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AXESSTEL INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements Statements in the following discussion and throughout this report that are not historical in nature are "forward-looking statements". Although we believe the expectations reflected in these forward-looking statements are reasonable, such statements are inherently subject to risk and we can give no assurances that our expectations will prove to be correct. Actual results could differ from those described in this report because of numerous factors, many of which are beyond our control. These factors include, without limitation, those described under Item 1A "Risk Factors." We undertake no obligation to update these forward-looking statements to reflect events or circumstances after the date of this report or to reflect actual outcomes. Please see "Special Note Regarding Forward Looking Statements" at the beginning of this report. The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes and other financial information appearing elsewhere in this report. Overview We provide wireless voice, broadband access and connected home solutions for the worldwide telecommunications market. Our product portfolio includes phones, wireline replacement terminals, 3G and 4G broadband gateway devices, and security alert systems used to access voice calling, high-speed data and connected home management services. Our wireless phones, 3G and 4G gateway devices, and security alert systems have similar functionality to phones, modems and alarm systems that use traditional wireline telecommunications and cable networks; however, our products are wireless and can be substituted for wired devices. Our products are based on CDMA (Code Division Multiple Access), GSM (Global System for Mobile Communications), GPRS (General Packet Radio Service), WCDMA (Wideband Code Division Multiple Access), and HSPA (High-Speed Packet Access) technologies. We develop and manufacture our products with third party engineering and manufacturing suppliers, principally based in China. Our internal design team works with these manufacturers to develop and customize products to incorporate our design and functional requirements on their baseline designs. We strive to retain intellectual property rights in key areas, while outsourcing commoditized work. We use this approach to reduce research and development expenses, shorten time to market for new products, and leverage supply chains and economies of scale to reduce product costs. We sell our products to telecommunications operators worldwide. In developing countries where large segments of the population do not have telephone or internet service, telecommunications operators deploy wireless networks as a more cost effective alternative to traditional wired communications. In developed countries telecommunications operators are using wireless networks to augment or supplant existing wire-line infrastructure. Currently, our largest customers are located in Poland, South Africa and the United States. Recent Developments We experienced mixed results in the first quarter of 2013, with some revenue and cash flow challenges, but also some positive trends with respect to our new Home Alert product line, gross margin percentage, and working capital. Our business is subject to volatility quarter to quarter, based on the timing of large customer orders and the impact of new product releases. Those factors impacted the first quarter, but underlying the top-line results, we made significant progress on a number of key initiatives during the quarter. Challenges for the first quarter included: • Revenue of $10.1 million • No orders for gateway products from our largest customer in Europe • No orders for wireline replacement terminals from our largest customer in North America • Delays in account receivable collection as a result of delayed collection from a customer in Europe and minor testing and warranty issues in MEA Despite these setbacks, highlights for the first quarter included: • Strong sales of our Home Alert product line to new customers in the MEA region • Gross margins of 29% due to strong margins on the Home Alert product line • Net income of $84,000 on lower than expected revenue • New $2.3 million term loan from Silicon Valley Bank • Improvement in working capital by $95,000 13 -------------------------------------------------------------------------------- Table of Contents Revenues were $10.1 million for the first quarter of 2013, down from $12.0 million in the first quarter of last year. The decline in revenues resulted primarily from slower sales of our top-selling gateway product, which were $4.3 million in the first quarter of 2013, down from $9.0 million in the prior year. In Europe, our most significant customer in Scandinavia did not place orders during the first quarter as it worked though accumulated inventory. The customer plans to conduct a marketing campaign to bolster demand for its wireless broadband service and our gateway devices during the second quarter, and we expect to receive additional orders either