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MATTERSIGHT CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) Critical Accounting Policies and Estimates Our management's discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to the costs and timing of completion of client projects, our ability to collect accounts receivable, the timing and amounts of expected payments associated with cost reduction activities, and the ability to realize our net deferred tax assets, contingencies, and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. The fiscal year-end dates referenced herein for fiscal years 2013, 2012, and 2011 are December 31, 2013, December 31, 2012, and December 31, 2011, respectively. We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. Discontinued Operations ICS Business Unit Transaction The Company sold the ICS Business Unit and "eLoyalty" registered trademark / trade name to Magellan Acquisition Sub, LLC, a Colorado limited liability company and wholly-owned subsidiary of TeleTech Holdings, Inc., a Delaware corporation, closed on May 28, 2011, and the Company changed its name from eLoyalty Corporation to Mattersight Corporation effective May 31, 2011. Therefore, the results of operations of the ICS Business Unit are reported as discontinued operations for all periods presented. Additionally, certain corporate and general costs that had historically been allocated to the ICS Business Unit were reallocated to the Company and are reflected in all periods presented. Revenue Recognition Continuing Operations Behavioral Analytics Revenue Behavioral Analytics revenue consists of Managed services revenue and Consulting services revenue derived from the performance of Behavioral Analytics. Managed services revenue consists of planning, deployment, training, and subscription fees derived from Behavioral Analytics contracts. Planning, deployment, and training fees, which are considered to be installation fees related to Behavioral Analytics subscription contracts, are deferred until the installation is complete and are then recognized over the subscription period of the applicable subscription contract. The subscription periods of these contracts generally range from three to five years after the go-live date or, in cases where the Company contracts with a client for a short-term pilot of Behavioral Analytics prior to committing to a longer subscription period, if any, the subscription or pilot periods generally range from three to twelve months after the go-live date. Installation costs incurred are deferred up to an amount not to exceed the amount of deferred installation revenue and additional amounts that are recoverable based on the contractual arrangement. These costs are included in Prepaid expenses and Other long-term assets. Such costs are amortized over the subscription period. Costs in excess of the foregoing revenue amount are expensed in the period incurred. 11 -------------------------------------------------------------------------------- Table of Contents The amount of revenue generated from subscription fees is based on a number of factors, such as the number of users to whom the Behavioral Analytics Service is provided, the type and number of Behavioral Analytics offerings deployed to the client, and in some cases, the number of hours of calls analyzed during the relevant month of the subscription period. This revenue is recognized as the service is performed for the client. Consulting services revenue primarily consists of fees charged to the Company's clients to provide post-deployment follow-on consulting services, which include custom data analysis, the implementation of enhancements, and training. These follow-on consulting services are generally performed for the Company's clients on a fixed-fee basis. Revenue is recognized as the services are performed, with performance generally assessed on the ratio of actual hours incurred to-date compared to the total estimated hours over the entire term of the contract. Other Revenue Other revenue consists of Marketing Managed Services revenue and CRM Services revenue. Marketing Managed Services revenue is derived from marketing application hosting. This revenue is generally in the form of fixed monthly fees received from the Company's clients and is recognized as the services are performed for the client. Any related setup fee would be recognized over the term of the hosting contract. CRM Services revenue consists of fees generated from the Company's operational consulting services, which are provided to the Company's clients on a time-and-materials or fixed-fee basis. The Company recognizes revenue as the services are performed for time-and-materials projects. For fixed-fee projects, revenue is recognized based on the ratio of hours incurred to-date compared to the total estimated hours over the entire term of the contract. Reimbursed Expenses Reimbursed expenses revenue includes billable costs related to travel and other out-of-pocket expenses incurred while performing services for the Company's clients. The cost of third-party product and support may be included within this category if the transaction does not satisfy the requirements for gross reporting. An equivalent amount of reimbursable expenses is included in Cost of revenue. Unearned Revenues Payments received for Managed services contracts in excess of the amount of revenue recognized for these contracts are recorded as unearned revenue until revenue recognition criteria are met. Allowance for Doubtful Accounts The Company maintains allowances for doubtful accounts for estimated losses resulting from clients not paying for unpaid or disputed invoices for contractual services provided. Additional allowances may be required if the financial condition of our clients deteriorates. Discontinued Operations ICS Business Unit Managed services revenue included in the ICS Business Unit consisted of fees generated from the Company's contact center support and monitoring services. Support and monitoring services generally were contracted for a fixed fee, and the revenue was recognized ratably over the term of the contract. Support fees that were contracted on a time-and-materials basis were recognized as the services were performed for the client. For fixed fee Managed services contracts, where the Company provided support for third-party software and hardware, revenue was recorded at the gross amount of the sale. If the contract did not meet the requirements for gross reporting, then Managed services revenue was recorded at the net amount of the sale. Consulting services revenue included in the ICS Business Unit consisted of the modeling, planning, configuring, or integrating of an Internet Protocol network solution within the Company's clients' contact center environments. These services were provided to clients on a time-and-materials or fixed-fee basis. For the integration of a system, the Company recognized revenue as the services were performed, with performance generally assessed on the ratio of hours incurred to date compared to the