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APPLIED DNA SCIENCES INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with our Unaudited Condensed Consolidated Financial Statements and Notes thereto, included elsewhere within this report. The Quarterly Report contains forward-looking statements, including statements using terminology such as "can", "may", "believe", "designed to", "will", "expect", "plan", "anticipate", "estimate", "potential" or "continue", or the negative thereof or other comparable terminology regarding beliefs, plans, expectations or intentions regarding the future. You should read statements that contain these words carefully because they: ? discuss our future expectations; ? contain projections of our future results of operations or of our financial condition; and ? state other "forward-looking" information. We believe it is important to communicate our expectations. However, forward looking statements involve risks and uncertainties and our actual results and the timing of certain events could differ materially from those discussed in forward-looking statements as a result of certain factors, including those set forth under "Risk Factors," "Business" and elsewhere in our Annual Report on Form 10-K and Form 10-K/A for the fiscal year ended September 30, 2013. All forward-looking statements and risk factors included in this document are made as of the date hereof, based on information available to us as of the date thereof, and we assume no obligations to update any forward-looking statement or risk factor, unless we are required to do so by law. Introduction Using biotechnology as a forensic foundation, we create unique security solutions addressing the challenges of modern commerce. Whether working in supply chain security, brand protection or law enforcement applications, it is our goal to help establish secure flourishing environments that foster quality, integrity and success. With impenetrable taggants, high-resolution DNA authentication, and comprehensive reporting, our botanical DNA-based technologies are designed to deliver what we believe to be the greatest levels of security, deterrence and legal recourse strength. SigNature ® DNA . SigNature DNA is our platform ingredient, at the core of all our security solutions. From application to application the vehicle which carries SigNature DNA is custom designed to suit the application. Exhaustive development efforts have yielded a flexible and durable marker with all the accuracy provided by nature. SigNature DNA is based on full, double stranded plant DNA, and provides forensic power and protection for a wide array of applications. Highly secure, robust, durable and, in our belief, cost-effective, SigNature DNA markers are an ingredient that can be used to fortify brand protection efforts; mark, track and convict criminals; and strengthen supply chain security. Custom DNA sequences can be embedded into a wide range of host carriers including ink, varnish, thread, laminates and metal coatings. These items can then be tested for the presence of SigNature DNA Markers through optical screening or a forensic level authentication. Hundreds of millions of SigNature DNA marks now exist in the public domain on items ranging from consumer product packaging to microcircuits to guitars. We believe that no marks have ever been copied. SigNature DNA, SigNature® T DNA, fiberTyping®, DNANet® and digitalDNA®, our principal anti-counterfeiting and product authentication solutions and our Counterfeit Prevention Authentication Program can be used in numerous industries, including microcircuits and other electronics, cash-in-transit (transport and storage of banknotes), homeland security, textiles and apparel, identity cards and other secure documents, law enforcement, industrial materials, pharmaceuticals, wine, and luxury consumer goods. SigNature T DNA and fiberTyping . There is one common thread that runs through the global textile industry: success breeds counterfeiting and diversion. SigNature T botanical DNA markers are used for brand protection efforts and raw material source compliance programs. In situations where natural fibers like cotton or wool are in play, we can isolate and type inherent DNA, making it possible to verify the presence of specified materials. This fiberTyping process provides DNA verification to help manufacturers, retailers and brand owners ensure quality, safety and compliance of their products. DNANet. Recognizing that DNA-based evidence is the cornerstone of the modern era of law enforcement, we have created what we believe to be the ultimate crime fighting tool: DNANet, a botanical DNA marker that can be used to definitively link evidence and offenders to specific crime scenes. Whether deployed as a residential asset marker, an offender spray or fog in a retail location or a degradation dye in cash handling boxes, DNA markers facilitate conviction, and establish a heightened level of deterrence. DNANet, which includes our SmartDNA product line, is a unique and patented security system and effective crime protection system for stores, warehouses, banks, pharmacies, ATMs and the protection of valuables. The system contains a water-based, non-toxic spray which may be triggered during a crime, marking the perpetrator and remaining on their person for weeks after the crime. Each unit is designed to be unique to each store, warehouse or sting operation, allowing the police and prosecutors to link criminals to the crimes. Assets acquired from RedWeb Technologies including Sentry 500 Intruder Spray Systems and Advanced Molecular Taggant Technology and our SmartDNA product line are now included in the DNANet family of products. 