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IMAGE SENSING SYSTEMS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Overview General. We provide software based computer enabled detection ("CED") products and solutions that use advanced signal processing software algorithms to detect and monitor objects in a designated field of view. Our technology analyzes signals from a sophisticated sensor and passes the information along to management systems, controllers or directly to users. Our core products, the Autoscope® Video Vehicle Detection System, RTMS® Radar Detection System and CitySync Automatic Number Plate Recognition ("ANPR") System, operate using our proprietary application software in conjunction with video cameras or radar and commonly available electronic components. Our systems are used by traffic managers primarily to improve the flow of vehicle traffic and to enhance safety at intersections, main thoroughfares, freeways and tunnels and by parking and toll managers and law enforcement officials to read license plates for various safety, security, access and enforcement ANPR applications. Autoscope systems are sold to distributors and end users of traffic management products in North America, the Caribbean and Latin America by Econolite Control Products, Inc. ("Econolite"), our exclusive licensee in these regions. We sell CitySync systems to distributors and end users in North America. As described below, we announced a change to our RTMS selling model in December 2011. We sell all of our systems to distributors and end users in Europe and Asia through our European and Hong Kong subsidiaries, respectively. The majority of our sales are to end users that are funded by government agencies responsible for traffic management or traffic law enforcement. RTMS Business Model Change and Restructuring. In December 2011, we announced certain changes to our RTMS business model. Beginning in 2012, we gave an exclusive license to manufacture and distribute RTMS products in North America to Econolite under terms substantially the same as our Autoscope royalty arrangement. In conjunction with this agreement, certain of our sales and marketing employees dedicated to RTMS are now employed directly by Econolite. As a result, in 2012, revenue earned from sales of RTMS in North America are in the form of a royalty rather than a sale directly to the purchaser, and there will be no cost of revenue, as Econolite will now be responsible for manufacturing and post-sales support. Simultaneously with the RTMS changes, we put a plan in place for restructuring aspects of our North American RTMS and CitySync businesses. Most significantly, the assembly of our RTMS product has been moved from our Toronto facility to a third party, and our production and administrative support headcount has been reduced. Trends and Challenges in Our Business We believe the growth in our business can be attributed primarily to the following global trends: • worsening traffic caused by increased numbers of vehicles in metropolitan areas without corresponding expansions of road infrastructure and the need to automate safety, security and access applications for automobiles and trucks, which has increased demand for our products; • advances in information technology, which have made our products easier to market and implement; • the continued funding allocations for centralized traffic management services and automated enforcement schemes, which has increased the ability of our primary end users to implement our products; and • general increases in the cost-effectiveness of electronics, which make our products more affordable for end users. We believe our continued growth primarily depends upon: • continued adoption and governmental funding of intelligent transportation systems ("ITS") and other automated applications for traffic control, safety and enforcement in developed countries; • a propensity by traffic engineers to implement lower cost technology-based solutions rather than civil engineering solutions such as widening roadways; • countries in the developing world adopting above-ground detection technology, such as video or radar, instead of in-pavement loop technology to manage traffic; - 11 - -------------------------------------------------------------------------------- Table of Contents • the use of CED to provide solutions to security/surveillance and environmental issues associated with increasing automobile use in metropolitan areas; and • our ability to develop new products, such as hybrid CED devices incorporating, for example, radar and video technologies, that provide increasingly accurate information and enhance the end users' ability to cost-effectively manage traffic, security/surveillance and environmental issues. Because the majority of our end users are governmental entities, we are faced with challenges related to potential delays in purchase decisions by those entities and changes in budgetary constraints. These contingencies could result in significant fluctuations in our revenue between periods. The continued European sovereign debt crisis is further adding to the unpredictability of purchase decisions, creating more delays than usual and decreasing governmental budgets, and it is likely to continue to negatively affect our revenue. Key Financial Terms and Metrics Revenue. We derive revenue from two sources: (1) royalties received from Econolite for sales of the Autoscope and RTMS systems in North America, the Caribbean and Latin America and (2) revenue received from the direct sales of our CitySync systems in North America, the Caribbean and Latin America and all of our systems in Europe and Asia. We calculate the royalties using a profit sharing model where the gross profit on sales of Autoscope and RTMS products made through Econolite are shared equally with Econolite. This royalty arrangement has the benefit of decreasing our cost of revenues and our