ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
Management's Discussion and Analysis of Financial Condition and Results of Operations discusses the Company's consolidated financial statements for the periods indicated, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to revenue recognition, bad debts, product warranties, inventories, long lived assets, goodwill and other intangible assets, income taxes and contingencies and litigation. Management bases its estimates and judgments on historical experience and on various other factors including general market conditions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. Results for the periods reported herein are not necessarily indicative of results that may be expected in future periods.
Overview
The Company designs, assembles and markets video management systems and system components for use in security, surveillance, safety and communication applications by a broad group of end users worldwide. The Company’s product line consists of various elements of a video system, including DVR's, NVR's, video encoders, decoders, servers and related video management software, data storage units, analog, digital and HD megapixel fixed and robotic cameras, virtual and analog matrix video switchers and controls, and system peripherals.
The Company sells video surveillance system components in a highly competitive worldwide marketplace principally to authorized security distributors, dealers and system integrators. Such dealers and integrators typically resell and install the Company’s products directly to end users, among other services. The Company’s sales are principally project based and are largely dependent upon winning projects, construction activities and the timing of funding. Sales will vary from period to period depending upon many factors including seasonal and geographic trends in construction activities and the timing of deliveries due to changes in project schedules and funding. The Company usually does not have a large backlog as its customer orders are typically deliverable within three months or often upon receipt of order.
The Company competes in a market of rapid technology shifts which enhance the performance capability of security systems. As a result, the Company spends a significant amount on new product development. In fiscal 2015 and 2014, the Company incurred $5.1 million and $4.6 million of engineering and development expense or 11% and 13% of net sales, respectively. The Company’s expenditures for product development are substantially less than its major competitors. The ongoing market shift to IP based products and network technologies will continue to burden the Company’s development resources and increase ongoing annual expense for product development. Further, the Company’s sales effort requires a high level of customer service and technical support for its products. The Company routinely considers various strategic options that may augment or supplement its present product offerings and technology platforms.
The Company has a foreign sales and distribution subsidiary in Europe that conducts business in British pounds and Euros that represented approximately 20% of the Company’s consolidated sales for fiscal 2015. It also has an Israel based engineering and development subsidiary that incurs a majority of its operating expenses in Shekels that represented approximately 16% of the Company’s operating expenses for fiscal 2015. The Company has historically entered into selected forward currency exchange contracts during favorable exchange rate conditions to help stabilize the impact of changing exchange rates and will consider doing so in the future, financing permitted. However, such hedging activities cannot entirely eliminate the long term effects of foreign currency exchange movements.
The Company continues to incur operating losses due to decreased revenue levels and ongoing strategic investments. Refer to the Liquidity and Capital Resources section for further discussion.
Results of Operations
Three Months Ended
March 31, 2016
Compared with
March 31, 2015
Net sales for the quarter ended March 31, 2016 decreased by $2.3 million (22%) to $8.0 million compared with $10.3 million in the year ago period. Sales in the Americas decreased $1.3 million (17%) to $6.2 million compared with $7.5 million in the year ago period, while Europe, Middle East and Africa (EMEA) sales decreased $1.0 million (36%) to $1.8 million compared with
$2.8 million in the year ago period. The Americas market was negatively impacted by certain camera line production issues and the EMEA market experienced a delay in receipt of certain expected orders that were fulfilled in the subsequent quarter. Order intake for the quarter ended March 31, 2016 decreased by $4.3 million (37%) to $7.3 million compared with $11.6 million in the year ago period. Americas order intake decreased by $3.6 million (38%) to $5.8 million compared with $9.4 million in the year ago period while EMEA order intake decreased 30% to $1.6 million compared with $2.2 million in the year ago period. The backlog of unfilled orders was $2.6 million at March 31, 2016 compared with $2.4 million at September 30, 2015.
Gross profit margins for the quarter ended March 31, 2016 decreased to 33.0% compared with 38.0% in the year ago period. Principal factors contributing to the decrease were the recognition of $150,000 (1.9%) of additional inventory provisions relating to the rework and transition of the Company's IQinVision camera line to a new contact manufacturing partner and the impact of predominantly fixed indirect production costs on lower sales (1.6%).