15 digitalDNA. digitalDNA is a security solution that utilizes the flexibility of mobile communications, the instant accessibility of secure, cloud-based data, and the absolute certainty of DNA to make item tracking and authentication fast, easy and definitive, while providing the opportunity to create a new customer interface. digitalDNA begins with a DNA-secured form of the QR ("quick read") code or other two dimensional code. A unique identification code is created for each article, and represented in an easy-to-read QR style barcode. The product uses forensic authentication of a botanical DNA marker, embedded within a secure QR code, and physically included within the ink used to digitally print the code. Should there ever be a question about the validity of a digitalDNA code, a laboratory-based analysis can be conducted to determine authenticity. Counterfeit Prevention Authentication Program. Our turnkey program for electronics, military, commercial, and aerospace contractors called the Counterfeit Prevention Authentication Program ("CPA" Program) empowers end-users to verify the originality or provenance of parts which have been marked by their suppliers with our SigNature DNA Markers. Plan of Operations General To date, the substantial portion of our revenues have been generated from sales of Signature DNA and fiberTyping, our principal anti-counterfeiting and product authentication solutions. We expect to continue to grow revenues from sales of our SigNature DNA platform ingredient, our fibertyping, DNANet, and digitalDNA offerings and the Counterfeit Prevention Authentication Program. We have continued to incur expenses in expanding our laboratory and office facilities and increasing our personnel to meet current and anticipated future demand. We have limited sources of liquidity. We have developed or are currently attempting to develop business in the following target markets: microcircuits and other electronics, homeland security, cash-in-transit, textile and apparel authentication, secure documents, pharmaceuticals, consumer products, law enforcement, industrial materials, fine wine, art and collectibles, and digital and recording media. Our developments in the semiconductor authentication, cash-in-transit and textile and apparel authentication have contributed to the increase in our revenues. We intend to pursue both domestic and international sales opportunities in each of these vertical markets. Critical Accounting Policies Financial Reporting Release No. 60, published by the SEC, recommends that all companies include a discussion of critical accounting policies used in the preparation of their financial statements. While all these significant accounting policies impact our financial condition and results of operations, we view certain of these policies as critical. Policies determined to be critical are those policies that have the most significant impact on our consolidated financial statements and require management to use a greater degree of judgment and estimates. Actual results may differ from those estimates. We believe that given current facts and circumstances, it is unlikely that applying any other reasonable judgments or estimate methodologies would cause a material effect on our condensed consolidated results of operations, financial position or liquidity for the periods presented in this report. The accounting policies identified as critical are as follows: ? Revenue recognition; ? Equity based compensation. ? Fair value of financial instruments Revenue Recognition We recognize revenue in accordance with Accounting Standards Codification ("ASC") 605, Revenue Recognition ("ASC 605"). ASC 605 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred and/or service has been performed; (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 or services provided and the collectability of those amounts. Provisions for allowances and other adjustments are provided for in the same period the related sales are recorded. We defer any revenue for which the product has not been delivered, service hasn't been provided, or is subject to refund until such time that we and the customer jointly determine that the product has been delivered, service has been provided, or no refund will be required. At June 30, 2014 and September 30, 2013, the Company recorded deferred revenue of $348,624 and 148,503, respectively. Revenue arrangements with multiple components are divided into separate units of accounting if certain criteria are met, including whether the delivered component has stand-alone value to the customer. Consideration received is allocated among the separate units of accounting based on their respective selling prices. The selling price for each unit is based on vendor-specific objective evidence, or VSOE, if available, third party evidence if VSOE is not available, or estimated selling price if neither VSOE nor third party is available. The applicable revenue recognition criteria are then applied to each of the units. Revenue for a government contract award, which supports our development efforts on specific projects, is recognized as milestones under the contract are achieved as per the contract. We recognized revenue of approximately $0 and $50,000 from this contract during the three and nine month periods ended June 30, 2014, respectively. 