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TELKONET INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the accompanying financial statements and related notes thereto. Critical Accounting Policies and Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. On an ongoing basis, we evaluate significant estimates used in preparing our consolidated financial statements including those related to revenue recognition, fair value of financial instruments, guarantees and product warranties, stock based compensation, potential impairment of goodwill and other long-lived assets, contingent liabilities and business combinations. We base our estimates on historical experience, underlying run rates and various other assumptions that we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results could differ from these estimates. The following are critical judgments, assumptions, and estimates used in the preparation of the consolidated financial statements. Revenue Recognition For revenue from product sales, we recognize revenue in accordance with ASC 605-10, "Revenue Recognition" and ASC 605-10-S99 guidelines that require that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and (4) collectability is reasonably assured. Determination of criteria (3) and (4) are based on management's judgments regarding the fixed nature of the selling prices of the products delivered and the collectability of those amounts. Provisions for discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period the related sales are recorded. The guidelines also address the accounting for arrangements that may involve the delivery or performance of multiple products, services and/or rights to use assets. Multiple-Element Arrangements ("MEAs"):The Company accounts for contracts that have both product and installation under the MEAs guidance in ASC 605. The Company believes the volume of these contracts will continue to increase. Arrangements under such contracts include multiple deliverables, a combination of equipment and services. The deliverables included in the MEAs are separated into more than one unit of accounting when (i) the delivered element has value to the customer on a stand-alone basis, and (ii) delivery of the undelivered element(s) is probable and substantially in our control. Arrangement consideration is then allocated to each unit, delivered or undelivered, based on the relative selling price of each unit of accounting based first on vendor-specific objective evidence ("VSOE") if it exists, second on third-party evidence ("TPE") if it exists and on estimated selling price ("ESP") if neither VSOE or TPE exist. · VSOE - Based on its pricing and discounting practices for the specific product or service when sold separately, considering geographical, customer, and other economic or marketing variables, as well as renewal rates or stand-alone prices for the service element(s). · TPE - If we cannot establish VSOE of selling price for a specific product or service included in a multiple-element arrangement, we use third-party evidence of selling price. We determine TPE based on sales of comparable amount of similar product or service offered by multiple third parties considering the degree of customization and similarity of product or service sold. · ESP - The estimated selling price represents the price at which we would sell a product or service if it were sold on a stand-alone basis. When neither VSOE nor TPE exists for all elements, we determine ESP for the arrangement element based on sales, cost and margin analysis, as well as other inputs based on our pricing practices. Adjustments for other market and Company-specific factors are made as deemed necessary in determining ESP. When MEAs include an element of customer training, it is not essential to the functionality, efficiency or effectiveness of the MEA. Therefore the Company has concluded that this obligation is inconsequential and perfunctory. As such, for MEAs that include training, customer acceptance of said training is not deemed necessary in order to record the related revenue, but is recorded when the installation deliverable is fulfilled. Historically, training revenues have not been significant. 22 We provide call center support services to properties installed by us and also to properties installed by other providers. In addition, we provide the property with the portal to access the Internet. We receive monthly service fees from such properties for our services and Internet access. We recognize the service fee ratably over the term of the contract. The prices for these services are fixed and determinable prior to delivery of the service. The fair value of these services is known due to objective and reliable evidence from standalone executed contracts. We report such revenues as recurring revenues. Total revenues do not include sales tax as we consider ourselves a pass through conduit for collecting and remitting sales taxes. Fair Value of Financial Instruments The Company accounts for the fair value of financial instruments in accordance with ASC 