selling, marketing and product support expenses because these costs and expenses are borne primarily by Econolite. Although this royalty model has a positive impact on our gross margin, it also negatively impacts our total revenue, which would be higher if all the sales made by Econolite were made directly by us. The royalty arrangement is exclusive under a long-term agreement. Cost of Revenue. There is no cost of revenue related to royalties, as virtually all manufacturing, warranty and related costs are incurred by Econolite. Cost of revenue related to product sales consists primarily of the amount charged by our third party contractors to manufacture hardware platforms, which is influenced mainly by the cost of electronic components. The cost of revenue also includes logistics costs, estimated expenses for product warranties, restructuring costs and inventory reserves. The key metric that we follow is achieving certain gross margin percentages by geographic region and to a lesser extent by product line. Operating Expenses. Our operating expenses fall into three categories: (1) selling, marketing and product support; (2) general and administrative; and (3) research and development. Selling, marketing and product support expenses consist of various costs related to sales and support of our products, including salaries, benefits and commissions paid to our personnel; commissions paid to third parties; travel, trade show and advertising costs; second-tier technical support for Econolite; and general product support, where applicable. General and administrative expenses consist of certain corporate and administrative functions that support the development and sales of our products and provide an infrastructure to support future growth. General and administrative expenses reflect management, supervisory and staff salaries and benefits, professional fees, travel, rent and costs associated with being a public company, such as board of director fees, listing fees and annual reporting expenses. Research and development expenses consist mainly of salaries and benefits for our engineers and third party costs for consulting and prototyping. We measure all operating expenses against our annually approved budget, which is developed with achieving a certain operating margin as a key focus. Also included in operating expenses are restructuring costs and non-cash expense for intangible asset amortization. Non-GAAP Operating Measure. We use non-GAAP net income (loss) to analyze our business. Non-GAAP net income (loss) excludes the impact, net of tax, of restructuring charges and amortizing the intangible assets. Non-GAAP net income (loss) also excludes the impact, net of tax, of restructuring charges. Management believes that this non-GAAP operating measure, when shown in conjunction with GAAP measures, facilitates the comparison of our current to historical operating results. We use this non-GAAP information to evaluate short-term and long-term operating trends in our core operations. Further, we believe that this non-GAAP measure improves management's and investors' ability to compare our financial performance with other companies in the technology industry. Non-GAAP information is not prepared in accordance with GAAP and should not be considered a substitute for or an alternative to GAAP financial measures and may not be computed the same as similarly titled measures used by other companies. - 12 - -------------------------------------------------------------------------------- Table of Contents Reconciliations of GAAP net income (loss) to non-GAAP net income (loss) are as follows (dollars in thousands, except per share amounts): Three-Month Periods Ended March 31, 2012 2011 GAAP net loss $ (668 ) $ (808 ) Adjustments to reconcile to non-GAAP net loss Amortization of intangible assets 408 412 Restructuring 76 - Impact on income taxes of amortization and restructuring (143 ) (140 ) Non-GAAP net loss $ (327 ) $ (536 ) GAAP diluted loss per share $ (0.14 ) $ (0.17 ) Non-GAAP diluted loss per share (0.07 ) (0.11 ) Seasonality. Our quarterly revenues and operating results have varied significantly in the past due to the seasonality of our business. Our first quarter generally is the weakest due to weather conditions that make roadway construction more difficult in North America, Europe and northern Asia. We expect such seasonality to continue for the foreseeable future. Additionally, our international revenues have a significant large project component, resulting in revenue fluctuations. Accordingly, we believe that quarter-to-quarter comparisons of our financial results should not be relied upon as an indication of our future performance. No assurance can be given that we will be able to achieve or maintain profitability on a quarterly or annual basis in the future. Segments. We currently operate in three reportable segments: Autoscope, RTMS and CitySync. Autoscope is our machine-vision product line, and revenue consists of royalties (all of which are received from Econolite), as well as a portion of international sales. RTMS is our radar product line. CitySync is our ANPR product. All segment revenues are derived from external customers. As a result of business model changes and modifications in how we manage our business, we may reevaluate our segment definitions in the future. Financial information by reportable segment for the three-month period ended is summarized as follows (in thousands): For the three months ended March 31, 2012 Autoscope RTMS CitySync Total Revenue $ 2,887 $ 783 $ 1,587 $ 5,257 Gross profit 2,586 413 944 3,943 Amortization of intangible assets - 192 216 408 Intangible assets and goodwill - 3,394 7,495 10,889 For the three months ended March 31, 2011 Autoscope RTMS CitySync Total Revenue $ 3,064 $ 961 $ 2,120 $ 6,145 Gross profit 2,905 441 1,135 4,481 Amortization of intangible assets - 192 220 412 Intangible assets and goodwill 525 11,518 12,187 24,230 - 13 - -------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth, for the periods indicated, certain statements of operations data as a percent of total revenue and gross margin on product sales and royalties as a percentage of product sales and royalties, respectively. Three-Month Periods Quarter Over Ended March 31, Quarter 2012 2011 Change Product sales 55.3 % 56.1 % (15.6 )% Royalties 44.7 43.9 (13.0 ) Total revenue 100.0 100.0 (14.5 ) Gross profit - product sales 54.8 51.7 (10.5 ) Gross profit - royalties 100.0 100.0 (13.0 ) Selling, marketing and product support 35.2 42.6 (29.4 ) General and administrative 23.4 23.9 (16.4 ) Research and development 24.2 16.7 23.4 Amortization of intangible assets 7.8 6.7 (1.0 ) Restructuring 1.4 - nm Loss from operations (16.9 ) (17.1 ) (15.3 ) Income tax benefit (4.1 ) (3.9 ) (9.2 ) Net loss (12.7 ) (13.1 ) (17.3 ) Total revenue decreased to $5.3 million in the three month period ended March 31, 2012 from $6.1 million in the same period in 2011, a decrease of 14.5%. Royalty income decreased to $2.3 million in the first quarter of 2012 from $2.7 million in the same period in 2011, a decrease of 13.0%. The decrease in royalty income was mainly due to lower Autoscope royalties slightly offset by the inclusion of the first three month period of RTMS royalties. The three month period ended March 31, 2012 was the first period in which RTMS revenues included royalty income. Product sales decreased to $2.9 million in the first quarter of 2012 from $3.4 million in the same period in 2011, a decrease of 15.6%. The decrease in product sales was mainly due to lower sales volume in North America resulting from the transition of our RTMS product line to a royalty model. Revenue for the RTMS segment decreased to $0.8 million in 2012 from $1.0 million in 2011, a decrease of 18.6%. The decrease in revenue for the RTMS segment is due to the transition of this product line to a royalty model in North America offset by an increase in the volume of RTMS products sold to end customers. Revenue for the Autoscope segment decreased to $2.9 million in 2012 from $3.1 million in 2011, a decrease of 5.8%. Revenue for the CitySync segment decreased to $1.6 million in 2012 from $2.1 million in 2011, a decrease of 25.1%. The decreases for the Autoscope and CitySync segments are due to lower sales volume in 2012 and are reflective of a difficult environment for selling security applications to government customers in Europe and the United States that we believe was caused by constrained government budgets. Gross margins for product sales increased to 54.8% in the three months ended March 31, 2012 from 51.7% in the same period in 2011. Gross margins for the CitySync product line have historically been lower than gross margins for the Autoscope and RTMS product lines and therefore the mix of the product lines in any given period can result in varying margins. Generally, lower sales volumes of CitySync products will reduce gross margins because of fixed manufacturing costs for these products. Gross margins on royalty income remained consistent at 100.0% in each of the three month periods ended March 31, 2012 and 2011. We anticipate that gross margins for our product sales will be higher in 2012 as compared to 2011, while we expect royalty gross margins will be 100% in 2012 consistent with 2011. Selling, marketing and product support expense decreased to $1.8 million or 35.2% of total revenue in the first three months of 2012 from $2.6 million or 42.6% of total revenue in the first three months of 2011. Our selling, marketing and product support expense decreased mainly due to the restructuring activities. We anticipate that selling, marketing and product support expense will decrease both in terms of dollar amount and as a percentage of revenue in 2012 as compared to 2011 as we realize the impact of restructuring initiatives and the RTMS business model change. - 14 - -------------------------------------------------------------------------------- Table of Contents General and administrative expense decreased to $1.2 million or 23.4% of total revenue in the first quarter of 2012, from $1.5 million or 23.9% of total revenue in the same period in 2011. General and administrative expenses decreased in 2012 mainly due to the restructuring activities that were announced in the fourth quarter of 2011. We anticipate that general and administrative expense will decrease both in terms of dollar amount and as a percentage of revenue in 2012 as compared to 2011 as we realize the impact of restructuring initiatives and the RTMS business model change. Research and development expense increased to $1.3 million or 24.2% of total revenue in the first quarter of 2012, up from $1.0 million or 16.7% of total revenue for the same period in 2011. The increase was mainly related to the increased expenditures on our hybrid and other product developments. We anticipate that research and development expense will remain similar or decrease slightly in terms of dollar amount in 2012 as compared to 2011. Amortization of intangibles expense was $408,000 in the three months ended March 31, 2012 compared to $412,000 million in 2011 and reflects the amortization of intangible assets acquired in acquisitions. Assuming there are no changes to our intangible assets, we anticipate amortization expense will be approximately $1.6 million in 2012. As discussed above, in December 2011, we announced a change to our North American business model for the RTMS product line and certain restructuring initiatives. In the period ended March 31, 2012, we recognized restructuring expense of $76,000 related mainly to employee severance. Other income was $5,000 in the first quarter of 2012, primarily consisting of interest income, as compared to income of $4,000 in the first quarter of 2011. Income tax benefit of $218,000, or 24.6% of our pretax loss, was recorded for the three months ended March 31, 