UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2007
1-32146 |
Commission file number |
DOCUMENT SECURITY SYSTEMS, INC. |
(Exact name of registrant as specified in its charter) |
New York | 16-1229730 | |
(State of incorporation) | (IRS Employer Identification Number) |
28 Main Street East, Suite 1525 |
Rochester, NY 14614 |
(Address of principal executive office) |
(585) 325-3610 |
(Registrant's telephone number) |
Indicate by check mark whether the registrant:
(1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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.
Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o | Accelerated filer o | Non-accelerated filer x |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)
Yes x No o
Applicable only to corporate issuers
As of August 9, 2007 (the most recent practicable date), there were 13,676,030 shares of the issuer's Common Stock, $0.02 par value per share, outstanding.
FORM 10-Q TABLE OF CONTENTS | ||||
PART I | FINANCIAL INFORMATION | |||
Item 1 | Financial Statements | |||
Consolidated Balance Sheets | 3 | |||
Consolidated Statements of Operations | 4 | |||
Consolidated Statements of Cash Flows | 5 | |||
Notes to Financial Statements | 6 | |||
Item 2 | Management's Discussion and Analysis of Financial Condition and Results of Operations | 14 | ||
Item 3 | Quantitative and Qualitative Disclosures about Market Risk | 26 | ||
Item 4 | Controls and Procedures | 26 | ||
PART II | OTHER INFORMATION | |||
Item 1 | Legal Proceedings | 27 | ||
Item 1a | Risk Factors | 28 | ||
Item 2 | Unregistered Sales of Equity Securities and Use of Proceeds | 29 | ||
Item 3 | Defaults upon Senior Securities | 29 | ||
Item 4 | Submission of Matters to a Vote of Security Holders | 29 | ||
Item 5 | Other Information | 29 | ||
Item 6 | Exhibits | 29 | ||
SIGNATURES |
2
PART I
ITEM 1 - FINANCIAL STATEMENTS
DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES | ||||||||||
Consolidated Balance Sheets |
June 30, | December 31, | ||||||
2007 | 2006 | ||||||
(unaudited) | (audited) | ||||||
ASSETS | |||||||
Current assets: | |||||||
Cash and cash equivalents | $ | 3,251,094 | $ | 5,802,615 | |||
Accounts receivable, net of allowance of $39,000 ($74,000 -2006) | 693,797 | 618,622 | |||||
Inventory | 301,159 | 239,416 | |||||
Prepaid expenses and other current assets | 397,152 | 224,782 | |||||
Assets held for sale | 38,000 | - | |||||
Total current assets | 4,681,202 | 6,885,435 | |||||
Fixed assets, net | 578,919 | 637,732 | |||||
Other assets | 146,935 | 156,734 | |||||
Goodwill | 1,396,734 | 1,396,734 | |||||
Other intangible assets, net | 6,773,529 | 5,389,564 | |||||
Total Assets | $ | 13,577,319 | $ | 14,466,199 | |||
LIABILITIES AND STOCKHOLDERS' EQUITY | |||||||
Current liabilities: | |||||||
Accounts payable | $ | 1,595,937 | $ | 1,283,503 | |||
Accrued expenses & other current liabilities | 540,007 | 877,261 | |||||
Deferred revenue | 677,827 | 564,439 | |||||
Current portion of capital lease obligations | 31,336 | 34,814 | |||||
Total current liabilities | 2,845,107 | 2,760,017 | |||||
Long-term capital lease obligations | 35,780 | 50,417 | |||||
Long-term deferred revenue | 189,188 | 466,875 | |||||
Commitments and contingencies (see Note 8) | |||||||
Stockholders' equity | |||||||
Common stock, $.02 par value; | |||||||
200,000,000 shares authorized, 13,676,030 shares issued and outstanding (13,544,724 in 2006) | 273,521 | 270,894 | |||||
Additional paid-in capital | 30,371,801 | 28,145,793 | |||||
Accumulated deficit | (20,138,078 | ) | (17,227,797 | ) | |||
Total stockholders' equity | 10,507,244 | 11,188,890 | |||||
Total Liabilities and Stockholders' Equity | $ | 13,577,319 | $ | 14,466,199 | |||
See accompanying notes |
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DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES | |||||||||||||
Consolidated Statements of Operations | |||||||||||||
(unaudited) | |||||||||||||
Three Months Ended | Six Months Ended | ||||||||||||
June 30, | June 30, | June 30, | June 30, | ||||||||||
2007 | 2006 | 2007 | 2006 | ||||||||||
Revenue | |||||||||||||
Security printing | $ | 826,734 | $ | 970,572 | $ | 1,818,382 | $ | 1,462,655 | |||||
Royalties | 294,157 | 60,081 | 592,953 | 96,695 | |||||||||
Digital solutions | 11,969 | - | 174,771 | - | |||||||||
Legal products | 161,663 | 145,028 | 337,345 | 315,086 | |||||||||
Total Revenue | 1,294,523 | 1,175,681 | 2,923,451 | 1,874,436 | |||||||||
Costs of revenue | |||||||||||||
Security printing | 547,575 | 562,548 | 1,055,538 | 889,854 | |||||||||
Digital solutions | 3,507 | - | 37,014 | - | |||||||||
Legal products | 90,593 | 76,791 | 193,767 | 179,508 | |||||||||
Total costs of revenue | 641,675 | 639,339 | 1,286,319 | 1,069,362 | |||||||||
Gross profit | 652,848 | 536,342 | 1,637,132 | 805,074 | |||||||||
Operating expenses: | |||||||||||||
Selling, general and administrative | 1,811,586 | 1,370,558 | 3,608,732 | 2,311,953 | |||||||||
Research and development | 108,889 | 96,282 | 203,297 | 168,884 | |||||||||
Amortization of intangibles | 433,090 | 268,275 | 778,729 | 488,275 | |||||||||
Operating expenses | 2,353,565 | 1,735,115 | 4,590,758 | 2,969,112 | |||||||||
Operating loss | (1,700,717 | ) | (1,198,773 | ) | (2,953,626 | ) | (2,164,038 | ) | |||||
Other income (expense): | |||||||||||||
Interest income | 34,179 | 17,242 | 74,987 | 44,138 | |||||||||
Gain/(loss) on foreign currency adjustments | (945 | ) | - | (4,291 | ) | - | |||||||
Interest expense | (1,296 | ) | (5,381 | ) | (2,449 | ) | (10,844 | ) | |||||
Loss before income taxes and discontinued operations | (1,668,779 | ) | (1,186,912 | ) | (2,885,379 | ) | (2,130,744 | ) | |||||
Income taxes | 4,738 | - | 9,476 | - | |||||||||
Loss from continuing operations | (1,673,517 | ) | (1,186,912 | ) | (2,894,855 | ) | (2,130,744 | ) | |||||
Loss from discontinued operations (Note 5) | (26,821 | ) | (19,625 | ) | (15,426 | ) | (70,355 | ) | |||||
Net loss | $ | (1,700,338 | ) | $ | (1,206,537 | ) | $ | (2,910,281 | ) | $ | (2,201,099 | ) | |
Net loss per share -basic and diluted: | |||||||||||||
Continuing operations | $ | (0.12 | ) | $ | (0.09 | ) | $ | (0.21 | ) | $ | (0.17 | ) | |
Discontinued operations | 0.00 | 0.00 | 0.00 | 0.00 | |||||||||
Net Loss | $ | (0.12 | ) | $ | (0.09 | ) | $ | (0.21 | ) | $ | (0.17 | ) | |
Weighted average common shares outstanding, basic and diluted | 13,625,408 | 12,850,491 | 13,605,327 | 12,824,935 | |||||||||
See accompanying notes
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DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
For the Six Months Ended June 30,
2007 | 2006 | |||||
(unaudited) | (unaudited | ) | ||||
Cash flows from operating activities: | ||||||
Net loss | $ | (2,910,281 | ) | $ | (2,201,099 | ) |
Adjustments to reconcile net loss to net cash used by operating activities: | ||||||
Depreciation and amortization expense | 870,247 | 607,410 | ||||
Stock based compensation | 633,040 | 280,450 | ||||
(Increase) decrease in assets: | ||||||
Accounts receivable | (75,175 | ) | (362,012 | ) | ||
Inventory | (61,743 | ) | (57,600 | ) | ||
Prepaid expenses and other assets | (238,656 | ) | (8,385 | ) | ||
Increase (decrease) in liabilities: | ||||||
Accounts payable | 360,023 | 293,126 | ||||
Accrued expenses | (49,754 | ) | (69,096 | ) | ||
Deferred revenue | (164,299 | ) | - | |||
Net cash used by operating activities | (1,636,598 | ) | (1,517,206 | ) | ||
Cash flows from investing activities: | ||||||
Purchase of fixed assets | (70,705 | ) | (69,887 | ) | ||
Acquisition of business | - | (1,301,670 | ) | |||
Increase in other intangible assets | (661,709 | ) | (77,841 | ) | ||
Net cash used by investing activities | (732,414 | ) | (1,449,398 | ) | ||
Cash flows from financing activities: | ||||||
Repayment of long-term debt | - | (25,075 | ) | |||
Repayment of capital lease obligations | (18,115 | ) | (16,333 | ) | ||
Payment of stock issuance costs | (519,619 | ) | - | |||
Issuance of common stock, net | 355,225 | 757,770 | ||||
Net cash (used) provided by financing activities | (182,509 | ) | 716,362 | |||
Net increase (decrease) in cash and cash equivalents | (2,551,521 | ) | (2,250,242 | ) | ||
Cash and cash equivalents beginning of period | 5,802,615 | 3,953,482 | ||||
Cash and cash equivalents end of period | $ | 3,251,094 | $ | 1,703,240 |
See accompanying notes.
