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EMAGIN CORP - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Introduction The following discussion should be read in conjunction with the Financial Statements and Notes thereto. Our fiscal year ends December 31. This document contains certain forward-looking statements including, among others, anticipated trends in our financial condition and results of operations and our business strategy. These forward-looking statements are based largely on our current expectations and are subject to a number of risks and uncertainties. (See Part I, Item 1A, "Risk Factors "). Actual results could differ materially from these forward-looking statements. Important factors to consider in evaluating such forward-looking statements include (i) changes in external factors or in our internal budgeting process which might impact trends in our results of operations; (ii) unanticipated working capital or other cash requirements; (iii) changes in our business strategy or an inability to execute our strategy due to unanticipated changes in the industries in which we operate; and (iv) various competitive market factors that may prevent us from competing successfully in the marketplace. Overview We design, manufacture and supply miniature displays, which we refer to as OLED-on-silicon-microdisplays, and microdisplay modules for virtual imaging, primarily for incorporation into the products of other manufacturers. Microdisplays are typically smaller than many postage stamps, but when viewed through a magnifier they can contain all of the information appearing on a high-resolution personal computer screen. Our microdisplays use organic light emitting diodes, or OLEDs, which emit light themselves when a current is passed through the device. Our technology permits OLEDs to be coated onto silicon chips to produce high resolution OLED-on-silicon microdisplays. We believe that our OLED-on-silicon microdisplays offer a number of advantages in near to the eye applications over other current microdisplay technologies, including lower power requirements, less weight, fast video speed without flicker, and wider viewing angles. In addition, many computer and video electronic system functions can be built directly into the OLED-on-silicon microdisplay, resulting in compact systems with lower expected overall system costs relative to alternate microdisplay technologies. We have devoted significant resources to the development and commercial launch of our OLED microdisplay products into military, industrial and medical applications world-wide. First sales of our SVGA+ microdisplay began in May 2001 and we launched the SVGA-3D microdisplay in February 2002. In 2008 the SXGA microdisplay became our first digital display, and in 2011 we introduced the VGA OLED-XL, our lowest powered microdisplay, and the WUXGA OLED-XL which exceeds 1080p HD resolution. As of January 31, 2014 and 2013, we had a backlog of approximately $13.4 million in products ordered for delivery through December 31, 2014 and 2013, respectively. This backlog consists of non-binding purchase orders and purchase agreements. These products are being applied or considered for near-eye and headset applications in products such as thermal imagers, night vision goggles, entertainment headsets, handheld Internet and telecommunication appliances, viewfinders, and wearable computers to be manufactured by original equipment manufacturer (OEM) customers. We have also continued to ship our Z800 3DVisor personal display systems. In addition to marketing OLED-on-silicon microdisplays as components, we also offer microdisplays as an integrated package, which we call microviewer that includes a compact lens for viewing the microdisplay and electronic interfaces to convert the signal from our customer's product into a viewable image on the microdisplay. We have also expanded our design and production activities to include display/optical subsystem assemblies for both military and commercial end-use products. We have developed a strong intellectual property portfolio that includes patents, manufacturing know-how and unique proprietary technologies to create high performance OLED-on-silicon microdisplays and related optical systems. We believe our technology, intellectual property portfolio and position in the marketplace, gives us a leadership position in OLED and OLED-on-silicon microdisplay technology. We are one of only a few companies in the world to market and produce significant quantities of high resolution full-color small molecule OLED-on-silicon microdisplays. In 2010, we announced the award from ITT Night Vision for design and development of a display/optical assembly for the U.S. Army Enhanced Night Vision Goggle. We began deliveries to ITT Exelis under this program in 2012. In 2011, we opened additional avenues of growth by securing R&D contracts with ITT, the Department of Energy, the U.S. Navy and others while completing contracts with TATRC and other government agencies. We continued display shipments under the FELIN soldier program, Javelin program, U.S. Army thermal weapon sight remote viewer program, the Viper II thermal sight program and others. In 2012, we developed a new XGA microdisplay, working with an important new customer, for the electronic view finder market. We were awarded a follow-on contract by the U.S. Navy for development of a high brightness, high resolution microdisplay to be used for head-mounted avionics applications. We were also awarded a contract by the U.S. Special Operations Command to optimize our WUXGA (1920 x 1200) microdisplay for mass production and dual use applications. 