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INOD > SEC Filings for INOD > Form 10-Q on 12-Nov-2013All Recent SEC Filings

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Form 10-Q for INNODATA INC


12-Nov-2013

Quarterly Report


MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

Disclosures in this Form 10-Q contain certain forward-looking statements, including without limitation, statements concerning our operations, economic performance, and financial condition. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The words "project," "head start," "believe," "expect," "should," "anticipate," "indicate," "point to," "forecast," "likely" and other similar expressions generally identify forward-looking statements, which speak only as of their dates.

These forward-looking statements are based largely on our current expectations, and are subject to a number of risks and uncertainties, including without limitation, that contracts could be terminated by clients, projected or committed volumes of work may not materialize; that our Innodata Advanced Data Solutions segment ("IADS") is a new venture that has incurred losses since inception and has not reported any substantial revenues, and the Company has written off the assets of IADS and is currently continuing to invest in IADS; the primarily at-will nature of the contracts with our clients and the ability of our clients to reduce, delay or cancel projects; continuing Content Services segment revenue concentration in a limited number of clients; continuing Content Services segment reliance on project-based work; inability to replace projects that are completed, canceled or reduced; depressed market conditions; changes in external market factors; the ability and willingness of our clients and prospective clients to execute business plans which give rise to requirements for digital content and professional services in knowledge processing; difficulty in integrating and deriving synergies from acquisitions, joint venture and strategic investments; potential undiscovered liabilities of companies that we acquire; changes in our business or growth strategy; the emergence of new or growing competitors; various other competitive and technological factors; and other risks and uncertainties indicated from time to time in our filings with the Securities and Exchange Commission.

Our actual results could differ materially from the results referred to in the forward-looking statements. In light of these risks and uncertainties, there can be no assurance that the results referred to in the forward-looking statements contained in this Form 10-Q will occur.

We undertake no obligation to update or review any guidance or changes in the status of client contracts, client relationships, or other forward-looking information, whether as a result of new information, future developments or otherwise.

Business Overview

Innodata (NASDAQ: INOD) is a global provider of business process, information technology and professional services that are focused on digital enablement. Our clients comprise several of the world's leading digital retailers that sell digital content; preeminent publishers and other providers of online business information products; and enterprises in information-intensive industries (such as aerospace, defense, financial services, healthcare, high technology, insurance, and manufacturing) that create and manage large volumes of content to support their products or operations.

We operate in two reporting segments: Content Services (CS) and Innodata Advanced Data Solutions (IADS).

Our CS segment provides solutions to digital retailers, information services companies, publishers and enterprises that have one or more of the following broad business requirements: development of digital content (including eBooks); development of new digital information products; and operational support of existing digital information products and systems.

Many of our clients are driving or are responding to rapid and fundamental changes in the way end users discover, consume and create published information. For some of our publishing and information services clients, this means transforming information products from print to digital; for others, it means migrating already-digital products from web-only distribution to multiple-channel distribution that includes mobile and tablet devices and incorporates mobility, social platform and semantic search; and for others still it means re-tooling pure search-based information products into workflow-embedded analytical tools that combine content with software to enable context-aware decision-making; and for a select number of our information services clients, it means embracing the content-as-a-service model to integrate content with other tools, applications and data. Each of these transformations requires shifts in products, as well as the technology and the operations that support them.

We are one of the largest producers of eBooks, serving four of the five leading digital retailers of eBooks as well as 80 leading trade, education and professional publishers that sell eBooks. We manufacture both standard eBooks and interactive eBooks in a variety of formats (including EPUB, Mobi and Kindle) and in 12 major languages (including Japanese and Chinese). In addition, we distribute eBooks on behalf of publishers and authors to more than 25 eBook retailers across North America, the United Kingdom, Australia and 24 countries in the European Union. We have produced over one million eBooks since the third quarter of 2011.

We help our clients develop high-value information products and knowledge repositories. Our clients include four of the ten largest information industry companies in the world, spanning financial, legal, healthcare and scientific information.