late in the second quarter or in the third quarter. We are also bringing our new dual mode gateway device to market in Europe. That device supports both GSM and CDMA technologies and is designed for use on the edge of network coverage, allowing wireless carriers with rural coverage areas to expand their addressable market. Customers in Scandinavia and Poland conducted homologation and testing on the new dual mode gateway during the first quarter. We have completed testing with one customer and expect testing for the second customer to be completed in the second quarter with orders following shortly thereafter. Based on discussions with these customers, we expect overall sales for our gateway products to pick up again in the late second or early third quarter. Sales of our wireline replacement terminals were also down from the prior year. Terminal sales were $1.6 million for the quarter, down from $2.6 million in the prior year. Sprint was our principal customer for terminals in North America in 2012. We did not receive any orders for terminals from Sprint during the first quarter of 2013, as it bought its requirements from another vendor. We did have strong sales of terminals to regional wireless carriers. Our regional customers in North America purchased $1.6 million of terminals during the first quarter of 2013, compared to $553,000 for all of 2012. We are completing development of the second generation of our wireline replacement terminal, which is targeted for the North American market. We are continuing to work with Sprint and other national vendors in North America to be a second source for their wireline replacement terminal opportunities. Finally, we are developing an upgraded wireline replacement terminal product which integrates our Home Alert product features. This product is scheduled to launch in the second half of 2013. Offsetting the lower gateway and terminal sales were strong numbers from the launch of our new Axesstel Home Alert product line. We sold $4.0 million of our new security alert devices in the first quarter of 2013, primarily to new customers in the MEA region. In the first two quarters following its release, we have sold $7.5 million of our alert devices to five new customers in Africa. As these customers initiate their marketing campaigns and sell through initial inventories, we expect to receive follow-on orders. We are also receiving interest from other carriers in that region. Wireless carriers in North America are conducting homologation and testing of our alert devices for launch later in 2013, and we are continuing to receive interest in the product line from carriers in other markets as well. We have multiple product releases scheduled for our Axesstel Home Alert product line throughout 2013 that are targeted to address the requirements of specific geographic regions or customers. Overall, revenues in the first quarter of 2013 by geographic region based on customer locations were as follows: Three Months Ended March 31, March 31, 2013 2012 Revenues Europe $ 4,318,780 $ 6,650,010 MEA 4,011,500 929,000 North America (United States and Canada) 1,640,752 3,950,976 Latin America 153,400 367,600 Asia 0 134,415 Total revenues $ 10,124,432 $ 12,032,001 Revenues by product line for the first quarter of 2013 were as follows: Three Months Ended March 31, March 31, 2013 2012 Revenues Broadband gateways $ 4,318,780 $ 9,020,529 Security alert systems 4,011,500 0 Wireline replacement terminals 1,640,752 2,643,512 Phones 153,400 367,960 Total revenues $ 10,124,432 $ 12,032,001 Sales of our Home Alert product lines boosted gross margin for the first quarter to a record 29%, compared to 26% in the first quarter of 2012. We also kept operating expenses near historic lows. Operating expenses during the quarter were $2.7 million compared to $2.3 million for the first quarter of 2012. Through the combination of improved gross margin percentage and tight control over operating expenses, we were able to generate net income of $84,000 for the three months ended March 31, 2013 on $10.1 million of revenue. This compares to net income of $472,000 for the three months ended March 31, 2012, generated on $12.0 million of revenue. We continued to see improvement in working capital in the first quarter. In addition to our Q1 2013 net income of $84,000, in March 2013, we entered into a $2.3 million three year term loan with Silicon Valley Bank. The term loan bolstered our cash position, reduced our short-term borrowing requirements, and further improved our working capital position. Payments on the term loan are interest only during the first six months and then require equal fixed monthly payments of principal and interest over the remaining 30 months of the loan. In addition, a one-time payment of $45,000 is due at the time the loan is repaid. Interest on the Silicon Valley Bank term loan accrues at 6% per annum. In September 2012, we entered into a $7.7 million promissory note with WNC as part of a settlement of all amounts arising out of our past manufacturing relationship. The WNC Note obligates us to make payments of $50,000 per month, plus