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FRANKLIN WIRELESS CORP - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and related notes included elsewhere in this report. This report contains certain forward-looking statements relating to future events or our future financial performance. These statements are subject to risks and uncertainties which could cause actual results to differ materially from those discussed in this report. You are cautioned not to place undue reliance on this information which speaks only as of the date of this report. We are not obligated to publicly update this information, whether as a result of new information, future events or otherwise, except to the extent we are required to do so in connection with our obligation to file reports with the SEC. For a discussion of the important risks to our business and future operating performance, see the discussion under the caption "Item 1A. Risk Factors" and under the caption "Factors That May Influence Future Results of Operations" below. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report might not occur. BUSINESS OVERVIEW We are engaged in the design, manufacture and sale of broadband high speed wireless data communication products such as third generation ("3G") and fourth generation ("4G") wireless modules and modems. We focus primarily on wireless broadband modems, which provide a flexible way for consumers to connect to wireless broadband networks from laptop or desktop computers. Our broadband wireless data communication products are positioned at the convergence of wireless communications, mobile computing and the Internet, each of which we believe represents a growing market. We market and sell our products through two channels: directly to wireless operators, and indirectly through strategic partners and distributors. Our global customer base extends from the United States to countries in South America, the Caribbean, EMEA and Asia. Certain of our products are certified by Sprint, C-Spire Wireless and other wireless operators located in the United States and also by wireless operators located in Caribbean and South American countries. FACTORS THAT MAY INFLUENCE FUTURE RESULTS OF OPERATIONS We believe that our revenue growth will be influenced largely by (1) the successful maintenance of our existing customers, (2) the rate of increase in demand for wireless data products, (3) customer acceptance for our new products, (4) new customer relationships and contracts, and (4) our ability to meet customers' demands. We have entered into and expect to continue to enter into new customer relationships and contracts for the supply of our products, and this may require significant demands on our resources, resulting in increased operating, selling, and marketing expenses associated with such new customers. 11 CRITICAL ACCOUNTING POLICIES Revenue Recognition We recognize revenue in accordance with ASC 605, "Revenue Recognition," when persuasive evidence of an arrangement exists, the price is fixed or determinable, collection is reasonably assured and delivery of products has occurred or services have been rendered. Accordingly, we recognize revenues from product sales upon shipment of the products to the customers or when the products are received by the customers in accordance with shipping or delivery terms. We provide a warranty for one year, which is covered by our vendors under the purchase agreements. Any net warranty related expenditures made by us have not historically been material. Capitalized Product Development Costs Accounting Standards Codification ("ASC") Topic 350, "Intangibles - Goodwill and Other" includes software that is part of a product or process to be sold to a customer and shall be accounted for under Subtopic 985-20. Our products contain embedded software internally developed by FTI which is an integral part of these products because it allows the various components of the products to communicate with each other and the products are clearly unable to function without this coding. The costs of product development that are capitalized once technological feasibility is determined (noted as Technology in progress in the Intangible Assets table, in Note 2 to Notes to Financial Statements) include payroll, employee benefits, and other headcount-related expenses associated with product development. We determine that technological feasibility for our products is reached after all high-risk development issues have been resolved. Once the products are available for general release to our customers, we cease capitalizing the product development costs and any additional costs, if any, are expensed. The capitalized product development costs are amortized on a product-by-product basis using the greater of straight-line amortization or the ratio of the current gross revenues to the current and anticipated future gross revenues. The amortization begins when the products are available for general release to the Company's customers. As of June 30, 2014 and June 30, 2013, capitalized product development costs in progress were $39,545 and $32,500, respectively, and these amounts are included in intangible assets in our consolidated balance sheets. During the year ended June 30, 2014, we incurred $560,615 in capitalized product development costs, and such amounts are primarily comprised of certifications and licenses. All expenses incurred before technological feasibility is reached are expensed and included in our consolidated statements of comprehensive income (loss). Income Taxes Deferred income tax assets and liabilities are recorded for differences between the financial statement and tax basis of the assets and liabilities that will result in taxable or deductible amounts in the future based on enacted laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. We have evaluated the available evidence supporting the realization of our gross deferred tax assets, including the amount and timing of future taxable income, and have determined it is more likely than not that the assets will be fully realized and no valuation allowance is necessary as of June 30, 2014. As of June 30, 2014, we have federal and state net operating loss carryforwards of approximately $4.0 million and $1.7 million, which expire through 2023 and 2017, respectively. The utilization of net operating loss carryforwards may be subject to limitations under the provisions of the Internal Revenue Code Section 382 and similar state provisions. Under the provision of ASC 740 "Application of the Uncertain Tax Position Provisions" related to accounting for uncertain tax positions, which prescribes a recognition threshold and measurement process for recording in the financial statements, uncertain tax positions taken or expected to be taken in a tax return, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. Tax benefits of an uncertain tax position will not be recognized if it has less than a 50% likelihood of being sustained based on technical merits. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In June 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2011-05, Presentation of Comprehensive Income, eliminates the option of presenting the components of other comprehensive income (OCI) as part of the statement of changes in stockholders' equity. The ASU instead permits an entity to present the total of comprehensive income, the components of net income, and the components of OCI either in a single continuous statement of comprehensive income or in two separate but consecutive statements. With either format, the entity is required to present each component of net income along with total net income, each component of OCI along with the total for OCI, and a total amount for comprehensive income. Also, the ASU requires entities to present, for either format, reclassification adjustments for items that are reclassified from OCI to net income in the statement(s) where the components of net income and the components of OCI are presented. This ASU is to be applied retrospectively. For public entities, the ASU is effective for interim and annual periods beginning after December 15, 2011. We have adopted this guidance and note that it does not have any material impact on our consolidated financial statements. 12 In September 2011, the FASB issued ASU 2011-08, Testing Goodwill for Impairment, which permits entities to determine first whether it is necessary to apply the traditional two-step goodwill impairment test, based on qualitative factors. An entity also has the option to bypass the qualitative assessment for any reporting unit in any period and proceed directly to the first step of the two-step goodwill impairment test; an entity may resume performing the qualitative assessment in any subsequent period. Also under the amendments, an entity is no longer permitted to carry forward its detailed calculation of a reporting unit's fair value from a prior year. The ASU also includes examples of events and circumstances for an entity to consider in evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, which supersede the previous examples of events and circumstances that an entity should consider when testing goodwill for impairment between annual tests. An entity having a reporting unit with a zero or negative carrying amount will also consider the revised list of factors in determining whether to perform the second step of the impairment test. The ASU is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. We have adopted this guidance and note that it does not have any material impact on our consolidated financial statements. In May 2014, the FASB issued Accounting Standards Update No. 2014-09 (ASU 2014-09), Revenue from Contracts with Customers. ASU 2014-09 will eliminate transaction- and industry-specific revenue recognition guidance under current U.S. GAAP and replace it with a principle based approach for determining revenue recognition. ASU 2014-09 will require that companies recognize revenue based on the value of transferred goods or services as they occur in the contract. The ASU also will require additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. ASU 2014-09 is effective for reporting periods beginning after December 15, 2016, and early adoption is not permitted. Entities can transition to the standard either retrospectively or as a cumulative-effect adjustment as of the date of adoption. Management is currently assessing the impact the adoption of ASU 2014-09 and has not determined the effect