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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Disclosures in this Form 10-Q contain certain forward-looking statements, including without limitation, statements concerning our operations, economic performance, and financial condition. These forward-looking statements are made pursuant to the safe harbor provisions 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. The words "estimate," "believe," "expect," "anticipate," "intend" and other similar expressions generally identify forward-looking statements, which speak only as of their dates. These forward-looking statements are based largely on our current expectations, and are subject to a number of risks and uncertainties, including without limitation, that our IADS segment has not reported any revenues to date and is subject to the risks and uncertainties of early-stage companies; the primarily at-will nature of the contracts between our Content Services segment and its customers and the ability of customers to reduce, delay or cancel projects; continuing Content Services revenue concentration in a limited number of customers, continuing Content Services reliance on project-based work; inability to replace projects that are completed, cancelled or reduced; depressed market conditions; changes in external market factors; the ability and willingness of our customers and prospective customers to execute business plans which give rise to requirements for digital content and professional services in knowledge processing; difficulty in integrating and deriving synergies from acquisitions, joint venture and strategic investments; potential undiscovered liabilities of companies that we acquire; changes in our business or growth strategy; the emergence of new or growing competitors; various other competitive and technological factors; and other risks and uncertainties indicated from time to time in our filings with the Securities and Exchange Commission. Our actual results could differ materially from the results referred to in the forward-looking statements. In light of these risks and uncertainties, there can be no assurance that the results referred to in the forward-looking statements contained in this Form 10-Q will occur. We undertake no obligation to update or review any guidance or other forward-looking information, whether as a result of new information, future developments or otherwise. Business Overview We provide services, products and solutions that our clients use to create, manage, use and distribute digital information. Our clients include preeminent media, publishing and information services companies, as well as enterprises that are prominent in information technology, manufacturing, aerospace, defense, financial services, government, healthcare and law. We operate in two separate reporting segments. Our Content Services segment (CS) provides business process, technology and consulting services to assist clients in managing digital content. Most of our clients are in the process of transforming from print publishing to online publishing; from search-based information products to workflow-based information products; or from web-based distribution to multiple-channel distribution that includes mobile, tablet and e-reading devices. These transformations require the adoption of new strategies, technologies and processes. We help our clients set digital content production and product strategies; integrate new technologies and processes; and improve the quality and efficiency of content creation, enrichment and transformation. Our clients include legal and business information providers as well as scientific, technical and medical publishers; enterprises that create and manage large volumes of product support content; governmental agencies that manage large volumes of content in support of mission; and retail digital content distribution platforms. 18 -------------------------------------------------------------------------------- In the second quarter of 2011, we launched Innodata Advanced Data Solutions (IADS) as a separate segment to perform advanced data analysis. IADS operates through two divisions. The Synodex division of IADS offers a range of data analysis services in the healthcare, medical and insurance areas. The docGenix division of IADS provides software products and services that facilitate the generation and analysis of standardized and non-standardized documents for swaps, derivatives, repos, securities lending, prime brokerage, investment management and clearing. We presently own 77% of the Synodex division, a limited liability company, and 78% of the docGenix division, a limited liability company. We purchased certain assets of the docGenix division from a third party for $0.4 million. The divisions are at an early stage of development, and reported no revenues in the second quarter of 2011. Each of our segments is organized and managed around three vectors: a vertical industry focus, a horizontal service/process focus, and a supportive operations focus. The vertically-aligned groups understand our customers' businesses and strategic initiatives. The vertical group for each particular industry includes experts hired from that industry. Our service/process-aligned groups are comprised of engineering personnel responsible for creating secure and efficient custom workflows integrate proprietary and third-party technologies, and globally-distributed delivery personnel responsible for executing our customer engagements in accordance with service-level agreements. We deliver services from facilities in the United States, India, the Philippines, Sri Lanka and Israel. Our support groups are responsible for managing a diverse group of enabling functions that include human