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TMCNet:  OVERLAND STORAGE INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.

[February 13, 2013]

OVERLAND STORAGE INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.

(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions that are difficult to predict.

Words and expressions reflecting optimism, satisfaction or disappointment with current prospects, as well as words such as "believes," "hopes," "intends," "estimates," "expects," "projects," "plans," "anticipates" and variations thereof, or the use of future tense, identify forward-looking statements, but their absence does not mean that a statement is not forward-looking. Such forward-looking statements are not guarantees of performance and our actual results could differ materially from those contained in such statements. Factors that could cause or contribute to such differences include, but are not limited to: our ability to maintain and increase sales volumes of our products; our ability to continue to aggressively control costs and operating expenses; our ability to achieve the intended cost savings and maintain quality with our manufacturing partner; our ability to generate cash from operations; the ability of our suppliers to provide an adequate supply of components for our products at prices consistent with historical prices; our ability to raise outside capital and to repay our debt as it comes due; our ability to introduce new competitive products and the degree of market acceptance of such new products; the timing and market acceptance of new products introduced by our competitors; our ability to maintain strong relationships with branded channel partners; our ability to regain compliance with the continued listing requirements of, and thereby maintain the listing of our common stock on the NASDAQ Capital Market; customers', suppliers' and creditors' perceptions of our continued viability; rescheduling or cancellation of customer orders; loss of a major customer; our ability to enforce our intellectual property rights and protect our intellectual property; general competition and price measures in the market place; unexpected shortages of critical components; worldwide information technology spending levels; and general economic conditions. In evaluating such statements we urge you to specifically consider various factors identified in this report, including the matters set forth under the heading "Risk Factors" in Item 1A of Part II of this report, and set forth in our annual report on Form 10-K for the fiscal year ended June 30, 2012 filed with the Securities and Exchange Commission ("SEC") on September 13, 2012 under the caption "Risk Factors" in Item 1A of Part I, any of which could cause actual results to differ materially from those indicated by such forward-looking statements.


We are a trusted global provider of unified data management and data protection solutions designed to enable small and medium enterprises ("SMEs"), distributed enterprises, and small and medium businesses ("SMBs") to anticipate and respond to data storage requirements. Whether an organization's data is locally or globally based, our solutions consolidate and protect data for easy and cost-effective management of different tiers of information. We enable companies to expend fewer resources on information technology ("IT"), allowing them to focus on being more responsive to the needs of their customers.

We develop and deliver a comprehensive solution set of award-winning products and services for storing data throughout the organization and during the entire data lifecycle. Our SnapScale™ clustered network attached storage ("NAS") products allow customers to scale-out in capacity and performance as their storage needs grow. Our SnapServer® products are unified NAS servers that integrate into businesses requiring simple, expandable block and file storage.

Our SnapSAN® products are storage area network ("SAN") arrays designed to ensure primary and secondary data is accessible and protected regardless of its location. Our SnapScale™, SnapServer® and SnapSAN® solutions are available with backup, replication and mirroring software in highly scalable configurations.

These solutions provide simplified disk-based data protection and maximum flexibility to protect mission critical data for both continuous local backup and remote disaster recovery. Our NEO SERIES® and REO SERIES® libraries are tape and virtual tape solutions designed to meet the need for cost-effective, reliable data storage for long-term archiving and compliance requirements.

Our approach emphasizes long-term investment protection for our customers and reduces the complexities and ongoing costs associated with storage management.

Moreover, most of our products are designed with a scalable architecture which enables companies to purchase additional storage as needed, on a just-in-time basis, and make it available instantly without downtime.

End users of our products include SMEs, SMBs, distributed enterprise companies such as divisions and operating units of large multi-national corporations, governmental organizations, and educational institutions. Our products are used in a broad range of industries including financial services, video surveillance, healthcare, retail, manufacturing, telecommunications, broadcasting, research and development, and many others.

12 -------------------------------------------------------------------------------- Table of Contents Overview This overview discusses matters on which our management primarily focuses in evaluating our financial position and operating performance.

Generation of revenue. We generate the majority of our revenue from sales of our data protection products. The balance of our revenue is provided by selling maintenance contracts and rendering related services. The majority of our sales are generated from sales of our branded products through a worldwide channel, which includes systems integrators and VARs.

