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TKOI > SEC Filings for TKOI > Form 10-Q on 14-Nov-2012All Recent SEC Filings

Show all filings for TELKONET INC

Form 10-Q for TELKONET INC


14-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of the Company's financial condition and results of operations should be read in conjunction with the accompanying condensed consolidated financial statements and related notes thereto for the quarter ended September 30, 2012, as well as the Company's consolidated financial statements and related notes thereto and management's discussion and analysis of financial condition and results of operations in the Company's Form 10-K for the year ended December 31, 2011, filed April 23, 2012.

Business

Telkonet, Inc., formed in 1999 and incorporated under the laws of the state of Utah, is a Clean Technology company that designs, develops and markets proprietary energy efficiency and smart grid networking products and services. Our SmartEnergy, EcoSmart and Series 5 SmartGrid networking technologies enable us to provide innovative clean technology solutions and have helped position Telkonet as a leading Clean Technology provider.

Our Telkonet SmartEnergy, Networked Telkonet SmartEnergy and EcoSmart energy efficiency products incorporate our patented Recovery Time™ technology, providing continuous monitoring of climate and environmental conditions to dynamically adjust a room's temperature, accounting for the occupancy of the room. Our SmartEnergy and EcoSmart platforms maximize energy savings while at the same time ensuring occupant comfort and extending equipment life expectancy. This technology is particularly attractive to customers in the hospitality industry, as well as the education, healthcare and government/military markets, who are continually seeking ways to reduce costs and meet federal and state mandates without impacting building occupant comfort. By reducing energy consumption automatically when a space is unoccupied, our customers can realize significant cost savings without diminishing occupant comfort. This technology may also be integrated with property management systems and building automation systems and used in load shedding initiatives. This feature provides management companies and utilities enhanced opportunity for cost savings, environmental awareness and energy management. Telkonet's energy management systems are lowering heating, ventilation and air conditioning, or HVAC, costs in hundreds of thousands of rooms worldwide and qualify for state and federal energy efficiency and rebate programs.

The Series 5 SmartGrid networking technology allows commercial, industrial and consumer users to connect computers to a communications network using the existing low voltage electrical grid. The Series 5 SmartGrid networking technology uses powerline communications, or PLC, technology to transform existing electrical infrastructure into a communications backbone. Operating at 200 Mbps, the PLC platform offers a secure alternative in grid communications, transforming a traditional electrical distribution system into a "smart grid" that delivers electricity in a manner that can save energy, reduce cost and increase reliability.

On March 4, 2011, the Company sold its Series 5 Power Line Carrier product line and related business assets to Dynamic Ratings ("Dynamic Ratings"). The sales price was $1,000,000 in cash. In connection with the sale, Dynamic Ratings lent the Company an additional $700,000 in the form of a 6% promissory note dated March 4, 2011. Concurrent with the sale, the Company entered into a Distributorship Agreement and a Consulting Agreement with Dynamic Ratings. Under the Distributorship Agreement, the Company was designated as a distributor of the Series 5 product to the non-utility sector and will receive preferred pricing for purchases of Series 5 product. Under the Consulting Agreement, the Company agreed to provide Dynamic Ratings with ongoing transition assistance and consulting services for the Series 5 product. The Distributorship Agreement and the Consulting Agreement have initial terms that expire on March 31, 2014 and March 31, 2013, respectively. Any sales incentives and consulting compensation amounts payable to the Company under the Distributorship Agreement and the Consulting Agreement will be applied to the balance of the promissory note.

Telkonet's EthoStream Hospitality Network is now one of the largest high speed internet access (HSIA) solution providers in the world, with a customer base of more than 2,300 properties representing approximately 233,000 hotel rooms. This network provides Telkonet with the opportunity to market our energy efficiency solutions. The EthoStream Hospitality Network is backed by a 24/7 U.S.-based in-house support center that uses integrated, web-based management tools enabling proactive customer support. We utilize direct and indirect sales channels in all areas of our business. With a growing Value-Added Reseller (VAR) network, we continue to broaden our reach throughout the industry. Utilizing key integrators and strategic partners, we've been able to increase penetration in each of our targeted markets. The impact of this effort is a growing percentage of Telkonet's business is driven by our indirect sales channels.