resources, recruiting, network and communications technology infrastructure and physical infrastructure and facilities. Our sales staff, program managers and consultants operate primarily from our North American offices, European locations, as well as from customer sites. Revenues We price our business process services based on the quantity delivered or resources utilized and generally recognize revenue in the period in which the services are performed and delivered. A substantial majority of our technology and consulting services are provided on a project basis that generates non-recurring revenues. We price our technology and consulting services on an hourly basis for actual time and expense incurred, or on a fixed-fee, turn-key basis. Revenues for contracts billed on a time-and-materials basis are recognized as services are performed. Revenues under fixed-fee contracts, which are not significant to the overall revenues, are recognized on a percentage-of-completion method of accounting as services are performed or milestones are achieved. We consider the criteria of reporting revenue gross as a principal versus net as an agent. Factors considered in determining whether we are the principal in the transaction include whether we are the primary obligor, have risks and rewards of ownership, and bear the risk that the customer may not pay for the services performed. If there are circumstances where the above criteria are not met and therefore we are not the principal in providing services, amounts received from customers are presented net of payments in the condensed consolidated statement of operations. Revenue includes reimbursement of out-of-pocket expenses, with the corresponding out-of-pocket expenses included in direct operating costs. Direct Operating Costs Direct operating costs consist of direct payroll, occupancy costs, depreciation and amortization, travel, telecommunications, computer services and supplies, and other direct expenses that are incurred in providing services to our customers. 19 --------------------------------------------------------------------------------Selling and Administrative Expenses Selling and administrative expenses consist of management and administrative salaries, sales and marketing costs, new services research and related software development, professional fees and consultant costs, and other administrative overhead costs. Results of Operations Three Months Ended June 30, 2011 and 2010 Revenues Revenues were $16.3 million for the three months ended June 30, 2011 compared to $15.4 million for the similar period in 2010, an increase of approximately 6%. Revenues in the 2011 period reflect a $1.2 million increase over the 2010 period in revenues from our top two customers and a one-time fee of $0.6 million for early termination of an engagement, partially offset by a net decline in revenue from other customers. Our top two customers generated $5.1 million or 31% of revenues for the three months ended June 30, 2011 compared to $3.9 million or 25% of revenues for the three months ended June 30, 2010. Another customer accounted for less than 10% of our revenues for the three months ended June 30, 2011, and $2.0 million or 13% of our revenues for the three months ended June 30, 2010. No other customer accounted for 10% or more of our total revenues in either period. Further, revenues from customers located in foreign countries (principally in Europe) amounted to $5.2 million or 32% and $5.6 million or 37% of our total revenues for the three months ended June 30, 2011 and 2010, respectively. There were no revenues for the three months ended June 30, 2011 from our recently formed IADS segment. Direct Operating Costs Direct operating costs were $11.4 million and $12.1 million for the three months ended June 30, 2011 and 2010, respectively, a decline of approximately $0.7 million or 6%. The decrease in direct operating costs was attributable to a decrease in direct labor costs achieved primarily from productivity gains. The productivity gains were principally the result of increased efficiency, improvements in our processes and innovation in our technology. These declines partially offset a $0.4 million increase in direct operating costs from foreign exchange rate fluctuations caused by a strengthening of the Philippine peso and Indian rupee against the U.S. dollar. Included in total direct operating costs is approximately $0.1 million in start-up costs that we incurred for the IADS segment. The changes in direct operating expenses mentioned above resulted in a decline of direct operating costs as a percentage of revenues to 70% for the three months ended June 30, 2011 from 79% for the three months ended June 30, 2010. 20 --------------------------------------------------------------------------------Selling and Administrative Expenses Selling and administrative expenses were $4.1 million or 25% as a percentage of revenues during the three months ended June 30, 2011 compared to $3.8 million or 25% as a percentage of revenues for the three months ended June 30, 2010. The increase in selling and administrative costs is primarily due to an increase in compensation costs of new personnel hired for sales, and other administrative costs including approximately $0.2 million incurred for the IADS segment, which were partially offset by routine cost efficiencies and approximately $0.2 million from recovery of bad debts from a previously fully reserved account receivable. Income Taxes For the three months ended June 30, 2011, the provision for income taxes was primarily comprised of the provision we recorded for our foreign subsidiaries. The provision was partially offset by the tax benefit recorded for the U.S. entity. The benefit from income tax recorded by the U.S. entity resulted