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MATTERSIGHT CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Background Mattersight Corporation (together with its subsidiaries and predecessors, "Mattersight," "we," "us," or the "Company") is a leader in enterprise analytics focused on customer and employee interactions and behaviors. Through its Behavioral Analytics Service and related services (collectively, "Behavioral Analytics"), Mattersight captures and analyzes customer and employee interactions, employee desktop data, and other contextual information to optimally route customers to the best available employee, improve operational performance, and predict future customer and employee outcomes. Mattersight's analytics are based on millions of proprietary algorithms and the application of unique behavioral models. The Company's SaaS delivery model combines analytics in the cloud with deep customer partnerships to drive significant business value. Mattersight's solutions are used by leading companies in the healthcare, insurance, financial services, telecommunications, cable, utilities, education, hospitality, and government industries. Through the performance of Behavioral Analytics, the Company generates two types of revenue: (1) Managed services revenue, which is recurring, annuity revenue from long-term (generally three- to five-year) contracts and pilots, which are shorter-term (generally three to twelve months), and includes subscription and amortized deployment revenue; and (2) Consulting services revenue, which is generally project-based and sold on a time-and-materials or fixed-fee basis and includes follow-on consulting services revenue. Set forth below is a more detailed description of the Company's current Behavioral Analytics offerings. Behavioral Analytics The Company's multi-channel technology captures the unstructured data of voice interactions (conversations), related customer and employee data, and employee desktop activity, and applies millions of proprietary algorithms against those interactions. Each interaction contains hundreds of attributes that get scored and ultimately detect patterns of behavior or business process that provide the transparency and predictability necessary to enhance revenue, improve the customer experience, improve efficiency, and predict and navigate outcomes. Adaptive across industries, programs, and industry-specific processes, the Company's Behavioral Analytics offerings enable its clients to drive measurable economic benefit through the improvement of contact center performance, customer satisfaction and retention, fraud reduction, and streamlined back office operations. Specifically, through its Behavioral Analytics offerings, Mattersight helps its clients: • Identify optimal customer/employee behavioral pairing for call routing; • Identify and understand customer personality; • Automatically measure customer satisfaction and agent performance on every analyzed call; • Improve rapport between agent and customer; • Reduce call handle times while improving customer satisfaction; • Identify opportunities to improve self-service applications; • Improve cross-sell and up-sell success rates; • Improve the efficiency and effectiveness of collection efforts; 15 -------------------------------------------------------------------------------- Table of Contents • Measure and improve supervisor effectiveness and coaching; • Improve agent effectiveness by analyzing key attributes of desktop usage; • Predict likelihood of customer attrition; • Predict customer satisfaction and Net Promoter Scores® without customer surveys; • Predict likelihood of debt repayment; • Predict likelihood of a sale or cross-sell; and • Identify fraud callers and improve authentication processes. The Company has designed a highly-scalable, flexible, and adaptive application platform to enable the Company to implement and operate its Behavioral Analytics offerings for its clients. These offerings are primarily delivered through a SaaS model, as a managed subscription service from which Mattersight derives Managed services revenue and Consulting services revenue. Managed services revenue consists of revenue from deployment and subscription services and Consulting services revenue consists of revenue from post-deployment follow-on services, including coaching, training, and custom data analysis. In addition to our Behavioral Analytics offerings, Mattersight also generates revenue from the following services: (1) Marketing Managed Services, which consist of marketing application hosting services, from which the Company derives Managed services revenue; and (2) CRM Services, which consist of operational consulting services that enhance business performance through improved process efficiencies and redesign of workflows, from which the Company derives Consulting services revenue. Types of Revenue Managed Services Revenue Managed services revenue is primarily driven by the execution of new Behavioral Analytics contracts, under which we deploy and provide our proprietary Behavioral Analytics Service on a subscription basis. Based on each client's business requirements, the client's selection of our Behavioral Analytics offerings are configured and integrated into the client's environment and then deployed in either a remote-hosted or an on-premise hosted environment. Thereafter, the Behavioral Analytics offerings are provided, on a subscription basis, for a period that is generally three to five years after the go-live date or, in the cases where the Company contracts with a client for a short-term pilot of a Behavioral Analytics offering prior to committing to a longer subscription period, if any, the subscription or pilot periods generally range from three to twelve months after the go-live date. The fees and costs related to the initial deployment are deferred and amortized over the subscription period. We also generate Managed services revenue from Marketing Managed Services, specifically, from hosted