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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) FACTORS THAT MAY AFFECT FUTURE RESULTS From time to time, information provided by the Company or statements made by its employees may contain "forward-looking" information which involves risks and uncertainties. In particular, statements contained in this report which are not historical facts (including, but not limited to, the Company's expectations regarding earnings, earnings per share, revenues, operating cash flows, dividends, future business, growth opportunities, new accounts, customer base, test volume, sales and marketing strategy, business strategy, general and administrative expenses, marketing and selling expenses, research and development expenses, anticipated operating results, foreign drug testing laws and regulations, required investments in plant, property and equipment, strategies with respect to governmental agencies and regulations, cost savings, capital expenditures, liquidity of investments and anticipated cash requirements) may be "forward-looking" statements. The Company's actual results may differ from those stated in any "forward-looking" statements. Factors that may cause such differences include, but are not limited to, risks associated with employee hiring practices of the Company's principal customers, development of markets for new products and services offered by the Company, costs associated with capacity expansion, government regulation (including, but not limited to, Food and Drug Administration regulations and foreign government regulation including Brazilian commercial drivers license drug test regulations), competition and general economic conditions. With respect to the continued payment of cash dividends, factors include, but are not limited to, available surplus, cash flow, capital expenditure reserves required, debt service obligations, and other factors that the Board of Directors of the Company may take into account. OVERVIEW Revenues for the second quarter of 2014 were $7.7 million, an increase of 12% from second quarter 2013 revenue of $6.9 million. The Company reported net income of $0.16 per diluted share for the three months ended June 30, 2014 and $0.20 for the same period in 2013. The positive impact of revenue growth on earnings was offset by expenditures related to an increase in capacity related to the previously announced opportunity in Brazil and research and development of additional tests for drugs of abuse. At June 30, 2014, the Company had $2.3 million of cash. The Company has borrowed $6.0 million through an equipment financing arrangement for the purchase of additional equipment related to expanding capacity. The Company distributed $802 thousand or $0.15 per share of cash dividends to its shareholders in the three months ended June 30, 2014. The Company has paid 71 consecutive quarterly cash dividends. 11 RESULTS OF OPERATIONS Revenues were $7.7 million for three months ended June 30, 2014 compared to revenues of $6.9 million for the three months ended June 30, 2013, representing an increase of 12%. The increase in revenues for the three months ended June 30, 2014 was a result of an increase in testing volume of 13%. The average revenue per sample decreased 1% from the comparative period in 2013, which was primarily driven by the mix of customers. Revenues for the six months ended June 30, 2014 were $14.7 million, representing an increase of 11% in revenues from the comparable period of 2013 of $13.3 million. The increase was primarily due to an increase in volume, as test samples increased 12% from the first half of 2013. Gross profit was $3.9 million for the three months ended June 30, 2014, compared to $4.1 million for the three months ended June 30, 2013, representing a decrease of 5%. Direct costs increased by $1.0 million or 35% for the three months ended June 30, 2014 compared to the same period in 2013, mainly due to increased costs related to capacity expansion and a greater volume of samples. The gross profit margin was 51% for the three months ended June 30, 2014 and 59% for the comparable period of 2013. Gross profit for the six months ended June 30, 2014 increased $121 thousand to $7.7 million compared to $7.6 million for the comparable period in 2013. Direct costs increased by $1.3 million or 22% for the six months ended June 30, 2014 when compared to the same period in 2013, mostly due to increased costs related to capacity expansion and a greater volume of samples. The gross profit margin for the six month period ended June 30, 2014 was 52% compared to 57% for the comparable period in 2013. General and administrative ("G&A") expenses were $1.1 million for the three months ended June 30, 2014, compared to $1.0 million for the three months ended June 30, 2013. As a percentage of revenue, G&A expenses were 15% for the three months ended June 30, 2014 and 2013. General and administrative expenses were $2.3 million and $2.0 million for the six months ended June 30, 2014 and 2013, respectively. As a percentage of revenue, G&A expenses were 16% and 15% for the six months ended June 30, 2014 and 2013, respectively. Marketing and