2012, compared to an income tax benefit of $240,000, or 22.9% of pretax income, for the three months ended March 31, 2011. We expect the effective rate in 2012 to be below 30%. Liquidity and Capital Resources At March 31, 2012, we had $5.7 million in cash and cash equivalents and $2.8 million in short-term investments, compared to $5.2 million in cash and cash equivalents and $2.1 million in short-term investments at December 31, 2011. Our investment objectives are to preserve principal, maintain liquidity, and achieve the best available return consistent with our primary objectives of safety and liquidity. Net cash provided by operating activities was $1.3 million in the first three months of 2012, compared to cash used in operating activities of $2.1 million in the same period in 2011. The primary reason for the increase in cash was the collection of outstanding receivables and conversion of inventory, offset by payments related to the reduction in accounts payable. We anticipate that average receivable collection days in 2012 will improve compared to 2011 and will not have a material impact on our liquidity. Net cash used in investing activities was $1.0 million for the first quarter of 2012, compared to cash used in investing activities of $2.2 million in the first quarter of 2011. There was $2.9 million of purchases offset by sales or maturities of marketable securities in the first quarter of 2012. Our planned additions of property and equipment are discretionary, and we do not expect them to exceed historical levels in 2012. We have a revolving line of credit agreement with Associated Bank, National Association. The revolving line of credit provides for up to $5.0 million at an annual interest rate equal to the greater of 4.5% or LIBOR plus 2.75%, as reset from time to time by the bank. Advances on the line of credit cannot exceed a borrowing base determined under a formula, which is a percentage of the amounts of eligible receivables. The line of credit currently has no borrowings outstanding and matures on May 1, 2013. We believe that on an ongoing basis, we will have regular availability to draw a minimum of $3.0 million on our line of credit based on our qualifying assets. We believe that cash and cash equivalents on hand at March 31, 2012, along with the availability of funds under our $5.0 million revolving line of credit and cash provided by operating activities, will satisfy our projected working capital needs, investing activities, and other cash requirements for the foreseeable future. Off-Balance Sheet Arrangements We do not participate in transactions or have relationships or other arrangements with an unconsolidated entity, including special purpose and similar entities or other off-balance sheet arrangements. - 15 - -------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies Our significant accounting policies are described in Note 1 to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2011. The accounting policies used in preparing our interim 2012 Condensed Consolidated Financial Statements set forth elsewhere in this Quarterly Report on Form 10-Q are the same as those described in our Annual Report on Form 10-K. Cautionary Statement: This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange of 1934, as amended. Forward-looking statements represent our expectations or beliefs concerning future events and can be identified by the use of forward-looking words such as "expects," "believes," "may," "will," "should," "intends," "plans," "estimates," or "anticipates" or other comparable terminology. Forward-looking statements are subject to risks and uncertainties that may cause our actual results to differ materially from the results described in the forward-looking statements. Factors that might cause such differences include, but are not limited to: • historical dependence on a single product for most of our revenue; • budget constraints by governmental entities that purchase our products, including constraints caused by declining tax revenue; • continuing ability of our licensee to pay royalties owed; • the mix of and margin on the products we sell; • dependence on third parties for manufacturing and marketing our products; • dependence on single-source suppliers to meet manufacturing needs; • our increased international presence; • failure to secure adequate protection for our intellectual property rights; • development of a competing product by another business using the underlying technology included in the patent we had licensed from the University of Minnesota, which expired in 2006; • our inability to develop new applications and product enhancements; • unanticipated delays, costs and expenses inherent in the development and marketing of new products, including ANPR products; • our inability to respond to low-cost local competitors in Asia and elsewhere; • our inability to properly manage a growth in revenue and/or production requirements; • the influence over our voting stock by affiliates; • our inability to hire and retain key scientific and technical personnel; • our inability to achieve and maintain effective internal controls; • our inability to successfully integrate acquisitions; • political and economic instability, including recent volatility in the economic environment of the European Union caused by the ongoing sovereign debt crisis in Europe; - 16 - -------------------------------------------------------------------------------- Table of Contents • our inability to comply with international regulatory restrictions over hazardous substances and electronic waste; and • conditions beyond our control such as war, terrorist attacks, health epidemics and economic recession. We caution that the forward-looking statements made in this report or in other announcements made by us are further qualified by the risk factors set forth in Item 1A. to our Annual Report on Form 10-K for the fiscal year ended December 31, 2011. |