21 -------------------------------------------------------------------------------- Index In 2013, we began working with an important new customer with significant volume purchases of our displays for a U.S. military program. We continued our development of higher brightness displays. In June, we announced the world's brightest color OLED microdisplay. We continue work with the U.S. Navy to develop an even higher brightness 2k by 2k display for use in avionics and daylight headsets. We strengthened our manufacturing capability with the addition of several new pieces of manufacturing equipment, better optimized our new OLED deposition and added a vice president of manufacturing position. On March 5, 2014, the Company received a notification to stop shipments to a customer pending review of a possible wire bonding problem in a microdisplay. Similar notices from two other customers have been received by the Company. These customers, who supply systems to government programs that include the Company's displays, have indicated that they will not accept the Company's displays until the issue has been resolved. Hence, this issue will result in a delay of shipments to these customers, which will impact the revenue for the quarter ended March 31, 2014. The Company believes that upon completion of its review and with concurrence of the applicable customers, anticipated shipments of the Company's products to such customers will resume shortly. However, because we cannot predict the extent of the delay at this time, and because the Company will make use of excess capacity resulting from the delay in shipments to continue to manufacture and ship products to other customers, we cannot estimate the impact on revenue for the quarter ended March 31, 2014. Company History As of January 1, 2003, we were no longer classified as a development stage company. We transitioned to manufacturing our product and have significantly increased our marketing, sales, and research and development efforts, and expanded our operating infrastructure. Currently, most of our operating expenses are labor related and semi-fixed. If we are unable to generate significant revenues, our net income in any given period could be less than expected. Critical Accounting Policies The SEC defines "critical accounting policies" as those that require application of management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods. Not all of the accounting policies require management to make difficult, subjective or complex judgments or estimates. However, the following policies could be deemed to be critical within the SEC definition. Revenue and Cost Recognition Revenue on product sales is recognized when persuasive evidence of an arrangement exists, such as when a purchase order or contract is received from the customer, the price is fixed, title and risk of loss to the goods has changed and there is a reasonable assurance of collection of the sales proceeds. We obtain written purchase authorizations from our customers for a specified amount of product at a specified price and consider delivery to have occurred at the time of shipment. Revenues from research and development activities relating to firm fixed-price contracts and cost-type contracts are generally recognized on the percentage-of-completion method of accounting as costs are incurred (cost-to-cost basis). Progress is generally based on a cost-to-cost approach however an alternative method may be used such as physical progress, labor hours or others depending on the type of contract. Physical progress is determined as a combination of input and output measures as deemed appropriate by the circumstances. Contract costs include all direct material, labor and subcontractor costs and an allocation of allowable indirect costs as defined by each contract, as periodically adjusted to reflect revised agreed upon rates. These rates are subject to audit by the other party. Product Warranty We offer a one-year product replacement warranty. In general, our standard policy is to repair or replace the defective products. We accrue for estimated returns of defective products at the time revenue is recognized based on historical activity as well as for specific known product issues. The determination of these accruals requires us to make estimates of the frequency and extent of warranty activity and estimate future costs to replace the products under warranty. If the actual warranty activity and/or repair and replacement costs differ significantly from these estimates, adjustments to cost of revenue may be required in future periods. Use of Estimates In accordance with accounting principles generally accepted in the United States of America, management utilizes certain estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments related to, among others, allowance for doubtful accounts, warranty reserves, inventory reserves, stock-based compensation expense, deferred tax asset valuation allowances, litigation and other loss contingencies. Management bases its estimates and judgments on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates. 22 -------------------------------------------------------------------------------- Index Fair Value of Financial Instruments eMagin's cash, cash equivalents, accounts receivable, short-term investments, and accounts payable are stated at cost which approximates fair value due to the short-term nature of these instruments. In addition, the long-term investments are stated at cost which approximates fair value. Stock-based Compensation eMagin maintains several stock equity incentive plans. The 2005 Employee Stock Purchase Plan (the "ESPP") provides our employees with the opportunity to purchase common stock through payroll deductions. Employees may purchase stock semi-annually at a price that is 85% of the fair market value at certain plan-defined dates. As of December 31, 2013, the number of shares of common stock available for issuance was 300,000. As of December 31, 2013, the plan had not been implemented. The Amended and Restated 2003 Employee Stock Option Plan (the "2003 Plan") provided for grants of shares of common stock and options to purchase shares of common stock to employees, officers, directors and consultants. The 2003 Plan terminated July 2, 2013. No additional options can be granted from the 2003 Plan