selling expenses were $1.2 million for the three months ended June 30, 2014 and 2013. Total marketing and selling expenses represented 15% of revenue for the three months ended June 30, 2014, compared to 17% for the comparable period of 2013. Marketing and selling expenses were $2.3 million for the six months ended June 30, 2014 and 2013. Total marketing and selling expenses represented 15% of revenue for the six months ended June 30, 2014, compared to 17% for the comparable period of 2013. Research and development ("R&D")expenses for the three months ended June 30, 2014 were $277 thousand compared to $190 thousand for the comparable period of 2013, an increase of 46%. R&D expenses represented 4% and 3% of revenue for the three months ended June 30, 2014 and 2013, respectively. Research and development expenses for the six months ended June 30, 2014 were $622 thousand compared to $355 thousand in the prior year. R&D expenses represented 4% and 3% of revenue for the six months ended 2014 and 2013, respectively. The increase in R&D expenses related to additional tests of drugs of abuse. 12 Provision for income taxes During the three months ended June 30, 2014 and 2013, the Company recorded tax provisions of $466 thousand and $669 thousand, respectively. These provisions represented effective tax rates of 35% for the three months ended June 30, 2014 and 39% for the comparable period of 2013. During the six months ended June 30, 2014 and June 30, 2013, the Company recorded tax provisions of $879 thousand and $1.1 million, respectively. These provisions represented effective tax rates of 35% for the six month periods ended June 30, 2014 and 38% for the comparative period last year. The 35% represents the current estimate of the year-end tax rate. The Company continues to monitor the effective tax rate but does not expect a significant change for the remaining six months of 2014. LIQUIDITY AND CAPITAL RESOURCES At June 30, 2014, the Company had approximately $2.3 million of cash. The Company's operating activities provided net cash of $199 thousand for the six months ended June 30, 2014. Investing activities used $6.2 million of cash while financing activities provided $4.4 million of cash during the first six months of 2014. Cash provided by operating activities of $199 thousand reflected net income of $1.6 million adjusted for depreciation and amortization of $469 thousand and stock-based compensation of $288 thousand. This was affected by the following changes in assets and liabilities: an increase in accounts receivable of $1.3 million, an increase in prepaid expenses, income tax receivable and other current assets of $89 thousand, an increase in accounts payable of $669 thousand, a decrease in accrued expenses of $1.4 million, and an increase for deferred income tax assets of $113 thousand Cash used in investing activities of $6.2 million included equipment and leasehold improvements of $5.8 million related to the Company's capacity expansion, cost of internally developed software of $247 thousand, and other assets of $145 thousand which were purchased during the first six months of 2014. We anticipate spending $0.6 million to $0.8 million in additional capital purchases and leasehold improvements for the remainder of 2014. Cash provided by financing activities of $4.4 million included $6.0 million of proceeds from long term debt used to purchase equipment related to capacity expansion and $48 thousand from proceeds from exercise of stock options, which was offset by $1.6 million in cash dividends to shareholders, $53 thousand from repayment of debt, and $37 thousand from proceeds from issuance of stock. On July 28, 2014, the Company declared a quarterly dividend of $0.15 per share for a total of $806 thousand, which will be paid on August 18, 2014 to shareholders of record on August 7, 2014. 13 Contractual obligations and other commercial commitments as of June 30, 2014 were as follows: Less Than 1-3 4-5 After 5 One Year Years years Years Total (in thousands) Debt principal $ 1,232 $ 2,400 $ 2,315 $ - $ 5,947 Operating leases $ 979 $ 1,058 $ 60 $ - $ 2,097 Total $ 2,211 $ 3,458 $ 2,375 $ - $ 8,044 At June 30, 2014, the Company's principal sources of liquidity included an aggregate of approximately $2.3 million of cash and its $6.0 million equipment financing. During the third quarter, the Company expects to expand the equipment financing arrangement to fund additional equipment purchases of an estimated $900 thousand to $1.1 million. Management currently believes that such funds, together with cash generated from operations, should be adequate to fund anticipated working capital and capital equipment requirements for the next 12 months. Depending upon the Company's results of operations and capital needs, the Company may use various financing sources to raise additional funds. 