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ISCI > SEC Filings for ISCI > Form 10-Q on 14-May-2013All Recent SEC Filings

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Form 10-Q for ISC8 INC. /DE


14-May-2013

Quarterly Report


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

In this report, the terms "ISC8 Inc.," "ISC8," "Irvine Sensors," "Irvine Sensors Corporation," "Company," "we," "us" and "our" refer to ISC8 Inc. ("ISC8") and its subsidiaries.

Introduction

The following information should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto in Part I, Item 1 of this Quarterly Report on Form 10-Q ("Quarterly Report"), and with Management's Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended September 30, 2012.

Overview

We are engaged in the design, development, manufacture and sale of a family of security products, consisting of cyber security solutions for government and commercial applications. Our current operations are located in California, Texas, and Italy with other employees and consultants in various other locations globally. Our operation in Italy was acquired in connection with our acquisition of certain software assets of Bivio Software in October 2012, described below.

As of March 31, 2013, we had approximately $34.9 million of debt, exclusive of debt discounts, and approximately $3.2 million of accounts payable and accrued expenses.

-20-

Acquisition of Bivio Software

On October 12, 2012, pursuant to the terms of the Foreclosure Sale Agreement between the Company and GF Acquisition Co. 2012, LLC ("GFAC") dated October 4, 2012 (the "Foreclosure Sale Agreement"), the Company acquired substantially all of the assets of the NetFalcon and Network Content Control System Business (the "Bivio Software") of Bivio Networks, Inc. and certain of its subsidiaries (collectively, "Bivio"), an international provider of cyber security solutions and products. The purchase price of those assets (the "Acquisition") was $600,000 payable in cash to GFAC, and the issuance to GFAC of a warrant to purchase the Company's common stock. The fair value of the warrants issued was $85,000. In addition, the Company assumed certain liabilities, including accounts payable, contractual obligations, reclamation obligations and other liabilities related to Bivio Software.

Critical Accounting Estimates

Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP"). As such, management is required to make judgments, estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. The significant accounting policies that are most critical to aid in fully understanding and evaluating reported financial results are the same as those disclosed in our Form 10-K for the fiscal year ended September 30, 2012 filed with the SEC on December 28, 2012.

Results of Continuing Operations

The following discussions relate to the Company's results of continuing operations after reclassifying the operations of our Thermal Imaging Business and Government Business as discontinued operations due to the sale of the Thermal Imaging Business on January 31, 2012, and the discontinuance of the Government Business on March 19, 2013.

Total Revenues. Our total revenues are generally derived from sales and support of cyber security products. Our total revenues increased in the 13-week period ended March 31, 2013 as compared to the 13-week period ended April 1, 2012 and changed in composition as shown in the following table and discussed more fully below.

13-Week Comparisons                               Total Revenues
13 weeks ended April 1, 2012                     $              -
Dollar increase in current comparable 13 weeks            102,000

13 weeks ended March 31, 2013                    $        102,000
Percentage increase in current 13 weeks                      100%



26-Week Comparisons                               Total Revenues
26 weeks ended April 1, 2012                     $              -
Dollar increase in current comparable 26 weeks            196,000

26 weeks ended March 31, 2013                    $        196,000
Percentage increase in current 26 weeks                      100%

The increase in our total revenue in the 13-week and 26-week periods ended March 31, 2013 as compared to the 13-week and 26-week periods ended April 1, 2012 was primarily the result of the acquisition of Bivio Software and its software maintenance revenue. Our software-related revenue did not exist in the periods ended April 1, 2012. Effective March 19, 2013, we discontinued our Government Business. As a result, our business and results of operations have been and will continue to be materially affected in the short-term, as we transition to our cyber security business. We are currently promoting sales of our other recently introduced products, which if achieved, although no assurances can be given, we believe could become a material contributor to our total revenue in the period ending September 30, 2013 ("Fiscal 2013"). However we are not certain that such outcome will materialize during Fiscal 2013 or at all.

