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DSS > SEC Filings for DSS > Form 10-Q on 13-Nov-2012All Recent SEC Filings

Show all filings for DOCUMENT SECURITY SYSTEMS INC

Form 10-Q for DOCUMENT SECURITY SYSTEMS INC


13-Nov-2012

Quarterly Report


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

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 that could cause actual results to differ materially from the results anticipated in the forward-looking statements, including, without limitation, those contained in our Annual Report on Form 10-K for the year ended December 31, 2011, and as follows:

Our limited operating history with our business model.

The inability to adequately protect our intellectual property.

Intellectual property infringement or other claims presently unknown to us, which could be filed against us, or against our customers or our intellectual property, which could be costly to defend and result in our loss of significant rights.

The failure of our products and services to achieve market acceptance.

Changes in document security technology and standards which could render our applications and services obsolete.

The inability to compete in our market, especially against established industry competitors with greater market presence and financial resources.

The inability to meet our growth strategy of acquiring complementary businesses and assets and expanding our existing operations..

Overview

Document Security Systems, Inc. (referred to in this report as "Document Security Systems", "Document Security," "DSS," "we," "us," "our" or "Company") was formed in New York in 1984 and, in 2002, chose to strategically focus on becoming a developer and marketer of secure technologies. We specialize in fraud and counterfeit protection for all forms of printed documents and digital information. The Company holds numerous patents for optical deterrent technologies that provide protection of printed information from unauthorized scanning and copying. We operate three production facilities including a security and commercial printing facility, a packaging facility and a plastic card facility where we produce secure and non-secure documents for our customers. We license our anti-counterfeiting technologies to printers and brand-owners. In addition, we have a digital division which provides cloud computing services for its customers, including disaster recovery, back-up and data security services.

Prior to 2006, the Company's primary revenue source in its document security division was derived from the licensing of its technology. In 2006, the Company began a series of acquisitions designed to expand its ability to produce its products for end-user customers. In 2006, we acquired Plastic Printing Professionals, Inc., a privately held plastic cards manufacturer located in the San Francisco, California area, referred to herein as "P3" or the "DSS Plastics Group". In 2008, we acquired substantially all of the assets of DPI of Rochester, LLC, a privately held commercial printer located in Rochester, New York, referred to herein as "Secuprint" or "DSS Printing Group". In 2010, the Company acquired Premier Packaging Corporation, referred to herein as "Premier", "Premier Packaging" or "DSS Packaging Group". Prior to the acquisition, Premier was a privately held packaging company located in Victor, New York.

In May 2011, we acquired ExtraDev, Inc. ("ExtraDev"), a privately held information technology and cloud computing company located in Rochester, New York. ExtraDev is also referred to herein as the "DSS Digital Group".

In 2011, we rebranded as "DSS" and now do business in four operating segments as follows:

DSS Printing Group - Provides secure and commercial printing services for end-user customers along with technical support for the Company's technology licensees. The division produces a wide array of printed materials such as security paper, vital records, prescription paper, birth certificates, receipts, manuals, identification materials, entertainment tickets, secure coupons, parts tracking forms, brochures, direct mailing pieces, catalogs, and business cards. The division also provides the basis of research and development for the Company's security printing technologies.

DSS Plastics Group - Manufactures laminated and surface printed cards which can include magnetic stripes, bar codes, holograms, signature panels, invisible ink, micro fine printing, guilloche patterns, Biometric, Radio Frequency Identification (RFID) and watermarks for printed plastic documents such as ID cards, event badges, and driver's licenses.

DSS Packaging Group - Produces custom paperboard packaging serving clients in the pharmaceutical, beverage, photo packaging, toy, specialty foods and direct marketing industries, among others. The division incorporates our security technologies into printed packaging to help companies prevent or deter brand and product counterfeiting.

DSS Digital Group - Provides data center centric solutions to businesses and governments delivered via the "cloud". This division is also developing proprietary digital data security technologies based on the Company's optical deterrent technologies.