a payment by March 31 each year equal to 50% of the prior years net income less $600,000. In the first quarter of 2013, we made payments of $1.8 million on the Note. At March 31, 2013, the aggregate amount outstanding under the Note was $5.8 million. Against these positive trends, we experienced delayed collections of accounts receivable which resulted in higher loan balances under our bank credit facilities. In Europe, a significant customer has been slow to pay for fourth quarter 2012 shipments. We collected a significant portion of this account following the end of the quarter and expect the balance to be paid shortly. In MEA, we had two testing and warranty events on our new phone and Home Alert products that caused a delay in collection in our accounts receivables out of that region. In one situation, the wireless carrier used the wrong version of the software in its acceptance testing for the product. 14 -------------------------------------------------------------------------------- Table of Contents Once the testing software was replaced, the products were accepted, but the retesting delayed the wireless carrier's launch of the products to its customers and payment of our account. In the second event, a minor repair was required to replace a capacitor on an order of security alert devices. The aggregate repair cost was only $30,000 for the quarter, but the turn-around time for the repair delayed collection from the wireless carrier. Because of these events, our accounts receivable balance increased during the first quarter by $6.7 million to $21.9 million. We increased borrowings under our working capital based credit line to manage our accounts payable to our key vendors. At March 31, 2013, we had borrowings of $6.0 million under our $7.0 million credit line. We expect to collect the accounts and pay down our working capital based credit line to more normal levels over the next several months. Subsequent to the end of the first quarter, we renewed our 10 million Yuan ($1.6 million) term loan with the commercial bank in China on the same basic terms as the previous loan. The new term loan matures on April 8, 2014. Outlook In order to achieve profitability under our current business model, we need to generate minimum revenues of $50 to $60 million annually with gross margins in the mid to low twenty percent range. We have developed a significant base of customers and key products and will continue to work closely with new and current customers to launch additional products in 2013. We are looking to maintain our market share in Europe with our broadband gateway devices and expand our addressable market with the launch of our dual-mode gateway device. We are looking to add functionality in our next generation wireline replacement terminals and look for additional OEM opportunities in North America. However, that market has become more challenging with larger Chinese competitors offering significant price reductions for a base model terminal. We have launched the initial products in our Axesstel Home Alert product line with new key customers in the MEA region. Based on initial discussions with wireless network operators in North America and globally, we expect that product line will be well received in a number of other markets as well and has the potential to be one of our largest selling product lines. Our primary operating goals for 2013 are to maintain consistent profitability and to increase revenue by ten to fifteen percent year over year. First quarter 2013 revenues were lower than first quarter 2012. We now anticipate that first half revenue will be lower than planned due to a slower rollout of our new products in 2013 and delays in customer testing and customer acceptance. We are releasing the next generation of our core products, as well as additions to our Home Alert products. Initial customer feedback suggests that these products will be well received, but the precise timing and success of these product introductions will have a material impact on our full year results. The slower first half of the year will make it more difficult to meet our goal for annual revenue growth. However, we believe we will be very well positioned for growth in the second half of the year and beyond. For the year, we are targeting gross margins in the mid twenty percent range. The economic and competitive climate remains challenging and price competition in our markets remains intense. We anticipate erosion in the average selling prices for our products in 2013. Any significant shift in product mix or reduction of average selling prices that are not offset by cost reductions will negatively impact gross margins. We believe that our current operating infrastructure can support higher revenues, and if we can successfully scale our revenues, we expect to reduce operating expenses as a percentage of revenue. Revenues We sell our products directly and through third party distributors to telecommunications operators worldwide. Revenues are recorded at the prices charged to the telecommunications operator or, in the case of sales to distributors, at the