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APPLIED VISUAL SCIENCES, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) General You should read the following summary together with the more detailed information and consolidated financial statements and notes thereto and schedules appearing elsewhere in this report. Throughout this report when we refer to the "Company," "Applied Visual Sciences," "we," "our" or "us," we mean Applied Visual Sciences, Inc., and its subsidiaries. This discussion and analysis of our 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. The 20 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 on-going basis, we evaluate our critical accounting policies and estimates, including those related to revenue recognition, intangible assets, and contingencies. We base our estimates on historical experience, where available, and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions and conditions. Except for historical information, the statements and other information contained in this Management's Discussion and Analysis is forward-looking. Our actual results could differ materially from the results discussed in the forward-looking statements, which include certain risks and uncertainties. These risks and uncertainties include the rate of market development and acceptance of our "intelligent imaging informatics" ("3i™") technology (particularly for our PinPoint™ and Signature Mapping™ products), the unpredictability of our sales cycle, the limited revenues and significant operating losses generated to date, and the possibility of significant ongoing capital requirements. Our independent registered public accounting firm's report on the consolidated financial statements included herein for the years ended December 31, 2011, contains an explanatory paragraph wherein they expressed an opinion that there is substantial doubt about our ability to continue as a going concern. Accordingly, careful consideration of such opinions should be given in determining whether to continue or become our stockholder. Overview Applied Visual Sciences, Inc. was incorporated under the name Guardian Technologies International, Inc., in the Commonwealth of Virginia in 1989 and reincorporated in State of Delaware in February 1996. We changed our name to Applied Visual Sciences, Inc., on July 9, 2010. Applied Visual Sciences, Inc. and its subsidiaries are collectively referred to herein as the "Company," "Applied Visual Sciences, Inc.," "Applied Visual," "us," "we," or "our." Applied Visual Sciences is a software technology company that designs and develops imaging informatics solutions for delivery to its target markets through its two operating subsidiaries: Guardian Technologies International, Inc. for aviation/homeland security and Signature Mapping Medical Sciences, Inc., for healthcare. On March 23, 2012, the Company established a new entity; Instasis Imaging, Inc., for the development, marketing, and sales of a suite of imaging analytic applications for the automated detection of breast cancer. The Company utilizes imaging technologies and analytics to create integrated information management technology products and services that address critical problems experienced by corporations and governmental agencies in healthcare and homeland security. Each product and service can improve the quality and response time of decision-making, organizational productivity, and efficiency within the enterprise. Our product suite integrates, streamlines, and distributes business and clinical information and images across the enterprise. Please refer to and carefully consider the factors described in Part I, Item 1A - Risk Factors of our Form 10-K for the year ended December 31, 2011, and Part II, Item 1A - Risk Factors of this Report. Our Business Strategy Our strategic vision is to position our core technology as the de facto standard for digital image analysis, knowledge extraction, and detection. Our strategy is based upon the following principal objectives: · Maintain product development and sales/marketing focus on large, underserved, and rapidly growing markets with a demonstrated need for intelligent imaging informatics. · Leverage Applied Visual Sciences, Inc.'s technology, experienced management team, research and development infrastructure. · Focus our talents on solving highly challenging information problems associated with digital imaging analysis. · Establish an international market presence through the development of a significant OEM/Reseller network. · Build and maintain a strong balance sheet to ensure the availability of capital for product development, acquisitions, and growth. · Seek to broaden our investment appeal to large institutions. To achieve our strategic vision, we are aware of the need to exercise the financial and operational discipline necessary to achieve the proper blend of resources, products and strategic partnerships. These efforts can accelerate our ability to develop, deploy and service a broad range of intelligent imaging informatics solutions directly to our target markets and indirectly through OEM/value added reseller ("VAR") partners. During 2012, we continued implementing changes across the spectrum of our business. We refined our marketing strategy for PinPoint™ and Signature Mapping™, and enhanced our Signature Mapping™ product offerings. 