On October 1, 2012, Document Security Systems, Inc., a New York corporation
("DSS"), entered into an Agreement and Plan of Merger (the "Merger Agreement")
with DSSIP, Inc., a Delaware corporation and wholly-owned subsidiary of DSS ("Merger Sub"), and Lexington Technology Group, Inc., a Delaware corporation ("Lexington"), and Hudson Bay Master Fund Ltd., as representative of Lexington's stockholders ("Lexington Representative") solely for certain purposes (as described in the Merger Agreement), pursuant to which Merger Sub will merge with and into Lexington, with Lexington being the surviving corporation (the "Surviving Corporation") and will continue its existence as a wholly-owned subsidiary of DSS through an exchange of capital stock of Lexington for capital stock of DSS (the "Merger").

Lexington is a private intellectual property monetization company that acquired a patent portfolio of six patents and four pending patent applications relating to technology invented by Thomas Bascom (the "Bascom Portfolio"). Lexington is focused on the economic benefits of intellectual property assets through acquiring or internally developing patents or other intellectual property assets (or interests therein) and then monetizing such assets through a variety of value enhancing initiatives, including, but not limited to: licensing, customized technology solutions (such as applications for medical electronic health records), strategic partnerships and litigation. Through its wholly-owned subsidiary Bascom Research, LLC ("Bascom Research"), Lexington currently develops software applications based on the Bascom Portfolio that are focused on applying computational and data structures to complex data sets in the medical field. Lexington has a strategic relationship with LinkSpace, LLC, a contextual search company, and a consulting agreement with Mednest LLC, a professional technology incubation advisor, to develop medical-related software applications in the RFID and electronic health record space. Lexington intends to attempt to enter into sponsored research agreements and partnerships with other companies and universities in order to further develop applications for the technology relating to the Bascom Portfolio. On October 3, 2012, Bascom Research initiated patent infringement lawsuits in the United States District Court for the Eastern District of Virginia against five companies, including Facebook, Inc. and LinkedIn Corporation, for unlawfully using systems that incorporate features claimed in patents owned by Bascom Research.

Pursuant to the terms of the Merger Agreement, upon completion of the Merger (the "Effective Time") and subject to the Beneficial Ownership Condition (as defined below), each share of then-issued and outstanding common stock of Lexington, par value $0.0001 per share ("Lexington Common Stock") and each share of then-issued and outstanding Series A Convertible Preferred Stock of Lexington, par value $0.0001 per share ("Lexington Preferred Stock") (other than shares of Lexington Common Stock and Lexington Preferred Stock held in treasury or owned by DSS or any direct or indirect wholly owned subsidiary of DSS or Lexington that will be canceled and retired at the Effective Time) will be automatically converted into (i) the right to receive shares of DSS common stock, par value $0.02 per share ("DSS Common Stock"), (ii) Warrants (as described below), (iii) shares of DSS Common Stock to be held in escrow (as described below, the "Escrow Shares") and, as applicable, shares of DSS's Series A Convertible Preferred Stock ("DSS Preferred Stock"), determined by multiplying each of (x) 17,250,000 plus the number of Additional Shares (as defined below) and Exchanged Shares (as defined below), if any, (y) 4,859,894, and (z) 7,100,000 by a fraction, the numerator of which shall be one and the denominator of which shall be the sum of (A) the number of shares of Lexington Common Stock plus (B) the number of shares of Lexington Preferred Stock, in each case issued and outstanding immediately prior to the Effective Time (such fraction referred to as the "Common Stock Exchange Ratio").

At the Effective Time of the Merger, DSS will issue to the holders of Lexington Common Stock and Lexington Preferred Stock (on a pro rata as-converted basis) an aggregate of 4,859,894 warrants to purchase an aggregate of 4,859,894 shares of DSS Common Stock with an exercise price of $4.80 per share and a term of five years commencing upon the closing of the Merger (the "Warrants"). As a condition to the closing of the Merger, DSS, Lexington Representative and American Stock Transfer & Trust Company, LLC, as escrow agent, will enter into an escrow agreement (the "Escrow Agreement"). Pursuant to the Escrow Agreement, at the Effective Time, DSS shall deposit the Escrow Shares into an escrow account to be released to the holders of Lexington Common Stock (pro rata on a fully-diluted basis as of the Effective Time) if and when the closing price per share of DSS Common Stock exceeds $5.00 per share (as adjusted for stock splits, stock dividends and similar events) for 40 trading days within a continuous 90 trading day period following the closing of the Merger. If within one year following the closing of the Merger, such threshold is not achieved, the shares of DSS Common Stock held in escrow shall be cancelled and returned to the treasury of DSS.

