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DSS > SEC Filings for DSS > Form 10-Q on 15-May-2013All Recent SEC Filings

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Form 10-Q for DOCUMENT SECURITY SYSTEMS INC


15-May-2013

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, 2012, 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, 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. ("P3"), a privately held plastic cards manufacturer located in the San Francisco, California area. P3 is also referred to herein as 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 ("Premier Packaging"), a privately held packaging company located in the Rochester NY area. Premier Packaging is also referred to herein as the DSS Packaging Group. In May 2011, we acquired all of the capital stock of ExtraDev, Inc. ("ExtraDev"), a privately held information technology and cloud computing company located in the Rochester, New York area. ExtraDev had approximately $837,000 in revenue for the calendar year ended December 31, 2010. ExtraDev is also referred to herein as the DSS Digital Group.

In October 2012, the Company introduced AuthentiGuard®, an iPhone application for authentication, targeted to major pharmaceutical and other companies worldwide. The application is a cloud-enabled solution that permits efficient and cost effective authentication for packaging, documents and credentials. The solution embeds customizable, covert AuthentiGuard® Prism technology that resists duplication on copiers and scanners in a product's packaging. Product verification using the iPhone application creates real-time, accurate authentication results for brand owners that can be integrated into existing information systems.

The Company does 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, business cards, etc. 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 developed the Company's iPhone based application that integrates some of the Company's traditional optical deterrent technologies into proprietary digital data security based solutions for brand protection and product diversion prevention.

On October 1, 2012, DSS entered into an Agreement and Plan of Merger (the "Merger Agreement") with Lexington Technology Group, Inc. ("Lexington") pursuant to which a wholly-owned subsidiary of DSS will merge with and into Lexington, with Lexington surviving the merger as a wholly-owned subsidiary of DSS (the "Merger"). Defined terms contained in the descriptions of the Merger which follow shall have the meanings ascribed to them in the Merger Agreement, filed with the Securities and Exchange Commission on October 4, 2012.

If the Merger is completed, the holders of Lexington Common Stock and Lexington Preferred Stock will have the right to receive, for each share of Lexington Common Stock or Lexington Preferred Stock they hold, as applicable, certain DSS securities, the number of which is based on the Common Stock Exchange Ratio, as such ratio is calculated pursuant to the terms of the Merger Agreement. The Common Stock Exchange Ratio was equal to 0.881 as of May 3, 2013.

The exact Common Stock Exchange Ratio, and therefore the actual number of DSS securities to be issued in respect of each share of Lexington capital stock, will not be determined until immediately prior to the completion of the Merger. Assuming the Merger had been completed on May 3, 2013, the following aggregate number of DSS securities would have been issued in the Merger to the holders of Lexington Common Stock and Preferred Stock:

• up to 19,990,559 shares of DSS Common Stock;

• 7,100,000 shares of DSS Common Stock to be held in escrow;

• up to 500,000 shares of DSS Common Stock if Lexington's cash balance exceeds $7.25 million to a maximum of $9.0 million at the effective time of the Merger;

• up to 4,859,894 Warrants with an exercise price of $4.80 per share that are exercisable for an aggregate of 4,859,894 shares of DSS Common Stock;

• additional shares of DSS convertible preferred stock, or warrants with an exercise price of $.02 per share if the proposal to authorize DSS Preferred Stock is not approved by DSS stockholders, to any Lexington preferred stockholder that would beneficially own more than 9.99% of DSS Common Stock as a result of this Merger; and

• for Lexington option holders only, 2,000,000 options to purchase DSS Common Stock in exchange for their options to purchase 3,600,000 shares of Lexington Common Stock.

Lexington is a private intellectual property monetization company that recently acquired a patent portfolio of six patents and four pending patent applications relating to technology invented by Thomas Bascom (the "Bascom Portfolio") and invested in VirtualAgility, a developer of user-friendly programming platforms that facilitate the creation of sophisticated business applications without programming or coding. 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

On October 3, 2012, Lexington, through its wholly-owned subsidiary, 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. The patents-in-suit relate to the data structure used by social and business networking web sites and Web 2.0 corporate intranets. On December 12, 2012, the lawsuits were transferred to the United States District Court for the Northern District of California.

Immediately following the completion of the Merger (without taking into account any shares of DSS Common Stock held by Lexington stockholders prior to the completion of the Merger), the former stockholders of Lexington are expected to own approximately 51% of the outstanding common stock of the combined company and the current stockholders of DSS are expected to own approximately 49% of the outstanding common stock of the combined company. In addition, Lexington stockholders will own 100% of the outstanding DSS preferred stock, if approved.