customer and campaign data management. We expect that this source of Managed services revenue will continue to diminish over time as we focus on growth through Behavioral Analytics, including predictive behavioral routing. Consulting Services Revenue In addition to the Consulting services revenue generated by our Behavioral Analytics contracts, we derive a portion of this type of revenue from CRM Services for long-standing accounts. We expect Consulting services revenue from CRM Services to continue to diminish over time as demand for these services continues to decline and we focus on growth through Behavioral Analytics. We bill for Consulting services on a time-and-materials or fixed-fee basis. Business Outlook Based upon Mattersight's business development efforts and third-party market research, we believe there has been a fundamental shift in the way large enterprises view data. The trends suggest that large enterprises today appreciate that there is value in data that can be derived from their front and back offices, but they have not yet established efficient and effective methods to capture, analyze, and create value from this data. We seek to help large enterprises capitalize on this data with our Behavioral Analytics offerings and, as a leader in this rapidly growing market, we believe we are uniquely positioned to capitalize on this opportunity. We believe the market potential in the U.S. for enterprise analytics, including our current offerings, is significant and we estimate it to be less than 5% penetrated. 16 -------------------------------------------------------------------------------- Table of Contents Our business strategy to increase revenue, profitability, and capture market share includes the following elements: • Win business with new clients, focusing on predictive behavioral routing; • Develop partnerships and strategic alliances to expand sales leverage, improve brand awareness, and reach new industries while providing value to our mutual clients; • Increase up-sell and cross-sell opportunities by deepening and broadening our relationships with existing clients; • Continue to invest in innovative proprietary technology, new applications, and delivery methods; • Continue bookings growth and improve operating leverage; and • Expand our sales and marketing efforts with seasoned enterprise sales agents and strategic marketing professionals. Resulting from our delivery of measurable economic benefit to our clients, penetration within existing accounts continues to increase, due to adoption of our base Behavioral Analytics offerings across separate and distinct business units, as well as the adoption of new applications within existing business units. For this reason, we will continue to invest in further penetrating what we estimate to be a large existing base market with a less expensive cost of acquisition. In addition, our strategy to further invest in sales and marketing, coinciding with the fundamental shift in enterprise data utilization described above, has led to an increasing number of discussions with potential new clients and strategic partners. Critical Accounting Policies and Estimates Our management's discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to the costs and timing of completion of client projects, our ability to collect accounts receivable, the timing and amounts of expected payments associated with cost reduction activities, and the ability to realize our net deferred tax assets, contingencies, and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our condensed consolidated financial statements. Revenue Recognition Behavioral Analytics Revenue Behavioral Analytics revenue consists of Managed services revenue and Consulting services revenue derived from the performance of Behavioral Analytics. Managed services revenue consists of planning, deployment, training, and subscription fees derived from Behavioral Analytics contracts. Planning, deployment, and training fees, which are considered to be installation fees related to Behavioral Analytics subscription contracts, are deferred until the installation is complete and are then recognized over the applicable subscription period. Subscription periods generally range from three to five years after the go-live date or, in cases where the Company contracts with a client for a short-term pilot of a Behavioral Analytics offering prior to committing to a longer subscription period, if any, the subscription or pilot periods generally range from three to twelve months after the go-live date. Installation costs incurred are deferred up to an amount not to exceed the amount of deferred installation revenue and additional amounts that are recoverable based on the contractual arrangement. These costs are included in Prepaid expenses and Other long-term assets. Such costs are amortized over the subscription period. Costs in excess of the foregoing revenue amount are expensed in the period incurred. The amount of revenue generated from subscription fees is based on a number of factors, such as the number of users to whom the Behavioral Analytics offering is provided, the type and number of Behavioral Analytics offerings deployed to the client, and in some cases, the number of hours of calls analyzed during the relevant month of the subscription period. This revenue is recognized as the service is performed for the client. 