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INOD > SEC Filings for INOD > Form 10-K on 15-Mar-2013All Recent SEC Filings

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Form 10-K for INNODATA INC


15-Mar-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this report. In addition to historical information, this discussion includes forward-looking information that involves risks and assumptions which could cause actual results to differ materially from management's expectations. See "Forward-Looking Statements" included elsewhere in this report.

Executive Overview

We are a global provider of business process, information technology (IT) and professional services that are focused on digital enablement. We operate in two reporting segment: Content Services (CS) and Innodata Advanced Data Solutions (IADS).

The following table sets forth, for the period indicated, certain financial data expressed for the three years ended December 31, 2012:

(Dollars in millions)

                                                              Years Ended December 31,
                                2012       % of revenue        2011       % of revenue        2010       % of revenue

Revenues                      $   86.6             100.0 %   $   73.9             100.0 %   $   61.5             100.0 %
Direct operating costs            57.4              66.3 %       50.1              67.8 %       47.3              76.9 %
Selling and administrative
expenses                          22.2              25.6 %       19.1              25.8 %       15.6              25.4 %
Impairment charge                  0.5               0.9 %          -                 -            -                 -
Income (loss) from
operations                         6.5               7.5 %        4.7               6.4 %       (1.4 )            -2.3 %
Other income                      (0.3 )                         (0.6 )                         (0.2 )
Income (loss) before
provision for
(benefit from) income taxes        6.8                            5.3                           (1.2 )
Provision for (benefit
from) income taxes                 1.2                            1.4                           (0.5 )
Net income (loss)                  5.7                            3.9                           (0.7 )
Loss attributable to
non-controlling interest           1.8                            0.6                              -
Net income (loss)
attributable to Innodata
Inc. and Subsidiaries         $    7.5                       $    4.5                       $   (0.7 )

Revenues

We price our services based on the quantity delivered or resources utilized, and we recognize revenue in the period in which the services are performed and delivered. Revenues for contracts billed on a time-and-materials basis are recognized as services are performed. Revenues under fixed-fee contracts, which are not significant to the overall revenues, are recognized on the percentage of completion method of accounting, as services are performed or milestones are achieved.

We formed our IADS segment in mid-2011 to design and develop new capabilities to enable clients in the financial services, insurance, medical and healthcare sectors to improve decision-support through digital technologies. IADS operates through two subsidiaries: Synodex and docGenix. Synodex offers a range of data analysis services in the healthcare, medical and insurance areas. docGenix provides services to financial services institutions. As of December 31, 2012, we own 77% of Synodex, a limited liability company, and 94% of docGenix, a limited liability company. The subsidiaries are at an early stage of development, and reported minimal revenues in 2012. There were no revenues in 2011.

Our top two clients generated approximately 41%, 30% and 17% of the Company's total revenues in the fiscal years ended December 31, 2012, 2011 and 2010, respectively. Another client accounted for less than 10% of our total revenues for the year ended December 31, 2012, but for 14% and 10% of our total revenues for the year ended December 31, 2011 and 2010, respectively. One other client accounted for less than 10% of our total revenues for the years ended December 31, 2012 and 2011, but for 11% of our total revenues for the year ended December 31, 2010. No other client accounted for 10% or more of revenues during these periods. Further, in the years ended December 31, 2012, 2011 and 2010, revenues from non-U.S. clients accounted for 24%, 30% and 33%, respectively, of the Company's revenues. We may lose any of these, or our other major clients, as a result of our failure to meet or satisfy our clients' requirements, the completion or termination of a project or engagement, or the client's selection of another service provider. We may also experience significant volume fluctuation.

Our services are typically subject to client requirements, and in many cases are terminable upon 30 to 90 days' notice.

Direct Operating Costs

Direct operating costs consist of direct payroll, occupancy costs, depreciation and amortization, travel, telecommunications, computer services and supplies, realized gains and losses on settlement of foreign currency forward contracts and other direct expenses that are incurred in providing services to our clients.

Selling and Administrative Expenses

Selling and administrative expenses consist of management and administrative salaries and incentives, sales and marketing costs, new services research and related software development, professional fees and consultant costs and other administrative overhead costs.

Results of Operations

Year Ended December 31, 2012 Compared to the Year Ended December 31, 2011

Revenues

Total revenues were $86.6 million for the year ended December 31, 2012, a 17% increase from the $73.9 million for the year ended December 31, 2011. Revenues from the Content Services segment were $85.4 million and $73.9 million for the years ended December 31, 2012 and 2011, respectively. Revenues from the IADS segment were $1.2 million for the year ended December 31, 2012. There were no revenues from the IADS segment for the year ended December 31, 2011.