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 offers a range of services for healthcare, medical and insurance companies, and docGenix provides services to certain financial services institutions. As of September 30, 2013, Innodata owns 83% of Synodex and 94% of docGenix, both limited liability companies.

Each of our segments is organized and managed around three vectors: a vertical industry focus, a horizontal service/process focus, and a supportive operations focus.

The vertically-aligned groups understand our clients' businesses and strategic initiatives. The vertical group for each particular industry includes experts hired from that industry.

Our horizontal service/process-aligned groups include engineering personnel and delivery personnel. Our engineering teams are responsible for creating secure and efficient custom workflows and integrating proprietary and third-party technologies to automate manual processes and improve the consistency and quality of our work product. These tools include categorization engines that utilize pattern recognition algorithms based on comprehensive rule sets and related heuristics, data extraction tools that automatically retrieve specific types of information from large data sources, and workflow systems that enable various tasks and activities to be performed across our multiple facilities.

Our globally distributed delivery personnel are responsible for executing our client engagements in accordance with service-level agreements. We deliver services from facilities in the United States, India, the Philippines, Sri Lanka and Israel.

Other support groups are responsible for managing diverse enabling functions including human resources, organizational development, network and communications technology infrastructure support and physical infrastructure and facilities management.

Our sales staff, program managers and consultants operate primarily from our North American offices, European locations, as well as from client sites.

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 consider standard accounting criteria for determining whether to report revenue gross as a principal versus net as an agent. Factors considered include whether we are the primary obligor, have risks and rewards of ownership, and bear the risk that a client may not pay for the services performed. If there are circumstances where the above criteria are not met and therefore we are not the principal in providing services, amounts received from clients are presented net of payments in the condensed consolidated statements of operations and comprehensive income (loss).

Revenues include reimbursement of out-of-pocket expenses, with the corresponding out-of-pocket expenses included in direct operating costs.

Direct Operating Costs

Direct operating costs consist of direct payroll, occupancy costs, depreciation and amortization, travel, telecommunications, computer services and supplies, realized gain (loss) on forward contracts, foreign currency revaluation gain
(loss), 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, sales and marketing costs, new services research and related software development, professional fees and consultant costs, and other administrative overhead costs.

Results of Operations

Three Months Ended September 30, 2013 and 2012

Revenues

Total revenues were $15.7 million for the three months ended September 30, 2013 compared to $19.7 million for the three months ended September 30, 2012, a decline of $4 million or approximately 20%. Revenues from the CS segment were $15.5 million and $19.7 million for the three months ended September 30, 2013 and 2012, respectively, a decline of $4.2 million or approximately 21%. This decline is principally attributable to a reduction in eBook-related services that we performed for one of our significant clients. Revenues from the IADS segment were $0.2 million for the three months ended September 30, 2013.

Three clients generated approximately 42% and 46% of our total revenues for the three months ended September 30, 2013 and 2012, respectively. One additional client accounted for 11% of our total revenues for the three months ended September 30, 2013 but accounted for less than 10% of our total revenues for the three months ended September 30, 2012. No other client accounted for 10% or more of total revenues during these periods. Further, for the three months ended September 30, 2013 and 2012, revenues from non-U.S. clients accounted for 37% and 28%, respectively, of our total revenues.

Direct Operating Costs

Direct operating costs were $12 million and $13.5 million for the three months ended September 30, 2013 and 2012, respectively, a decline of $1.5 million or 11%. Direct operating costs for the CS segment were $10.6 million and $12.9 million for the three months ended September 30, 2013 and 2012, respectively, a decline of $2.3 million or 18%. Direct operating costs for the IADS segment were $1.4 million and $0.6 million for the respective periods, net of intersegment profits, an increase of $0.8 million.

Direct operating costs as a percentage of total revenues increased to 76% for the three months ended September 30, 2013 compared to 69% for the three months ended September 30, 2012. Direct operating costs for the CS segment as a percentage of CS segment revenues were 68% for the three months ended September 30, 2013 compared to 66% for the three months ended September 30, 2012.

