December 15, 2011
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Edgar Online, Inc.
The following discussion and analysis should be read in conjunction with our audited Consolidated Financial Statements and the notes thereto and other financial information appearing in Item 8 of this Annual Report on Form 10-K.
This discussion and analysis compares our consolidated results of operations for the Fiscal year ended September 30, 2011 ("Fiscal 2011"), with those for the Fiscal year ended September 30, 2010 ("Fiscal 2010"), and is based on or derived from the audited Consolidated Financial Statements included in Item 8 in this Annual Report. All figures in the following discussion are presented on a consolidated basis. All dollar amounts and percentages presented herein have been rounded to approximate values.
Cautionary statement for purposes of the "Safe Harbor" provisions of the Private Securities Litigation Reform Act of 1995
The following management's discussion and analysis includes "forward-looking statements", as such term is used within the meaning of the Private Securities Litigation Reform Act of 1995. These "forward-looking statements" are not based on historical fact and involve assessments of certain risks, developments, and uncertainties in our business looking to the future. Such forward looking statements can be identified by the use of forward-looking terminology such as "may", "will", "should", "expect", "anticipate", "estimate", "intend", "continue", or "believe", or the negatives or other variations of these terms or comparable terminology. Forward-looking statements may include projections, forecasts, or estimates of future performance and developments. Forward-looking statements contained in this Annual Report are based upon assumptions and assessments that we believe to be reasonable as of the date of this Annual Report. Whether those assumptions and assessments will be realized will be determined by future factors, developments, and events, which are difficult to predict and may be beyond our control. Actual results, factors, developments, and events may differ materially from those we assumed and assessed. Risks, uncertainties, contingencies, and developments, including those discussed in this Management's Discussion and Analysis of Financial Condition and Results of Operations and those identified in "Risk Factors" in Item 1A of this Annual Report on Form 10-K, could cause our future operating results to differ materially from those set forth in any forward looking statement. There can be no assurance that any such forward looking statement, projection, forecast or estimate contained can be realized or that actual returns, results, or business prospects will not differ materially from those set forth in any forward looking statement.
Given these uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. The Company disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein to reflect future results, events or developments.
Business Overview
Trends and Economic Environment
In executing the channel-building and product development elements of our strategy, during Fiscal 2011 we have incurred, and we intend to continue to incur, significantly increased selling, general, and administrative expenses as we devote resources to recruit, hire and compensate experienced sales, design, operations, and administrative professionals, and to develop and/or acquire new product offerings. Insofar as most of our new personnel were hired in the second half of Fiscal 2011, with further investment in personnel planned for the first quarter of Fiscal 2012, the fourth quarter of Fiscal 2011, and succeeding reporting periods will begin to reflect more fully our investments in resources, while the anticipated benefits of such hires in the form of increased sales and profit will take significantly longer to be realized, if at all. At the same time, we are investing resources in bringing new products to market, particularly in terms of funding product development activities with prospective partners. We anticipate that the measure of success of our strategy as reflected in our results of operations will be determined by the strength of new distribution channels, by the speed in which we can bring new products to market, and by the success and acceptance of these products in the marketplace.
With regard to our OEM business, we have recently been awarded several large programs by two major diabetic customers. We anticipate that these programs will begin to contribute meaningfully to revenues beginning in late Fiscal 2012. While these new programs will increase our sales volume, we anticipate that gross margins on certain of these new or prospective programs will be lower than the gross margins seen in the first part of Fiscal 2011. Our business remains highly concentrated by customer and product type, especially in the diabetic case product line. However, as we indicated in previous reports, we intended to build on the 10% growth in revenue that was contributed by "other products" in Fiscal 2010, and in Fiscal 2011 we have exceeded such targets. Accordingly, even as diabetic product sales continue to increase, we believe that we are making progress in diversifying the customer base.