5
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)
1. Basis of Presentation and Significant Accounting Policies
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, these statements do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, the accompanying balance sheets and related interim statements of operations and cash flows include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in accordance with U.S. generally accepted accounting principles. All significant intercompany transactions have been eliminated.
Interim results are not necessarily indicative of results expected for a full year. For further information regarding Document Security Systems, Inc (the “Company”) accounting policies, refer to the audited consolidated financial statements and footnotes thereto included in the Company's Form 10-K for the fiscal year ended December 31, 2006.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates and assumptions.
Revenue Recognition - Sales of security and other printing products, and legal products are recognized when a product or service is delivered, shipped or provided to the customer and all material conditions relating to the sale have been substantially performed.
We recognize revenue from technology licenses over the term of license agreements once all the following criteria for revenue recognition have been met: (1) persuasive evidence of an agreement exists; (2) the right and ability to use the product or technology has been rendered; (3) the fee is fixed and determinable and not subject to refund or adjustment; and (4) collection of the amounts due is reasonably assured.
For digital solutions sales, revenue is recognized in accordance with the American Institute of Certified Public Accountant's Statement of Position (SOP) No. 97-2, "Software Revenue Recognition," as modified by SOP No. 98-9, "Modification of SOP No. 97-2, Software Revenue Recognition with Respect to Certain Transactions" and Staff Accounting Bulletin (SAB) No. 104, "Revenue Recognition." Accordingly, revenue is recognized when all of the following conditions are satisfied: (1) there is persuasive evidence of an arrangement; (2) the service or product has been provided to the customer; (3) the amount of fees to be paid by the customer is fixed or determinable (4) the collection of our fees is reasonably assured.
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We also enter into arrangements under which we provide hosted software applications. We recognize revenue for these arrangements based on the provisions of EITF No. 00-3, Application of AICPA SOP 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entity’s Hardware (“EITF 00-3”), and the provisions of Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements”, when there is persuasive evidence of an arrangement, collection of the resulting receivable is probable, the fee is fixed or determinable and acceptance has occurred. Our revenues related to these arrangements consist of system implementation service fees and software subscription fees. We have determined that the system implementation services represent set-up services that do not qualify as separate units of accounting from the software subscriptions as the customer would not purchase these services without the purchase of the software subscription. As a result, we recognize system implementation fees ratably over a period of time from when the core system implementation services are completed and accepted by the customer over the remaining customer relationship life, which we have determined is the contractual life of the customer’s subscription agreement. We recognize software subscription fees, which typically commence upon completion of the related system implementation, ratably over the applicable subscription period. Amounts billed and/or collected prior to satisfying our revenue recognition policy are reflected as deferred revenue.
Share-Based Payments - The Company measures compensation expense for its non-employee stock-based compensation under the Financial Accounting Standards Board (FASB) Emerging Issues Task Force (EITF) Issue No. 96-18, "Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services". The EITF applies when the fair value of the equity instrument issued is used to measure the transaction, as this is more reliable than the fair value of the services received. The fair value is determined based on the measurement date which is the date that the commitment for performance by the counterparty has been reached or the counterparty's performance is complete. Prior to the measurement date, the fair value is determined at each reporting date and used as an estimate of the expected fair value to record compensation as the services are being performed and the instruments are being earned.
Recent Accounting Pronouncements -In July 2006, the Financial Accounting Standards Board (“FASB”) issued Financial Interpretation 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS 109, Accounting for Income Taxes and requires a two-step approach to evaluate tax positions and determine if they should be recognized in the financial statements. The two-step approach involves recognizing any tax positions that are “more likely than not” to occur and then measuring those positions to determine if they are recognizable in the financial statements. The interpretation is effective for fiscal years beginning after December 15, 2006. We adopted FIN 48 on January 1, 2007. (See Note 7)
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2. Inventory
Inventory consisted of the following:
June 30, | December 31, | |||||||
2007 | 2006 | |||||||
(unaudited) | (audited) | |||||||
Finished Goods | $ | 193,658 | $ | 145,206 | ||||
Materials | 107,501 | 94,210 | ||||||
$ | 301,159 | $ | 239,416 |
3. Other Intangible Assets
Other intangible assets are comprised of the following:
June 30, 2007 | December 31, 2006 | |||||||||||||||||||||
Useful Life | Gross Carrying Amount | Accumulated Amortizaton | Net Carrying Amount | Gross Carrying Amount | Accumulated Amortizaton | Net Carrying Amount | ||||||||||||||||
Royalty rights | 5 years | $ | 90,000 | $ | 63,000 | $ | 27,000 | $ | 90,000 | $ | 54,000 | $ | 36,000 | |||||||||
Other intangibles | 5 years | 1,187,595 | 219,474 | 968,121 | 666,300 | 149,036 | 517,264 | |||||||||||||||
Patent and contractual rights | Varied (1 | ) | 7,853,800 | 2,075,392 | 5,778,408 | 6,212,400 | 1,376,100 | 4,836,300 | ||||||||||||||
$ | 9,131,395 | $ | 2,357,866 | $ | 6,773,529 | $ | 6,968,700 | $ | 1,579,136 | $ | 5,389,564 | |||||||||||
(1)- patent rights are amortized over their expected useful life which is generally the legal life of the patent. As of June 30, 2007 the weighted average remaining useful life of these assets in service was 4.2 years.
4. Shareholders’ Equity
Stock Issued for Patent Defense Costs - On November 14, 2006, the Company entered into an agreement with McDermott Will & Emery LLP (“MWE”), its lead counsel on its European Central Bank (“ECB Litigation”) patent infringement and related cases. The agreement with MWE allows the Company to use its common stock with a value not to exceed $1.2 million to eliminate the Company’s cash requirements for MWE’s legal fees related to the ECB patent validity litigation. During the six months ended June 30, 2007, 60,866 restricted common shares were issued to MWE to pay for approximately $746,000 of legal fees incurred through June 30, 2007.
Stock Issued in Private Placement - On January 22, 2007, the Company sold 6 units at a price of $50,000 per unit for gross cash proceeds of $300,000, consisting of 35,280 unregistered shares of our common stock and five-year warrants to purchase up to an aggregate of 17,640 shares of our common stock, at an exercise price of $11.75 per share. The fair market value of these warrants was determined using the Black Scholes option pricing model at $107,000. The Company incurred placement agent fees associated with the offering equal to 9% commissions, or $27,000. In addition, during the six months ended June 30, 2007, the Company paid $470,000 of private placement fees related to an offering that occurred during 2006.
Restricted Stock - On May 3, 2007, the Company granted 25,000 restricted shares that will vest over two years to a member of its senior management team. These shares were valued at the fair value on the grant date at approximately $312,000. Also on May 3, 2007, the Company granted 445,000 restricted shares of common stock pursuant to the Company’s 2004 Employee Stock Option Plan to certain members of senior management. These shares only vest upon the occurrence of certain events over the next 5 years, which include a change of control or other merger or acquisition of the Company, the achievement of certain financial goals, including among other things a successful result of the Company’s patent infringement lawsuit against the European Central Bank. These shares, if vested, would result in the recording of stock based compensation expense of approximately $5,563,000 over the period beginning when any of the contingent vesting events is deemed to be probable over the expected requisite service period.