14 CRITICAL ACCOUNTING POLICIES Management believes the most critical accounting policies are as follows: Revenue Recognition The Company is in the business of performing drug testing services and reporting the results thereof. The Company's drug testing services includetraining for collection of samples and storage of positive samples for its customers for an agreed-upon fee per unit tested of samples. The revenues are recognized when the predominant deliverable, drug testing, is provided and reported to the customer. The Company recognizes revenue under ASC 605, Revenue Recognition. In accordance with ASC 605, the Company considers testing, training and storage elements as one unit of accounting for revenue recognition purposes, as the training and storage costs are de minimis and do not have stand-alone value to the customer. The Company recognizes revenue as the service is performed and reported to the customer, since the predominant deliverable in each arrangement is the testing of the units. The Company also provides expert testimony, when and if necessary, to support the results of the tests, which is generally billed separately and recognized as the services are provided. Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates, including bad debts, stock compensation expense, and income taxes, and assumptions that affect the reported amounts of assets and liabilities and 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. Actual results could differ from those estimates. Allowance for Doubtful Accounts The allowance for doubtful accounts is based on management's assessment of the collectability of its customer accounts. Management reviews its accounts receivable aging for doubtful accounts and specifically identifies accounts that may not be collectible. The Company routinely assesses the financial strength of its customers and, as a consequence, believes that its accounts receivable credit risk exposure is limited. The Company maintains an allowance for potential credit losses but historically has not experienced any significant losses related to individual customers or groups of customers in any particular industry or geographic area. Bad debt expense has been within management's expectations. 15 Capitalized Development Costs The Company capitalizes costs related to significant software projects developed or obtained for internal use. Costs incurred during the preliminary project work stage or conceptual stage, such as determining the performance requirements, system requirements and data conversion, are expensed as incurred. Costs incurred in the application development phase, such as coding, testing for new software and upgrades that result in additional functionality, are capitalized and are amortized using the straight-line method over the useful life of the software for 5 years. Costs incurred during the post-implementation/operation stage, including training costs and maintenance costs, are expensed as incurred. The Company capitalized internally developed software costs of $247 thousand and $379 thousand for the six months ended June 30, 2014 and 2013, respectively. Determining whether particular costs incurred are more properly attributable to the preliminary or conceptual stage, and thus expensed, or to the application development phase, and thus capitalized and amortized, depends on subjective judgments about the nature of the development work, and our judgments in this regard may differ from those made by other companies. General and administrative costs related to developing or obtaining such software is expensed as incurred. Income Taxes The Company accounts for income taxes using the liability method, which requires the Company to recognize a current tax liability or asset for current taxes payable or refundable and a deferred tax liability or asset for the estimated future tax effects of temporary differences between the financial statement and tax reporting bases of assets and liabilities to the extent that they are realizable. Deferred tax expense (benefit) results from the net change in deferred tax assets and liabilities during the year. A deferred tax valuation allowance is required if it is more likely than not that all or a portion of the recorded deferred tax assets will not be realized. The Company follows the guidance of ASC 740, Income Taxes ("ASC 740"). ASC 740 contains a two-step approach to recognizing and measuring uncertain tax positions (tax contingencies). The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on an audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately forecast actual outcomes. The Company operates within multiple taxing jurisdictions and could be subject to audit in these jurisdictions. These audits may involve complex issues, which may require an extended period of time to resolve. The Company has provided for its estimated taxes payable in the accompanying financial statements. Interest and penalties related to income tax matters are recognized as a general and administrative expense. The Company did not have any unrecognized tax benefits and did not have any interest or penalties accrued as of June 30, 2014 or December 31, 2013. 16 The above listing is not intended to be a comprehensive list of all of the Company's accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for management's judgment in their application. There are also areas in which management's judgment in selecting any available alternative would not produce a materially different result. |