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ISNS > SEC Filings for ISNS > Form 10-K on 6-Mar-2014All Recent SEC Filings

Show all filings for IMAGE SENSING SYSTEMS INC

Form 10-K for IMAGE SENSING SYSTEMS INC


6-Mar-2014

Annual Report


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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the Selected Financial Data and our financial statements and the accompanying notes included elsewhere in this Annual Report on Form 10-K. Our actual results could differ materially from those anticipated in the forward-looking statements included in this discussion as a result of certain factors, including, but not limited to, those discussed in "Risk Factors" and "Information Regarding Forward-Looking Statements" included elsewhere in this Annual Report on Form 10-K.

General. We provide software based computer enabled detection ("CED") products and solutions that use advanced signal processing software algorithms to detect and monitor objects in a designated field of view. Our technology analyzes signals from a sophisticated sensor and passes the information along to management systems, controllers or directly to users. Our core products, the Autoscope® Video Vehicle Detection System, Autoscope® Radar Detection System and License Plate Recognition ("LPR") System, operate using our proprietary application software in conjunction with video cameras or radar and commonly available electronic components. Our systems are used by traffic managers primarily to improve the flow of vehicle traffic and to enhance safety at intersections, main thoroughfares, freeways and tunnels and by parking and toll managers and law enforcement officials to read license plates for various safety, security, access and enforcement LPR applications.

Autoscope® video and radar systems are sold to distributors and end users of traffic management products in North America, the Caribbean and Latin America by Econolite Control Products, Inc. ("Econolite"), our exclusive licensee in these regions. We sell LPR systems to distributors and end users in North America. We sell all of our systems to distributors and end users in Europe and Asia through our European and Hong Kong subsidiaries, respectively. The majority of our sales are to end users that are funded by government agencies responsible for traffic management or traffic law enforcement.

Autoscope® Radar Business Model Change. Beginning in 2012, we changed part of our Autoscope® radar business model by granting an exclusive license to manufacture and distribute Autoscope® radar products in North America to Econolite under terms substantially the same as our Autoscope royalty arrangement. In conjunction with this agreement, certain of our sales and marketing employees dedicated to Autoscope® radar became employed directly by Econolite. As a result, in 2012, revenue earned from sales of Autoscope® radar in North America are in the form of a royalty rather than a sale directly to the purchaser, and there is no cost of revenue in 2012 and future periods, as Econolite is now responsible for manufacturing and post-sales support, except for transitional legacy items.

Simultaneously with the Autoscope® radar changes, we restructured aspects of our North American Autoscope® radar and LPR businesses. Most significantly, the assembly of our Autoscope® radar product was moved from our Toronto facility to a third party, and our production and administrative support headcount was reduced early in 2012.

Trends and Challenges in Our Business

We believe the growth in our business can be attributed primarily to the following global trends:

• worsening traffic caused by increased numbers of vehicles in metropolitan areas without corresponding expansions of road infrastructure and the need to automate safety, security and access applications for automobiles and trucks, which has increased demand for our products;

• advances in information technology, which have made our products easier to market and implement;

• the continued funding allocations for centralized traffic management services and automated enforcement schemes, which has increased the ability of our primary end users to implement our products; and

• general increases in the cost-effectiveness of electronics, which make our products more affordable for end users.

We believe our continued growth primarily depends upon:

• continued adoption and governmental funding of intelligent transportation systems ("ITS") and other automated applications for traffic control, safety and enforcement in developed countries;

• a propensity by traffic engineers to implement lower cost technology-based solutions rather than civil engineering solutions such as widening roadways;

• countries in the developing world adopting above-ground detection technology, such as video or radar, instead of in-pavement loop technology to manage traffic;


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• the use of CED to provide solutions to security/surveillance and environmental issues associated with increasing automobile use in metropolitan areas; and

• our ability to develop new products, such as hybrid CED devices incorporating, for example, radar and video technologies, that provide increasingly accurate information and enhance the end users' ability to cost-effectively manage traffic, security/surveillance and environmental issues.

Because the majority of our end users are governmental entities, we are faced with challenges related to potential delays in purchase decisions by those entities and changes in budgetary constraints. These contingencies could result in significant fluctuations in our revenue between periods. The ongoing difficult economic environment in Europe and the United States is further adding to the unpredictability of purchase decisions, creating more delays than usual and decreasing governmental budgets, and it is likely to continue to negatively affect our revenue.