Operating expenses for the second quarter of fiscal 2016 increased $5.5 million to $11.1 million compared with $5.5 million for the year ago period. In the current quarter, the Company charged off its entire $6.0 million goodwill carrying value originating from the August 2014 IQinVision business combination. This noncash charge was principally based upon an updated assessment of the Company's continuing depressed market valuation and operating losses. The prior year quarter included $224,000 of severance charges in connection with a merger related integration and restructuring plan. Excluding the effects of the current quarter goodwill writeoff and the prior year quarter severance charges, operating expenses decreased $244,000 in the current quarter. Selling, general and administrative (SG&A) expenses for the current quarter decreased $358,000 to $3.7 million compared with $4.1 million in the year ago period. This decrease included $319,000 of restructuring plan cost reductions by the Company's EMEA subsidiary. Engineering and development expenses increased $114,000 to $1.3 million for the current quarter compared with $1.2 million for the year ago period. The Company continued to fund the development and test of its next generation video management system solution that is scheduled to first launch in October 2016.
The Company incurred an operating loss of $8.4 million for the second quarter of fiscal 2016 compared with an operating loss of $1.6 million in the year ago period.
The Company recorded a gain on the sale of its United Kingdom based operating facility of $785,000 in the second quarter of fiscal 2016.
The Company provides for a valuation allowance against its deferred tax assets due to the uncertainty of future realization and, thus, no tax benefit has been recognized on reported pretax losses for both periods (see Note 9: Income Taxes).
As a result of the foregoing, the Company reported a net loss of $7.7 million for the second quarter of fiscal 2016 compared with a net loss of $1.8 million in the year ago period.
Results of Operations
Six Months Ended
March 31, 2016
Compared with
March 31, 2015
Net sales for the six months ended March 31, 2016 decreased by $1.6 million (8%) to $18.9 million compared with $20.4 million in the year ago period. Sales in the Americas decreased $923,000 (6%) to $14.7 million compared with $15.7 million in the year ago period, while Europe, Middle East and Africa (EMEA) sales decreased $644,000 (13%) to $4.1 million compared with $4.8 million in the year ago period. Order intake for the six months ended March 31, 2016 decreased by $3.2 million (14%) to $19.0 million compared with $22.2 million in the year ago period. Americas order intake decreased by $2.3 million (13%) to $15.2 million compared with $17.5 million in the year ago period while EMEA order intake decreased 19% to $3.9 million compared with $4.8 million in the year ago period.
Gross profit margins for the six months ended March 31, 2016 decreased to 36.6% compared with 37.5% in the year ago period principally due to the recognition of $150,000 (0.8%) of additional inventory provisions relating to the rework and transition of the Company's IQinVision camera line to a new contract manufacturing partner.
Operating expenses for the six months ended March 31, 2016 increased $4.8 million to $16.3 million compared with $11.5 million for the year ago period due principally to the $6.0 million writeoff of goodwill in the current year period. The prior year period included $573,000 of severance charges in connection with a merger related integration and restructuring plan. Excluding the effects of the current year period goodwill writeoff and the prior year period severance charges, operating expense decreased $600,000 in the current year period. Selling, general and administrative (SG&A) expenses for the current year period decreased $726,000 to $7.7 million compared with $8.4 million in the year ago period. This decrease included $495,000 of restructuring plan cost reductions by the Company's EMEA subsidiary. Engineering and development expenses increased $126,000 to $2.7 million for the current year period compared with $2.5 million for the year ago period.
The Company incurred an operating loss of $9.4 million for the first six months of fiscal 2016 compared with an operating loss of $3.8 million in the year ago period.
The Company recorded a gain on the sale of its United Kingdom based operating facility of $785,000 in the first six months of fiscal 2016.
The Company provides for a valuation allowance against its deferred tax assets due to the uncertainty of future realization and, thus, no tax benefit has been recognized on reported pretax losses for both periods (see Note 9: Income Taxes).
As a result of the foregoing, the Company reported a net loss of $8.6 million for the first six months of fiscal 2016 compared with a net loss of $4.0 million in the year ago period.