price to the distributor. Our products are sold on a fixed price-per-unit basis. The telecommunications operators resell our products to end users as part of the end users' service activation. All of our sales are based on purchase orders or other short-term arrangements. We negotiate the pricing of our products based on the quantity and the length of the time for which deliveries are to be made. For orders involving a significant number of units, or which involve deliveries over a long period of time, we typically receive rolling forecasts or a predetermined quantity for a fixed period of time from our customers, which in turn allows us to forecast internal volume and component requirements for manufacturing. In order to minimize our collection risks, we attempt to sell to our international customers under guaranteed letters of credit or open terms secured by credit insurance. At times, we extend credit based on our evaluation of the customer's financial condition. In order to minimize foreign exchange risk, we have made all sales to date in United States dollars. Cost of Goods Sold Cost of goods sold consists of direct materials, manufacturing expense, freight expense, warranty expense, royalty fees, and the cost of obsolete inventory. The wireless communications industry has been characterized by declining average selling prices, particularly over the past three years. We expect this trend to continue. We actively manage our costs of goods sold through the following initiatives: outsourcing manufacturing to larger contract manufacturers who can achieve economies of scale; increasing our purchasing power through increased volume; using standardized parts across our product lines; contracting with manufacturing partners in low cost regions; engineering our products with new technologies and expertise to decrease the number of components; and increasing reliance on software based applications rather than hardware. 15 -------------------------------------------------------------------------------- Table of Contents Research and Development Research and development expenses consist primarily of salaries and related payroll expenses for engineering personnel, facility expenses, employee travel, contract engineering fees, prototype development costs, test fees and depreciation of developmental test equipment for software, mechanical and hardware product development. We expense research and development costs as they are incurred. Selling, General and Administrative Selling, general and administrative expenses consist primarily of salaries and related payroll expenses for executive and operational management, finance, human resources, information technology, sales and marketing, program management and administrative personnel. Other costs include facility expenses, employee travel, bank and financing fees, insurance, legal expense, internal and external commissions, collection fees, accounting, consulting and professional service providers, board of director expense, stockholder relations, amortization of intangible assets, depreciation expense of software and other fixed assets, and bad debt expense. Critical Accounting Policies and Estimates Management believes that the most critical accounting policies important to understanding our financial statements and financial condition are our policies concerning Revenue Recognition, Accounts Receivable, and Warranty Costs. Revenue Recognition Our Revenue Recognition policy calls for us to recognize revenue on sales when ownership and title pass to the customer. We generally sell our products either FCA (Free Carrier) shipping port, or DDU (Delivery Duty Unpaid). When we ship FCA shipping port, title and risk of loss pass when product is received by the customer's freight forwarder. When we ship DDU, title and risk of loss pass when product is received at the customer's warehouse. Because our sales are characterized by large orders, the timing of when the revenue is recognized may have a significant impact on results of operations. Accounts Receivable-Allowance for Doubtful Accounts Under our Accounts Receivable policy, our management exercises judgment in establishing allowances for doubtful accounts based on information collected from individual customers. Several factors make these allowances significant to our financial position. We have traditionally experienced high customer concentration, resulting in large accounts receivable from individual customers. The determination of the credit worthiness of these customers and whether or not an allowance is appropriate could have a significant impact on our results of operations. Warranty Costs Our standard terms of sale provide a limited warranty, generally for a period of one to two years from purchase or initialization of the product. We establish a warranty reserve based on management's estimates of anticipated service and replacement costs over the term of outstanding warranties. Management's estimates are based on historical warranty experience. However, we frequently introduce new products to the market. In addition, our products are purchased from third