of the standard on our ongoing financial reporting. RESULTS OF OPERATIONS The following table sets forth, for the years ended June 30, 2014 and 2013, our statements of operations including data expressed as a percentage of sales: 2014 2013 (as a percentage of sales) Net sales 100.0% 100.0% Cost of goods sold 85.9% 77.9% Gross profit 14.1% 22.1% Operating expenses 23.6% 22.6% Income (loss) from operations (9.5% ) (0.5% ) Other income, net 4.6% 0.3% Net income (loss) before income taxes (4.9% ) (0.2% ) Income tax provision (benefit) (1.7% ) 0.5% Net income (loss) (3.2% ) (0.7% ) Non-controlling interest in net loss of subsidiary 0.0% 1.2% Net income (loss) attributable to Parent Company stockholders (3.2% ) 0.5% YEAR ENDED JUNE 30, 2014 COMPARED TO YEAR ENDED JUNE 30, 2013 NET SALES - Net sales decreased by $1,797,357, or 5.5%, to $30,952,897 for the year ended June 30, 2014 from $32,750,254 for the corresponding period of 2013. For the year ended June 30, 2014, net sales by geographic regions, consisting of South America and the Caribbean, the United States, EMEA (Europe, the Middle East and Africa) and Asia were $2,109,320 (6.8% of net sales), $18,036,635 (58.3% of net sales), $3,789,414 (12.2% of net sales) and $7,017,528 (22.7% of net sales), respectively. Net sales in the South American and Caribbean regions increased by $460,868, or 27.9%, to $2,109,320 for the year ended June 30, 2014, from $1,648,452 for the corresponding period of 2013. The increase was primarily due to the general nature of sales in these regions, which often fluctuate significantly from period to period due to timing of orders placed by a relatively small number of customers. Net sales in the United States decreased by $11,941,684, or 39.8%, to $18,036,635 for the year ended June 30, 2014, from $29,978,319 for the corresponding period of 2013. The decrease in net sales was due to several factors, including lower market demand for USB modems, the timing of orders placed by certain carrier customers and the discontinuation of a chipset used as a component in one of the Company's products, which negatively affected sales during the year ended June 30, 2014. In addition, a large customer who purchased four of the Company's product models during the year ended June 30, 2013, did not make any significant repeat purchases during the year ended June 30, 2014. These decreases were partially offset by the launch of new products in the United States. Net sales in EMEA increased by $3,789,414, to $3,789,414 for the year ended June 30, 2014, from $0 for the corresponding period of 2013. The increase in net sales was due to the addition of a new carrier customer in Africa. Net sales in Asia increased by $5,894,045, or 524.6%, to $7,017,528 for the year ended June 30, 2014, from $1,123,483 for the corresponding period of 2013. The increase in net sales was primarily due to higher product and component sales generated by FTI, which typically vary from period to period. 13 GROSS PROFIT- Gross profit decreased by $2,854,796, or 38.3%, to $4,378,604 for the year ended June 30, 2014, from $7,233,400 for the corresponding period of 2013. The decrease was primarily due to the change in net sales as indicated above. The gross profit in terms of net sales percentage was 14.1% for the year ended June 30, 2014, compared to 22.1% for the corresponding period of 2013. The decrease in gross profit in terms of net sales and net sales percentage was due to variations in customer and product mix, competitive selling prices and product costs which generally vary from period to period and region to region. OPERATING EXPENSES- Operating expenses decreased by $109,644, or 1.5%, to $7,292,592 for the year ended June 30, 2014, from $7,402,236 for the corresponding period of 2013. Decreases in commissions and bad debt expense were partially offset by increases in legal fees and shipping expenses. Shipping expenses vary based on product volumes and customer and supplier shipping terms which vary from product to product. OTHER INCOME, NET- Other income, net increased by $1,324,987 to $1,421,244 for the year ended June 30, 2014, from $96,257 for the corresponding period of 2013. The increase was primarily due to the reversal of expenses associated with certain marketing related activities that were incurred in prior periods which expired during the year ended June 30, 2014. LIQUIDITY AND CAPITAL RESOURCES Our historical operating results, capital resources and financial position, in combination with current projections and estimates, were considered in management's plan and intentions to fund our operations over a reasonable period of time, which we define as the twelve month period ending June 30, 2015. For purposes of liquidity disclosures, we assess the likelihood that we have sufficient available working capital and other principal sources of liquidity to fund our operating activities and obligations as they become due. Our principal source of liquidity as of June 30, 2014 consisted of cash and cash equivalents of $8,240,595. We believe we have sufficient available capital to cover our existing operations and obligations through at least June 30, 2015. Our long-term future cash requirements will depend on numerous factors, including our revenue