We continue to operate in a very challenging pricing and gross margin environment with our OEM customers. The global economy continues to face headwinds, and our OEM customers remain very price sensitive. As reflected in the "gross profit" discussions below, we are encountering higher costs from our China-based suppliers due to materials and labor price increases, placing continuing pressure on profit margins. As the expected launch of new and replacement diabetic programs increasingly replace mature programs, we anticipate that the impact of materials and labor cost increases from our China-based suppliers will become more evident in this product line and gross profit generally. Product mix factors may exacerbate this trend. In many cases, we are not able to pass higher costs through to customers, particularly
when replacement program products resemble their predecessor or historically similar products for which customers have become accustomed to a narrow price range. See "Risk Factors" in Item 1.A of this Annual Report. We are actively looking at alternative sources of supply, as well as other geographic regions to expand and diversify our manufacturing capabilities in order to mitigate this trend.
Variability of Revenues and Results of Operation
Because a high percentage of our sales revenues is highly concentrated in a few large customers, and because the volumes of these customers' order flows to us are highly variable, with short lead times, our quarterly revenues, and consequently our results of operations, are susceptible to significant variability over a relatively short period of time.
Critical Accounting Policies and Estimates
We have identified the accounting policies and significant estimation processes below as critical to our business operations and the understanding of our results of operations. The discussion below is not intended to be comprehensive.
In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for management's judgment of a particular transaction. In other cases, management is required to exercise judgment in the application of accounting principles with respect to particular transactions. The impact and any associated risks related to these policies on our business operations are discussed throughout this "Management's Discussion and Analysis of Financial Condition and Results of Operations" where such policies affect reported and expected financial results. For a detailed discussion of the applications of these and other accounting policies, refer to Item 8. "Financial Statements and Supplementary Data" in this Annual Report. Our preparation of our consolidated financial statements requires us to make estimates and assumptions that are believed to be reasonable under the circumstances. There can be no assurance that actual results will not differ from those estimates and such differences could be significant.
Cash and Cash Equivalents
Cash and cash equivalents consist primarily of cash on deposit and highly liquid money market accounts. The Company minimizes its credit risk associated with cash and cash equivalents by investing in high quality instruments and by periodically evaluating the credit quality of the primary financial institution issuers of such instruments. The Company holds cash and cash equivalents at major financial institutions in the United States, the amounts of which may significantly exceed FDIC insured limits, and in Europe. At September 30, 2011, this amount was approximately $10.5 million. Historically, the Company has not experienced any losses due to such cash concentrations.
Accounts Receivable
Accounts receivable consist of unsecured trade accounts with customers or their contract manufacturers. The Company performs periodic credit evaluations of its customers including an evaluation of days outstanding, payment history, recent payment trends, and perceived credit worthiness, and believes that adequate allowances for any uncollectible receivables are maintained. Credit terms to the majority of customers are generally net thirty (30) days to net sixty (60) days; however, the Company typically extends to its largest customers payment terms up to 90 days. The Company has not historically experienced significant credit or collection problems with its OEM customers or their contract manufacturers.
None of these customers or their contract manufacturers is or has been in default to the Company, and payments are generally received from them on a timely basis. Three customers, including their affiliates and contract manufacturers, accounted for approximately 71% and 75% of the Company's accounts receivable at September 30, 2011 and 2010, respectively. At September 30, 2011 and 2010, the allowance for doubtful accounts was approximately $14,000 and $19,000, respectively.
Inventory Valuation
Inventories consist primarily of finished goods and are stated at the lower of cost (determined by the first-in, first-out method) or market. Based on management's estimates, an allowance is made to reduce excess, obsolete, or otherwise un-saleable inventories to net realizable value. The allowance is established through charges to cost of goods sold on the Company's consolidated statements of operations. As reserved inventory is disposed of, the Company charges off the associated allowance. In determining the adequacy of the allowance, management's estimates are based upon several factors, including analyses of inventory levels, historical loss trends, sales history, and projections of future sales demand. The Company's estimates of the allowance may change from time to time based on management's assessments, and such changes could be material. At September 30, 2011, the Company did not record an allowance for obsolete inventory. At September 30, 2010, the allowances for obsolete inventory was approximately $28,000.