Liquidity and Capital Resources
Net cash used in operating activities was $1.8 million for the first six months of fiscal 2016, which included a $2.7 million net loss net of non-cash charges, a $2.1 million reduction in trade and accrued liabilities and a $624,000 increase in inventories, offset in part by a $4.4 million decrease in accounts receivable. Net cash provided by investing activities was $1.4 million for the first six months of fiscal 2016 consisting principally of $1.5 million of proceeds from the sale of the Company's United Kingdom operating facility. Net cash provided by financing activities was $5,000 for the first six months of fiscal 2016 representing proceeds from the exercise of stock options. As a result of the foregoing, cash (exclusive of marketable securities) decreased by $219,000 for the first six months of fiscal 2016 after the effect of exchange rate changes on the cash position of the Company.
The Company continues to incur operating losses due to decreased revenue levels and ongoing strategic investments. Since 2012, the Company has made a significant investment in the development of a completely new, and strategically critical, video management system (VMS). The first release of this product offering is scheduled for October 2016 and is ultimately expected to significantly enhance the Company’s market competitiveness. The funding of this major development effort has contributed to the ongoing operating losses and depletion of cash reserves. The Company has also encountered issues with certain of its camera offerings that has negatively impacted its revenues in the recent quarter. Although steps have been taken to correct these issues, their market impact may linger throughout the balance of this fiscal year. In response, a cost restructuring plan has been implemented, which will phase in material operating expense reductions over the remaining two quarters of fiscal 2016. This measure is not anticipated to eliminate near term loss levels as the Company must continue funding of its upcoming new VMS product launch.
At March 31, 2016, the Company had $2.2 million of cash reserves and a $3 million unused asset based credit facility, which is subject to a borrowing formula and matures in June 2017. Cash losses over the past several years have been financed in part by the sale of the Company’s two principal operating facilities and ongoing management of working capital levels. The Company presently plans to draw on its credit facility to finance its near term working capital needs. Based upon these plans, the Company presently believes that it will have sufficient cash to meet its anticipated operating cost and capital expenditure requirements for at least the next twelve months. However, the Company may need additional capital in the future to finance its strategic growth plans.
Off-Balance Sheet Arrangements
The Company does not have any off-balance sheet transactions, arrangements or obligations (including contingent obligations) that have, or are reasonably likely to have, a material effect on the Company’s financial condition, results of operations, liquidity, capital expenditures or capital resources.
Critical Accounting Policies
The Company's significant accounting policies are fully described in Note 1 to the Company's consolidated financial statements included in its
September 30, 2015
Annual Report on Form 10-K. Management believes the following critical accounting policies, among others, affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.
Revenue is generally recognized when products are sold and title is passed to the customer. Advance service billings are deferred and recognized as revenues on a pro rata basis over the term of the service agreement. Pursuant to Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 605-25-05, the Company evaluates multiple-element revenue arrangements for separate units of accounting, and follows appropriate revenue recognition policies for each separate unit. Elements are considered separate units of accounting provided that (i) the delivered item has stand-alone value to the customer, (ii) there is objective and reliable evidence of the fair value of the undelivered item, and (iii) if a general right of return exists
relative to the delivered item, delivery or performance of the undelivered item is considered probable and substantially within the control of the Company. As applied to the Company, under arrangements involving the sale of product and the provision of services, product sales are recognized as revenue when the products are sold and title is passed to the customer, and service revenue is recognized as services are performed.
For products that include software and for separate licenses of the Company’s software products, the Company recognizes revenue in accordance with the provisions of FASB Accounting Standards Update (ASU) 2009-13, “Revenue Recognition (Topic 605) - Multiple-Deliverable Revenue Arrangements” (ASU 2009-13). ASU 2009-13 provides revenue recognition guidance for establishing separate units of accounting in a multiple element arrangement and requires the allocation of arrangement consideration to each deliverable in the arrangement based on the fair value of the elements. The fair value for each deliverable is based on vendor-specific objective evidence ("VSOE") if available, third-party evidence ("TPE") if VSOE is not available, or best estimate of selling price ("BESP") if neither VSOE nor TPE is available. BESP must be determined in a manner that is consistent with that used to determine the price to sell the specific elements on a standalone basis.
The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of its customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
The Company provides for the estimated cost of product warranties at the time revenue is recognized. While the Company engages in product quality programs and processes, including monitoring and evaluating the quality of its component suppliers, its warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. Should actual product failure rates, material usage or service delivery costs differ from its estimates, revisions to the estimated warranty liability may be required.
