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ZIXI > SEC Filings for ZIXI > Form 10-Q on 6-Aug-2013All Recent SEC Filings

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Form 10-Q for ZIX CORP


6-Aug-2013

Quarterly Report


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

NOTE ON FORWARD-LOOKING STATEMENTS AND RISK FACTORS

Statements in this report which are not purely historical facts or which necessarily depend upon future events, including statements about trends, uncertainties, hopes, beliefs, anticipations, expectations, plans, intentions or strategies for the future, may be forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. Forward-looking statements involve risks and uncertainties that could cause actual events or results to differ materially from the events or results described in the forward-looking statements, including risks and uncertainties described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012. Any of these risk factors could have a material adverse effect on our business, financial condition or financial results and reduce the value of an investment in our securities. We may not succeed in addressing these and other risks associated with an investment in our securities, with our business and with our achieving any forward-looking statements. Readers are cautioned not to place undue reliance on forward-looking statements. All forward-looking statements are based upon information available to us on the date the statements are made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.


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Overview

ZixCorp® offers email encryption and data loss prevention solutions to meet the data protection and compliance needs of organizations primarily in the healthcare, financial services, insurance and government sectors. ZixCorp Email Encryption Service enables the secure exchange of email for sensitive information and offers the industry's only fully transparent delivery, such that secure email can be sent and received without extra steps or passwords. ZixCorp has the world's largest email encryption community with tens of millions of members and growing by approximately 100,000 members per week. Our members include all federal financial regulators-such as those on the Federal Financial Institutions Examination Council (FFIEC)-divisions of the U.S. Treasury, the U.S. Securities and Exchange Commission (SEC), the Financial Industry Regulatory Agency (FINRA), one in every five U.S. banks, more than 30 Blue Cross Blue Shield organizations and one in every five U.S. hospitals.

ZixCorp® Email Encryption is a comprehensive secure messaging service, which allows an enterprise to use policy-driven rules to determine which email messages should be sent securely to comply with regulations or company-defined policies. ZixCorp's main differentiation in the marketplace is our exceptional ease of use. The best example of this is our ability to provide transparent delivery of secure, encrypted email between our ZixGateway® subscribing customers. More than 30 percent of all ZixCorp encrypted messages are received transparently, which allows recipients to access secure email just like regular email-without any extra steps or passwords. Most email encryption solutions are focused on the sender. They typically introduce an added burden on receivers, often requiring additional user authentication with creation of a new user identity and password. We designed our solution to alleviate the receiver's burden by enabling the delivery of encrypted email automatically and transparently. ZixCorp enables transparent delivery by (1) ZixDirectory®, the world's largest email encryption community which is designed to share identities, (2) ZixCorp's Best Method of Delivery ™, which is designed to deliver email according to the sender's encryption policy, and (3) ZixGateway®, which is an enterprise gateway that automatically decrypts the message. The result is secure encrypted email exchange that is transparent for both sender and receiver.

In March 2013 the Company launched ZixDLPTM, an email-specific data loss prevention ("DLP") solution. ZixDLP addresses business's greatest source of data loss-email. By focusing strictly on email, ZixCorp provides a straightforward DLP approach that decreases the cost, reduces deployment time from months to hours and minimizes impact on customer resources and workflow.

The Company has also launched ZixOneTM, a unique bring-your-own-device (BYOD) secure mobile email application. ZixOne sets itself apart in the BYOD market by meeting the employees' desire to use their own devices for work and maintain control and privacy while giving IT the ability to secure data and meet compliance needs. ZixOne is scheduled for commercial availability on Sept. 3, 2013.

Our business operations and service offerings are supported by the ZixData Center™, a SysTrust/SOC3 certified, SOC2 accredited, PCI Level 1, DSS V2.0 certified facility. The operations of the ZixData Center are independently audited annually to maintain AICPA SysTrust/SOC3 certification in the areas of security, confidentiality, integrity and availability. Auditors also produce a SOC2 (formerly SAS70 Type II) report on the effectiveness of operational controls used over the audit period. The ZixData Center is staffed 24 hours a day with a proven 99.99% reliability rate.

Critical Accounting Policies and Estimates

The preparation of financial statements and related disclosures in accordance with accounting principles generally accepted in the United States requires the Company's management to make estimates and assumptions that affect the amounts reported in the Company's condensed consolidated financial statements and accompanying notes. Actual results could differ from these estimates and assumptions. Critical accounting policies and estimates are defined as those that are both most important to the portrayal of the Company's financial condition and results and require management's most subjective judgments.

We describe our significant accounting policies in Note 2, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2012. We discuss our Critical Accounting Policies and Estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2012.