base, profit margins, product development activities, market acceptance of our products, future expansion plans and ability to control costs. If we are unable to achieve our current business plan or secure additional funding that may be required, we would need to curtail our operations or take other similar actions outside the ordinary course of business in order to continue to operate as a going concern. OPERATING ACTIVITIES- Net cash used in operating activities for the year ended June 30, 2014 was $1,707,651, and net cash provided by operating activities for the year ended June 30, 2013 was $4,898,047. The $1,707,651 in net cash used in operating activities for the year ended June 30, 2014 was primarily due to our net loss and the increases in inventory and accounts receivable of $1,704,823 and $303,846, respectively and the gain on debt extinguishment of $1,300,448, which were partially offset by the decrease in accounts payable of $1,361,070 and the non-cash charge for amortization of $1,287,806. The $4,898,047 in net cash provided by operating activities for the year ended June 30, 2013 was primarily due to the decreases in accounts receivable and inventory of $7,515,203 and $1,484,310, respectively, and the non-cash charge for amortization of $1,383,722, which were partially offset by the decrease in accounts payable of $5,861,873. INVESTING ACTIVITIES- Net cash used in investing activities for the years ended June 30, 2014 and 2013 was $357,477 and $1,460,492, respectively. The $357,477 in net cash used in investing activities for the year ended June 30, 2014 was primarily due to the payments for capitalized development costs and purchases of property and equipment of $310,615 and $127,894, respectively. We capitalize product development costs because such products are expected to be sold in future periods and provide economic benefit to the Company. The $1,460,492 in net cash used in investing activities for the year ended June 30, 2013 was primarily due to the purchases of intangible assets and property and equipment of $689,676 and $431,452, respectively, as well as payments for capitalized product development of $252,279. FINANCING ACTIVITIES- Net cash provided by financing activities for the year ended June 30, 2014 was $96,074, and net cash used in financing activities for the year ended June 30, 2013 was $2,383,914. The $96,074 in net cash provided by financing activities for the year ended June 30, 2014 was primarily due to the issuance of stock related to stock options exercised. 14 The $2,383,914 in net cash used in financing activities for the year ended June 30, 2013 was primarily due to the repurchase of our Common Stock from the Sherman Group in the amount of $2,406,414. Under the terms of the Stock Repurchase Agreement, we agreed to repurchase 1,538,602 shares of our Common Stock from the members of the Sherman Group for a purchase price of $2,831,028, or $1.84 per share, representing a premium of $440,000 from the market price on the date of the Agreement, which was recorded in operating expenses in the period ended June 30, 2012. In addition to the purchase price, a commission of $15,386 associated with this repurchase was recorded as a reduction of capital. OFF-BALANCE SHEET ARRANGEMENTS None. CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS The following table summarizes our contractual obligations and commitments as of June 30, 2014, and the effect such obligations could have on our liquidity and cash flow in future periods: Payments Due by June 30, 2015 2016 2017 2018 Thereafter Total Leases $ 305,278 $ 51,311 $ - $ - $ - $ 356,589 Borrowings from banks 148,295 - - - - 148,295 Total $ 453,573 $ 51,311 $ - $ - $ - $ 504,884 On July 27, 2010, we entered into a Common Stock Repurchase Agreement with C-Motech (the "Agreement"), under which we agreed to repurchase 3,370,356 shares of our Common Stock from C-Motech for $3,500,000. A total of 1,803,684 shares were repurchased on the date of the Agreement in exchange for non-cash consideration in the amount of $1,873,065, which represented amounts owed to the Company by C-Motech for certain marketing funds as well as the settlement of a price dispute for products previously purchased by the Company from C-Motech. Under the Agreement, the remaining 1,566,672 shares were to be repurchased by us upon payment of the balance, $1,626,935, on or before December 31, 2010. On January 28, 2011 (the "Amendment Date") the Agreement was amended to reflect (1) a change in the date the 1,566,672 shares are to be repurchased from C-Motech from December 31, 2010 to March 31, 2011, and (2) a change to the non-cash consideration of $1,873,065. In exchange for the 1,803,684 shares, we were to pay cash to C-Motech (in the same amount) for the shares, by March 31, 2011. In addition, in a separate agreement dated January 28, 2011, C-Motech agreed to pay us $1,873,065, for amounts owed, by March 31, 2011. The purpose of these revisions was to more clearly differentiate each party's payment obligations to the other with respect to this transaction. Following the Amendment Date, we paid C-Motech $1,873,065 in exchange for the 1,803,684 shares previously transferred to us by C-Motech, and C-Motech paid us $1,873,065 for amounts owed, of