17 -------------------------------------------------------------------------------- Table of Contents Consulting services revenue primarily consists of fees charged to the Company's clients to provide post-deployment follow-on consulting services, which include custom data analysis, the implementation of enhancements, and training. These follow-on consulting services are generally performed for the Company's clients on a fixed-fee basis. Revenue is recognized as the services are performed, with performance generally assessed on the ratio of actual hours incurred to-date compared to the total estimated hours over the entire term of the contract. Other Revenue Other revenue consists of Marketing Managed Services revenue and CRM Services revenue. Marketing Managed Services revenue is derived from marketing application hosting. This revenue is generally in the form of fixed monthly fees received from the Company's clients and is recognized as the services are performed for the client. Any related setup fee would be recognized over the term of the hosting contract. CRM Services revenue consists of fees generated from the Company's operational consulting services, which are provided to the Company's clients on a time-and-materials or fixed-fee basis. The Company recognizes revenue as the services are performed for time-and-materials projects. For fixed-fee projects, revenue is recognized based on the ratio of hours incurred to-date compared to the total estimated hours over the entire term of the contract. Reimbursed Expenses Reimbursed expenses revenue includes billable costs related to travel and other out-of-pocket expenses incurred while performing services for the Company's clients. The cost of third-party product and support may be included within this category if the transaction does not satisfy the requirements for gross reporting. An equivalent amount of reimbursable expenses is included in Cost of revenue. Unearned Revenue Payments received for Managed services contracts in excess of the amount of revenue recognized for these contracts are recorded as unearned revenue until revenue recognition criteria are met. Allowance for Doubtful Accounts The Company maintains allowances for doubtful accounts for estimated losses resulting from clients not paying for unpaid or disputed invoices for contractual services provided. Additional allowances may be required if the financial condition of our clients deteriorates. Stock Warrants In accordance with Accounting Standards Codification ("ASC") ASC 480-10 ("Distinguishing Liabilities from Equity"), the Company classified certain warrants to purchase Common Stock that do not meet the requirements for classification as equity, as liabilities. Such liabilities are initially recorded at fair value with subsequent changes in fair value recorded as a component of gain or loss on warrant liability on the condensed consolidated statements of operations in each reporting period. If these warrants subsequently meet the requirements of equity classification, the Company reclassifies the fair value to equity. Fair value of the warrants was measured using a Monte Carlo option pricing model and in applying this model certain assumptions were used. See Note Thirteen, "Stock Warrants" of the "Notes to Condensed Consolidated Financial Statements" included elsewhere in this Quarterly Report on Form 10-Q. Stock-Based Compensation Stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the vesting period. Determining fair value of stock-based awards at the grant date requires certain assumptions. The Company uses historical information as the basis for the selection of expected life, expected volatility, expected dividend yield assumptions, and anticipated forfeiture rates. The risk-free interest rate is selected based on the yields from U.S. Treasury Strips with a remaining term equal to the expected term of the options being valued. Severance and Related Costs Severance and related costs includes cost-reduction actions, principally consisting of personnel reductions and an office consolidation. The portion of the accruals that related to employee severance represents contractual severance for identified employees and generally is not subject to a significant revision. The portion of the accruals that related to office space reductions, office closures, and associated contractual lease obligations are based in part on assumptions and estimates of the timing and amount of sublease rentals, which may be affected by overall economic and local market conditions. To the extent estimates of the success of our sublease efforts changed, adjustments increasing or decreasing the related accruals have been recognized. 18 -------------------------------------------------------------------------------- Table of Contents Income Taxes We have recorded income tax valuation allowances on our net deferred tax assets to account for the unpredictability surrounding the timing of realization of our U.S. and non-U.S. net deferred tax assets due to uncertain economic conditions. The valuation allowances may be reversed at a point in time when management determines realization of these tax assets has become more likely than not, based on a return to predictable levels of profitability. The Company uses an asset and liability approach for financial accounting and reporting of income taxes. Deferred income taxes are provided when tax laws and financial accounting standards differ with respect to the amount of income for the year, the basis of assets and liabilities and for tax loss carryforwards. The Company does not provide U.S. deferred income taxes on earnings of U.S. or foreign subsidiaries, which are expected to be indefinitely reinvested. The Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Significant judgment is used to determine the likelihood of the benefit. There is additional guidance on derecognition, classification, interest and penalties on income taxes, accounting in interim periods, and disclosure requirements. Other Significant Accounting Policies For a description of the Company's other significant accounting policies, see Note Two "Summary of Significant Accounting Policies" of the "Notes to Consolidated Financial Statements" included in our Annual Report on Form 10-K for the year ended December 31, 2013. Forward-Looking Statements Statements in this Quarterly Report on Form 10-Q that are not historical facts are "forward-looking statements" and are made pursuant to the safe harbor provisions of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). These forward-looking statements, which may be identified by use of words such