Results of Operations

Second Quarter 2013 Summary of Operations

Financial

• Revenue for the quarter ended June 30, 2013, was $11.8 million compared with $10.3 million for the same period in 2012, representing a 14% increase.


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• Gross margin for the quarter ended June 30, 2013, was $9.9 million or 84% of revenues compared with $8.5 million or 82% of revenues for the comparable period in 2012.

• Net income for the quarter ended June 30, 2013, was $1.9 million compared with net income of $2.6 million in the comparable period in 2012.

• Ending cash and cash equivalents were $26.3 million on June 30, 2013, compared with $23.0 million on December 31, 2012.

Operations

• New first year orders ("NFYOs") for the quarter ended June 30, 2013, were $2.4 million. As of June 30, 2013, backlog was $63.4 million.

Revenues

Email Encryption is a subscription-based service. The following table sets forth
a quarter-over-quarter comparison of the Company's revenues:



                                                                                    3-month Variance                                                 6-month Variance
                                              Three Months Ended June 30,             2013 vs. 2012              Six Months Ended June 30,             2013 vs. 2012
(in thousands)                                 2013                 2012               $            %            2013                2012               $            %
Revenues                                  $       11,838       $       10,343     $     1,495        14 %    $      23,602       $      20,644     $     2,958        14 %

The increase in revenue was due to the growth inherent in a successful subscription model with steady additions to the subscriber base coupled with a high rate of existing customer renewals.

Revenue Indicators - Backlog, Orders and Deployments

Backlog - Our end-user order backlog is comprised of contractually bound agreements that we expect to amortize into revenue as the services are performed. The timing of revenue is affected by both the length of time required to deploy a service and the length of the service contract.

As of June 30, 2013, total backlog was $63.4 million and we expect approximately 55% of the total backlog to be recognized as revenue during the next twelve months. As of June 30, 2013, the backlog was comprised of the following elements: $18.3 million of deferred revenue that has been billed and paid, $8.0 million billed but unpaid, and approximately $37.1 million of unbilled contracts. The second quarter ending backlog was a 14% increase over the $55.5 million backlog at the end of the second quarter 2012 and 10% above the ending backlog of $57.7 million at December 31, 2012.

Orders - Total orders were $15.6 million and $13.6 million for the three-month periods ended June 30, 2013 and 2012, respectively. Total orders include contract renewals, NFYOs, and in the case of new multi-year contracts, the years beyond the first year of service. NFYOs were $2.4 million and $2.5 million for the three-month period ended June 30, 2013 and 2012, respectively.

Cost of Revenues

The following table sets forth a quarter-over-quarter comparison of the cost of
revenues:



                                                                                  3-month Variance                                               6-month Variance
                                             Three Months Ended June 30,            2013 vs. 2012             Six Months Ended June 30,            2013 vs. 2012
(in thousands)                                2013                2012              $              %           2013               2012             $             %
Cost of revenues                          $       1,903       $       1,812     $      91           5 %    $      3,839       $      3,667     $     172           5 %


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Cost of revenues is comprised of costs related to operating and maintaining the ZixData Center, a field deployment team, customer service and support and the amortization of Company-owned, customer-based computer appliances. A significant portion of the total cost of revenues relates to the ZixData Center, which currently has excess capacity. Accordingly, cost of revenues is relatively fixed and is therefore expected to grow at a slower pace than revenue. The minor period over period cost increases depicted in the table above resulted primarily from increases in average headcount.

Research and Development Expenses

The following table sets forth a quarter-over-quarter comparison of our research
and development expenses:



                                                                                   3-month Variance                                               6-month Variance
                                              Three Months Ended June 30,            2013 vs. 2012             Six Months Ended June 30,            2013 vs. 2012
(in thousands)                                 2013                2012               $            %            2013               2012              $            %
Research and development expenses          $       2,488       $       1,465     $     1,023        70 %    $      5,099       $      2,942     $     2,157        73 %

Research and development expenses consist primarily of salary, benefits, and stock-based compensation for our development staff, and other direct and indirect costs associated with enhancing our existing products and services and developing new products and services. The 70% and 73% increases in expenses for the three and six month periods ended June 30, 2013, respectively compared to the same respective periods in 2012 resulted from additional headcount, both new employees and independent contractors, primarily related to new product development. As announced in July of 2012, the Company increased new product investment spending to deliver two new products, ZixDLP and ZixOne. ZixDLP, an email data loss prevention product, was delivered in March 2013 and is now commercially available. The Company launched a beta version of ZixOne, a bring your own device ("BYOD") management solution in May 2013. Commercial availability for ZixOne is currently scheduled for late in the third quarter 2013. Research and development expenses for the second half of 2013 are expected to remain relatively flat with the expenses incurred in the first half 2013.