Key Financial Terms and Metrics

Revenue. We derive revenue from two sources: (1) royalties received from Econolite for sales of the Autoscope® video and Autoscope® radar (2012 and later) systems in North America, the Caribbean and Latin America and (2) revenue received from the direct sales of our Autoscope® radar (2011 and before) and LPR systems in North America, the Caribbean and Latin America and all of our systems in Europe and Asia. Royalties are calculated using a profit sharing model where the gross profits on sales of product made through Econolite are shared equally with Econolite. This royalty arrangement has the benefit of decreasing our cost of revenues and our selling, marketing and product support expenses because these costs and expenses are borne primarily by Econolite. Although this royalty model has a positive impact on our gross margin, it also negatively impacts our total revenue, which would be higher if all the sales made by Econolite were made directly by us. The royalty arrangement is exclusive under a long-term agreement.

Cost of Revenue. There is no cost of revenue related to royalties, as virtually all manufacturing, warranty and related costs are incurred by Econolite. Cost of revenue related to product sales consists primarily of the amount charged by our third party contractors to manufacture hardware platforms, which is influenced mainly by the cost of electronic components. The cost of revenue also includes logistics costs, estimated expenses for product warranties, restructuring costs and inventory reserves. The key metric that we follow is achieving certain gross margin percentages on product sales by geographic region and to a lesser extent by product line.

Operating Expenses. Our operating expenses fall into three categories: (1) selling, marketing and product support; (2) general and administrative; and (3) research and development. Selling, marketing and product support expenses consist of various costs related to sales and support of our products, including salaries, benefits and commissions paid to our personnel; commissions paid to third parties; travel, trade show and advertising costs; second-tier technical support for Econolite; and general product support, where applicable. General and administrative expenses consist of certain corporate and administrative functions that support the development and sales of our products and provide an infrastructure to support future growth. These expenses include management, supervisory and staff salaries and benefits, legal and auditing fees, travel, rent and costs associated with being a public company, such as board of director fees, listing fees and annual reporting expenses. Research and development expenses consist mainly of salaries and benefits for our engineers and third party costs for consulting and prototyping. We measure all operating expenses against our annually approved budget, which is developed with achieving a certain operating margin as a key focus. Also included in operating expenses are acquisition related expenses, income related to the earn-out reversal, impairment charges, restructuring costs and non-cash expense for intangible asset amortization.


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Non-GAAP Operating Measure. We prepare our consolidated financial statements in accordance with U.S. generally accepted accounting principles ("GAAP"). However, we use Non-GAAP Income (Loss) from Operations to analyze our business. We define Non-GAAP Income (Loss) from Operations as income (loss) from operations before amortization of intangible assets, investigation matter expense, restructuring expense, and goodwill impairment for the applicable periods. Management believes Non-GAAP Income (Loss) from Operations is a useful indicator of our financial performance and our ability to generate cash flows from operations. Our definition of Non-GAAP Income (Loss) from Operations may not be comparable to similarly titled definitions used by other companies. The table below reconciles Non-GAAP Income (Loss) from Operations, which is a non-GAAP financial measure, to comparable GAAP financial measures:

                                                            Year Ended December 31,
                                                          2013        2012       2011

               Income (loss) from operations            $ (11,970 ) $ (3,561 ) $ (13,048 )
               Amortization of intangible assets            1,554      1,622       1,650
               Investigation matter                         3,723          -           -
               Restructuring charges                            -        430         287
               Goodwill impairment                              -      3,175      11,685
               Non-GAAP income (loss) from operations   $  (6,693 ) $  1,666   $     574

Seasonality. Our quarterly revenues and operating results have varied significantly in the past due to the seasonality of our business. Our first quarter generally is the weakest due to weather conditions that make roadway construction more difficult in parts of North America, Europe and northern Asia. We expect such seasonality to continue for the foreseeable future. Additionally, our international revenues have a significant large project component, resulting in a varying revenue stream. Accordingly, we believe that quarter-to-quarter comparisons of our financial results should not be relied upon as an indication of our future performance. No assurance can be given that we will be able to achieve or maintain profitability on a quarterly or annual basis in the future.

