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INTERPHASE CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) Application of Critical Accounting Policies The Company's consolidated financial statements are based on the selection and application of significant accounting policies, which require management to make significant estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Management believes the following are some of the more critical judgment areas in the application of the Company's accounting policies that affect the Company's financial condition, results of operations, and cash flows. Management has reviewed these critical accounting policies and related disclosures with the Audit Committee of the Board of Directors. 23 -------------------------------------------------------------------------------- Revenue Recognition: Revenues consist of product and service revenues and are recognized in accordance with ASC Topic 605, "Revenue Recognition." Product revenues and electronic manufacturing services revenues are recognized upon shipment, provided fees are fixed and determinable, a customer purchase order is obtained (when applicable), and collection is probable. Sales tax collected from customers and remitted to the applicable taxing authorities is accounted for on a net basis, with no impact to revenues. Service revenue, other than electronics manufacturing services revenue, is recognized as the services are performed. Deferred revenue consists primarily of service revenue not yet performed. Our long-term engineering design services are typically provided on a fixed-fee basis. The revenues for such projects that require significant customization and integration are recognized using the percentage-of-completion method. In using the percentage-of-completion method, revenues are generally recorded based on the percentage of effort incurred to date on a contract relative to the estimated total expected contract effort. Significant judgment is required when estimating total contract effort and progress to completion on the arrangements as well as whether a loss is expected to be incurred on the contract. Management uses historical experience, project plans and an assessment of the risks and uncertainties inherent in the arrangement to establish these estimates. Uncertainties include implementation delays or performance issues that may or may not be within our control. Changes in these estimates could result in a material impact on revenues and net earnings (loss). If we are unable to develop reasonably dependable cost or revenue estimates, the completed contract method is applied under which all revenues and related costs are deferred until the contract is completed. Warranty Reserve: The Company offers to its customers a limited warranty that its products will be free from defect in the materials and workmanship for a specified period. The Company has established a warranty reserve, as a component of accrued liabilities, for any potential claims. The Company estimates its warranty reserve based upon an analysis of all identified or expected claims and an estimate of the cost to resolve those claims. Changes in claim rates and differences between actual and expected warranty costs could impact the warranty reserve estimates. Accounts Receivable and Allowance for Doubtful Accounts: The Company records accounts receivable at their net realizable value, which requires management to estimate the collectability of the Company's trade receivables. A considerable amount of judgment is required in assessing the realization of these receivables, including the current creditworthiness of each customer and related aging of the past due balances. Management evaluates all accounts periodically and a reserve is established based on the best facts available to management. This reserve is also partially determined by using percentages applied to certain aged receivable categories based on historical results and is reevaluated and adjusted as additional information is received. After all attempts to collect a receivable have failed, the receivable is written off against the allowance for doubtful accounts. Allowance for Returns: The Company maintains an allowance for returns, based upon expected return rates, when such return rates are estimable. The estimates of expected return rates are generally a factor of historical returns. Changes in return rates could impact the allowance for return estimates. 24 -------------------------------------------------------------------------------- Inventories: Inventories are valued at the lower of cost or market and include material, labor and manufacturing overhead. Cost is determined on a first-in, first-out basis. Valuing inventories at the lower of cost or market involves an inherent level of risk and uncertainty due to technology trends in the industry and customer demand for our products. In assessing the ultimate realization of inventories, management is required to make judgments as to future demand requirements and compare that with the current or committed inventory levels. Reserve requirements generally increase as projected demand decreases due to market conditions, technological and product life cycle changes as well as longer than previously expected