We reported net revenue of $12.6 million for the second quarter of fiscal 2013, compared with $15.1 million for the second quarter of fiscal 2012. We reported net revenue of $24.3 million for the first half of fiscal 2013, compared with $29.2 million for the first half of fiscal 2012. The decline in net revenue resulted in a net loss of $4.3 million, or $0.15 per share, for the second quarter of fiscal 2013 compared with a net loss of $4.3 million, or $0.18 per share, for the second quarter of fiscal 2012. The decline in net revenue resulted in a net loss of $9.1 million, or $0.33 per share, for the first half of fiscal 2013 compared with a net loss of $9.6 million, or $0.42 per share, for the first half of fiscal 2012.

Intellectual property rights. In August and October 2010, we filed patent infringement lawsuits in the United States District Court for the Southern District of California and United States International Trade Commission ("ITC"), respectively, against various parties. Both lawsuits claim infringement of two of our United States patents, Nos. 6,328,766 and 6,353,581.

In November 2011, we entered into a multi-year settlement and cross-licensing agreement with IBM pursuant to which we released all claims we had against Dell and IBM in the United States District Court for the Southern District of California and at the ITC. However, our infringement case against BDT AG and its affiliates continues.

In July 2012, the ITC released the public version of the Initial Determination, which finds that the six asserted claims of U.S. Patent No. 6,328,766 are valid.

The Initial Determination found no infringement of United States Patent No.

6,353,581, but concluded the asserted claims of the patent were valid. We petitioned the full Commission of the ITC for a review of some of the Initial Determination findings. See "Item 1. Legal Proceedings" for additional information on the patent litigation lawsuits.

In June 2012, we filed five additional patent infringement lawsuits in the United States District Court for the Southern District of California against seven companies. See "Item 1. Legal Proceedings" for additional information on these patent litigation lawsuits.

In August 2012, Quantum Corporation filed counterclaims against us in the United States District Court for the Southern District of California action, alleging trademark infringement and unfair competition claims, and infringement of United States Patent Nos. 5,491,812, 6,542,787, 6,498,771 and 5,925,119 by our products. Quantum is seeking monetary damages from us and injunctive relief.

Liquidity and capital resources. At December 31, 2012, we had a cash balance of $3.2 million, compared to $10.5 million at June 30, 2012. In the first half of fiscal 2013, we incurred a net loss of $9.1 million. Our credit facility provides for an up to $8.0 million secured revolving loan and may be used to fund our working capital and our general business requirements. At December 31, 2012, we had a balance of $3.5 million recorded as current debt, and a remaining external borrowing capacity of $1.0 million. Cash management and preservation continue to be a top priority. We expect to incur negative operating cash flows through the fourth quarter of fiscal 2013 as we continue to reshape our business model and further improve operational efficiencies.

Management has projected that cash on hand and available borrowings under its credit facility, combined with issuing new debt or equity securities, will be sufficient to allow us to continue operations for the next 12 months.

Significant changes from our current forecasts, including but not limited to: (i) shortfalls from projected sales levels, (ii) unexpected increases in product costs, (iii) increases in operating costs, and/or (iv) changes in the historical timing of collecting accounts receivable could have a material adverse impact on our liquidity. This could force us to make further reductions in spending, extend payment terms with suppliers, liquidate assets where possible, and/or suspend or curtail planned programs. Any of these actions could materially harm our business, results of operations and future prospects.

13 -------------------------------------------------------------------------------- Table of Contents On February 13, 2013, we completed a private placement of $13.25 million convertible promissory notes, or the Notes. The Notes are scheduled to mature in February 2017 and bear interest at a rate of 8% per annum payable semi-annually.

We may, subject to certain limitations, pay interest in cash or in shares of common stock, at our option beginning the quarter ending June 30, 2013. The Notes are convertible into shares of common stock at an initial conversion price of $1.30 per share. We have also granted certain registration rights to the Note purchasers. The Notes are secured by a pledge of 65% of the stock of each of our foreign subsidiaries.

