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TELULAR CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (in thousands except when referring to ARPUs, units or share data)(Edgar Glimpses Via Acquire Media NewsEdge) Forward Looking Information This report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Telular includes certain estimates, projections and other forward-looking statements within the meaning of section 27A of the Securities Act of 1933 and section 21E of the Securities Exchange Act of 1934 in its reports and in other publicly available material. Statements regarding expectations, including performance assumptions and estimates relating to capital requirements, as well as other statements that are not historical facts, are forward-looking statements. These statements reflect management's judgments based on currently available information and involve a number of risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. With respect to these forward-looking statements, management has made assumptions regarding, among other things, customer growth and retention, pricing, operating costs and the economic environment. The words "estimate", "project", "intend", "expect", "believe", "target" and similar expressions are intended to identify forward-looking statements. Forward-looking statements are found throughout Management's Discussion and Analysis. The reader should not place undue reliance on forward-looking statements, which speak only as of the date of this report. Except as required by law, Telular is not obligated to publicly release any revisions to forward-looking statements to reflect events after the date of this report or unforeseen events. Introduction The following management's discussion and analysis is intended to help the reader understand the results of operations and financial condition of Telular Corporation. This discussion is provided as a supplement to, and should be read in conjunction with, our Annual Report on Form 10-K for the year ended September 30, 2012 and our financial statements and accompanying notes. Telular develops products and services that utilize wireless networks to provide data connectivity among people and machines. Telular's software-as-a-service ("SaaS") offerings are created through Telular's competence in developing complex software systems and wireless electronics that utilize the data transport capabilities of today's commercial wireless networks. To enable these services, Telular is a significant reseller of such commercial wireless services. We generate a majority of our revenue through the delivery of machine-to-machine ("M2M") services such as event monitoring and asset tracking services through our Telguard, SkyBitz and TankLink business lines. A portion of our revenue comes from the sale of specialty wireless hardware products designed by Telular for use exclusively with our M2M services. Our operating expense levels are based in large part on our expectations for our future revenues. If anticipated sales in any quarter do not occur as expected, expenditure and inventory levels could be disproportionately high, and our operating results for that quarter, and potentially for future quarters, could be adversely affected. Certain factors that could significantly impact expected results are described in Item 1A, Risk Factors. The market for Telular's products is primarily in North and South America and consists of a number of vertical applications including Telguard security alarm conveyance, SkyBitz asset tracking; and TankLink storage tank level monitoring. These markets are addressed primarily through indirect channels consisting of third party agents, Value Added Resellers ("VARs") and distributors along with in-house sales and customer support teams. A direct sales model is utilized for certain large customers in each line of business. Fabrication of Telular's products is accomplished through contract manufacturers located in China, Mexico and the United States. The following discussion details areas of product delivery and research either recently undertaken or anticipated in fiscal 2013. Telguard - Telular's engineering team perpetually updates the Telguard product and service portfolio through incremental feature development, both in hardware devices and software functionality. In fiscal 2012, Telular completed and launched the conversion of the entire Telguard hardware product line to 3G/4G capability. Product innovation within this space is important for the long-term success of Telguard and we expect to continue to enhance our Telguard software platform and underlying hardware products going forward. In fiscal 2012, the Telguard Message Center ("TMC"), which contains the underlying core software for the Telguard service, was enhanced such that Telular can offer service to security dealers in Canada. Furthermore, the architecture of TMC will be updated so that it can support newly developed features and even more end-users and increased traffic volume in the future. During fiscal 2013 we plan to enhance dramatically the interactive services and home automation features of our Telguard service line and continue to enhance the capabilities of TMC. 21 -------------------------------------------------------------------------------- SkyBitz - On February 1, 2012, SkyBitz released to the market its newest hardware device, the GTP series, which for the first time provides global satellite tracking capability via the Iridium satellite network. Subsequent to the release of the first GTP model, additional work was undertaken to complete variations of that device that allowed for GPS location capability, remote antenna mounting and cargo sensing capability. For fiscal 2013, we upgraded the SkyBitz terrestrial device to operate on 3G/4G networks and are developing internally a terrestrial device that is expected to deliver superior cellular service at a lower cost than the current terrestrial solution. In 2013, we are also working on updating the version of SkyBitz's InSight SaaS application. TankLink - In fiscal 2013, we released the TankLink 90, the industry's first 3G/4G wireless tank monitoring solution. Telular plans to further enhance all elements of the TankLink portfolio during fiscal 2013 to update the hardware as well as support additional customer use cases for the solution. Other M2M Solutions -Telular continues to evaluate additional M2M markets to determine the viability of creating or acquiring M2M service in these markets. Competition Telular believes our advantages over the competition include: Greater Focus -Telular is focused on creating M2M solutions, which we develop by combining our historical competency in designing wireless networking electronics and real-time transaction processing