-21-

Cost of Revenues. Cost of revenue includes wages and related benefits of our personnel, as well as subcontractor, independent consultant and vendor expenses directly incurred in the manufacture of products sold, plus related overhead expenses. The comparison of cost of revenue for the 13-week and 26-week periods ended March 31, 2013 and April 1, 2012 is shown in the following table and discussed more fully below:

                                                                                      Percentage of
13-Week Comparisons                                             Cost of Revenue       Total Revenue
13 weeks ended April 1, 2012                                   $               -                  0%
Dollar increase in current comparable 13 weeks                            44,000

13 weeks ended March 31, 2013                                  $          44,000                 43%
Percentage decrease in current 13 weeks                                     100%



                                                                                      Percentage of
26-Week Comparisons                                             Cost of Revenue       Total Revenue
26 weeks ended April 1, 2012                                   $               -                  0%
Dollar increase in current comparable 26 weeks                            81,000

26 weeks ended March 31, 2013                                  $          81,000                 42%
Percentage decrease in current 26 weeks                                     100%

The increase in absolute dollar cost of revenue associated with continuing operations in the 13-week and 26-week periods ending March 31, 2013 compared to the 13-week and 26-week periods ended April 1, 2012 is the result of no software-related revenue existing in the periods ended April 1, 2012.

General and Administrative Expense. General and administrative expense largely consists of wages and related benefits for our executive, financial, administrative and marketing staff, as well as professional fees, primarily legal and accounting fees and costs, plus various fixed costs such as rent, utilities and telephone. The comparison of general and administrative expense for the 13-week and 26-week periods ended March 31, 2013 and April 1, 2012 is shown in the following table and discussed more fully below:

                                                   General and
                                                  Administrative       Percentage of
13-Week Comparisons                                  Expense           Total Revenue
13 weeks ended April 1, 2012                     $      1,094,000                100%
Dollar increase in current comparable 13 weeks          1,226,000

13 weeks ended March 31, 2013                    $      2,320,000               2275%
Percentage increase in current 13 weeks                      112%



                                                   General and
                                                  Administrative       Percentage of
26-Week Comparisons                                  Expense           Total Revenue
26 weeks ended April 1, 2012                     $      2,206,000                 100 %
Dollar increase in current comparable 26 weeks          2,084,000

26 weeks ended March 31, 2013                    $      4,290,000                2289 %
Percentage increase in current 26 weeks                       94%

The increase in absolute dollars of general and administrative expense in the 13-week and 26-week periods ended March 31, 2013 as compared to the 13-week and 26-week periods ended April 1, 2012 consisted of a combination of increased stock-based compensation expense, marketing and legal fees, severance expense, as well as facilities expense related to cyber development in Texas. This was partially offset by a decrease in travel, bid and proposal fees, professional fees and stockholder-related expense.

-22-

Research and Development Expense. Research and development expense primarily consists of wages and related benefits for our research and development staff, independent contractor consulting fees and subcontractor and vendor expenses directly incurred in support of internally funded research and development projects, plus associated overhead expenses. Research and development expense for the 13-week and 26-week periods ended March 31, 2013 as compared to the 13-week and 26-week periods ended April 1, 2012 is shown in the following table and discussed more fully below:

                                                  Research and
                                                  Development        Percentage of
13-Week Comparisons                                 Expense          Total Revenue
13 weeks ended April 1, 2012                     $    1,504,000                 100 %
Dollar increase in current comparable 13 weeks          295,000

13 weeks ended March 31, 2013                    $    1,799,000                1764 %
Percentage increase in current 13 weeks                      20 %

The changes in research and development expense in the 13-week and 26-week periods ended March 31, 2013 as compared to the 13-week and 26-week periods ended April 1, 2012, are largely related to the development expense of our Texas-based cyber security office, which we opened and commenced staffing in April 2011 and the acquisition of the research facility in Italy in connection with the acquisition of Bivio Software. Many of those expenses relate to hiring of highly-skilled development and support staff, software licensing expense, consulting fees and various operating leases of facilities and equipment to support product development. We also signed a joint development agreement with Cavium, Inc. to provide design and engineering services. We expect to continue to allocate significant resources to the development of our cyber security products in future periods, which may result in further increases in research and development expense as compared to prior fiscal periods. However, no assurances can be given that we will capitalize on our research and development initiatives.