On February 13, 2013, in a private placement transaction, we entered into an agreement to sell an aggregate of 1,020,409 shares of our common stock to an institutional investor for a total issuance price of approximately $1.0 million and net proceeds of approximately $0.9 million. The purchase price for one share of our common stock was $0.98. We expect to close this transaction on February 19, 2013.

As of December 31, 2012, we had negative working capital of $2.7 million, reflecting a decrease in current assets of $10.1 million and an increase in current liabilities of $0.1 million, compared to June 30, 2012. The decrease in current assets is primarily attributable to cash used in operating activities, and a $1.5 million decrease in accounts receivable due to lower sales volumes primarily in our taped-based products sold in EMEA. The increase in current liabilities is primarily attributable to a $3.5 million increase in current debt related to the maturity date of our credit facility, offset by a $2.7 million decrease in accounts payable and accrued liabilities related to operating activities, and a $0.8 million decrease in our stock appreciation rights valuation liability.

Industry trends. We estimate that the cost of managing digital assets is four times the cost of acquiring storage devices. Furthermore, many SMEs and SMBs are seeking to implement tiered storage for primary and secondary data utilizing a combination of low cost SATA (Serial ATA) drives, high performance SAS (Serial Attached SCSI) drives and Solid State Drives ("SSDs"). International Data Corporation ("IDC") estimates that the total NAS market will grow at approximately 9.1% through 2015, and the growth rate for NAS storage systems in price bands up to $15,000, where our SnapServer® solutions lie, is estimated to be 17.3%. According to IDC, tape storage still constitutes approximately 7.3% of the total storage revenue in the global storage market. Sales of tape automation appliances represented 33.0% and 33.7% of our revenue during the first half of fiscal 2013 and 2012, respectively.

Recent Developments In October 2012, we released our SnapScale X2™, a clustered NAS solution that enables organizations with rapid or unpredictable data growth to scale capacity and performance without adding management complexity. This addition to our current product portfolio expands our total addressable market in the growing Scale-Out NAS market.

On February 13, 2013, we completed a private placement of $13.25 million convertible promissory notes, or the Notes. The Notes are scheduled to mature in February 2017 and bear interest at a rate of 8% per annum payable semi-annually.

We may, subject to certain limitations, pay interest in cash or in shares of common stock, at our option beginning the quarter ending June 30, 2013. The Notes are convertible into shares of common stock at an initial conversion price of $1.30 per share. We have also granted certain registration rights to the Note purchasers. The Notes are secured by a pledge of 65% of the stock of each of our foreign subsidiaries. In connection with this transaction, we have agreed to dismiss the lawsuit against the Tandberg entities.

On February 13, 2013, in a private placement transaction, we entered into an agreement to sell an aggregate of 1,020,409 shares of our common stock to an institutional investor for a total issuance price of approximately $1.0 million and net proceeds of approximately $0.9 million. The purchase price for one share of our common stock was $0.98. We expect to close this transaction on February 19, 2013.

Critical Accounting Policies and Estimates We describe our significant accounting policies in Note 1, "Operations and Summary of Significant Accounting Policies," of the notes to the consolidated financial statements included in our annual report on Form 10-K for the fiscal year ended June 30, 2012; and we discuss our critical accounting policies and estimates in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," of that report. Unless otherwise described below, there have been no material changes in our critical accounting policies and estimates.