software with the data transport capabilities of commercial wireless networks. This focus allows us to develop high functioning software and products best suited to our customers' needs, resulting in products that are easier to install and maintain and are more reliable. Our primary competitors have the bureaucracy normally associated with large companies and the management distraction associated with overseeing a broad array of products and services; many of which are unrelated to one another. More Experience - Telular has been in the wireless electronics business for over 20 years. We have been creating and operating real-time transaction processing software for over a decade and understand the importance of high reliability in that regard. We have deployed products in more than 130 countries worldwide, reflecting the quality, reliability and innovation of our product portfolio. Broader Product line -Telguard, our largest line of business, includes targeted software features and a more diverse set of hardware products than any of our competitors and we believe this gives our customers a greater selection of features and hardware devices from which to choose. Similarly, SkyBitz has an array of satellite and terrestrial wireless radio devices that support the asset tracking services it provides, which we believe encompasses a wider selection of application-specific devices than most of its competitors. Economies of Scale -Telguard's fully integrated end-to-end wireless solution is now utilized by over 639,700 individual subscribers, which helps to minimize costs on a per user basis. This large customer base also reflects our significant experience and demonstrates credibility to the market. Service and Support - Telular provides customers with comprehensive customer service and product support. We believe that our commitment and ability to provide superior service differentiates us from our competition. There are several firms that compete with Telular's Telguard products and services. These primary competitors include: Honeywell, Alarm.com, DSC and Numerex. Based on internal estimates, we believe we have a portion of the market share for all currently active cellular alarm communicators in the United States, having introduced the first such device for digital cellular networks in April 2005 and the first such device for 3G/4G networks in November 2012. Demand for cellular communicators has increased markedly over the past few years. We believe this is due to consumers eliminating traditional telephone lines and therefore, requiring an alternative communication method to enable a home security system. If this trend continues, we believe that we and our competitors will continue to see substantial demand for products and related services. Telular's Telguard hardware products will only interface with Telular's proprietary message center, which interprets and forwards any alarms received to our security monitoring customers in near real-time. We believe our competitive advantages for this service include that our hardware products interface with the vast majority of alarm panels on the market and that installers can quickly activate the hardware and service. 22 -------------------------------------------------------------------------------- Telular's SkyBitz offering has several primary competitors in asset tracking for truck trailers. These include: ID Systems, Qualcomm and FleetLocate. In addition, there are a number of other, smaller competitors making the market for truck trailer asset tracking increasingly competitive. Telular differentiates our SkyBitz solutions by providing advanced features on the web portal through which our customers receive tracking data, maximizing battery life on the tracking units to minimize the frequency of changing batteries and through efficient design and manufacturing of our products to enable a low cost solution for our customers. Positively, we are seeing new demand for SkyBitz's services in other sectors, including oil/gas field services and intermodal transportation. There are numerous, small competitors to Telular's TankLink offering. The most significant of these is Centeron, a division of Robertshaw Industries, which in turn is a subsidiary of Invensys, Inc. More often, the TankLink offering competes against the pre-existing, manual methods utilized by tank owners to determine the fill level and reorder timing for products held within tank vessels. Telular believes the key to growing our TankLink revenue is lowering our prices to the greatest extent possible in order to cost justify implementation of the TankLink solution. While we have lowered prices somewhat to spur demand, we may further test the price elasticity of our TankLink solution in fiscal 2013. OUTLOOK The statements contained in this outlook are based on current expectations. These statements are forward looking, and actual results may differ materially. We expect to expend most of our marketing and product development resources on the M2M space, including continuing to capitalize on our favorable market position in the domestic security alarm market by virtue of our well-regarded Telguard offering, as well as continuing to improve overall penetration in the asset tracking and tank level monitoring markets through SkyBitz and TankLink, respectively. UNIT SALES During the second quarter of fiscal 2013, Telular sold approximately 40,100 Telguard units, compared with approximately 30,900 Telguard units for the same period in fiscal 2012. This increase was primarily due to continued demand for Telguard's 3G/4G products and to increased sales of the Personal Emergency Response System ("PERS") units. On a consolidated basis for the second quarter of fiscal 2013, Telular sold approximately 53,800 monitoring and asset tracking units with an average selling price ("ASP") of $185 compared with 40,500 units sold with an ASP of $186 in the same period of fiscal 2012. The increase in units and decrease in ASP is primarily due to product mix. For the six months ended March 31, 2013, Telular sold approximately 77,400 Telguard units, compared with approximately 61,700 Telguard units for the same period in fiscal 2012. This increase was primarily due to continued demand for Telguard's 3G/4G products and for increased sales of the PERS units. On a consolidated basis for the six months ended March 31, 2013, Telular sold approximately 104,600 monitoring and asset tracking units with an ASP of $194 compared with 72,620 units sold with an ASP of $171. This increase is due primarily to product mix and as a result of having a full six months of SkyBitz unit sales in the current six month period. SkyBitz was acquired on February 1, 2012, and therefore, the six month period ended March 31, 