total estimated hours over the entire term of the contract. For all other consulting services, the Company recognized revenue as the services were performed for the client. Revenue from the sale of Product, which was generated primarily from the resale of third-party software and hardware by the Company, was generally recorded at the gross amount of the sale when it was delivered to the client. For the ICS Business Unit, the Company utilized vendor-specific objective evidence of selling price ("VSOE") to allocate revenue to various elements in an arrangement. We determined VSOE based on our normal pricing and discounting practices for the product or service when sold separately. In determining VSOE, we required that a substantial majority of the selling prices for a product or consulting services fall within a reasonably narrow pricing range, generally evidenced by approximately 80% of such historical standalone transactions falling within plus or minus 20% of the median selling price. For the ICS Business Unit's managed services, we established VSOE through the stated renewal approach. 12 -------------------------------------------------------------------------------- Table of Contents We were able to establish VSOE for our product and service offerings except for software. If we were not able to establish VSOE for an offering, we attempted to establish fair value by utilizing third-party evidence of selling price ("TPE"), which was established by obtaining evidence from comparable offerings from a peer company. If the Company was unable to establish fair value using VSOE or TPE, then the Company used estimated selling prices ("ESP") in its allocation of revenue. To determine ESP, we applied significant judgment as we weighed a variety of factors, based on the facts and circumstances of the arrangement. These factors included internal costs, gross margin objectives, and existing portfolio pricing and discounting. Within discontinued operations, some of our sales arrangements had multiple deliverables containing software and related software components. Such sale arrangements were subject to the accounting guidance in ASC 985-605, Software Revenue Recognition. Stock-Based Compensation Stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the vesting period. Determining fair value of stock-based awards at the grant date requires certain assumptions. The Company uses historical information as the basis for the selection of expected life, expected volatility, expected dividend yield assumptions, and anticipated forfeiture rates. The risk-free interest rate is selected based on the yields from U.S. Treasury Strips with a remaining term equal to the expected term of the options being valued. Goodwill Goodwill is tested annually for impairment or more frequently if an event or circumstance indicates that an impairment loss may have been incurred. In performing our annual impairment test, we first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value, including goodwill. If it is concluded that this is the case for one or more reporting units, we perform a detailed quantitative assessment using a two-step test approach. In the first step, the fair value of each reporting unit is compared with its carrying value. If the fair value exceeds the carrying value, then goodwill is not impaired and no further testing is performed. The second step is performed if the carrying value exceeds the fair value. The implied fair value of the reporting unit's goodwill must be determined and compared to the carrying value of the goodwill. If the carrying value of a reporting unit's goodwill exceeds its implied fair value, then an impairment loss equal to the difference will be recorded. A detailed determination of the fair value of a reporting unit may be carried forward from one year to the next if specific criteria have been met. The Company currently operates in a single business segment or reporting unit. In 2013, after completing our annual qualitative review, we concluded that it was not more likely than not that the carrying value of our reporting unit exceeded its fair value. Accordingly, we concluded that further quantitative analysis and testing was not required, and no goodwill impairment charge was required. There has been no impairment identified as a result of the annual reviews of goodwill as of December 31, 2013 and December 31, 2012. The carrying value of goodwill was $1.0 million as of December 31, 2013 and December 31, 2012. Intangible Assets Intangible assets reflect costs related to patent and trademark applications, Marketing Managed Services customer relationships acquired in 2004, and the 2003 purchase of a license for certain intellectual property. Patent and trademark applications are amortized over 120 months. The other intangible assets are fully amortized. The original cost of intangible assets as of December 31, 2013 and December 31, 2012 was $3.2 million and $2.9 million, respectively. Accumulated amortization of intangible assets as of December 31, 2013 and December 31, 2012 was $2.8 million and $2.7 million, respectively. Currently, amortization expense of intangible assets is expected to be $68 thousand annually. Severance and Related Costs Severance and related costs includes cost-reduction actions, principally consisting of personnel reductions and an office consolidation. The portion of the accruals that related to employee severance represents contractual severance for identified employees and generally is not subject to a significant revision. The portion of the accruals that related to office space reductions, office closures, and associated contractual lease obligations are based in part on assumptions and estimates of the timing and amount of sublease rentals, which may be affected by overall economic and local market conditions. To the extent estimates of the success of our sublease efforts changed, adjustments increasing or decreasing the related accruals have been recognized. 13 -------------------------------------------------------------------------------- Table of Contents Income Taxes We have recorded income tax valuation allowances on our net deferred tax assets to account for the unpredictability surrounding the timing of realization of our U.S. and non-U.S. net deferred tax assets due to uncertain economic conditions. The valuation allowances may be reversed at a point in time when management determines realization of these tax assets has become more likely than not, based on a return to predictable levels of profitability. The Company uses an asset and liability approach for financial accounting and reporting of income taxes. Deferred income taxes are provided when tax laws and financial accounting standards differ with respect to the amount of income for the year, the basis of assets and liabilities and for tax loss carryforwards. The Company does not provide U.S. deferred income taxes on earnings of U.S. or foreign subsidiaries, which are expected to be indefinitely reinvested. The Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Significant