usage periods. The Company has experienced significant changes in required reserves in the past due to changes in strategic direction, such as discontinuances of product lines and declining market conditions. It is possible that significant changes in this estimate may occur in the future as market conditions change. Stock-Based Compensation: The Company accounts for stock-based compensation under the provisions of ASC Topic 718, "Compensation - Stock Compensation." Management estimates are necessary in determining compensation expense for both restricted stock and stock options with performance-based vesting criteria. Compensation expense for this type of stock-based award is recognized over the period from the date the performance condition is determined to be probable of occurring through the date the applicable condition is expected to be met. If the performance condition is not considered probable of being achieved, no expense is recognized until such time as the performance condition is considered probable of being met, if ever. Management evaluates whether performance conditions are probable of occurring on a quarterly basis. Income Taxes: The Company determines its deferred taxes using the liability method. Deferred tax assets and liabilities are based on the estimated future tax effects of differences between the financial statement basis and tax basis of assets and liabilities given the provisions of enacted tax law. The Company's consolidated financial statements include deferred income taxes arising from the recognition of revenues and expenses in different periods for income tax and financial reporting purposes. The Company records a valuation allowance to reduce its deferred income tax assets to the amount that is believed to be realizable. The Company considers recent historical losses, future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. Management is continuously assessing the realizability of deferred tax assets. The Company recognizes the impact of uncertain tax positions taken or expected to be taken on an income tax return in the financial statements at the amount that is more likely than not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized in the financial statements unless it is more likely than not of being sustained. The Company is periodically engaged in various tax audits by federal, state and foreign governmental authorities incidental to its business activities. The Company records reserves for its estimated probable losses of these proceedings, if applicable. The Company is currently under a tax audit in France. 25 --------------------------------------------------------------------------------Consolidated Statement of Operations as a Percentage of Revenue Year ended December 31, 2012 2011 2010 Revenues 100.0 % 100.0 % 100.0 % Cost of sales 55.6 % 52.1 % 49.5 % Gross margin 44.4 % 47.9 % 50.5 % Research and development 23.7 % 17.3 % 36.1 % Sales and marketing 24.2 % 15.9 % 24.8 % General and administrative 21.9 % 16.0 % 21.1 % Restructuring charge 1.8 % - 18.3 % Loss from operations (27.3 )% (1.4 )% (49.9 )% Interest income, net 0.2 % 0.1 % 0.6 % Other loss, net (0.1 )% - (0.4 )% Loss before income tax (27.2 )% (1.3 )% (49.7 )%Income tax provision (benefit) 0.1 % 1.0 % (3.5 )% Net loss (27.3 )% (2.3 )% (46.2 )% Overview Our 2012 financial results reflect a general slowdown in telecommunications spending worldwide. This slowdown, coupled with the shift in subscriber growth toward emerging countries, where our customers have not been able to secure dominate market share, and the shift from circuit-switched network architectures toward packet-based IP network architectures resulted in a significant reduction in revenues from our telecommunications products. We expected that the revenue growth from our engineering design and manufacturing services offerings along with revenues generated by the market release of penveu to be sufficient to not only offset the reductions in the telecommunications products but to provide a source of overall revenue growth in 2012. While revenue from our engineering design and manufacturing services increased approximately 31% in 2012, it was the delay in bringing penveu to market which had the largest impact on our plan to fill this revenue gap. While we were excited to announce penveu to the market in April of 2012, we encountered several delays in the market release of the product due to several significant technical issues with the product. However, we believe that these technical issues have been largely resolved, and we expect to provide beta units to customers for testing soon. We expect penveu to be a major revenue producer for us in 2013. Additionally, we expect to continue to achieve revenue growth in engineering design and manufacturing services and anticipate some stabilization to occur in our telecommunications product revenues in 2013. 