primarily from losses incurred by the U.S. entity during the three months ended June 30, 2011. One of our foreign subsidiaries enjoyed a tax holiday in 2011. In addition, certain of our foreign subsidiaries enjoy preferential tax rates. Certain overseas income is not subject to tax in the U.S. unless repatriated. For the three months ended June 30, 2010, the provision for income taxes was primarily comprised of the provision we recorded for the U.S. Parent and certain of our foreign subsidiaries. In addition, the provision for income tax also includes the provision we recorded for one of our Indian subsidiaries for uncertain tax positions. As this subsidiary has been continually subject to tax audits by the Indian Bureau of Taxation, we assessed the likelihood of an unfavorable assessment for the three months ended June 30, 2010 and recorded a provision of $60,000. Certain overseas income is not subject to tax in the U.S. unless repatriated. Net Income (Loss) We generated net income of $0.8 million in the three months ended June 30, 2011 compared to a net loss of $0.9 million in the three months ended June 30, 2010. The change was primarily attributable to an increase in gross margins resulting from an increase in revenues, increase in productivity due to improvements in processes and technology partly offset by unfavorable foreign exchange rates and start-up costs incurred for the IADS segment. The change in net income also reflects an increase in interest income and a decrease in the provision for income taxes. Six Months Ended June 30, 2011 and 2010 Revenues Revenues were approximately $31.0 million for the six months ended June 30, 2011 compared to $30.9 million for the similar period in 2010. Revenues in the 2011 period reflect a $2.0 million increase over the 2010 period in revenues from our top two customers and a one-time fee of $0.6 million for early termination of an engagement, partially offset by a net decline in revenue from other customers. Our top two customers generated $9.8 million or 32% for the six months ended June 30, 2011 compared to $7.9 million or 25% of revenues for the six months ended June 30, 2010. Another customer accounted for less than 10% of our revenues for the six months ended June 30, 2011, and $3.7 million or 12% of our revenues for the six months ended June 30, 2010. No other customer accounted for 10% or more of our total revenues in either period. 21 -------------------------------------------------------------------------------- Further, revenues from customers located in foreign countries (principally in Europe) amounted to $10.8 million or 34% and $10.5 million or 34% of our total revenues for the six months ended June 30, 2011 and 2010, respectively. There were no revenues for the six months ended June 30, 2011 from our recently formed IADS segment. Direct Operating Costs Direct operating costs were $22.0 million and $24.4 million for the six months ended June 30, 2011 and 2010, respectively, a decline of approximately $2.4 million or 10%. The decrease in direct operating costs was attributable to a decrease in labor costs achieved primarily from productivity gains. The productivity gains were principally the result of increased efficiency, improvements in our processes and innovation in our technology. These declines partially offset a $0.8 million increase in direct operating costs from foreign exchange rate fluctuations caused by a strengthening of the Philippine peso and Indian rupee against the U.S. dollar. Included in total direct operating costs is approximately $0.1 million in start-up costs that we incurred for the IADS segment. The changes in direct operating expenses mentioned above resulted in a decline of direct operating costs as a percentage of revenues to 71% for the six months ended June 30, 2011 from 79% for the six months ended June 30, 2010. Selling and Administrative Expenses Selling and administrative expenses were $8.1 million and $7.9 million for the six months ended June 30, 2011 and 2010, respectively, an increase of approximately 3%. The increase in selling and administrative expenses for the six months ended June 30, 2011 is principally attributable to compensation costs of new personnel hired for sales, severance costs of $0.3 million, increase in miscellaneous administrative costs including approximately $0.2 million incurred for the IADS segment. These increases were partially offset by recovery of bad debts of approximately $0.5 million from a previously fully reserved account receivable. As a percentage of revenue, selling and administrative costs remained at 26% for the six months ended June 30, 2011 and 2010. Income Taxes For the six months ended June 30, 2011, the provision for income taxes was primarily comprised of the provision we recorded for our foreign subsidiaries, which included a tax benefit recorded by one of our foreign subsidiaries. The provision was partially offset by the tax benefit recorded for the U.S. entity. The benefit from income tax recorded by the U.S. entity resulted primarily from losses incurred by the U.S. entity during the six months ended June 30, 2011. One of our foreign subsidiaries enjoyed a tax holiday in 2011. In addition, certain of our foreign subsidiaries enjoy preferential tax rates. Certain overseas income is not subject to tax in the U.S. unless repatriated. 