2012 only had two months of sales activity. SERVICE REVENUE Service revenues have grown consistently, increasing to $14,250 in the second quarter of fiscal 2013 compared to $11,418 of the same period in fiscal 2012. This increase is due to increased activations in the event monitoring segment and the inclusion of the services revenues of the asset tracking segment, which is represented by SkyBitz. SkyBitz was acquired on February 1, 2012, and therefore only two months of service revenues were included in the second quarter of fiscal 2012. Service revenues represent 57% of total sales in the second quarter of fiscal 2013 compared to 58% for the same period of fiscal 2012. Telguard service average revenue per unit ("ARPU") was $4.42 for the second quarter of fiscal 2013 as compared to $4.32 for the same period of fiscal 2012. The increase in ARPU was due to the combination of adding new subscribers and customer mix. Specifically, new customers are being activated with a higher ARPU as compared to those customers who are being deactivated. Our Telguard subscriber base rose in the quarter to approximately 639,700 from 621,700 subscribers at the end of the first quarter of fiscal 2013. This increase was due primarily to a strong overall demand of our Telguard products. Telular, on a company-wide basis, ended the first quarter of fiscal 2013 with approximately 877,500 billable units, with an ARPU of $5.50 as compared to 798,400 billable units and an ARPU of $5.47 for the same period of fiscal 2012. 23 -------------------------------------------------------------------------------- For the six month period ended March 31, 2013, service revenues were $28,229 compared to $19,704 for the same period of fiscal 2012. This increase is primarily due the inclusion of the service revenues of the asset tracking segment and increased activations in the event monitoring segment. In fiscal 2012, SkyBitz's only had two months of sales activity as compared to a full six months of sales activity in fiscal 2013. Service revenues represent 57% of total sales for the first six months of fiscal 2013 compared to 59% for the same period in fiscal 2012. Telguard ARPU was $4.43 for the six months ended March 31, 2013 as compared to $4.30 for the same period of fiscal 2012. The increase in ARPU was due to the combination of adding new subscribers and customer mix. Specifically, new customers are being activated with a higher ARPU as compared to those customers who are being deactivated. Our Telguard subscriber base rose in the period to approximately 639,700 from 617,500 subscribers at the end of the fourth quarter of fiscal 2012. This increase was due primarily to a strong overall demand of our Telguard products. RECENT DEVELOPMENTS Amendment to Second Amended and Restated Loan and Security Agreement On April 4, 2013, Telular executed the Second Amendment with SVB. Under the Second Amendment, Telular can borrow up to $5,000 in a revolving line of credit with the same interest rate terms as the Second Amended Loan Agreement. The revolving line of credit will terminate on the same day as the term loan matures under the Second Amended Loan Agreement, February 1, 2017, and any outstanding advance under the Second Amendment will then be due. The revolving line of credit is secured by substantially of the assets of Telular. Loan fees and related costs of $13 are being amortized over the term of the revolving line of credit Proposed Acquisition by Avista Capital Partners On April 29, 2013, Telular and Avista Capital Partners jointly announced that they have entered into a definitive agreement providing for the acquisition of Telular for $12.61 per share in cash and approximately $18.5 million in assumed net debt, or approximately $253 million in total consideration. The purchase price represents a 31% premium to the closing share price on April 26, 2013, the last full trading day before the proposed acquisition was announced, and a 27% premium to the 60-day average share price. The proposed acquisition has fully committed financing and is expected to close within 50-75 days of the signing of the definitive agreement. Shareholder Litigation On May 2, 2013, a putative stockholder class action complaint was filed in the Chancery Division of the Circuit Court of Cook County, Illinois, captioned Nicholas v. Telular Corp. et al., Case No. 2013-CH-11752 (which we refer to as the "Nicholas Complaint"). The Nicholas Complaint names as defendants Telular and certain officers and directors of the Telular Board (whom we refer to as the "Nicholas Complaint Defendants"). The Nicholas Complaint asserts two causes of action: breach of fiduciary duty against the Nicholas Complaint Defendants and aiding and abetting a breach of fiduciary duty against Telular. The Nicholas Complaint alleges that the Nicholas Complaint Defendants breached their fiduciary duties by causing Telular to enter into the Merger Agreement, by agreeing to sell Telular at an inadequate price, by failing to maximize the value of Telular, and by agreeing to preclusive deal protection devices that unduly restrict the ability of other potential acquirers to bid successfully for Telular. The plaintiff in the Nicholas Complaint seeks an injunction prohibiting consummation of the proposed transaction, rescission, to the extent already implemented, of the Merger Agreement, and fees and costs associated with prosecuting the action. On May 6, 2013, a putative stockholder class action complaint was filed in the Chancery Court of the State of Delaware, captioned Eichenbaum v. Telular Corp. et al., Case No. 8527 (which we refer to as the "Eichenbaum Complaint"). The Eichenbaum Complaint names as defendants, Telular, certain officers and directors of the Telular Board (whom we refer to as the "Eichenbaum Complaint Defendants"), Avista Capital Partners, Parent and Purchaser. The complaint asserts two causes of action: breach of fiduciary duty against the Eichenbaum Complaint Defendants and aiding and abetting a breach of fiduciary duty against Telular, Avista Capital Partners, Parent and Purchaser. The Eichenbaum Complaint alleges that the Eichenbaum Complaint Defendants breached their fiduciary duties by causing Telular to enter into the Merger Agreement, by agreeing to sell Telular at an inadequate price, by failing to maximize the value of Telular, and by agreeing to preclusive deal protection devices that unduly restrict the ability of other potential acquirers to bid successfully for Telular. The plaintiff in the Eichenbaum Complaint seeks an injunction prohibiting consummation of the proposed transaction, rescission and rescissory damages (to the extent the proposed transaction has already been consummated), an accounting by the Eichenbaum Complaint Defendants to the