Property and Equipment
Property and equipment consist of furniture, fixtures, and equipment and leasehold improvements and are recorded at cost. Expenditures for major additions and improvements are capitalized and minor replacements, maintenance, and repairs are charged to expense as incurred. When property and equipment are retired or otherwise disposed of, the cost and accumulated depreciation are removed from the accounts and any resulting gain or loss is included in the results of operations for the respective period. Depreciation is provided over the estimated useful lives of the related assets using the straight-line method for financial statement purposes. The estimated useful life for furniture, fixtures and equipment ranges from three to ten years. Amortization of leasehold improvements is computed using the straight-line method over the shorter of the remaining lease term or the estimated useful lives of the improvements. The Company recorded approximately $74,000 and $54,000 of depreciation and amortization expense in Fiscal 2011 and 2010, respectively. Depreciation and amortization for production related property and equipment is included as acomponent of costs of goods sold in the accompanying consolidated statements of operations. Depreciation and amortization for selling and general and administrative related property and equipment, is included as a component of operating expenses in the accompanying consolidated statements of operations.
Revenue Recognition
We generally recognize revenue from product sales to customers when: (1) title and risk of loss are transferred (in general, these conditions occur at either point of shipment or point of destination, depending on the terms of sale); (2) persuasive evidence of an arrangement exists; (3) we have no continuing obligations to the customer; and (4) collection of the related accounts receivable is reasonably assured.
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Shipping and Handling Costs
We classify shipping and handling costs (including inbound and outbound freight charges, purchasing and receiving costs, inspection costs, warehousing costs, internal transfer costs, and other costs associated with our Hong Kong distribution facility and network) as a component of cost of goods sold in the accompanying consolidated statements of operations. This classification may not be comparable to similar companies within our industry.
Income Taxes
We account for its income taxes in accordance with accounting principles generally accepted in the United States of America, which requires, among other things, recognition of future tax benefits and liabilities measured at enacted rates attributable to temporary differences between financial statement and income tax bases of assets and liabilities and to net tax operating loss carryforwards to the extent that realization of these benefits is more likely than not. We periodically evaluate the realizability of our net deferred tax assets. See Note 8 to the Notes to Consolidated Financial Statements. Our policy is to account for interest and penalties relating to income taxes, if any, in "income tax expense" in the statement of operations. For the fiscal years presented in the accompanying consolidated statements of operations no income tax related interest or penalties were assessed or recorded.
Share-Based Payment Expense
We recognize share-based equity compensation in our consolidated statements of operations at the grant-date fair value of our stock options and other equity-based compensation. The determination of grant-date fair value is estimated using an option-pricing model, which includes variables such as the expected volatility of our share price, the exercise behavior of our employees, interest rates, and dividend yields. These variables are projected based on our historical data, experience, and other factors. Changes in any of these
variables could result in material increases to the valuation of options granted in future periods and increases in the expense recognized for share-based payments. Refer to Note 7 Share-Based Compensation of this Annual Report.
Results of Operations for Fiscal 2011 compared to Fiscal 2010
Net loss
We incurred a net loss of $2.9 million in Fiscal 2011 compared to net loss of $1.7 million in Fiscal 2010. The increase in net loss is primarily the result of higher sales and marketing expenses, as well as higher general and administrative expenses, which were offset, in part, by an increased gross profit on higher sales and "other income" (primarily interest income) in Fiscal 2011, as reflected in the table below:
(thousands of dollars)Fiscal Fiscal Increase
2011 2010 (Decrease)
Net......................................................................................$22,777 $18,997 3,780
Gross
profit.......................................................................................5,065 4,232 833
Sales and marketing expenses................................................(3,391) (2,167) 1,224
General and administrative expenses......................................(4,688) (3,636) 1,052
Other income 58 10 48
Income taxes 56 (124) 180
Net
loss*...................................................................................($2,900) ($1,686) 1,214
* Table may not total due to rounding.
Basic and diluted loss per share was ($0.36) for Fiscal 2011, compared to($0 .21) for Fiscal 2010. The increase in loss per share in Fiscal 2011 was due to the increase in net loss, which was offset, in small part, by the increase in weighted average shares outstanding in Fiscal 2011.