820, which defines fair value for accounting purposes, establishes a framework for measuring fair value and expands disclosure requirements regarding fair value measurements. Fair value is defined as an exit price, which is the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date. The degree of judgment utilized in measuring the fair value of assets and liabilities generally correlates to the level of pricing observability. Financial assets and liabilities with readily available, actively quoted prices or for which fair value can be measured from actively quoted prices in active markets generally have more pricing observability and require less judgment in measuring fair value. Conversely, financial assets and liabilities that are rarely traded or not quoted have less price observability and are generally measured at fair value using valuation models that require more judgment. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency of the asset, liability or market and the nature of the asset or liability. We have categorized our financial assets and liabilities that are recurring, at fair value into a three-level hierarchy in accordance with these provisions. Guarantees and Product Warranties The Company records a liability for potential warranty claims. The amount of the liability is based on the trend in the historical ratio of claims to sales. The products sold are generally covered by a warranty for a period of one year. In the event the Company determines that its current or future product repair and replacement costs exceed its estimates, an adjustment to these reserves would be charged to earnings in the period such determination is made. During the years ended December 31, 2013 and 2012, the Company experienced approximately between 1% and 4% of returns related to product warranties. As of December 31, 2013 and 2012, the Company recorded warranty liabilities in the amount of $77,943 and $69,743, respectively, using this experience factor range. Stock Based Compensation We account for our stock based awards in accordance with ASC 718, which requires a fair value measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors, including employee stock options and restricted stock awards. We estimate the fair value of stock options granted using the Black-Scholes valuation model. This model requires us to make estimates and assumptions including, among other things, estimates regarding the length of time an employee will retain vested stock options before exercising them and the estimated volatility of our common stock price. The fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. Changes in these estimates and assumptions can materially affect the determination of the fair value of stock-based compensation and consequently, the related amount recognized in our consolidated statements of operations. Goodwill and Other Intangibles In accordance with the accounting guidance on goodwill and other intangible assets, we perform an annual impairment test of goodwill at our reporting unit level and other intangible assets at our unit of account level, or more frequently if events or circumstances change that would more likely than not reduce the fair value of our reporting units below their carrying value. Amortization is recorded for other intangible assets with determinable lives using the straight line method over the 12 year estimated useful life. Goodwill is subject to a periodic impairment assessment by applying a fair value test based upon a two-step method. The first step of the process compares the fair value of the reporting unit with the carrying value of the reporting unit, including any goodwill. We utilize a discounted cash flow valuation methodology (income approach) to determine the fair value of the reporting unit. This approach is developed from management's forecasted cash flow data. If the fair value of the reporting unit exceeds the carrying amount of the reporting unit, goodwill is deemed not to be impaired. If the carrying amount exceeds fair value, we calculate an impairment loss. Any impairment loss is measured by comparing the implied fair value of goodwill to the carrying amount of goodwill at the reporting unit, with the excess of the carrying amount over the fair value recognized as an impairment loss. 23 Significant assumptions used in our goodwill impairment test at December 31, 2013 and 2012 included: expected revenue growth rates, reporting unit profit margins, working capital levels, discount rates of 12.4% and 12.9% for Ethostream and 21.8% and 17.5% for SSI, respectively, and a terminal value multiple. The expected future revenue growth rates and the expected reporting unit profit margins were determined after considering our historical revenue growth rates and reporting unit profit margins, our assessment of future market potential, and our expectations of future business performance. At December 31, 2013, the Company determined that the value of Smart Systems International's goodwill was impaired based upon management's assessment of operating results and forecasted discounted cash flow and has recorded an impairment charge of $2,774,016. The goodwill and intangible asset impairment charge was non-cash in nature and did not impact our liquidity, cash flows provided by operating activities or future operations. Long-Lived Assets We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable in accordance with ASC 360-10. Recoverability is measured by comparison of the carrying amount to the future net undiscounted cash flows which the assets are expected to generate. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds its fair value. Contingent Liabilities - Sales Tax During 2012, the Company engaged a sales tax consultant to assist in determining the extent of its potential sales tax exposure. Based upon this analysis, management determined the Company had probable exposure for certain unpaid obligations, including interest and penalty, of approximately $1,100,000 including and prior to the year ended December 31, 2011. The Company had approximately $1,100,000 and $1,200,000 accrued for this exposure as of December 31, 2013 and 2012, respectively. The Company continues to manage the liability by establishing voluntary disclosure agreements (VDAs) with the applicable states, which establishes a maximum look-back period and payment arrangements. However, if the aforementioned methods prove unsuccessful and the Company is examined or challenged by taxing authorities, there exists possible exposure of an additional $450,000, not including any applicable interest and penalties. During 2012, the Company successfully executed and paid in full VDAs in five states totaling approximately $23,000 and is current with the subsequent filing requirements. During 2013, the Company successfully executed and paid in full VDAs in fourteen states totaling approximately $263,000 and is current with the subsequent filing requirements. VDAs have been submitted with an additional fifteen states and the Company is awaiting notification of acceptance. Two states offer no voluntarily disclosure program. EBITDA The Company defines EBITDA as net income (loss), excluding income tax expense (benefit), interest expense, interest income, and depreciation and amortization expense. Management believes that certain non-GAAP financial measures may be useful in certain instances to provide additional meaningful comparisons between current results and results in prior operating periods. Adjusted earnings before interest, taxes, depreciation and amortization and other non-operating income and expenses ("Adjusted EBITDA") is a metric used by management and frequently used by the financial community. Adjusted EBITDA provides insight into an organization's operating trends and facilitates comparisons between peer companies, since interest, taxes, depreciation and amortization can differ greatly between organizations as a result of differing capital structures and tax strategies. Adjusted EBITDA excludes certain items that are unusual in nature or not comparable from period to period. While management believes that non-GAAP measurements are useful supplemental information, such adjusted results are not intended to replace our GAAP financial results. 24 RECONCILIATION OF NET INCOME (LOSS) TO ADJUSTED EBITDA FOR THE YEARS ENDED DECEMBER 31, (Unaudited) 2013 2012 Net income (loss) $ (3,994,731 ) $ 390,080 Interest expense, net 18,141 26,274(Benefit) provision for income taxes 349,823 (31,271 ) Depreciation and amortization 258,517 260,830 EBITDA (3,368,250 ) 645,913 Adjustments: Gain on sale of product line (41,902 ) (15,408 ) Impairment of goodwill 2,774,016 - Stock-based compensation 89,565 201,643 Adjusted EBITDA $ (546,571 ) $ 832,148 Results of Operations Year Ended December 31, 2013 Compared to Year Ended December 31, 2012 Revenues The table below outlines our product versus recurring revenues for comparable periods: Year Ended December 31, 2013 2012 Variance Product $ 10,123,407 73% $ 8,537,170 67% $ 1,586,237 19% Recurring 3,766,439 27% 4,221,206 33% (454,767 ) -11% Total $ 13,889,846 100% $ 12,758,376 100% $ 1,131,470 9% Product revenue Product revenue principally arises from the sale and installation of EcoSmart Suite of products, SmartGrid and High Speed Internet Access equipment. These include TSE, Telkonet Series 5, Telkonet iWire, and wireless networking products. We market and sell to the hospitality, education, healthcare and government/military markets. The Telkonet Series 5 and the Telkonet iWire products consist of the Telkonet Gateways, Telkonet Extenders, the patented Telkonet Coupler, and Telkonet iBridges. The EcoSmart Suite of products consist of thermostats, sensors, controllers, wireless networking products switches, outlets and a control platform. The HSIA product suite consists of gateway servers, switches and access points. For the year ended December 31, 2013, product revenue increased $1.59 million when compared to the prior year. Product revenue in 2013 included approximately $5.00 million attributed to the sale and installation of energy management products, approximately $4.97 