The $11.4 million increase in the Content Services segment is principally attributable to higher revenues from e-book related services that we performed for one of our significant clients. We experienced sequential declines in revenue from this client in the last three quarters of 2012.

Our top two clients generated $35 million or 41% and $22.2 million or 30% of our total revenues in the fiscal years ended December 31, 2012 and 2011, respectively. Another client accounted for less than 10% of our total revenues for the year ended December 31, 2012, but for 14% of our total revenues for the year ended December 31, 2011. No other client accounted for 10% or more of revenues during these periods.

Further, in the years ended December 31, 2012 and 2011, revenues from non-U.S. clients accounted for 24% and 30%, respectively, of our total revenues.

Direct Operating Costs

Direct operating costs were approximately $57.4 million and $50.2 million for years ended December 31, 2012 and 2011, respectively, an increase of $7.2 million or approximately 14%. Direct operating costs for the Content Services segment were $53.3 million and $49.6 million for the years ended December 31, 2012 and 2011, respectively, an increase of $3.7 million or approximately 7%. Direct operating costs for the IADS segment were approximately $4.1 million and $0.6 million for the respective periods, net of intersegment profits.

The increase in direct operating costs for the Content Services segment was principally attributable to an increase in production headcount and other operating costs in support of increased revenues. The increase in direct operating costs was partially offset by a decrease in direct labor costs achieved primarily from productivity gains. The productivity gains were principally the result of increased efficiency, improvements in our processes and innovation in our technology.

The increase in direct operating costs for the IADS segment represents production costs for initial engagements, increase in production labor costs to perform pilot engagements and facility overhead costs for our new delivery center in Asia.

Direct operating costs as a percentage of total revenues declined to 66% for the year ended December 31, 2012 compared to 68% for the year ended December 31, 2011. Direct operating costs for the Content Services segment as a percentage of Content Services segment revenues were approximately 62% for the year ended December 31, 2012, compared to 67% for the year ended December 31, 2011.

Selling and Administrative Expenses

Selling and administrative expenses were $22.2 million and $19.1 million for the years ended December 31, 2012 and 2011, respectively, an increase of $3.1 million, or approximately 16%. Selling and administrative costs for the Content Services segment were $19.3 million and $17.5 million in these respective periods. Selling and administrative expenses for the IADS segment for the respective periods were $2.9 million and $1.6 million, net of intersegment profits.

The increase in selling and administrative expenses for the Content Services segment for the year ended December 31, 2012 is principally attributable to compensation costs of new hires, wage increases and an increase in other miscellaneous administrative costs. During the year ended December 31, 2011, we recorded approximately $0.5 million from the recovery of bad debts from a previously fully reserved account receivable.

Selling and administrative expenses for the Content Services segment, as a percentage of Content Services segment revenues, declined to 23% for the year ended December 31, 2012, from 24% for the year ended 2011, and this was primarily as a result of higher revenues.

The $1.3 million increase in selling and administrative expenses for the IADS segment is primarily attributable to compensation costs of new personnel hired for sales and marketing and increases in other administrative costs.

Impairment Charge

docGenix provided services to three clients in 2012 and we expect to continue to provide services to some of these clients in 2013. The existing docGenix product and service offering did not gain traction in the market place beyond its initial clients. In order to reach a broader market we will need to revise our approach from that represented by the existing product and service. As a result in the fourth quarter of 2012, we evaluated the carrying value of the fixed assets of our docGenix subsidiary compared to its fair value and concluded that the carrying value exceeds its fair value. This resulted in an impairment charge of $0.5 million.

Restructuring Costs

In the second half of 2012, we restructured our operations, and recorded a one-time charge of approximately $0.2 million ($0.1 million in direct operating costs and $0.1 million in selling, general and administrative costs) representing severance and other personnel-related expenses. We expect cost savings of approximately $3.0 million per year from this restructuring activity.

Income Taxes

For the year ended December 31, 2012, our U.S. entity recorded a benefit from income tax on account of losses incurred by our U.S. entity. With respect to our foreign subsidiaries, we recorded a provision for income taxes in accordance with the local tax regulations. As some of our foreign subsidiaries are subject to tax holidays or preferential tax rates, our overall effective tax rate was lower compared to the U.S. statutory tax rate. In addition, the earnings of our foreign subsidiaries are not subject to tax in the U.S. unless the earnings are repatriated.