22 -------------------------------------------------------------------------------- For the six months ended June 30, 2010, the provision for income taxes was primarily comprised of the provision we recorded for one of our Indian subsidiaries for uncertain tax positions. As this subsidiary has been continually subject to tax audits by the Indian Bureau of Taxation, we assessed the likelihood of an unfavorable assessment for the fiscal year ended March 31, 2010 and for the six months ended June 30, 2010, and recorded a provision of $360,000. In addition, the provision for income taxes also includes the provision we recorded for the U.S. Parent and certain of our foreign subsidiaries. Certain overseas income is not subject to tax in the U.S. unless repatriated. Net Income (Loss) We generated net income of $0.8 million in the six months ended June 30, 2011 compared to a net loss of $2.3 million in the six months ended June 30, 2010. The change was primarily attributable to an increase in gross margins resulting from an increase in revenues, increase in productivity due to improvements in processes and technology partly offset by unfavorable foreign exchange rates and start-up costs incurred for the IADS segment. The change in net income also reflects an increase in interest income and a decrease in the provision for income taxes. Liquidity and Capital Resources Selected measures of liquidity and capital resources, expressed in thousands, are as follows: June 30, 2011 December 31, 2010 Cash and cash equivalents $ 11,690 $ 14,120 Short term and long term investments - other 15,228 13,875 Working capital 24,629 26,088 At June 30, 2011, we had cash and cash equivalents of $11.7 million and short term and long term investments of $15.2 million. We have used, and plan to use, these funds for (i) expansion of existing operations; (ii) general corporate purposes, including working capital; and (iii) possible business acquisitions. As of June 30, 2011, we had working capital of approximately $24.6 million as compared to working capital of approximately $26.1 million as of December 31, 2010. We do not anticipate any near-term liquidity issues. Net Cash Provided By Operating Activities Cash provided by our operating activities for the six months ended June 30, 2011 was $1.3 million resulting from a net income of $0.8 million, adjustments for non-cash items of $1.7 million and $1.2 million used by working capital changes. Adjustments for non-cash items primarily consisted of $1.6 million for depreciation and amortization and $(0.4) million for deferred income taxes. Working capital activities primarily consisted of a use of cash of $1.2 million for an increase in accounts receivable primarily related to an increase in revenue, and a source of cash of $0.1 million for accounts payable, accrued expenses and accrued salaries, wages and related benefits representing the timing of expenditures and payments. Cash provided by our operating activities for the six months ended June 30, 2010 was $2.0 million resulting from a net loss of $2.3 million, adjustments for non-cash items of $2.2 million and $2.1 million provided by changes in working capital. Adjustments for non-cash items primarily consisted of $1.9 million for depreciation and amortization and $0.2 million for pension costs. Working capital activities primarily consisted of a source of cash of $1.6 million as a result of collections of accounts receivable, a use of cash of $0.4 million for accounts payable and accrued expenses representing payments made to vendors and suppliers and a source of cash of $0.5 million related to income and other taxes. 23 --------------------------------------------------------------------------------At June 30, 2011, our days' sales outstanding for accounts receivable were approximately 54 days as compared to 61 days as of December 31, 2010. Net Cash Used in Investing Activities For the six months ended June 30, 2011, we spent cash approximating $1.2 million for capital expenditures, compared to approximately $1.2 million for the six months ended June 30, 2010. Capital spending in 2011 principally consisted of the purchase of technology equipment including workstations, and computer software and leasehold improvements. Also included within the capital expenditure is cost incurred to acquire computer software for the IADS segment. Capital spending in 2010 related principally to technology equipment and computer software. During the next twelve months, we anticipate that capital expenditures for ongoing technology, hardware, software, leasehold improvements, fittings, equipment and infrastructure upgrades and establishment of new delivery centers will approximate $4.5 to $5.0 million, a portion of which we may finance. Also, included in the investing activities during the six months ended June 30, 2011 and 2010 is the purchase of short term and long term investments consisting of certificates of deposit, and amounting to $1.4 million and $7.6 million, respectively. Net Cash Used in Financing Activities In April 2011, we renewed a vendor agreement, which expired in February 2011, to acquire certain additional software licenses and to receive support and subsequent software upgrades on these and other currently owned software licenses through February 2014, for a total cost of approximately $1.4 million, representing a non-cash investing and financing activity. As of June 30, 2011, we paid $0.3 million under this agreement. The agreement, which expired in February 2011, was originally entered into in February 2008 for a total cost of approximately $1.6 million. In conjunction with this agreement, we paid approximately $0.3 million during the six months ended June 30, 2011. Total payments of long term obligations, including the vendor agreement, approximated $0.3 million and $0.4 million for the six months ended June 30, 2011 and 2010, respectively. In June 2010, our Board of Directors authorized the repurchase of up to $2.1 million of our common stock. During the six months ended June 30, 2011, we repurchased 342,000 shares of our common stock at a cost of approximately $0.9 million, at a volume-weighted average price of $2.57 per share. No shares were repurchased