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Net Sales
Net sales increased $3.8 million, or 20%, to $22.8 million in Fiscal 2011 from $19.0 million in Fiscal 2010 due to higher sales of diabetic products, which increased $2.5 million, or 18%, and higher sales of "Other Products", which increased $1.2 million, or 26%. The tables below set forth net sales by product line and geographic location of our customers for the periods indicated.
(millions of dollars)
APAC Americas Europe Total*
Diabetic Products.................................................. $9.1 $2.6 $5.0 $16.7
Other Products....................................................... 1.4 3.8 1.0 6.1
Totals*................................................................... $10.4 $6.4 $5.9 $22.8
Net Sales for Fiscal 2010
(millions of dollars)
APAC Americas Europe Total*
Diabetic Products................................................... $7.4 $3.0 $3.8 $14.1
Other Products....................................................... 0.9 3.2 0.8 4.9
Totals*................................................................... $8.2 $6.2 $4.6 $19.0
* Tables may not total due to rounding.
Diabetic Product Sales
We design to the order of, and sell carrying cases for blood glucose diagnostic kits directly to, OEMs (or their contract manufacturers). The OEM customer or its contract manufacturer packages our carry cases "in box" as a custom accessory for the OEM's blood glucose testing and monitoring kits, or to alesser extent, sell them through their retail distribution channels.
Sales of cases and related accessories for blood glucose monitoring kits increased $2.5 million, or 18%, to $16.7 million in Fiscal 2011 from $14.1 million in Fiscal 2010. This increase was due primarily to higher sales to two of our major diabetic customers, as presented in the table below, which sets forth our sales by diabetic customer for the periods indicated.
(millions of dollars)
Fiscal Fiscal Increase
2011 2010 (Decrease)
Diabetic Customer A........................................................... $8.4 $7.4 $1.0
Diabetic Customer B........................................................... 3.7 3.6 0.1
Diabetic Customer C........................................................... 3.7 2.8 0.9
All other Diabetic Customers.............................................. 0.8 0.3 0.5
Totals*............................................................................... $16.7 $14.1 $2.5
* Table may not total due to rounding.
Sales of carrying cases for blood glucose monitoring kits represented 73% of our total net sales in Fiscal 2011 compared to 74% of our total net sales in Fiscal 2010.
Other Product Sales
We design and sell carrying solutions primarily to OEMs for a diverse array ofother portable electronic and other products, including bar code scanners, GPS and location devices, cellular telephones, laptop computers, MP3 players, firearms, sporting and recreational products, and aeronautical products.
Sales of other products increased $1.2 million, or 26%, to $6.2 million in Fiscal 2011 from $4.9 million in Fiscal 2010. Included in the Fiscal 2011 amount is $0.4 million of sales to Flash Ventures, Inc. (refer to Note 3 - Note Receivable in the Notes to Financial Statements), which we consider as non-recurring usiness. The balance of the increase was primarily driven by higher sales to five existing customers, which totaled $1.5 million in the aggregate and individually accounted for 10% or more of total increase in other products. Smaller increases in several other customer accounts, totaling $0.3 million in the aggregate, also contributed to the higher sales of "Other Products" in Fiscal 2011. These sales increases were offset, in part, by decreases in sales to several customers, most of which were individually immaterial, except to two customers, which each decreased $0.2 million, respectively.
Sales of other products represented 27% of our net sales in Fiscal 2011 compared to 26% of net sales in Fiscal 2010.
Gross Profit
Gross profit increased $0.8 million, or 20%, to $5.1 million in Fiscal 2011 from $4.2 million in Fiscal 2010. The increase resulted primarily from the $3.8 million, or 20%, increase in net sales in Fiscal 2011 and, to a much lesser extent, from decreases from Fiscal 2010, in absolute terms, in tooling, packaging and warehousing costs, as well as the cost of operating our Hong Kong sourcing and quality control functions. In addition, as a percentage of sales, all components of our Cost of Goods Sold, with the exception of our Material Costs, were lower in Fiscal 2011, which improved our gross margin from Fiscal 2010. However, the increase in Material Costs, as a percentage of sales, offset the factors that improved our gross margin in Fiscal 2011. As a result, our gross margin was 22% in both Fiscal 2011 and 2010.