Segments. We currently operate in three reportable segments: Intersection, Highway and LPR. Autoscope® video is our machine-vision product line, and revenue consists of royalties (all of which are received from Econolite), as well as a portion of international product sales. Video products are normally sold in the Intersection segment. The Autoscope® radar is our radar product line, and revenue consists of royalties (all of which are received from Econolite), as well as a portion of international sales. Radar products are normally sold in the Highway segment. Autoscope® license plate recognition is our LPR product line. All segment revenues are derived from external customers. As a result of business model changes and modifications in how we manage our business, we may reevaluate our segment definitions in the future.


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The following tables set forth selected unaudited financial information for each of our reportable segments (in thousands):

                                             For the year ended December 31, 2013
                                        Intersection      Highway       LPR      Total
   Revenue                             $       13,428    $    6,414   $ 6,448   $ 26,290
   Gross profit                                11,559         1,862     2,980     16,401
   Amortization of intangible assets                -           488     1,066      1,554
   Intangible assets                                -           942     5,521      6,463

                                             For the year ended December 31, 2012
                                        Intersection      Highway       LPR      Total
   Revenue                             $       16,031    $    4,118   $ 4,814   $ 24,963
   Gross profit                                14,010         1,798     2,449     18,257
   Goodwill impairment                              -         1,372     1,803      3,175
   Amortization of intangible assets                -           748       874      1,622
   Intangible assets                                -         1,430     5,059      6,489

                                             For the year ended December 31, 2011
                                        Intersection      Highway       LPR      Total
   Revenue                             $       17,445    $    7,366   $ 5,710   $ 30,521
   Gross profit                                15,096         3,512     2,696     21,304
   Goodwill impairment                            525         7,392     3,768     11,685
   Amortization of intangible assets                -           768       882      1,650
   Intangible assets and goodwill                   -         3,551     7,457     11,008


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Results of Operations

The following table sets forth, for the periods indicated, certain statements of operations data as a percent of total revenue and gross profit on product sales and royalties as a percentage of international sales and royalties, respectively.

                                                    Year Ended December 31,
                                                   2013        2012      2011
        Product sales                                 55.9 %     50.3 %    57.3 %
        Royalties                                     44.1       49.7      42.7
        Total revenue                                100.0      100.0     100.0
        Gross profit - product sales                  32.7       46.6      47.3
        Gross profit - royalties                     100.0      100.0     100.0
        Selling, marketing and product support        44.8       29.2      34.8
        General and administrative                    23.9       20.7      20.7
        Research and development                      19.2       16.6      14.5
        Investigation matter                          14.2          -         -
        Amortization of intangible assets              5.9        6.5       5.4
        Goodwill impairment                              -       12.7      38.3
        Restructuring charges                            -        1.7       0.9
        Acquisition related expenses (income)            -          -      (2.0 )
        Loss from operations                         (45.5 )    (14.3 )   (42.8 )
        Income tax expense (benefit)                  15.0       (0.7 )    (9.9 )
        Net loss                                     (60.5 )    (13.4 )   (32.8 )

Year Ended December 31, 2013 Compared to Year Ended December 31, 2012. Total revenue increased to $26.3 million in 2013 from $25.0 million in 2012, an increase of 5.3%. Royalty income decreased to $11.6 million in 2013 from $12.4 million in 2012, a decrease of 6.5%. The decrease in royalties was the result of a decrease in Autoscope® video royalties slightly offset by an increase in Autoscope® radar royalties. Autoscope® video royalties were lower in 2013 compared to 2012 as a result of lower unit volume. Product sales increased to $14.7 million in 2013 from $12.6 million in 2012, an increase of 16.9%. The increase in product sales was mainly due to higher sales volume in Europe and Asia.

Revenue for the Intersection segment decreased to $13.4 million in 2013 from $16.0 million in 2012, a decrease of 16.2%. The increase in the Intersection segment was mainly due to lower sales volume in Europe.

Revenue for the Highway segment increased to $6.4 million in 2013 from $4.1 million in 2012, an increase of 55.8%. The increase in Highway was due mainly to higher sales worldwide.

Revenue for the LPR segment increased to $6.4 million in 2013 from $4.8 million in 2012, an increase of 33.9%. The increase in revenue for the LPR segment in 2013 over 2012 is due to higher sales volumes in North America and Europe.