8
Stock Options - On March 26, 2007, the Company issued 150,000 options to purchase the Company’s shares at $10.89 per share to a third party consultant that vest over a 3 years, subject to certain vesting acceleration provisions. During the six months ended June 30, 2007, the Company recognized approximately $93,000 of compensation expense associated with these options. The Company records stock based payment expense related to these options at the then current fair value of at each reporting date as the services are performed in accordance with EITF 96-18.
During 2007, the Company has issued 157,500 options to purchase the Company’s shares at exercise prices ranging from $11.10 to $12.50 per share to employees and directors that vest between 1 to 2 years. During the six months ended June 30, 2007, the Company recognized approximately $107,000 of compensation expense associated with these options. The Company values stock options utilizing the Black Scholes option pricing model. The Company records stock based payment expense related to these options based on the grant date fair value in accordance with FASB 123R.
In June 2007, the Company's Board of Directors approved the addition of 500,000 shares of Company Stock authorized to be issued under the Company's 2004 Employee's Stock Option Plan. The approval and any grants covered under these shares are subject to shareholder approval.
Stock Warrants -During the six months ended June 30, 2007, the Company received approximately $55,000 in proceeds from the exercise of warrants to purchase 12,125 shares of our common stock.
On June 13, 2007, the Company entered into an agreement with International Barcode Technologies, also known as BTI, to extend the expiration date of warrants to purchase 500,000 shares of common stock of the Company at a purchase price of $10.00 per share that the Company previously issued to BTI with an original expiration date of June 16, 2007 to December 31, 2007 in exchange for which BTI has agreed to provide the Company with a license to market and produce BTI’s advanced barcode technologies in the United States for five years. The value of the extension of the warrant was determined to be approximately $521,000 using the Black-Scholes option pricing model. This amount was recorded as an other intangible asset and will be amortized over the expected useful life of the license agreement of five years.
Stock-Based Compensation - Stock-based compensation includes expense charges for all stock-based awards to employees, directors and consultants. Such awards include option grants, warrant grants, and restricted stock awards. During the three and six months ended June 30, 2007, the Company recognized approximately $297,000 and $633,000, respectively ($253,000 and $280,000- 2006, respectively) in stock-based compensation.
As of June 30, 2007, there was approximately $8.9 million of total unrecognized compensation costs related to non-vested options and restricted stock granted under the Company’s stock option plans, the cost of which will be recognized if earned over a period not to exceed 5 years. The total fair value of options and restricted shares that vested during the six-month period ended June 30, 2007 was $318,000 ($59,000 - 2006).
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5. Discontinued Operations
In June 2007, the Company’s Board of Directors approved a plan to sell various assets relating to its retail copying and quickprinting operations, a component of its Document Security and Production segment. On July 19, 2007, the Company entered into an agreement to sell certain assets and the operations of the division. The sale includes fixed assets with a net book value of approximately $38,000. The Company expects to finalize the sale during the third quarter of 2007 and expects that the gain from the sale to not be significant. In accordance with SFAS 144, the disposal of assets constitute a component of the entity and have been accounted for as discontinued operation and accordingly, the assets have been segregated from continuing operations in the accompanying balance sheet and classified as assets held for sale. The operating results relating to these assets held for sale are segregated and reported as discontinued operations in the accompanying 2007 and 2006 consolidated statement of operations. The results of operations directly attributed to the division’s operations that have been reclassified from continuing operations are as follows:
Three Months Ended | Six Months Ended | ||||||||||||
June 30, | June 30, | June 30, | June 30, | ||||||||||
2007 | 2006 | 2007 | 2006 | ||||||||||
Revenues | $ | 98,786 | $ | 134,124 | $ | 219,491 | $ | 298,079 | |||||
Cost of sales | 54,229 | 79,304 | 101,804 | 195,478 | |||||||||
Operating expenses | 71,378 | 74,445 | 133,113 | 172,956 | |||||||||
Loss from discontinued operations | $ | (26,821 | ) | $ | (19,625 | ) | $ | (15,426 | ) | $ | (70,355 | ) |
6. Earnings Per Share
Basic earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted earnings per share is computed by including the number of additional shares that would have been outstanding if dilutive potential shares had been issued. In periods of losses, diluted loss per share is computed on the same basis as basic loss per share as the inclusion of any other potential shares outstanding would be anti-dilutive. If the Company had generated earnings during the six-month period ended June 30, 2007, 693,671 (904,496- 2006) common equivalent shares would have been added to the weighted average shares outstanding to compute the diluted weighted average shares outstanding.
7. Income Taxes
We adopted the Financial Accounting Standard Board’s Interpretation No. 48, Accounting for Income Tax Uncertainties (“FIN 48”), on January 1, 2007. FIN 48 clarifies the accounting for uncertain income tax positions recognized in financial statements and requires the impact of a tax position to be recognized in the financial statements if that position is more likely than not of being sustained by the taxing authority. As of January 1, 2007, there were no unrecognized tax positions. Our policy is to recognize interest and penalties on unrecognized tax positions in provision for income taxes in the consolidated statements of operations. As of June 30, 2007, the Company has no accrued interest or penalties related to uncertain tax positions. Tax years beginning in 2003 are subject to examination by taxing authorities, although net operating loss and credit carryforwards from all years are subject to examinations and adjustments for at least three years following the year in which the attributes are used.
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8. Commitments and Contingencies
Operating Lease
On May 19, 2007, the Company entered in to a seven-year operating lease for an approximately 25,000 square foot production facility in Brisbane, California. Pursuant to the terms of the lease, the Company will be responsible for future minimum lease commitments as follows:
2007 | $ 109,058 | |
2008 | $ 241,217 | |
2009 | $ 248,454 | |
2010 | $ 255,907 | |
2011 | $ 263,585 | |
2012 | $ 271,492 | |
Thereafter | $ 433,535 | |
$ 1,823,248 |
Legal Matters
Pursuant to an agreement made in December 2004, the Company is required to share the economic benefit derived from settlements, licenses or subsequent business arrangements that the Company obtains from any infringer of patents formerly owned by the Wicker Family. For infringement matters involving certain U.S. patents, the Company will be required to disburse 30% of the settlement proceeds. For infringement matters involving certain foreign patents, including the lawsuit against the European Central Bank described in Part II Item 1 - Legal Proceedings, the Company will be required to disburse 14% of the settlement proceeds. These payments do not apply to licenses or royalties to patents that the Company has developed or obtained from persons other than the Wicker Family. As of June 30, 2007, there have been no settlement amounts related to these agreements.
The Company is engaged in a patent dispute with the European Central Bank (see Part II Item 1- Legal Proceedings). The patent dispute includes patent validity suits that the Company is engaged in nine European national courts. To date, the Company has been able to significantly mitigate the cash outlays required for legal costs associated with the dispute by negotiating legal fee caps and using shares of its common stock for payments. However, the Company will be required to pay additional legal costs and related fees, each of which may be significant, in each of the nine validity suits. In addition, each party to the lawsuit will typically be responsible for reimbursements to the other party for a portion of the winning party’s legal fees related to individual rulings each of the various cases. To date, the Company has received a favorable ruling regarding validity in the German Court and an unfavorable ruling regarding validity in the English Court. In the English Court, the Company was ordered to pay 180,000 pounds (USD $365,000) to the ECB for legal cost reimbursement, of which 90,000 pounds (USD $182,000) was paid on April 4, 2007 and the remaining 90,000 pounds (USD 182,000) is included in accrued expenses at June 30, 2007. The Company is awaiting a determination by the German Court on the amount that it will receive from the ECB for reimbursement of the Company’s legal costs. As the validity cases and the infringement case ensue, the Company will be required to utilize outside counsel in each foreign court and could continue to receive adverse rulings which will require the Company to reimburse the ECB legal costs which would likely be significant, with current estimates of the potential remaining litigation costs relating to patent validity, not including costs covered by fees caps negotiated with its lead counsel, of between $1,000,000 to $2,000,000. The payment of these amounts and the payment of additional legal fees could adversely affect the Company’s financial position and would likely require the Company to raise additional funds, which may not be on terms favorable to the Company.
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In May 2005, the Company made an agreement with its legal counsel in charge of the Company’s patent infringement litigation in the Court of First Instance with the European Central Bank which capped its fees for all matters associated with that infringement litigation at $540,000 plus expenses, and a $150,000 contingent payment upon a successful ruling or settlement on the Company’s behalf in that litigation. The Company will record the $150,000 in the period in which the Company has determined that a successful ruling or settlement is probable.
In addition to the foregoing, we are subject to other legal proceedings that have arisen in the ordinary course of business and have not been finally adjudicated. Although there can be no assurance in this regard, in the opinion of management, none of the legal proceedings to which we are a party, whether discussed herein or otherwise, will have a material adverse effect on our results of operations, cash flows or our financial condition.