Our direct sales efforts target the hospitality, education, commercial, utility and government/military markets. Taking advantage of legislation, including the Energy Independence and Security Act of 2007, or EISA, the Energy Policy Act of 2005, and the American Recovery and Reinvestment Act we've focused our sales efforts in areas with available public funding and incentives, such as rebate programs offered by utilities for efficiency upgrades. Through our proprietary platform, technology and partnerships with energy efficiency providers, we intend to position our Company as a leading provider of energy management solutions.

Forward Looking Statements

In accordance with the Private Securities Litigation Reform Act of 1995, we can obtain a "safe-harbor" for forward-looking statements by identifying those statements and by accompanying those statements with cautionary statements which identify factors that could cause actual results to differ materially from those in the forward-looking statements. Accordingly, the following "Management's Discussion and Analysis of Financial Condition and Results of Operations" may contain certain forward-looking statements regarding strategic growth initiatives, growth opportunities and management's expectations regarding orders and financial results for the remainder of 2012 and future periods. These forward-looking statements are based on current expectations and current assumptions which management believes are reasonable. However, these statements involve risks and uncertainties that could cause actual results to differ materially from any future results encompassed within the forward-looking statements. Factors that could cause or contribute to such differences include those risks affecting the Company's business as described in the Company's filings with the SEC, including the current reports on Form 8-K, which factors are incorporated herein by reference. The Company expressly disclaims a duty to provide updates to forward-looking statements, whether as a result of new information, future events or other occurrences.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. On an ongoing basis, we evaluate significant estimates used in preparing our condensed consolidated financial statements including those related to revenue recognition, fair value of financial instruments, guarantees and product warranties, sales tax obligations, stock based compensation, potential impairment of goodwill and other long lived assets and business combinations. We base our estimates on historical experience, underlying run rates and various other assumptions that we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results could differ from these estimates. The following are critical judgments, assumptions, and estimates used in the preparation of the consolidated financial statements.

Revenue Recognition

For revenue from product sales, we recognize revenue in accordance with ASC 605-10, and ASC Topic 13 guidelines that require that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and (4) collectability is reasonably assured. Determination of criteria (3) and (4) are based on management's judgments regarding the fixed nature of the selling prices of the products delivered and the collectability of those amounts. Provisions for discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period the related sales are recorded. We defer any revenue for which the product has not been delivered or is subject to refund until such time that we and the customer jointly determine that the product has been delivered or no refund will be required. The guidelines also address the accounting for arrangements that may involve the delivery or performance of multiple products, services and/or rights to use assets.

We provide call center support services to properties installed by us and also to properties installed by other providers. In addition, we provide the property with the portal to access the Internet. We receive monthly service fees from such properties for our services and Internet access. We recognize the service fee ratably over the term of the contract. The prices for these services are fixed and determinable prior to delivery of the service. The fair value of these services is known due to objective and reliable evidence from contracts and standalone sales. We report such revenues as recurring revenues.

Total revenues do not include sales tax as we consider ourselves a pass through conduit for collection and remitting sales tax.

Fair Value of Financial Instruments

The Company accounts for the fair value of financial instruments in accordance with ASC 820, which defines fair value for accounting purposes, established a framework for measuring fair value and expand disclosure requirements regarding fair value measurements. Fair value is defined as an exit price, which is the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date. The degree of judgment utilized in measuring the fair value of assets and liabilities generally correlates to the level of pricing observability. Financial assets and liabilities with readily available, actively quoted prices or for which fair value can be measured from actively quoted prices in active markets generally have more pricing observability and require less judgment in measuring fair value. Conversely, financial assets and liabilities that are rarely traded or not quoted have less price observability and are generally measured at fair value using valuation models that require more judgment. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency of the asset, liability or market and the nature of the asset or liability. We have categorized our financial assets and liabilities that are recurring, at fair value into a three-level hierarchy in accordance with these provisions.

New Accounting Pronouncements

For information regarding recent accounting pronouncements and their effect on the Company, see "New Accounting Pronouncements" in Note B of the Notes to Unaudited Condensed Consolidated Financial Statements contained herein.