during the six months ended June 30, 2010. Future Liquidity and Capital Resource Requirements We have a $7.0 million line of credit pursuant to which we may borrow up to 80% of eligible accounts receivable. Borrowings under the credit line bear interest at the bank's alternate base rate plus 0.5% or LIBOR plus 2.5%. The line, which expires in June 2012, is collateralized by our accounts receivable. We have no outstanding obligations under this credit line as of June 30, 2011. We believe that our existing cash and cash equivalents, short term and long term investments, funds generated from our operating activities and funds available under our credit facility will provide sufficient sources of liquidity to satisfy our financial needs for the next twelve months. However, if circumstances change, we may need to raise debt or additional equity capital in the future. Contractual Obligations The table below summarizes our contractual obligations (in thousands) at June 30, 2011 and the effects that those obligations are expected to have on our liquidity and cash flows in future periods. 24 -------------------------------------------------------------------------------- Payments Due by Period Less than After Contractual Obligations Total 1 year 1-3 years 4-5 years 5 years Capital lease obligations $ 25 $ 25 $ - $ - $ - Vendor obligations 1,036 457 579 - - Non-cancelable operating leases 6,857 1,700 3,360 1,603 194 Total contractual cash obligations $ 7,918 $ 2,182 $ 3,939 $ 1,603 $ 194 Future expected obligations under our pension benefit plan have not been included in the contractual cash obligations table above. Inflation, Seasonality and Prevailing Economic Conditions Our most significant costs are the salaries and related benefits of our employees in Asia. We are exposed to higher inflation in wage rates in the countries in which we operate. We generally perform work for our customers under project-specific contracts, requirements-based contracts or long-term contracts. We must adequately anticipate wage increases, particularly on our fixed-price contracts. There can be no assurance that we will be able to recover cost increases through increases in the prices that we charge for our services to our customers. Our quarterly operating results are subject to certain fluctuations. We experience fluctuations in our revenue and earnings as we replace and begin new projects, which may have some normal start-up delays, or we may be unable to replace a project entirely. These and other factors may contribute to fluctuations in our operating results from quarter to quarter. In addition, as some of our Asian facilities are closed during holidays in the fourth quarter, we typically incur higher wages, due to overtime, that reduce our margins. Critical Accounting Policies and Estimates Our discussion and analysis of our results of operations, liquidity and capital resources is based on our consolidated financial statements which have been prepared in conformity with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates and judgments, including those related to revenue recognition, allowance for doubtful accounts and billing adjustments, long-lived assets, goodwill, valuation of deferred tax assets, value of securities underlying stock-based compensation, litigation accruals, pension benefits, valuation of derivative instruments and estimated accruals for various tax exposures. We base our estimates on historical and anticipated results and trends and on various other assumptions that we believe are reasonable under the circumstances, including assumptions as to future events. These estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. By their nature, estimates are subject to an inherent degree of uncertainty. Actual results may differ from our estimates and could have a significant adverse effect on our results of operations and financial position. For a discussion of our critical accounting policies see Part II, Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2010. There have been no material changes to our critical accounting policies during the six months ended June 30, 2011. 25 --------------------------------------------------------------------------------Recent Accounting Pronouncements In October 2009, the Financial Accounting Standard Board ("FASB") issued an amendment to its accounting guidance on revenue arrangements with multiple deliverables. This new accounting guidance addresses the unit of accounting for arrangements involving multiple deliverables and how consideration should be allocated to separate units of accounting, when applicable. This guidance is effective for fiscal years beginning on or after June 15, 2010. Early adoption is permitted. The adoption of this guidance did not have an impact on our condensed consolidated financial statements. In January 2010, the FASB issued an amendment regarding improving disclosures about fair value measurements. This new guidance requires some new disclosures and clarifies some existing disclosure requirements about fair value measurement. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. The adoption of this guidance did not have an impact on our condensed consolidated financial statements. In June 2011, the FASB issued a standard regarding the presentation of other comprehensive income ("OCI"). The new guidance eliminates the option of presenting OCI in the statement of changes in equity, and requires to report items of OCI in either (1) a continuous statement of comprehensive income or (2) two separate but consecutive statements. The guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. We will adopt the guidance as required. The adoption of this guidance is not expected to have an impact on our condensed consolidated financial statements. |