Interest Expense. Our interest expense for the 13-week and 26-week periods ended March 31, 2013, compared to the 13-week and 26-week periods ended April 1, 2012, increased as shown in the following table and discussed more fully below:

13-Week Comparisons                               Interest Expense
13 weeks ended April 1, 2012                     $        1,470,000
Dollar increase in current comparable 13 weeks            2,336,000

13 weeks ended March 31, 2013                    $        3,806,000
Percentage increase in current 13 weeks                        159%



26-Week Comparisons                               Interest Expense
26 weeks ended April 1, 2012                     $        3,139,000
Dollar increase in current comparable 26 weeks            2,654,000

26 weeks ended March 31, 2013                    $        5,793,000
Percentage increase in current 26 weeks                         85%

The increase in interest expense in the 13 weeks and 26 weeks ended March 31, 2013 as compared to April 1, 2012 was attributable primarily to interest and amortization of debt discounts and financing related costs as a result of our capital structure and continued fund raising efforts.

Change in Fair Value of Derivative Liability. We recorded a decrease in the change in fair value of derivative liability for the 13-week and 26-week period ended March 31, 2013, as compared to the 13-week and 26-week period ended April 1, 2012. This is shown in the following table and discussed more fully below:

                                                  Change in Fair Value of
13-Week Comparisons                                Derivative Liability
13 weeks ended April 1, 2012                     $             (14,160,000 )
Dollar decrease in current comparable 13 weeks                  13,694,000

13 weeks ended March 31, 2013                    $                (466,000 )
Percentage decrease in current 13 weeks                               (97% )

-23-

                                                  Change in Fair Value of
26-Week Comparisons                                Derivative Liability
26 weeks ended April 1, 2012                     $             (16,470,000 )
Dollar decrease in current comparable 26 weeks                  20,951,000

26 weeks ended March 31, 2013                    $               4,481,000
Percentage decrease in current 26 weeks                             (127%)

The Company revalued its derivatives as of March 31, 2013 and recorded a decrease in their fair value of approximately $0.5 million and an increase of approximately $4.5 million for the 13-week and 26-week periods, respectively, mainly as a result of quarterly valuations based on a decrease of our stock price from last quarter. Given the price volatility of our common stock, we anticipate that there could be additional substantial change in fair value of derivative liability expense that we will be required to record in future reporting periods, unless and until the Subordinated Notes are converted into, and/or the warrants are exercised for the purchase of common stock pursuant to their respective terms. Although no assurances can be given, in the event of such conversion or exercise, the derivative liability associated with these instruments would be eliminated.

Net Loss from Continuing Operations. Our net loss from continuing operations decreased in the 13-week and 26-week periods ended March 31, 2013, compared to the 13-week and 26-week periods ended April 1, 2012, as shown in the following table and discussed more fully below:

                                                     Net Loss
                                                  from Continuing
13-Week Comparisons                                 Operations
13 weeks ended April 1, 2012                     $    (18,227,000)
Dollar decrease in current comparable 13 weeks           9,827,000

13 weeks ended March 31, 2012                    $     (8,400,000)
Percentage decrease for current 13 weeks                     (54%)



                                                     Net Loss
                                                  from Continuing
26-Week Comparisons                                 Operations
26 weeks ended April 1, 2012                     $    (24,766,000)
Dollar decrease in current comparable 26 weeks          15,749,000

26 weeks ended March 31, 2012                    $     (9,017,000)
Percentage decrease for current 26 weeks                     (64%)

The decrease in net loss from continuing operations in the 13-week and 26-week periods ended March 31, 2013 compared to the 13-week and 26-week periods ended April 1, 2012 was largely due to a change in fair value of derivative instruments, a non cash item, discussed above which mainly related to lower stock prices during the current period, offset in part by an increase total cost and expenses and interest expenses in the comparable periods.