party design and manufacturing firms, or are comprised of components acquired from third party suppliers, which are manufactured and assembled to our specifications by contract manufacturers. As a result, we may have limited experience from which to establish an estimate for an applicable warranty reserve for a specific product. Any significant change in warranty expense may have a substantial impact on our results of operations. Accounting Policies and Estimates Please see "Note 3-Significant Accounting Policies" to our financial statements for a more complete discussion of the accounting policies we have identified as the most important to an understanding of our current financial condition and results of operations. The preparation of financial statements in conformity with United States generally accepted accounting principles, or "GAAP," requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Management routinely makes judgments and estimates about the effects of matters that are inherently uncertain. As the number of variables and assumptions affecting the probable future resolution of the uncertainties increase, these judgments become even more subjective and complex. 16 -------------------------------------------------------------------------------- Table of Contents Quarterly Results of Operations The following table sets forth, for the periods indicated, the consolidated statements of operations data and the percentages of total revenues. ($ in thousands) Three Months Ended March 31, 2013 2012 Revenues $ 10,124 100.00 % $ 12,032 100.00 % Cost of goods sold 7,157 70.70 8,855 73.60 Gross margin 2,967 29.30 3,177 26.40 Operating expenses Research and development 697 6.88 576 4.79 Sales and marketing 659 6.51 738 6.13 General and administrative 1,312 12.95 1,002 8.33 Total operating expenses 2,668 26.34 2,316 19.25 Operating income 299 2.96 861 7.15 Interest expense, net 211 2.09 364 3.02 Income before income taxes 88 0.87 497 4.13 Income tax provision 4 0.04 25 0.21 Net income $ 84 0.83 % $ 472 3.92 % Comparison of the Three Months Ended March 31, 2013 to the Three Months Ended March 31, 2012 Revenues For the three months ended March 31, 2013, which we refer to as "Q1 2013", revenues were $10.1 million compared to $12.0 million for the three months ended March 31, 2012, which we refer to as "Q1 2012", representing a 16% decrease. The decreased revenue was primarily attributable to lower sales of our gateway products, as our primary customer in Scandanavia did not order during the quarter as it worked through existing inventory. In addition, sales of our wireline replacement terminals were lower during the quarter as Sprint in North America did not place orders, fulfilling its requirements from a Chinese vendor. These decreases were partially offset by sales of our new Home Alert security alert devices to new customers in the MEA region. In Q1 2013, our revenues were derived principally from four customers, which together represented 97% of revenues, and individually represented 43%, 24%, 16% and 14% of revenues. In Q1 2012, our revenues were derived principally from four customers, which together represented 88% of revenues, and individually represented 34%, 21%, 20% and 13% of revenues. Our revenues for Q1 2013 consisted of 43% for gateway devices, 40% for security alert systems, 16% for wireline replacement terminals and 1% for phone products. For Q1 2012, our revenues consisted of 75% for gateway devices, 22% for wireline replacement terminals and 3% for phone products. Our objective is to increase revenues through maintaining close relationships with our core customers and helping them expand their markets. At the same time, we are actively seeking opportunities where we have the ability to deliver products that address unique customer requirements with the potential to lead to significant sales at attractive margins. Cost of Goods Sold For Q1 2013, cost of goods sold was $7.2 million compared to $8.9 million for Q1 2012, a decrease of 19%. This decrease is mainly attributable to the 16% decrease of revenues from the comparative periods combined with reductions in the average cost of our products. Gross Margin For Q1 2013, gross margin as a percentage of revenues was 29% compared to 26% for Q1 2012. The increased gross margin percentage from the comparative period was mainly attributable to product mix, including the sale of our new Home Alert products which currently support higher margins than our gateway and wireline replacement terminals. 