The decline in direct operating costs for the CS segment was principally attributable to a decrease in production headcount due to a decline in CS revenues; however, direct operating costs as a percentage of CS segment revenues have increased. Since our direct operating costs are comprised of both fixed and variable costs, a decline in revenues does not translate into a proportionate decline in direct operating costs.

Direct operating costs for the IADS segment represents certain production costs for initial engagements, including pilot engagements, and facility overhead costs for our new delivery center in Asia.

Impairment Charge

Our Synodex subsidiary of the IADS segment has not achieved significant revenue to date and has incurred losses since inception. As a result in the third quarter of 2013, we evaluated the carrying value of the fixed assets of our Synodex subsidiary compared to its fair value and concluded that that the carrying value exceeds its fair value. This resulted in an impairment charge of $5.5 million for the three months ended September 30, 2013.

Selling and Administrative Expenses

Selling and administrative expenses were $4.0 million, or 25% as a percentage of total revenues during the three months ended September 30, 2013, and $5.2 million, or approximately 27% as a percentage of total revenues for the three months ended September 30, 2012, and represents a decrease of $1.2 million or approximately 24%. Selling and administrative expenses for the CS segment were $3.6 million and $4.6 million in these respective periods. Selling and administrative expenses for the IADS segment for the respective periods were $0.4 million and $0.7 million, net of intersegment profits.

We restructured our operations over the past few quarters which resulted in cost savings in the third quarter of 2013. This led to a decline in selling and administrative expenses for the CS segment during the three months ended September 30, 2013 compared to the three months ended September 30, 2012.

Selling and administrative expenses for the CS segment as a percentage of CS segment revenues was 23% for both the three months ended September 30, 2013 and September 30, 2012.

The $0.3 million decrease in selling and administrative expenses for the IADS segment is primarily attributable to compensation costs of an executive who left the company at the end of 2012.

Income Taxes

Our Synodex subsidiary of the IADS segment has not achieved significant revenue to date and has incurred losses since inception. Our U.S. entity incurred losses primarily on account of the losses of Synodex. In assessing the realization of deferred tax assets, we considered whether it is more likely than not that all or some portion of the U.S. deferred tax assets will not be realizable. As the expectation of future taxable income resulting from Synodex cannot be predicted with certainty, we created a $7.1 million valuation allowance against all the U.S. deferred tax assets. The Company also recorded a valuation allowance of $0.7 million on all deferred tax assets arising from unrealized losses on foreign currency forward contracts.

For the three months ended September 30, 2013, we recorded a provision for income taxes in accordance with local tax regulations for our foreign subsidiaries. Some of our foreign subsidiaries are subject to tax holidays or preferential tax rates which reduces our overall effective tax rate when 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 three months ended September 30, 2012, 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, thereby lowering our overall effective tax rate 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.

Net Income (Loss)

We generated a net loss of $11.7 million in the three months ended September 30, 2013 compared to net income of $1.3 million in the three months ended September 30, 2012. Net loss for the CS segment was $4.6 million for the three months ended September 30, 2013, compared to net income of $2.6 million for the three months ended September 30, 2012, net of intersegment profits. The change was primarily attributable to the $7.1 million valuation allowance referred to in "Income Taxes" and a decline in gross margins resulting from lower revenues offset by a decline in selling and administrative expenses. Net loss for the IADS segment was $7.1 million for the three months ended September 30, 2013 compared to $1.3 million for the three months ended September 30, 2012, net of intersegment profits. The increase in net loss was primarily on account of the $5.5 million impairment charge for our Synodex subsidiary referred to in "Impairment Charge" in addition to continuing losses from operations.

Nine Months Ended September 30, 2013 and 2012

Revenues

Total revenues were $48.8 million for the nine months ended September 30, 2013 compared to $67.6 million for the nine months ended September 30, 2012, a decline of $18.8 million or approximately 28%. Revenues from the CS segment were $47.9 million and $66.8 million for the nine months ended September 30, 2013 and 2012, respectively, a decline of $18.9 million or approximately 28%. This decline is principally attributable to a reduction in eBook-related services that we performed for one of our significant clients. Revenues from the IADS segment were $0.9 million and $0.8 million for the nine months ended September 30, 2013 and 2012, respectively, most of which were attributable to the first half of 2013.

