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MARLBOROUGH SOFTWARE DEVELOPMENT HOLDINGS INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) All statements, trend analysis and other information contained in the following discussion relative to markets for our products and trends in revenue, gross margin and anticipated expense levels, as well as other statements, including words such as "may," "anticipate," "believe," "plan," "estimate," "expect," and "intend" and other similar expressions constitute forward-looking statements. These forward-looking statements are subject to business and economic risks and uncertainties and our actual results of operations may differ materially from those contained in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed under Item 1A Risk Factors in our Annual Report on Form 10-K, as may be supplemented from time to time in our quarterly reports on Form 10-Q, as well as other risks and uncertainties referenced in this report. EXECUTIVE OVERVIEW Marlborough Software Development Holdings Inc. ("MSDH" or "We" or the "Company") was formed on July 18, 2011 in conjunction with our former parent company's, Bitstream Inc.'s ("Bitstream's"), planned merger (the "Bitstream Merger") with and acquisition by Monotype Imaging Holdings Inc., a Delaware corporation ("Monotype") pursuant to an agreement and plan of merger (the "Bitstream Merger Agreement") entered into by and between Bitstream and Monotype on November 10, 2011 (the "Separation Date"). On the Separation Date, Bitstream transferred and assigned to MSDH all of the assets and liabilities relating to, arising from or in connection with Bitstream's Pageflex and BOLT product lines (the "Separation") pursuant to the terms and conditions of a Contribution Agreement dated November 10, 2011 by and between Bitstream and MSDH (the "Contribution Agreement"). As part of the Bitstream Merger Agreement, Bitstream entered into a transition services agreement with Monotype covering the provision of various transitional services, including information technology, data migration, finance, accounting and financial reporting services by MSDH to Bitstream and product support services to be provided by Bitstream to MSDH. On March 14, 2012, Bitstream distributed all of the shares of MSDH common stock to the stockholders of Bitstream on a pro rata basis (the "Distribution") pursuant to the terms and conditions of the Distribution Agreement dated November 10, 2011 between Bitstream and MSDH (the "Distribution Agreement"). On March 19, 2012, Bitstream completed the Bitstream Merger with Monotype. MSDH and Bitstream have entered into certain ancillary agreements in connection with the Separation and Distribution ("Separation" and "Distribution") that provide for indemnification of Bitstream with respect to certain liabilities of the Pageflex and BOLT products contributed to MSDH. MSDH is a software development company focused on bringing innovative and proprietary software products to a wide variety of markets. Our core software products include mobile browsing technologies and variable data publishing, Web-to-print, and multi-channel communications technologies. Automated Marketing Communication and Print Production Technologies. The Pageflex product line enables companies across the globe to communicate their marketing messages more easily and effectively. It is the advanced technology for brand management, web-to-print applications, and sophisticated personalized communications based on customer information. We pioneered flexible variable data software in 1997 and have been a technology innovator in the document customization arena ever since. The platform produces rich, creative, award-winning document designs that look like they were given the individual attention of a graphic designer but were, in reality, created on-the-fly with Pageflex variable publishing technology. Print service providers, marketing service providers, corporate marketers, and publishers use Pageflex products to ensure design integrity and brand control while empowering local users to customize and personalize print collateral, email campaigns, and 1-to-1 marketing Web sites. Pageflex products enable companies worldwide to manage, streamline, and automate their document production processes, communicate more personally with their customers, and control their brand and market messaging while enabling their remote employees, franchises, and consumers to use a self-serve model to order customized communications. Pageflex products are purchased by both corporations and the printing companies that support them, who also use the software to control and track production processes in order to improve their business ROI. Mobile Browsing Technologies. BOLT provides a consistent, full desktop-style browsing experience on almost any handset. The BOLT mobile browser offers faithful rendering of Web pages and supports streaming video from popular media sharing sites such as YouTube and MySpace for mobile phones of all types. Compatible with most handsets that support the J2ME or BREW/BMP operating systems, BOLT's advanced features include video support, W3C based widget support, direct Facebook and Twitter integration, six levels of magnification, international localization, copy/paste, FOTA updates, and additional usability features such as auto-complete url, save page, secure browsing, patented split-screen minimap, password manager, rss subscriptions, automatic socket support, history and keypad shortcuts. BOLT is a WebKit-based cloud computing mobile browser. This cloud computing architecture is the key to BOLT's capabilities. Web pages are first loaded by the BOLT servers, then transcoded and sent to the BOLT mobile browser client on handsets. This client/server approach maintains the integrity of Web page layouts, reduces packet consumption on data networks, dramatically improves page load speeds, and enables advanced features such as video streaming. At present, BOLT does not provide significant revenues and we do not