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| DMC > SEC Filings for DMC > Form 10-Q/A on 30-Dec-2008 | All Recent SEC Filings |
30-Dec-2008
Quarterly Report
FORWARD-LOOKING STATEMENTS
Certain statements contained herein constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 (the "1995 Reform Act"). Document Security Systems, Inc. desires to avail itself of certain "safe harbor" provisions of the 1995 Reform Act and is therefore including this special note to enable us to do so. Except for the historical information contained herein, this report contains forward-looking statements (identified by the words "estimate," "project," "anticipate," "plan," "expect," "intend," "believe," "hope," "strategy" and similar expressions), which are based on our current expectations and speak only as of the date made. These forward-looking statements are subject to various risks, uncertainties and factors, including, without limitation, those contained in our Form 10-K for the year ended December 31, 2007 and those described herein that could cause actual results to differ materially from the results anticipated in the forward-looking statements.
Overview
Document Security Systems, Inc. (referred to in this report as "Document Security," "we," "us," "our" or "Company") markets and sells products designed to protect valuable information from unauthorized scanning, copying, and digital imaging. We develop sophisticated security technologies that are applied during the normal printing process and by virtually all printing methods including traditional offset, gravure, flexo, digital or via the Internet on paper, plastic, or packaging. We believe we are a leader of customized document protection solutions for companies and governments worldwide. We hold eight patents that protect our technology and have over a dozen patents in process or pending. Our technologies and products are used by federal, state and local governments, law enforcement agencies and are also applied by a broad variety of industries,, including financial institutions, high technology and consumer goods, entertainment and gaming, healthcare/pharmaceutical, defense and genuine parts industries. Our customers use our technologies where there is a need for enhanced security for protecting and verification of critical financial instruments and vital records, or where there are concerns of counterfeiting, fraud, identity theft, brand protection and liability.
Our core business is counterfeit prevention, brand protection and validation of authentic print media, including government-issued documents, currency, private corporate record and, securities. We believe we are a world leader in the research and development of optical deterrent technologies and have commercialized these technologies with a broad suite of products that offer our customers a wide array of document security solutions to satisfy their specific anti-counterfeiting requirements. Our technology can be used in securing sensitive and critical documents such as currency, automobile titles, spare parts forms for the aerospace industry, gift certificates, permits, checks, licenses, receipts, prescription and medical forms, engineering schematics, ID cards, labels, original music, coupons, homeland security manuals, consumer product and pharmaceutical packaging, tickets, and school transcripts. In addition, we have developed a digital product to implement our technologies in Internet-based environments utilizing standard desktop printers. We believe that our digital technology greatly expands the reach and potential market for our technologies and solutions.
Technologies
We have developed or acquired over 30 technologies that provide to our customers a wide spectrum of solutions. Our primary anti-counterfeiting products and technologies are marketed under the AuthentiGuard trade names.
Products and Services
Document Security Solutions and Production: Our technology portfolio allows us to create unique custom secure paper, plastic, packaging and Internet-based solutions. We market to end-users that require anti-counterfeiting and authentication features in a wide range of printed materials like documents, vital records, driver's licenses, birth certificates, receipts, manuals, identification materials, entertainment tickets, coupons, parts tracking forms, as well as product packaging including pharmaceutical and a wide range of consumer goods. We manufacture plastic ID cards at our wholly owned subsidiary called Plastic Printing Professionals, in San Francisco, CA, and we produce our custom security paper products either internally at our small printing facility in Rochester, NY, or outsourced at our various licensees. Through our strategic licensee program, we can offer our customers a wide range of production capabilities to meet the customized requirements.
Security Paper: Our primary product for the retail end-user market is AuthentiGuard Security Paper. AuthentiGuard Security Paper uses our Pantograph 4000 technology, and is a paper that reveals hidden warning words, logos or images using The Authenticator - our proprietary viewing lens - or when the paper is faxed, copied, scanned or re-imaged. The hidden warning words appear on the duplicate or the computer digital file and essentially prevents important documents from being counterfeited. We market and sell our Security Paper primarily through two major paper distributors: Boise Cascade and PaperlinX Limited.