14 -------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth certain financial data as a percentage of net revenue: Three Months Ended Six Months Ended December 31, December 31, 2012 2011 2012 2011 Net revenue 100.0 % 100.0 % 100.0 % 100.0 % Cost of revenue 63.5 66.8 64.9 67.1 Gross profit 36.5 33.2 35.1 32.9 Operating expenses: Sales and marketing 34.6 27.0 34.9 29.3 Research and development 12.6 14.2 13.1 15.9 General and administrative 21.9 20.2 23.2 21.0 69.1 61.4 71.2 66.2 Loss from operations (32.6 ) (28.2 ) (36.1 ) (33.3 ) Other income (expense), net (0.8 ) (0.3 ) (1.1 ) 0.6 Loss before income taxes (33.4 ) (28.5 ) (37.2 ) (32.7 ) Provision for income taxes 0.5 0.1 0.5 0.4 Net loss (33.9 )% (28.6 )% (37.7 )% (33.1 )% A summary of the sales mix by product follows: Three Months Ended Six Months Ended December 31, December 31, 2012 2011 2012 2011 Tape-based products: NEO Series® 33.5 % 37.5 % 33.0 % 33.7 % Disk-based products: REO Series® 1.4 1.6 1.2 1.5 SnapServer® 17.9 13.8 17.4 15.2 19.3 15.4 18.6 16.7 Service 38.2 39.9 40.6 41.8 Spare parts and other 9.0 7.2 7.8 7.8 100.0 % 100.0 % 100.0 % 100.0 % 15-------------------------------------------------------------------------------- Table of Contents The Second Quarter of Fiscal 2013 compared with the Second Quarter of Fiscal 2012 Net Revenue. Net revenue decreased to $12.6 million during the second quarter of fiscal 2013 from $15.1 million during the second quarter of fiscal 2012, a decrease of $2.5 million, or 16.6%. The decline was due to lower revenue from our Overland branded products, primarily as a result of decreased sales volumes in our taped-based products sold in the Americas, EMEA and APAC, and decreased service revenue primarily from our sole OEM customer. OEM net revenue, which is primarily made up of service revenue, accounted for 13.5% and 14.5% of net revenues in the second quarter of fiscal 2013 and 2012, respectively.

Product Revenue Net product revenue decreased to $7.8 million during the second quarter of fiscal 2013 from $9.1 million during the second quarter of fiscal 2012. The decrease of approximately $1.3 million, or 14.3%, was primarily associated with a decrease of $0.9 million in tape-based products sold in EMEA, related to our belief of the uncertainty in the European economy, and decreases of $0.3 million in tape-based products sold both in the Americas and APAC. The decreases were partially offset by an increase in disk-based products.

Service Revenue Net service revenue decreased to $4.8 million during the second quarter of fiscal 2013 from $6.0 million during the second quarter of fiscal 2012. The decrease of approximately $1.2 million, or 20.0%, was primarily due to decreased service revenue from our sole OEM customer. In addition, there was a decrease in our extended service contracts primarily related to lower tape-based product sales.

Gross Profit. Overall gross profit decreased to $4.6 million during the second quarter of fiscal 2013 compared to $5.0 million during the second quarter of fiscal 2012. Gross margin at 36.5% for the second quarter of fiscal 2013 increased from 33.2% for the second quarter of fiscal 2012.

Product Revenue Gross profit on product revenue during the second quarter of fiscal 2013 was $1.4 million compared to $1.2 million during the second quarter of fiscal 2012.

The increase of $0.2 million, or 16.7%, was primarily due to decreased product cost related to new source suppliers. Gross margin on product revenue at 18.6% for the second quarter of fiscal 2013 increased from 13.8% for the second quarter of fiscal 2012 primarily due to operational efficiencies and improved product costs.

Service Revenue Gross profit on service revenue during the second quarter of fiscal 2013 was $3.1 million compared to $3.8 million during the second quarter of fiscal 2012.

The decrease of $0.7 million, or 18.4%, was primarily due to decreased service revenue from our sole OEM customer, and a decrease in our extended service contracts. Gross margin on service revenue at 65.4% for the second quarter of fiscal 2013 increased from 62.5% for the second quarter of fiscal 2012. This increase was primarily the result of ongoing cost reductions related to service contracts.

16 -------------------------------------------------------------------------------- Table of Contents Share-based Compensation Expense. During the second quarter of fiscal 2013 and 2012, we recorded share-based compensation expense of approximately $1.3 million and $1.4 million, respectively. Share-based compensation expense for the third quarter of fiscal 2013 is expected to be approximately $1.1 million.

The Company recorded the following compensation expense related to its share-based compensation awards (in thousands): Three Months Ended December 31, 2012 2011 Cost of product sales $ 33 $ 17 Sales and marketing 262 202 Research and development 81 158 General and administrative 875 992 $ 1,251 $ 1,369 Sales and Marketing Expense. Sales and marketing expense in the second quarter of fiscal 2013 increased to $4.4 million from $4.1 million during the second quarter of fiscal 2012. The increase of $0.3 million, or 7.3%, was primarily a result of an increase of $0.2 million in advertising and promotion expense due to reductions in partner-sponsored marketing programs, and an increase of $0.1 million in employee and related expenses associated with an increase in average headcount.