class for all damages suffered as a result of the alleged wrongdoing, and fees and costs associated with prosecuting the action. On May 6, 2013, a putative stockholder class action complaint was filed in the Chancery Division of the Circuit Court of Cook County, Illinois, captioned Levin v. Barker et al., Case No. 22013-CH-11977 (which we refer to as the "Levin Complaint"). The Levin Complaint names as defendants Telular, certain officers and directors of the Telular Board (whom we refer to as the "Levin Complaint Defendants"), Sponsors, Parent and Purchaser. The Levin Complaint asserts two causes of action: breach of fiduciary duty against the Levin Complaint Defendants and aiding and abetting a breach of fiduciary duty against Telular, Sponsors, Parent and Purchaser. The Levin Complaint alleges that the Levin Complaint Defendants breached their fiduciary duties by causing Telular to enter into the Merger Agreement, by agreeing to sell Telular at an inadequate price, by failing to maximize the value of Telular, and by agreeing to preclusive deal protection devices that unduly restrict the ability of other potential acquirers to bid successfully for Telular. The plaintiff in the Levin Complaint seeks an injunction prohibiting consummation of the proposed transaction, rescission and rescissory damages (to the extent the proposed transaction has already been consummated), an accounting by the Levin Complaint Defendants to the class for all damages suffered as a result of the alleged wrongdoing, and fees and costs associated with prosecuting the action. Announced Departure of Joseph A. Beatty On January 27, 2013, Mr. Joseph A. Beatty notified the Board of Directors of Telular that he will resign as President, Chief Executive Officer and Director of Telular for personal reasons. Mr. Beatty has agreed to remain as president and chief executive officer until the closing of the proposed acquisition by Avista. 24--------------------------------------------------------------------------------RESULTS OF OPERATIONS Second quarter fiscal year 2013 compared to second quarter fiscal year 2012 Revenues and Cost of Sales Change 2013 2012 Amount Percentage Revenues by Segment: Event monitoring $ 16,422 $ 13,861 $ 2,561 18 % Asset tracking 8,371 5,933 2,438 41 % Total revenues $ 24,793 $ 19,794 $ 4,999 25 % Change 2013 2012 Amount Percentage Revenues M2M service revenue $ 14,250 $ 11,418 $ 2,832 25 % M2M hardware sales 10,538 7,986 2,552 32 % Subtotal M2M 24,788 19,404 5,384 28 % Other product sales 5 390 (385 ) -99 % Total revenue 24,793 19,794 4,999 25 % Cost of sales M2M service cost of sales 4,137 3,155 982 31 % M2M hardware cost of sales 7,584 5,879 1,705 29 % Subtotal M2M 11,721 9,034 2,687 30 % Other product cost of sales 5 334 (329 ) -99 % Total cost of sales 11,726 9,368 2,358 25 % Gross margin $ 13,067 $ 10,426 $ 2,641 25 % Revenues Segment Event Monitoring ("EM") revenues increased 18% primarily due to the 28% increase in EM hardware sales, which was driven by continued growth of both security monitoring and tank monitoring hardware sales. The increase in Asset Tracking ("AT") revenues of $2,438 was primarily due the inclusion of SkyBitz activity for the full second quarter of fiscal 2013 compared to a partial second quarter for fiscal 2012. SkyBitz is the sole line of business in the AT segment. Type M2M service revenues increased 25% showing steady growth as a result of an increase in activations, the inclusion of SkyBitz for the full three months of the second quarter of fiscal 2013 as compared to two months of revenues in fiscal 2012, an overall higher ARPU and the inclusion of asset tracking services revenues. Telguard activated approximately 36,300 new subscribers during the second quarter of fiscal 2013 increasing its subscriber base to approximately 639,700. Telguard's ARPU increased to $4.42 for the second quarter of fiscal 2013, compared to $4.32 for the same period of fiscal 2012. This increase was due to a more favorable customer mix. New customers are being activated with a higher ARPU as compared to those customers who are being deactivated. M2M hardware sales increased 32% due to the inclusion of SkyBitz for the full three months of the second quarter of fiscal 2013 as compared to two months of revenues in the second quarter of fiscal 2012, and continued strong demand for Telguard products. Telular sold approximately 40,100 Telguard units during the second quarter of fiscal 2013, compared to 30,900 units during the same period of fiscal 2012. This increase was primarily due to stronger overall demand for our Telguard 3G/4G and PERS products. The ASP for Telguard units increased slightly to $138 for the second quarter of fiscal 2013 compared to $132 for the same period of fiscal 2012 due to a more favorable product mix. TankLink hardware revenues increased 62% for the second quarter of fiscal 2013 as compared to the same period of fiscal 2012. This increase is primarily due to increased unit volume sales. TankLink is focusing efforts to increase its revenue through its indirect sales channels which should result in increased unit sales, possibly at a lower ASP. Other product sales, which were primarily terminal products, decreased 99% because Telular is no longer selling these products. 25 --------------------------------------------------------------------------------Cost of Sales M2M service cost of sales increased 31% primarily as a result of including SkyBitz and due to increased billable units. As a percentage of service revenue, service cost was 29% for the second quarter of fiscal 2013 and 28% for the same period of fiscal 2012. Gross margin for M2M service was 71% for the second quarter of fiscal 2013 and 72% for the same period of fiscal 2012. M2M hardware cost of sales increased 29% primarily as a result of including SkyBitz and an increase in sales volume for both Telguard and TankLink. Contributing to an increase in hardware costs was the higher per unit cost to manufacture the 3G/4G units. Gross margin for monitoring hardware was approximately 28% for the second quarter of fiscal 2013, compared to 26% for the same period of fiscal 2012. The increase in gross margin was primarily due to product mix. Other product cost of sales decreased primarily as a result of decreased sales of other products. Operating Expenses Change % of Revenues 2013 2012 Amount Percentage 2013 2012 Engineering and development $ 2,540 $ 2,030 $ 510 25 % 10 % 10 % Selling and marketing 3,352 2,699 653 24 % 13 % 14 % General and administrative 3,882 3,644 238 7 % 16 % 18 % $ 9,774 $ 8,373 $ 1,401 39 % 42 % Engineering and Development The increase of $510 (25%) in engineering and development was primarily due to the following: · $385 increase in payroll and related benefits primarily