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ZIXI > SEC Filings for ZIXI > Form 10-Q on 7-Nov-2012All Recent SEC Filings

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Form 10-Q for ZIX CORP


7-Nov-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

NOTE ON FORWARD-LOOKING STATEMENTS AND RISK FACTORS

Statements in this report which are not purely historical facts or which necessarily depend upon future events, including statements about trends, uncertainties, hopes, beliefs, anticipations, expectations, plans, intentions or strategies for the future, may be forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. Forward-looking statements involve risks and uncertainties that could cause actual events or results to differ materially from the events or results described in the forward-looking statements, including risks and uncertainties described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011. Any of these risk factors could have a material adverse effect on our business, financial condition or financial results and reduce the value of an investment in our securities. We may not succeed in addressing these and other risks associated with an investment in our securities, with our business and with our achieving any forward-looking statements. Readers are cautioned not to place undue reliance on forward-looking statements. All forward-looking statements are based upon information available to us on the date the statements are made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Overview

We are a leader in providing secure, Internet-based applications in a Software as a Service ("SaaS") model. ZixCorp® Email Encryption Service enables the use of secure email for sensitive information exchange primarily in the healthcare, financial services, insurance and government sectors. More than 1,500 hospitals and over 1,800 financial institutions, including some of the most influential companies and government organizations, use our Email Encryption Service. Wellpoint and the Securities and Exchange Commission ("SEC") are among these notable customers. Our Email Encryption Service is enhanced by ZixDirectory®, which includes approximately 33 million members. ZixDirectory allows for emails to be sent seamlessly whenever possible, across the largest email encryption community in the world.

The business operations and service offerings are supported by the ZixData Center™, a network operations center dedicated to secure electronic transaction processing. The operations of the ZixData Center are independently audited annually to maintain AICPA SysTrustSM certification in the areas of security, confidentiality, integrity and availability. Auditors also produce a SOC2 report on the effectiveness of operational controls used over the audit period. The center is staffed 24 hours a day with a proven 99.99% reliability. We enable email communications to be sent in a trusted, safe, and secure manner. This is our core competency and we believe it is a competitive advantage.

Critical Accounting Policies and Estimates

The preparation of financial statements and related disclosures in accordance with accounting principles generally accepted in the United States requires the Company's management to make estimates and assumptions that affect the amounts reported in the Company's condensed consolidated financial statements and accompanying notes. Actual results could differ from these estimates and assumptions. Critical accounting policies and estimates are defined as those that are both most important to the portrayal of the Company's financial condition and results and require management's most subjective judgments.

We describe our significant accounting policies in Note 2, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2011. We discuss our Critical Accounting Policies and Estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2011.

Results of Operations

Third Quarter 2012 Summary of Operations

Financial

• Revenue for the quarter ended September 30, 2012, was $11,023,000 compared with $9,558,000 for the same period in 2011 representing a 15% increase.

• Gross margin for the quarter ended September 30, 2012, was $9,136,000 or 83% of revenues compared with $7,769,000 or 81% of revenues for the comparable period in 2011.

• Net income for the quarter ended September 30, 2012, was $1,943,000 compared with net income of $2,571,000 for the same period in 2011.

• Ending cash and cash equivalents were $23,031,000 on September 30, 2012, compared with $20,680,000 on December 31, 2011.

Operations

• New first year orders ("NFYOs") for the quarter ended September 30, 2012, were $2,586,000. As of September 30, 2012, backlog was $57,010,000.


Revenues

Email Encryption is a subscription-based service. The following table sets forth
a period-over-period comparison of the Company's revenues:



                                                          3-month Variance                                                    9-month Variance
               Three Months Ended September 30,             2012 vs. 2011            Nine Months Ended September 30,            2012 vs. 2011
                 2012                    2011                $            %              2012                 2011               $            %
Revenues   $      11,023,000       $      9,558,000     $  1,465,000       15 %    $     31,667,000       $  28,260,000     $  3,407,000       12 %

The increase in Email Encryption revenue was due to the growth inherent in a successful subscription model with steady additions to the subscriber base coupled with a high rate of existing customer renewals.

Revenue Indicators - Backlog and Orders

Backlog - Our end-user order backlog is comprised of contractually bound agreements that we expect to amortize into revenue as the services are performed. The timing of revenue is affected by both the length of time required to deploy a service and the length of the service contract.