judgment is used to determine the likelihood of the benefit. There is additional guidance on derecognition, classification, interest and penalties on income taxes, accounting in interim periods, and disclosure requirements. Intraperiod tax allocation requires that the provision for income taxes be allocated between continuing operations and other categories of earnings (such as discontinued operations or other comprehensive loss) for each tax jurisdiction. In periods in which there is a year-to-date pre-tax loss from continuing operations and pre-tax income in other categories of earnings, the tax provision is first allocated to the other categories of earnings. A related tax benefit is then recorded in continuing operations. While intraperiod tax allocation in general does not change the overall tax provision, it does affect the amount of tax provision included in each category. For fiscal year 2013, the intraperiod allocation was not applicable because we no longer have any discontinued operations activity. Included in continuing operations income tax provision was tax expense of $38 thousand for the year ended December 31, 2012 and a tax benefit of $5.9 million for the year ended December 31, 2011. Included in discontinued operations income tax provision was a tax benefit of $0.3 million for the year ended December 31, 2012 and tax expense of $6.8 million for the year ended December 31, 2011. Other Significant Accounting Policies For a description of the Company's other significant accounting policies, see Note Two "Summary of Significant Accounting Policies" of the "Notes to Consolidated Financial Statements" included in Part II Item 8 of this Form 10-K. Forward-Looking Statements Statements in this Form 10-K that are not historical facts are "forward-looking statements" and are made pursuant to the safe harbor provisions of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). These forward-looking statements, which may be identified by use of words such as "plan," "may," "might," "believe," "expect," "intend," "could," "would," "should," and other words and terms of similar meaning, in connection with any discussion of our prospects, financial statements, business, financial condition, revenues, results of operations, or liquidity, involve risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. In addition to other factors and matters contained or incorporated in this document, important factors that could cause actual results or events to differ materially from those indicated by such forward-looking statements include, without limitation, those noted under "Risk Factors" included in Part I Item 1A of this Form 10-K for the year ended December 31, 2013, as well as the following: • Uncertainties associated with the attraction of, and the ability to execute contracts with, new clients, the continuation of existing, and execution of new, engagements with existing clients, and the timing of related client commitments; • Reliance on a relatively small number of clients for a significant percentage of our revenue; • Risks involving the variability and predictability of the number, size, scope, cost, and duration of, and revenue from, client engagements; • Management of the other risks associated with complex client projects and new service offerings, including execution risk; and • Management of growth and development of, and introduction of, new service offerings. We cannot guarantee any future results, levels of activity, performance, or achievements. The statements made in this Form 10-K represent our views as of the date of this Form 10-K, and it should not be assumed that the statements made in this Form 10-K remain accurate as of any future date. Moreover, we assume no obligation to update forward-looking statements, except as may be required by law. 14 -------------------------------------------------------------------------------- Table of Contents Business Outlook Based upon Mattersight's business development efforts and third-party market research, we believe there has been a fundamental shift in the way large enterprises view data. The trends suggest that large enterprises today appreciate that there is value in data that can be derived from their front and back offices, but they have not yet established efficient and effective methods to capture, analyze, and create value from this data. We seek to help large enterprises capitalize on this data with our Behavioral Analytics solutions and, as a leader in this rapidly growing market, we believe we are uniquely positioned to capitalize on this opportunity. We believe the market potential in the U.S. for enterprise analytics, including our current offerings, is significant and we estimate it to be less than 5% penetrated. Our business strategy to increase revenue, profitability, and capture market share includes the following elements: • Win business with new clients, focusing on predictive behavioral routing; • Develop partnerships and strategic alliances to expand sales leverage, improve brand awareness, and reach new industries while providing value to our mutual clients; • Increase up-sell and cross-sell ratios by deepening and broadening our relationships with existing clients; • Continue to invest in innovative proprietary technology, new applications, and delivery methods; • Continue bookings growth and improve operating leverage; and • Expand our sales and marketing efforts with seasoned enterprise sales agents and strategic marketing professionals. Resulting from our delivery of measurable economic benefit to our clients, we have seen increased penetration within existing accounts, due to an increase in adoption of our base Behavioral Analytics offerings across separate and distinct business units, as well as the adoption of new applications within existing business units. For this reason, we will continue to focus on further penetrating what we estimate to be a large existing base market with a less expensive cost of acquisition. In addition, our strategy to further invest in sales and marketing, coinciding with the fundamental shift in enterprise data utilization described above, has led to an increasing number of discussions with potential new clients and strategic partners. Year Ended December 31, 2013 Compared with the Year Ended December 31, 2012 Services Revenue Services revenue is total revenue excluding reimbursable expenses that are billed to our clients. Our services revenue increased $0.7 million, or 2%, to $34.2 million in fiscal year 2013, from $33.5 million in fiscal year 2012. Behavioral Analytics revenue was $33.0 million in fiscal year 2013 and was $32.1 million in fiscal year 2012. The $0.9 million, or 3%, increase in Behavioral Analytics revenue in fiscal year 2013 was primarily due to revenue associated with new client agreements, expansion of several existing clients, and the payment by a customer of an early termination fee in connection with the cancellation of a contract. Other revenue decreased by $0.1 million, or 8%, to $1.2 million in fiscal year 2013, from $1.3 million