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EMAGIN CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations Statement of Forward-Looking Information(Edgar Glimpses Via Acquire Media NewsEdge) In this quarterly report, references to "eMagin Corporation," "eMagin," "Virtual Vision," "the Company," "we," "us," and "our" refer to eMagin Corporation and its wholly owned subsidiary, Virtual Vision, Inc. Except for the historical information contained herein, some of the statements in this Report contain forward-looking statements that involve risks and uncertainties. These statements are found in the sections entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Risk Factors." They include statements concerning: our business strategy; expectations of market and customer response; liquidity and capital expenditures; future sources of revenues; expansion of our proposed product line; and trends in industry activity generally. In some cases, you can identify forward-looking statements by words such as "may," "will," "should," "expect," "plan," "could," "anticipate," "intend," "believe," "estimate," "predict," "potential," "goal," or "continue" or similar terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including, but not limited to, the risks outlined under "Risk Factors," that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. For example, assumptions that could cause actual results to vary materially from future results include, but are not limited to: our ability to successfully develop and market our products to customers; our ability to successfully implement resolutions related to customer stop orders; our ability to generate customer demand for our products in our target markets; the development of our target markets and market opportunities; our ability to manufacture suitable products at competitive cost; our ability to successfully launch new equipment on our manufacturing line; market pricing for our products and for competing products; the extent of increasing competition; technological developments in our target markets and the development of alternate, competing technologies in them; and sales of shares by existing shareholders. Although we believe that the expectations reflected in the forward looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Unless we are required to do so under federal securities laws or other applicable laws, we do not intend to update or revise any forward-looking statements. Overview In the second quarter, eMagin continued deliveries of our display products, shipping products to over 87 different customers. Our new OLED deposition tool had its best quarter yet in terms of throughput after we had successfully addressed a number of problems with the tool. Investments continued in developing new processes that provide ultra-high brightness displays, an important attribute for applications that are used in direct sunlight or daylight such as wearable personal headsets and avionic head mounted displays (HMD). Our technical team successfully demonstrated a direct-patterned ultra-high brightness display in June, and is on track to begin producing high-resolution, high-brightness displays for sale later this year. A new tool for low-volume production has been installed and is currently being brought up to manufacturing readiness. We successfully met the challenges associated with a first quarter 2014 stop ship order from three of our customers regarding a product issue. A stop ship order essentially delays product shipments until the particular issue(s) are resolved with the customer. The issues relating to the stop ship order have now been mostly resolved. For the first customer, shipments have resumed with no expected loss of revenue. Shipments to the second customer resumed and shipments continued uninterrupted to this customer for its other programs. The customer changed to a new display configuration for this program as did the third customer. No loss of overall revenue is expected for the second customer but some shipments originally scheduled for 2014 may extend into 2015. For the third customer, production shipments of the new display configuration are expected to begin shipping once their qualification process is complete and we expect less revenue under this program than we originally anticipated. As a result of the status of the stop ship orders, improved R&D contract outlook and demand for our state-of-the-art microdisplays, we continue to anticipate that the last three quarters of 2014 will have higher average revenue than Q1 2014. Financial Result In the second quarter, revenues rebounded from first quarter, which was impacted by the stop order, as revenues increased to $7.0 million from revenues of $6.3 million last quarter. Gross margin sustained the improvement we saw in first quarter over Q4 last year in the second quarter, which was significant in improving bottom line results in both quarters. Operating expenses decreased from first quarter as second quarter operating loss narrowed to $1.0 million from $1.6 million in the first quarter of 2014. 