as "plan," "may," "might," "believe," "expect," "intend," "could," "would," "should," and other words and terms of similar meaning, in connection with any discussion of our prospects, financial statements, business, financial condition, revenues, results of operations, or liquidity, involve risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. In addition to other factors and matters contained or incorporated in this Quarterly Report on Form 10-Q, important factors that could cause actual results or events to differ materially from those indicated by such forward-looking statements include, without limitation, those noted under "Risk Factors" included in Part I Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2013, as well as the following: • Uncertainties associated with the attraction of, and the ability to execute contracts with, new clients, the continuation of existing, and execution of new, engagements with existing clients, the conversion of free pilots to paid subscription contracts, and the timing of related client commitments; • Reliance on a relatively small number of clients for a significant percentage of our revenue; • Risks involving the variability and predictability of the number, size, scope, cost, and duration of, and revenue from, client engagements; • Management of the other risks associated with complex client projects and new service offerings, including execution risk; and • Management of growth and development of, and introduction of, new service offerings. We cannot guarantee any future results, levels of activity, performance, or achievements. The statements made in this Quarterly Report on Form 10-Q represent our views as of the date of this report, and it should not be assumed that the statements made in this report remain accurate as of any future date. Moreover, we assume no obligation to update forward-looking statements, except as may be required by law. 19 -------------------------------------------------------------------------------- Table of Contents Third Quarter of 2014 Compared with Third Quarter of 2013 Services Revenue Services revenue is total revenue excluding reimbursable expenses that are billed to our clients. Our services revenue decreased $0.9 million, or 11%, to $7.7 million in the third quarter of 2014, from $8.6 million in the third quarter of 2013. Services revenue decreased $0.9 million in the third quarter of 2014 primarily due to the previously announced expiration of our contract with Vangent, Inc. on December 31, 2013. Behavioral Analytics revenue was $7.5 million in the third quarter of 2014 and $8.3 million in the third quarter of 2013. The $0.8 million, or 9%, decrease in Behavioral Analytics revenue in the third quarter of 2014 was also primarily due to the previously announced expiration of our contract with Vangent, Inc. on December 31, 2013. Other revenue decreased by $0.2 million, or 54%, to $0.1 million in the third quarter of 2014, from $0.3 million in the third quarter of 2013. The Company's top five clients accounted for 73% of total revenue in the third quarter of 2014 and 68% of total revenue in the third quarter of 2013. The top 10 clients accounted for 90% of total revenue in the third quarter of 2014 and 91% of total revenue in the third quarter of 2013. In the third quarter of 2014, three clients accounted for 10% or more of total revenue and in 2013, four clients accounted for 10% or more of total revenue. In the third quarter of 2014, United HealthCare Services, Inc., Progressive Casualty Insurance Company, and HealthCare Service Corporation accounted for 25%, 20%, and 11% of total revenue, respectively. In the third quarter of 2013, Vangent, Inc., Progressive Casualty Insurance Company, Allstate Insurance Company, and United HealthCare Services, Inc., accounted for 20%, 16%, 13%, and 11% of total revenue, respectively. Higher concentration of revenue with a single client or a limited group of clients creates increased revenue risk if one of these clients significantly reduces its demand for our services. Cost of Revenue Before Reimbursed Expenses, Exclusive of Depreciation and Amortization Cost of Services Cost of services primarily consists of labor costs, including salaries, fringe benefits, and incentive compensation, royalties, and other client-related third-party outside services. Cost of services excludes depreciation and amortization. Cost of Behavioral Analytics revenue was $2.4 million, or 31% of Behavioral Analytics revenue in the third quarter of 2014, compared to $2.7 million, or 33% of Behavioral Analytics revenue, in the third quarter of 2013. The favorable decrease in cost and percentage was primarily due to improved productivity in our Delivery organization resulting in lower compensation costs, better leverage of our cost structure supporting our subscription clients, and by the decline in revenue. Cost of Other revenue was less than $0.1 million in the third quarter of 2014, compared to $0.2 million, or 54% of Other revenue, in the third quarter of 2013. Sales, Marketing and Development Sales, marketing and development expenses consist primarily of salaries, incentive compensation, commissions, and employee benefits for business development, account management, marketing, and product development personnel. The personnel costs included in this item are net of any labor costs directly related to the generation of revenue, which are represented in Cost of services. Sales, marketing and development expenses increased $0.7 million, or 15%, to $5.6 million, in the third quarter of 2014 from $4.9 million in the third quarter of 2013. The $0.7 million increase is due to higher compensation expenses in connection with the hiring of additional personnel in our development organization. General and Administrative General and administrative expenses consist primarily of salaries, incentive compensation, and employee benefits for administrative personnel, as well as facilities costs, a provision for uncollectible amounts, and costs for our corporate technology infrastructure and applications. General and administrative expenses increased $0.1 million, or 4%, to $2.3 million in the third quarter of 2014 from $2.2 million in the third quarter of 2013. The $0.1 million increase is due to slightly higher compensation expense. 