The Company writes down its inventory for estimated obsolescence and slow moving inventory equal to the difference between the carrying cost of inventory and the estimated net realizable market value based upon assumptions about future demand and market conditions. Technology changes and market conditions may render some of the Company’s products obsolete and additional inventory write-downs may be required. If actual future demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required.
The Company evaluates the establishment of technological feasibility of its software in accordance with ASC 985 ("Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed"). The Company has determined that technological feasibility for its new products is reached shortly before products are released for field testing. Costs incurred after technological feasibility has been established have not been material and are expensed as incurred.
The Company assesses the recoverability of the carrying value of its long-lived and intangible assets whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. The Company evaluates the recoverability of such assets based upon the expectations of undiscounted cash flows from such assets. If the sum of the expected future undiscounted cash flows were less than the carrying amount of the asset, a loss would be recognized for the difference between the fair value and the carrying amount.
The Company’s goodwill represents the excess of the purchase price over the fair value of net identifiable assets acquired in the recent business combination. Goodwill is not amortized and is tested for impairment at least annually. When evaluating goodwill for impairment, the Company may first perform an assessment of qualitative factors to determine if the fair value of the reporting unit is more-likely-than-not greater than its carrying amount. If, based on the review of the qualitative factors, the Company determines it is not more-likely-than-not that the fair value of a reporting unit is less than its carrying value, the required two-step impairment test can be bypassed. If the Company does not perform a qualitative assessment or if the fair value of the reporting unit is not more-likely-than-not greater than its carrying value, the Company must perform the first step of the two-step impairment test, and calculate the estimated fair value of the reporting unit. If the carrying value of the reporting unit exceeds the estimated fair value, there is an indication that impairment may exist and the second step must be performed to measure the amount of impairment loss. The amount of impairment for goodwill is measured as the excess of its carrying amount over its fair value. The Company conducted an impairment test at March 31, 2016 using the income approach and determined that its goodwill carrying value was fully impaired. As a result, the Company recorded an impairment charge of $6.0 million in the quarter ended March 31, 2016. This noncash charge was principally based upon an updated assessment of the Company's continuing depressed market valuation and operating losses.
The Company's ability to recover the reported amounts of deferred income tax assets is dependent upon its ability to generate sufficient taxable income during the periods over which net temporary tax differences become deductible. The Company provides for a valuation allowance against all deferred tax assets due to the uncertainty of future realization. The Company plans to provide
a full valuation allowance against its deferred tax assets until such time that it can achieve a sustained level of profitability or other positive evidence arises that would demonstrate an ability to recover such assets.
The Company accrues liabilities for identified tax contingencies that result from positions that are being challenged or could be challenged by tax authorities. The Company believes that its accrual for tax liabilities is adequate for all open years, based on Management’s assessment of many factors, including its interpretations of the tax law and judgments about potential actions by tax authorities. However, it is possible that the ultimate resolution of any tax audit may be materially greater or lower than the amount accrued.
Accounting for restructuring activities, as compared to regular operating cost management activities, requires an evaluation of formally committed and approved plans. Restructuring activities have comparatively greater strategic significance and materiality and may involve exit activities, whereas regular cost containment activities are more tactical in nature and are rarely characterized by formal and integrated action plans or exiting a particular product, facility or service.
The Company is subject to proceedings, lawsuits and other claims related to labor, product and other matters. The Company assesses the likelihood of an adverse judgment or outcomes for these matters, as well as the range of potential losses. A determination of the reserves required, if any, is made after careful analysis. The required reserves may change in the future due to new developments.
Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995
Statements in this Report on Form 10-Q that are not strictly historical facts including, without limitation, statements included under the “Management’s Discussion and Analysis” caption, are “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, that should be considered as subject to the many risks and uncertainties that exist in the Company's operations and business environment. The forward-looking statements are based on current expectations and involve a number of known and unknown risks and uncertainties that could cause the actual results, performance and/or achievements of the Company to differ materially from any future results, performance or achievements, express or implied, by the forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, and that in light of the significant uncertainties inherent in forward-looking statements, the inclusion of such statements should not be regarded as a representation by the Company or any other person that the objectives or plans of the Company will be achieved. The Company assumes no obligation to publicly update or revise its forward-looking statements or to advise of changes in the assumptions and factors on which they are based.