in fiscal year 2012. The decrease in revenue was mainly due to the completion of several contracts for Marketing Managed Services. The Company's top five clients accounted for 69% of total revenue in fiscal year 2013 and 66% of total revenue in fiscal year 2012. The top 10 clients accounted for 90% of total revenue in fiscal year 2013 and 89% of total revenue in fiscal year 2012. In fiscal year 2013, there were four clients that accounted for 10% or more of total revenue, whereas three clients accounted for 10% or more of total revenue in fiscal year 2012. In fiscal year 2013, Vangent, Inc., Progressive Casualty Insurance Company, Allstate Insurance Company, and United HealthCare Services, Inc., accounted for 21%, 15%, 13%, and 11% of total revenue, respectively. In fiscal year 2012, Vangent, Inc., Allstate Insurance Company, and Progressive Casualty Insurance Co. accounted for 19%, 16%, and 13% of total revenue, respectively. Higher concentration of revenue with a single client or a limited group of clients creates increased revenue risk if one of these clients significantly reduces its demand for our services. As previously announced, our contract with Vangent, Inc. expired on December 31, 2013. Cost of Revenue Before Reimbursed Expenses, Exclusive of Depreciation and Amortization Cost of Services Cost of services primarily consists of labor costs, including salaries, fringe benefits, and incentive compensation, royalties, and other client-related third-party outside services. Cost of services excludes depreciation and amortization. Cost of Behavioral Analytics revenue was $10.1 million, or 31% of Behavioral Analytics revenue in fiscal year 2013, compared to $12.2 million, or 38% of Behavioral Analytics revenue, in fiscal year 2012. The favorable decrease in cost and percentage was primarily due to improved productivity in our Delivery organization resulting in lower compensation costs and better leverage of our cost structure supporting our subscription clients. 15 -------------------------------------------------------------------------------- Table of Contents Cost of other revenue was $0.6 million, or 51% of Other revenue in fiscal year 2013, compared to $0.7 million, or 53% of Other revenue, in fiscal year 2012. The favorable $0.1 million decrease in cost and percentage was primarily due to lower CRM Service revenue. Sales, Marketing and Development Sales, marketing and development expenses consist primarily of salaries, incentive compensation, commissions, and employee benefits for business development, account management, marketing, and product development personnel. The personnel costs included in this item are net of any labor costs directly related to the generation of revenue, which are represented in Cost of services. Sales, marketing and development expenses decreased $1.3 million, or 6%, to $21.8 million in fiscal year 2013 from $23.1 million in fiscal year 2012. This decrease is primarily due to lower compensation expense. General and Administrative General and administrative expenses consist primarily of salaries, incentive compensation, and employee benefits for administrative personnel, as well as facilities costs, a provision for uncollectible amounts, and costs for our corporate technology infrastructure and applications. General and administrative expenses increased $0.5 million, or 6%, to $8.8 million in fiscal year 2013 from $8.3 million in fiscal year 2012. This increase is primarily due to higher compensation expense. Severance and Related Costs Severance and related costs includes cost-reduction actions, principally consisting of personnel reductions and an office consolidation. Cash savings related to cost-reduction actions taken during fiscal year 2013 are anticipated to be $0.2 million annually. Costs related to office space reductions and office closures were paid pursuant to contractual lease terms through January 2012. In fiscal year 2013, there was $0.2 million of expense which was related to severance and related costs for the elimination of one position. In fiscal year 2012, the $0.7 million of expense was related to severance and related costs for the elimination of one position. Depreciation Depreciation expense remained constant at $3.4 million in fiscal years 2013 and 2012. Amortization of Intangibles Amortization of intangibles remained constant at $0.1 million in fiscal years 2013 and 2012. Operating Loss Primarily as a result of the factors described above, we experienced an operating loss of $10.8 million for fiscal year 2013, compared to an operating loss of $15.0 million for fiscal year 2012, a $4.3 million, or 28% improvement. Interest and Other Expense, Net Non-operating interest and other expense was $0.7 million of expense in fiscal year 2013 compared to $0.4 million of expense in fiscal year 2012. The increase of $0.3 million of expense was primarily related to interest expense on our short-term debt and capital lease obligation. Income Tax Benefit (Provision) The income tax benefit was $0.2 million in fiscal year 2013 and the tax provision was less than $0.1 million in fiscal year 2012. The income tax benefit in fiscal year 2013 was due to a favorable tax ruling on a previously accrued income tax liability. As of December 31, 2013, total net deferred tax assets of $67.6 million were fully offset by a valuation allowance. The level of uncertainty in predicting when we will achieve profitability, sufficient to utilize our net U.S. and non-U.S. operating losses and realize our remaining deferred tax assets, requires that an income tax valuation allowance be recognized in the financial statements. 16 -------------------------------------------------------------------------------- Table of Contents Income from Discontinued Operations There was no income from discontinued operations in fiscal year 2013. The income from discontinued operations in fiscal year 2012 was $0.2 million, net of tax benefit of $0.3 million, due to a favorable Internal Revenue Service ("IRS") ruling on a previously accrued income tax liability partially offset by settlement costs relating to a former employee of the ICS Business Unit. Net Loss Available to Common Stockholders We reported net loss available to holders of Common Stock of $11.8 million in fiscal year 2013 compared to net loss available to holders of Common Stock of $15.9 million in fiscal year 2012. Accrued dividends to holders of Series B Stock were $0.6 million in both fiscal years 2013 and 2012. In fiscal year 2013, there was net loss of $0.70 per share on a basic and diluted basis, compared to net loss of $0.99 per share on a basic and diluted basis in fiscal year 2012. Year Ended December 31, 2012 Compared with the Year Ended December 31, 2011 Services Revenue Services revenue is total revenue excluding reimbursable expenses that are billed to our clients. Our services revenue increased $4.7 million, or 16%, to $33.5 million in fiscal year 2012, from $28.8 million in fiscal year 2011. Behavioral Analytics revenue was $32.1 million in fiscal year 2012 and was $27.3 million in fiscal