Two clients generated approximately 27% and 44% of our total revenues for the nine months ended September 30, 2013 and 2012, respectively. Two additional clients accounted for 25% of our total revenues for the nine months ended September 30, 2013 but each accounted for less than 10% of our total revenues for the nine months ended September 30, 2012. No other client accounted for 10% or more of total revenues during these periods. Further, for the nine months ended September 30, 2013 and 2012, revenues from non-U.S. clients accounted for 33% and 23%, respectively, of our total revenues.

Direct Operating Costs

Direct operating costs were $38.2 million and $44.3 million for the nine months ended September 30, 2013 and 2012, respectively, a decline of $6.1 million or approximately 14%. Direct operating costs for the CS segment were $34.2 million and $41.1 million for the nine months ended September 30, 2013 and 2012, respectively, a decline of $6.9 million or approximately 17%. Direct operating costs for the IADS segment were $4.0 million and $3.2 million for the respective periods, net of intersegment profits.

Direct operating costs as a percentage of total revenues increased to 78% for the nine months ended September 30, 2013 compared to 65% for the nine months ended September 30, 2012. Direct operating costs for the CS segment as a percentage of CS segment revenues were 71% for the nine months ended September 30, 2013 compared to 62% for the nine months ended September 30, 2012.

The decline in direct operating costs for the CS segment was principally attributable to a decrease in production headcount due to a decline in CS revenues; however, direct operating costs as a percentage of CS segment revenues have increased. Since our direct operating costs are comprised of both fixed and variable costs, a decline in revenues does not translate into a proportionate decline in direct operating costs.

Direct operating costs for the IADS segment represents certain production costs for initial engagements, some of which have not generated follow-on engagements and some of which have not generated adequate revenues, and including pilot engagements, and facility overhead costs for our new delivery center in Asia.

Impairment Charge

Our Synodex subsidiary of the IADS segment has not achieved significant revenue to date and has incurred losses since inception. As a result in the third quarter of 2013, we evaluated the carrying value of the fixed assets of our Synodex subsidiary compared to its fair value and concluded that that the carrying value exceeds its fair value. This resulted in an impairment charge of $5.5 million for the nine months ended September 30, 2013.

Selling and Administrative Expenses

Selling and administrative expenses were approximately $13.0 million, or approximately 27% as a percentage of total revenues during the nine months ended September 30, 2013, and $16.8 million, or 25% as a percentage of total revenues for the nine months ended September 30, 2012, and represents a decrease of $3.8 million or approximately 23%. Selling and administrative expenses for the CS segment were $11.3 million and $14.5 million in these respective periods. Selling and administrative expenses for the IADS segment for the respective periods were $1.7 million and $2.3 million, net of intersegment profits.

We restructured our operations over the past few quarters which resulted in cost savings in the third quarter of 2013. This led to a decline in selling and administrative expenses for the CS segment during the nine months ended September 30, 2013 compared to the nine months ended September 30, 2012.

Selling and administrative expenses for the CS segment as a percentage of CS segment revenues was 24% for the nine months ended September 30, 2013 compared to 21% for the nine months ended September 30, 2012.

Income Taxes

Our Synodex subsidiary of the IADS segment has not achieved significant revenue to date and has incurred losses since inception. Our U.S. entity incurred losses primarily on account of the losses of Synodex. In assessing the realization of deferred tax assets, we considered whether it is more likely than not that all or some portion of the U.S. deferred tax assets will not be realizable. As the expectation of future taxable income resulting from Synodex cannot be predicted with certainty, we created a $7.1 million valuation allowance against all the U.S. deferred tax assets. The Company also recorded a valuation allowance of $0.7 million on all deferred tax assets arising from unrealized losses on foreign currency forward contracts.

For the nine months ended September 30, 2013, we recorded a provision for income taxes in accordance with local tax regulations for our foreign subsidiaries. Some of our foreign subsidiaries are subject to tax holidays or preferential tax rates which reduces our overall effective tax rate when 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 nine months ended September 30, 2012, 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, thereby lowering our overall effective tax rate 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.