20 -------------------------------------------------------------------------------- Table of Contents Severance and Related Costs There were no severance and related costs in the third quarter of 2014. In the third quarter of 2013, there was $0.2 million of expense which was related to severance and related costs for the elimination of one position. Depreciation and Amortization Depreciation and amortization decreased $0.1 million, or 17%, to $0.8 million in the third quarter of 2014 from $0.9 million in the third quarter of 2013. The decrease is due to capital lease disposals and assets that became fully depreciated near the end of the second quarter of 2014. Operating Loss Primarily as a result of the factors described above, we experienced an operating loss of $3.5 million for the third quarter of 2014, compared to an operating loss of $2.5 million for the third quarter of 2013. Interest and Other Expense, Net Interest and other expense increased $0.5 million, to $0.7 million in the third quarter of 2014 from $0.2 million in the third quarter of 2013. The $0.5 million increase was primarily related to a $0.5 million write-off of deferred financing fees in connection with the termination of our PfG Facility effective August 14, 2014. Change in Fair Value of Warrant Liability The change in fair value of warrant liability was less than $0.1 million in the third quarter of both 2014 and 2013. Income Tax (Provision) Benefit The income tax provision was less than $0.1 million in the third quarter of both 2014 and 2013. As of September 30, 2014, total net deferred tax assets of $70.0 million were fully offset by a valuation allowance. The level of uncertainty in predicting when we will achieve profitability sufficient to utilize our net U.S. and non-U.S. operating losses and realize our remaining deferred tax assets requires that an income tax valuation allowance be recognized in the financial statements. Net Loss Available to Common Stockholders We reported net loss available to holders of Common Stock of $4.3 million in the third quarter of 2014 compared to net loss available to holders of Common Stock of $2.8 million in the third quarter of 2013. Accrued dividends to holders of Series B Stock were $0.1 million in the third quarter of both 2014 and 2013. In the third quarter of 2014, there was net loss of $0.21 per share on a basic and diluted basis, compared to net loss of $0.17 per share on a basic and diluted basis in the third quarter of 2013. First Nine Months of 2014 Compared with First Nine Months of 2013 Services Revenue Services revenue is total revenue excluding reimbursable expenses that are billed to our clients. Our services revenue decreased $3.1 million, or 12%, to $21.9 million in the first nine months of 2014, from $25.0 million in the first nine months of 2013. The $3.1 million decrease in services revenue in the first nine months of 2014 was primarily due to the previously announced expiration of our contract with Vangent, Inc. on December 31, 2013. Behavioral Analytics revenue was $21.3 million in the first nine months of 2014 and $24.1 million in the first nine months of 2013. The $2.8 million, or 11%, decrease in Behavioral Analytics revenue in the first nine months of 2014 was also primarily due to the previously announced expiration of our contract with Vangent, Inc. on December 31, 2013. Other revenue decreased by $0.4 million, or 37%, to $0.6 million in the first nine months of 2014, from $1.0 million in the first nine months of 2013. This decrease in revenue was primarily due to the completion of the CRM Services contract. The Company's top five clients accounted for 75% of total revenue in the first nine months of 2014 and 68% of total revenue in the first nine months of 2013. The top 10 clients accounted for 91% of total revenue in the first nine months of 2014 and 90% of total revenue in the first nine months of 2013. In the first nine months of 2014 and 2013, four clients each accounted for 10% or more of total revenue. In the first nine months of 2014, United HealthCare Services, Inc., Progressive Casualty Insurance Company, HealthCare Service Corporation, and Allstate Insurance Company accounted for 24%, 21%, 11%, and 10% of total revenue, respectively. In the first nine months of 2013, Vangent, Inc., Progressive Casualty Insurance Company, Allstate Insurance Company, and United HealthCare Services, Inc., accounted for 19%, 15%, 14%, and 11% of total revenue, respectively. Higher concentration of revenue with a single client or a limited group of clients creates increased revenue risk if one of these clients significantly reduces its demand for our services. 21 -------------------------------------------------------------------------------- Table of Contents Cost of Revenue Before Reimbursed Expenses, Exclusive of Depreciation and Amortization Cost of Services Cost of services primarily consists of labor costs, including salaries, fringe benefits, and incentive compensation, royalties, and other client-related third-party outside services. Cost of services excludes depreciation and amortization. Cost of Behavioral Analytics revenue was $6.6 million, or 31% of Behavioral Analytics revenue, in the first nine months of 2014, compared to $8.0 million, or 33% of Behavioral Analytics revenue, in the first nine months of 2013. The favorable decrease in cost and percentage was primarily due to (i) improved productivity in our Delivery organization resulting in lower compensation costs, (ii) better leveraging of the cost structure supporting our subscription clients, and (iii) the decline in revenue. Cost of other revenue was $0.2 million, or 38% of Other revenue in the first nine months of 2014, compared to $0.5 