Technology Licensing: We license our anti-counterfeiting technology and trade secrets through licensing arrangements with security printers. We seek licensees that have a broad customer base that can benefit from our technologies or have unique and strategic capabilities that expand the capabilities that we can offer our potential customers. Revenue from licensing can take several forms. Licenses can be for a single technology or for a package of technologies.
Digital Solutions: We also offer our technologies in digital forms that are deliverable via internet and intranet environments. In October 2008, we launched our first branded digital solution called AuthentiGuard® DX. AuthentiGuard® DX is a networked appliance that allows the author of any Microsoft Office document (Outlook, Word, Excel, or PowerPoint) to secure nearly any of its alphanumeric content when it is printed or digitally stored. AuthentiGuard® DX prints selected content using our patented technology so that it cannot be read by the naked eye. Reading the hidden content or authenticating the document is performed with a proprietary viewing device or software.
Additionally, we sell custom hosted or server-based digital solutions for our customers. Depending on our customer's specific requirements, we host a secure server that accepts user inputs and delivers custom, variable secure documents for output at the user location, or offer a bundled server solution that allows for the production of custom, variable secure documents within the user's network environment.
Legal Products: We also own and operate Legalstore.com, an Internet company which sells legal supplies and documents, including security paper and products for the users of legal documents and supplies in the legal, medical and educational fields. While not a component of our core business strategy, we continuously seek to maximize the revenue and profitability of this operation.
Results of Operations for the Three and Nine Months Ended September 30, 2008
The following discussion and analysis provides information that our management believes is relevant to an assessment and understanding of our results of operations and financial condition. The discussion should be read in conjunction with the financial statements and footnotes in this quarterly report and in our annual report on Form 10-K for the year ended December 31, 2007. On September 25, 2007, the Company sold its copying and quick-printing business to an unrelated third party. In accordance with FASB 144, the Company accounts for the revenue and expenses of this operation, which was a component of its security printing segment, as a discontinued operation. All amounts have been adjusted to reflect the Company's results after the effect of discontinued operations.
Revenue
Three Months Three Months Nine Months Nine Months
Ended September Ended September % change vs. Ended September Ended September % change vs.
30, 2008 30, 2007 2007 30, 2008 30, 2007 2007
Revenue
Security printing & products $ 1,334,000 $ 946,000 41 % $ 3,421,000 $ 2,765,000 24 %
Royalties 181,000 278,000 -35 % 1,402,000 871,000 61 %
Digital solutions 8,000 9,000 -11 % 25,000 184,000 -86 %
Legal products 150,000 176,000 -15 % 483,000 513,000 -6 %
Total Revenue 1,673,000 1,409,000 19 % 5,331,000 4,333,000 23 %
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For the three months ended September 30, 2008, revenue increased 19% from the same period in 2007. The increase in revenue was primarily the result of strong growth in sales of our security products. The Company has sought to become a full-service provider of printing and production for its customers. During the quarter, the Company saw 20% sales growth at its Plastic Printing division as that division began to see the benefit of recent capital investments that increased its production capacity and expanded its production capabilities. Sales for paper based security products grew 30% from the same quarter of 2007, as the Company benefited from increased sales of its safety paper for prescriptions, and custom projects, including voter registration paper used for a foreign election, and coupons for a Fortune 500 customer.
Royalty revenue decreased primarily due to the absence of royalty revenue as a result of the new agreement with the Ergonomics Group in the second quarter of 2008, as described below, which previously had contributed approximately $60,000 per quarter of royalty revenue. Otherwise, royalty revenue reflected reductions in technology usage reported by its remaining licensing customers.
Legalstore.com saw an approximately 15% decline in orders from the 2007 quarter, which we believe was due to slowing conditions in the general economy along with the effects of an issue with its adword placements on one of the major search engine sites. The Company addressed its adword issue at the end of the quarter, and expects legal products to return to historical levels in the fourth quarter of 2008.