12-------------------------------------------------------------------------------- Table of Contents New Business In the second quarter, there has been significant interest in our new products especially for our high brightness options, our XLS and XLT type products. The XLS provides our customers with significantly higher brightness in color for the latest Augmented Reality optical and image overlay systems. Samples have been delivered and are being added to the system architecture for both commercial and military applications. We believe XLT is becoming the technology of choice for military avionic systems. We expect that revenue from this market segment will become significant in the 2015 through the 2020 time frame. Recently, the Company was notified it has been awarded a number of new R&D contracts. This was announced in a press release dated July 17, 2014. We believe these awards will significantly increase R&D contract revenues in the coming quarters above the level of the past two quarters beginning in third quarter 2014. The awards also provide funding for important research and development regarding the Company's high brightness and OLED manufacturing process improvement initiatives. The first of these R&D contracts has been signed and details will be released once the necessary approvals have been obtained from third parties. New Technology Development During the second quarter progress was made in a number of technology areas, including the ultra-high brightness OLED display development effort. An ultra-high brightness VGA-type demonstration display was fabricated and demonstrated. Additionally, a new tool was installed in July to produce ultra-high brightness and high resolution directly patterned color OLED devices. Prototype ultra-high resolution high brightness OLED displays are expected to be fabricated and sampled to customers in Q3 2014. As a result of further R&D efforts, the already existing high brightness OLED-XLS product lifetime was improved by about 25 percent. Also, the R&D team has developed a new seal structure that has the potential to increase the overall yield and reliability of our display products. Certain displays for certain customers are already receiving displays with this new seal process. The production qualification of our new DSVGA display was completed in the second quarter. This display is targeted to replace the long-running SVGA+ display with our latest digital technology and product improvements. First samples of our SXGA096 product are scheduled to be available in the third quarter. The SXGA096 will provide the high resolution on a SXGA display but with a smaller form factor and lower cost of production than larger pixel SXGA displays. Manufacturing Throughput improved during the second quarter thanks in part to the deployment of a 24/7 operation in our clean rooms and to the new OLED deposition tool which was successfully run to its rated maximum run rate for several weeks. The higher volume not only led to additional sales but also to building inventory that supported the Company's commercial activities during its early July factory shutdown. The shutdown addressed equipment maintenance but also major improvements in clean room and packaging operations. Additional equipment in the display assembly area was ordered and delivered in the second quarter that will improve process consistency as well as reducing cycle time. The results are expected to materialize during the third quarter. At July 31, 2014, we had a total of 91 employees, of which 88 were full-time employees as compared to a total of 111 employees, of which 107 were full-time employees at December 31, 2013. A detailed discussion of our business may be found in Part I, "Business," of our 2013 Annual Report on Form 10-K for the year ended December 31, 2013 as filed with the Securities and Exchange Commission on March 13, 2014. CRITICAL ACCOUNTING POLICIES Revenue and Cost Recognition Revenue on product sales is recognized when persuasive evidence of an arrangement exists, such as when a purchase order or contract is received from the customer, the price is fixed, title and risk of loss to the goods has changed and there is a reasonable assurance of collection of the sales proceeds. We obtain written purchase authorizations from our customers for a specified amount of product at a specified price and consider delivery to have occurred at the time of shipment. Revenues from research and development activities relating to firm fixed-price contracts and cost-type contracts are generally recognized on the percentage-of-completion method of accounting as costs are incurred (cost-to-cost basis). Progress is generally based on a cost-to-cost approach however an alternative method may be used such as physical progress, labor hours or others depending on the type of contract. Physical progress is determined as a combination of input and output measures as deemed appropriate by the circumstances. Contract costs include all direct material, labor and subcontractor costs and an allocation of allowable indirect costs as defined by each contract, as periodically adjusted to reflect revised agreed upon rates. These rates are subject to audit by the other party. 13-------------------------------------------------------------------------------- Table of Contents Income Taxes Our deferred tax assets and their potential realizability are evaluated each quarter to determine if any changes should be made to the valuation allowance. At December 31, 2013, we determined that based on all available evidence, both positive and negative, and based on the weight of the available evidence, including our 2013 operating loss and projected cumulative loss through 2014, it was more likely than not that none of our deferred tax assets would be realized and therefore, recorded a full valuation allowance. As we incurred an operating loss for the six month period ended June 30, 2014 and are still projecting a cumulative loss through 2014, it is still more likely than not that none of our deferred tax assets would be realized and therefore, we continued to record a full valuation allowance. Other critical accounting policies, as described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013, relate to product warranty, use of estimates, fair value of financial instruments and stock-based compensation, and additional information on accounting for income taxes. RESULTS OF OPERATIONS THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2014 COMPARED TO THREE AND SIX MONTHS ENDED JUNE 30, 2013 Revenues Three Months Ended Six Months Ended June 30, June 30, 2014 2013 Change 2014 2013 Change (unaudited) (unaudited) (in