due to including three months of SkyBitz engineering and development activity in the second quarter of fiscal 2013 as compared to two months of activity in the second quarter of fiscal 2012, general salary increases and increases in non-cash compensation; · $90 increase in outsourced engineering consultants due to additional projects at SkyBitz; and · $35 increase in expenses related to building prototypes. Selling and Marketing The increase in selling and marketing of $653 (24%) was primarily due to the following: · $555 increase in payroll expenses primarily due to including three months of SkyBitz selling and marketing activity in the second quarter of fiscal 2013 as compared to two months of activity in the second quarter of fiscal 2012, general salary increases, increased commissions and increases in non-cash compensation; · $201 increase in the SmartLogix earnout; which was completely paid out during the period; and, · $19 increase in travel expenses. The increases were offset by a $122 decrease in specific expenditures such as trade shows, advertising and collateral. General and Administrative The increase of $238 (7%) was primarily due to a $448 increase amortization expense related to the acquisition of SkyBitz and due to including three months of amortization expense in the second quarter of fiscal 2013 as compared to two months of amortization expense in the second quarter of fiscal 2012, offset by a $210 decrease in SkyBitz's professional fees, primarily related to legal and audit fees. 26--------------------------------------------------------------------------------Other Expense Other expense for the three months ended March 31, 2013 increased $32 compared to the same period of fiscal 2012. This increase was primarily due to interest expense related to the Second Amended Loan Agreement with SVB entered into in connection with the acquisition of SkyBitz on February 1, 2012. Income Taxes The provision for income taxes increased $526 to $1,253 for the first quarter of fiscal 2013 as compared to $727 for the same period of fiscal 2012 primarily as a result of increased net income before taxes. First six months of fiscal year 2013 compared to the first six months of fiscal year 2012 Revenues and Cost of Sales Change 2013 2012 Amount Percentage Revenues by Segment: Event monitoring $ 32,000 $ 27,566 $ 4,434 16 % Asset tracking 17,575 5,933 11,642 >100 % Total revenues $ 49,575 $ 33,499 $ 16,076 48 % Change 2013 2012 Amount Percentage Revenues M2M service revenue $ 28,229 $ 19,704 $ 8,525 43 % M2M hardware sales 21,327 13,017 8,310 64 % Subtotal M2M 49,556 32,721 16,835 51 % Other product sales 19 778 (759 ) -98 % Total revenue 49,575 33,499 16,076 48 % Cost of sales M2M service cost of sales 8,161 5,465 2,696 49 % M2M hardware cost of sales 15,907 9,112 6,795 75 % Subtotal M2M 24,068 14,577 9,491 65 % Other product cost of sales 17 982 (965 ) -98 % Total cost of sales 24,085 15,559 8,526 55 % Gross margin $ 25,490 $ 17,940 $ 7,550 42 % Revenues Segment EM revenues increased 16% primarily due to the 21% increase in EM hardware sales, which was driven by continued growth of both security monitoring and tank monitoring hardware sales. The increase in AT revenues of $11,642 was primarily due the inclusion of SkyBitz activity for the entire first six months of fiscal 2013 and compared to only two months for fiscal 2012. SkyBitz is the sole line of business in the AT segment. Type M2M service revenues increased 43% showing steady growth as a result of an increase in activations, the inclusion of SkyBitz for the full six months of the first half of fiscal 2013 as compared to two months of revenues in fiscal 2012, an overall higher ARPU and the inclusion of asset tracking services revenues. Telguard activated approximately 71,700 new subscribers during the first six months of fiscal 2013 increasing its subscriber base to approximately 639,700. Telguard's ARPU increased to $4.43 for the first six months of fiscal 2013, compared to $4.30 for the same period of fiscal 2012. This increase was due to a more favorable customer mix. New customers are being activated with a higher ARPU as compared to those customers who are being deactivated. 27 -------------------------------------------------------------------------------- M2M hardware sales increased 64% due to the inclusion of SkyBitz for the full six months of the first half of fiscal 2013 as compared to two months of revenues in the second quarter of fiscal 2012, and continued strong demand for Telguard products. Telular sold approximately 77,400 Telguard units during the first six months of fiscal 2013, compared to 61,700 units during the same period of fiscal 2012. This increase was primarily due to stronger overall demand for our Telguard 3G/4G and PERS products. The ASP for Telguard units increased slightly to $137 for the first six months of fiscal 2013 compared to $133 for the same period of fiscal 2012 due to a more favorable product mix. TankLink hardware revenues increased 50% for the first six months of fiscal 2013 as compared to the same period of fiscal 2012. This increase is primarily due to increased unit volume sales. TankLink is focusing efforts to increase its revenue through its indirect sales channels which should result in increased unit sales, possibly at a lower ASP. Other product sales, which were primarily terminal products, decreased 98% because Telular is no longer selling these products. Cost of Sales M2M service cost of sales increased 49% primarily as a result of including SkyBitz for the full period and due to increased billable units. As a percentage of service revenue, service cost was 29% for the first six months of fiscal 2013 and 28% for the same period of fiscal 2012. Gross margin for M2M service was 71% for the second quarter of fiscal 2013 and 72% for the same period of fiscal 2012. M2M hardware cost of sales increased 75% primarily as a result of including SkyBitz and an increase in sales volume for both Telguard and TankLink. Contributing to an increase in hardware costs was the higher per unit cost to manufacture the 3G/4G units. Gross margin for monitoring hardware was approximately 25% for the first six months of fiscal 2013, compared to 30% for the same period of fiscal 2012. The decrease in gross margin was primarily due to product mix. Other product cost of sales decreased primarily as a result of decreased sales of other products. Operating Expenses Change % of Revenues 2013 2012 Amount Percentage 2013 2012 Engineering and development $ 4,635 $ 3,317 $ 1,318 40 % 9 % 10 % Selling and marketing 6,517 4,484 2,033 45 % 13 % 13 % General and administrative 7,413 5,518 1,895 34 % 15 % 16 % $ 18,565 $ 13,319 $ 5,246 37 % 39 % Engineering and Development The increase of $1,318 (40%) in