make significant expenditures in regard to BOLT. 13-------------------------------------------------------------------------------- Table of Contents Certain Financial and Operating Metrics In connection with the ongoing operation of our business, our management regularly reviews key financial and operating metrics, such as revenue, gross margin, expenses, and capital expenditures, among others. Management considers these financial and operating metrics critical to understanding and improving our business, reviewing our historical performance, comparing our performance versus other companies and identifying current and future trends, and for planning purposes. Certain Trends and Uncertainties The following represents a summary of known trends and uncertainties which could have a significant impact on our financial condition and results of operations. This summary should be considered along with the factors discussed under the headings "Risk Factors" and "Forward-Looking Statements" elsewhere in our Form 10-K filed with the SEC on March 29, 2013. • The Pageflex and Bolt product activities were conducted by Bitstream as a whole and integrated with the Fonts products activities. Our historical financial information may not be representative of our results as a separate company. • We continue to closely monitor current economic conditions, particularly as they impact our customers. We believe that our customers continue to experience some amount of economic hardship. If this economic hardship continues or worsens, our financial results could be adversely impacted. • We continue to develop new products and new versions of our existing product offerings. However, we have recently reduced our R&D investment and our current focus is on supporting our existing products with reduced staffing levels. Failure to develop and launch new products and versions could negatively impact our financial results. CRITICAL ACCOUNTING POLICIES Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America consistently applied. The preparation of these unaudited condensed consolidated financial statements requires us to make significant estimates and judgments that affect the amounts reported in our unaudited condensed consolidated financial statements and the accompanying notes. These items are regularly monitored and analyzed by management for changes in facts and circumstances, and material changes in these estimates could occur in the future. Changes in estimates are recorded in the period in which they become known. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from our estimates. While all of our accounting policies impact the unaudited condensed consolidated financial statements, certain policies are viewed to be critical. Critical accounting policies are those that are both most important to the portrayal of our financial condition and results of operations and that require management's most subjective or complex judgments and estimates. We consider the following accounting policies to be critical in fully understanding and evaluating our financial results: • Allocation Methodologies • Revenue Recognition • Stock-based Compensation • Impairment of Goodwill and Other Long-Lived Assets • Accounts Receivable • Software Development Costs • Income Taxes Please refer to the critical accounting policies set forth in our Annual Report on Form 10-K as of and for the fiscal year ended December 31, 2012, filed with the Securities and Exchange Commission, or the SEC, on March 29, 2013, for a description of all critical accounting policies. The critical accounting policies included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012 have not materially changed. 14-------------------------------------------------------------------------------- Table of Contents OVERVIEW RESULTS OF OPERATIONS (in thousands, except percentages and per share amounts) Revenue and Gross Profit: Three Months Ended March 31, Change % of % of 2013 Revenue 2012 Revenue Dollars Percent Revenue Software licenses $ 534 28.1 % $ 416 23.5 % $ 118 28.4 % Services 1,369 71.9 1,352 76.5 17 1.3 Total revenue 1,903 100.0 1,768 100.0 135 7.6 Cost of Revenue Software licenses 308 57.7 170 40.9 138 81.2 Services 400 29.2 556 41.1 (156 ) (28.1 ) Total cost of revenue 708 37.2 726 41.0 (18 ) (2.5 ) Gross Profit $ 1,195 62.8 % $ 1,042 59.0 % $ 153 14.7 % Software License Revenue We recognize software license revenue from direct sales and licensing agreements of our products and products from third parties, licensing agreements with OEMs, and from the resale of our products through various resellers. We recognize reseller revenue on a sell-in basis and bear no obligation after the license has been delivered to the reseller. The increase in revenue from software licenses for the three month period ended March 31, 2013 as compared to the three month period ended March 31, 2012 was due primarily to increases in sales commitments with certain of our OEM and reseller customers. Our license revenue for OEM and reseller customers is reported to us only after the sale is made and we have no visibility into their sales pipeline. License revenue may vary quarter to quarter and there can be no assurance that revenue levels will continue to increase at similar levels as compared to the prior year. Service Revenue Services revenue increased for the three months ended March 31, 2013 as compared to the three months ended March 31, 2012 due primarily to consulting projects completed during the three months ended March 31, 2013, partially offset by a decrease resulting from an end-of-life support contract in the three months ended March 31, 2012 which resulted in non-recurring support revenue for the three month period ended March 31, 2013. Other product services revenue for customer support, consulting, custom design and training services were generally consistent period over period. Consulting, design and training services vary with specific requirements of customers and may be affected more by economic concerns as customers may delay