21 We may engage in one or more acquisitions of businesses that are complementary, and may form wholly-owned subsidiaries to operate within defined vertical markets Our Core Technology Our core technology is an "intelligent imaging informatics" ("3i™") engine that is capable of extracting embedded knowledge from digital images, and has the capacity to analyze and detect image anomalies. The technology is not limited by type of digital format. It can be deployed across divergent digital sources such as still images, x-ray images, video and hyper-spectral imagery. To date, the technology has been tested in the area of threat detection for baggage scanning at airports, for bomb squad applications and the detection of tuberculosis by analyzing digital images of stained sputum slides captured through a photo microscopy system. Varying degrees of research and development have been conducted in the areas of detection for cargo scanning, people scanning, military target acquisition in a hyper-spectral environment, satellite remote sensing ground surveys and mammography CAD products and radiologists' diagnostic imaging tools, and while product development in these areas is ongoing, there can be no assurance that we will successfully develop product offerings in these areas. We are currently focused on providing software technology solutions and services in two primary markets - aviation/homeland security with PinPoint™ and healthcare technology with Signature Mapping™ solutions. However, as new or enhanced solutions are developed, we expect to expand into other markets such as military and defense utilizing hyper-spectral technology, and imaging diagnostics for the medical industry. Patents and Proprietary Rights We rely on a combination of common law trademark, service mark, copyright and trade secret law and contractual restrictions to establish and protect our proprietary rights and promote our reputation and the growth of our business. We do not own any patents that would prevent or inhibit our competitors from using our technology or entering our market, although we intend to seek such protection as appropriate. It is our practice to require all of our employees, consultants and independent contractors to enter into agreements containing non-disclosure, non-competition and non-solicitation restrictions and covenants, and while our agreements with some of our customers and suppliers include provisions prohibiting or restricting the disclosure of proprietary information, we can not assure you that these contractual arrangements or the other steps taken by us to protect our proprietary rights will prove sufficient protection to prevent misappropriation of our proprietary rights or to deter independent, third-party development of similar proprietary assets. The United States Patent & Trademark Office ("USPTO") has granted the Company six patents, all of which are related to our underlying 3i™ technology. We also have nine pending patents applications (U.S. and foreign) that further cover the implementation of our core 3i™ technology. We cannot provide assurance that any or all of the remaining patent applications or the provisional application will be issued patents, or that they will not be challenged, or that rights granted to us would actually provide us with an advantage over our competitors. Prior art searches have been conducted and, based on the results of these searches; we believe that we do not infringe any third party patents identified in the searches. Date Granted Patent No. Patent Description February 17, 2009 7,492,937 System and Method for Identifying Objects of Interest in Image Data February 24, 2009 7,496,218 System and Method for Identifying Objects of Interest in Image Data October 19, 2010 7,817,833 System and Method for Identifying Feature of Interest in Hyperspectral Data November 23, 2010 7,840,048 System and Method for Determining Whether There is an Anomaly in Data March 15, 2011 7,907,762 Method of Creating a Divergence Transform for Identifying a Feature of Interest in Hyperspectral Data October 25, 2011 8,045,805 Method for Determining Whether a Feature of Interest Anomaly is Present in an Image Due to the rapid pace of technological change in the software industry, we believe patent, trade secret and copyright protection are less significant to our competitive edge than factors such as the knowledge, ability and experience of our personnel, new product development, frequent product enhancements, name recognition and the ongoing reliability of our products. Aviation/Homeland Security Technology Solution - PinPoint™ Through our wholly-owned subsidiary, Guardian Technologies, we market our PinPoint™ product, which is an "intelligent imaging informatics" (3i™) technology for the detection of guns, explosives, and other threat items contained in baggage in the airport environment or for building security applications. PinPoint™ can identify threat items, notify screeners of the existence of threat items, and speed the security process by eliminating unnecessary baggage checks, provide the screener with an instantaneous