As of September 30, 2012, total backlog was $57,010,000 and we expect approximately 57% of the total backlog to be recognized as revenue during the next twelve months. The backlog as of September 30, 2012, was comprised of the following elements: $19,882,000 of deferred revenue that has been billed and paid, $5,325,000 billed but unpaid, and approximately $31,803,000 of unbilled contracts.

Orders - Total orders were $12,660,000 and $9,687,000 for the three month periods ended September 30, 2012 and 2011, respectively. Total orders include contract renewals, NFYOs, and in the case of new multi-year contracts, the years beyond the first year of service. NFYOs were $2,586,000 and $1,641,000 for the three months ended September 30, 2012 and 2011, respectively.

Cost of Revenues

The following table sets forth a period-over-period comparison of the cost of
revenues:



                                                                                       3-month Variance                                                       9-month Variance
                                           Three Months Ended September 30,              2012 vs. 2011              Nine Months Ended September 30,             2012 vs. 2011
                                             2012                    2011                 $             %             2012                   2011                 $            %
Cost of revenues                       $       1,887,000       $       1,789,000     $     98,000        5 %    $      5,554,000       $      5,362,000     $     192,000       4 %

Cost of revenues is comprised of costs related to operating and maintaining the ZixData Center, a field deployment team, customer service and support and the amortization of Company-owned, customer-based computer appliances. A significant portion of the total cost of revenues relates to the ZixData Center, which currently has excess capacity. The five percent increase in the third quarter of 2012 compared to the same quarter last year as well as the four percent increase for the year to date comparative periods, resulted primarily from increases in average wages and benefits for existing staff plus minor increases in software maintenance and software license expenses.

Research and Development Expenses

The following table sets forth a period-over-period comparison of our research
and development expenses:



                                                                                        3-month Variance                                                       9-month Variance
                                            Three Months Ended September 30,              2012 vs. 2011              Nine Months Ended September 30,             2012 vs. 2011
                                              2012                    2011                 $            %              2012                   2011                $            %
Research and Development                $       2,046,000       $       1,343,000     $    703,000       52 %    $      4,988,000       $      3,948,000     $  1,040,000       26 %

Research and development expenses consist primarily of salary, benefits, and stock-based compensation for our development staff, plus the cost of development contractors and other direct and indirect costs associated with enhancing our existing products and services and developing new products and services. The $703,000 increase in the third quarter of 2012 compared to the same quarter last year resulted primarily from additional research and development investments including wages and benefits of $241,000 due to increases in average R&D headcount and contracted services of $461,000. Similarly, the $1,040,000 increase for the nine months ended September 30, 2012, compared to the same period last year resulted primarily from additional research and development investment including wages and benefits of $450,000 due to an increase in average R&D headcount, and increases of $568,000 in contracted services and other expenses totaling approximately $22,000.


We will further increase our R&D spending in the fourth quarter of 2012 to address two new product opportunities in email data loss prevention ("DLP") and "Bring Your Own Device" ("BYOD") security management. Our plan is to launch our new DLP product in early 2013 and our new BYOD solution in the middle of 2013.

Selling, General and Administrative Expenses

The following table sets forth a period-over-period comparison of our selling,
general and administrative expenses:



                                                                                         3-month Variance                                                       9-month Variance
                                           Three Months Ended September 30,               2012 vs. 2011              Nine Months Ended September 30,             2012 vs. 2011
                                             2012                    2011                  $             %               2012                 2011                $             %
Selling, general and administrative    $       5,020,000       $       3,754,000      $  1,266,000        34 %     $     13,720,000       $  11,310,000      $  2,410,000        21 %

Selling, general and administrative expenses consist primarily of salary, sales commissions, stock-based compensation and benefit costs for marketing, sales, executive and administrative personnel as well as costs associated with advertising, promotions, professional services and general corporate activities. The increase of $1,266,000 in the third quarter of 2012 compared to 2011 resulted primarily from; (i) higher sales commissions and incentive plan bonus accruals of $403,000, (ii) an increase in wages and benefits of approximately $76,000 resulting from an increase in average headcount, (iii) an increase in professional fees, primarily outside legal fees of $353,000, (iv) an increase in stock-based compensation expense of $103,000, (v) an increase in consulting expenses, primarily marketing, of $252,000 and other miscellaneous increases totaling $80,000. For the nine month period ended September 30, 2012 compared to the same period last year, SG&A expenses increased $2,410,000. This increase resulted primarily from; (i) higher sales commissions and incentive bonus accruals of approximately $766,000, (ii) an increase in wages and benefits of approximately $197,000 resulting from an increase in average headcount, (iii) an increase in stock-based compensation expense of approximately $299,000, (iv) an increase in consulting, primarily marketing of $252,000, and (v) an increase in professional fees, primarily outside legal counsel, of $727,000, and other net increases of $169,000.