million for the sale and installation of HSIA products, and approximately $0.15 million attributable to the sale of Telkonet Series 5 Smart Grid products. The increase in product revenue can be attributed to management's commitment of resources to sales and marketing efforts and personnel. Recurring Revenue Recurring revenue is primarily attributed to recurring services. The Company recognizes revenue ratably over the service month for monthly support revenues and defers revenue for annual support services over the term of the service period. The recurring revenue consists primarily of HSIA support services and advertising revenue. Advertising revenue is based on impression-based statistics for a given period from customer site visits to the Company's login portal page under the terms of advertising agreements entered into with third-parties. A component of our recurring revenue is derived from fees, less payback costs, associated with approximately 1% of our hospitality customers who do not internally manage guest-related, internet transactions. 25 Recurring revenue includes approximately 2,300 hotels in our broadband network portfolio. We currently support approximately 234,000 HSIA rooms, with approximately 8.0 million monthly users. For the year ended December 31, 2013, recurring revenue decreased by 11% when compared to the prior year. The decrease of recurring revenue was primarily attributed to a $0.15 million decrease in advertising revenue and a $0.30 million decrease due to a reduction of HSIA customers. The reduction of HSIA customers can be attributed to management's decision not to pursue renewing customer accounts with lower profit margins. Cost of Sales Year ended December 31, 2013 2012 Variance Product $ 6,034,294 60% $ 4,726,241 55% $ 1,308,053 28% Recurring 1,069,558 28% 1,178,077 28% (108,519 ) -9% Total $ 7,103,852 51% $ 5,904,318 46% $ 1,199,534 20% Costs of Product Sales Costs of product sales include equipment and installation labor related to the sale of SmartGrid and broadband networking equipment, including EcoSmart technology and Telkonet iWire. For the year ended December 31, 2013, cost of product sales increased by 28% when compared to the prior year. The increase was attributed to the additional cost of materials associated with the increase in product sales as well as salaries and travel expenses associated with the installations. Costs of Recurring Revenue Recurring costs are comprised of labor and telecommunication services for our Customer Service department. For the year ended December 31, 2013, costs of recurring revenue decreased by 9% when compared to the prior year. This variance is partially attributed to $0.19 million decrease in Internet Service Provider costs. The majority of the decrease in costs of recurring revenue was associated with management's decision not to pursue renewing customer accounts with lower profit margins. The decrease was partially offset by an increase in salaries and wages. Gross Profit Year ended December 31, 2013 2012 Variance Product $ 4,089,113 40% $ 3,810,929 45% $ 278,184 7% Recurring 2,696,881 72% 3,043,129 72% (346,248 ) -11% Total $ 6,785,994 49% $ 6,854,058 54% $ (68,064 ) -1% Gross Profit on Product Revenue Gross profit on product revenue for the year ended December 31, 2013 increased by 7% compared to the prior year period. The variance was a result of increased product sales and installations. Gross profit as a percentage of sales decreased approximately 5% for the year ended December 31, 2013. The decrease is attributed to the lower margins on HSIA product compared to energy management product. HSIA product revenue grew by approximately $2.10 million for the year ended December 31, 2013. Gross Profit on Recurring Revenue For the year ended December 31, 2013, our gross profit decreased by 11% when compared to the prior year. The variance was mainly attributed to a $0.15 million decrease in advertising revenue which yields higher gross margins. 26 Operating Expenses Year ended December 31, 2013 2012 Variance Total $ 10,454,663 $ 6,484,383 $ 3,970,280 61% The Company's operating expenses are comprised of research and development, selling, general and administrative expenses, goodwill impairment and depreciation and amortization expense. During the year ended December 31, 2013, operating expenses increased by 61% when compared to the prior year. This increase is primarily related to a non-cash goodwill impairment charge on Smart Systems International of $2.77 million in 2013. Excluding this non-cash charge, operating expenses would have increased by $1.20 million or 18%. Research and Development Year ended December 31, 2013 2012 Variance Total $ 1,174,048 $ 984,853 $ 189,195 19% Our research and development costs related to both present and future products are expensed in the period incurred. Total expenses for research and development increased by 19% for the year ended December 31, 2013. This increase is attributed to additional expenditures for salaries, consulting fees, and certification and testing costs associated with the continued