. If this comparison indicates there is impairment, the amount of the impairment is typically calculated using discounted expected future cash flows.
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Revenue Recognition and Accounts Receivable Reserves.The Company records revenue when it is realized, or realizable, and earned. Revenues from software licenses are recognized upon shipment, delivery or customer acceptance, based on the substance of the arrangement or as defined in the sales agreement provided there are no significant remaining vendor obligations to be fulfilled and collectability is reasonably assured. Software sales revenue is generated from licensing software to new customers and from licensing additional users and new applications to existing customers.
The Company’s sales arrangements typically include services in addition to software. Service revenues are generated from support and maintenance, processing, training, consulting, and customization services. For sales arrangements that include bundled software and services, the Company accounts for any undelivered service offering as a separate element of a multiple-element arrangement. Amounts deferred for services are determined based upon vendor-specific objective evidence of the fair value of the elements. Support and maintenance revenues are recognized on a straight-line basis over the term of the agreement. Revenues from processing, training, consulting, and customization are recognized as provided to customers. If the services are essential to the functionality of the software, revenue from the software component is deferred until the essential service is complete.
If an arrangement to deliver software or a software system, either alone or together with other products or services, requires significant production, modification, or customization of software, the service element does not meet the criteria for separate accounting set forth in the guidance related software revenue recognition. If the criteria for separate accounting are not met, the entire arrangement is accounted for in with conformity guidance related to contract accounting. The Company carefully evaluates the circumstances surrounding the implementations to determine whether the percentage-of-completion method or the completed-contract method should be used. Most implementations relate to the Company’s Telemanagement products and are completed in less than 30 days once the work begins. The Company uses the completed-contract method on contracts that will be completed within 30 days since it produces a result similar to the percentage-of-completion method. On contracts that will take over 30 days to complete, the Company uses the percentage-of-completion method of contract accounting.
The Company also realizes patent license fee and enforcement revenues. These revenues are realized once the Company has received a signed settlement or judgment and the collection of the receivable is deemed probable.
The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. The Company continuously monitors collections and payments from its customers and the allowance for doubtful accounts is based on historical experience and any specific customer collection issues that the Company has identified. 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. Where an allowance for doubtful accounts has been established with respect to customer receivables, as payments are made on such receivables or if the customer goes out of business with no chance of collection, the allowances will decrease with a corresponding adjustment to accounts receivable as deemed appropriate.
Legal Costs Related to Patent Enforcement Activities.Hourly legal costs incurred while pursuing patent license fee and enforcement revenues are expensed as incurred. Legal fees that are contingent on the successful outcome of an enforcement claim are recorded when the patent license fee and enforcement revenues are realized.
Stock Based Compensation.The Company recognizes the cost of employee services received in exchange for awards of equity instruments, such as stock options and restricted stock, based on the fair value of those awards at the date of grant. The Company uses the Black-Scholes-Merton formula to calculate the fair value of the stock options.
The Company recognizes compensation cost net of a forfeiture rate and recognizes the compensation cost for only those awards expected to vest on a straight-line basis over the requisite service period of the award, which is generally the vesting term. The Company estimated the forfeiture rate based on its historical experience and its expectations about future forfeitures.
Included within selling, general and administrative expense for the three months ended September 30, 2010 and September 30, 2009 was $9,388 and $27,313, respectively, of stock-based compensation. Included within selling, general and administrative expense for the nine months ended September 30, 2010 and September 30, 2009 was $40,387 and $85,144, respectively, of stock-based compensation. Stock-based compensation expenses are recorded in the Corporate Allocation segment as these amounts are not included in internal measures of segment operating performance.
The Company estimates it will recognize approximately $47,000, $38,000, $24,000 and $0 for the fiscal years ending December 31, 2010, 2011, 2012 and 2013, respectively, of compensation costs for nonvested stock options previously granted to employees.