26 --------------------------------------------------------------------------------Results of Operations Revenues: Total revenues for the years ended December 31, 2012, 2011 and 2010 were $13.9 million, $22.0 million and $18.2 million, respectively. Revenues decreased by 37% in 2012 compared to 2011. This decrease was primarily attributable to our telecommunications product revenues, which decreased by approximately 43% to $10.1 million in 2012 compared to $17.8 million in 2011. This decrease reflects a general slowdown in telecommunications spending worldwide. This slowdown, coupled with the shift in subscriber growth toward emerging countries, where our customers have not been able to secure dominate market share, and the shift from circuit-switched network architectures toward packet-based IP network architectures resulted in a significant reduction in revenues from our telecommunications products. Additionally, our enterprise product revenues decreased approximately 75% to $393,000 in 2012 compared to $1.6 million in 2011 because the major customer roll-out driving this product line has been completed. Our services revenues increased approximately 31% to $3.2 million in 2012 compared to approximately $2.5 million in 2011. All other revenues decreased slightly to $134,000 in 2012 compared to $162,000 in 2011. Revenues increased by 21% in 2011 compared to 2010. This increase was primarily attributable to our telecommunications product revenues, which increased by approximately 18% to $17.8 million in 2011 compared to $15.1 million in 2010, primarily as the result of design wins that, in some cases, we won over two years ago. Additionally, our services revenues, including our first meaningful revenues from electronic manufacturing services, increased approximately 77% to $2.5 million in 2011 compared to approximately $1.4 million in 2010. Our enterprise product revenues were consistent at $1.6 million in 2011 and 2010. All other revenues increased slightly to $162,000 in 2011 compared to $158,000 in 2010. Gross Margin: Gross margin as a percentage of revenue for the years ended December 31, 2012, 2011 and 2010 was 44%, 48% and 50%, respectively. The decrease in gross margin percentage in 2012 compared to 2011 was primarily due to decreased utilization of our manufacturing facility.We believe that pricing pressures in the industry and our anticipated future mix of our products and services may continue to reduce our gross margin percentage in future periods. The decrease in gross margin percentage in 2011 compared to 2010 was primarily due to a shift in product mix toward lower margin products and services, partially offset by increased utilization of our manufacturing facility and a decrease of $140,000 in excess and obsolete inventory charges. Research and Development: Our investment in the development of new products through research and development was $3.3 million, $3.8 million and $6.6 million in 2012, 2011 and 2010, respectively. As a percentage of revenue, research and development expenses were 24%, 17% and 36% for 2012, 2011 and 2010, respectively. Research and development expenses decreased in 2012 compared to 2011 by $524,000. During 2012, there was an increase in professional services activities, which resulted in an increase in services revenues. Engineering costs associated with these activities generate revenue; therefore, the related expenses are recorded as cost of sales rather than research and development operating expenses, resulting in a decrease of approximately 32% in research and development expenses in 2012 compared to 2011. In addition, there was a decrease in personnel and related expenses of approximately 31%, primarily as a result of the 2012 restructuring plan. See Note 7 in the notes to the consolidated financial statements for more information regarding the 2012 restructuring plan. Furthermore, variable research and development project-related expenses decreased approximately 19% during the year. The increase in research and development expense as a percentage of total revenue is due to revenue decreasing at a higher rate than research and development expense. We will continue to monitor the level of our investments in research and development concurrently with actual revenue results. 27 -------------------------------------------------------------------------------- Research and development expenses decreased in 2011 compared to 2010 by approximately $2.8 million. The decrease was primarily due to the closure of our European engineering and support center located in Chaville, France as a result of the 2010 restructuring plan. See Note 7 in the notes to the consolidated financial statements for more information regarding the 2010 restructuring plan. The decrease in research and development expense as a percentage of total revenue is due to revenue increasing while research and development expense decreased. Sales and Marketing: Sales and marketing expenses were $3.4 million, $3.5 million and $4.5 million in 2012, 2011 and 2010, respectively. As a percentage of revenue, sales and marketing expenses were 24%, 16% and 25% for 2012, 2011 and 2010, respectively. Sales and marketing expenses decreased by $140,000 in 2012 compared to 2011. The increase in sales and marketing expense as a percentage of total revenue was due to revenue decreasing at a higher rate than sales and marketing expense. We will continue to monitor the level of our investments in sales and marketing concurrently with actual revenue results. Sales and marketing expenses decreased by approximately $1.0 million in 2011 compared to 2010. The decrease was primarily due to the closure of