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VICON INDUSTRIES INC /NY/ - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) General Management's Discussion and Analysis of Financial Condition and Results of Operations discusses the Company's consolidated financial statements for the periods indicated, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to revenue recognition, bad debts, product warranties, inventories, long lived assets, income taxes and contingencies and litigation. Management bases its estimates and judgments on historical experience and on various other factors including general market conditions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. Results for the periods reported herein are not necessarily indicative of results that may be expected in future periods. Overview The Company designs, assembles and markets video management systems and system components for use in security, surveillance, safety and communication applications by a broad group of end users worldwide. The Company's product line consists of various elements of a video system, including DVR's, NVR's, video encoders, decoders, servers and related video management software, data storage units, analog, HD and IP fixed and robotic cameras, virtual and analogue matrix video switchers and controls, and system peripherals. The Company sells video surveillance system components in a highly competitive worldwide marketplace principally to authorized security dealers and system integrators. Such dealers and integrators typically resell and install the Company's products directly to end users, among other services. The Company's sales are principally project based and are largely dependent upon winning projects, construction activities and the timing of funding. Sales will vary from period to period depending upon many factors including seasonal and geographic trends in construction activities and the timing of deliveries due to changes in project schedules and funding. The Company usually does not have a large backlog as its customer orders are typically deliverable within three months or often upon receipt of order. The Company competes in a market of rapid technology shifts which enhance the performance capability of security systems. As a result, the Company spends a significant amount on new product development. For the six months ended March 31, 2014, the 10-------------------------------------------------------------------------------- Table of Contents Company incurred $2.2 million of engineering and development expense or 15% of net sales. The Company's expenditures for product development are substantially less than its major competitors. The ongoing market shift to IP based products and network technologies will continue to burden the Company's development resources and increase ongoing annual expense for product development. Further, the Company's sales effort requires a high level of customer service and technical support for its products. The Company routinely considers various strategic options that may augment or supplement its present product offerings and technology platforms, among other benefits. The Company has a foreign sales and distribution subsidiary in Europe that conducts business in British pounds and Euros that represented approximately 36% of the Company's consolidated sales for the six months ended March 31, 2014. It also has an Israel based engineering and development subsidiary that incurs a majority of its operating expenses in Shekels that represented approximately 23% of the Company's operating expenses for the six months ended March 31, 2014. The Company has historically entered into selected forward currency exchange contracts during favorable exchange rate conditions to help stabilize the impact of changing exchange rates. However, nothing can totally eliminate the long term effects of foreign currency exchange movements. Results of Operations Three Months Ended March 31, 2014 Compared with March 31, 2013 Net sales for the quarter ended March 31, 2014 decreased 19% to $7.0 million compared with $8.7 million in the year ago period. North America sales decreased 30% to $4.6 million compared with $6.6 million in the year ago period while Europe, Middle East and Africa (EMEA) sales increased 16% to $2.4 million compared with $2.1 million in the year ago period. Order intake for the quarter ended March 31, 2014 decreased 24% to $7.0 million compared with $9.2 million in the year ago period. North America order intake decreased 31% to $5.0 million compared with $7.3 million in the year ago period while EMEA order intake increased 5% to $2.0 million compared with $1.9 million in the year ago period. The Company's North American sales and order rates were affected by, among other things, cyclical weakness in markets served and lack of major project business. The backlog of unfilled orders increased $114,000 to $2.7 million at March 31, 2014 compared with $2.6 million at September 30, 2013. Gross profit margins for the second quarter of fiscal 2014 decreased to 37.1% compared with 38.9% in the year ago period due principally to increased pricing pressures in markets served. Total operating expenses for the second quarter of fiscal 2014 decreased $234,000 to $4.5 million compared with $4.8 million in the year ago period. Selling, general and administrative expense for the second quarter of fiscal 2014 decreased $544,000 to $3.2 million compared with $3.7 million in the year ago period. Engineering and development expense for the second quarter of fiscal 2014 were $1.1 million compared with $1.1 million in the year ago period. The Company incurred $264,000 of financial advisory and legal expenses for the second quarter of fiscal 2014 pertaining to the merger and related activities. Operating