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New Accounting Pronouncements
FASB ASU No. 2009-13 — Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements - a consensus of the FASB Emerging Issues Task Force applies to multiple-deliverable revenue arrangements that are currently within the scope of Topic 605-25. This ASU also provides principles and application guidance on whether multiple deliverables exist, how the arrangement should be separated, and the consideration allocated, requires an entity to allocate revenue in an arrangement using estimated selling prices of deliverables if a vendor does not have vendor-specific objective evidence or third-party evidence of selling price, eliminates the use of the residual method and requires an entity to allocate revenue using the relative selling price method. The consensus significantly expands the disclosure requirements for multiple-deliverable revenue arrangements. This ASU should be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with earlier application permitted. Alternatively, an entity can elect to adopt this ASU on a retrospective basis. The Company has not yet determined the effect of the adoption of this ASU on the Company’s results of operations or financial position.
FASB ASU No. 2009-14 — Software (Topic 985): Certain Revenue Arrangements That Include Software Elements — a consensus of the FASB Emerging Issues Task Force was issued concurrently with ASU No. 2009-13 and focuses on determining which arrangements are within the scope of the software revenue guidance in Topic 985 and which are subject to the guidance in ASU No. 2009-13. This ASU removes tangible products from the scope of the software revenue guidance and provides guidance on determining whether software deliverables in an arrangement that includes a tangible product are within the scope of the software revenue model or the guidance in revenue arrangements with multiple deliverables model, ASU No. 2009-13. Generally, if the software contained in or part of the arrangement with the tangible product is essential to the tangible product’s functionality, then the software is excluded from the software revenue guidance. The ASU also provides factors to consider in evaluating whether the software was essential to the tangible product or not. The disclosure requirements, effective date, and transition methods for this ASU are the same as those for ASU No. 2009-13. An entity must adopt both ASUs in the same period using the same transition method. The Company has not yet determined the effect of the adoption of this ASU on the Company’s results of operations or financial position.
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Item 3. Quantitative and Qualitative Disclosures about Market Risk.
Not Applicable.
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Item 4. Controls and Procedures.
The Company, under the supervision and with the participation of its management, including its principal executive officer and principal financial officer, evaluated the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation, the principal executive officer and principal financial officer concluded that as of September 30, 2010, the Company’s disclosure controls and procedures were effective in reaching a reasonable level of assurance that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, to allow timely decisions regarding required disclosure.
The Company’s principal executive officer and principal financial officer also conducted an evaluation of internal control over financial reporting (“Internal Control”) to determine whether any changes in Internal Control occurred during the quarter covered by this report that have materially affected or which are reasonably likely to materially affect Internal Control. Based on that evaluation, there has been no such change during the quarter covered by this report.
A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. The Company conducts periodic evaluations to enhance, where necessary its procedures and controls.
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PART II — OTHER INFORMATION
Item 1 — Legal Proceedings.
The Company is from time to time subject to claims and administrative proceedings that are filed in the ordinary course of business and are unrelated to Patent Enforcement.
Qwest Corporation
The Company previously disclosed that on May 11, 2004, an action was brought against the Company in the United States District Court for the Western District of Washington by Qwest Corporation seeking a declaratory judgment of non-infringement and invalidity of the Company’s Patent No. 5,287,270. An amended complaint was filed on July 13, 2004 adding Qwest Communications Corporation to that action. The Company filed a motion with the United States District Court for the Western District of Washington seeking to dismiss that action or, in the alternative, to transfer it to the United States District Court for the Southern District of Indiana.
On November 12, 2004, the United States District Court for the Western District of Washington granted the Company’s motion to the extent of transferring the action to the United States District Court for the Southern District of Indiana. The Company asserted counterclaims alleging patent infringement and the United States District Court for the Southern District of Indiana then consolidated the transferred action with the pending patent infringement lawsuit disclosed above under “BellSouth Corporation et al.”