The increase in material costs, which as a percentage of sales, increased 2% in Fiscal 2011 was attributable primarily to our "Other Products line, where we experienced lower average margins due partly to changes in product mix, and partly to increased materials, labor, and other production costs from our Hong Kong based suppliers. These pricing pressures are presently more evident in our Other Products line, where the product life cycles are generally much shorter than those included in our Diabetic Products line. We are also experiencing increased costs of materials with regard to our Diabetic Products line, especially in respect of new and replacement programs for diabetic case products, but the impact of pricing pressures on mature programs sales in this product line remained relatively muted in Fiscal 2011.
Sales and Marketing Expenses
Sales and marketing expenses increased $1.2 million, or 56%, to $3.4 million in Fiscal 2011 from $2.2 million in Fiscal 2010. The significantly higher level of expense reflects our focus on growing sales generally, developing our capability to sell into the retail channel, and developing new products (particularly for retail), and the ramp-up of necessary resources applied to achieve these goals, and is primarily due to the following:
- $0.6 million increase in personnel expense due to: i) the restructuring and growth of our sales force and ii) higher sales commissions accrued in respect of the higher sales levels achieved in the Fiscal 2011;
- $0.3 million increase in travel and entertainment expenses incurred by new sales and sales support personnel added globally during Fiscal 2011 primarily in connection with development of prospective new sales channels;
º $140 thousand increase in product development and design costs; and
º $180 thousand increase in the aggregate in occupancy, telecommunication, and general office expenses.
In connection with the potential retail channel business we have hired 15 employees. To date, these employees have not generated any revenue.
Lesser fluctuations in other components of sales and marketing expenses were immaterial.
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General and administrative expenses increased $1.1 million, or 29%, to $4.7 million in Fiscal 2011 from $3.6 million in Fiscal 2010 due primarily to the following:
º $0.6 million increase in personnel expense resulting from: i) hires of additional information technology, operations, and accounting personnel during the period; ii) retention bonus to an executive; iii) relocation expense and increased salary expenses associated with the relocation of the Company's headquarters to California; iv) recruitment and signing fees attributable to new hires; v) increased payroll taxes and benefits attributable to personnel hires; and vi) associated higher level of share based compensation awards.
º $160 thousand increase in travel and entertainment expenses attributable primarily to relocation-related travel in connection with identification and establishment of new office space in California and related personnel relocation travel, as well as travel by executives associated with strategic and business development activities.
º $250 thousand increase in the aggregate in telecommunications costs (resulting from hosting and connectivity charges associated with the Company's IT infrastructure, as well as cellular telephone charges) and general office costs (primarily computer expenses and office supplies);
º $160 thousand increase in professional fees including: i) legal, taxation, and accounting consulting fees incurred in connection with the proposed Flash Ventures transaction, as well as other strategic and business development activities; ii) consulting fees relating to the Company's internal control environment; and iii) legal fees resulting from the Targus matter
Other Income (Expense)
Other income (expense), consisting primarily of interest income on cash and cash equivalent balances and on short term notes receivable (refer to Note 3 - Notes Receivable in our Notes to Financial Statements), as well as foreign currency transaction gains and losses, improved to $58 thousand of income in Fiscal 2011
from $10 thousand of income in Fiscal 2010. This improvement resulted from a $65 thousand increase in interest income in Fiscal 2011, due primarily to the Flash note receivable, and to a lesser extent, interest bearing short-term investments.