development of our next generation energy efficiency products. Selling, General and Administrative Expenses Year ended December 31, 2013 2012 Variance Total $ 6,248,082 $ 5,238,700 $ 1,009,382 19% Selling, general and administrative expenses increased for the year ended December 31, 2013 over the prior year by 19%. The majority of this increase was attributed to salaries and wages of approximately $0.40 million, commissions of approximately $0.17 million, the Linksmart Wireless Technology, LLC litigation settlement of approximately $0.12 million and bad debts of approximately $0.19 million. Goodwill Impairment Year ended December 31, 2013 2012 Variance Total $ 2,774,016 $ 0 $ 2,774,016 100% During the year ended December 31, 2013, the Company recorded a $2.77 million goodwill impairment charge on Smart Systems International. Liquidity and Capital Resources We have financed our operations since inception primarily through private and public offerings of our equity securities, the issuance of various debt instruments and asset based lending. Working Capital Our working capital (current assets in excess of current liabilities) decreased by $985,050 during the year ended December 31, 2013 from a working capital surplus of $414,649 at December 31, 2012 to working a capital deficit of $570,401 at December 31, 2013. 27 Series A Preferred The Company has designated 215 shares of preferred stock as Series A Preferred Stock ("Series A"). Under certain circumstances, on November 19, 2014 and for a period of 180 days thereafter, we may be required to redeem the shares of Series A for $5,000 per share plus any accrued but unpaid dividends. The aggregate redemption price payable to holders of shares of Series A will be payable by the Company in three equal annual installments. The first of these three installments will be due within 60 days of the requisite holders' written notice requesting redemption. For information regarding the Series A, please see Note I of the notes to consolidated financial statements. Business Loan On September 11, 2009, the Company entered into a Loan Agreement in the aggregate principal amount of $300,000 with the Wisconsin Department of Commerce (the "Department"). The outstanding principal balance bears interest at the annual rate of 2%. Payment of interest and principal is to be made in the following manner: (a) payment of any and all interest that accrues from the date of disbursement commenced on January 1, 2010 and continued on the first day of each consecutive month thereafter through and including December 31, 2010; (b) commencing on January 1, 2011 and continuing on the first day of each consecutive month thereafter through and including November 1, 2016, the Company shall pay equal monthly installments of $4,426; followed by a final installment on December 1, 2016 which shall include all remaining principal, accrued interest and other amounts owed by the Company to the Department under the Loan Agreement. The Company may prepay amounts outstanding under the credit facility in whole or in part at any time without penalty. The Loan Agreement is secured by substantially all of the Company's assets and the proceeds from this loan were used for the working capital requirements of the Company. The Loan Agreement contains covenants which required, among other things, that the Company keep and maintain 75 existing full-time positions and create and fill 35 additional full-time positions in Milwaukee, Wisconsin by December 31, 2012. On June 18, 2012, the Department agreed to permanently waive all penalties associated with the Company's noncompliance with this covenant. The outstanding borrowings under the agreement as of December 31, 2013 and 2012 were $154,463 and $203,947, respectively. Promissory Note On March 4, 2011, the Company sold all its Series 5 PLC product line assets to Wisconsin-based Dynamic Ratings, Inc. ("Purchaser") under an Asset Purchase Agreement ("APA"). Per the APA, the Company signed an unsecured Promissory Note (the "Note") due to Purchaser in the aggregate principal amount of $700,000. The outstanding principal balance bears interest at the annual rate of 6% and was originally due on March 31, 2014. The Note may be prepaid in whole or in part, without penalty at any time. The Note contains certain earn-out provisions that encompass both the Company's and Purchaser's revenue volumes. Amounts earned under the earn-out provisions were applied against the Note on June 30, 2012 and June 30, 2013. For the periods ended June 30, 2013 and June 30, 2012, the non-cash reduction of principal calculated under these provisions and applied to the Note was $41,902 and $15,408, respectively. Payments not made when due, by maturity acceleration or otherwise, shall bear interest at the rate of 12% per annum from the date due until fully paid. Effective April 30, 2013, Purchaser approved an amendment to certain terms of the Note. Telkonet commenced a monthly payment of principal and interest of $20,000 to be applied against the outstanding balance starting May 1, 2013. The interest