our European engineering and support center located in Chaville, France as a result of the 2010 restructuring plan. See Note 7 in the notes to the consolidated financial statements for more information regarding the 2010 restructuring plan. The decrease in sales and marketing expense as a percentage of total revenue was due to revenue increasing while sales and marketing expense decreased. General and Administrative: General and administrative expenses were $3.0 million, $3.5 million and $3.8 million in 2012, 2011 and 2010, respectively. As a percentage of revenue, general and administrative expenses were 22%, 16% and 21% in the years ended December 31, 2012, 2011 and 2010, respectively. General and administrative expenses decreased by $495,000 in 2012 compared to 2011. Approximately 31% of the decrease in general and administrative expenses was due to a decrease in legal services expense. Additionally, there was a decrease in variable compensation expense of approximately 22% and a decrease in depreciation and amortization expense of approximately 20%. See Note 12 in the notes to the consolidated financial statements for more information regarding legal proceedings. The increase in general and administrative expense as a percentage of total revenue was due to revenue decreasing at a higher rate than general and administrative expense. General and administrative expenses decreased by $314,000 in 2011 compared to 2010. General and administrative expenses decreased by $300,000 as a result of the 2010 restructuring plan and by approximately $225,000 due to lower headcount related expenses that were not associated with the 2010 restructuring plan. See Note 7 in the notes to the consolidated financial statements for more information regarding the restructuring plan. These decreases were partially offset by increases of approximately $250,000 related to legal services. See Note 12 in the notes to the consolidated financial statements for more information regarding legal proceedings. The decrease in general and administrative expense as a percentage of total revenue was due to revenue increasing while general and administrative expense decreased. 28 -------------------------------------------------------------------------------- Restructuring Charge: On October 19, 2012, we committed to a plan intended to improve the balance between our telecommunications product expenses with the reduced revenue levels of this product line. Under the 2012 restructuring plan, we reduced our workforce by 10 regular full-time positions. As a result of the 2012 restructuring plan, we recorded a restructuring charge of $253,000, classified as an operating expense, in the fourth quarter of 2012 related to future cash expenditures to cover employee severance and benefits. This plan is expected to result in savings of approximately $1.0 million to $1.6 million in annualized operating costs. See Note 7 in the notes to the consolidated financial statements for more information regarding the 2012 restructuring plan. On September 30, 2010, we initiated a restructuring plan to mitigate gross margin erosion by reducing manufacturing and procurement costs, streamline research and development expense and focus remaining resources on key strategic growth areas, and reduce selling and administrative expenses through product rationalization and consolidation of support functions. Under the 2010 restructuring plan, we reduced our worldwide work force by 39 regular full-time positions, including the closure of our European engineering and support center located in Chaville, France. As a result of the 2010 restructuring plan, we recorded a restructuring charge of approximately $3.3 million, classified as an operating expense, in the third quarter of 2010 related to future cash expenditures to cover employee severance and benefits and other related costs. See Note 7 in the notes to the consolidated financial statements for more information regarding the 2010 restructuring plan. Interest Income, Net: Interest income, net of interest expense, was $25,000, $22,000 and $102,000 in 2012, 2011 and 2010, respectively. The decrease in interest income, net of interest expense, in 2011 compared to 2010 was primarily due to lower investment balances and lower rates of return on our investments. Other Loss, Net: Other loss, net was $12,000 in 2012, zero in 2011 and $79,000 in 2010. Other loss, net in 2010 primarily relates to the change in market value of a foreign exchange derivative financial instrument which resulted in a loss of approximately $62,000. We did not hold any foreign exchange contracts during 2012 or 2011. See Note 4 in the notes to the consolidated financial statements for more information regarding our derivative financial instruments. Income Taxes: The effective income tax rates for the periods presented differ from the U.S. statutory rate as we continue to provide a full valuation allowance for our net deferred tax assets at December 31, 2012, 2011 and 2010. The income tax expense for 2012 was nearly equally due to tax in domestic and foreign jurisdictions. The income tax expense for 2011 was primarily due to tax in a foreign jurisdiction. The tax benefit rate for 2010 was 7%. The income tax benefit for 2010 was primarily due to a 30% research and development tax credit earned by our operations in France. The benefits from the research and development tax credit were partially offset by tax expense related to income generated in France. We no longer generate tax credits from French research and development activities because we closed our French operations at the end of 2010. Net Loss: We reported a net loss of approximately $3.8 million, $505,000 and $8.4 million for the twelve months ended December 31, 2012, 2011 and 2010, respectively. 