16 Equity Based Compensation We follow Accounting Standards Codification subtopic 718, Compensation ("ASC 718") which requires all share-based payments to employees, including grants of employee stock options, and consultants, to be recognized in the statement of operations based on their fair values. Fair Value of Financial Instruments The valuation techniques utilized are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect internal market assumptions. These two types of inputs create the following fair value hierarchy: Level 1 - Quoted prices in active markets for identical assets or liabilities. Level 2 - Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the related asset or liabilities. Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of assets or liabilities. The Company utilizes observable market inputs (quoted market prices) when measuring fair value whenever possible. For fair value measurements categorized within Level 3 of the fair value hierarchy, the Company's accounting and finance department, who report to the Chief Financial Officer, determine its valuation policies and procedures. The development and determination of the unobservable inputs for Level 3 fair value measurements and fair value calculations are the responsibility of the Company's accounting and finance department and are approved by the Chief Financial Officer. Use of Estimates In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required 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 revenue and expenses during the reporting period. Actual results could differ from those estimates. Remediation of Weakness in Internal Controls We concluded that our disclosure controls and procedures were not effective as of June 30, 2014 as the result of a material weakness in our internal control over financial reporting as of September 30, 2013 that was not yet remediated as of June 30, 2014. The material weakness, which arose primarily due to the need for more enhanced and formalized documentation and procedures regarding the financial statement closing and review process, is further described in Item 4 of this Quarterly Report on Form 10-Q. Our management has developed a remediation action plan and we are actively engaged in the implementation of the plan to fully remediate our material weakness. The principal elements of our remediation include the following: ? Our CEO has appointed a Sarbanes-Oxley project leadership team, consisting of our CFO and our Controller, that are overseeing the project; ? Together with a consultant that we have engaged, we have enhanced our review procedures and the documentation thereof; and ? We have implemented these enhanced procedures as we prepared our Form 10-Q for the period ended June 30, 2014. 17 Comparison of Results of Operations for the Three Month Periods Ended June 30, 2014 and 2013 Revenues For the three month periods ended June 30, 2014 and 2013, we generated $841,197 and $644,842, respectively, in revenues from operations. The increase in revenues of $196,355 or 30% was primarily from an increase of approximately $85,000 in sales of DNANet kits in Europe. The increase was also related to a term sheet entered into with a provider of polyolefins where the Company has agreed to cooperate in the development and supply of markers and related additives for polyolefin products. We also had an increase in sales of approximately $30,000 to a Cash in-transit customer. Costs and Expenses Selling, General and Administrative Selling, general and administrative expenses for the three month periods ended June 30, 2014 decreased by $292,363 or 9% from $3,240,815 for the three month period ended June 30, 2013 to $2,948,452 for the three month period ended June 30, 2014. The decrease is primarily attributable to reduction in stock based compensation expense for stock option modifications. During both the three month periods ended June 30, 2014 and 2013, we extended the term of options, which resulted in a charge to the statement of operations of approximately $43,000 and $409,000, for the three month periods ended June 30, 2014 and 2013, respectively, a decrease of $366,000. The other significant decreases were consulting expense, which decreased approximately $130,000 due to our entering into a distributor agreement with a company in Sweden that during fiscal 2013 was paid as a consultant. Bad debt expense also decreased by approximately $70,000 for the three month period ended June 30, 2014 as compared to the same period in the prior fiscal year. There was also a decrease in travel expense of approximately $69,000 and office expense/building repairs of $65,000. These decreases were partially offset by higher salary expense of approximately $235,000 due to an increase in headcount from 44 as of June 30, 2013 to 58 as of June 30, 2014. The increase in the number of employees compared to the same period in the prior year was due to an increase for production, sales, information technology and finance, to meet the anticipated future demand for sales. Selling, General and Administrative expenses also increased due to an increase in rent and related utilities by approximately $80,000 as a result of the larger office space and our now paying utilities as compared to them being included as part of the rent during the three month period ended June 30, 2013. Legal fees also increased by approximately $130,000, related to legal fees incurred for the SmartWater litigation, as disclosed in footnote G of the accompanying condensed consolidated financial statements. Research and Development Research and development expenses increased to $266,331 for the three month period ended June 30, 2014 from $184,981 for the three month period ended June 30, 2013. The increase of $81,350 