Upon the consummation of the Merger, only the holders of Lexington Preferred Stock who would, after giving effect to the Merger and receipt of the merger consideration, beneficially own more than 9.99% of DSS Common Stock (the "Beneficial Ownership Condition") shall receive for each share of Lexington Preferred Stock they hold the same merger consideration as outlined above except that such holders shall receive a combination of DSS Common Stock and DSS Preferred Stock that is convertible into (or if the proposal to authorize DSS Preferred Stock is not approved by the stockholders, $.02 Warrants (as defined below) exercisable for) that number of shares of DSS Common Stock they would have received if they had been a holder of Lexington Common Stock immediately prior to the Effective Time in such amounts that would enable such holders, after giving effect to the Merger, to beneficially own no more than 9.99% of DSS Common Stock upon consummation of the Merger.

Those holders of Lexington Preferred Stock who do not exceed the Beneficial Ownership Condition and accordingly will not receive DSS Preferred Stock or $.02 Warrants (as defined below), will receive DSS Common Stock and the other types of merger consideration in exchange for their Lexington Preferred Stock based on the Common Stock Exchange Ratio. In the event DSS's stockholders approve the issuance of the merger consideration, but do not approve the authorization of the DSS Preferred Stock, then the holders of Lexington Preferred Stock that satisfy the Beneficial Ownership Condition shall receive warrants to purchase DSS Common Stock with an exercise price of $0.02 per share (the "$.02 Warrants"). Each $.02 Warrant is exercisable at any time after the date of issuance for a period of ten years. If at any time between the three month anniversary of the issuance date and the expiration date, there is no effective registration statement registering the resale of the shares issuable under the Warrants, then the holder may elect to exercise the Warrants, or a portion thereof, by way of a cashless exercise. Except under certain circumstances, no holder may exercise its Warrants or $.02 Warrants if such exercise would result in such holder beneficially owning in excess of 9.99% of the number of shares of DSS common stock outstanding immediately after giving effect to the issuance of shares of common stock upon exercise of the Warrant. In addition, under certain circumstances, a holder of the Warrants will be entitled to participate in any distribution of DSS's assets (or the right to acquire its assets) or any declared cash dividend, to the same extent such holder would have participated therein if such holder had held the shares of common stock acquirable upon complete exercise of the Warrants.

The DSS Preferred Stock will have the powers, preferences and privileges and other rights as will be set forth in a Certificate of Amendment to the Certificate of Incorporation of DSS to be filed by DSS subsequent to closing, which rights include, among other things, the right to participate in any dividends and distributions paid to common stockholders on an as-converted basis, pro rata with the holders of DSS Common Stock. Upon the occurrence of any Liquidation Event (as such term is defined in the Certificate of Amendment), after the payment of all debts and liabilities of DSS, any remaining assets shall be distributed pro rata to the holders of DSS Common Stock and DSS Preferred Stock on an as-converted basis. The DSS Preferred Stock will be non-voting, except as required by law and in certain defined instances, including in connection with a fundamental transaction. Each share of DSS Preferred Stock shall be initially convertible into one share of DSS Common Stock.

No fractional shares of DSS Common Stock or DSS Preferred Stock will be issued in connection with the Merger. Instead, each Lexington stockholder who would be otherwise entitled to receive a fractional share will receive from DSS, in lieu thereof, the next highest whole number shares of DSS Common Stock or DSS Preferred Stock, as applicable.