For the first nine months of 2008, revenue increased 23% compared to the first nine months of 2007 primarily as a the result of the significant impact of royalty revenue recognized in the second quarter of 2008 along with a 24% growth in the company's sales of its security printing and products. During the second quarter of 2008, the Company recognized approximately $542,000 of previously deferred royalty revenue as the result of a new agreement with the Ergonomic Group in April 2008. Under a previous agreement with the Ergonomic Group, the Company received $1,000,000 in non-refundable license and royalty fees, of which $500,000 was recognized as royalty revenue pro-ratably over a two year license period and the remaining $500,000 was considered a prepaid royalty, to be recognized as revenue when sales of products using the licensed technology were made. This agreement was cancelled and a new agreement with the Ergonomic Group that covers the Company's newest digital technologies was established. As a result, the non refundable license and royalty payment no longer met the criteria for deferral and was recognized in the second quarter of 2008.
These growth areas were partially offset by a significant decline in digital solutions sales during the first nine months of 2008 as compared to the first nine months of 2007 due to the absence of any digital solutions implementations during 2008.
Cost of Sales and Gross Profit
Three Months Three Months Nine Months Nine Months
Ended September Ended September % change vs. Ended September Ended September % change vs.
30, 2008 30, 2007 2007 30, 2008 30, 2007 2007
Costs of revenue
Security printing & products $ 636,000 $ 636,000 0 % $ 2,028,000 $ 1,691,000 20 %
Digital solutions 4,000 3,000 33 % 11,000 41,000 -73 %
Legal products 86,000 83,000 4 % 258,000 276,000 -7 %
Total cost of revenue 726,000 722,000 1 % 2,297,000 2,008,000 14 %
Gross profit
Security printing & products 698,000 310,000 125 % 1,393,000 1,074,000 30 %
Royalties 181,000 278,000 -35 % 1,402,000 871,000 61 %
Digital solutions 4,000 6,000 -33 % 14,000 143,000 -90 %
Legal products 64,000 93,000 -31 % 225,000 237,000 -5 %
Total gross profit 947,000 687,000 38 % 3,034,000 2,325,000 30 %
Three Months Three Months Nine Months Nine Months
Ended September Ended September % change vs. Ended September Ended September % change vs.
30, 2008 30, 2007 2007 30, 2008 30, 2007 2007
Gross profit percentage:
Gross profit percentage: 57 % 49 % 16 % 57 % 54 % 6 %
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Gross profit increased 38% to $947,000 in the thrid quarter of 2008 as compared to the $687,000 of gross profit realized in the third quarter of 2007, primarily the result of stong sales of the company's security printing and products and the ability of the Company to increase its margins through operating efficiencies and material cost savings that the Company was able to generate at its plastics division's new facility. The increase in gross profits of this group was partially offset by decreases in royalty, digital solution and legal products profits, respectively, for reasons discussed above. For the nine months ended September 30, 2008, the Company's gross profit increased at a slightly higher rate as the Company's gross profit percentage increased 6 percentage points as compared to the 2007 period.
Operating Expenses
Three Months Three Months Nine Months Nine Months
Ended September Ended September % change vs. Ended September Ended September % change vs.