or 44% is attributable to the increased laboratory space with our new corporate headquarters as well as an increase in research and development to support the expansion of our business and markets. In particular, we have multiple workstreams in progress toward a launch of new products for field detection and rapid reading of optical marks which use the SigNature DNA ingredient. Depreciation and Amortization In the three month period ended June 30, 2014, depreciation and amortization increased by $51,144 from $62,280 for the three month period ended June 30, 2013 to $113,424 for the three month period ended June 30, 2014. The increase is attributable to depreciation and amortization expense for the leasehold improvements and lab equipment purchased during the second half of the fiscal year ended September 30, 2013 primarily related to the relocation of our corporate offices. The increase also relates to amortization for the intellectual property purchased from RedWeb Technologies during May 2013. Gain from Change in Fair Value of Warrant Liability Gain from change in fair value of warrant liability during the three month periods ended June 30, 2014 and 2013 was $515,543 and $707,289, respectively. These changes in fair value relate to warrants containing certain reset provisions which required us to classify them as liabilities and mark the warrants to market and record the change in fair value at each reporting period, and upon exercise as a non cash adjustment to our current period operations. Comparison of Results of Operations for the Nine Month Periods Ended June 30, 2014 and 2013 Revenues For the nine month periods ended June 30, 2014 and 2013, we generated $2,075,698 and $1,307,117, respectively, in revenues from operations. The increase in revenues of $768,581 or 59% was primarily from an increase in sales to suppliers of the United States Defense Logistics Agency ("DLA") of approximately $350,000 from renewals of existing contracts as well as the signing of new contracts. The increase in revenue is also related to a term sheet entered into with a provider of polyolefins where we agreed to cooperate in the development and supply of markers and related additives for polyolefin products. The increase relates to a higher level of sales in the textile industry, primarily for an exclusivity contract with one customer, and to a smaller extent, an increase in fiberTyping sales. 18 Costs and Expenses Selling, General and Administrative Selling, general and administrative expenses for the nine month period ended June 30, 2014 increased by $1,577,241 or 19% from $8,516,390 for the nine month period ended June 30, 2013 to $10,093,631 for the nine month period ended June 30, 2014. The increase is primarily attributable to an increase in payroll of approximately $830,000 due to an increase in headcount from 44 as of June 30, 2013 to 58 as of June 30, 2014. The increase in the number of employees compared to the same period in the prior year was due to an increase for production, sales, information technology and finance, to meet the anticipated future demand for sales. The increase is also due to shares of Common Stock issued to a consultant for settlement of their fees during the nine month period ended June 30, 2014 for $337,500. Rent and related utilities expense increased by approximately $253,000 as a result of the larger office space and our now paying utilities as compared to them being included as part of rent during the period ended June 30, 2013. Legal fees also increased by approximately $285,000, related to legal fees incurred for the SmartWater litigation, as disclosed in footnote G of the accompanying condensed consolidated financial statements. Research and Development Research and development expenses increased to $1,085,416 for the nine month period ended June 30, 2014 from $509,132 for the nine month period ended June 30, 2013. The increase of $576,284 or 113% is attributable to the increased laboratory space with our new corporate headquarters as well as an increase in research and development to support the expansion of our business and markets. In particular, we have multiple workstreams in progress toward a launch of new products for field detection and rapid reading of optical marks which use the SigNature DNA ingredient. Depreciation and Amortization During the nine month period ended June 30, 2014, depreciation and amortization increased by $220,343 from $105,105 for the nine month period ended June 30, 2013 to $325,448 for the nine month period ended June 30, 2014. The increase is attributable to depreciation and amortization expense for the leasehold improvements and lab equipment purchased during the second half of the fiscal year ended September 30, 2013 related to the relocation of our corporate offices. The increase also relates to amortization for the intellectual property purchased from RedWeb Technologies during May 2013 and purchases of lab equipment during the nine month period ended June 30, 2014 of approximately $210,000. Loss from Change in Fair Value of Warrant Liability Loss from change in fair value of warrant liability during the nine month periods ended June 30, 2014 and 2013 was $1,663,316 and $6,145,229, respectively. These losses relate to warrants containing certain reset provisions which required us classify them as liabilities and mark the warrants to market and record the change in fair value at each reporting period, and upon exercise as a non cash adjustment to our current period operations. Liquidity and Capital Resources Our liquidity needs consist of our working