It is currently expected that the Merger will be treated by DSS as a reverse merger under the acquisition method of accounting in accordance with GAAP. For accounting purposes, Lexington is considered to be acquiring DSS in this transaction. However, certain assumptions made by DSS and certain factors may change from the date of this filing to the date of the Merger that could cause the Merger to not being considered a reverse merger, and if so, then the Merger would be accounted for as a business combination with DSS as the accounting acquirer.

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. The Company has filed a Form S-4 Registration Statement with the SEC regarding the proposed Merger. The Merger requires approval by the stockholders of both Lexington and DSS, and if approved, we currently estimate that the Merger will close on or about July 1, 2013, if approved by our stockholders.

Results of Operations for the Three Months Ended March 31, 2013 Compared to the Three Months Ended March 31, 2012

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, 2012.

Revenue



                                    Three Months          Three Months
                                   Ended March 31,       Ended March 31,
                                        2013                  2012            % change
Revenue
Printing                          $         899,000     $         670,000            34 %
Packaging                                 1,552,000             2,095,000           -26 %
Plastic IDs and cards                       828,000               680,000            22 %
Licensing and digital solutions             491,000               398,000            23 %
Total Revenue                     $       3,770,000     $       3,843,000            -2 %

For the three months ended March 31, 2013, revenue was $3.8 million, which was a decrease of 2% from the three months ended March 31, 2012. During the quarter, the Company realized revenue increases in all of its divisions except for its packaging division. The Company's packaging division was negatively impacted by the timing of orders from its largest customer, which had significantly increased its orders for its post-holiday products during the fourth quarter in 2012 as compared to the previous year, in which the customer ordered its post-holiday products in early January. The Company expects that this customer will resume its normal order levels during the remainder of 2013. Revenues at the Company's printing division increased 34% during the first quarter of 2013 as compared to the same period in 2012 which reflected the positive impact of an increase in secure coupon orders as well as a large commercial printing order. The Company's plastic group's revenue increased 22% during the first quarter of 2013 as compared to the same period in 2012, primarily due to new projects for RFID cards, along with an increase in sales for sports event badges. Finally, the Company's licensing and digital sales increased 23% during the first quarter of 2013 as compared to the same period in 2012 which reflected an increase in licensing royalties from the Company's largest licensee.

Cost of Revenue and Gross Profit



                                    Three Months          Three Months
                                   Ended March 31,       Ended March 31,
                                        2013                  2012            % change

Costs of revenue
Printing                          $         534,000     $         507,000             5 %
Packaging                                 1,190,000             1,630,000           -27 %
Plastic IDs and cards                       509,000               400,000            27 %
Licensing and digital solutions              82,000                55,000            49 %
Total cost of revenue             $       2,315,000     $       2,592,000           -11 %

Gross profit
Printing                          $         365,000     $         163,000           124 %
Packaging                                   362,000               465,000           -22 %
Plastic IDs and cards                       319,000               280,000            14 %
Licensing and digital solutions             409,000               343,000            19 %
Total gross profit                $       1,455,000     $       1,251,000            16 %
Gross profit percentage                          39 %                  33 %          19 %

For the three months ended March 31, 2013, gross profit increased 16% to $1,455,000 as compared to the three months ended March 31, 2012. The increase in gross profit was primarily due to a 124% 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 14% increase in gross profits in the Company's plastics group and a 19% increase in licensing and digital solutions gross profits. These increases were partially offset by a 22% decrease in gross profits from the packaging division during the first quarter of 2013 as compared to the same period in 2012 due to the decrease in packaging revenue experienced during the first quarter of 2013.

Operating Expenses



                                                     Three Months          Three Months
                                                    Ended March 31,       Ended March 31,
                                                         2013                  2012             % change

Operating Expenses
Sales, general and administrative compensation     $       1,135,000     $       1,065,000              7 %
Professional Fees                                            414,000               187,000            121 %
Sales and marketing                                           82,000                82,000              0 %
Rent and utilities                                           157,000               151,000              4 %
Other                                                        222,000               183,000             21 %
                                                           2,010,000             1,668,000             21 %

Other Operating Expenses
Non-production depreciation and amortization                  34,000                32,000              6 %
Research and development, including research and
development costs paid by equity instruments                  59,000               148,000            -60 %
Stock based compensation                                     340,000                98,000            247 %
Amortization of intangibles                                   84,000                76,000             11 %
                                                             517,000               354,000             46 %

Total Operating Expenses                           $       2,527,000     $       2,022,000             25 %

Sales, general and administrative compensation costs, excluding stock base compensation, was 7% higher in the first quarter of 2013 as compared to the first quarter of 2012 due to the higher headcount at the Company's digital group which offset decreases in headcount in the Company's other divisions. The Company has increased headcount at it digital division to support the development and roll-out of its AuthentiGuard® iPhone application.