design changes, custom development and training. Cost of Revenue Cost of revenue includes hosting costs, royalties and fees paid to third parties for the license of rights to technology, costs incurred in the fulfillment of custom orders, costs incurred in providing customer support, maintenance and training, and costs associated with the duplication, packaging and shipping of products. Cost of revenue also includes amortization of acquired-technology from the acquisition of assets from Press-Sense Ltd. and the amortization of capitalized internally developed software related to the translation of our products into multiple languages. Cost of Software License Revenue The increase in cost of software license revenue for the three months ended March 31, 2013 as compared to the same period ended March 31, 2012 was primarily related to the amortization of internally developed software related to the translation of Pageflex products into multiple languages. Cost of Service Revenue The decrease in cost of services revenue for the three months ended March 31, 2013, as compared to the same period in 2012 was primarily due to decreases in salary and related expenses related to the work force reductions announced in August 2012. Our cost of services infrastructure decreased during the first three months of 2013 and we expect these costs to remain lower throughout the rest of this year as compared to last year. 15-------------------------------------------------------------------------------- Table of Contents Operating Expenses: Three Months Ended March 31, % of % of Change 2013 Revenue 2012 Revenue Dollars Percent Marketing and selling $ 717 37.7 % $ 1,067 60.3 % $ (350 ) (32.8 )% Research and development 833 43.7 1,885 106.7 (1,052 ) (55.8 ) General and administrative 629 33.1 1,232 69.7 (603 ) (48.9 ) Total operating expenses $ 2,179 114.5 % $ 4,184 236.7 % $ (2,005 ) (47.9 )% Marketing and Selling ("M&S") Expense Marketing and selling ("M&S") expense consists primarily of salaries and benefits, commissions, travel expense and facilities costs related to sales and marketing personnel, as well as marketing program-related costs. The decrease in M&S for the three months ended March 31, 2013 as compared to the three months ended March 31, 2012 related primarily to decreases in salaries and benefits. We expect that our M&S expense will remain below the levels of the prior year due to a decrease in M&S resources. Research and Development ("R&D") Expense Research and development ("R&D") expense consists primarily of salary and benefit costs, contracted third-party development costs, and facility costs related to software developers and management. R&D expense decreased for the three months ended March 31, 2013 as compared to the three months ended March 31, 2012 primarily due to the reduction in R&D resources related to both the BOLT browser product development and the publishing products. R&D expense for the three months ended March 31, 2013 also decreased as a result of stock compensation expense from the acceleration of Bitstream options and restricted stock awards caused by the merger of Bitstream on March 19, 2012 which was included in the three months ended March 31, 2012. We expect our R&D costs to remain below the levels of the prior year due to the reduction in workforce that we announced in August 2012. General and Administrative ("G&A") Expense G&A expense consists primarily of salaries, benefits, and other related costs including travel and facility expenses for finance, human resource, legal and executive personnel, legal and accounting professional services, provision for bad debts, directors fees and director and officer insurance. G&A expense decreased for the three months ended March 31, 2013 as compared to the three months ended March 31, 2012, consisting primarily of decreases in salaries and benefits due to the reduction in workforce that we announced in August 2012 and a decrease in professional services costs. The G&A expense decreases also include the non-recurrence of Bitstream stock compensation expense and G&A bonus and related tax expense, both related to the Bitstream merger with Monotype during the first quarter of 2012, which were partially offset by a management fee allocation to Bitstream in accordance with the management fee agreement between MSDH and Bitstream during the first quarter of 2012. In addition, the first quarter of 2012 included $2,250 of transaction costs related to the spinout of MSDH from Bitstream Inc. and the merger of Bitstream into Monotype Imaging Inc., which were fully allocated to Bitstream during the first quarter, resulting in a net effect of zero. We expect MSDH G&A expense to remain below the levels reported in the prior year during the remainder of the year ended December 31, 2013 when compared to 2012. Interest and Other Income (Expense), Net: Interest and other income (expense), net consists primarily of foreign currency transactions gains or losses. Provision for Income Taxes: The provision for income taxes consists of foreign taxes in Israel and U.S. federal tax expense related to the deferred tax liability created by the taxable amortization of Goodwill. There was no significant change in the provision for taxes for the three months ended March 31, 2013 and 2012. For purposes of MSDH's consolidated financial statements, income tax expense and deferred tax balances, for the short period through the Separation date, have been recorded as if the Company had filed tax returns on a separate return basis from Bitstream. The calculation of income taxes for the Company on a separate return basis requires a considerable amount of judgment and use of both estimates and allocations. In most cases, the tax losses and tax credits of Bitstream that are included in these financial statements of MSDH have either been utilized by Bitstream's other businesses or remained with Bitstream post-separation. Balances at December 31, 2012 include preliminary amounts available to the Company as of the Separation Date and have been derived from preliminary data from the consolidated Bitstream tax returns which have not been filed as of the date of this report. 