rate remains unchanged at 6% and the maturity date was extended to January 1, 2016. The outstanding principal balance of the Note as of December 31, 2013 and 2012 was $506,024 and $684,592, respectively. Revolving Credit Facility On May 31, 2013, the Company entered into a Revolving Credit Facility (the "Agreement") with Bridge Bank, NA, (the "Bank") in a principal amount not to exceed $2,000,000. The Agreement is subject to a borrowing base that is equal to the sum of 80% of the Company's eligible accounts receivable and 25% of the eligible inventory. On August 1, 2013 the Agreement was modified to include the eligible receivables and the eligible inventory of Ethostream. The Agreement is available for working capital and other lawful general corporate purposes. The outstanding principal balance of the facility bears interest at Prime Rate plus 2.75%. The Company's borrowing base at December 31, 2013 was approximately $791,000 and the outstanding balance was zero. As of September 30 and December 31, 2013, the Company was in violation of a financial performance covenant. The outstanding balance at March 31, 2014 is $200,000. The Company is currently in negotiations with the Bank to modify the existing Agreement. Cash flow analysis Cash provided by operations was $2,641 during the year ended December 31, 2013 and cash used in operations was $188,985 during the year ended December 31, 2012. As of December 31, 2013, our primary capital needs included costs incurred to increase energy management sales, inventory procurement, funding performance bonds and managing current liabilities. 28 Cash used in investing activities was $407,577 during the year ended December 31, 2013 and cash provided by investing activities was $47,905 during the year ended December 31, 2012. During the year ended December 31, 2012, the Company was awarded a contract that included a bonding requirement. During the year ended December 31, 2013, the Company satisfied this requirement with cash collateral supported by an irrevocable standby letter of credit in the amount of $382,000. Cash used in financing activities to repay indebtedness was $186,150 during the year ended December 31, 2013. Cash provided by financing activities was $343,747 during the year ended December 31, 2012. The Company received proceeds of $405,000 from the exercise of 3,115,390 Series B Convertible Redeemable Preferred Stock warrants for common stock during 2012. We are working to manage our current liabilities while we continue to make changes in operations to improve our cash flow and liquidity position. Our independent registered public accounting firm's report on our consolidated financial statements for the year ended December 31, 2013 includes an explanatory paragraph relating to our ability to continue as a going concern. We have incurred operating losses and operating cashflow deficits in past years and we are dependent upon our ability to continue profitable operations and/or obtain necessary funding from outside sources, including by the sale of our securities, or obtaining loans from financial institutions, where possible. These factors, among others, raise doubt about our ability to continue as a going concern and may also affect our ability to obtain financing in the future. Management expects that global economic conditions will continue to present a challenging operating environment through 2014; therefore working capital management will continue to be a high priority for 2014. The Company continues to manage the approximate $1,100,000 sales tax liability by establishing VDAs with the applicable states, which establish a maximum look-back period and payment arrangements. However, if the aforementioned methods prove unsuccessful and the Company is examined or challenged by taxing authorities, there exists possible exposure of an additional $450,000, not including any applicable interest and penalties. During 2013, the Company successfully executed and paid in full VDAs in fourteen states totaling approximately $263,000 and is current with the subsequent filing requirements. The Company has submitted VDAs with an additional fifteen states and awaits notification of acceptance. Two states offer no voluntarily disclosure program. During 2012, the Company successfully executed and paid in full VDAs in five states totaling approximately $23,000 and is current with the subsequent filing requirements. The Company has submitted VDAs with an additional twenty-seven states and awaits notification of acceptance. The Company also confirmed that one customer had self-assessed, further reducing our liability and expense associated with that liability by approximately $151,000. Inflation We do not believe that inflation has had a material effect on our business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could adversely affect our business, financial condition and results of operations. Off-Balance Sheet Arrangements None. New Accounting Pronouncements See Note B of the Consolidated Financial Statements for a description of a new accounting pronouncement. |