engineering and development was primarily due to having six months of SkyBitz engineering and development expenses for the first six months of fiscal 2013 as compared to having two months of SkyBitz engineering and development expenses for the same period of fiscal 2012. Selling and Marketing The increase in selling and marketing of $2,033 (45%) was primarily due to having six months of SkyBitz selling and marketing expenses for the first six months of fiscal 2013 as compared to having two months of SkyBitz selling and marketing expenses for the same period of fiscal 2012, $220 increase in the SmartLogix earnout (which has been completely paid in the second quarter of fiscal 2013) and a $137 increase in payroll and benefits primarily due to increased commissions and non-cash compensation. General and Administrative The increase of $1,895 (34%) was primarily due to having six months of SkyBitz general and administrative expenses for the first six months of fiscal 2013 as compared to having two months of SkyBitz general and administrative expenses for the same period of fiscal 2012. The largest single component of this increase is $1,862 of amortization expense related to the intangibles recorded as a result of the SkyBitz acquisition. 28-------------------------------------------------------------------------------- Other Expense Other expense for the six months ended March 31, 2013 increased $247 compared to the same period of fiscal 2012. This increase was primarily due to interest expense related to the Second Amended Loan Agreement with SVB entered into in connection with the acquisition of SkyBitz on February 1, 2012. Income Taxes The provision for income taxes increased $802 to $2,473 for the first six months of fiscal 2013 as compared to $1,671 for the same period of fiscal 2012 primarily as a result of increased net income before taxes. For the six months ended March 31, 2013 and 2012, the effective tax rates were 37.9% and 37.4%, respectively. LIQUIDITY AND CAPITAL RESOURCES Management regularly reviews net working capital in addition to available cash to determine if it has enough cash to operate the business. On March 31, 2013, Telular had $6,920 of cash and cash equivalents and working capital of $16,956, compared to cash and cash equivalents of $12,676 and working capital of $16,630 on September 30, 2012. Simultaneous with the acquisition of SkyBitz on February 1, 2012, Telular executed a Second Amended Loan Agreement with SVB. Under the Second Amended Loan Agreement, Telular borrowed $30,000 in the form of a term loan that was applied as a portion of the cash consideration for the acquisition of SkyBitz. The term loan matures on February 1, 2017, the 5th anniversary of the amendment. The loan requires quarterly payments of interest and principal, with annual principal amortization of 10%, 15%, 20%, 20% and 25% in each of the first five years, respectively, with the final 10% due on the maturity date. At the option of Telular, interest will be incurred based on a rate ranging from 2.25% to 2.75% (depending on the calculation of the senior leverage ratio) above the published LIBOR rates, or at a rate of .25% to .75% above the Prime interest rate. The interest rate was 3% as of March 31, 2013. The Second Amended Loan Agreement requires Telular to comply with certain financial covenants such as maintaining a maximum senior leverage ratio and a minimum fixed charge coverage ratio. As long as the senior leverage ratio is greater than 1.0 to 1.0 as of any fiscal year-end, Telular must make additional principal payments based on excess cash flow, as defined in the Second Amended Loan Agreement, calculated on an annual basis. During January 2013, Telular repaid $1,612 of principal based on this excess cash flow calculation. The loan is secured by substantially all of the assets of Telular. At March 31, 2013 the outstanding loan balance was $25,388 and Telular was in compliance with all financial covenants. Loan fees and related costs of $338 are being amortized over the term of the loan. On April 4, 2013, Telular executed the Second Amendment with SVB. Under the Second Amendment, Telular can borrow up to $5,000 in a revolving line of credit with the same interest rate terms as the Second Amended Loan Agreement (see above). The revolving line of credit will terminate on the same day as the term loan matures under the Second Amended Loan Agreement, February 1, 2017, and any outstanding advance under the Second Amendment will then be due. The revolving line of credit is secured by substantially of the assets of Telular. Loan fees and related costs of $13 are being amortized over the term of the revolving line of credit. Management expects trade accounts receivable and inventory to turn into cash in short periods of time. As such, given Telular's level of cash and cash equivalents, trade accounts receivable, inventory and the new revolving line of credit, management believes Telular has adequate resources to fund current and planned operations in a manner consistent with historical practices. 29 --------------------------------------------------------------------------------Operations Telular generated $1,548 of cash from operations during the first six months of fiscal year 2013 compared to cash generated of $4,803 during the same period of fiscal year 2012. The components of the cash generated are as follows: The increase in trade accounts receivable is due primarily to the $ (1,964 ) timing of customer payments and increased sales volume. The increase in inventory reflects Telular's incremental build-up to (1,672 ) support sales growth. The increase in prepaid expenses and other assets is primarily due (2,830 ) to $2,500 paid to a business partner: $500 for joint development and $2,000 for royalties. No royalties have been earned to date in accordance with the agreement. Trade accounts payable primarily consists of amounts due to (1,410 ) Telular's contract manufacturers and inventory suppliers. The decrease reflects timing of payments related to inventory purchases from these vendors. The decrease in accrued liabilities was primarily due to payments (1,524 ) made during the first quarter for bonuses earned in fiscal 2012. Non-cash expenses: $3,135 amortization expense, primarily related to 6,160 the intangibles purchased in the acquisition of of SkyBitz; $974 from stock based compensation; $734 of depreciation expense; $1,300 increase in deferred tax provision primarily due to the utilization of net operating loss carryforwards; and, $17 loss on disposal of operating assets. Net cash provided by other working capital items dueprimarily to an 737 increase in income taxes payable 4,051 Income from continuing operations; cash provided. $ 1,548 Total cash provided by