expense reductions principally resulted from reduced personnel and lower variable selling costs associated with reduced sales. The Company incurred an operating loss of $1.9 million in the second quarter of fiscal 2014 compared with an operating loss of $1.4 million in the year ago period. Interest income was $5,000 for the second quarter of fiscal 2014 compared with $19,000 in the year ago period. The Company recorded income tax expense of $8,000 in both periods which represents minimum foreign subsidiary income taxes. The Company provides for a valuation allowance against its deferred tax assets due to the uncertainty of future realization and, thus, no tax benefit has been recognized on reported pretax losses for both periods (see Note 9: Income Taxes). As a result of the foregoing, the Company reported a net loss of $1.9 million for the second quarter of fiscal 2014 compared with a net loss of $1.4 million in the year ago period. 11 -------------------------------------------------------------------------------- Table of Contents Results of Operations Six Months Ended March 31, 2014 Compared with March 31, 2013 Net sales for the six months ended March 31, 2014 decreased 23% to $15.1 million compared with $19.8 million in the year ago period. North America sales decreased 36% to $9.7 million compared with $15.1 million in the year ago period while Europe, Middle East and Africa (EMEA) sales increased 16% to $5.4 million compared with $4.7 million in the year ago period. Order intake for the six months ended March 31, 2014 decreased 28% to $15.3 million compared with $21.3 million in the year ago period. North America order intake decreased 36% to $10.7 million compared with $16.8 million in the year ago period while EMEA order intake increased 1% to $4.6 million compared with $4.5 million in the year ago period. The Company's North American sales and order rates were affected by, among other things, cyclical weakness in markets served and lack of major project business. Gross profit margins for the first six months of fiscal 2014 decreased to 37.1% compared with 37.7% in the year ago period due principally to increased pricing pressures in markets served. Total operating expenses for the first six months of fiscal 2014 decreased $282,000 to $9.1 million compared with $9.4 million in the year ago period. Selling, general and administrative expense for the first six months of fiscal 2014 decreased $890,000 to $6.4 million compared with $7.3 million in the year ago period. Engineering and development expense for the first six months of fiscal 2014 increased $183,000 to $2.2 million compared with $2.0 million in the year ago period. The Company incurred $424,000 of financial advisory, legal and Board of Director expenses for the first six months of fiscal 2014 pertaining to the merger and related activities. Operating expense reductions principally resulted from reduced personnel and lower variable selling costs associated with reduced sales. The Company incurred an operating loss of $3.5 million for the first six months of fiscal 2014 compared with an operating loss of $1.9 million in the year ago period. Interest income was $9,000 for the first six months of fiscal 2014 compared with $50,000 in the year ago period. Other income of $6,000 for the first six months of fiscal 2013 represents gains in the market value of certain equity securities held and on the sales of certain marketable securities. The Company recorded income tax expense of $16,000 in both periods which represents minimum foreign subsidiary income taxes. The Company provides for a valuation allowance against its deferred tax assets due to the uncertainty of future realization and, thus, no tax benefit has been recognized on reported pretax losses for both periods (see Note 9: Income Taxes). As a result of the foregoing, the Company reported a net loss of $3.5 million for the first six months of fiscal 2014 compared with a net loss of $1.9 million in the year ago period. Liquidity and Capital Resources Net cash used in operating activities was $1.6 million for the first six months of fiscal 2014, which included a net loss of $3.2 million after non-cash charges and a $1.8 million pay down of accounts payable and accrued liabilities, offset in part by reductions in accounts receivable and inventories of $2.9 million and $782,000, respectively. Net cash used in investing activities was $33,000 for the first six months of fiscal 2014 consisting principally of general capital expenditures. There were no cash flow effects from financing activities for the first six months of fiscal 2014. As a result of the foregoing, cash (exclusive of marketable securities) decreased by $1.6 million for the first six months of fiscal 2014 after the minimal effect of exchange rate changes on the cash position of the Company. The Company believes that it will have sufficient cash to meet its anticipated operating costs and capital expenditure requirements for at least the next twelve months. Off-Balance Sheet Arrangements The Company does not have any off-balance sheet transactions, arrangements or obligations (including contingent obligations) that have, or are reasonably likely to have, a material effect on the Company's financial condition, results of operations, liquidity, capital expenditures or capital resources. 