16-------------------------------------------------------------------------------- Table of Contents At December 31, 2012, the Company's deferred tax assets, net of deferred tax liabilities, but before consideration of valuation allowances, was $3,396 and its valuation allowances were $3,585. The Company has estimated the net deferred tax assets available post-separation from preliminary consolidated tax returns of Bitstream Inc. as discussed above. The tax loss and credit carry forwards at December 31, 2012 represent $3,681 of deferred tax assets. The tax carry forwards include U.S. tax carry forwards for federal and state net operating losses, general business credits and state tax credits. Our effective tax rate is based on pre-tax income and the tax rates applicable to that income in the various state jurisdictions in which we operate. An estimated effective tax rate for a year is applied to our quarterly operating results, adjusted for losses in tax jurisdictions where the losses cannot be tax benefited due to valuation allowances. In the event that there is a significant unusual or discrete item recognized, or expected to be recognized, in our quarterly operating results, including the resolution of prior-year tax matters, the tax attributable to that item would be separately calculated and recorded at the same time as the unusual or discrete item. Significant judgment is required in determining our effective tax rate and in evaluating its tax positions. We establish reserves when it is deemed more likely than not we will not realize the full tax benefit of the position. We periodically adjust these reserves in light of changing facts and circumstances. Tax regulations may require items of income and expense to be included in a tax return in different periods than the items are reflected in the consolidated financial statements. As a result, the effective tax rate reflected in the consolidated financial statements may be different than the tax rate reported in the income tax return. Some of these differences are permanent, such as expenses that are not deductible on the tax return, and some are temporary differences, such as depreciation expense. Temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in the tax return in future years for which we have already recorded the tax benefit in the financial statements. Deferred tax liabilities generally represent tax expense recognized in the financial statements for which payment has been deferred or expense for which we have already taken a deduction on an income tax return, but has not yet been recognized in the consolidated financial statements. We account for income taxes in accordance with authoritative guidance, which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of the temporary differences between the book and tax basis of recorded assets and liabilities. We make estimates and judgments with regard to the calculation of certain income tax assets and liabilities. This guidance requires that deferred tax assets be reduced by valuation allowances if, based on the consideration of all available evidence, it is more likely than not that some portion of the deferred tax asset will not be realized. Significant weight is given to evidence that can be objectively verified. We evaluate deferred income taxes on a quarterly basis to determine whether valuation allowances are required by considering available evidence, including historical and projected taxable income and tax planning strategies that are both prudent and feasible. As of March 31, 2013, our U.S. operations had generated four consecutive years of pre-tax losses. Because of our recent history of losses, we believe that the weight of negative historic evidence precludes us from considering any forecasted income from our analysis of the recoverability of its U.S. deferred tax assets. We also considered in our analysis tax planning strategies that are prudent and can be reasonably implemented. Based on all available positive and negative evidence, we concluded that a full valuation allowance should be recorded against the net deferred tax assets of our U.S. operations. LIQUIDITY AND CAPITAL RESOURCES (dollar amounts in thousands) At March 31, 2013, our primary source of liquidity comes from our cash of $1,673. Our cash at March 31, 2013 of $1,673 includes $447 held by our Israeli subsidiary that is not available to fund domestic operations unless these funds were repatriated. We do not intend to repatriate funds and, if we do, we will accrue and pay any applicable taxes on the repatriated funds, as required. The Pageflex and BOLT products historically were funded directly through the conduct of our operations as a component of Bitstream. For the three months ended March 31, 2013 and 2012, we incurred net losses of $1,037 and $3,220, respectively. Our former parent, Bitstream, contributed capital of $0 and $9,005 for the three months ended March 31, 2013 and 2012, respectively. As of March 31, 2013, we had a working capital deficit of $1,645. Our operating activities used cash during the three months ended March 31, 2013 and 2012 of $344 and $3,705, respectively. The decreased usage of cash during the three months ended March 31, 2013 as compared to the same period in the prior year resulted primarily from a decreased net loss of $2,183, an increase in contributions from operating assets and liabilities of $73, and an increase in add-backs of non-cash expense items of $1,105. Cash used in operating activities has historically been affected by the amount of net loss, changes in operating assets and liabilities and add-backs of non-cash expense items such as depreciation and amortization and the expense associated with stock-based awards. 