million, or 53% of Other revenue, in the first nine months of 2013. Sales, Marketing and Development Sales, marketing and development expenses consist primarily of salaries, incentive compensation, commissions, and employee benefits for business development, account management, marketing, and product development personnel. The personnel costs included in this item are net of any labor costs directly related to the generation of revenue, which are represented in Cost of services. Sales, marketing and development expenses decreased $0.2 million, or 1%, to $16.3 million in the first nine months of 2014 from $16.5 million in the first nine months of 2013. This favorable decrease is primarily due to lower compensation expense, including lower commission expense due to reduced revenue. General and Administrative General and administrative expenses consist primarily of salaries, incentive compensation, and employee benefits for administrative personnel, as well as facilities costs, a provision for uncollectible amounts, and costs for our corporate technology infrastructure and applications. General and administrative expenses increased $0.3 million, or 3%, to $6.9 million in the first nine months of 2014 from $6.6 million in the first nine months of 2013. The $0.3 million increase is due to slightly higher compensation expense. Severance and Related Costs There were no severance and related costs in the first nine months of 2014. In the first nine months of 2013, there was $0.2 million of expense which was related to severance and related costs for the elimination of one position. Depreciation and Amortization Depreciation and amortization decreased $0.5 million, or 20%, to $2.3 million in the first nine months of 2014 from $2.8 million in the first nine months of 2013. The decrease is due to capital lease disposals and assets that became fully depreciated near the end of the second quarter of 2014. Operating Loss Primarily as a result of the factors described above, we experienced an operating loss of $10.3 million for the first nine months of 2014, compared to an operating loss of $9.5 million for the first nine months of 2013. Interest and Other Expense, Net Interest and other expense was $1.0 million of expense in the first nine months of 2014 compared to $0.4 million of expense in the first nine months of 2013. The $0.6 million increase was primarily related to a $0.5 million write-off of deferred financing fees in connection with the termination of our PfG Facility effective August 14, 2014 and our capital lease obligations. 22 -------------------------------------------------------------------------------- Table of Contents Change in Fair Value of Warrant Liability The change in fair value of warrant liability was $0.1 million in the first nine months of 2014 and less than $0.1 million in the first nine months of 2013. The $0.1 million increase was primarily related to an increase in our common stock price which is the main driver in calculating the fair value of our outstanding warrants. Income Tax (Provision) Benefit The income tax provision was less than $0.1 million in the first nine months of 2014 and the tax benefit was $0.2 million in the first nine months of 2013. The income tax benefit in the first nine months of 2013 was due to a favorable tax ruling on a previously accrued income tax liability. As of September 30, 2014, total net deferred tax assets of $70.0 million were fully offset by a valuation allowance. The level of uncertainty in predicting when we will achieve profitability, sufficient to utilize our net U.S. and non-U.S. operating losses and realize our remaining deferred tax assets, requires that an income tax valuation allowance be recognized in the financial statements. Net Loss Available to Common Stockholders We reported net loss available to holders of Common Stock of $11.9 million in the first nine months of 2014 compared to net loss available to holders of Common Stock of $10.1 million in the first nine months of 2013. Accrued dividends to holders of Series B Stock were $0.4 million in the first nine months of both 2014 and 2013. In the first nine months of 2014 and 2013, there was net loss of $0.61 per share on a basic and diluted basis. Liquidity and Capital Resources Introduction Our principal capital requirements are to fund working capital needs, capital expenditures for Behavioral Analytics and infrastructure requirements, and other revenue generation and growth investments. As of September 30, 2014, our principal capital resources consisted of our cash and cash equivalents balance of $18.3 million, which includes $0.1 million in foreign bank accounts. The increase in cash during the first nine months of 2014 was primarily from proceeds received from the sale of Shares pursuant to the Purchase Agreement of $11.1 million, net of fees, and an increase in unearned revenue, partially offset by the net loss before non-cash items, payment of Company bonuses, capital lease principal payments, capital expenditures, and the acquisition of treasury stock. The decrease in cash during the first nine months of 2013 was primarily the result of the net loss before non-cash items, capital lease principal payments, capital expenditures, and the acquisition of treasury stock, partially offset by a $4.1 million increase in unearned revenue. Cash Flows from Operating Activities Net cash used in operating activities during the first nine months of 2014 was $3.5 million compared to cash of $3.1 million during the first nine months of 2013. During the first nine months of 2014, net cash used in operating activities consisted primarily of the net loss before non-cash items of $5.7 million, partially offset by a $1.4 million increase in unearned revenue. During the first nine months of 2013, net cash provided by operating activities consisted primarily of a $4.1 million increase in unearned revenue, partially offset by the net loss before non-cash items of $1.9 million. Days Sales Outstanding ("DSO") was 32 days at September 