Interest Expense

We incurred no interest expense in the three months ended September 30, 2012, and incurred $1,000 for the nine months ended September 30, 2012. We incurred no interest expense in the three months ended September 30, 2011, and incurred $7,000 for the nine months ended September 30, 2011, consisting of imputed interest related to a license subscription promissory note payable.

Investment and Other Income

Investment and other income was $6,000 and $17,000 for the three and nine months ended September 30, 2012, respectively. Investment and other income was $8,000 and $76,000 for the three and nine months ended September 30, 2011, respectively. Other income consists of interest and other income items earned in the normal course of business.

Provision for Income Taxes

The provision for income taxes was $133,000 and $119,000 for the three month periods ended September 30, 2012 and 2011, respectively, and $409,000 and $132,000 for the nine month periods ended September 30, 2012 and 2011, respectively. The operating losses incurred by the Company's U.S. operations in past years and the resulting net operating losses for U.S. Federal tax purposes are subject to a $55,055,000 reserve because of the uncertainty of future taxable income levels sufficient to utilize the net operating losses. Our September 30, 2012, provision of $409,000 includes $144,000 in state taxes currently payable based on gross revenues, $82,000 related to deferred state taxes, $124,000 related to the federal Alternative Minimum Tax, and $59,000 in taxes related to our Canadian operations. Our September 30, 2011 provision of $132,000 consisted of a benefit from refundable tax credits on our U.S. operations totaling $4,000, and taxes related to our Canadian operations totaling $54,000; and $80,000 in state taxes based on gross revenues.

There were no penalty-related charges to selling, general and administrative expenses accrued or recognized for the same comparative periods. Additionally, we have not taken a tax position that would have a material effect on the financial statements or the effective tax rate for the three month period ended September 30, 2012. We are currently subject to a three-year statute of limitations by major tax jurisdictions.


At September 30, 2012, the Company partially reserved its U.S. net deferred tax assets due to the uncertainty of future taxable income sufficient to utilize net loss carryforwards prior to their expiration. The Company did not reserve a portion, $50,275,000, of its U.S. net deferred tax assets. The majority of this unreserved portion related to $40,845,000 in U.S. net operating losses ("NOLs") because we believe the Company will generate sufficient taxable income in future years to utilize these NOLs prior to their expiration. The remaining balance consists of $6,179,000 relating to temporary differences between GAAP and tax-related expense, $2,259,000 relating to U.S. state income tax credits and net operating loss carryovers, $983,000 related to Alternative Minimum Tax credits, and $9,000 of our Canadian deferred tax asset relating to temporary differences between GAAP and tax-related expense.

At the end of 2011, the Company recorded a $15,000,000 tax benefit by reducing the valuation allowance related to its deferred tax assets. This reduction was determined through an assessment of future deferred tax asset utilization following accounting guidance which relies largely on historical earnings. Using the same methodology, and updating the future taxable earnings estimates based on first, second and third quarter 2012 actual earnings, the Company believes its future taxable earnings estimate to be established at the end of 2012 will exceed the estimate used at the end of 2011. For this reason, the Company offset its first, second and third quarter 2012 federal deferred tax provision by reducing its valuation allowance by an equal amount, thereby eliminating from its deferred tax provision federal taxes in excess of the estimated Alternative Minimum Tax from the Company's first, second and third quarter 2012 financial statements. The Company will reevaluate the need for its valuation allowance at December 31, 2012, following the same assessment methodology that was performed at December 31, 2011. Adjusting our valuation allowance could have a significant impact on operating results in the period that it becomes more likely than not that an additional portion of our deferred tax assets will or will not be realized.

We have determined that utilization of existing net operating losses against future taxable income is not subject to limitation by Section 382 of the Internal Revenue Code. Future ownership changes, however, may limit the Company's ability to fully utilize its existing net operating loss carryforwards against future taxable income.

As indicated earlier, the operating losses incurred by our U.S. operations and the resulting net operating losses for U.S. Federal tax purposes are subject to a partial reserve. Significant judgment is required in determining any reserve recorded against the deferred tax asset. In assessing the need for a reserve, we consider all available evidence, including past operating results, estimates of future taxable income, and the feasibility of tax planning strategies.