9. Supplemental Cash Flow Information
During the six months ended June 30, 2007, the Company issued 60,866 shares of Common Stock valued at approximately $746,000 in conjunction with the payment of legal expenses which were capitalized as other intangible assets. In addition, the Company extended the term of previously issued warrants to a warrant holder in exchange for a license valued at approximately $521,000. During the six months ended June 30, 2006, the Company issued 18,704 shares of Common Stock valued at $250,000 in conjunction with the acquisition of Plastic Printing Professionals.
10. Segment Information
The Company's businesses are organized, managed and internally reported as four operating segments. Three of these operating segments, Document Security Systems, Plastic Printing Professionals and Patrick Printing, respectively, are engaged in various aspects of developing and applying printing technologies and procedures to produce, or allow others to produce, documents with a wide range of features, including the Company’s patented technologies and trade secrets. For the purposes of providing segment information, these three operating segments have been aggregated into one reportable segment in accordance with Financial Accounting Standards Board (“FASB”) Statement No. 131- “Disclosures about Segments of an Enterprise and Related Information”. A summary of the two segments is as follows:
Document Security and Production | License, manufacture and sale of document security technologies, including digital security print solutions and secure printed products at Document Security Systems and Plastic Printing Professionals divisions. In July 2007, the Company entered into an agreement to sell the assets of its retail printing and copying division, a former component of the Document Security and Production segment, to an unrelated third party as this operation was not critical to the Company’s core operations. The results of this division are reported as discontinued operations and are not a component of these segment results (See Note 5). |
Legal Supplies | Sale of specialty legal supplies, primarily to lawyers and law firms located throughout the United States as Legalstore.com. |
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Approximate information concerning the operations by reportable segment for the three and six months ended June 30, 2007 and 2006 is as follows. The Company relies on intersegment cooperation and management does not represent that these segments, if operated independently, would report the results contained herein:
Document | |||||||||||||
Security & | |||||||||||||
3 months ended June 30, 2007: | Legal Supplies | Production | Corporate | Total | |||||||||
Revenues from external customers | $ | 162,000 | $ | 1,133,000 | $ | - | $ | 1,295,000 | |||||
Depreciation and amortization | 3,000 | 459,000 | 17,000 | 479,000 | |||||||||
Segment profit or (loss) from continuing operations | 3,000 | (945,000 | ) | (732,000 | ) | (1,674,000 | ) | ||||||
3 months ended June 30, 2006: | |||||||||||||
Revenues from external customers | $ | 145,000 | $ | 1,031,000 | $ | - | $ | 1,176,000 | |||||
Depreciation and amortization | 1,000 | 302,000 | 28,000 | 331,000 | |||||||||
Segment profit or (loss) from continuing operations | (18,000 | ) | (625,000 | ) | (544,000 | ) | (1,187,000 | ) |
Document | |||||||||||||
Security & | |||||||||||||
6 months ended June 30, 2007: | Legal Supplies | Production | Corporate | Total | |||||||||
Revenues from external customers | $ | 337,000 | $ | 2,586,000 | $ | - | $ | 2,923,000 | |||||
Depreciation and amortization | 6,000 | 835,000 | 29,000 | 870,000 | |||||||||
Segment profit or (loss) from continuing operations | 2,000 | (1,419,000 | ) | (1,478,000 | ) | (2,895,000 | ) | ||||||
6 months ended June 30, 2006: | |||||||||||||
Revenues from external customers | $ | 315,000 | $ | 1,559,000 | $ | - | $ | 1,874,000 | |||||
Depreciation and amortization | 2,000 | 549,000 | 56,000 | 607,000 | |||||||||
Segment profit or (loss) from continuing operations | (30,000 | ) | (1,074,000 | ) | (1,027,000 | ) | (2,131,000 | ) | |||||
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FORWARD-LOOKING STATEMENTS
Certain statements contained herein constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “1995 Reform Act”). Document Security Systems, Inc. desires to avail itself of certain “safe harbor” provisions of the 1995 Reform Act and is therefore including this special note to enable us to do so. Except for the historical information contained herein, this report contains forward-looking statements (identified by the words "estimate," "project," "anticipate," "plan," "expect," "intend," "believe," "hope," "strategy" and similar expressions), which are based on our current expectations and speak only as of the date made. These forward-looking statements are subject to various risks, uncertainties and factors, including, without limitation, those contained in our Form 10-K for the year ended December 31, 2006 and those described herein that could cause actual results to differ materially from the results anticipated in the forward-looking statements.
Overview
Document Security Systems, Inc. (referred to in this report as “Document Security,” “we,” “us,” “our” or “Company”) markets and sells products designed to protect valuable information from unauthorized scanning, copying, and digital imaging. We develop sophisticated security technologies that are applied during the normal printing process and by all printing methods including traditional offset, gravure, flexo, digital or via the internet on paper, plastic, or packaging. We believe we are a leader of customized document protection solutions for companies and governments worldwide. We hold seven patents that protect our technology and have over a dozen patents in process or pending. Our technologies and products are used by federal, state and local governments, law enforcement agencies and are also applied to a broad variety of industries as well, including financial institutions, high technology and consumer goods, entertainment and gaming, healthcare/pharmaceutical, defense and genuine parts industries. Our customers use our technologies where there is a need for enhanced security for protecting and verification of critical financial instruments and vital records, or where there are concerns of counterfeiting, fraud, identity theft, brand protection and liability.
Our core business is counterfeit prevention, brand protection and validation of authentic print media, including government-issued documents, currency, private corporate records, securities and more. We believe we are a world leader in the research and development of optical deterrent technologies and have commercialized these technologies with a broad suite of products that offer our customers a wide array of document security solutions that satisfy their specific anti-counterfeiting requirements. We provide document security technology to security printers, corporations and governments worldwide. Our technology can be used in securing sensitive and critical documents such as currency, automobile titles, spare parts forms for the aerospace industry, gift certificates, permits, checks, licenses, receipts, prescription and medical forms, engineering schematics, ID cards, labels, original music, coupons, homeland security manuals, consumer product and pharmaceutical packaging, tickets, and school transcripts. In addition, we have developed an On-DemandTM product to implement our technologies in Internet-based environments utilizing standard desktop printers. We believe that our On-Demand technology greatly expands the reach and potential market for our technologies and solutions.
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Technologies
We have developed or acquired over 30 technologies that provide to our customers a wide spectrum of solutions. Our primary anti-counterfeiting products and technologies are marketed under the following trade names:
· | AuthentiGuard™ On-Demand |
· | AuthentiGuard™Laser Moiré |
· | AuthentiGuard™ Prism |
· | AuthentiGuard™ Pantograph 4000 |
· | AuthentiGuard™ Survivor 21 |
· | AuthentiGuard™ Obscurascan |
· | AuthentiGuard™ Block-Out |
· | AuthentiGuard™ MicroPerf |
· | AuthentiGuard™ Phantom |
· | AuthentiGuard™VeriGlow. |
The Company also seeks to expand its capabilities and product offerings, from time to time, that are complementary to the Company's document security technologies. The Company promotes the concept that layers of security provide the strongest level of security for any given document, including documents containing RFID and biometric technologies.
In June 2007, the Company entered into an agreement with International Barcode Corporation, (BTI) to license the right to market and produce BTI's advanced RSS bar-code technologies in the United States. In late 2006, GSI adopted RSS bar codes as the standard for all scanning systems by 2010. DSS believes that the adoption of RSS technology will be a part of a major upgrade cycle in document technologies by companies around the world, and that the incorporation of RSS technologies into its product suite will enable the Company to be a benefactor of this market trend.
Our ability to compete effectively depends in part to our ability to maintain the proprietary nature of our technology, products and manufacturing processes. We principally rely upon patent, trademark, trade secrets and contract law to establish and protect our proprietary rights. By aggressively defending our intellectual property rights, we believe that we may be able to secure a potentially significant amount of additional and ongoing revenue by securing licensing agreements with those persons, companies or governments that we believe are infringing our Patents.
Products and Services
Document Security Solutions and Production: Our technology portfolio allows us to create unique custom secure paper, plastic, packaging and Internet-based solutions. We target end-users that require anti-counterfeiting and authentication features in a wide range of printed materials like documents, vital records, driver’s licenses, birth certificates, receipts, manuals, identification materials, entertainment tickets, coupons, parts tracking forms, as well as product packaging including pharmaceutical and a wide range of consumer goods.