Liquidity and Capital Resources

Our liquidity in terms of both cash and cash equivalents decreased in the first
26 weeks of Fiscal 2013, largely as a result of losses generated from continuing
operations, partially offset by an increase in software revenue. As a result, we
continued to have a working capital deficit for the current period as shown in
the following table and discussed more fully below:

                                                Cash and            Working Capital
                                            Cash Equivalents           (Deficit)
September 30, 2012                         $        1,738,000      $     (10,091,000 )
Dollar decrease as of March 31, 2013               (1,416,000 )           (9,645,000 )

March 31, 2013                             $          322,000      $     (19,736,000 )
Percentage decrease as of March 31, 2013                 (81% )                 (96% )

-24-

The $1.4 million use of cash during the 26-week period ended March 31, 2013 is a result of the following components: cash used in operating activities of $7.3 million, cash used in investing activities of $0.6 million, and cash provided by financing activities of $7.5 million. Cash used in operating activities was a result of the $9.0 million net loss from continuing operations and $3.7 million change in fair value of derivative liability, partially offset by $4.5 million in non-cash interest expense, and other less significant factors related to various timing and cash deployment effects. Cash provided by investing activities was a result of $1.2 million in proceeds from sale of Thermal Imaging Division, partially offset by $0.6 million used in acquisition related costs and property and equipment expenditures. Cash provided by financing activities was a result of $4.2 million in proceeds from the issuance of the 2013 Notes and $3.2 million in proceeds from the issuance of the JPT Notes. Cash used in discontinued operations of $0.8 million was mainly a result of $2.7 in net loss partially offset by the final payment of $1.2 million associated with the Thermal Imaging Sale.

As of March 31, 2013 we have used a significant portion of the cash obtained from both from the Thermal Imaging Sale, the Revolving Credit Facility and 2013 Notes to fund our operations, and have been unable to maintain positive cash flow during the 26-week period due to insufficient revenues. To continue to fund anticipated operating expenses and satisfy indebtedness, we will have to seek additional financing, and no assurances can be given that such financing would be available on a timely basis, on terms that are acceptable, or at all. Failure to do so and meet the repayment or other obligations of our existing debt could result in default and acceleration of debt maturity, which could materially adversely affect our business, and financial condition, and threaten our viability as a going concern.

Off-Balance Sheet Arrangements

Our conventional operating leases are either immaterial to our financial statements or do not contain the types of guarantees, retained interests or contingent obligations that would require their disclosures as an "off-balance sheet arrangement" pursuant to Regulation S-K Item 303(a)(4). As of March 31, 2013 and September 30, 2012, we did not have any other relationships with unconsolidated entities or financial partners, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Contractual Obligations and Commitments

Debt. At March 31, 2013, we had approximately $34.9 million of debt, exclusive of discounts, which consisted of (i) a Senior Secured Revolving Credit Facility, in the original principal amount of $5.0 million; (ii) JP Convertible 2013 Notes with an aggregate principal balance of approximately $2.6 million, (iii) Senior Subordinated Secured Convertible 2013 Notes with an aggregate principal balance of approximately $6.1 million.; (iv) Senior Subordinated Notes with an aggregate principal balance of approximately $5.1 million, and (v) Subordinated Secured Convertible Notes with an aggregate principal balance of approximately $16.1 million. Each of these instruments are described more fully below.

Senior Secured Revolving Credit Facility

In December 2011, we entered into a Loan and Security Agreement (the "Loan Agreement") with Partners for Growth, L.P. ("PFG") pursuant to which we obtained the two-year, $5.0 million line of credit (the "Revolving Credit Facility"). Upon execution of the Loan Agreement, we borrowed the entire $5.0 million available thereunder and used approximately $1.9 million of that Revolving Credit Facility to repay the Secured Promissory Note. We used the remaining proceeds of the Revolving Credit Facility, less expenses thereof, for general working capital purposes.

The maturity date for the Revolving Credit Facility is December 14, 2013 (the "Maturity Date"). Interest on the Revolving Credit Facility accrues at the rate of 12% per annum. Interest on the Revolving Credit Facility is payable monthly on the third business day of each month for interest accrued during the prior month, and the remaining balance is payable on the Maturity Date. Each of Costa Brava and Griffin, individually and collectively, jointly and severally, have unconditionally guaranteed repayment to PFG of $2.0 million of our monetary obligations under the Loan Agreement.

To secure the payment of all of our obligations under the Revolving Credit Facility when due, we granted to PFG a first position, continuing security interest in substantially all of our assets, including substantially all of our intellectual property. In addition, Costa Brava, Griffin and certain other of our existing creditors have agreed that, while any obligations remain outstanding by us to PFG, their respective security interests in and liens on our assets shall be subordinated and junior to those of PFG.