12-------------------------------------------------------------------------------- Table of Contents Merger Agreement On March 28, 2014, the Company entered into an agreement and plan of merger and reorganization (the "Merger Agreement"), pursuant to which its wholly owned subsidiary, VI Merger Sub, Inc., a California corporation ("Merger Sub"), will be merged with and into IQinVision, Inc., a California corporation ("IQinVision"), with IQinVision surviving as a wholly owned subsidiary of the Company (the "Merger"). Pursuant to the terms of the Merger Agreement, at the effective time of the Merger (the "Effective Time"), the issued and outstanding shares of capital stock of IQinVision will, in the aggregate, be converted into the right to receive an aggregate number of shares of the Company's common stock equal to the Outstanding Equity (as defined below) of the Company immediately prior to the Effective Time (the "Merger Consideration"). The Merger Agreement defines "Outstanding Equity" to mean, with respect to the Company, the total number of shares outstanding of the Company's common stock then issued and outstanding, excluding outstanding options to purchase the Company's common stock and any other securities convertible into the Company's common stock. In addition, all outstanding IQinVision options and stock appreciation rights, as well as IQinVision's 2011 Stock Incentive Plan and 2001 Stock Incentive Plan, will be assumed by the Company. Each option and stock appreciation right IQinVision assumed in the Merger will be converted into an option to purchase or stock appreciation right with respect to, as applicable, a number of shares of the Company's common stock representing the number of IQinVision shares subject to such option or stock appreciation right multiplied by the Common Stock Per Share Merger Consideration, as such term is defined in the Merger Agreement. The exercise price of each option and the base value per share of the Company's common stock for each stock appreciation right will be proportionately adjusted. Following the consummation of the transactions contemplated by the Merger Agreement, the shareholders of the Company immediately prior to the Effective Time and the shareholders of IQinVision immediately prior to the Effective Time will each own approximately 50% of the outstanding shares of common stock of the Company after the Merger. Completion of the Merger is subject to a number of conditions, including, but not limited to (i) approval of the issuance of shares of the Company's common stock in connection with the Merger by the Company's shareholders and the adoption and approval of the Merger Agreement and the transactions contemplated thereby by IQinVision's shareholders; (ii) the effectiveness of a registration statement on Form S-4 to be filed by the Company with the Securities and Exchange Commission to register the issuance of the shares of the Company's common stock in connection with the Merger, which will contain a proxy statement/prospectus/consent solicitation; (iii) approval for listing on the NYSE MKT LLC of such shares of the Company's common stock; (iv) exercise of dissenters' rights by no more than 10% of IQinVision's shareholders; and (v) other customary closing conditions. The Company cannot predict whether and when these other conditions will be satisfied. As permitted by the Merger Agreement, the Company may declare a special cash dividend of $0.55 per share payable with respect to shares of the Company's common stock held by shareholders of the Company as of a record date prior to the Effective Time and payable within 15 days after the Effective Time. The Merger Agreement contains termination rights in favor of each of the Company and IQinVision in certain circumstances and further provides that, upon termination of the Merger Agreement under specified circumstances, either the Company or IQinVision may be required to pay the other party a termination fee of $750,000. In addition, either party may terminate the Merger Agreement if the Merger has not been completed by September 28, 2014 (the "Outside Termination Date"), provided that if the registration statement on Form S-4 is not declared effective by September 28, 2014, then either party is generally entitled to extend the Outside Termination Date by 60 days. Critical Accounting Policies The Company's significant accounting policies are fully described in Note 1 to the Company's consolidated financial statements included in its September 30, 2013 Annual Report on Form 10-K. Management believes the following critical accounting policies, among others, affect its more significant judgments and estimates used in the preparation of its consolidated financial statements. Revenue is generally recognized when products are sold and title is passed to the customer. Advance service billings are deferred and recognized as revenues on a pro rata basis over the term of the service agreement. Pursuant to Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 605-25-05, the Company evaluates multiple-element revenue arrangements for separate units of accounting, and follows appropriate revenue recognition policies for each separate unit. Elements are considered separate units of accounting provided that (i) the delivered item has stand-alone value to the customer, (ii) there is objective and reliable evidence of the fair value of the undelivered item, and (iii) if a general right of return exists relative to the delivered item, delivery or performance of the undelivered item is considered probable and substantially within the control of the Company. As applied to the Company, under arrangements involving the sale of product and the provision of 13-------------------------------------------------------------------------------- Table of Contents services, product sales are recognized as revenue when the products are sold and title is passed to the customer, and service revenue is recognized as services are performed. For products that include software and for separate licenses of the Company's software products, the Company recognizes revenue in accordance with the provisions of FASB Accounting Standards Update (ASU) 2009-13, "Revenue Recognition (Topic 605) - Multiple-Deliverable Revenue