17 -------------------------------------------------------------------------------- Table of Contents We do not expect any significant inventory write offs or non-recurring transactions in 2013 that would impact gross margins. We are targeting gross margins in the mid-twenties. However, intense price competition and aggressive new product releases by our competitors could put additional pressure on gross margins. Research and Development For Q1 2013, research and development expenses were $697,000 compared to $576,000 for Q1 2012, an increase of 21%. As a percentage of revenues, research and development expenses for Q1 2013 were 7% compared to 5% for Q1 2012. The increase from the comparable period is mainly attributable to increased development expense associated with third party fees and certification of the initial products in our Home Alert product line. We anticipate that 2013 research and development expenses will increase over 2012 levels due to increased certification and test fees from the anticipated launch of our second generation wireline replacement terminal and additional products in our Home Alert product line. Sales and Marketing For Q1 2013, sales and marketing expenses were $659,000 compared to $738,000 for Q1 2012, a decrease of 11%. As a percentage of revenue, sales and marketing expenses were 7% in Q1 2013 compared to 6% in Q1 2012. The decrease was mainly due to a decrease in the commission accrued of $267,000 due to a change in estimate. We expect sales and marketing expenses to remain stable in 2013, with the exception of fluctuating selling expenses based on the revenue levels and the customer mix experienced during the year. General and Administrative For Q1 2013, general and administrative expenses were $1.3 million compared to $1.0 million for Q1 2012, an increase of 31%. As a percentage of revenue, general and administration expenses were 13% in Q1 2013 compared to 8% in Q1 2012. The change from the comparable period is primarily attributable to an increase of $200,000 in the bad debt reserve in Q1 2013 for certain aged receivables compared to a recovery of bad debt expense of $48,000 in Q1 2012. We expect 2013 general and administrative expenses to remain at similar levels as experienced during 2012. Interest Expense, net For Q1 2013, interest expense was a net expense of $211,000. This amount was comprised of interest expense of $102,000 associated with debt and financing activities and non-cash imputed interest amortization of $109,000 associated with the note payable discount on the promissory note issued to WNC. For Q1 2012, interest expense was $364,000. Substantially all of the expense resulted from interest expense associated with debt and financing activities. Provision for Income Taxes For Q1 2013 and 2012, we recorded income tax provisions of $4,000 and $25,000, respectively. Currently, we have established a full reserve against all deferred tax assets. Net Income For Q1 2013, net income was $84,000 compared to net income of $472,000 for Q1 2012. Liquidity and Capital Resources Liquidity Because of slow customer collections from sales generated late in the fourth quarter of 2012, our accounts receivable balance increased significantly by $6.7 million to $21.9 million at March 31, 2013. The delay in collections caused us to draw down heavily on our working capital based credit facility in order to manage our account payable balances with key vendors. Borrowings under our line of credit were $6.0 million at March 31, 2013, against an aggregate borrowing limit of $7.0 million. We expect that we will collect the accounts and that our receivables balance, and corresponding bank loan balances will return to more historic levels over the next several months. 18 -------------------------------------------------------------------------------- Table of Contents The following table summarizes key items affecting liquidity at March 31, 2013 and December 31, 2012: ($ in thousands) March 31, December 31, 2013 2012 Cash and cash equivalents $ 2,179 $ 1,875 Accounts receivable $ 21,912 $ 15,199 Accounts payable $ 12,450 $ 10,203 Working capital (deficit) $ (2,069 ) $ (2,164 ) Bank financings $ 9,840 $ 3,477 Note payable, net of discount $ 5,298 $ 6,946 For the three months ended March 31, 2013, we used $4.3 million of cash from operations which was derived from changes in operating assets and liabilities of $4.8 million less the cash net income of $510,000 (net income adjusted for depreciation and amortization expense, stock based compensation, provisions for losses on accounts receivable, note payable discount and imputed interest). During the three months ended March 31, 2013, we consumed $1,000 of cash for investing activities, and at March 31, 2013, we did not have any significant commitments for capital expenditures. Financing activities generated $4.6 million of cash during the three months ended March 31, 2013, including $6.4 million for net bank financings offset by $1.8 million for repayments to the Note payable to WNC. Bank Financing We currently have three bank financing arrangements. In September 2012, we entered into a one year $7.0 million credit facility with Silicon Valley Bank or "SVB". The facility is a working capital based revolving line of credit where SVB, in its discretion, will make advances in the amount of up to 80% of the value of (i) eligible accounts receivable and (ii) eligible purchase orders for inventory in transit to a customer. For each account receivable or purchase order financed, we pay interest based on SVB's prime rate, plus a specified margin, multiplied by the face amount of the eligible account receivable or purchase order. For eligible accounts receivable, the specified