which $1,581,457 was booked to other income and $291,608 was booked to cost of goods sold. The repurchase of the remaining 1,566,672 shares has not been completed. We have provided formal notification to C-Motech that it is in breach of its obligations and we have also provided a demand to sell the shares back to us. We have attempted to tender payment for the shares without results, and we are unable to determine whether or not this repurchase will take place. We have been advised that there are two individuals who claim to have purchased the shares from C-Motech through its former CEO; however, the authority of the former CEO to agree to the sale of the shares is being disputed by C-Motech. It is our understanding that this matter is currently being adjudicated in U.S. and Korean courts. As of the date of this Report, C-Motech is the registered owner of certificates representing 1,566,672 shares, which were issued by the Company in C-Motech's name. On May 7, 2013, we filed a lawsuit against C-Motech in the Superior Court of California for the County of San Diego for breach of the Agreement and breach of other contracts between the parties relating to indemnification and other obligations. On February 25, 2014, C-Motech answered the complaint and on February 26, 2014, C-Motech filed a Notice of Removal from the Superior Court of the State of California for the County of San Diego to the United States District Court for the Southern District of California. On June 19, 2014, C-Motech filed a voluntary petition for relief under Chapter 15 of the U.S. Bankruptcy Code and on June 27, 2014, C-Motech filed a Motion for Recognition of a Foreign Main Proceeding under Chapter 15 of the U.S. Bankruptcy Code and Further Relief. On July 10, 2014, this motion was heard in the U.S. Bankruptcy Court for the Southern District of California during which the Court ordered that C-Motech's bankruptcy proceeding in South Korea was recognized as a foreign main proceeding and that our lawsuit against C-Motech in the U.S. District Court is stayed. The effect of this ruling is that we must participate in C-Motech's bankruptcy proceeding in South Korea if we wish to pursue our various claims against C-Motech. We are currently considering our options with respect to this ruling. 15 LEASES We lease approximately 11,318 square feet located in San Diego, California, at a monthly rent of $16,576, and the lease expires on August 31, 2015. In addition to monthly rent, the lease provides for periodic cost of living increases in the base rent. Rent expense related to the operating lease was $198,914 for the years ended June 30, 2014 and 2013. Our facility is covered by an appropriate level of insurance and we believe it to be suitable for our use and adequate for our present needs. Our Korea-based subsidiary, Franklin Technology, Inc. ("FTI"), leases approximately 10,000 square feet of office space in Seoul, Korea, at a monthly rent of approximately $8,000, and the lease expires on September 1, 2015. In addition to monthly rent, the lease provides for periodic cost of living increases in the base rent and payment of common area costs. The facility is covered by an appropriate level of insurance and we believe it to be suitable for our use and adequate for our present needs. Rent expense related to the operating lease was approximately $96,000 for the years ended June 30, 2014 and 2013. We lease two corporate housing facilities for our vendors and employees who travel, under non-cancelable operating leases that expire on September 13, 2015 and July 31, 2014, respectively. In April 2014, the lease for the corporate housing facility with July 31, 2014 expiration was terminated. Rent expense related to the operating leases was $20,209 and $21,721 for the years ended June 30, 2014 and 2013, respectively. FUTURE LIQUIDITY AND CAPITAL REQUIREMENTS For the next twelve months, we may incur in excess of $5.0 million for capital expenditures, software licenses and for testing and certifying new products. We believe we will be able to fund our future cash requirements for operations from our cash available, operating cash flows, bank lines of credit and issuance of equity securities. We believe these sources of funds will be sufficient to continue our operations and planned capital expenditures. However, we will be required to raise additional debt or equity capital if we are unable to generate sufficient cash flow from operations to fund the expansion of our sales and to satisfy the related working capital requirements for the next twelve months. Our ability to satisfy such obligations also depends upon our future performance, which in turn is subject to general economic conditions and regional risks, and to financial, business and other factors affecting our operations, including factors beyond our control. See Item 1A, "Risk Factors" included in this report. If we are unable to generate sufficient cash flow from operations to meet our obligations and commitments, we will be required to raise additional debt or equity capital. Additionally, we may be required to sell material assets or operations or delay or forego expansion opportunities. We might not be able to effect these alternative strategies on satisfactory terms, if at all. |