Additionally, our custom security solutions include our On-Demand technology that provides custom hosted or server-based digital solutions for our customers. Depending on our customer’s specific requirements, we host a secure server that accepts user inputs and delivers custom, variable secure documents for output at the user location, or offer a bundled server solution that allows for the production of custom, variable secure documents within the user’s network environment.
Security Paper: Our primary product for the retail end-user market is AuthentiGuard Security Paper. AuthentiGuard Security Paper uses our Pantograph 4000 technology. It is a paper that reveals hidden warning words, logos or images using The Authenticator- our proprietary viewing lens - or when the paper is faxed, copied, scanned or re-imaged in any form. The hidden words appear on the duplicate or the computer digital file and essentially prevents important documents from being counterfeited. We market and sell our Security Paper primarily through two major paper distributors: Boise Cascade and PaperlinX Limited.
Technology Licensing: We license our anti-counterfeiting technology and trade secrets through licensing arrangements with security printers. We seek licensees that have a broad customer base that can benefit from our technologies or have unique and strategic capabilities that expand the capabilities that we can offer our potential customers. Revenue from Licensing can take several forms. Licenses can be for a single technology or for a package of technologies. Licensee's can choose from a variety of payment models, such as:
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· | Pay one price per year - Licensee will estimate their annual usage and a single payment is paid and reviewed each year based on actual results. |
· | Pay a percentage of sales of the technology - Licensees only pay as they sell product containing the technology. If, for example, they sell $1 million in our security technology printing, they would pay us from 2.5% to 10% of the sales price of their jobs. |
· | Pay on a per piece method - Licensees pay royalties based on a price per piece. A pre-determined price schedule is implemented based on job volumes and a per-piece price is utilized. Typically, the higher the volume, the lower the price per piece. |
· | Joint venture licensing- profit sharing arrangement with clients where DSS shares the net profit of all products sold containing DSS Technologies. |
Legal Products: We also own and operate Legalstore.com, an Internet company which sells legal supplies and documents, including security paper and products for the users of legal documents and supplies in the legal, medical and educational fields. While not a component of our core business strategy, we continuously seek to maximize the revenue and profitability of this operation.
Results of Operations for the Three and Six Months Ended June 30, 2007
The following discussion and analysis provides information that our management believes is relevant to an assessment and understanding of our results of operations and financial condition. The discussion should be read in conjunction with the financial statements and footnotes in this quarterly report and in our annual report on Form 10-K for the year ended December 31, 2006. All amounts have been adjusted to reflect the Company’s results after affect of discontinued operations. During the second quarter of 2007, the Board of Directors approved a plan to sell and the Company entered into a preliminary agreement to sell its copying and quick-printing business to a private investor. In accordance with FASB 144, the Company accounts for the revenue and expenses of this operation, which is a component of its security printing segment, as a discontinued operation.
The following discussion also includes a non-GAAP financial measure which has been reconciled to the most comparable GAAP financial measure of net loss. Our management believes that this performance measure is a relevant indicator of the Company’s financial performance.
Summary
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Three Months Ended June 30, 2007 | Six Months Ended June 30, 2007 | ||||||||||||
$ | % change vs. 3 months ended June 30, 2006 | $ | % change vs. 6 months ended June 30, 2006 | ||||||||||
Revenue, net | 1,295,000 | 10 | % | 2,923,000 | 56 | % | |||||||
Costs of revenue | 642,000 | 0 | % | 1,286,000 | 20 | % | |||||||
Gross profit | 653,000 | 22 | % | 1,637,000 | 103 | % | |||||||
Total Operating Expenses | 2,353,000 | 35 | % | 4,591,000 | 55 | % | |||||||
Operating loss | (1,700,000 | ) | 42 | % | (2,954,000 | ) | 37 | % | |||||
Other income (expense): | |||||||||||||
Interest income | 34,000 | 100 | % | 75,000 | 70 | % | |||||||
Gain (loss) from Foreign Currency Transactions | (1,000 | ) | (4,000 | ) | |||||||||
Interest expense | (1,000 | ) | (80 | %) | (2,000 | ) | (82 | %) | |||||
Loss before income taxes | (1,668,000 | ) | 40 | % | (2,885,000 | ) | 35 | % | |||||
Income taxes | 5,000 | - | 10,000 | - | |||||||||
Loss from discontinued operations | 27,000 | 37 | % | 15,000 | (79 | %) | |||||||
Net loss | (1,700,000 | ) | 41 | % | (2,910,000 | ) | 32 | % |
Revenue
Three Months Ended June 30, 2007 | Six Months Ended June 30, 2007 | ||||||||||||
$ | % change vs. 3 months ended June 30, 2006 | $ | % change vs. 6 months ended June 30, 2006 | ||||||||||
Revenue | |||||||||||||
Security printing | $ | 827,000 | (15 | %) | $ | 1,818,000 | 24 | % | |||||
Royalties | 294,000 | 390 | % | 593,000 | 511 | % | |||||||
Digital solutions | 12,000 | 175,000 | |||||||||||
Legal products | 162,000 | 12 | % | 337,000 | 7 | % | |||||||
Total Revenue | 1,295,000 | 10 | % | 2,923,000 | 56 | % |
For the three-month period ended June 30, 2007, revenue from continuing operations increased 10% from the same period ended June 30, 2006. The increase in revenue resulted primarily from increases in royalty revenue from the licensing of the Company’s patented technology. Sales of security printing, after factoring in discontinued operations, declined 15% from the prior year’s quarter due to the timing of large orders. In the three months ended June 30, 2006, the Company completed its initial shipments to Paperlinx of its SecureLinx line of safety paper. During the 2007 quarter, the Company did not have any corresponding large orders that were shipped, including any shipments of driver’s license order which the Company anticipates making shipments during the third and fourth quarter of 2007. In addition, the Company did not have any implementations of its new line of digital security solutions during the June 30, 2007 quarter. The Company continues to anticipate that digital solution sales will be a significant component of it revenue during the remainder of 2007.
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For the six-month period ended June 30, 2007, revenue from continuing operations increased 56% from the same period ended June 30, 2006. The increase in revenue was primarily due to increases in royalty revenue from the licensing of the Company’s patented technology, a digital solution sale for a custom On-Demand solution in the first quarter of 2007 and an increase in sales of security products and documents, including initial shipments on a foreign driver license project. In addition, the security printing revenue increase reflects the effect of the Company’s acquisition in February 2006 of Plastic Printing Professionals. The Company expects that revenues will continue to increase at a similar pace, especially during the fourth quarter of 2007 as the Company begins the national roll-out of its "On-Demand" Product Suite, with its partner, The Ergonomic Group. The product roll-out is supported by the newly developed website, www.authenticate-360.com which provides interactive information on the impact of couterfeiting and how "On-Demand" products help mitigate these risks.
Legal Products
Revenue from our legal supplies business, Legalstore.com, grew 12% during the second quarter of 2007 compared with the second quarter of 2006, and 7% through the first six months of 2007 compared to 2006. While we view our legal supplies business segment as a non-core part of our company, we continue to seek growth opportunities for the business. The Company is currently redesigning the Legalstore.com’s website and e-commerce platform along with expanding its product offerings.
Cost of Sales and Gross Profit
Three Months Ended June 30, 2007 | Six Months Ended June 30, 2007 | ||||||||||||
$ | % change vs. 3 months ended June 30, 2006 | $ | % change vs. 6 months ended June 30, 2006 | ||||||||||
Costs of revenue | |||||||||||||
Security printing & products | $ | 548,000 | (3 | %) | $ | 1,055,000 | 19 | % | |||||
Digital solutions | 3,000 | 37,000 | |||||||||||
Legal products | 91,000 | 18 | % | 194,000 | 8 | % | |||||||
Total cost of sales | 642,000 | 0 | % | 1,286,000 | 20 | % | |||||||
Gross profit | |||||||||||||
Security printing & products | 279,000 | (32 | %) | 763,000 | 33 | % | |||||||
Royalties | 294,000 | 390 | % | 593,000 | 511 | % | |||||||
Digital solutions | 9,000 | 138,000 | |||||||||||
Legal products | 71,000 | 4 | % | 143,000 | 6 | % | |||||||
Total gross profit | 653,000 | 22 | % | 1,637,000 | 103 | % |
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Three Months Ended June 30, 2007 | Six Months Ended June 30, 2007 | ||||||||||||
% | % change vs. 3 months ended June 30, 2006 | % | % change vs. 6 months ended June 30, 2006 | ||||||||||
Gross profit percentage: | |||||||||||||
Security printing & products | 34 | % | (20 | %) | 42 | % | 7 | % | |||||
Royalties | 100 | % | 0 | % | 100 | % | 0 | % | |||||
Digital solutions | 75 | % | 79 | % | |||||||||
Legal supplies | 44 | % | (7 | %) | 42 | % | (1 | %) | |||||
Gross profit percentage: | 50 | % | 11 | % | 56 | % | 30 | % |
Gross Profit
During the second quarter of 2007, gross profit from continuing operations increased 22% to $653,000 as compared to the second quarter of 2006. Increases in profits from license royalty agreements were partially offset by a 20% decline in gross profit from the security print operations, which were negatively impacted by the lack of delivery of any large orders during the quarter as discussed above.