year 2011. The $4.8 million, or 18%, increase in Behavioral Analytics revenue in fiscal year 2012 was primarily due to increased subscription fees associated with the conversion of several deployments to the subscription phase of the contract. Other revenue decreased by $0.2 million, or 13%, to $1.3 million in fiscal year 2012, from $1.5 million in fiscal year 2011. The decrease in revenue was mainly due to the completion of several contracts for Marketing Managed Services. The Company's top five clients accounted for 66% of total revenue in fiscal year 2012 and 70% of total revenue in fiscal year 2011. The top 10 clients accounted for 89% of total revenue in fiscal year 2012 and 90% of total revenue in fiscal year 2011. In fiscal years 2012 and 2011, there were three clients that accounted for 10% or more of total revenue. In fiscal year 2012, Vangent, Inc., Allstate Insurance Company, and Progressive Casualty Insurance Company accounted for 19%, 16%, and 13% of total revenue, respectively. In fiscal year 2011, Vangent, Inc., Allstate Insurance Company, and Health Care Service Corporation accounted for 22%, 15%, and 14% of total revenue, respectively. Higher concentration of revenue with a single client or a limited group of clients creates increased revenue risk if one of these clients significantly reduces its demand for our services. As previously announced, our contract with Vangent, Inc. expired on December 31, 2013. Cost of Revenue Before Reimbursed Expenses, Exclusive of Depreciation and Amortization Cost of Services Cost of services primarily consists of labor costs, including salaries, fringe benefits, and incentive compensation, royalties, and other client-related third-party outside services. Cost of services excludes depreciation and amortization. Cost of Behavioral Analytics revenue was $12.2 million, or 38% of Behavioral Analytics revenue in fiscal year 2012, compared to $12.2 million, or 45% of Behavioral Analytics revenue, in fiscal year 2011. The percentage decrease in the Cost of Behavioral Analytics revenue was primarily due to improved leverage of our cost structure resulting from higher subscription revenue in fiscal year 2012 compared to fiscal year 2011. Cost of Other revenue was $0.7 million, or 53% of Other revenue in fiscal year 2012, compared to $1.0 million, or 66% of Other revenue, in fiscal year 2011. The decrease in cost was largely due to lower compensation expense of $0.2 million, driven by the lower demand for our CRM Services. Sales, Marketing and Development Sales, marketing and development expenses consist primarily of salaries, incentive compensation, commissions, and employee benefits for business development, account management, marketing, and product development personnel. The personnel costs included in this item are net of any labor costs directly related to the generation of revenue, which are represented in Cost of services. Sales, marketing and development expenses increased $3.1 million, or 16%, to $23.1 million in fiscal year 2012 from $20.0 million in fiscal year 2011. This increase was due to higher headcount associated with the continued investment in our development, selling and marketing organizations. 17 -------------------------------------------------------------------------------- Table of Contents General and Administrative General and administrative expenses consist primarily of salaries, incentive compensation, and employee benefits for administrative personnel, as well as facilities costs, a provision for uncollectible amounts, and costs for our corporate technology infrastructure and applications. General and administrative expenses decreased $0.8 million, or 10%, to $8.3 million in fiscal year 2012 from $9.1 million in fiscal year 2011. This decrease was due to lower compensation expense of $0.7 million, primarily due to the reduction in our administrative staff as a result of the sale of the ICS Business Unit. Severance and Related Costs Severance and related costs includes cost-reduction actions, principally consisting of personnel reductions and an office consolidation. Cash savings related to cost-reduction actions for fiscal year 2012 are anticipated to be $0.3 million annually. The cost-reduction actions taken during fiscal year 2011 resulted in annual cash savings of $0.1 million. Costs related to office space reductions and office closures were paid pursuant to contractual lease terms through January 2012. Severance and related costs were $0.7 million in fiscal year 2012 and $0.3 million of income in fiscal year 2011. In fiscal year 2012, the $0.7 million of expense for continuing operations was related to severance and related costs for the elimination of one position. In fiscal year 2011, the $0.3 million of income for continuing operations was related to the favorable renegotiation of an office lease, partially offset by severance and related costs for the elimination of one position and an office consolidation. Depreciation Depreciation increased $0.2 million, or 6%, to $3.4 million in fiscal year 2012 compared to $3.2 million in fiscal year 2011. The increase of $0.2 million in depreciation is primarily related to increased capital expenditures in fiscal year 2012. Amortization of Intangibles Amortization of intangibles decreased $0.1 million, or 54%, to $0.1 million in fiscal year 2012 compared to $0.2 million in fiscal year 2011. The decrease in amortization was primarily related to a $0.1 million charge in fiscal year 2011 to write off patent applications that the Company determined it no longer wished to pursue. Operating Loss Primarily as a result of the factors described above, we experienced an operating loss of $15.0 million for fiscal year 2012, compared to an operating loss of $16.6 million for fiscal year 2011, a $1.6 million, or 9% improvement. Interest and Other (Expense) Income, Net Non-operating interest and other (expense) income was $0.4 million of expense in fiscal year 2012 and was $0.1 million of income in fiscal year 2011. In fiscal year 2012, the $0.4 million of expense was primarily related to interest expense on our short-term debt and capital lease obligation. In fiscal year 2011, the $0.1 million of income was primarily related to favorable exchange rates on intercompany settlements, partially offset by interest expense on our capital lease obligation. Income Tax (Provision) Benefit The income tax provision was less than $0.1 million for fiscal year 2012 and the tax benefit was $5.9 million in fiscal year 2011. The $5.9 million tax benefit in fiscal year 2011 was primarily related to the tax accounting treatment of the gain on the sale of the ICS Business Unit. As of December 31, 2012, total net deferred tax assets of $63.8 million were fully offset by a valuation allowance. The level of uncertainty in predicting when we will achieve profitability, sufficient to utilize our net U.S. and non-U.S. operating losses and realize our remaining deferred tax assets, requires that an income tax valuation allowance be recognized in the financial statements. Income from Discontinued Operations The income from discontinued operations in fiscal year 2012 was $0.2 million, net of tax benefit of $0.3 million, and in fiscal year 2011 was $28.9 million, net of tax of $6.8 million. 