-25-

Senior Subordinated Secured Convertible 2013 Notes and Senior Subordinated Secured Convertible 2012 Notes

Effective as of September 28, 2012, we issued and sold to The Griffin Fund LP Senior Subordinated Secured Convertible 2012 Notes due November 30, 2012 in the aggregate principal amount of $1.2 million (the "2012 Notes"). The 2012 Notes are convertible at $0.12 per share, or the price of shares sold by us to one or more investors and raising gross proceeds to us of at least $1.0 million. During the 26-week period ended March 31, 2013 we issued an additional $4.2 million of the 2012 Notes. Since the conversion price was not fixed, such instrument was considered to be a derivative. The 2012 Notes were due March 31, 2013.

On February 2, 2013, we authorized the issuance of Senior Subordinated Secured Convertible 2013 Notes (the "2013 Notes") that are a part of a series of notes, along with the 2012 Notes, in the aggregate amount of $10 million. As additional consideration for the purchase of the 2013 Notes, we issued shares of its common stock to each investor with a value equal to 25% of the principal amount of the 2013 Notes purchased by such investor. All 2012 Notes outstanding in the principal balance of $5.4 million as well as $0.2 million in paid in kind interest were cancelled and exchanged by each investor for 2013 Notes. The maturity date of the 2013 Notes is the earlier of 6 months after issuance, or the closing of a debt or equity financing resulting in gross proceeds to us in excess of $5 million (a "Qualified Financing"). However, the Holders may, at any time, convert the outstanding principal balance of their respective 2013 Notes into shares of our common stock at a conversion price equal to $0.12 per share. Further, within fifteen (15) business days after the closing of a Qualified Financing, each investor may convert the outstanding principal and interest under their 2013 Note into the securities issued in the Qualified Financing, on the same terms and conditions as the other investors in the Qualified Financing. During the 26-week period ended March 31, 2013 the Company issued 2013 Notes in the amount of $3.1 million. As of May 6, 2013 we have issued $6.1 million of the $10 million aggregate amount of these series of Notes.

Senior Subordinated Notes

In March 2011, we issued and sold to two accredited investors, Costa Brava Partnership III L.P. ("Costa Brava") and The Griffin Fund LP ("Griffin") 12% Senior Subordinated Secured Promissory Notes due March 2013 (the "Senior Subordinated Notes") in the aggregate principal amount of $4.0 million. In July 2011, the Senior Subordinated Notes were amended to permit the holders to demand repayment any time on or after July 16, 2012, in partial consideration for permitting the issuance of additional Subordinated Secured Convertible Promissory Notes as discussed below. Because of this demand, the Senior Subordinated Notes have been classified as current obligations in our Consolidated Balance Sheet as of March 31, 2013.

The Senior Subordinated Notes bear interest at a rate of 12% per annum paid by adding the amount of such interest to the outstanding principal amount of the Senior Subordinated Notes as "paid-in-kind" ("PIK") interest. As a result of the addition of such interest, the outstanding principal amount of the Senior Subordinated Notes at March 31, 2013 was $5.1 million.

The Senior Subordinated Notes are secured by substantially all of our assets pursuant to Security Agreements dated March 16, 2011 and March 31, 2011 between us and Costa Brava as representative of the Senior Subordinated Note holders, but the liens securing the Senior Subordinated Notes are subordinate to the liens securing the indebtedness of us to PFG under the Revolving Credit Facility.

Subordinated Secured Convertible Notes

In December 2010, we entered into a Securities Purchase Agreement with Costa Brava and Griffin, pursuant to which we issued and sold to Costa Brava and Griffin 12% Subordinated Secured Convertible Notes due December 23, 2015 (the "Subordinated Notes") in the aggregate principal amount of $7.8 million and sold in a subsequent closing in March 2011 additional Subordinated Notes to Costa Brava and Griffin for an aggregate purchase price of $1.2 million. In July 2011, we sold additional Subordinated Notes to five accredited investors, including Costa Brava and Griffin, in the aggregate principal amount of $5,000,000. In . . .

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