During the first six months of 2007, gross profit from continuing operations increased 103% to $1,637,000. Along with increases as the result of license agreements and a digital solution implementation, the Company realized significant growth in security printing gross profits during the first quarter of 2007 primarily due to the impact of a large secure driver’s license project which was delivered during the first quarter of 2007. As a result, the Company’s gross profit margin has increased 30% during the first six months of 2007 as compared to the first six months of 2006.
Operating Expenses
Three Months Ended June 30, 2007 | Six Months Ended June 30, 2007 | ||||||||||||
$ | % change vs. 3 months ended June 30, 2006 | $ | % change vs. 6 months ended June 30, 2006 | ||||||||||
Selling, general and administrative | |||||||||||||
General and administrative compensation | $ | 534,000 | 37 | % | $ | 947,000 | 45 | % | |||||
Stock based payments | 297,000 | 17 | % | 633,000 | 126 | % | |||||||
Professional Fees | 364,000 | (4 | %) | 684,000 | (7 | %) | |||||||
Sales and marketing | 391,000 | 74 | % | 910,000 | 135 | % | |||||||
Depreciation and amortization | 20,000 | (29 | %) | 40,000 | (30 | %) | |||||||
Other | 205,000 | 109 | % | 395,000 | 98 | % | |||||||
Research and development | 109,000 | 14 | % | 203,000 | 20 | % | |||||||
Amortization of intangibles | 433,000 | 62 | % | 779,000 | 60 | % | |||||||
Total Operating Expenses | 2,353,000 | 36 | % | 4,591,000 | 55 | % |
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Selling, General and Administrative
The Company’s selling, general and administrative costs increases generally reflect increases to the size of our organization as the result of the Company’s acquisition of P3 and increases in executive management, sales and operations personnel integral to the company’s sales growth strategy.
General and administrative compensation costs from continuing operations increased during the second quarter of 2007 reflect the impact of personnel additions at the Company during the second half of 2006, and the hiring of an in-house counsel that had formerly worked for the Company in a retainer arrangement. In addition, the Company incurred annual payrate increases on average of approximately 6% for existing employees as compared to 2006 rates. General and administrative compensation cost from continuing operations increased during the first six months of 2007 for these same reasons as well as due to the impact of the acquisition of P3 in February 2006.
Stock-based payments during the three months ended June 30, 2007 were flat as compared to the three months ended June 30, 2006, however, the makeup of the expense between the two periods was different. The 2007 period reflects expenses due to options and restricted stock grants to several recently added employees, including an addition to the Company’s senior management team. In addition, the Company issued options to a third-party financial advisor in March of 2007. The Company believes that the grant of equity instruments is an important component of its overall compensation program that is needed to attract and retain its human resources as well as obtain the services of various third parties without consuming its cash resources. Stock-based compensation during the three months ended June 30, 2006, include approximately $223,000 of expense recognized for the issuance of warrants to International Barcode Corporation (d/b/a Barcode Technology) (“BTI”) in June 2006 in consideration for a cross-marketing relationship that enables the Company to expedite its entry into the Chinese market for secure documents. These warrants were fully vested as of March 31, 2007 and were set to expire in June of 2007. On June 13, 2007, the Company entered into an agreement with BTI to extend the expiration date of the warrants to December 31, 2007 in exchange for which BTI has agreed to provide the Company with a license agreement to market and produce BTI’s advanced barcode technologies in the United States for five years The value of the extension of the warrant was determined to be approximately $521,000. This amount was recorded as an other intangible asset and will be amortized over the expected useful life of the license agreement of five years.
In addition, on May 3, 2007, the Company granted a total of 445,000 restricted shares to certain members of senior management. These shares only vest upon the occurrence of certain events over the next 5 years, which include a change of control or other merger or acquisition of the Company, the achievement of certain financial goals, including among other things a successful result of the Company’s patent infringement suit against the European Central Bank. These shares, if vested, would result in the recording of stock based compensation expense of approximately $5,563,000 over the period beginning when any of the contingent vesting events is deemed to be probable over the expected requisite service period.
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Three Months Ended June 30, 2007 | Six Months Ended June 30, 2007 | ||||||||||||
$ | % change vs. 3 months ended June 30, 2006 | $ | % change vs. 6 months ended June 30, 2006 | ||||||||||
Professional Fees Detail | |||||||||||||
Accounting and auditing | $ | 52,000 | 0 | % | $ | 165,000 | 42 | % | |||||
Consulting | 106,000 | (5 | %) | 197,000 | 40 | % | |||||||
Legal Fees | 80,000 | (24 | %) | 135,000 | (37 | %) | |||||||
Stock Transfer, SEC and Investor Relations | 126,000 | 85 | % | 187,000 | (6 | %) | |||||||
$ | 364,000 | 9 | % | $ | 684,000 | 2 | % |
Professional fees include legal, accounting, shareholder services, investor relations, and consulting costs. During the first six months of 2007, accounting and auditing fee increases generally reflect an increase in costs as a result of the growth in the Company as compared to the same period of 2006, along with additional costs associated with the Company’s Sarbanes Oxley compliance requirements which is effective in 2007. Consulting fees increased during the first six months of 2007 as compared to 2006 due to addition of an intellectual property consultant, a new agreement with a German consulting firm, and the use of various financial consultants. Legal fees decreased due to the hiring of an in-house counsel that had formerly worked for the Company in a retainer arrangement and due to a general decrease in activity in the Company’s non-ECB related litigation. These legal costs do not include approximately $1,485,000,of legal and related costs incurred during the first half of 2007 associated with the application and defense of our patents which the company capitalizes and amortizes over the expected life of the patent. (See Part I -Financial Information -Note 8) As compared to 2006, second quarter SEC and investor relations costs increased due to the timing of certain printing and mailing costs associated with the Company’s annual shareholders meeting. However, year-to-date stock transfer, SEC and Investor Relations costs have decreased slightly during 2007 as compared to 2006 primarily as a result of a reduction in certain investor relations consulting costs.
Sales and marketing expenses, including sales and marketing personnel costs, increased in the second quarter and through the first six months of 2007 as a result of significant expansion in the resources that the Company is investing to grow the size of its sales and marketing team and increase the reach of its products through expansion of its marketing efforts. During the second quarter of 2007, the Company’s costs included several international business development efforts, including meetings in Germany, the United Kingdom, Mexico, Indonesia and the Dominican Republic. In addition, the Company invested its marketing efforts towards the roll-out of the Company’s On-Demand product offerings in conjunction with its partner, The Ergonomic Group.
Other expenses from continuing operations are primarily rent and utilities, office supplies, IT support, bad debt expense and insurance costs. Increases in 2007 reflect costs associated with a larger organization.
Research and Development
We invest in research and development to improve our existing technologies and develop new technologies that will enhance our position in the document security market. Research and development costs consist primarily of compensation costs for our four persons who spend all or at least half of their time on developing new technologies or developing new uses for our existing technology. In addition, we incur costs for the use of third party printers’ facilities to test our technologies on equipment that we do not have access to internally. We seek patent protection for many of our inventions, and we currently have over a dozen formal patents applications pending, including provisional and PCT patent applications and applications that have entered the National Phase in various countries, including the United States, Canada, Europe, Japan, Brazil, Mexico, Indonesia and South Africa. We expect that our research and development costs will continue at current levels for the foreseeable future.
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Amortization of intangibles
We amortize the costs associated with the patents that we acquired in 2005 and the legal costs associated with the development and defense of our patents, including the costs associated with our suit against the European Central Bank for patent infringement. In addition, we amortize our acquired intangibles from business combinations. A significant portion of these assets were acquired by the issuance of equity in the company. Our amortizable patent asset base at June 30, 2007 was approximately $5.8 million and will generate approximately $1.5 million in annual amortization expense during the next 4 years. The Company reviews these assets for impairment annually. If an impairment, such as unfavorable ruling in the Company’s patent infringement lawsuits or an assessment of non-commerciability of certain of its patents, then the Company would write-off a portion of these assets, which could be a significant expense in the period incurred.