30, 2014, compared to 23 days at December 31, 2013, an increase of nine days. Because a high percentage of our revenue is dependent on a relatively small number of clients, delayed payments by a few of our larger clients could result in a reduction of our available cash, which in turn may cause fluctuation in our DSO. We do not expect any significant collection issues with our clients; see "Accounts Receivable Customer Concentration" for additional information on cash collections. Cash Flows from Investing Activities The Company used $0.8 million of cash in investing activities during the first nine months of 2014 compared to $1.2 million of cash in investing activities during the first nine months of 2013. Capital expenditures were primarily used to purchase computer hardware and software during the first nine months of 2014 and 2013. We currently expect to incur new capital investments of between $1.0 million and $2.0 million for fiscal year 2014 and plan on funding approximately $1.0 million to $1.5 million of these purchases with capital leases. 23 -------------------------------------------------------------------------------- Table of Contents Cash Flows from Financing Activities Net cash provided by financing activities was $9.3 million during the first nine months of 2014 compared to cash used in financing activities of $2.6 million during the first nine months of 2013. Net cash proceeds of $9.3 million during the first nine months of 2014 were primarily attributable to proceeds of $11.1 million, net of fees, from the sale of the Shares pursuant to the Purchase Agreement, partially offset by (i) $1.2 million of principal payments under our capital lease obligations and (ii) $0.7 million of cash used to acquire treasury stock to meet employee tax obligations associated with the Company's stock-based compensation programs. The $2.6 million of net cash used during the first nine months of 2013 was primarily attributable to: (i) $1.7 million of principal payments under our capital lease obligations and (ii) $0.9 million of cash used to acquire treasury stock. Historically, we have not paid cash dividends on our Common Stock, and we do not expect to do so in the future. The Board of Directors did not declare a dividend payment on Series B Stock, which was accrued, for the dividend periods July 1, 2012 through December 31, 2012, January 1, 2013 through June 30, 2013, July 1, 2013 through December 31, 2013, and January 1, 2014 through June 30, 2014 (the aggregate amount of these dividends was approximately $1.2 million). A cash dividend on the Series B Stock of $0.3 million was paid on January 3, 2012, for the dividend period July 1, 2011 through December 31, 2011, and a cash dividend of $0.3 million was paid on July 2, 2012, for the dividend period January 1, 2012 through June 30, 2012. Under the terms of the Certificate of Designations for the Series B Stock, unpaid dividends are cumulative and accrue at the rate of 7% per annum, payable semi-annually in January and July. The amount of each dividend accrual will be decreased by any conversions of the Series B Stock into Common Stock, as such conversions require the Company to pay accrued but unpaid dividends at the time of conversion. Conversions of Series B Stock became permissible at the option of the holder after June 19, 2002. The Company expects to acquire between $0.1 million and $0.2 million of treasury stock during the third quarter of 2014 to meet employee tax obligations associated with the Company's stock-based compensation programs. Liquidity Our near-term capital resources consist of our current cash balance, together with anticipated future cash flows, financing from capital leases, and our revolving line of credit (See "Credit Facility" below). Our balance of cash and cash equivalents was $18.3 million as of September 30, 2014. We anticipate that our current unrestricted cash resources, together with operating revenue and capital lease financing, should be sufficient to satisfy our short-term working capital and capital expenditure needs for the next twelve months. Management will continue to assess opportunities to maximize cash resources by actively managing our cost structure and closely monitoring the collection of our accounts receivable. If, however, our operating activities, capital expenditure requirements, or net cash needs differ materially from current expectations due to uncertainties surrounding the current capital market, credit and general economic conditions, competition, or the termination of a large client contract, then there is no assurance that we would have access to additional external capital resources on acceptable terms. Credit Facility On June 27, 2014, the Company, together with the Co-Borrowers, entered into a Second Amendment to the Amended and Restated Loan and Security Agreement with Silicon Valley Bank (the "Second Amendment"). The Second Amendment amends our financial covenants under the Amended and Restated Loan Agreement entered into by the Company, together with the Co-Borrowers, and Silicon Valley Bank on May 20, 2013 (the "Credit Facility") by: (i) reducing the tangible net worth requirement from $3.0 million to $1.25 million and (ii) adding a minimum revenue requirement. The Company's $10.0 million revolving line of credit matures in 2015. Through the maturity date, the Company is obligated to pay a fee equal to one-eighth of one percent (0.125%) per annum of the average unused portion of the Credit Facility, payable quarterly in arrears. The Company has a zero balance outstanding under the Credit Facility as of September 30, 2014. 