29 -------------------------------------------------------------------------------- Recently Announced Product: On April 18, 2012 we announced the debut of penveu, a handheld device that adds interactivity to the installed base of projectors and large screen displays; making any flat surface, from pull down screens to HDTVs, an interactive display system. Using embedded computer vision technology, penveu works with any device with a VGA connection and requires no software or driver installation, no particular operating system, and no periodic calibration. penveu is targeted at the education and enterprise markets. An independent source estimates the interactive whiteboard market to grow to approximately $1.85 billion in revenue in 2017. However, penveu also has the unique ability to turn the estimated over 51 million projectors and 7 million large screen displays that are currently installed worldwide into interactive display devices. The retail price of penveu will be less than 25% of the average price of a typical installed interactive whiteboard, and unlike an interactive whiteboard, penveu will not require the time and expense of installation. penveu will be offered and sold through our website, other online retailers and catalogs. We continue to make significant investments in development, marketing and infrastructure associated with penveu to position this important product for a successful market release in 2013. Liquidity and Capital Resources Consolidated Cash Flows Cash and cash equivalents decreased by $3.5 million for the year ended December 31, 2012. Cash and cash equivalents increased by $2.7 million for the year ended December 31, 2011. Cash and cash equivalents decreased by $3.3 million for the year ended December 31, 2010. Cash flows are impacted by operating, investing and financing activities. Operating Activities: Trends in cash flows from operating activities for 2012, 2011 and 2010 are generally similar to the trends in our earnings adjusted by the (recovery of)/provision for uncollectible accounts and returns, provision for excess and obsolete inventories, depreciation and amortization, amortization of stock-based compensation and write-off of impaired capitalized software, property and equipment. Cash used in operating activities totaled $3.6 million compared to a net loss of $3.8 million for the year ended December 31, 2012. Cash provided by operating activities totaled $771,000 compared to a net loss of $505,000 for the year ended December 31, 2011. Cash used in operating activities totaled $6.7 million compared to a net loss of $8.4 million for the year ended December 31, 2010. We recovered $4,000 during 2012 and $22,000 during 2011 in uncollectible accounts and returns due to improved collection results in each year. Provision for excess and obsolete inventories decreased by $3,000 and $140,000 in 2012 and 2011, respectively. Depreciation and amortization decreased by $188,000 and $160,000 in 2012 and 2011, respectively. Amortization of stock-based compensation increased by $316,000 and $34,000 in 2012 and 2011, respectively. The increase in amortization of stock-based compensation during 2012 was primarily due to the issuance of 194,500 time-based stock options during 2012. See Note 9 in the notes to the consolidated financial statements for more information on stock-based compensation. During 2012 and 2011, there were no write-offs of capitalized software, property and equipment. During 2010, there were write-offs of capitalized software, property and equipment of $29,000 primarily related to the restructuring actions taken during the third quarter of 2010. Changes in assets and liabilities result primarily from the timing of production, sales, purchases and payments. Such changes in assets and liabilities generally tend to even out over time and result in trends in cash flows from operating activities generally reflecting earnings trends. 30 -------------------------------------------------------------------------------- Investing Activities: Net cash used in investing activities totaled $790,000 for the year ended December 31, 2012. Net cash provided by investing activities totaled $1.3 million and $3.6 million in 2011 and 2010, respectively. Cash used in or provided by investing activities in each of the three years presented related principally to our investments in marketable securities, additions to property and equipment and capitalized software purchases. Additions to property and equipment during 2012 primarily related to software and equipment purchases for penveu and for our manufacturing function. Additions to property and equipment during 2011 primarily related to software and equipment purchases for our engineering, manufacturing and administrative