Professional feesincreased 121% during the first quarter of 2013 as compared to the first quarter of 2012 primarily due to legal and shareholder filing fees, related to the Company costs to file its Registration Statement on Form S-4 and amendments thereto with the SEC in conjunction with its potential merger with Lexington, and an increase in investor relations costs.

Sales and marketing costs primarily consist of internet and trade publication advertising, travel costs, and trade show participation expenses. There was no significant change in sales and marketing costs between the first quarter of 2012 and 2013.

Other operating expenses consist primarily of equipment maintenance and repairs, office supplies, IT support, bad debt expense and insurance costs. Other expenses for the three months ended March 31, 2013 increased 21% as compared to the same period in 2012, primarily due to higher insurance costs.

Research and developmentcosts consist primarily of compensation costs for research personnel, third-party research costs, and consulting costs. During the three months ended March 31, 2013, the Company's research and development costs decreased 60% from the same period in 2012, primarily due to the absence of costs for ipCapital, a third party consulting firm that the Company used during 2012 to increase its intellectual property portfolio of patents and trade secrets in the security field.

Stock based compensationincludes expense charges for all stock based awards to employees, directors and consultants, except for stock based compensation allocated to research and development. Such awards include option grants, warrant grants, and restricted stock awards. Stock based compensation for the three months ended March 31, 2013 increased 247% from the three months ended March 31, 2012, primarily due to the estimated value of warrants issued to certain of the Company's management and board members that will vest upon the completion of the Company's proposed merger with Lexington, which the Company expects to occur in the second quarter of 2013. If the merger is not completed, then these expenses will be reversed.

Amortization of intangibles expense increased in the first quarter of 2013 as compared to 2012 due to the increase in the Company's patent asset base due to the costs capitalized during 2012 by the Company for its patent applications filed during 2012, primarily related to the Company's digital product lines.

Net Loss and Loss per Share



                                            Three Months          Three Months
                                           Ended March 31,       Ended March 31,
                                                2013                  2012                % change
Net loss                                  $      (1,132,000 )   $      (1,074,000 )                  5 %

Net loss per share, basic and diluted     $           (0.05 )   $           (0.05 )                  0 %

Weighted average common shares
outstanding, basic and diluted                   21,708,550            20,074,170                    8 %

During the three months ended March 31, 2013, the Company had a net loss of $1,132,000, representing a 5% increase from the net loss during the three months ended March 31, 2012. The increase in net loss was significantly impacted by the $242,000 increase in stock based compensation expense and approximately $107,000 in legal, accounting and filing and printing costs associated with the Company's proposed merger with Lexington.

LIQUIDITY AND CAPITAL RESOURCES

The Company has historically met its liquidity and capital requirements primarily through the private placement of equity securities and debt financings. As of March 31, 2013, the Company had cash of approximately $1.2 million. In addition, the Company had approximately $1,000,000 available to its Packaging division under a revolving credit line.

Operating Cash Flow- During the first three months of 2013, the Company used approximately $347,000 of cash for operations, a 30% decrease from the Company's use of cash for operations during the first three months 2012.

Investing Cash Flow - During the first three months of 2013, the Company spent approximately $18,000 on equipment additions at its corporate and plastic divisions.

Financing Cash Flows- During the first three months of 2013, the Company used approximately $326,000 to pay down its revolving credit line balance and scheduled long-term debt payments.

Future Capital Needs- As of March 31, 2013, the Company had cash of approximately $1.2 million and had $1,000,000 available to its Packaging division under a revolving credit line. In addition, the Company will receive at least $6,250,000 from its merger partner, Lexington Technology Group (See Note
1) if the merger is completed. The Company believes that its proposed merger will be completed in the second quarter of 2013 and therefore, the Company believes that its current cash and the cash it will receive in the Merger and the availability of funds under its credit line resources provide it sufficient resources in order to fund its operations and meet its obligations for at least the next twelve months. However, if the merger is not completed in the expected time period, and if the Company cannot generate sufficient cash from its operations in the future, the Company may need to raise additional funds in order to fund its working capital needs and pursue its growth strategy. However, there is no guarantee we will be able to raise such funds if necessary.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that have, or are reasonably likely to have, an effect on our financial condition, financial statements, revenues or expenses.

Critical Accounting Policies and Estimates

As of March 31, 2013, our critical accounting policies and estimates have not changed materially from those set forth in our Annual Report on Form 10-K for the year ended December 31, 2012.

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