On January 9, 2008, the United States District Court for the Southern District of Indiana issued its claim construction for U.S. Patent No. 5,287,270. On January 18, 2008, the Qwest entities filed a motion for stay and a summary judgment motion of invalidity based on the construction of one of the claim terms. The motions were fully briefed on an expedited basis and on February 26, 2008, the court denied the motions. Fact discovery closed on December 23, 2008. Expert discovery was completed on April 1, 2009. On April 15, 2009, the parties filed various summary judgment motions related to patent infringement and invalidity and immunity from suit concerning the Networx government contracts. On September 22, 2009, the Court granted the Qwest entities’ motion for summary judgment of immunity from suit concerning the Networx government contracts, thereby requiring the Company to sue the Government in the Court of Federal Claims. On October 29, 2009, the Court ruled on the parties’ patent invalidity and noninfringement summary judgment motions. The Court held that the Company’s U.S. Patent No. 5,287,270 was valid but not infringed by the Qwest entities. In November 2009, the Company filed a Notice of Appeal to the United States Court of Appeals for the Federal Circuit (Federal Circuit). The Qwest entities subsequently cross appealed. Briefing before the Federal Circuit commenced February 19, 2010 and was completed in July 2010. Oral argument before the Federal Circuit took place on November 4, 2010. A decision is expected in the first half of 2011.
Item 1A — Risk Factors.
In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009 and in Part II, “Item 1A-Risk Factors” in our quarterly report on Form 10-Q for the quarter ended June 30, 2010, which could materially affect our business, financial condition or future results. The risk factors in our Annual Report on Form 10-K and quarterly report on Form 10-Q have not materially changed. The risks in our Annual Report on Form 10-K and quarterly report on Form 10-Q are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.
Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds.
None.
Item 3—Defaults Upon Senior Securities.
None.
Item 4 — (Removed and Reserved)
Item 5 — Other Information.
In October 2010, in order to supplement the Company’s liquidity, Fairford advanced to the Company $500,000. On November 12, 2010, the Company approved the terms and conditions of the advance from Fairford and approved the Company issuing a demand note to Fairford, in the aggregate principal amount of $500,000 bearing interest at LIBOR plus 4%. The demand note has no term and is due on demand. The Company intends to seek a replacement revolving loan facility. If the Company is not successful in obtaining a replacement revolving loan facility, it will seek additional funds from Fairford. There can be no assurance that Fairford will provide additional funding to the Company, if needed, or that the Company will be successful in obtaining a replacement revolving loan facility.
The $500,000 advance from Fairford, created a technical default regarding the loan covenant on limitation on additional indebtedness under the revolving line of credit agreement. The bank granted a waiver of the technical default of the loan covenants created by the advance from Fairford. Furthermore, in connection with the waiver, the bank reduced the maximum available under the revolving line of credit from $3,000,000 to $2,000,000.
As of September 30, 2010, Fairford beneficially owned 63.7% of the Company’s outstanding Class A common stock. Fairford Holdings Scandinavia AB (“Fairford Scandinavia”), a wholly-owned subsidiary of Fairford, owns stock warrants to purchase 1,040,170 shares of the Company’s Class A common stock. Mr. Osseiran, the majority holder of the Company’s Class A common stock and a director of the Company, is a director of Fairford, the President of Fairford Scandinavia and a grantor and sole beneficiary of a revocable trust which is the sole stockholder of Fairford. Mr. Dahl, a director of the Company, is a director of Fairford and the Chairman of Fairford Scandinavia
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Item 6 — Exhibits.
Exhibit 11.1 | Statement re computation of per share earnings, incorporated by reference to Note 6 to Consolidated Financial Statements included in this Quarterly Report on Form 10-Q | ||
Exhibit 31.1- | Chief Executive Officer Certification pursuant to Securities Exchange Act Rule 13a-14(a) / 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | ||
Exhibit 31.2- | Chief Financial Officer Certification pursuant to Securities Exchange Act Rule 13a-14(a) / 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | ||
Exhibit 32.1- | Section 1350 Certification of the Chief Executive Officer | ||
Exhibit 32.2- | Section 1350 Certification of the Chief Financial Officer |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
/s/ John Birbeck | ||||
John Birbeck | Date: November 12, 2010 | |||
Chief Executive Officer (Principal Executive Officer) | ||||
/s/ Manfred Hanuschek | ||||
Manfred Hanuschek | Date: November 12, 2010 | |||
Chief Financial Officer (Principal Financial Officer) | ||||
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