Gross profit for product sales decreased to 32.7% in 2013 from 46.6% in 2012. Gross profit for the LPR product line have historically been lower than gross profit for the Intersection and Highway product lines and therefore the mix of the product lines sold in any given period can result in varying profit. Generally, lower sales volumes of Highway or LPR products will reduce gross profit because of fixed manufacturing costs for these products. We anticipate that gross profit for our product sales will be higher in 2014 as compared to 2013, while we expect royalty gross profit will be 100% in 2014.

Selling, marketing and product support expense increased to $11.8 million or 44.8% of total revenue in 2013 from $7.3 million or 29.2% of total revenue in 2012. Our selling, marketing and product support expense increased mainly due to our investments in additional sales and marketing resources. We anticipate that annual selling, marketing and product support expense will increase in dollar amount in 2014 as compared to 2013.

General and administrative expense increased to $6.3 million or 23.9% of total revenue in 2013, from $5.2 million or 20.7% of total revenue in 2012. General and administrative expenses increased in 2013 mainly as a result of legal and other professional fees related to the investigation and remediation actions described in Note 15 of our Notes to Consolidated Financial Statements set forth elsewhere in this Annual Report on Form 10-K and severance costs related to the separation from former employees. Our direct costs related to the investigation were approximately $3.7 million for the year ended December 31, 2013 and immaterial in 2012. We are unable to determine the likely outcome or range of loss, if any, from the investigation, or predict with certainty the timeline for resolution of the investigation. We anticipate that annual general and administrative expenses will decrease as a percentage of revenue in 2014 as compared to 2013.


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Research and development expense increased to $5.0 million or 19.2% of total revenue in 2012, from $4.1 million or 16.6% of total revenue in 2012. The increase was mainly related to the increased expenditures on new research and development projects, the acceleration of previously existing projects and other product developments.

Amortization of intangibles was $1.6 million in both 2013 and 2012 and reflects the amortization of intangible assets acquired in acquisitions. Assuming there are no changes to our intangible assets, we anticipate amortization expense will be approximately $1.8 million in 2014.

Other income, net was $6,000 and $29,000 in 2013 and 2012, respectively, primarily consisting of interest income.

Income tax expense of $3.9 million, or 33.3% of our pretax loss, was recorded for the year ended December 31, 2013, compared to income tax benefit of $180,000, or 5.4% of pretax loss, for the year ended December 31, 2012. The income tax expense increase is primarily driven by the recognition of a valuation allowance of $8.1 million for the United States and United Kingdom jurisdictions in 2013.

Year Ended December 31, 2012 Compared to Year Ended December 31, 2011. Total revenue decreased to $25.0 million in 2012 from $30.5 million in 2011, a decrease of 18.2%. Royalty income decreased to $12.4 million in 2012 from $13.0 million in 2011, a decrease of 5.0%. The decrease in royalties was the result of a decrease in Autoscope® video royalties slightly offset by the inclusion of Autoscope® radar royalties as a result of changing our Autoscope® radar product line to a royalty business model in January 2012. Autoscope® video royalties were lower in 2012 compared to 2011 as a result of lower unit volume. Product sales decreased to $12.6 million in 2012 from $17.5 million in 2011, a decrease of 28.1%. The decrease in product sales was mainly due to the Autoscope® radar model change and to a lesser extent lower sales volume in Europe resulting, in part, from economic pressures. Revenue for the Intersection segment decreased to $16.0 million in 2012 from $17.4 million in 2011, a decrease of 8.1%. Revenue for the Highway segment decreased to $4.1 million in 2012 from $7.4 million in 2011, a decrease of 44.1%. The decrease in LPR was due to lower sales volume in North America and, to a lesser extent, in Europe. The decrease in the Highway segment was due mainly to the business model change that resulted in revenues in the form of a royalty rather than a direct product sale to a purchaser. Revenue for the LPR segment decreased to $4.8 million in 2012 from $5.7 million in 2011, a decrease of 15.7%. This was due to lower sales volume in 2012 and is reflective of a difficult environment for selling security applications to government customers in Europe and the United States that we believed was caused by constrained government budgets.