Selling and Marketing Expenses

The following table sets forth a quarter-over-quarter comparison of our selling
and marketing expenses:



                                                                                   3-month Variance                                               6-month Variance
                                              Three Months Ended June 30,            2013 vs. 2012             Six Months Ended June 30,            2013 vs. 2012
(in thousands)                                 2013                2012               $            %            2013               2012              $            %
Selling and marketing expenses             $       3,640       $       2,521     $     1,119        44 %    $      7,250       $      5,052     $     2,198        44 %

Selling and marketing expenses consist primarily of salary, commissions, travel, stock-based compensation and employee benefits for selling and marketing personnel and costs associated with promotional activities and advertising campaigns. The quarter over quarter expense increase resulted primarily from higher average headcount and sales commissions accounting for approximately $0.7 million of the total increase. Additionally, marketing expenses increased approximately $0.4 million due to non-headcount expenses relating primarily to new marketing campaigns and programs designed to increase awareness and demand for the Company's products and services. The 44% increase in the first half of 2013 compared to the same period in 2012 resulted primarily from higher average headcount and sales commissions which increased by approximately $1.4 million during the period. Additionally, marketing expenses increased approximately $0.8 million due to non-headcount marketing expenses relating to new marketing campaigns described above.


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General and Administrative Expenses

The following table sets forth a quarter-over-quarter comparison of our general
and administrative expenses:



                                                                                   3-month Variance                                               6-month Variance
                                              Three Months Ended June 30,            2013 vs. 2012             Six Months Ended June 30,            2013 vs. 2012
(in thousands)                                 2013                2012              $              %           2013               2012              $            %
General and administrative expenses        $       1,892       $       1,849     $      43           2 %    $      4,898       $      3,648     $     1,250        34 %

General and administrative expenses consist primarily of salary and bonuses, travel, stock-based compensation and benefits for administrative and executive personnel as well as fees for professional services and other general corporate activities. The increase in the six month period ended June 30, 2013, compared to the same period in 2012 resulted primarily from a year-over-year increase in outside legal counsel fees associated with litigation ($1.1 million) and minor net expense increases and decreases incurred in providing other general corporate services. We have settled those litigation matters for which we incurred substantially all of our increased legal expenses. We expect to incur no additional costs for those settled litigation matters. Please see Claims and Proceedings under Footnote 7 to the condensed consolidated financial statements.

Provision for Income Taxes

The provision for income taxes was $108 thousand and $58 thousand for the three-month periods ended June 30, 2013 and 2012, respectively, and $202 thousand and $276 thousand, for the six-month periods ended June 30, 2013 and 2012, respectively. The operating losses incurred by the Company's U.S. operations in past years and the resulting net operating losses for U.S. Federal tax purposes are subject to a $49.4 million reserve because of the uncertainty of future taxable income levels sufficient to utilize our net operating losses and credits. Our June 30, 2013, provision of $202 thousand includes $56 thousand in state taxes currently payable based on gross revenues, $59 thousand related to deferred state taxes, $28 thousand related to the federal Alternative Minimum Tax, and $59 thousand in taxes related to our Canadian operations. Our June 30, 2012, provision of $276 thousand consisted of $102 thousand in state taxes payable based on gross revenues, $54 thousand related to deferred state taxes, $75 thousand related to the federal Alternative Minimum Tax, and taxes related to our Canadian operations totaling $45 thousand.

There were no penalty-related charges to selling, general and administrative expenses accrued or recognized for the three month periods ended June 30, 2013 and 2012. Additionally, we have not taken a tax position that would have a material effect on the financial statements or the effective tax rate for the three-month period ended June 30, 2013. We are currently subject to a three-year statute of limitations by major tax jurisdictions.

At June 30, 2013, the Company partially reserved its U.S. net deferred tax assets due to the uncertainty of future taxable income sufficient to utilize net loss carryforwards prior to their expiration. The Company did not reserve a portion, $52.6 million, of its U.S. net deferred tax assets. The majority of this unreserved portion related to $43.9 million in U.S. net operating losses ("NOLs") because we believe the Company will generate sufficient taxable income in future years to utilize these NOLs prior to their expiration. The remaining balance consists of $5.6 million relating to temporary differences between GAAP and tax-related expense, $2.1 million relating to U.S. state income tax credits and net operating loss carryovers, and $1 million related to Alternative Minimum Tax credits.