continuing operations Investing Activities Investing activities used $1,651 of cash for the first six months of fiscal 2013 for the acquisition of capital equipment. This compares to cash used by investing activities of $43,353 for the same period of fiscal 2012: $42,783 for the acquisition of SkyBitz and $570 for the purchase of capital equipment. The capital equipment purchases for the first six months of fiscal 2013 were primarily for the re-architecture of the Telguard website, the establishment of the Telguard message center at a secure offsite location and improvements in Telular's internal technology network. Financing Activities Financing activities used $5,653 of cash for the first six months of fiscal 2013 as a result of the payment of cash dividends of $4,109, the repayment of loan principal of $3,112 and the repurchase of outstanding warrants of $113. Offsetting these payments was $1,681 of cash received from the exercise of stock options. For the same period of fiscal year 2012, cash of $36,055 was generated from investing activities as follows: · $30,000 of proceeds from the new loan from SVB for the acquisition of SkyBitz; · $8,760 related to stock issued for the acquisition of SkyBitz · $739 related to the exercise of stock options; less, · $3,444 of dividends paid during the period. Critical Accounting Policies Telular's financial statements are based on the selection and application of significant accounting policies, which require management to make significant estimates and assumptions. Telular believes that the following represent the critical accounting policies that currently affect the presentation of Telular's financial condition and results of operations. Revenue Recognition Telular's revenue is primarily generated from three sources: · The sale of hardware units, under non-recurring agreements; · The provision of monitoring services, under recurring agreements; and, · The provision of ancillary services such as installation and non-warranty repairs and royalty revenue. Revenue is recognized when persuasive evidence of an agreement exists, the hardware unit or the service has been delivered, fees and prices are fixed and determinable and collectability is probable when all other significant obligations have been fulfilled. 30 -------------------------------------------------------------------------------- Telular recognizes revenue and associated costs from hardware unit sales at the time of shipment of products which is when title transfers. Hardware unit discounts are recorded as a reduction in revenue in the same period that the revenue is recognized. Telular offers customers the right to return hardware units that do not function properly within a limited time after delivery, see the section entitled "Reserve for Warranty" below. Telular continuously monitors and tracks such hardware unit returns and records a provision for the estimated amount of such future returns, based on historical experience. While such returns have historically been within expectations, Telular cannot guarantee that it will continue to experience the same return rates that it has experienced in the past. Any significant increase in hardware unit failure rates and the resulting credit returns could have a material adverse impact on operating results for the period or periods in which such returns materialize. Monitoring service revenue is recognized at the time the service is provided. Payments received in advance of providing monitoring services are deferred and recognized over the period in which the service is delivered. Costs associated with providing the monitoring service are recorded when the service is provided. For those arrangements that include multiple deliverables, Telular follows the guidance in Accounting Standard Codification ("ASC") Subtopic 605-25, as amended by Accounting Standards Update ("ASU") 2009-13. ASC Subtopic 605-25 established criteria for determining if a revenue arrangement has multiple deliverables. ASU 2009-13 amended the multiple-element revenue guidance to (1) modify the separation criteria by eliminating the criterion that requires objective and reliable evidence of fair value for the undelivered item, and (2) eliminate the use of the residual method of allocation and instead required that arrangement consideration be allocated, at the inception of the arrangement, to all deliverables based on their relative selling price. Certain multiple-element revenue arrangements include both product and monitoring services. Telular has determined that the revenue from multiple-deliverable arrangements has met the criteria for treating each revenue source as a separate element. Consideration is allocated to the deliverables at inception of an arrangement using the relative selling price method, based on Telular's best estimate of selling price. Key factors that are considered when establishing a selling price are the industry segment to which the products and services are sold, estimated selling price of our competitors, where available, and an internally established gross margin range. Product revenue is billed and recognized upon shipment to the customer while monitoring services revenue is billed periodically, usually monthly, and recognized when the service is provided. Telular recognizes ancillary service revenues when the service is delivered. Costs associated with these services are recorded in the period the service is delivered. Royalty revenue, which is based on a percentage of sales by the licensee, is estimated by Telular, based upon historical data provided by the licensee, in the period in which management estimated the sales have taken place. Telular periodically reconciles these estimates to the actual payments received from the licensee, adjusting revenue accordingly. Historically, Telular's estimates have not been materially different than the payments received from the licensee. Allowance for Doubtful Accounts Telular maintains an allowance for doubtful accounts for estimated losses resulting from the inability of customers to make payment for products and services. Telular evaluates the collectibility of customer receivables by considering the payment history and the financial stability of its customers. If Telular believes that an account receivable may not be collected, a charge is recorded to the allowance account. At March 31, 2013 and September 30, 2012, the allowance for doubtful accounts related to trade accounts receivable was $402 and $351, respectively. Reserve for Obsolescence Significant management judgment is required to determine the reserve for obsolete or excess inventory. Telular currently considers inventory quantities greater than a one-year supply based on current year activity, to be excess unless that