For the year ended December 31, 2011, we recorded a provision for income taxes for the U.S. entity and certain, but not all of our foreign subsidiaries, as certain foreign subsidiaries are subject to tax holidays or preferential tax rates. In addition, the earnings of our foreign subsidiaries are not subject to tax in the U.S. unless the earnings are repatriated.

The effective tax rate at 17% was lower for the year ended December 31, 2012 compared to 26% for the year ended December 31, 2011 as the income attributable to our higher tax jurisdictions was lower.

Beginning in 2002, unremitted earnings of foreign subsidiaries have been included in the consolidated financial statements without giving effect to the United States taxes that may be payable on distribution to the United States, because such earnings are not anticipated to be remitted to the United States. If such earnings were to be distributed, we could be subject to United States income taxes that may not be fully offset by foreign tax credits. Determination at this time, of the amount of unrecognized deferred tax liability related to these earnings is not practicable.

In assessing the realization of deferred tax assets, we consider whether it is more likely than not that all or some portion of the deferred tax assets will not be realizable. The ultimate realization of the deferred tax assets is dependent upon the generation of future taxable income during the periods in which temporary differences are deductible and net operating losses are available. We consider many factors when assessing the likelihood of future realization of the deferred tax assets, including our recent cumulative earnings, expectation of future taxable income, the carryforward periods available to us for tax reporting purposes, and other relevant factors. At December 31, 2012 and 2011, we had no valuation allowance on our deferred tax assets.

Pursuant to an income tax audit by the Indian Bureau of Taxation in March 2006, one of our Indian subsidiaries received a tax assessment approximating $339,000, including interest, through December 31, 2012, for the fiscal tax year ended March 31, 2003. We disagree with the basis of the tax assessment and filed an appeal with the Appeal Officer against the assessment. In October 2010, the matter was resolved with a judgment in our favor. Under the Indian Income Tax Act, however, the income tax assessing officer has a right to appeal against the judgment passed by the Appeal Officer. In December 2010, the income tax assessing officer exercised this right, against which we filed an application to defend the case and we intend to contest it vigorously. The Indian Bureau of Taxation has also completed an audit of our Indian subsidiary's income tax return for the fiscal tax year ended March 31, 2004. The ultimate outcome was favorable, and there was no tax assessment imposed for the fiscal tax year ended March 31, 2004. In 2008 and 2009, the Indian subsidiary received a final tax assessment for the fiscal years ended March 31, 2005 and 2006 from the Indian Bureau of Taxation. The tax assessment amounted to $340,000 and $345,000, including interest through December 31, 2012, for the fiscal years ended March 31, 2005 and 2006, respectively. We disagree with the basis of these tax assessments, have filed an appeal against the assessments, and we intend to contest the assessment vigorously. In January 2012, the Indian subsidiary received a final tax assessment approximately $1.1 million, including interest, for the fiscal year ended March 31, 2008 from the Indian Bureau of Taxation. We disagree with the basis of this tax assessment, and have filed an appeal against the assessment. Due to this assessment, we recorded a tax provision amounting to $323,000 including interest through December 31, 2012. Based on recent experience and the current development, we believe that the tax provision of $323,000 including interest is adequate. The Indian Bureau of Taxation commenced an audit of this subsidiary's income tax return for the fiscal year ended March 31, 2010. The ultimate outcome cannot be determined at this time. As we are continually subject to tax audits by the Indian Bureau of Taxation, we have assessed the likelihood of an unfavorable assessment for all fiscal years where we are not subject to a final tax assessment as of December 31, 2012, and have recorded an additional tax provision amounting to approximately $1.0 million including interest through December 31, 2012. In January 2013, one of our Philippine subsidiaries received an informal tax assessment for an amount totaling $3.8 million for the year ended December 31, 2009. Although, we have not yet received formal notice of this assessment, we have had a discussion with the tax examiner. Based on this discussion, we believe that it is reasonably likely that we will be successful in contesting the assessment. Accordingly, we recorded no tax provision on said informal tax assessment. In addition, we will continuously monitor the outcome and will record an appropriate tax provision in the event there is any change in circumstances.

We had unrecognized tax benefits of $2.4 million and $2.3 million at December 31, 2012 and 2011, respectively. The portion of unrecognized tax benefits relating to interest and penalties was $0.7 million and $0.6 million at December 31, 2012 and 2011, respectively. The unrecognized tax benefits as of December 31, 2012 and 2011, if recognized, would have an impact on our effective tax rate.