margin is 1.0% and for eligible purchase orders the margin is 1.4%. However, if our EBITDA for any trailing six month period falls below $1.0 million, the specified margins increase to 3.0% and 3.2%, respectively. On March 28, 2013, we entered into an amendment to the credit facility that reduced the specified margin for eligible accounts receivable to 0.75% (down from 1.00%) and if our EBITDA for any trailing six month period falls below $1.0 million, the specified margin for eligible accounts receivable increases to 2.50% (down from 3.00%). At March 31, 2013, we had borrowings of $6.0 million under this credit facility and the effective interest rate on the borrowed funds was 6% per annum. In April 2012, we entered into a one year term loan with a commercial bank in China, totaling 10,000,000 Chinese Yuan (equivalent to $1.6 million at March 31, 2013). This loan bore interest based on the People's Bank of China twelve month adjustable rate, which was 7% per annum at March 31, 2013. This loan was repaid in April 2013 and we entered into a new working capital loan with the same commercial bank in China on the same basic terms as the previous loan. The term of the new loan expires on April 8, 2014. In March 2013, we entered into a three year term loan with SVB, totaling $2.3 million, with monthly payments of interest only during the first six months, and then equal monthly payments of principal and interest over the remaining 30 months of the loan. In addition, we are required to make a one-time final payment of $45,000 at the time the loan is repaid. At March 31, 2013, we had borrowings of $2.3 million under this facility. Interest on the term loan accrues at 6.00% per annum. Note Payable In September 2012, we entered into a Payment Confirmation Agreement with Wistron NeWeb Corporation. In connection with the Payment Confirmation Agreement we settled all disputes with our former contract manufacturer, including an $8.2 million account payable, in exchange for payment of $458,000 in cash and the issuance of a promissory note with a face value of $7.7 million. The Note obligates us to make payments of $50,000 each month. In addition, we are required to make a payment on or before March 31 each year equal to 50% of the prior year's net income less $600,000. The Note does not bear interest. Therefore, we discounted the Note based on an imputed interest rate of 6.25% over an estimated repayment term of three years, resulting in a Note payable discount of $791,000 at the time of issuance. The discount is being charged to interest expense during the term of the Note. During the first quarter we made payments against the Note aggregating to $1.8 million. At March 31, 2013, the balance of the Note payable had a face value of $5.8 million and a discounted value of $5.3 million. Credit Terms with Manufacturers In addition to credit facilities, we rely on open credit terms with our manufacturing partners to help fund our working capital requirements. Generally, we order products from our contract manufacturers only upon receipt of a purchase order from a customer. Often, we can finance our accounts receivable and use the proceeds from that borrowing to pay our manufacturers. However, our contract manufacturers order certain parts with long lead times based on rolling sales forecasts that we provide. If our forecasts are inaccurate and our contract manufacturers do not use the long lead time parts, or if we have a customer notify us of their cancellation or inability to pay for a purchase order, our contract manufacturers have the right, after a specified period of time, to deliver the parts or finished goods inventory to us and demand payment. 19 -------------------------------------------------------------------------------- Table of Contents We rely on those open credit terms to support our working capital requirements and reduce our borrowing costs. If our contract manufacturers restrict their credit terms with us, we may need to identify alternative manufacturers or secure additional capital in order to finance the production of our products. Based on our current operating projections, we expect to generate positive cash from operations over the next twelve month period, and believe that our existing capital resources will be sufficient to fund our working capital needs during that time. However, if we experience a substantial decline in product sales or our bank lenders or contract manufacturers refuse to extend us credit under their current terms, we may not generate sufficient cash to cover our operating expenses. If needed, we intend to secure additional working capital through the sale of debt or equity securities. No arrangements or commitments for any such financings are in place at this time, and we cannot give any assurances about the availability or terms of any future financing. Recent Accounting Pronouncements Our management does not believe that any recently issued, but not yet effective, accounting standards, if adopted, will have a material effect on our financial statements. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements. |