Revenues



The table below outlines product versus recurring revenues for comparable
periods:



                                        Three Months Ended
              September 30, 2012          September 30, 2011             Variance

Product     $  2,161,753        66%     $  1,632,160        58%     $ 529,593       32%
Recurring      1,127,025        34%        1,162,559        42%       (35,534 )     -3%
Total       $  3,288,778       100%     $  2,794,719       100%     $ 494,059       18%




                                         Nine Months Ended
              September 30, 2012          September 30, 2011              Variance

Product     $  5,481,365        63%     $  4,760,120        58%     $  721,245       15%
Recurring      3,197,925        37%        3,445,234        42%       (247,309 )     -7%
Total       $  8,679,290       100%     $  8,205,354       100%     $  473,936        6%

Product Revenue

Product revenue principally arises from the sale and installation of SmartEnergy, SmartGrid and High Speed Internet Access equipment. These include TSE, Telkonet Series 5, Telkonet iWire, and wireless networking products. We market and sell to the hospitality, education, healthcare and government/military markets. The Telkonet Series 5 and the Telkonet iWire products consist of the Telkonet Gateways, Telkonet Extenders, the patented Telkonet Coupler, and Telkonet iBridges. The SmartEnergy product suite consists of thermostats, sensors, controllers, wireless networking products and a control platform. The HSIA product suite consists of gateway servers, switches and access points.

For the three and nine months ended September 30, 2012, product revenue increased by 32% and 15% respectively, when compared to the prior year periods. Product revenue in 2012 includes approximately $3.4 million attributed to the sale and installation of energy management products, and approximately $2.1 million for the sale and installation of HSIA products. The increase in product revenue can be attributed to management's commitment of resources to sales and marketing expense and personnel.

Recurring Revenue

Recurring revenue is primarily attributed to recurring services. The Company recognizes revenue ratably over the service month for monthly support revenues and defers revenue for annual support services over the term of the service period. The recurring revenue consists primarily of HSIA support services and advertising revenue. Advertising revenue is based on impression-based statistics for a given period from customer site visits to the Company's login portal page under the terms of advertising agreements entered into with third-parties. A component of our recurring revenue is derived from fees, less pay back costs, associated with approximately 1% of our hospitality customers who do not internally manage guest-related, internet transactions.

Recurring revenue includes approximately 2,300 hotels in our broadband network portfolio. We currently support approximately 233,000 HSIA rooms. For the three and nine months ended September 30, 2012, recurring revenue decreased by 3% and 7%, respectively, when compared to the prior year periods.

Cost of Sales



                                         Three Months Ended
               September 30, 2012           September 30, 2011             Variance

Product     $    1,166,848       52%      $   1,002,816       61%     $ 164,032       16%
Recurring          292,264       26%            294,846       25%        (2,582 )     -1%
Total        $   1,459,112       43%      $   1,297,662       46%     $ 161,450       12%




                                         Nine Months Ended
               September 30, 2012           September 30, 2011             Variance

Product     $    2,969,512       53%      $   2,728,980       57%     $ 240,532       9%
Recurring          858,988       27%            849,962       25%         9,026       1%
Total        $   3,828,500       44%      $   3,578,942       44%     $ 249,558       7%

Product Costs

Costs of product sales include equipment and installation labor related to the sale of SmartGrid and broadband networking equipment, including EcoSmart technology, Telkonet Series 5 and Telkonet iWire. For the three and nine months ended September 30, 2012, product costs as a percentage of sales increased by 16% and 9%, respectively, when compared to the prior year periods. The increase was attributed to the increase in product sales.

Recurring Costs

Recurring costs are comprised of labor and telecommunication services for our Customer Service department. For the three months ended September 30, 2012, recurring costs decreased by 1% when compared to the prior year period. The decrease is attributed to the decrease in recurring sales. For the nine months ended September 30, 2012, recurring costs increased by 1% when compared to the prior year period. The increase was primarily due to additional customer support staff and related expenses incurred during the nine month period ended September 30, 2012.