18 -------------------------------------------------------------------------------- Table of Contents The income from discontinued operations of $0.2 million in fiscal year 2012 was due to a favorable IRS ruling on a previously accrued income tax liability, partially offset by settlement costs relating to litigation with a former employee of the ICS Business Unit. The pretax loss from discontinued operations of $0.8 million in fiscal year 2011 was due to the impact of the results of the ICS Business Unit and the transaction costs associated with the sale of the ICS Business Unit. The pretax gain from the sale of assets included in discontinued operations in fiscal year 2011 was $36.5 million. Net (Loss) Income Available to Common Stockholders We reported net loss available to common stockholders of $15.9 million in fiscal year 2012 compared to net income available to common stockholders of $10.6 million in fiscal year 2011. Accrued dividends to holders of Series B Stock were $0.6 million in fiscal year 2012 and $1.3 million in fiscal year 2011. In fiscal years 2012 and 2011, the Company paid $0.1 million and $6.6 million on the Series B Stock fair value over stated value, respectively. In fiscal year 2012, there was net loss of $0.99 per share on a basic and diluted basis, compared to net income of $0.74 per share on a basic and diluted basis in fiscal year 2011. For 2011, the net income was a result of the gain from the completion of the sale of the ICS Business Unit. Liquidity and Capital Resources Introduction Our principal capital requirements are to fund working capital needs, capital expenditures for Behavioral Analytics and infrastructure requirements, and other revenue generation and growth investments. As of December 31, 2013, our principal capital resources consisted of our cash and cash equivalents balance of $13.4 million, which includes $0.2 million in foreign bank accounts. The decrease in cash during fiscal year 2013 was primarily the result of the net loss before non-cash items, a $3.7 million net payment under our credit facility, capital lease principal payments, capital expenditures, and the acquisition of treasury stock, partially offset by proceeds of $5.6 million, net of fees, received from the sale of the Shares pursuant to the terms of the Purchase Agreement and a $1.9 million increase in unearned revenue. The decrease in cash during fiscal year 2012 was primarily the result of the net loss before non-cash items, a decrease in unearned revenue reflecting the recognition of previously deferred revenue, the purchase of shares of Series B Stock, capital lease principal payments, capital expenditures, and the acquisition of treasury stock, partially offset by proceeds from our revolving line of credit agreement and a decrease in prepaid expenses. Restricted cash decreased $1.5 million for fiscal year 2012. Prior to June 30, 2012, restricted cash was primarily used as collateral for letters of credit issued in support of future capital lease obligations. See "Credit Facility" description below. Cash Flows from Operating Activities Net cash provided by operating activities of continuing operations during fiscal year 2013 was $1.6 million and cash used in operating activities of continuing operations during fiscal year 2012 was $11.0 million. During fiscal year 2013, net cash provided by operating activities consisted primarily of a $1.9 million increase in unearned revenue, partially offset by the net loss before non-cash items of $1.9 million. During fiscal year 2012, cash outflows of $11.0 million from operating activities consisted primarily of the net loss before non-cash items of $7.9 million and a $4.6 million decrease in unearned revenue reflecting the recognition of previously deferred revenue, offset by a decrease in prepaid expense. There was no net cash used in operating activities of discontinued operations during fiscal year 2013. Net cash provided by operating activities of discontinued operations during fiscal year 2012 was $24 thousand. Days Sales Outstanding ("DSO") was 23 days at December 31, 2013, compared to 26 days at December 31, 2012, an improvement of three days. Because a high percentage of our revenue is dependent on a relatively small number of clients, delayed payments by a few of our larger clients could result in a reduction of our available cash, which in turn may cause fluctuation in our DSO. We do not expect any significant collection issues with our clients; see "Accounts Receivable Customer Concentration" for additional information on cash collections. As of December 31, 2013, there were no outstanding liabilities for severance and related costs. 19 -------------------------------------------------------------------------------- Table of Contents Cash Flows from Investing Activities The Company used $1.5 million of cash in continuing investing activities during fiscal year 2013 compared to $2.2 million of cash in continuing investing activities during fiscal year 2012. Capital expenditures were primarily used to purchase computer hardware and software during fiscal years 2013 and 2012. We currently expect to incur new capital investments of between $4.0 million and $5.0 million for fiscal year 2014 and plan on funding approximately $3.0 million to $3.8 million of these purchases with capital leases. There was no net cash used in discontinued investing activities during fiscal years 2013 and 2012. Cash Flows from Financing Activities Net cash used in continuing financing activities was $1.1 million during fiscal year 2013 compared to $1.8 million during fiscal year 2012. The $1.1 million of net cash used during fiscal year 2013 was primarily attributable to a $3.7 million net payment under our credit facility, $2.1 million of principal payments under our capital lease obligations, and $1.1 million of cash used to acquire treasury stock, partially offset by proceeds of $5.6 million, net of fees, from the sale of the Shares pursuant to the Purchase Agreement. Net cash outflows of $1.8 million during fiscal year 2012 were primarily attributable to $3.7 million to purchase shares of Series B Stock, $2.3 million of principal payments under our capital lease obligations, $1.1 million of cash used to acquire treasury stock, and $0.6 million for cash dividend payments on Series B Stock, partially offset by proceeds from our revolving line of credit agreement of $3.7 million and a decrease in restricted cash of $1.5 million. There was no net cash used in discontinued financing activities during fiscal year 2013 and 2012. Historically, we have not paid cash dividends on our Common Stock, and we do not expect to do so in the future. The Board of Directors did not declare a dividend payment on Series B Stock, which was accrued, for the dividend periods July 1, 2012 through December 31, 2012, January 1, 2013 through June 30, 2013, and July 