Liquidity and Capital Resources
During Fiscal 2011, we used $1.8 million of cash in operations compared to a use of $1.7 million in Fiscal 2010. Net cash used in operating activities in Fiscal 2011 consisted of net loss of $2.9 million, adjusted by $0.5 million for non-cash items (primarily share based compensation), and offset by net cash provided by working capital items of $0.6 million. As to working capital items, cash provided by operations consisted of an increase in prepaid and other assets (current and long-term) of $0.8 million and a decrease in accrued expenses and other current liabilities of $0.3 million. These changes were offset, in part, by decreases in accounts receivables and inventory of $0.7 million and $20 thousand, respectively, and an increase in accounts payable of $0.5 million. The increase in prepaid and other assets (current and long term) is due primarily to advanced royalties paid to a strategic partner (refer to Note 11 - License Agreement - in Notes to Financial Statements), prepaid rents (for the Company's California headquarters and its JAFZA branch office), prepaid tooling and mold costs in support of firm purchase orders, prepaid telecommunication and IT costs, and insurance premiums. The decrease in accrued expenses and other current liabilities is primarily due to payments made during the Fiscal 2011 in respect of items accrued as of September 30, 2010: (i) $229 thousand in severance payments to a former officer of the Company; (ii) $142 thousand in settlement costs paid to a shareholder (iii) $225 thousand in sales commissions; and (iv) $130 thousand in wages. The decrease in accounts receivable is due to an improvement in our days sales outstanding and timing differences in cash payments received immediately prior to the close of our fiscal year. The increase in accounts payable is due to higher materials purchases made in the fourth quarter of Fiscal 2011 compared to the fourth quarter of Fiscal 2010 and are primarily in support of sales orders received in our OEM channel.
During Fiscal 2010, we used $1.7 million of cash in operations consisting of a net loss of $1.7 million, reduced by $0.4 million for non-cash items, and increased by net changes in working capital items of $0.4 million. As to working capital items, uses of cash in operating activities in respect of increases in accounts receivable, inventories, and prepaid and other current assets were $1.4 million, $0.4 million, and $12 thousand, respectively. These changes were offset, in part, by increases in accounts payable and accrued expenses and other current liabilities of $0.6 million and $0.8 million, respectively, and a decrease in other assets of $14 thousand, which provided cash to operating activities.
In Fiscal 2011, net investing activities used $1.8 million of cash, primarily in short-term loans of $1.5 million made to prospective strategic partners (refer to Note 3 - Notes Receivable - in Notes to Financial Statements), of which $0.5 million was converted to advanced royalties (refer to Note 11 - License Agreement - in Notes to Financial Statements). In addition, net investing activities consisted of purchases of $0.3 million of property and equipment, primarily computer and telecommunications hardware and software. In Fiscal 2010, investing activities used $9 thousand in purchases of property and equipment.
At September 30, 2011, our current ratio (current assets divided by current liabilities) was 6.1; our quick ratio (current assets less inventories divided by current liabilities) was 5.8; and our working capital (current assets less current liabilities) was $18.3 million. As of such date, we had no short or long-term debt outstanding.
Our primary source of liquidity is our cash and cash equivalents on hand. The primary demands on our working capital currently are: i) operating losses, ii) accounts payable arising in the ordinary course of business, the most significant of which arise when our customers place orders with us and we order from our suppliers, and iii) development of strategic partnerships. Historically, our sources of liquidity have been adequate to satisfy working capital requirements arising in the ordinary course of business. Management's recently announced business strategy includes (i) increasing the Company's existing OEM business and (ii) expanding its product offerings and diversifying its distribution by moving into the retail channel. We anticipate that the building out of our product offerings and establishing a retail distribution channel through internal growth and development of strategic partnerships may lengthen the period required to increase net sales revenues expected to be generated by the new channel and products. Results of operations for Fiscal 2011 reflect the increase in operating costs brought to bear to achieve these goals. Accordingly, we anticipate significant uses of cash and capital resources going forward as a result of one or more of the following developments in future periods: (i) continued operating losses due to the investments incurred in conjunction with our implementation of management's strategy (see "Trends and Economic Environment" above), in particular in increased selling and other personnel expenses; (ii) use of capital in financing strategic partnerships in investing activities; and (iii) investments in working capital required to support new products and sales channels. We anticipate that our liquidity and financial resources for the next twelve months will be adequate to meet our operating and financial requirements.
There were no financing activities in Fiscal 2011. In Fiscal 2010, financing activities generated $67 thousand in proceeds from the exercise of stock options.
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