Net Income (loss)

We generated a net loss of $11.5 million in the nine months ended September 30, 2013 compared to net income of $6.8 million in the nine months ended September 30, 2012. Net loss for the CS segment was $(1.2) million for the nine months ended September 30, 2013, compared to net income of $11.5 million for the nine months ended September 30, 2012, net of intersegment profits. The change was primarily attributable to the $7.1 million valuation allowance referred to in "Income Taxes" and a decline in gross margins resulting from lower revenues offset by a decline in selling and administrative expenses. Net loss for the IADS segment was $10.3 million for the nine months ended September 30, 2013 compared to $4.7 million for the nine months ended September 30, 2012, net of intersegment profits. The increase in net loss was primarily on account of a $5.5 million impairment charge for our Synodex subsidiary referred to in "Impairment Charge" in addition to continuing losses from operations.

Liquidity and Capital Resources

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

                                  September 30, 2013     December 31, 2012

Cash and cash equivalents        $             25,104   $            25,425
Short term investments - other                  1,115                 3,091
Working capital                                27,550                32,784

At September 30, 2013, we had cash and cash equivalents of $25.1 million, of which about $22.4 million was held by our foreign subsidiaries located in Asia, and short term investments of $1.1 million, which was entirely held by our foreign subsidiaries located in Asia. Cash balances are held in bank deposits at leading U.S. and foreign commercial banks. We have used, and plan to use, such cash for (i) investments in IADS, which in the third quarter aggregated approximately $2.2 million and is expected to require similar investments in the fourth quarter of 2013, (ii) the expansion of our other operations; (iii) general corporate purposes, including working capital; and (iv) possible business acquisitions. As of September 30, 2013, we had working capital of approximately $27.6 million, as compared to working capital of approximately $32.8 million as of December 31, 2012. We have a $15 million line of credit that expires in June 2014 pursuant to which we may borrow up to 80% of eligible accounts receivable. Cash and cash equivalents held by foreign subsidiaries is subject to income taxes if repatriated.

Net Cash Provided By Operating Activities

Cash provided by our operating activities for the nine months ended September 30, 2013 was $1.5 million, resulting from a net loss of $13.4 million, adjustments for non-cash items of $14.5 million, and $0.4 million provided by working capital changes. Adjustment for non-cash items primarily consisted of a $5.5 million impairment charge for our Synodex subsidiary, $2.9 million for depreciation and amortization and $5.0 million for a deferred income tax provision arising primarily on account of a $7.1 million valuation allowance on all of our U.S. deferred tax assets. Working capital activities primarily consisted of a source of cash of $3.5 million as a result of net collections of accounts receivable, a use of cash of $1.5 million for a decrease in accrued salaries, a use of cash of $0.8 million for a decrease in income and other taxes and use of cash of $0.9 million for a decline in accounts payable and accrued expenses.

Cash provided by our operating activities for the nine months ended September 30, 2012 was $13.1 million, resulting from net income of $5.3 million, adjustments for non-cash items of $4.1 million, and $3.7 million provided by working capital changes. Adjustment for non-cash items primarily consisted of $2.9 million for depreciation and amortization and $0.8 million for stock-based compensation expense. Working capital activities primarily consisted of a source of cash of $4.2 million as a result of net collections of accounts receivable.

Our days' sales outstanding (DSO) for the nine months ended September 30, 2013 was approximately 70 days as compared to 76 days for the year ended December 31, 2012. The decrease is on account of the collection of outstanding amounts from one of our significant clients. We calculate DSO by first dividing the total revenues for the period over average net accounts receivable, which is the sum of net accounts receivable at the beginning of the period and net accounts receivable at the end of the period, to yield an amount we refer to as the "accounts receivable turnover". Then we take the total number of days within the period reported over the accounts receivable turnover to yield DSO expressed in number of days.

Net Cash Provided by (Used in) Investing Activities

For the nine months ended September 30, 2013 and 2012, cash used in our investing activities for capital expenditures was $3.5 million and $5.7 million, . . .

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