1, 2013 through December 31, 2013 (the aggregate amount of these dividends was approximately $0.9 million). A cash dividend on the Series B Stock of $0.3 million was paid on January 3, 2012, for the dividend period July 1, 2011 through December 31, 2011 and a cash dividend of $0.3 million was paid on July 2, 2012, for the dividend period January 1, 2012 through June 30, 2012. Under the terms of the Certificate of Designations for the Series B Stock, unpaid dividends are cumulative and accrue at the rate of 7% per annum, payable semi-annually in January and July. The amount of each dividend accrual will be decreased by any conversions of the Series B Stock into Common Stock, as such conversions require the Company to pay accrued but unpaid dividends at the time of conversion. Conversions of Series B Stock became permissible at the option of the holder after June 19, 2002. In fiscal year 2012, the Company spent approximately $0.1 million related to its Series B Stock tender offer. The Company expects to acquire between $0.5 million and $0.6 million of treasury stock during the first quarter of 2014 to meet employee tax obligations associated with the Company's stock-based compensation programs. 20 -------------------------------------------------------------------------------- Table of Contents Liquidity Our near-term capital resources consist of our current cash balance, together with anticipated future cash flows, financing from capital leases, and our revolving lines of credit (See "Credit Facility" below). Our balance of cash and cash equivalents was $13.4 million as of December 31, 2013. We anticipate that our current unrestricted cash resources, together with operating revenue and capital lease financing, should be sufficient to satisfy our short-term working capital and capital expenditure needs for the next twelve months. Management will continue to assess opportunities to maximize cash resources by actively managing our cost structure and closely monitoring the collection of our accounts receivable. If, however, our operating activities, capital expenditure requirements, or net cash needs differ materially from current expectations due to uncertainties surrounding the current capital market, credit and general economic conditions, competition, or the termination of a large client contract, then there is no assurance that we would have access to additional external capital resources on acceptable terms. Partners for Growth Credit Facility On August 19, 2013, the Company, together with its wholly-owned subsidiaries Mattersight Europe Holding Corporation and Mattersight International Holding, Inc., as co-borrowers, entered into a Loan and Security Agreement with Partners for Growth IV, L.P. ("PfG") (the "Credit Facility"). The Credit Facility is subordinated to the Company's existing $10.0 million credit facility with Silicon Valley Bank described below and, in combination therewith, increases the Company's aggregate lines of credit to $15.0 million. The Credit Facility provides for (a) a $3.0 million revolving line of credit maturing in 2016 (the "Tranche A Facility") and (b) a $2 million convertible term loan (the "Tranche B Facility"), which, if advanced, would be funded in two tranches of $1.0 million, each evidenced by a convertible promissory note (each, a "Convertible Note") maturing five years following the issuance thereof. Each Convertible Note would convert, at the option of the holder, into Common Stock at an exercise price of at least the 10-day volume weighted average per share of Common Stock ("10-Day VWAP") as of the date on which such Note is issued. If issued, the Convertible Notes, and the shares of Common Stock to be issued upon exercise of the Convertible Notes, will not be registered under the Securities Act of 1933, as amended, or any state securities law and will be issued pursuant to an exemption from registration provided by Section 4(2) of the Securities Act and/or Regulation D promulgated thereunder. Neither the Convertible Notes, nor the shares of Common Stock issuable upon exercise of Convertible Notes, may be subsequently offered or sold within the United States absent registration or exemption from such registration requirements and compliance with applicable state laws. The Company has not drawn on the Credit Facility as of December 31, 2013. With respect to the Tranche A Facility, the Company paid a commitment fee upon closing the Credit Facility of $60 thousand, equal to two percent (2.0%) of the Tranche A Facility commitment, and will pay an annual commitment fee of one percent (1.0%) of the Tranche A Facility commitment in each of 2014 and 2015 and (b) with respect to the Tranche B Facility, the Company paid a commitment fee upon closing the Credit Facility of $20 thousand, equal to one percent (1.0%) of the Tranche B Facility commitment, and will pay one percent (1.0%) of the Tranche B Facility commitment upon the advance of each Convertible Note. Furthermore, the principal amount outstanding under the Credit Facility, if drawn upon, will accrue interest at a fixed annual rate equal to nine and three quarters percent (9.75%) per annum, payable monthly, which, if the Company meets certain earnings and EBITDA targets, will be reduced to eight and three quarters percent (8.75%) per annum, payable monthly. The Credit Facility imposes usual and customary events of defaults and restrictions on actions of the Company and its subsidiaries, and provides that, upon the occurrence of an event of default, payment of all amounts payable under the Credit Facility may be accelerated and/or the lenders' commitments may be terminated. In addition, upon the occurrence of certain insolvency or bankruptcy related events of default, all amounts payable under the Credit Facility will automatically become immediately due and payable, and the lenders' commitments will automatically terminate. In connection with the execution of the Credit Facility, the Company granted warrants (the "PfG Warrants") to purchase up to $600 thousand of Common Stock to certain affiliates of PfG and to Silicon Valley Bank. The Company received the sum of approximately $4 thousand, which the parties agreed was fair consideration for the PfG Warrants. The PfG Warrants may be exercised at any time through the expiration thereof in 2018, at an exercise price equal to the lesser of (a) the 10-Day VWAP as of the issue date of the PfG Warrants and (b) the 10-Day VWAP as of the date that is six months following the issue date thereof. The Company also granted warrants (the "Conditional Warrants") to purchase up to $2.0 million of Common Stock to PfG, which may be exercised, at the same exercise price as is specified for the Convertible Notes, only if both (a) the Tranche B Facility is advanced and (b) the Company prepays the Tranche B Facility, in whole or in part, prior to the maturity date thereof. The Conditional Warrants may be exercised only in an amount equal to the principal amount of such prepayment. The PfG Warrants and the Conditional Warrants, and the shares of Common Stock