Gross Profit



                                          Three Months Ended
               September 30, 2012           September 30, 2011              Variance

Product     $      994,905       46%      $     629,344       39%     $ 365,561        58%
Recurring          834,761       74%            867,713       75%       (32,952 )      -4%
Total        $   1,829,666       56%      $   1,497,057       54%     $ 332,609        22%




                                           Nine Months Ended
               September 30, 2012           September 30, 2011               Variance

Product     $    2,511,853       46%      $   2,031,140       43%     $  480,713         24%
Recurring        2,338,937       73%          2,595,272       75%       (256,335 )      -10%
Total        $   4,850,790       56%      $   4,626,412       56%     $  224,378          5%

Product Gross Profit

The gross profit on product revenue for the three and nine months ended September 30, 2012 increased by 58% and by 24%, respectively, when compared to the prior year periods. The variances were a result of increased product sales and installations on energy management and HSIA sales.

Recurring Gross Profit

Our gross profit associated with recurring revenue decreased by 4% and 10%, respectively, for the three and nine months ended September 30, 2012. The decrease was mainly due to a decrease in advertising revenue which yields higher gross profit margins.

Operating Expenses

Three Months Ended September 30,
2012 2011 Variance

Total $ 1,324,168 $ 1,464,293 $ (140,125 ) -10%

Nine Months Ended September 30,
2012 2011 Variance

Total $ 4,867,017 $ 4,280,519 $ 586,498 14%

During the three months ended September 30, 2012, operating expenses decreased by 10% when compared to the prior year periods. Management confirmed that a customer had self assessed sales and use tax included in the sales tax liability calculation discussed in Note L. The recalculation resulted in a reduction to the Company's liability by approximately $132,000 and a reduction of interest due on that liability of approximately $19,000. During the nine months ended September 30, 2012 operating expense increased by 14%. The increase was the result of additional professional fees, a $132,174 charged to rent from the lease abandonment referenced in Note A during the period ended June 30, 2012, additional sales and marketing staff and related expenses.

Research and Development

Three Months Ended September 30,
2012 2011 Variance

Total $ 251,089 $ 197,674 $ 53,415 27%

Nine Months Ended September 30,
2012 2011 Variance

Total $ 732,154 $ 588,908 $ 143,246 24%

Our research and development costs related to both present and future products are expensed in the period incurred. Current research and development costs are associated with product development and integration. During the three and nine months ended September 30, 2012, research and development costs increased 27% and 24% when compared to the prior year periods. The increase is due to additional expenditures for test equipment and consulting.

Selling, General and Administrative Expenses

Three Months Ended September 30,
2012 2011 Variance

Total $ 1,009,814 $ 1,194,156 $ (184,342 ) -15%

Nine Months Ended September 30,
2012 2011 Variance

Total $ 3,937,522 $ 3,488,802 $ 448,720 13%

During the three months ended September 30, 2012, selling, general and administrative expenses decreased over the comparable prior year period by 15%. The decrease is primarily the result of a reduction in the sales and use tax liability and interest due on that balance. For the nine months ended September 30, 2012, general and administrative expenses increased by 13% over the comparable prior year period. The variance is a result of an increase in professional fees, a $132,174 charge to rent from the lease abandonment discussed in Note A, additional sales and marketing staff compensation and related expenses.

Liquidity and Capital Resources

We have financed our operations since inception primarily through private and public offerings of our equity securities, the issuance of various debt instruments and asset based lending.

Working Capital

Our working capital deficit decreased by $723,739 during the nine months ended September 30, 2012 from a working capital deficit (current liabilities in excess of current assets) of $774,915 at December 31, 2011 to a working capital deficit of $51,176 at September 30, 2012.

Business Loan

On September 11, 2009, the Company entered into a Loan Agreement in the aggregate principal amount of $300,000 with the Wisconsin Department of Commerce (the "Department"). The outstanding principal balance bears interest at the annual rate of 2%. Payment of interest and principal is to be made in the following manner: (a) payment of any and all interest that accrues from the date of disbursement commenced on January 1, 2010 and continued on the first day of each consecutive month thereafter through and including December 31, 2010; (b) commencing on January 1, 2011 and continuing on the first day of each consecutive month thereafter through and including November 1, 2016, the Company shall pay equal monthly installments of $4,426 each; followed by a final installment on December 1, 2016 which shall include all remaining principal, accrued interest and other amounts owed by the Company to the Department under the Loan Agreement. The Company may prepay amounts outstanding under the credit facility in whole or in part at any time without penalty. The Loan Agreement is secured by substantially all of the Company's assets and the proceeds from this loan were used for the working capital requirements of the Company. The Loan Agreement contains covenants which require, among other things, that the Company shall keep and maintain 75 existing full-time positions and create and fill 35 additional full-time positions in Milwaukee, Wisconsin by December 31, 2012. Under the terms of the Loan Agreement, for each new full time position not kept, created or maintained, the Company would be required to pay a penalty consisting of an incremental increase in the interest rate not to exceed 4%. In May of 2012, the Company notified the Department that due to the economic climate, it is unlikely that the 35 new full time position covenant will be met by December 31, 2012. On June 18, 2012, the Department agreed to waive all penalties associated with the covenant and keep the loan interest rate fixed at 2%. The outstanding borrowings under the agreement as of September 30, 2012 and December 31, 2011 were $216,165 and $252,454, respectively.