thousands) ($ in thousands) Product $ 6,956 $ 6,773 $ 183 $ 13,215 $ 14,901 $ (1,686 ) Contract $ 62 $ 255 $ (193 ) $ 81 $ 630 $ (549 ) Total revenue, net $ 7,018 $ 7,028 $ (10 ) $ 13,296 $ 15,531 $ (2,235 ) Revenues for the three and six months ended June 30, 2014 were approximately $7.0 million and $13.3 million, respectively, as compared to approximately $7.0 million and $15.5 million, respectively. Product revenue is comprised primarily of sales of displays, as well as sales of other hardware. For the three months ended June 30, 2014, product revenue increased approximately $0.2 million or 3% as compared to the three months ended June 30, 2013. The increase in product revenue is due primarily to an increase in the display average selling price. For the six months ended June 30, 2014, product revenue decrease 1.7 million or 11% as compared to the six months ended June 30, 2013. The year to date decrease is due primarily to fewer year to date display shipments. Contract revenue is comprised of revenue from research and development ("R&D") or non-recurring engineering ("NRE") contracts. For the three and six months ended June 30, 2014, contract revenue decreased approximately $0.2 million and $0.5 million, respectively, as compared to the three months and six months ended June 30, 2013, respectively. We believe the decrease is primarily the result of a reduction in funding of R&D contracts by the U.S. Government, due to recent budget issues. The U.S. Government is the source of most of our R&D contracts. 14-------------------------------------------------------------------------------- Table of Contents Cost of Goods Sold Three Months Ended Six Months Ended June 30, June 30, 2014 2013 Change 2014 2013 Change (unaudited) (unaudited) (in thousands) ($ in thousands) Product $ 4,838 $ 4,437 $ 401 $ 9,170 $ 8,974 $ 196 Contract $ 11 $ 200 $ (189 ) $ 26 $ 416 $ (390 ) Total cost of goods sold $ 4,849 $ 4,637 $ 212 $ 9,196 $ 9,390 $ (194 ) Cost of goods sold is comprised of costs of product and contract revenues. Cost of product revenue includes materials, labor and manufacturing overhead, warranty costs and depreciation related to our products. Cost of contract revenue includes direct and allocated indirect costs associated with performance of contracts. Cost of goods sold for the three month period ended June 30, 2014 as compared to the three month period ended June 30, 2013 increased $0.2 million. Cost of goods sold for the six month period ended June 30, 2014 as compared to the six month period ended June 30, 2013 decreased $0.2 million. Cost of goods sold as a percentage of revenues was 69% for both the three and six month periods ended June 30, 2014 as compared to 66% and 60%, respectively, for the three and six month periods ended June 30, 2013. The following table outlines product, contract and total gross profit and related gross margins for the three and six months ended June 30, 2014 and 2013 (dollars in thousands): Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 (unaudited) (unaudited)Product revenue gross profit $ 2,118 $ 2,336 $ 4,046 $ 5,927 Product revenue gross margin 30 % 34 % 31 % 40 % Contract revenue gross profit $ 51 $ 55 $ 54 $ 214 Contract revenue gross margin 82 % 21 % 68 % 34 % Total gross profit $ 2,169 $ 2,391 $ 4,100 $ 6,141 Total gross margin 31 % 34 % 31 % 40 % The gross profit for the three and six months ended June 30, 2014 as compared to the three and six months ended June 30, 2013 decreased approximately $0.2 million and $2.0 million, respectively. For both the three and six months ended June 30, 2014, the gross margin was 31% as compared to 34% and 40%, respectively, for the three and six months ended June 30, 2013. The product gross profit for the three and six months ended June 30, 2014 as compared to the three and six months ended June 30, 2013 decreased approximately $0.2 million and $1.9 million, respectively. Product gross margin was 30% and 31%, respectively, for the three and six months ended June 30, 2014 down from 34% and 40%, respectively, for the three and six month periods ended June 30, 2013. The 9% decrease in gross profit for the three month period and the 32% decrease in gross profit for the six month period was primarily due to higher labor, materials, warranty and other product costs and lower yields. The contract gross profit for the three months ended June 30, 2014 as compared to the same period in 2013 was relatively unchanged. The contract gross profit for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013 decreased approximately $0.2 million. Contract gross margin for the three and six months ended June 30, 2014 increased to 82% and 68%, respectively, from 21% and 34%, respectively, for the same three and six month periods in 2013. The change in the contract gross margin is due to the nature of the contract and the amount of third party expenses incurred in fulfilling the contract. 15-------------------------------------------------------------------------------- Table of Contents Operating Expenses Three Months Ended Six Months Ended June 30, June 30, 2014 2013 Change 2014 2013 Change (unaudited) (unaudited) ($ in thousands) ($ in thousands) Research and development expense $ 1,282 $ 1,454 $ (172 ) $ 2,708 $ 2,643 $ 65 Percentage of net revenue 18 % 21 % 20 % 17 % Selling, general and administrative expense $ 1,931 $ 2,077 $ (146 ) $ 4,050 $ 4,317 $ (267 ) Percentage of net revenue 28 % 30 % 30 % 28 % Total operating expenses $ 3,213 $ 3,531 $ (318 ) $ 6,758 $ 6,960 $ (202 ) Percentage of net revenue 46 % 51 % 50 % 45 % Research and Development. Research and development expenses are company-funded and include salaries and related benefits, development materials and other costs specifically allocated to the development of new technologies and microdisplay products, OLED materials and subsystems. R&D related costs associated with