We are subject to various tax audits and claims which arise in the ordinary course of business. Management currently believes that the ultimate outcome of these audits and claims will not have a material adverse effect on our consolidated financial position, results of operations or cash flows.

Net Income

We generated net income of $7.5 million in the year ended December 31, 2012 compared to $4.5 million in the year ended December 31, 2011. Net income for the Content Services segment was $13.8 million for the year ended December 31, 2012 compared to $6.7 million for the year ended December 31, 2011. The significant increase in net income for the Content Services segment was primarily due to an increase in gross margins resulting from higher revenues, and an increase in productivity due to improvements in processes and technology. This increase was partly offset by an increase in selling and administrative expenses primarily due to compensation costs of new hires, wage increases and an increase in other administrative costs. A lower provision for income taxes and higher losses attributable to non-controlling interests in the year ended December 31, 2012 compared to year ended December 31, 2011 also contributed to an increase in net income. Net loss for the IADS segment was $6.3 million for the year ended December 31, 2012 compared to $2.2 million for the year ended December 31, 2011, net of intersegment profits. The increase in net loss was principally on account of new personnel hired for operations, and sales and marketing, increase in facility overhead costs and other administrative costs, and a $0.5 million impairment charge for our docGenix subsidiary.

Year Ended December 31, 2011 Compared to the Year Ended December 31, 2010

Revenues

Revenues were $73.9 million for the year ended December 31, 2011 compared to $61.5 million for the year ended December 31, 2010, an increase of $12.4 million or approximately 20%. The $12.4 million increase in revenues is principally attributable to higher revenues from our e-book-related services that we perform for one of our larger clients and revenue from analytics services that we perform for a major accounting firm.

Our top three clients generated $32.6 million or 44% and $17.2 million or 28% of our revenues in the fiscal years ended December 31, 2011 and 2010, respectively. Another client accounted for less than 10% of our revenues for the year ended December 31, 2011, and for $6.6 million or 11% of our revenues for the year ended December 31, 2010. No other client accounted for 10% or more of our total revenues in either period.

Further, for the years ended December 31, 2011 and 2010, revenues from clients located in foreign countries (principally in Europe) amounted to $22.3 million or 30% and $20.5 million or 33%, respectively, of our total revenues.

There were no revenues for the year ended December 31, 2011 from our recently formed IADS segment.

Direct Operating Costs

Direct operating costs were approximately $50.2 million and $47.3 million for the years ended December 31, 2011 and 2010, respectively, an increase of $2.9 million or approximately 6%.

The increase in direct operating costs was attributable to an increase in production headcount and other operating costs in support of increased revenues. In addition, direct operating costs increased on account of foreign exchange rate fluctuations caused by a strengthening of the Philippine peso and Indian rupee against the U.S. dollar. The U.S. dollar depreciated against the Asian currencies in the first three quarters of 2011; however, it surged significantly in the fourth quarter of 2011. This resulted in a net loss on the settlement of foreign currency forward contracts in the fourth quarter of 2011. The realized gain on the settlement of forward contracts in 2011 was $1.2 million as compared to $2.2 million in 2010. The increase in direct operating costs was partially offset by a decrease in direct labor costs achieved primarily from productivity gains. The productivity gains were principally the result of increased efficiency, improvements in our processes and innovation in our technology.

Included in total direct operating costs is approximately $1.1 million in start-up costs that we incurred for the IADS segment during the year ended December 31, 2011.

The changes in revenues and direct operating expenses mentioned above resulted in a decline in direct operating costs as a percentage of revenues to 68% for the year ended December 31, 2011, from 77% for the year ended December 31, 2010. Excluding the start-up costs incurred for the IADS segment from the total direct operating costs, direct operating costs would have increased by approximately 4% in 2011 as compared to 2010 and, as a percentage of revenues, would have been 66% in 2011, compared to 77% in 2010.

Selling and Administrative Expenses

Selling and administrative expenses were $19.1 million and $15.7 million for the years ended December 31, 2011 and 2010, respectively, an increase of $3.4 million or 22%. Selling and administrative expenses as a percentage of revenues was 26% for the year ended December 31, 2011 and 25% for the year ended December 31, 2010.

The increase in selling and administrative expenses for the year ended December 31, 2011 is principally attributable to compensation costs of new personnel hired for sales and marketing, severance costs of $0.4 million, increases in variable employee incentives and $1.6 million on account of our continued investments for the IADS segment, which includes approximately $0.3 million incurred towards professional fees for creating best-in-class information and a data security environment for the IADS segment.