second opinion, and reduce processing time spent on false positives (baggage selected for security review that contains no threat items). We market and seek to license the PinPoint™ product primarily to the United States Transportation Services Administration (TSA) for use in airports, the Federal Protection Services for use in federal buildings and to foreign governments and airport authorities. We compete with manufacturers of baggage screening, luggage and large parcel screening, people screening for weapons and explosive detection, container and vehicle screening, and cargo screening equipment and certain software companies and academic institutions that are developing solutions to detect threat items. It is also our intent to distribute the product through various distribution methods. 22 The market for contraband detection systems has become intensely competitive and many of our competitors are better capitalized and have greater marketing and other resources than Applied Visual Sciences, Inc. PinPoint™ continues to be developed to address the market for contraband detection. The extended alpha version of PinPoint™ has been tested successfully at live carry-on baggage checkpoints in three international airports. Integration within currently deployed manufacturers' scanning equipment is a requisite to anticipated sales, and is considered a significant development risk. PinPoint™ is available for sale to customers; however no sales are anticipated until we are able to seamlessly integrate with the manufacturers' scanning equipment. To date the marketplace has placed a premium on the newest innovations in hardware technology and has failed to grasp how a threat detection software solution can improve their detection rate and reduce the frequency of false positives. It was expected that a major joint initiative between the Department of Homeland Security (DHS) and the National Electrical Manufacturers Association (NEMA) would open a path to both increase the interoperability of security equipment as well as provide a mechanism to use third party threat detection software as part of the screening solution. This enabling initiative is the Digital Imaging and Communications in Security (DICOS) standard, similar to the Digital Imaging and Communications in Medicine (DICOM) standard. With a defined standard for the output of each screening device, complimentary automated threat detection software can be appended to any x-ray equipment. Applied Visual Sciences, Inc co-chaired one of the three NEMA working groups drafting the DICOS standard, and the DICOS standard was published in October 2010. To date DHS has not made this standard a mandatory requirement for proposals or procurements which, as a result, has not enabled third party detection software providers the ability to enter the marketplace and has given an undue advantage to the existing security equipment providers. As highlighted below in the NEMA article, "DICOS - Homeland Security Spending Keeps on Growing" - Published by HYPE, expenditures for security solutions are increasing. Management believes Applied Visual Sciences, Inc. is well positioned to be a third party solution provider leveraging the standard output of all future security equipment procured by the US Government. "Global homeland security spending has received a major boost in light of recent international terrorist events, as countries look at new ways to thwart terrorists and secure borders. Spending in the industry is expected to triple to $178 billion by 2015. Security-related spending will include more sophisticated information technology and the protection of other vulnerable terrorist targets. With the initial focus on airport security, NEMA has stepped up its outreach to DHS and TSA. Currently developing DICOS, the new NEMA standard will capture scans of checked baggage so that scans can be read by threat detection software. The new standard will facilitate interoperability of security-imaging equipment. With DHS/TSA expected to purchase new equipment for over 400 U.S. airports, NEMA members have joined with DHS to develop the standard. Phase II of DICOS, for the testing of the new NEMA standards, began in April 2011, and NEMA has begun looking at other modalities. The security industry is looking at border, rail, seaport, industrial and nuclear plant security. We have been involved in a number of wide ranging U.S. Government proposals since 2011. We have teamed on a few of the proposals with large, well-known defense contractors, a federally funded research laboratory and directly. The proposals were submitted to various U.S. Government agencies. Unfortunately, almost of the projects were deferred due to the ongoing federal budget discussions in Congress and operational uncertainties within the funding agencies. At this point in time, we have no indication that any of these projects will be funded this fiscal year or the next budget cycle. We will continue to pursue opportunities for the deployment of our PinPoint™ product as opportunities develop. With these uncertainties and our ability to manage with limited cash resources during 2012, we have focused on the marketing and sale of our healthcare products, as better discussed below. |