30, 2008 30, 2007 2007 30, 2008 30, 2007 2007
Selling, general and administrative
General and administrative compensation $ 539,000 $ 514,000 5 % $ 1,622,000 $ 1,310,000 24 %
Professional Fees 206,000 352,000 -41 % 780,000 1,036,000 -25 %
Sales and marketing 204,000 466,000 -56 % 892,000 1,525,000 -42 %
Depreciation and amortization 42,000 20,000 110 % 126,000 61,000 107 %
Other 319,000 289,000 10 % 902,000 685,000 32 %
Research and development 73,000 111,000 -34 % 322,000 314,000 3 %
Stock based payments 480,000 338,000 42 % 1,506,000 971,000 55 %
Impairment of patent defense costs - - 292,000 -
Amortization of intangibles 541,000 480,000 13 % 1,605,000 1,259,000 27 %
Total Operating Expenses 2,404,000 2,570,000 -6 % 8,047,000 7,161,000 12 %
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Selling, General and Administrative
General and administrative compensation costs were 5% higher in the third quarter of 2008 as compared to the third quarter of 2007 which was primarily due to the impact of a bonus reversal of approximately $41,000 in the 2007 period, which offset the impact of salary reductions made by the Company during 2008. In addition, the 2008 amount reflects an increase in the cash compensation of the non-employee members of the Company's board of directors.
Professional fees - The decrease in professional fees during the third quarter and first nine months of 2008 reflect significant decreases in non-patent related legal fees, accounting fees, and stock transfer and investor relations fees. These costs savings reflect reduced SEC compliance costs and decreased legal activity, along with the impact of the Company's cost-cutting program it initiated in March 2008. For the nine months ended September 30, 2008, these cost savings were partially offset by increases in the use of consultants for sales and business development efforts during the first three months of 2008.
Three Months Three Months Nine Months Nine Months
Ended September Ended September % change vs. Ended September Ended September % change vs.
30, 2008 30, 2007 2007 30, 2008 30, 2007 2007
Professional Fees Detail
Accounting and auditing $ 40,000 $ 71,000 -44 % $ 213,000 $ 236,000 -10 %
Consulting 79,000 95,000 -17 % $ 341,000 292,000 17 %
Legal Fees 43,000 120,000 -64 % $ 94,000 255,000 -63 %
Stock Transfer, SEC and Investor
Relations 44,000 66,000 -33 % $ 132,000 253,000 -48 %
$ 206,000 $ 352,000 -41 % $ 780,000 $ 1,036,000 -25 %
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Sales and marketing expenses, including sales and marketing personnel costs, decreased in the third quarter and the first nine months of 2008 as the Company reduced sales and marketing headcount by four, reduced public relations and marketing costs and significantly reduced the amount spent on travel and entertainment. The Company reduced these costs as it realigned its sales process in order to maximize the results of its sales and marketing efforts with the goal of focusing of near term revenue opportunities.
Other operating expenses are primarily rent and utilities, office supplies, IT support, bad debt expense and insurance costs. Increases in the third quarter an first nine months of 2008 reflect costs increases associated with an increase in rent costs and one time costs associated with the move of the Company's plastic printing division to a larger facility, higher utility costs, and an increase in insurance costs.
Stock-Based Compensation. Stock-based compensation includes expense charges for all stock-based awards to employees, directors and consultants. Such awards include option grants, warrant grants, and restricted stock awards. Stock-based compensation increases in the three and nine month periods ended September 30, 2008 reflect equity-based payments made to employees, directors, and third-party consultants, including approximately $194,000 of expense as the result of the acceleration of vesting of restricted shares and $18,000 due to the modification of options to the Company's former President as the result of his separation from the Company in May 2008. In addition, on August 13, 2008, the Company cancelled 330,500 employee stock options with exercise prices ranging from $6.24 to $12.50, and replaced the cancelled options with 330,500 employee stock options with an exercise price of $6.00. No other terms of the options were modified. On the date of grant, the fair market value of the Company's Common Stock was $5.15. The repricing was treated as a modification under FAS123R, and resulted additional aggregate fair value expense determined using the Black- Scholes option pricing model of approximately $225,000, of which approximately $170,000 was expensed as of the grant date for fully vested options. The remaining fair value of the modified options will be expense proratably during the expected vesting period of the options thru 2010.
Research and Development
We invest in research and development to improve our existing technologies and develop new technologies that will enhance our position in the document security market. Research and development costs consist primarily of compensation costs, and costs for the use of third-party printers' facilities to test our technologies on equipment that we do not have access to internally. During the third quarter of 2008, the Company reduced its research and development by one person who was replaced on October 1, 2008.