Excluding the $1.6 million start-up costs incurred for the IADS segment, selling and administrative expenses would have increased by approximately 11% in 2011 as compared to 2010 and, as a percentage of revenues, would have been approximately 23% in 2011, compared to 25% in 2010.

Income Taxes

For the year ended December 31, 2011, we recorded a provision for income taxes primarily for our foreign subsidiaries, which was partially offset by a tax benefit recorded for the U.S. entity. The benefit from income tax recorded by the U.S. entity resulted from losses incurred by the U.S. entity during the year ended December 31, 2011. These losses were incurred primarily on account of start-up costs incurred for the IADS segment, with no associated revenue in 2011. Certain of the Company's foreign subsidiaries are subject to preferential tax rates. In addition, one of the foreign subsidiaries enjoys a tax holiday. Due to the tax holiday and the preferential tax rates, the income tax rate for the Company was substantially reduced. Certain overseas income is not subject to tax in the U.S. unless repatriated.

For the year ended December 31, 2010, we recorded a provision for income taxes primarily for our foreign subsidiaries, which was more than offset by the benefit recorded for the U.S. entity. The benefit from income tax recorded by the U.S. entity resulted primarily from losses incurred by the U.S. entity during the year ended December 31, 2011. One of our foreign subsidiaries enjoyed a tax holiday in 2010. In addition, certain of our foreign subsidiaries enjoy preferential tax rates. Certain overseas income is not subject to tax in the U.S. unless repatriated.

Net Income (Loss)

We generated net income of $4.5 million in 2011 compared with a net loss of $0.7 million in 2010. The change was primarily attributable to an increase in gross margins resulting from an increase in revenues, and an increase in productivity due to improvements in processes and technology. This increase was partly offset by unfavorable foreign exchange rates, an increase in selling and administrative expenses primarily due to hiring of new sales and marketing personnel, and an increase in variable employee incentives, and start-up costs incurred for the IADS segment amounting to $2.7 million. The change in net income also reflects an increase in interest income and an increase in the tax provision in 2011 compared to a tax benefit recorded in 2010.

Liquidity and Capital Resources

Selected measures of liquidity and capital resources, expressed in thousands, are as follows:

                                                     December 31,
                                            2012         2011         2010

              Cash and cash equivalents   $ 25,425     $ 11,389     $ 14,120
              Short term investments         3,091        5,828       13,875
              Working capital               32,784       28,148       26,088

At December 31, 2012 we had cash and cash equivalents of $25.4 million, of which $15.1 million was held by our foreign subsidiaries, and short term investments of $3.1 million which was entirely held by our operating foreign subsidiaries located in Asia. A significant portion of the amounts held outside of the Unites States could be repatriated to the United States, but under current law, would be subject to Unites States federal income taxes, less applicable foreign tax credit. However, our intent is to permanently reinvest these funds outside the Unites States.

We have used, and plan to use, our existing cash for (i) expansion of existing operations; (ii) general corporate purposes, including working capital; (iii) possible business acquisitions; and (iv) continuing investments in IADS. As of December 31, 2012, we had no third party debt and had working capital of approximately $32.8 million compared to working capital of approximately $28.1 million at December 31, 2011. We do not anticipate any near-term liquidity issues. Cash balances are held in bank deposits at leading U.S. and foreign commercial banks.

Net Cash Provided By (Used in) Operating Activities

Cash provided by our operating activities in 2012 was $17.8 million, resulting from net income of $5.7 million, adjustments for non-cash items of $5.3 million, and $6.8 million provided for working capital. Adjustments for non-cash items principally consisted of $3.9 million for depreciation and amortization, stock compensation expense of $1.0 million and an impairment charge of approximately $0.5 million relating to the IADS segment. Working capital activities primarily consisted of a source of cash of $7.4 million as a result of a decrease in accounts receivable, use of cash of $0.7 million from an increase in other assets, use of cash of $0.4 million from an increase in income and other taxes, partially offset by a source of cash of $0.5 million for prepaid expenses and other current assets.

Cash used in our operating activities in 2011 was $3.0 million, resulting from net income of $3.9 million, adjustments for non-cash items of $3.5 million, and $10.4 million used for working capital. Adjustments for non-cash items principally consisted of $3.4 million for depreciation and amortization, stock compensation expense of $0.8 million, $0.8 million for a net change in deferred taxes and $0.5 million for pension costs. Working capital activities primarily consisted of a use of cash of $13.0 million as a result of an increase in . . .

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