Net Income

The net income for the quarter ended September 30, 2012, of $1,943,000 is a $628,000 decline compared to the net income of $2,571,000 for the same period last year. Our increased revenue and resulting higher gross margin was offset by increased R&D and SG&A spending, and a higher tax expense, as discussed above.

Liquidity and Capital Resources

Overview

Based on our performance over the last four quarters and current expectations, we believe our cash, cash equivalents, commercial paper and cash generated from operations, will satisfy our working capital needs, capital expenditures, investment requirements, contractual obligations, commitments, future customer financings, and other liquidity requirements associated with our operations through at least the next twelve months. We plan for and measure our liquidity and capital resources through an annual budgeting process. At September 30, 2012, our cash, cash equivalents, and commercial paper totaled $23,031,000 and we held no debt.

Cash, cash equivalents and commercial paper at September 30, 2012, were $23,031,000, an increase of $2,351,000 from the December 31, 2011, balance. This increase includes the repurchase of approximately $9,000,000 of our common stock under a repurchase program approved by our Board of Directors in November 2011. We completed the share repurchase program during May 2012. This decrease in cash was partially offset by cash generated from the exercise of stock options, cash collections from customers, and relatively flat accounts payable and accrued expenses.

We believe a significant portion of all other spending is discretionary and flexible and that we have the ability to adjust overall cash spending to react, as needed, to any shortfalls in projected cash.

Sources and Uses of Cash Summary



                                              Nine Months Ended September 30,
                                                 2012                  2011
    Net cash provided by operations         $    12,092,000        $  10,661,000
    Net cash used in investing activities   $    (1,049,000 )      $  (3,393,000 )
    Net cash used in financing activities   $    (8,692,000 )      $ (12,149,000 )


Our primary source of liquidity from our operations is the collection of revenue in advance from our customers and accounts receivable from our customers, net of the timing of payments to our vendors and service providers.

Our investing activities in the first nine months of 2012 consisted of computer and networking equipment purchases. In the first nine months of 2011, we utilized $2,290,000 to purchase commercial paper and $1,103,000 to purchase computer and networking equipment

Cash used in financing activities in the first nine months of 2012 included the $9,000,000 repurchase of common stock described above. We repurchased $15,000,000 of common stock in the first nine months of 2011 and funded a $186,000 promissory note associated with computer operating system licenses in the first nine months of 2011. These usages were partially offset by $308,000 received from the exercise of stock options in the first nine months of 2012 and $3,037,000 received from the exercise of stock options and warrants in the first nine months of 2011.

Options of ZixCorp Common Stock

We have significant options outstanding that are currently vested. There is no assurance that any of these options will be exercised; therefore, the extent of future cash from additional option exercises is not certain. The following table summarizes the options that were outstanding as of September 30, 2012. The vested shares are a subset of the outstanding shares. The value of the shares is the number of shares multiplied by the exercise price for each share.

                                           Summary of Outstanding Options
                                                              Vested
                                         Total Value       (included in       Total Value of
 Exercise Price Range   Outstanding      Outstanding       Outstanding)           Vested
 $1.11 - $1.99             1,173,139     $  1,763,000          1,138,469     $      1,700,000
 $2.00 - $3.49             2,088,508        5,563,000          1,022,646            2,746,000
 $3.50 - $4.99             2,755,214       11,943,000          2,446,747           10,753,000
 $5.00 - $5.99               362,594        1,820,000            362,594            1,820,000
 $6.00 - $8.99               498,700        3,262,000            498,700            3,262,000
 $9.00 - $11.00              792,792        8,496,000            792,792            8,496,000

 Total                     7,670,947     $ 32,847,000          6,261,948     $     28,777,000

Off-Balance Sheet Arrangements

None.

Contractual Obligations, Contingent Liabilities and Commitments

A summary of our fixed contractual obligations and commitments at September 30, 2012, is as follows:

Payments Due by Period Total 1 Year Years 2 & 3 Years 4 & 5 Beyond 5 Years Operating leases $ 3,123,000 $ 1,385,000 $ 1,413,000 $ 325,000 -

We did not enter into any other material, non cancelable purchase commitments during the three month period ended September 30, 2012.

We have severance agreements with certain employees which would require the Company to pay approximately $2,227,000 if all such employees separated from employment with our Company in certain circumstances, including a "Change of Control" or termination without "Cause," as defined in the severance agreements.

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