capital requirements and research and development expenditure funding. As of June 30, 2014, we had working capital of $1,106,719. For the nine month period ended June 30, 2014, we generated a net cash flow deficit from operating activities of $6,271,019 consisting primarily of our loss of $10,961,143, net with non-cash adjustments of $325,448 in depreciation and amortization charges, $1,717,837 for stock-based compensation, $1,663,316 change in fair value of warrant liability, $337,500 in common stock issued for consulting services and $16,878 of bad debt expense. Additionally, we had a net decrease in operating assets of $136,562 and a net increase in operating liabilities of $492,583. Cash used in investing activities was $209,522 for the purchase of property, plant and equipment. Cash provided by financing activities was $2,145,956 in proceeds from the sale of common stock related to a private placement during June 2014. We have recurring net losses, which has resulted in an accumulated deficit of $197,654,754 as of June 30, 2014. We incurred a net loss of $10,961,143 and generated negative operating cash flow of $6,271,019 for the nine month period ended June 30, 2014. However, we have attained positive working capital of $1,106,719 as of June 30, 2014. At June 30, 2014, we had cash and cash equivalents of $2,025,716. Our current capital resources include cash and cash equivalents and other working capital resources. Historically, we have financed our operations principally from the sale of equity securities. During June 2014, we raised $2,145,956 in a private placement transaction (see Note E of the accompanying condensed consolidated financial statements). Our continuation as a going concern is dependent upon future revenues, obtaining additional capital and ultimately, upon attaining profitable operations. We will require additional funds to complete the continued development of our products, product manufacturing, and to fund expected additional losses from operations, until revenues are sufficient to cover our operating expenses. If we are unsuccessful in obtaining the necessary additional financing, we will most likely be forced to reduce operations. Management believes that it will be able to raise additional funds and we have executed engagement letters with an investment banker regarding possible financing. However, we have no formal commitments for any future funding, and may not be able to obtain additional financing on terms acceptable to us, if at all, in the future. 19 Our ability to continue as a going concern is dependent on our ability to successfully accomplish the plan described in the preceding paragraphs. The accompanying condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that might result from the outcome of this uncertainty. We expect capital expenditures to be less than $400,000 in fiscal 2014. Our primary investments will be in laboratory equipment to support prototyping, manufacturing, our authentication services, and outside services for our detector and reader development. Substantially all of the real property used in our business is leased under operating lease agreements. Subsequent Events On July 14, 2014, we were awarded a Phase II SBIR contract by the U.S. Missile Defense Agency ("MDA") for avoidance of counterfeit parts by expanding the scope and scale of our existing SigNature DNA® technology platform established in our Phase I SBIR contract for Federal Supply Class 5962 electronic components, and by developing an optical reader. The contract provides for monthly payments to us totaling approximately $975,000 over a two year period. Product Research and Development We anticipate spending approximately $1,400,000 for product research and development activities during the next twelve months. Acquisition of Plant and Equipment and Other Assets We do not anticipate the sale of any material property, plant or equipment during the next 12 months. Number of Employees We currently have fifty-two full-time employees and six part-time employees, including six in management, ten in research and development, one in Life Sciences, four in forensics, seven in quality assurance, five in finance and accounting, eight in operations, nine in sales and marketing, one in human resources, two administrative, two in information services and three in investor relations and communications. We expect to increase our staffing dedicated to sales, manufacturing and production, and forensic authentication services. Expenses related to travel, marketing, salaries, and general overhead will be increased as necessary to support our growth in revenue. In order for us to attract and retain quality personnel, we anticipate we will have to offer competitive salaries and benefits to future employees. We anticipate that it may become desirable to add additional full and or part time employees to discharge certain critical functions during the next 12 months. This projected increase in personnel is dependent upon our ability to generate revenues and obtain sources of financing. There is no guarantee that we will be successful in raising the funds required or generating revenues sufficient to fund the projected increase in the number of employees. As we continue to expand, we will incur additional costs for personnel. In June 2012 we began working with Insperity Inc. to help us manage many of our back-end administrative human resources and payroll responsibilities. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements. Inflation The effect of inflation on our revenue and operating results was not significant. |