Impairment of Patent Defense Costs
On March 19, 2008, the Company received notification that its appeal of the invalidation of its European Patent 455750B1 in the UK was not successful. As result of the adverse court decision, the Company recognized an impairment loss of $292,000 associated with the U.K appeal as of March 31, 2008. The impairment loss includes a judgment for reimbursement of estimated counterpart legal fees. The Company may be obligated to pay additional counter party legal fees associated with the decision, which the Company will expense as soon as the amount, if any, is estimatable.
Amortization of Intangibles
Amortization of intangibles expense increased 13% in the third quarter of 2008 as compared to the third quarter of 2007 which was primarily the result of an increase of $1.1 million in the Company's capitalized patent defense costs from December 2007 to September 2008. We amortize the costs associated with patent rights that we acquired in 2005 and legal costs associated with the registration and defense of our patents, including the costs associated with our lawsuit against the ECB for patent infringement and the related ECB countersuits for patent validity. A significant portion of these assets were acquired by the issuance of equity-based instruments. On August 20, 2008, the Company entered into an agreement with Trebuchet Capital Partners which agreed to pay substantially all of the litigation costs associated with its ECB litigation. Under the terms of the agreement the Company transferred and assigned a 49% interest of all of the Company's rights, title and interest in its European Patent 0455750B1 and the two parties agreed to equally share all proceeds generated from litigation relating to the Patent, including judgments and licenses or other arrangements entered into in settlement of any such litigation. The Company considered this a triggering event and reviewed its remaining capitalized patent costs related to the Patent for impairment as of September 30, 2008. With the assistance of Trebuchet, the Company determined that the expected eventual outcome of the legal action and recoverability of proceeds or added economic value of the patent was still in excess of the current carrying amount.
As a result of the Trebuchet agreement, and the transfer and assignment of our 49% interest in the patent, or $1,670,000, our net amortizable patent asset base at September 30, 2008 was approximately $2.9 million and will generate approximately $1.0 million in annual amortization expense during the next 3 years, as compared to approximately $2.0 million in annual amortization expense the Company was recognizing prior to the Trebuchet transaction.
In addition, the Company has approximately $683,000 of net other intangible assets as of September 30, 2008 that consist of a royalty right, a non-exclusive marketing right, as well as acquired intangibles including customer lists and a trade name. These assets will generate approximately $250,000 of annual amortization expense during the next 2.5 years. In addition, the Company has approximately $1,397,000 in goodwill derived from acquisitions. Goodwill is not amortized, but could become a component of expense if an impairment is determined. The Company reviews these assets for impairment annually or if a triggering event occurs. If an impairment, such as unfavorable ruling in the Company's patent validity or infringement lawsuits or an assessment of non-commerciability of certain of its patents, then the Company would write-off a portion of these assets, which could be a significant expense in the period incurred.
Other Income and Expense
On May 31, 2008, the Company was awarded a judgment of approximately $126,000 pursuant to a counterclaim by the Company in the matter "Frank LaLoggia v. Document Security Systems, Inc", which the Company won in June 2006. The Company expects to collect the full amount of the judgment.
On August 20, 2008, the Company entered into an agreement with Trebuchet Capital Partners, LLC. Pursuant to the Agreement, Trebuchet has agreed to pay substantially all of the litigation costs associated with pending validity proceedings initiated by the European Central Bank in eight European countries relating to the Company's European Patent 0 455 750B1 that the Company has claimed the European Central Bank ("ECB") infringed in printing of the Euros currency. Under the terms of the Agreement, and in consideration for Trebuchet's funding obligations, the Company assigned and transferred a 49% interest of the Company's rights, title and interest in the Patent to Trebuchet which allows Trebuchet to have as a separate and exclusive interest including a separate and distinct right to exploit the Patent. Pursuant to this transaction, the Company recognized a loss on the sale of patent assets for its assignment and transfer . . .
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