24 -------------------------------------------------------------------------------- Table of Contents The Credit Facility imposes various restrictions on the Company, including usual and customary limitations on the ability of the Company or any of its subsidiaries to incur debt and to grant liens upon their assets, and prohibits certain consolidations, mergers, and sales and transfers of assets by the Company and its subsidiaries. The Credit Facility includes usual and customary events of default for facilities of this nature (with customary grace periods, as applicable) and provides that, upon the occurrence of an event of default, payment of all amounts payable under the Credit Facility may be accelerated and/or the lenders' commitments may be terminated. In addition, upon the occurrence of certain insolvency or bankruptcy related events of default, all amounts payable under the Credit Facility will automatically become immediately due and payable, and the lenders' commitments will automatically terminate. See Note Nine "Short-Term Debt" of the "Notes to Condensed Consolidated Financial Statements" for further discussion. Accounts Receivable Customer Concentration As of September 30, 2014, two clients, United HealthCare Services, Inc., and CVS Caremark Corporation, accounted for 45% and 15% of total gross accounts receivable, respectively. Of these amounts, we have collected 37% from United HealthCare Services and 47% from CVS Caremark Corporation through November 4, 2014. Of the total September 30, 2014 gross accounts receivable, we have collected 46% as of November 4, 2014. Because we have a high percentage of our revenue dependent on a relatively small number of clients, delayed payments by a few of our larger clients could result in a reduction of our available cash. Capital Lease Obligations Capital lease obligations were $2.7 million as of September 30, 2014 and $2.8 million as of December 31, 2013. We are a party to a capital lease agreement with a leasing company to lease hardware and software. We expect to incur new capital lease obligations of between $1.0 million to $1.5 million for fiscal year 2014 as we continue to expand our investment in the infrastructure for Behavioral Analytics. Contractual Obligations Cash will also be required for operating leases and non-cancellable purchase obligations, as well as various commitments reflected as liabilities on our balance sheet as of September 30, 2014. These commitments are as follows: Less More (In millions) Than 1 1 - 3 3 - 5 Than 5 Contractual Obligations Total Year Years Years Years Letters of credit $ 0.7 $ 0.7 $ - $ - $ - Operating leases 1.8 1.2 0.6 - - Capital leases 3.1 2.0 1.1 - - Purchase obligations 1.7 1.7 - - - Total $ 7.3 $ 5.6 $ 1.7 $ - $ - Letters of Credit The amounts set forth in the chart above reflect standby letters of credit issued as collateral for capital leases. Specifically, these amounts reflect the face amount of these letters of credit that expire in each period presented. Leases The amounts set forth in the chart above reflect future principal, interest, and executory costs of the leases entered into by the Company for technology and office equipment, as well as office and data center space. Liabilities for the principal portion of the capital lease obligations are reflected on our balance sheet as of September 30, 2014 and December 31, 2013. Purchase Obligations Purchase obligations include $1.4 million of commitments reflected as liabilities on our balance sheet as of September 30, 2014, as well as $0.3 million of non-cancellable obligations to purchase goods or services in the future. As of December 31, 2013, purchase obligations included $0.9 million of commitments reflected as liabilities on our balance sheet, as well as $0.6 million of non-cancellable obligations to purchase goods or services in the future. 25 -------------------------------------------------------------------------------- Table of Contents Recent Accounting Pronouncements In August 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-15: Presentation of Financial Statements - Going Concern (Subtopic 205-40) ("ASU 2014-15"): Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern. The update sets forth a requirement for management to evaluate whether there are conditions and events that raise substantial doubt about an entity's ability to continue as a going concern, a responsibility that did not previously exist in U.S. GAAP. The amendments included in this update require management to assess an entity's ability to continue as a going concern by incorporating and expanding upon certain principles that are currently in U.S. auditing standards. Specifically, the amendments (i) provide a definition of the term substantial doubt, (ii) require an evaluation every reporting period, including interim periods, (iii) provide principles for considering the mitigating effect of management's plans, (iv) require certain disclosures when substantial doubt is alleviated as a result of consideration of management's plans, (v) require an express statement and other disclosures when substantial doubt is not alleviated, and (vi) require an assessment for a period of one year after the date that the financial statements are issued (or available to be issued). ASU 2014-15 will be effective for the Company in fiscal year 2016. The adoption of this ASU is not expected to have a material impact on the Company's condensed consolidated financial statements. In May 2014, FASB issued Revenue from Contracts with Customers (Topic 606) ("ASU 2014-09"). The new guidance sets forth a new five-step revenue recognition model that replaces the prior revenue recognition guidance in its entirety and is intended to eliminate numerous industry-specific pieces of revenue recognition guidance that have historically existed in U.S. GAAP. The underlying principle of the new standard is that a business or other organization will recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects what it expects in exchange for the goods or services. ASU 2014-09 provides alternative methods of initial adoption and is effective for annual periods beginning after December 15, 2016 and interim periods within those annual periods. Early adoption is not permitted. The Company is currently evaluating the impact that this standard will have on the Company's condensed consolidated financial statements. |