Gross margins for product sales decreased to 46.6% in 2012 from 47.3% in 2011. Gross margins for the LPR product line have historically been lower than gross margins for the Intersection and Highway product lines and therefore the mix of the product lines in any given period can result in varying margins. Generally, lower sales volumes of Highway or LPR products will reduce gross margins because of fixed manufacturing costs for these products. The decrease in gross margins for 2012 compared to 2011 was reflective of lower sales volume. Additionally, during 2012, we recorded a $200,000 lower of cost or market adjustment to inventory procured for a subsequently cancelled order. Gross margins on royalty income remained consistent at 100.0% in 2012 and 2011.

Selling, marketing and product support expense decreased to $7.3 million or 29.2% of total revenue in 2012 from $10.6 million or 34.8% of total revenue in 2011. Our selling, marketing and product support expense decreased mainly due to the workforce reduction resulting from restructuring activities and the Autoscope® radar business model change.

General and administrative expense decreased to $5.2 million or 20.7% of total revenue in 2012, from $6.3 million or 20.7% of total revenue in 2011. General and administrative expenses decreased in 2012 mainly as a result of restructuring initiatives, partially offset by severance for the separation of our former President and Chief Executive Officer, and the Autoscope® radar business model change.

Research and development expense decreased to $4.1 million or 16.6% of total revenue in 2012, down from $4.4 million or 14.5% of total revenue in 2012. The decrease was mainly related to decreased expenditures on our hybrid product development.

We recognized goodwill impairment charges in 2012 and 2011 of $3.2 million and $11.7 million, respectively, that were triggered by significant declines in our market capitalization.

As discussed above, beginning in January 2012, we changed our North American business model for the Autoscope® radar product line and undertook restructuring initiatives. In June 2012, we expanded the restructuring initiative to include aspects of our Europe-based LPR business and our non-China Asian business. The majority of restructuring expense recognized in 2012 related to employee severance.


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Amortization of intangibles expense was $1.6 million in both 2012 and 2011 and reflects the amortization of intangible assets acquired in acquisitions.

Other income, net was $29,000 and $9,000 in 2012 and 2011, respectively, primarily consisting of interest income.

Income tax benefit of $180,000, or 5.4% of our pretax loss, was recorded for the year ended December 31, 2012, compared to income tax benefit of $3.0 million, or 23.2% of pretax loss, for the year ended December 31, 2011. The decrease in the effective rate resulted from the nondeductible goodwill impairment charge, nondeductible stock option expense and valuation for net operating losses in certain jurisdictions.

Liquidity and Capital Resources

At December 31, 2013, we had $3.6 million in cash and cash equivalents and $2.6 million in short-term investments, compared to $8.3 million in cash and cash equivalents and $4.8 million in short-term investments at December 31, 2012. Our investment objectives are to preserve principal, maintain liquidity, and achieve the best available return consistent with the primary objectives of safety and liquidity.

Net cash used for operating activities was $5.5 million in 2013, compared to cash provided of $5.9 million in 2012 and cash used of $1.3 million in 2011. The primary reasons for the decrease in cash were the on-going expenses related to the investigation and investments made in the Company's product offerings. The primary reasons for the increase in cash in 2012 were collections of outstanding receivables and conversions of inventory, mostly driven by the transition to the Autoscope® radar royalty structure, offset by reductions in payables and the generation of operating income after taking into account non-cash charges for goodwill impairment, depreciation and amortization. We anticipate that average receivable collection days in 2014 will be similar to 2013 and that it will not have a material impact on our liquidity.

Net cash provided by investing activities was $791,000 in 2013, compared to cash used in investing activities of $3.2 million and $1.4 million in 2012 and 2011, respectively. Our planned additions of property and equipment are discretionary, and we do not expect them to exceed historical levels in 2014.

Net cash provided by financing activities was $9,000 in 2013, compared to cash provided of $121,000 and $105,000 in 2012 and 2011, respectively.

We have a revolving line of credit with Associated Bank, National Association ("Associated Bank") that was initially entered into as of May 1, 2008. Our current revolving line of credit agreement ("Credit Agreement") with Associated Bank provides up to $5.0 million of credit. The Credit Agreement expires in May 2014 and bears interest at an annual rate equal to the greater of (a) 4.5% or
(b) LIBOR plus 2.75%. Any advances are secured by inventories, accounts receivable and equipment. We are subject to certain financial covenants under the Credit Agreement, including minimum debt service coverage ratios, minimum cash flow coverage ratios and financial measures. At December 31, 2013, we had . . .

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