functions. Additions to property and equipment during 2010 primarily related to software and equipment purchases for our engineering and manufacturing functions. Purchases of marketable securities increased by approximately $4.5 million for 2012 compared to 2011. Purchases of marketable securities increased by approximately $3.3 million for 2011 compared to 2010. Proceeds from the sale of marketable securities increased by approximately $2.4 million for 2012 compared to 2011. Proceeds from the sale of marketable securities increased by approximately $1.2 million for 2011 compared to 2010. Financing Activities: Net cash provided by financing activities totaled $835,000 and $527,000 for the years ended December 31, 2012 and 2011, respectively. There was no net cash provided by or used in financing activities for the year ended December 31, 2010. Cash provided by financing activities for 2012 and 2011 consisted solely of proceeds from the exercise of stock options. Commitments At December 31, 2012, we had no material commitments to purchase capital assets; however, planned capital expenditures for 2013 are estimated at approximately $200,000, a significant portion of which relates to enhancements to our manufacturing equipment. Our significant long-term obligations are operating leases on facilities and phone systems and future debt payments. In addition, at December 31, 2012, we had approximately $50,000 of non-cancelable purchase commitments for materials and hardware. We have not paid any dividends since our inception and do not anticipate paying any dividends in 2013. The following table summarizes our future contractual obligations and payment commitments as of December 31, 2012 (in thousands): Contractual Obligation Payments due by period Total <1 year 1 - 3 years 3 - 5 years > 5 years Long-term debt obligation (1,2) $ 3,626 $ 42 $ 3,584 $ - $ - Operating lease obligations (3,4,5) $ 763 $ 630 $ 133 $ - $ - Total $ 4,389 $ 672 $ 3,717 $ - $ - (1) At December 31, 2012, we had borrowings of $3.5 million under a $5.0 million revolving credit facility with a bank. The revolving credit facility matures on December 19, 2015 and is secured throughout the term of the credit facility by marketable securities. 31-------------------------------------------------------------------------------- (2) We incur interest expense on the borrowings from the revolving credit facility at a rate of London Interbank Offered Rate ("LIBOR") plus 1.0% to 1.5% applicable margin rate based on certain factors included in our credit agreement. At December 31, 2012, our interest rate on the borrowings from the revolving credit facility was 1.2%. We used the 1.2% rate to estimate interest expense for 2013 through December 2015. The interest expense estimate is $42,000 annually for the years 2013 through December 2015. (3) We lease our facilities under non-cancelable operating leases with the longest terms extending to March 2014. (4) Our operating lease at our headquarters location includes a $140,000 letter of credit issued to our landlord which can only be used in the case of non-payment of such lease. The letter of credit, if accessed, would be funded by our existing revolving credit facility. (5) We lease our phone system under a non-cancelable operating lease extending to October 2014. Off-Balance Sheet Arrangements In an attempt to mitigate foreign currency risk, we have entered into, from time to time, foreign exchange contracts to purchase a fixed amount of Euros on a fixed date in the future at a fixed rate determined at the contract date. At December 31, 2012 and 2011, we had no foreign exchange contracts outstanding. Other Management believes that cash generated from operations and borrowing availability under the revolving credit facility, together with cash on hand, will be sufficient to meet our liquidity needs for working capital, capital expenditures and debt service for the next twelve months. To the extent our actual operating results or other developments differ from our expectations, our liquidity could be adversely affected. We periodically evaluate our liquidity requirements, alternative uses of capital, capital needs and available resources in view of, among other things, our capital expenditure requirements and estimated future operating cash flows. As a result of this process, we have in the past sought, and may in the future seek, to raise additional capital, refinance or restructure indebtedness, issue additional securities, repurchase shares of our common stock or take a combination of such steps to manage our liquidity and capital resources. In the normal course of business, we may review opportunities for acquisitions, joint ventures or other business combinations. In the event of any such transaction, we may consider using available cash, issuing additional equity securities or increasing the indebtedness of the Company or its subsidiaries. Recently Issued Accounting Pronouncements See Note 13 in the notes to the consolidated financial statements for more information regarding recently issued accounting pronouncements, including the expected dates of adoption and estimated effects on our consolidated financial statements. 32-------------------------------------------------------------------------------- |