inventory has alternative uses. Telular also provides for the total value of inventories that are determined to be obsolete based on criteria such as customer demand and changing technologies. At March 31, 2013, and September 30, 2012, the inventory reserves were $374 and $283, respectively. Changes in strategic direction, such as discontinuance or expansion of product lines, changes in technology or changes in market conditions, could result in significant changes in required reserves. Reserve for Warranty Telular maintains a reserve for products that are returned within Telular's warranty period due to inoperability. Telular has different warranty periods for its different product groups: the security monitoring products has a 24 month warranty period; the asset tracking and tank monitoring products typically have a 12 month warranty period. Significant management judgment is required to determine the warranty reserve. Telular utilizes historical information regarding units returned within the appropriate warranty period and the costs incurred to repair returned units. Telular then estimates required warranty reserves for future products that may be returned. As of March 31 2013 and September 30, 2012, the warranty reserve was $1,346 and $1,542, respectively. The decrease in the warranty reserve is primarily a result of the continued expiration of SkyBitz units that were sold under a five-year warranty. Telular is no longer offering such warranties for SkyBitz products. 31 --------------------------------------------------------------------------------Goodwill and Intangible Assets Telular evaluates the fair value and recoverability of its goodwill in accordance with Accounting Standards Update No. 2011-08, Intangibles - Goodwill and Other (Topic 350), at least annually or whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable. In determining fair value and recoverability, Telular makes projections regarding future cash flows. These projections are based on assumptions and estimates of: · growth rates for net revenues, cost of sales and operating expenses for the monitoring businesses; · anticipated future economic conditions; · the assignment of discount rates relative to risk associated with companies in similar industries, and, · estimates of terminal values. An impairment loss is assessed and recognized in operating earnings when the fair value of the asset is less than its carrying amount. As of March 31, 2013 and September 30, 2012, goodwill was not impaired. Telular reviews for the impairment of intangible assets whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Telular evaluates recoverability of other intangible assets by comparing the carrying amount of the intangible asset to future net undiscounted cash flows generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceed the fair value of the assets calculated using a discounted cash flow analysis. Income Taxes In determining income for financial statement purposes, Telular must make certain estimates and judgments. These estimates and judgments affect the calculation of certain tax liabilities and the determination of the recoverability of certain of the deferred tax assets, which arise from temporary differences between the tax and financial statement recognition of revenue and expense. In evaluating the ability to recover its deferred tax assets, Telular considers all available positive and negative evidence including its past operating results, the existence of cumulative losses and its forecast of future taxable income. In estimating future taxable income, Telular developed assumptions including the amount of future federal and state pre-tax operating income, the reversal of temporary differences, the utilization of net operating loss ("NOLs") carryforwards to offset taxable income and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates Telular is using to manage the underlying business. Telular has recorded significant valuation allowances that are intended to be maintained until it is more likely than not the deferred tax asset will be realized. The valuation allowance as of March 31, 2013 of $5,710 is primarily for state net operating losses that will expire before they can be realized. The realization of the remaining deferred tax assets is primarily dependent on future taxable income in the appropriate state jurisdiction. Significant factors that could negatively impact Telular's determination of the recognition of the net deferred tax assets would be changes in the ownership of Telular and changes in tax laws and rates. Based on Internal Revenue Code Section 382 ("Section 382"), changes in the ownership of Telular may limit the utilization of net operating loss carryforwards. Any Section 382 limitation may require that Telular record an additional valuation allowance against its deferred tax assets. Management is not aware, at this time, of any such ownership changes that would have a negative impact on the recognition of the net deferred tax assets. Any reduction in future taxable income may require that Telular record an additional valuation allowance against the deferred tax assets. An increase in the valuation allowance would result in additional income tax expense in such period and could have a material impact on Telular's future earnings. Changes in tax laws and rates could also affect recorded deferred tax assets and liabilities in the future. The State of Illinois increased its corporate income tax rate from 7.3% to 9.5% in January 2011. The State also suspended the use of net operating losses to offset current taxable income for three years. Telular implemented a tax strategy that would lower taxable income apportioned to Illinois, thereby lowering the current state tax payable. This strategy reduced Telular's estimated use of future net operating losses in Illinois, resulting in the increase in the valuation allowance against the net deferred tax assets which increased Telular's deferred tax provision. 32-------------------------------------------------------------------------------- In December 2011, the State of Illinois passed tax legislation allowing for the utilization of $100,000 of NOLs per year for the period over which the State suspended use of NOLs. Under the uncertain tax position provisions of ASC 740, Income Taxes, Telular would recognize liabilities for tax issues in the U.S based on Telular's estimate of whether, and the extent to which, additional taxes will be due. These tax liabilities would be recorded in income taxes in the Consolidated Balance Sheets. As of December 31, 2012, Telular has no uncertain tax positions recorded in its financial statements. Telular does not include interest and penalties related to income tax matters in income tax expense. |