though options granted before the plan terminated may be exercised until the grant expires. In 2013 prior to the termination of the 2003 Plan, there were 385,937 options granted from the 2003 Plan. The 2008 Incentive Stock Plan ("the 2008 Plan") adopted and approved by the Board of Directors on November 5, 2008 provides for grants of common stock and options to purchase shares of common stock to employees, officers, directors and consultants. The 2008 Plan has an aggregate of 2 million shares. In 2013, there were no options granted from this plan. The 2011 Incentive Stock Plan adopted and approved by the shareholders on November 3, 2011 provides for grants of common stock and options to purchase shares of common stock to employees, officers, directors and consultants. On June 7, 2012, at our Annual Meeting, the shareholders approved an Amended and Restated 2011 Incentive Stock Plan ("the 2011 Plan"). The 2011 Plan has an aggregate of 1.4 million shares. In 2013, there were no options granted from this plan. The 2013 Incentive Stock Plan ("the 2013 Plan") adopted and approved by the shareholders on May 17, 2013 provides for grants of common stock and options to purchase shares of common stock to employees, officers, directors and consultants. The 2013 Plan has an aggregate of 1.5 million shares. In 2013, there were 59,565 options granted from this plan. We account for the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors by estimating the fair value of stock awards at the date of grant using the Black-Scholes option valuation model. Stock-based compensation expense is reduced for estimated forfeitures and is amortized over the vesting period using the straight-line method. See Note 10 of the Consolidated Financial Statements - Stock Compensation for a further discussion on stock-based compensation. Income Taxes We are required to estimate income taxes in each of the jurisdictions in which we operate. The process involves estimating our current tax expense together with assessing temporary differences resulting from the differing treatment of items for accounting and tax purposes. These differences result in deferred tax assets and liabilities. Operating losses and tax credits, to the extent not already utilized to offset taxable income also represent deferred tax assets. We must assess the likelihood that any deferred tax assets will be recovered from future taxable income, and to the extent we believe that recovery is not likely, we must establish a valuation allowance. Significant judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against our deferred tax assets. In determining future taxable income, assumptions are made to forecast operating income, the reversal of temporary timing differences and the implementation of tax planning strategies. Management uses significant judgment in the assumptions it uses to forecast future taxable income which are consistent with the forecasts used to manage the business. Realization of the deferred tax asset is dependent upon future earnings which there is uncertainty as to the timing. In assessing the realizability of deferred tax assets, we evaluate both positive and negative evidence that may exist and consider whether it is more likely than not that some portion or all of the deferred tax assets will be realized. From inception through 2009, we maintained a full valuation allowance against our deferred tax assets as we were unable to determine that it was more likely than not that we would generate sufficient future taxable income to utilize them. In 2010, we determined that based on all available evidence, both positive and negative, and based on the weight of the available evidence, including our cumulative taxable income over the past three years and expected profitability in 2011 through 2013 that certain of our deferred tax assets were more likely than not realizable through future earnings. Accordingly, we reduced our valuation allowance by $9.1 million and recorded a corresponding tax benefit of $9.1 million. At December 31, 2011, we determined based on the weight of the available evidence, both positive and negative, it was more likely than not that $8.2 million of its deferred tax asset will be realized and no additional valuation allowance was released. 23 -------------------------------------------------------------------------------- Index In 2012, we determined that based on all available evidence, both positive and negative, and based on the weight of the available evidence, including our continued profitability and our forecasted earnings in 2013 through 2017 that certain of our deferred tax assets were more likely than not realizable through future earnings. Accordingly, we increased our deferred tax asset to $8.8 million by recording a $0.7 million reduction of our deferred tax asset valuation allowance and recorded a corresponding tax benefit of $0.7 million. In 2013, we determined that based on all available evidence, both positive and negative, and based on the weight of the available evidence, including the our recent operating loss in 2013 and a projected cumulative loss through 2014, it was more likely than not that any of our deferred tax assets will be realized therefore, we recorded a full valuation allowance. We recorded income tax expense of $8.9 million at December 31, 2013. Our effective income tax rate was an expense of 171% and a benefit of 37% in 2013 and 2012, respectively. The year over year change in our effective tax rate was primarily due to the recognition of a full valuation allowance on our deferred tax asset in 2013. Results of Operations The following table presents certain financial data as a percentage of total revenue for the periods indicated. Our historical operating results are not necessarily indicative of the results for any future period. Consolidated Statements of Operations Data: As a Percentage of Total Revenue Years Ended December 31, 2013 2012 Revenue 100 % 100 % Cost of goods sold 70 51 Gross profit 30 