Arrangements" (ASU 2009-13). ASU 2009-13 provides revenue recognition guidance for establishing separate units of accounting in a multiple element arrangement and requires the allocation of arrangement consideration to each deliverable in the arrangement based on the fair value of the elements. The fair value for each deliverable is based on vendor-specific objective evidence ("VSOE") if available, third-party evidence ("TPE") if VSOE is not available, or best estimate of selling price ("BESP") if neither VSOE nor TPE is available. BESP must be determined in a manner that is consistent with that used to determine the price to sell the specific elements on a standalone basis. The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of its customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. The Company provides for the estimated cost of product warranties at the time revenue is recognized. While the Company engages in product quality programs and processes, including monitoring and evaluating the quality of its component suppliers, its warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. Should actual product failure rates, material usage or service delivery costs differ from its estimates, revisions to the estimated warranty liability may be required. The Company writes down its inventory for estimated obsolescence and slow moving inventory equal to the difference between the carrying cost of inventory and the estimated net realizable market value based upon assumptions about future demand and market conditions. Technology changes and market conditions may render some of the Company's products obsolete and additional inventory write-downs may be required. If actual future demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required. The Company evaluates the establishment of technological feasibility of its software in accordance with ASC 985 ("Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed"). The Company has determined that technological feasibility for its new products is reached shortly before products are released for field testing. Costs incurred after technological feasibility has been established have not been material and are expensed as incurred. The Company assesses the recoverability of the carrying value of its long-lived assets whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. The Company evaluates the recoverability of such assets based upon the expectations of undiscounted cash flows from such assets. If the sum of the expected future undiscounted cash flows were less than the carrying amount of the asset, a loss would be recognized for the difference between the fair value and the carrying amount. The Company's ability to recover the reported amounts of deferred income tax assets is dependent upon its ability to generate sufficient taxable income during the periods over which net temporary tax differences become deductible. The Company provides for a valuation allowance against all deferred tax assets due to the uncertainty of future realization. The Company plans to provide a full valuation allowance against its deferred tax assets until such time that it can achieve a sustained level of profitability or other positive evidence arises that would demonstrate an ability to recover such assets. The Company accrues liabilities for identified tax contingencies that result from positions that are being challenged or could be challenged by tax authorities. The Company believes that its accrual for tax liabilities is adequate for all open years, based on Management's assessment of many factors, including its interpretations of the tax law and judgments about potential actions by tax authorities. However, it is possible that the ultimate resolution of any tax audit may be materially greater or lower than the amount accrued. The Company is subject to proceedings, lawsuits and other claims related to labor, product and other matters. The Company assesses the likelihood of an adverse judgment or outcomes for these matters, as well as the range of potential losses. A determination of the reserves required, if any, is made after careful analysis. The required reserves may change in the future due to new developments. 14-------------------------------------------------------------------------------- Table of Contents Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995 Statements in this Report on Form 10-Q and other statements made by the Company or its representatives that are not strictly historical facts including, without limitation, statements included herein under the Management's Discussion and Analysis captions "Overview", "Results of Operations", "Liquidity and Capital Resources" and "Critical Accounting Policies" are "forward-looking" statements within the meaning of the Private Securities Litigation Reform Act of 1995 that should be considered as subject to the many risks and uncertainties that exist in the Company's operations and business environment. The forward-looking statements are based on current expectations and involve a number of known and unknown risks and uncertainties that could cause the actual results, performance and/or achievements of the Company to differ materially from any future results, performance or achievements, express or implied, by the forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, and that in light of the significant uncertainties inherent in forward-looking statements, the inclusion of such statements should not be regarded as a representation by the Company or any other person that the objectives or plans of the Company will be achieved. The Company also assumes no obligation to update its forward-looking statements or to advise of changes in the assumptions and factors on which they are based, other than as required by law. |