fulfilling contracts are categorized as contract cost of goods sold. R&D expenses for the three months ended June 30, 2014 decreased approximately $0.2 million or 12% as compared to the three months ended June 30, 2013 and increased $65,000 or 2% for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013. As a percentage of revenue, Q2 2014 decreased to 18% of revenue as compared to 21% for Q2 2013 and for the year 2014 increased to 20% as compared to 17% for the year 2013. The changes in R&D costs are due to the amount of active R&D contract work and the nature of those contracts. A large portion of R&D expenses are labor oriented and tend to increase each year due to salary and benefit increase and lack of personnel turnover. Selling, General and Administrative. Selling, general and administrative ("SG&A") expenses consist principally of salaries and related benefits, professional services fees and marketing, general corporate, and administrative expenses. Selling, general and administrative expenses for the three and six months ended June 30, 2014 decreased approximately $0.2 million or 7% and $0.3 million or 6%, respectively, as compared to the three and six months ended June 30, 2013. As a percentage of revenue, Q2 2014 decreased to 28% of revenue as compared to 30% for Q2 2013 and for the year 2014 increased to 30% as compared to 28% for the year 2013. The decrease in SG&A expenses for the quarter and year to date is due to lower stock option expense offset by an increase in salaries and benefits. Other Income (Expense), net. Other income (expense), net consists primarily of interest income earned on investments, interest expense and gain/loss on sale of assets. For both the three and six month periods ended June 30, 2014 and 2013, interest expense was approximately $11 thousand and $21 thousand, respectively. We have no debt upon which we are incurring interest expense however we pay fees to keep our line of credit available. Other income of which the majority is interest income for the three and six months ended June 30, 2014 was approximately $7 thousand and $14 thousand, respectively, as compared to approximately $23 thousand and $36 thousand, respectively, for the three and six months ended June 30, 2013. Liquidity and Capital Resources We had approximately $5.6 million of cash, cash equivalents, and investments at June 30, 2014 as compared to approximately $11.0 million at December 31, 2013. Of the $5.6 million in cash, approximately $3.5 million was invested in certificates of deposit ("CDs"). Cash flow used by operating activities during the six months ended June 30, 2014 was approximately $6.0 million, attributable to our net loss of approximately $2.7 million and change in operating assets and liabilities of $4.8 million of which accounts receivable was a change of approximately $1.7 million and net inventories was approximately $2.4 million offset by our net non-cash expenses of $1.5 million. Cash flow provided by operating activities during the six months ended June 30, 2013 was approximately $0.3 million, attributable to our net non-cash expenses of $1.5 million offset by our net loss of approximately $0.8 million and change in operating assets and liabilities of $0.4 million. 16-------------------------------------------------------------------------------- Table of Contents Cash provided by investing activities during the six months ended June 30, 2014 was approximately $2.9 million of which net short-term investments proceeds were approximately $3.5 million offset by primarily equipment purchases of approximately $0.6 million. Presently, we have committed approximately $0.5 million for capital expenditures for the balance of 2014. Cash used in investing activities during the six months ended June 30, 2013 was approximately $0.3 million of which $0.6 million was used to purchase equipment offset by net proceeds of $0.3 million of short-term investments. Cash provided by financing activities during the six months ended June 30, 2014 was approximately $1.1 million from option and warrant exercises as compared to $0.3 million related to option exercises during the six month period ended June 30, 2013. Credit Facility At June 30, 2014, we had a credit facility with Access Business Finance, LLC ("Access") that provides for up to a maximum amount of $3 million based on a borrowing base equivalent of 75% of eligible accounts receivable. The interest on the credit facility is equal to the Prime Rate plus 4% but may not be less than 7.25% with a minimum monthly interest payment of $1 thousand. The credit facility will automatically renew on September 1, 2014 for a one year term unless written notice is provided. We did not draw on our credit facility during the six months ended June 30, 2014 or at any time since its inception in September 2010 and there is no outstanding balance. The credit facility contains the customary representations and warranties as well as affirmative and negative covenants. We were in compliance with all debt covenants as of June 30, 2014. Our cash needs to fund our operations and investment requirements over the next twelve months may be more than our current cash on hand, investments and the cash we anticipate generating from operations. We may not require additional funds over the next twelve months. If we do require additional funds, we believe we can raise sufficient funds. However, if we are unable to obtain sufficient funds, we may have to reduce the size of our organization and/or be forced to reduce and/or curtail our production and operations, all of which could have a material adverse impact on our business prospects. Off-Balance Sheet Arrangements We do not have any off balance sheet arrangements that are reasonably likely to have a current or future effect on our financial condition, revenues, results of operations, liquidity or capital expenditures. |