49 Operating expenses: Research and development 18 16 Selling, general and administrative 31 28 Total operating expenses 49 44 (Loss) income from operations (19 ) 5 Other income (expense), net - - (Loss) income before income taxes (19 ) 5 Income tax expense (benefit) 32 (2 ) Net (loss) income (51 ) % 7 % Year Ended December 31, 2013 Compared to Year Ended December 31, 2012 Revenues Revenues decreased approximately $2.6 million to a total of approximately $28.0 million for the year ended December 31, 2013 from approximately $30.6 million for the year ended December 31, 2012, an 8% decrease. In 2013, there was a 1% increase in display or product revenue as a result of a 1.5% decrease in the number of displays sold however it was offset by a 4% increase in the average selling price which was a result of changes in product and customer mix as compared to 2012. In 2013, contract revenue decreased $2.8 million or 62% from 2012. This decrease accounts for more than the total revenue decrease in 2013. We believe this decrease is the result of a reduction in funding of research and development contracts primarily by the U.S. government. Cost of Goods Sold Cost of goods sold is comprised of costs of product revenue and contract revenue. Cost of product revenue includes materials, labor and manufacturing overhead related to our products. Cost of contract revenue includes direct and allocated indirect costs associated with performance on contracts. 24 -------------------------------------------------------------------------------- Index Cost of goods sold for the year ended December 31, 2013 was approximately $19.6 million as compared to approximately $15.6 million for the year ended December 31, 2012, an increase of approximately $3.9 million. Cost of goods sold as a percentage of revenues was 70% for the year ended December 31, 2013 up from 51% for the year ended December 31, 2012 which is a result of increased labor and material costs, as 2% more good displays were produced in 2013 as compared to 2012. Depreciation increased $0.5 million due to the installation of new equipment. The following table outlines product, contract and total gross profit and related gross margins for the years ended December 31, 2013 and 2012 (dollars in thousands): For the Year ended December 31, 2013 2012 Product revenue gross profit $ 7,742 $ 12,586 Product revenue gross margin 29 % 48 % Contract revenue gross profit $ 684 $ 2,359 Contract revenue gross margin 41 % 53 % Total gross profit $ 8,426 $ 14,945 Total gross margin 30 % 49 % In 2013, total gross profit decreased approximately $6.5 million or 44% as product revenue gross profit decreased approximately $4.8 million and contract revenue gross profit decreased $1.7 million as compared to 2012. Gross margin was 30% for the year ended December 31, 2013 down from 49% for the year ended December 31, 2012. Product gross margin decreased from 48% in 2012 to 29% in 2013 due to changes in our product and customer mix and an increase in cost of goods sold due to increased production costs. The gross margin for Q4 2013 was lower totaling just 1% due to higher production costs including labor and depreciation as well as lower yields. Contract gross margin decreased from 53% in 2012 to 41% in 2013. Contract gross margin is dependent upon the mix of internal versus external third party costs, with the external third party costs causing a lower gross margin and reducing the contract gross profit. Research and Development Expenses Research and development expenses include salaries, development materials and other costs specifically allocated to the development of new microdisplay products, OLED materials and subsystems. Research and development expenses for the year ended December 31, 2013 were approximately $5.0 million as compared to approximately $4.7 million for the year ended December 31, 2012, an increase of approximately $0.3 million. The increase was primarily related to increases in personnel costs and related expenses to support research and development activities. Selling, General and Administrative Expenses Selling, general and administrative expenses consist principally of personnel costs, professional services fees, as well as other marketing, general corporate and administrative expenses. Selling, general and administrative expenses for the years ended December 31, 2013 and 2012 were approximately $8.6 million, respectively. For the year ended December 31, 2013 as compared to 2012, there was a decrease in non-cash compensation and professional fees offset by an increase in personnel costs and included a $0.5 million accrued expense for estimated legal expenses related to the GOT litigation. Other Income (Expense) Other income (expense), net consists primarily of interest income earned on investments and interest expense. For the year ended December 31, 2013, interest expense decreased approximately $2 thousand as compared to 2012 due to lower fees related to our line of credit offset by the capitalization of interest. We have no debt upon which we are incurring interest expense however we pay fees to keep our line of credit available. Other income for the year ended December 31, 2013 increased $11 thousand as compared to 2012 primarily due to a gain recorded on the sale of a fixed asset. Income Tax Expense (Benefit) For the year ended December 31, 2013, income tax expense was approximately $8.9 million as compared to an income tax benefit of approximately $0.6 million for the year ended December 31, 2012. In 2013, as a result of our recent history of operating losses, we determined that it was not more likely than not that we would generate sufficient future taxable income to utilize the deferred tax assets and as a result, we recorded a full valuation allowance. 