Promissory Note #1

On March 4, 2011, the Company sold all its Series 5 PLC product line assets to Wisconsin-based Dynamic Ratings, Inc. ("Purchaser") under an Asset Purchase Agreement ("APA"). Per the APA, the Company signed an unsecured Promissory Note ("Note #1") due to Purchaser in the aggregate principal amount of $700,000. The outstanding principal balance bears interest at the annual rate of 6% and is due on March 31, 2014. Note #1 may be prepaid in whole or in part, without penalty at any time. Note #1 contains certain earn-out provisions that encompass both the Company's and Purchaser's revenue volumes. Amounts earned under the earn-out provisions shall be applied against Note #1 on June 30, 2012 and June 30, 2013. Provided these provisions are met, the Company could potentially retire Note #1 prior to its expiration date. As of June 30, 2012, the non cash reduction of principal calculated under these provisions and applied to the note was $15,408.
Payments not made when due, by maturity acceleration or otherwise, shall bear interest at the rate of 12% per annum from the date due until fully paid. The outstanding principal balance of this note as of September 30, 2012 and December 31, 2011 was $684,592 and $700,000, respectively.

Promissory Note #2

From the sale of its Series 5 PLC product line assets, the Company used the proceeds received to retire substantially all of its obligations under its $1.6 million senior convertible debenture due May 29, 2011 and to cancel the related warrants covering 11.7 million shares of the Company's common stock. In exchange for the early retirement of debt and cancellation of warrants, the Company provided the third party with an unsecured one-year promissory note ("Note #2") for $50,000. The outstanding principal balance bore interest at the annual rate of 5.25% and was due on March 4, 2012. This note was paid in full prior to March 31, 2012.

Cash Flow Analysis

Cash used in continuing operations was $211,735 and $243,285 during the nine months ended September 30, 2012 and 2011, respectively. As of September 30, 2012, our primary capital needs included business strategy execution, inventory procurement and managing current liabilities.

Cash used in investing activities from continuing operations was $38,114 during the nine month period ended September 30, 2012 and cash provided by investing activities was $915,645 during the nine month period ended September 30, 2011. On March 4, 2011, the Company sold its Series 5 Power Line Carrier product line and related business assets for $1,000,000 in cash.

Cash provided by financing activities was $355,965 and $363,620 during the nine month periods ended September 30, 2012 and 2011, respectively. During the nine month period ended September 30, 2012, 3,115,390 of Series B preferred stock attached warrants were exercised to an equal number of common shares at an exercise price of $0.13 per share. The total proceeds received from these exercised warrants was $405,000. During the nine month period ended September 30, 2011, the Company sold its Series 5 Power Line Carrier product line and related business assets for $1,000,000 in cash. In connection with the sale, the purchaser lent the Company $700,000 in the form of a 6% promissory note dated March 4, 2011. The Company also issued Series B redeemable preferred stock during the first six months of 2011. Proceeds from the issuance were $1,355,000. The Company used the proceeds received to retire substantially all of its obligations under its $1.6 million senior convertible debenture due May 29, 2011.

Our independent registered public accountants report on our consolidated financial statements for the year ended December 31, 2011 includes an explanatory paragraph relating to our ability to continue as a going concern. We have incurred operating losses in the past years and we are dependent upon our ability to develop profitable operations and/or obtain necessary funding from outside sources, including by the sale of our securities, or obtaining loans from financial institutions, where possible. These factors, among others, raise doubt about our ability to continue as a going concern and may also affect our . . .

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