17 -------------------------------------------------------------------------------- Table of Contents Cash used in investing activities during the three months ended March 31, 2013 and 2012 was $1 and $293, respectively. Cash used in investing activities during the three months ended March 31, 2013 consisted of purchases of property and equipment. Cash used in investing activities during the three months ended March 31, 2012 consisted of increases in restricted cash, the capitalization of internally developed software, and purchases of property and equipment. Our financing activities for the three months ended March 31, 2012 provided cash of $9,005 which consisted entirely of contributions from Bitstream in connection with the Separation. There was no cash provided by financing activities for the three months ended March 31, 2013. We are utilizing approximately 40% of the leased square footage of the Marlborough, Massachusetts headquarters after the decrease in personnel associated with the Bitstream Merger and further subsequent reductions in our workforce. Management anticipates a reduction in operating costs through the elimination of certain fixed costs, including, without limitation, the possible sub-letting or returning to the landlord of the unutilized space that currently exists. However, there can be no assurance that management will be successful in implementing these cost-cutting plans or that such plans will be successful or, if successful, how long they will take to implement. The unaudited condensed consolidated financial statements have been prepared on a basis that contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business. MSDH's long-term viability is dependent on its ability to generate sufficient product revenue, net income and cash flows from operations to support its business as well as its ability to obtain additional financing. Management's plans also include reducing operating costs and delaying certain expenditures, if necessary, to maintain the Company's liquidity. The Separation from Bitstream Inc. has disrupted and may continue to disrupt our business and management, negatively affecting our business, operating results or financial condition and may cause other risks to the Company. MSDH has suffered recurring losses from operations, both before and after the Separation. For its liquidity, prior to Separation, the Company relied on contributions from Bitstream. As of March 19, 2012, MSDH had accumulated contributions of approximately $60,977 from its former Parent. After Separation, the Company has sought third party investors to reduce the Company's liquidity risks. MSDH received an equity commitment from two investors on October 10, 2012, scheduled to occur in two tranches. The first in the aggregate amount of $2,000 in exchange for 597 shares of 6.5% redeemable preferred stock and 2,985 common stock warrants closed on October 11, 2012. A second tranche of $1,500 of the same securities shall occur in 2013 if certain performance criteria specified in the investment documents are achieved by the end of the second quarter of 2013. The Company does not currently expect that these performance criteria will be met. The Company received commitments from certain customers with terms including the prepayment of software licenses in the aggregate amount of $850, with $425 payable in the fourth quarter of 2012 and $425 payable in the first and second quarters of 2013, subject in each case to the Company continuing to provide service and support to these customers. Additionally, management has restructured its global workforce in August 2012 and recently revised its operating plan to call for reduced expenses going forward, principally as a result of further reductions in force in May 2013. MSDH had a cash balance of $1,673 as of March 31, 2013. Management has recently revised its operating plan to call for reduced expenses going forward, principally as a result of further reductions in force in May 2013. Management believes that with its current operating plan, cash, together with cash generated from future operations is, and will be, sufficient to meet the Company's working capital and capital expenditure requirements through at least the next twelve months. The ability of the Company to satisfy its obligations and recover its costs will be primarily dependent upon the future financial and operating performance of the Company. Additionally, management's operating plans are designed to help control operating costs, to increase revenues and to raise additional capital until such time as the Company generates sufficient cash flows from operations. If there was a decrease in the demand for the Company's products due to either economic or competitive conditions, or management was unable to meet its plan, there could be a significant reduction in liquidity due to the possible inability of the Company to cut costs sufficiently. Potential Indemnification Obligations We enter into standard indemnification agreements in the ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally business partners or customers, in connection with any U.S. patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal, but we can provide no assurance that payments will not be required under these agreements in the future. In connection with the Separation of MSDH from Bitstream and the Merger of Bitstream with Monotype, the Company entered into certain indemnification agreements with Monotype. A detailed discussion of these agreements is included in our Form 10-K filed with the SEC on March 29, 2013. 18-------------------------------------------------------------------------------- Table of Contents OFF-BALANCE SHEET ARRANGEMENTSWe do not have any off-balance sheet arrangements or unconsolidated special-purpose entities within the meaning of Item 303(a)(4) of Regulation S-K. RECENT ACCOUNTING PRONOUNCEMENTSRecent Accounting Pronouncements Not Yet Adopted There have been no new accounting pronouncements during the three months ended March 31, 2013, as compared to the recent accounting pronouncements described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012, that are of significance, or potential significance, to us. |