In addition, the Company has approximately $1.0 million of other intangible assets as of June 30, 2007 that consist of various royalty rights and marketing and distribution rights as well as acquired intangibles including customer lists and trade names. These assets will generate approximately $200,000 of annual amortization expense during the next 5 years.
In addition, the Company has $1,397,000 in goodwill derived from acquisitions. Goodwill is not amortized, but could become a component of expense if an impairment is determined.
Discontinued operations
Revenue from the company’s retail printing and copying division decreased 26% for the three months and six months ended June 30, 2007 as compared to the 2006 periods. Revenue for the division represented approximately 7% of the Company’s consolidated revenue for the three months and six months ended June 30, 2007 as compared to 16% and 13% of consolidated revenue for the three months and six months ended June 30, 2006, respectively. The decline is sales was contributed to the Company’s shift of resources from its retail printing operations to its security research and operations since the middle of 2006. Operating losses from the division were less than 3% of consolidated operating losses for the Company during the three and six months ended 2007 and 2006, respectively.
Net loss and loss per share
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Three Months Ended June 30, 2007 | Six Months Ended June 30, 2007 | ||||||||||||
$ | % change vs. 3 months ended June 30, 2006 | $ | % change vs. 6 months ended June 30, 2006 | ||||||||||
Net loss | (1,700,000 | ) | 41 | % | (2,910,000 | ) | 32 | % | |||||
Net loss per share, basic and diluted | (0.12 | ) | 33 | % | (0.21 | ) | 24 | % | |||||
Weighted average common shares outstanding, basic and diluted | 13,625,408 | 6 | % | 13,605,327 | 6 | % |
During the second quarter and first half of 2007, the Company experienced a net loss of $1.7 million and $2.9 million, respectively. While we experienced growth in our sales and gross profits during these periods, these increases did not offset significant increases in our operating expenses, especially significant increases in amortization expense, stock based compensation, compensation and sales and marketing expenses.
During the second quarter and first half of 2007, our basic and diluted loss per share increased due to the increased dollar value of our loss partially offset by an increase in the weighted average common shares outstanding during each of these periods as compared to 2006. Our outstanding shares have increased as we have issued our common shares for warrants exercised and for the purchase of patent assets.
Non-GAAP Financial Performance Measure
The following adjusted Earnings before interest, taxes, depreciation, amortization and non-cash stock compensation expense (“Adjusted EBITDA”) is presented because the Company’s management believes it to be a relevant measure of the performance of the Company. The Adjusted EBITDA is used by the Company’s management to measure its core operating performance without certain non-cash expenditures. The reconciliation of Adjusted EBITDA to net loss, the most comparable GAAP measure is presented below.
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Adjusted EBITDA
Three Months Ended June 30, 2007 | Six Months Ended June 30, 2007 | ||||||||||||
$ | % change vs. 3 months ended June 30, 2006 | $ | % change vs. 6 months ended June 30, 2006 | ||||||||||
Net Loss | $ | (1,700,000 | ) | 41 | % | $ | (2,910,000 | ) | 32 | % | |||
Add back: | |||||||||||||
Depreciation | 47,000 | (25 | %) | 91,000 | (24 | %) | |||||||
Amortization of Intangibles | 433,000 | 62 | % | 779,000 | 60 | % | |||||||
Stock based payments | 297,000 | 17 | % | 633,000 | 126 | % | |||||||
Interest Income | (34,000 | ) | 100 | % | (75,000 | ) | 70 | % | |||||
Interest Expense | 1,000 | (80 | %) | 2,000 | (82 | %) | |||||||
Income Taxes | 5,000 | 9,000 | |||||||||||
Adjusted EBITDA | (951,000 | ) | 50 | % | (1,471,000 | ) | 9 | % |
As described above, Adjusted EBITDA is a non-GAAP measurement of financial performance that the Company believes is relevant to the understanding of the Company’s financial results. During the three months ended June 30, 2007, the Company experienced an increase in its Adjusted EBITDA loss as increases in its revenue and gross profit did not offset greater increases in its core operating expenses (core operating expenses are general and administrative compensation, professional fees, sales and marketing, other and research and development costs). The Company’s core operating expenses from continuing operations increased 33% and 58% during the second quarter and first six months of 2007, respectively, as compared to the 2006 periods, primarily due to increases in sales and marketing expenses. The Company expects that it will continue to incur Adjusted EBITDA losses unless is can increase its revenue levels. It is the Company’s belief that the amounts it is incurring during the current periods for sales and marketing are critical investments required to increase the required break-even revenue levels. However, there the Company cannot be certain that it will be able to successfully obtain these break-even levels which would require the Company to significantly reduce its costs structure.
LIQUIDITY AND CAPITAL RESOURCES
The Company’s cash flows and other key indicators of liquidity are summarized as follows:
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Six Months Ended | ||||||||||
June 30 | June 30 | |||||||||
2007 | 2006 | % | ||||||||
(unaudited) | (unaudited) | Change | ||||||||
Cash flows (used) provided by: | ||||||||||
Operating activities | $ | (1,637,000 | ) | $ | (1,517,000 | ) | (8 | %) | ||
Investing activities | (732,000 | ) | (1,449,000 | ) | 49 | % | ||||
Financing activities | (183,000 | ) | 716,000 | (126 | %) | |||||
Working capital | 1,836,000 | 1,069,000 | 72 | % | ||||||
Current ratio | 1.65 | x | 1.57 | x | 5 | % |
As of June 30, 2007, we had cash and cash equivalents of $3.3 million, a 43% decrease from December 31, 2006. As discussed below, the decrease in the Company’s cash position is primarily due to the payment of fees related to a private placement of equity which the Company closed on December 26, 2006 and January 22, 2007, the payment of legal fees associated with its patent applications and defense costs, as well as cash used for operations. As discussed below, the Company believes that its cash balance as of June 30, 2007 will satisfy its projected working capital and capital expenditure requirements, including the costs related to its patent defense litigations, for at least the next 12 months.
Operating Cash Flow - Over time, operating cash flows are expected to mirror Adjusted EBITDA results. During the first six months of 2007, the Company used approximately $1.6 million of cash for operations, which is slightly greater than the Adjusted EBITDA loss of $1.4 million during the same period. This variance is primarily due to the payment of prepaid rent of approximately $200,000 for the Company’s new facility it has leased for its plastic printing division. For the foreseeable future, the Company will continue to use cash for operations at a similar pace, only to be offset by increases in revenue. As of June 30, 2007, the Company believes that it will need to reach an annual revenue level of approximately $7.5 million in order to maintain positive operating cash flow.
Investing Cash Flow -During the first half of 2007, the Company used approximately $732,000 of cash for fixed asset additions and to invest in its patent portfolio, including the payment of legal costs associated with patent applications and the defense of our patents, which includes payments to cover third party experts fees and other fees associated with the Company’s litigation against the ECB. The Company was able to use its equity to pay for approximately $746,000 of patent related costs as a result of its agreement with its lead counsel in its ECB litigation.
Financing Cash Flows -During the first quarter of 2007, the Company received approximately $340,000 from the private placement of stock and the exercise of warrants which was offset by the payment of approximately $520,000 in fees associated with the private placements concluded in the fourth quarter of 2006 and the first quarter of 2007. As of June 30, 2007, the Company has approximately 929,000 warrants outstanding and exercisable at exercise prices below the closing market price of our Common stock as of June 30, 2007 of $13.79 that, if exercised, would produce approximately $9.4 million in cash proceeds to the Company.
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Cash flows from discontinued operations -During the six months ended June 30, 2007, operating cash flows from the company’s retail printing and copying division were essentially $0. In addition, during this period, the division did not have any investing or financing cash flow activities. Cash flows from discontinued operations are included in the consolidated statements of cash flows for the six months ended June 30, 2007 and 2006.
We mitigate our foreign currency risks principally by contracting primarily in U.S. dollars. To date, all of our billings were denominated in the U.S. dollar. However, certain of our legal fees are payable in foreign currencies, for which a gain or loss is recognized on foreign currency transactions is recognized when payments are made. To date and for the foreseeable future, gains and losses on such transactions have been minimal.
The Company maintains disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) that are designed to assure that information required to be disclosed in its Exchange Act reports 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 management, including the Chief Executive Officer and Acting Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.
In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide reasonable assurance only of achieving the desired control objectives, and management necessarily is required to apply its judgment in weighting the costs and benefits of possible new or different controls and procedures. Limitations are inherent in all control systems, so no evaluation of controls can provide absolute assurance that all control issues and any fraud within the company have been detected.