25 -------------------------------------------------------------------------------- Index Net (Loss) Income Net loss was approximately $14.1 million for the year ended December 31, 2013 as compared to net income of $2.3 million for the year ended December 31, 2012. Off-Balance Sheet Arrangements We have no off balance sheet arrangements that are reasonably likely to have a current or future effect on our financial condition, revenues, results of operations, liquidity or capital expenditures. Liquidity and Capital Resources As of December 31, 2013, we had approximately $11.0 million of cash, cash equivalents, and investments as compared to $13.4 million at December 31, 2012. As of December 31, 2013, we had approximately $4.0 million of cash and cash equivalents as compared to $4.4 million as of December 31, 2012, a decrease of $0.4 million. The decrease in cash was primarily due to cash used in operations of approximately $0.8 million offset by cash provided by financing activities of approximately $0.4 million. For the year ended December 31, 2013, operating activities used $0.8 million in cash, which was attributable to our net loss of approximately $14.1 million offset by approximately $11.8 million from the net non-cash expenses and the change in operating assets and liabilities of $1.5 million. For the year ended December 31, 2012, operating activities provided $4.8 million in cash, which was attributable to our net income of approximately $2.3 million, approximately $2.1 million from the net non-cash expenses and the change in operating assets and liabilities of $0.4 million. For the year ended December 31, 2013, investing activities provided approximately $0.1 million in cash of which approximately $2.0 million was from net investments maturing and approximately $1.9 million purchased equipment primarily for upgrading our production line. For the year ended December 31, 2012, investing activities used approximately $4.8 million in cash of which approximately $2.5 million purchased investments and approximately $2.3 million purchased equipment primarily for upgrading our production line. For the year ended December 31, 2013, financing activities provided approximately $0.4 million in cash from the exercise of stock options. For the year ended December 31, 2012, financing activities used approximately $3.2 million in cash of which approximately $3.1 million was used for dividend payments and approximately $0.4 million was for the purchase of treasury stock offset by proceeds from the exercise of stock options of approximately $0.3 million. Credit Facility At December 31, 2013, we had a credit facility with Access Business Finance, LLC ("Access") that provides for up to a maximum amount of $3 million based on a borrowing base equivalent of 75% of eligible accounts receivable. The interest on the credit facility is equal to the Prime Rate plus 4% but may not be less than 7.25% with a minimum monthly interest payment of $1 thousand. The credit facility will automatically renew on September 1, 2014 for a one year term unless written notice to terminate the credit facility is provided by either party. We did not draw on our credit facility in 2013 or at any time since its inception in September 2010. The credit facility contains the customary representations and warranties as well as affirmative and negative covenants. We were in compliance with all debt covenants as of December 31, 2013. We expect our business to experience growth which may result in higher accounts receivable levels and may require increased production and/or higher inventory levels. We anticipate that our cash needs to fund these requirements as well as other operating or investing cash requirements over the next twelve months will be less than our current cash on hand and the cash we anticipate generating from operations. We anticipate that we will not require additional funds over the next twelve months other than perhaps for discretionary capital spending. If unanticipated events arise during the next twelve months, we believe we can raise sufficient funds. However, if we are unable to obtain sufficient funds, we may have to reduce the size of our organization and/or be forced to reduce and/or curtail our production and operations, all of which could have a material adverse impact on our business prospects. 26 -------------------------------------------------------------------------------- Index Dividends and Stock Repurchase Plan In the year ended December 31, 2013, no dividends were declared or paid. In December 2012, our Board of Directors declared a special dividend of $0.10 per share to all common shares and preferred shares (on an as-converted basis) outstanding. The dividend in the aggregate amount of approximately $3.1 million was paid in cash on December 26, 2012 to all shareholders of record on December 20, 2012. This was a one-time special dividend. It is our intention to retain future profits for use in the development and expansion of our business and for general corporate purposes. Future decision to pay cash dividends are at the discretion of our Board of Directors. In August 2011, eMagin's Board of Directors approved a stock repurchase plan authorizing us to repurchase common stock not to exceed $2.5 million in total value. In 2013, we repurchased 12,066 shares totaling $36,021 in value. As of December 31, 2013, approximately $2.0 million remained under the stock repurchase plan. Contractual Obligations The following chart describes the outstanding contractual obligations of eMagin as of December 31, 2013 (in thousands): Payments Due by Period Total 1 Year 2-3 Years 4-5 Years Operating lease obligations $ 529 $ 529 $ - $ - Line of credit 9 9 - - Equipment purchase obligations 1,200 1,200 - - Purchase obligations (a) 2,565 2,565 - - Total $ 4,303 $ 4,303 $ - $ - (a) The majority of purchase orders outstanding contain no cancellation fees except for minor re-stocking fees. Effect of Recently Issued Accounting Pronouncements See Note 2 of the Consolidated Financial Statements in Item 8 for a full description of recent accounting pronouncements, including the expected dates of adoption and estimated effects on results of operations and financial condition. |