Immediately following the completion of the Merger, the former stockholders of Lexington are expected to own approximately 55% of the outstanding common and preferred stock of the combined company (on a fully-diluted basis) and the current stockholders of DSS are expected to own approximately 45% of the outstanding common stock of the combined company (on a fully-diluted basis) (without taking into account any shares of DSS Common Stock held by Lexington's stockholders prior to the completion of the Merger). The shareholders of Lexington will hold the largest percentage of the voting shares on a dilutive basis after the completion of the Merger at 55% of the combined entity. The percentages of ownership include the 7,100,000 shares held in escrow, which are eligible to be voted while in escrow. If the escrow shares are terminated (which will be determined after 1 year of the deal being consummated), Lexington shareholders would own a 45%, with DSS shareholders owning 55%. Lexington shareholders will represent the larger minority voting interest in the combined entity at 45% compared to DSS's organized group (consisting of management and the board) at 12%. After the closing of the acquisition, senior management of the combined entity is expected to include five officers; the CEO, CIO and CTO from Lexington, and the CFO and COO from DSS, resulting in more members of senior management representing Lexington including the chief decision marker. Based on the aforementioned, and after taking in consideration all relevant facts and circumstances (which included, among others, the relative voting rights of the combined entity on a diluted basis, the larger minority voting interest, and the composition of the senior management), the Company came to a conclusion that, Lexington is the accounting acquirer, as it is defined in FASB Topic ASC 805 "Business Combinations."

We have expended significant effort and management attention on the proposed Merger transaction. There is no assurance that the transaction contemplated by the Merger Agreement will be consummated. If the Merger transaction is not consummated for any reason, our business and operations, as well as the market price of our stock and warrants may be adversely affected. For accounting purposes, based on our preliminary assessment, Lexington was identified as the "Acquirer", as it is defined in FASB Topic ASC 805. As a result, in the post-combination consolidated financial statements, Lexington's assets and liabilities will be presented at its pre-combination amounts, and our assets and liabilities will be recognized and measured in accordance with the guidance for business combinations in ASC 805. The Company intends to file a Form S-4 Registration Statement with the SEC regarding the proposed Merger as soon as practicable. The Merger requires approval by the stockholders of both Lexington and DSS, and is estimated to be consummated during the first half of 2013.

Results of Operations for the Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011

This discussion should be read in conjunction with the financial statements and footnotes contained in this quarterly report and in our Annual Report on Form 10-K for the year ended December 31, 2011.

Revenue



                                                                                                                          Nine Months
                                         Three Months          Three Months                          Nine Months             Ended
                                        Ended September       Ended September                      Ended September       September 30,
                                           30, 2012              30, 2011           % change          30, 2012               2011            % change
Revenue
Printing                               $         693,000     $         832,000            -17 %   $       2,214,000     $     2,342,000              -5 %
Packaging                                      2,188,000             1,576,000             39 %           5,858,000           3,796,000              54 %
Plastic IDs and cards                            774,000               757,000              2 %           2,254,000           2,087,000               8 %
Licensing and digital solutions                  509,000               451,000             13 %           1,340,000             952,000              41 %

Total Revenue                          $       4,164,000     $       3,616,000             15 %   $      11,666,000     $     9,177,000              27 %

For the three months ended September 30, 2012, revenue was $4.2 million, an increase of $548,000, or 15% from the three months ended September 30, 2011. The revenue increase was primarily due to increases in packaging and licensing and digital solutions revenues. The Company's packaging group saw increased order activity from its largest customers during the quarter while the Company's licensing and digital solutions sales reflected increased usage of the Company's security technology from its licensees. For the first nine months of 2012, revenue has increased 27% over the first nine months in 2011, primarily due to the 54% increase in the Company's packaging group's sales along with a 41% increase in revenue from the Company's technology licensing and digital solutions groups, which was primarily the result of the Company's acquisition of ExtraDev in May of 2011.

Cost of Revenue and Gross Profit



                                                                                                                          Nine Months
                                         Three Months          Three Months                          Nine Months             Ended
                                        Ended September       Ended September                      Ended September       September 30,
                                           30, 2012              30, 2011           % change          30, 2012               2011            % change

Costs of revenue
Printing                               $         429,000     $         699,000            -39 %   $       1,568,000     $     2,083,000            -25 %
Packaging                                      1,640,000             1,125,000             46 %           4,471,000           2,763,000             62 %
Plastic IDs and cards                            433,000               454,000             -5 %           1,263,000           1,231,000              3 %
Licensing and digital solutions                  139,000                68,000            104 %             256,000              87,000            194 %

Total cost of revenue                          2,641,000             2,346,000             13 %           7,558,000           6,164,000             23 %