As required by Exchange Act Rule 13a-15(b), as of the end of the period covered by this report, management, under the supervision and with the participation of its Chief Executive Officer and the Acting Chief Financial Officer, evaluated the effectiveness of the Company's disclosure controls and procedures. Based on this evaluation, management concluded that the Company's disclosure controls and procedures were effective as of that date.
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OTHER INFORMATION
Information concerning pending legal proceedings is incorporated herein by reference to Note 8 to the Condensed Consolidated Financial Statements (Unaudited) in Part I of this Form 10-Q.
On August 1, 2005, we commenced a suit against the European Central Bank (the “ECB”) alleging patent infringement by the ECB and have claimed unspecified damages. We brought the suit in European Court of First Instance in Luxembourg. We alleged that all Euro banknotes in circulation infringe our European Patent 455750B1 (the “Patent”), which covers a method of incorporating an anti-counterfeiting feature into banknotes or similar security documents to protect against forgeries by digital scanning and copying devices. We will seek all remedies available to us under the law. In November 2005, the European Central Bank filed its answer to our complaint asserting procedural and jurisdictional arguments. The ECB contended that the proper venue was not in the Court of First Instance, but rather in each individual country that is a member of the ECB. We responded to the European Central Bank’s answer in late December 2005, arguing that the Court of First instance was the proper venue. The parties are awaiting the ruling from the Court of First Instance on jurisdiction.
On March 24, 2006, we received notice that the ECB has filed a separate claim in the United Kingdom and Luxembourg patent courts (Luxembourg being the seat of the European Court of First Instance) seeking the invalidation of the Patent. Claims to invalidity in each of the Netherlands, Belgium, Italy, France, Spain, Germany and Austria were subsequently served on the Company. The proceedings in Luxembourg have been withdrawn by the ECB due to procedural irregularities; the ECB have the option to recommence those proceedings, but have not yet done so.
On March 26, 2007, the High Court of Justice, Chancery Division, Patents Court in London, England (the “English Court”) ruled that the Patent that was awarded to us by the European Patent Office Technical Board of Appeal has been deemed invalid in the United Kingdom on the grounds of added subject matter. The ECB’s attacks that the Patent was not new and was not inventive were dismissed. The English Court’s decision does not affect the validity of the Patent in other European countries. On March 30, 2007, the Company was given permission by the English Court to appeal to the Court of Appeal the ruling and an appeal was filed on 30 April 2007. As a result of the ruling and according to English Court rules, the Company was also required to pay a portion of the ECB’s legal costs associated with the case. On April 2, 2007, the English Court ordered that the Company should pay 30% of the ECB’s reasonable legal costs, of which the Company paid 90,000 pounds (USD $182,000) on April 4, 2007. The remaining amounts (estimated to be a further 90,000 pounds) will be calculated in a separate procedure likely to take place after the appeal. However, the outcome of the appeal will also either uphold (if the ECB are successful) or reverse (if the Company is successful) the award of costs at first instance.
On March 27, 2007, the German Federal Patent Court (Bundespatentgericht) in Munich (the “German Court”) ruled, having seen the judgment of the English Court, that the Patent was valid in Germany. This ruling validates the Patent in Germany and confirms the legal basis of the Company’s infringement suit against the ECB. In addition, as a result of this ruling, the Company expects to be awarded reimbursements for a proportion of its costs associated with the German validity case, estimated at €35,000.
On June 4, 2007, a trial was held in the French High Court in Paris, regarding validity of the Patent. A decision in the French trial is expected in approximately the middle of September of 2007. Additional trials regarding validity are expected to take place in the six other countries from late 2007 into 2008.
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On January 31, 2003, we commenced an action, unrelated to the above ECB litigation, entitled New Sky Communications, Inc., As Successor-In-Interest To Thomas M. Wicker, Thomas M.Wicker Enterprises, Inc. and Document Security Consultants V. Adler Technologies, Inc. N/K/A Adlertech International, Inc. and Andrew McTaggert (United States District Court, Western District Of New York Case No.03-Cv-6044t(F)) regarding certain intellectual property in which we have an interest. We commenced this action alleging various causes of action against Adler Technologies, Inc. and Andrew McTaggert for breach of contract, breach of the duty of good faith and fair dealing, various business torts, including unfair competition and declaratory relief. Adler distributes and supplies anti-counterfeit document products and Mr. McTaggert is a principal of Adler. Adler had entered into several purported agreements with Thomas M. Wicker Enterprises and Document Security Consultants, both of which we acquired in 2002. These alleged agreements, generally, would have authorized Adler to manufacture in Canada our “Checkmate®” patented system for verifying the authenticity of currency and documents. Other purported agreements were signed between these parties and Thomas Wicker regarding other technology claimed to have been owned by Wicker and assigned to us. Among other things, we contend that certain of the purported agreements are not binding and/or enforceable. To the extent any of them are binding and enforceable, we claim that Adler has breached these purported agreements, failed to make an appropriate accounting and payments under them , and may have exceeded the scope of its license. Adler has denied the material allegations of the complaint and has counterclaimed against our company, claiming Adler owns or co-owns or has a license to use certain technologies of ours. In May 2005, we filed our first amended and supplemental complaint adding Blanks/USA and Raymond Maxon as additional defendants. In February 2007, we filed our second amended and supplemental complaint adding Judith Wu (McTaggart’s wife) and Arcis Digital Security, Inc. (a company in which Ms. Wu is involved) as additional defendants. Maxon has asserted a counterclaim against us contending that our purported acquisition of a certain patent from Thomas Wicker in 2002 gave rise to an alleged right on the part of Maxon to receive a portion of Thomas Wicker’s proceeds from such acquisition. We have denied the material allegations of all of the counterclaims. If Adler is successful, it may materially affect us, our financial condition, and our ability to market and sell certain of our technology and related products. This case is in discovery phase, and it is too soon to determine how the various issues raised by the lawsuit will be determined.
In addition to the foregoing, we are subject to other legal proceedings that have arisen in the ordinary course of business and have not been finally adjudicated. Although there can be no assurance in this regard, in the opinion of management, none of the legal proceedings to which we are a party, whether discussed herein or otherwise, will have a material adverse effect on our results of operations, cash flows or our financial condition.
ITEM 1a - RISK FACTORS
There have been no material changes from the risk factors disclosed in Part I, Item 1A, of the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 and Part II, Item 1A of the Company’s Quarterly Report in Form 10-Q for the quarter ended March 31, 2007.
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None
None
None
ITEM 5 - OTHER INFORMATION
None
ITEM 6 - EXHIBITS
The Exhibits listed below designated by an * are incorporated by reference to the filings by Document Security Systems, Inc. under the Securities Act of 1933 or the Securities and Exchange Act of 1934, as indicated. All other exhibits are filed herewith.
(a) | Exhibits | |
Item 3.1 Articles of Organization, as amended (incorporated by reference to exhibit 3.1 to the Company's Registration Statements No. 2-98684-NY on Form S-18).* Item 3.2 By-laws, as amended (incorporation by reference to exhibit 3.2 to the Company's Registration Statement No. 2-98684-NY on Form S-18).* Item 10.30 License and Distribution Agreement, dated November 8, 2006, between Document Security Systems, Inc and PT Sekur Grafika Item 10.31 Limited Exclusive Patent License Agreement, dated December 29, 2006, between Document Security Systems, Inc and Ergonomic Group, Inc. Item 10.32 License and Distribution Agreement, dated June 27, 2007, between Document Security Systems, Inc. and Cultura Interactiva S.A. de C.V. Item 10.33 Warrant No B-1, dated June 16, 2006, issued to International Barcode Corporation Item 10.34 Amendment to Warrant B-1, dated June 13, 2007, between Document Security Systems, Inc. and International Barcode Corporation Item 10.35 Letter Agreement, dated June 11, 2007, between Document Security Systems, Inc. and International Barcode Corporation Item 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes Oxley Act Item 31.2 Certifications of Acting Chief Financial Officer Pursuant to Section 302 of the Sarbanes Oxley Act Item 32.1 Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes Oxley Act Item 32.2 Certification of Acting Chief Financial Officer Pursuant to Section 906 of the Sarbanes Oxley Act |
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SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused this report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized.
DOCUMENT SECURITY SYSTEMS, INC. | ||
| | |
Date: August 14, 2007 | By: | /s/ Patrick White |
Patrick White Chief Executive Officer |
Date: August 14, 2007 | By: | /s/ Philip Jones |
Philip Jones Acting Chief Financial Officer (Vice President of Finance) |
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