At the end of 2012, the Company recorded a $2.3 million tax benefit by reducing the valuation allowance related to its deferred tax assets. This reduction was determined through an assessment of future deferred tax asset utilization following accounting guidance which relies largely on historical earnings. Using the same methodology, and updating the future taxable earnings estimates based on first and second quarter 2013 actual earnings, the Company believes its future U.S. federal taxable earnings estimate to be established at the end of 2013 will exceed the estimate used at the end of 2012. For this reason, the Company offset its first and second quarter 2013 federal deferred tax provision by reducing its valuation allowance by an equal amount, thereby eliminating from its deferred tax provision federal taxes in excess of the estimated Alternative Minimum Tax from the Company's first and second quarter 2013 financial statements. The Company expects to follow this same methodology in the third quarter of 2013 and will reevaluate the need for its valuation allowance at December 31, 2013, following the same assessment methodology that was performed at December 31, 2012. Adjusting our valuation allowance could have a significant impact on operating results in the period that it becomes more likely than not that an additional portion of our deferred tax assets will or will not be realized.

We have determined that utilization of existing net operating losses against future taxable income is not subject to limitation by Section 382 of the Internal Revenue Code. Future ownership changes, however, may limit the company's ability to fully utilize its existing net operating loss carryforwards against future taxable income.


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As indicated earlier, the operating losses incurred by our U.S. operations and the resulting net operating losses for U.S. Federal tax purposes are subject to a partial reserve. Significant judgment is required in determining any reserve recorded against the deferred tax asset. In assessing the need for a reserve, we consider all available evidence, including past operating results, estimates of future taxable income, and the feasibility of tax planning strategies.

Net Income

The net income for the three months ended June 30, 2013, of $1.9 million is a decrease of $772 thousand compared to the net income of $2.6 million for the same period last year. Our increased revenue and resulting higher gross margin was offset by increased R&D and SG&A spending, as discussed above.

Liquidity and Capital Resources

Overview

Based on our performance over the last four quarters and current expectations, we believe our cash and cash equivalents and cash generated from operations, will satisfy our working capital needs, capital expenditures, investment requirements, contractual obligations, commitments, future customer financings, and other liquidity requirements associated with our operations through at least the next twelve months. At June 30, 2013, our cash and cash equivalents totaled $26.3 million, an increase of $3.3 million from the December 31, 2012 balance, and we had no debt.

Sources and Uses of Cash Summary



                                                            Six Months Ended June 30,
(In thousands)                                             2013                  2012
Net cash provided by operations                         $     3,551          $       7,477
Net cash used in investing activities                   $      (948 )        $        (622 )
Net cash provided by (used in) financing activities     $       717          $      (8,748 )

Our primary source of liquidity from our operations is the collection of revenue in advance from our customers and accounts receivable from our customers, net of the timing of payments to our vendors and service providers.

Our investing activities consist primarily of computer and networking equipment purchases.

Financing activities include the receipt of $717 thousand from the exercise of stock options in the first two quarters of 2013. Cash used in financing activities in the first two quarters of 2012 included a $9.0 million repurchase of common stock, partially offset by $252 thousand received from the exercise of stock options.

Options of ZixCorp Common Stock

We have significant options outstanding that are currently vested. There is no assurance that any of these options will be exercised; therefore, the extent of future cash inflow from additional option activity is not certain. The following table summarizes the options that were outstanding as of June 30, 2013. The vested shares are a subset of the outstanding shares. The value of the shares is the number of shares multiplied by the exercise price for each share.

                                              Summary of Outstanding Options
                                         Total Value  of       Vested Options
                                           Outstanding          (included in        Total Value  of
                       Outstanding           Options            outstanding         Vested Options
Exercise Price Range     Options         (In  thousands)          options)          (In thousands)
$1.11 - $1.99             1,059,336     $           1,581            1,059,336     $           1,581
$2.00 - $3.49             2,053,187                 5,567            1,125,700                 3,012
$3.50 - $4.99             2,621,862                11,349            2,431,020                10,612
$5.00 - $5.99               286,500                 1,432              286,500                 1,433
$6.00 - $8.99               498,700                 3,262              498,700                 3,262
$9.00 - $11.00              792,792                 8,496              792,792                 8,496

Total                     7,312,377     $          31,687            6,194,048     $          28,396


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Off-Balance Sheet Arrangements

None.

Contractual Obligations, Contingent Liabilities and Commitments

A summary of our fixed contractual obligations and commitments at June 30, 2013, is as follows:

Payments Due by Period (In thousands) Total 1 Year Years 2 & 3 Beyond 3 Years Operating leases $ 11,683 $ 604 $ 2,269 $ 8,810

We have not entered into any material, non-cancelable purchase commitments at June 30, 2013.

We have severance agreements with certain employees which would require the Company to pay approximately $2.7 million if all such employees separated from employment with our Company following a change of control, as defined in the severance agreements.


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