Gross profit
Printing                                         264,000               133,000             98 %             646,000             259,000            149 %
Packaging                                        548,000               451,000             22 %           1,387,000           1,033,000             34 %
Plastic IDs and cards                            341,000               303,000             13 %             991,000             856,000             16 %
Licensing and digital solutions                  370,000               383,000             -3 %           1,084,000             865,000             25 %

Total gross profit                     $       1,523,000     $       1,270,000             20 %   $       4,108,000     $     3,013,000             36 %

Gross profit percentage                               37 %                  35 %            6 %                  35 %                33 %            6 %

For the three months ended September 30, 2012, gross profit increased 20% to $1,523,000 as compared to the three months ended September 30, 2011. The increase in gross profit was primarily due a 98% increase in gross profits in the Company's printing group, which benefited from a favorable product sales mix as the Company focused on higher margin projects, along with a 22% increase in gross profits in the Company's packaging group.

For the first nine months of 2012, the Company's gross profit has increased 36% over the first nine months of 2011. The Company saw a significant increase in gross profits from its printing groups as it has benefited from a lower cost structure and a more favorable product mix. In addition, each of the Company's packaging and plastics groups realized gross profit gains as a result of their revenue gains. Finally, gross profits from licensing and digital solutions sales increased 25% primarily due to the addition of gross profits from the Company's acquisition of ExtraDev, which occurred in May 2011.

Operating Expenses



                                                                                                                           Nine Months
                                          Three Months          Three Months                          Nine Months             Ended
                                         Ended September       Ended September                      Ended September       September 30,
                                            30, 2012              30, 2011           % change          30, 2012               2011            % change

Operating Expenses
Sales, general and administrative
compensation                            $       1,065,000     $       1,080,000             -1 %   $       3,176,000     $     2,684,000             18 %
Professional Fees                                 594,000               219,000            171 %             968,000             582,000             66 %
Sales and marketing                                67,000               127,000            -47 %             234,000             413,000            -43 %
Rent and utilities                                140,000               195,000            -28 %             438,000             547,000            -20 %
Other                                             208,000               212,000             -2 %             699,000             575,000             22 %
                                                2,074,000             1,833,000             13 %           5,515,000           4,801,000             15 %

Other Operating Expenses
Non-production depreciation and
amortization                                       33,000                31,000              6 %              97,000              94,000              3 %
Research and development, including
research and development costs paid
by equity instruments                             174,000                83,000            110 %             545,000             208,000            162 %
Stock based compensation                          196,000               114,000             72 %             449,000             319,000             41 %
Amortization of intangibles                        76,000                71,000              7 %             228,000             205,000             11 %
                                                  479,000               299,000             60 %           1,319,000             826,000             60 %

Total Operating Expenses                $       2,553,000     $       2,132,000             20 %   $       6,834,000     $     5,627,000             21 %

Sales, general and administrative compensation costs, excluding stock base compensation, increased in 2012 as compared to 2011 primarily due to the addition of employees as a result of the Company's acquisition of its cloud computing division in May 2011, offset by reductions of personnel in the Company's printing and packaging divisions.

Professional feesduring the three and nine months ended September 30, 2012 increased from the corresponding 2011 periods due to an increase in intellectual property consulting and investor relations costs, and approximately $461,000 of legal, accounting and consulting fees incurred in the third quarter of 2012 associated with the Company's proposed merger with Lexington.

Sales and marketing costs during the three and nine months ended September 30, 2012 decreased from the corresponding periods of 2011, as the Company significantly decreased its marketing costs, including costs incurred during 2011 to redesign the Company's logo, websites, sales collateral and trade-show booths, which did not re-occur in 2012.

Rent and utilitiesexpenses in 2012 have decreased due to the elimination of rent at the Company's packaging division as a result of that division's purchase of its facility in August 2011, offset by an increase in rent due to the Company's acquisition of ExtraDev in May 2011.

Other operating expenses consists primarily of equipment maintenance and repairs, office supplies, IT support, bad debt expense and insurance costs. Other expenses for the first nine months of 2012 include a one-time placement agent fee related to the placement of a convertible note and subsequent conversion in March 2012. . . .

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