to be issued upon exercise of the PfG Warrants and the Conditional Warrants, have not been and will not be registered under the Securities Act of 1933, as amended, or any state securities law and were issued pursuant to an exemption from registration provided by Section 4(2) of the Securities Act and/or Regulation D promulgated thereunder. Neither the PfG Warrants and the Conditional Warrants, nor the shares of Common Stock issuable upon exercise of the PfG Warrants and the Conditional Warrants, may be subsequently offered or sold within the United States absent registration or exemption from such registration requirements and compliance with applicable state laws. 21 -------------------------------------------------------------------------------- Table of Contents Silicon Valley Bank Credit Facility On May 30, 2013, the Company, together with its wholly-owned subsidiaries Mattersight Europe Holding Corporation and Mattersight International Holding, Inc., as co-borrowers, entered into an Amended and Restated Loan and Security Agreement with Silicon Valley Bank (the "Amended and Restated Credit Facility"). The Amended and Restated Credit Facility (i) extends the maturity date of the Company's $10.0 million revolving line with Silicon Valley Bank to 2015, (ii) modifies the borrowing base from one based upon the Company's unrestricted cash to one based upon the Company's available accounts receivable, (iii) provides for a varying interest rate based on the Company's ratio of unrestricted cash to debt, and (iv) requires the Company to maintain a tangible net worth of at least $3 million. The terms and conditions of the Amended and Restated Credit Facility are otherwise substantially the same as those contained in the Loan and Security Agreement, dated June 29, 2012, by and between the Company, the subsidiary co-borrowers thereto, and Silicon Valley Bank. The Company repaid the $3.7 million principal amount outstanding under the Amended and Restated Credit Facility on December 4, 2013. Through the maturity date, the Company is obligated to pay a fee equal to one-eighth of one percent (0.125%) per annum of the average unused portion of the Amended and Restated Credit Facility, payable quarterly in arrears. The Amended and Restated Credit Facility imposes various restrictions on the Company, including usual and customary limitations on the ability of the Company or any of its subsidiaries to incur debt and to grant liens upon their assets, and prohibits certain consolidations, mergers, and sales and transfers of assets by the Company and its subsidiaries. The Amended and Restated Credit Facility includes usual and customary events of default for facilities of this nature (with customary grace periods, as applicable) and provides that, upon the occurrence of an event of default, payment of all amounts payable under the Amended and Restated Credit Facility may be accelerated and/or the lenders' commitments may be terminated. In addition, upon the occurrence of certain insolvency or bankruptcy related events of default, all amounts payable under the Amended and Restated Credit Facility will automatically become immediately due and payable, and the lenders' commitments will automatically terminate. See Note Ten "Short-Term Debt" of the "Notes to Consolidated Financial Statements" included in Part II Item 8 of this Form 10-K. Accounts Receivable Customer Concentration As of December 31, 2013, four clients, United HealthCare Services, Inc., CVS Pharmacy, Inc., Allstate Insurance Company, and The Financial Times Limited accounted for 36%, 19%, 12%, and 11% of total gross accounts receivable, respectively. Of these amounts, we have collected 88% from United HealthCare Services, Inc., 100% from CVS Pharmacy, Inc., 78% from Allstate Insurance Company, and 71% from The Financial Times Limited through March 6, 2014. Of the total December 31, 2013 gross accounts receivable, we have collected 81% as of March 6, 2014. Because we have a high percentage of our revenue dependent on a relatively small number of clients, delayed payments by a few of our larger clients could result in a reduction of our available cash. Capital Lease Obligations Capital lease obligations as of December 31, 2013 and December 31, 2012 were $2.8 million and $2.3 million, respectively. We are a party to a capital lease agreement with a leasing company to lease hardware and software. We expect to incur new capital lease obligations of between $3.0 million to $3.8 million for fiscal year 2014 as we continue to expand our investment in the infrastructure for Behavioral Analytics. 22 -------------------------------------------------------------------------------- Table of Contents Contractual Obligations Cash will also be required for operating leases and non-cancellable purchase obligations, as well as various commitments reflected as liabilities on our balance sheet as of December 31, 2013. These commitments are as follows: Less More (In millions) Than 1 1 - 3 3 - 5 Than 5 Contractual Obligations Total Year Years Years Years Letters of credit $ 0.3 $ 0.3 $ - $ - $ - Operating leases 2.4 1.3 1.0 0.1 - Capital leases 3.3 1.9 1.4 - - Purchase obligations 1.5 1.5 - - - Total $ 7.5 $ 5.0 $ 2.4 $ 0.1 $ - Letters of Credit The amounts set forth in the chart above reflect standby letters of credit issued as collateral for capital leases. Specifically, these amounts reflect the face amount of these letters of credit that expire in each period presented. Leases The amounts set forth in the chart above reflect future principal, interest, and executory costs of the leases entered into by the Company for technology and office equipment, as well as office and data center space. Liabilities for the principal portion of the capital lease obligations are reflected on our balance sheet as of December 31, 2013 and December 31, 2012. Purchase Obligations Purchase obligations include $0.9 million of commitments reflected as liabilities on our balance sheet as of December 31, 2013, as well as $0.6 million of non-cancellable obligations to purchase goods or services in the future. As of December 31, 2012, purchase obligations include $0.9 million of commitments reflected as liabilities on our balance sheet, as well as $0.9 million of non-cancellable obligations to purchase goods or services in the future. Recent Accounting Pronouncements In July 2013, the Financial Accounting Standards Board ("FASB") issued ASU No. 2013-11, Income Taxes (Topic 740) - Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Carryforward Exists. ASU 2013-11 provides guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. An unrecognized tax benefit should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward with certain exceptions, in which case such an unrecognized tax benefit should be presented in the financial statements as a liability. The amendments in this ASU are effective for reporting periods beginning after December 15, 2013. The adoption of this ASU is not expected to have a material impact on the Company's condensed consolidated financial statements. |