Research and Development Expense. Research and development expense in the second quarter of fiscal 2013 decreased to $1.6 million from $2.2 million during the second quarter of fiscal 2012. The decrease of $0.6 million, or 27.3%, was primarily a result of a decrease of $0.3 million in employee and related expenses associated with a decrease in average headcount, a decrease of $0.2 million in development expense as a result of a lower level of new product development expenses from the prior year, and a decrease of $0.1 million in share-based compensation expense.

General and Administrative Expense. General and administrative expense in the second quarter of fiscal 2013 decreased to $2.8 million from $3.0 million during the second quarter of fiscal 2012. The decrease of $0.2 million, or 6.7%, was primarily a result of a decrease of $0.3 million in employee and related expenses associated with a decrease in average headcount offset by an increase in outside contractor expense, principally for financial and accounting services.

The First Half of Fiscal 2013 compared with the First Half of Fiscal 2012 Net Revenue. Net revenue decreased to $24.3 million during the first half of fiscal 2013 compared to $29.2 million during the first half of fiscal 2012, a decrease of $4.9 million, or 16.8%. The decline was primarily due to decreased revenue from our sole OEM customer, which represented approximately 12.6% of net revenue in the first half of fiscal 2013 compared to 15.1% of net revenue in the first half of fiscal 2012. In our branded channel, the decrease in net revenue was attributable to decreased volumes of our tape-based products sold in the EMEA and APAC regions and decreased volumes of our disk-based products sold in the Americas region.

Product Revenue Net product revenue decreased to $14.4 million during the first half of fiscal 2013 compared to $17.0 million during the first half of fiscal 2012. The decrease of $2.6 million, or 15.3%, was primarily associated with a decrease of $1.5 million in tape-based products sold in EMEA, related to our belief of the uncertainty in the European economy. In addition, there were decreases of $0.4 million in tape-based products sold in APAC, and $0.3 million in disk-based products sold in the Americas.

17 -------------------------------------------------------------------------------- Table of Contents Service Revenue Net service revenue decreased to $9.9 million in the first half of fiscal 2013 compared to $12.2 million during the first half of fiscal 2012. The decrease of $2.3 million, or 18.9%, was primarily due to decreased service revenue from our sole OEM customer. In addition, there was a decrease in our extended service contracts primarily related to lower tape-based product sales in EMEA and APAC.

As a percentage of total revenue, service revenue remained relatively constant 40.7% for the first half of fiscal 2013 compared to 41.8% for the first half of fiscal 2012.

Gross Profit. Gross profit in the first half of fiscal 2013 decreased to $8.5 million compared to $9.6 million in the first half of fiscal 2012. Gross margin increased to 35.1% in the first half of fiscal 2013 compared to 32.9% in the first half of fiscal 2012.

Product Revenue Gross profit on product revenue was $2.0 million for the first half of fiscal 2013 compared to $2.4 million for the first half of fiscal 2012. The decrease of $0.4 million was due primarily to the 15.1% decrease in total net product revenue. Gross margin on product revenue was 14.1% for the first half of fiscal 2013 compared to 14.3% for the first half of fiscal 2012. The decrease is primarily a result of fixed costs spread over a smaller revenue base.

Service Revenue Gross profit on service revenue was $6.5 million during the first half of fiscal 2013 compared to $7.2 million in the first half of fiscal 2012. The decrease of $0.7 million was primarily due to decreased service revenue from our sole OEM customer, and a decrease in our extended service contracts. Gross margin on service revenue at 65.8% for the first half of fiscal 2013 increased from 58.9% for the first half of fiscal 2012. This increase was primarily the result of ongoing cost reductions related to service contracts.

Share-based Compensation. During the first half of fiscal 2013 and 2012, we recorded share-based compensation expense of approximately $2.5 million and $2.8 million, respectively.

The following table summarizes share-based compensation by income statement caption (in thousands): Six Months Ended December 31, 2012 2011 Cost of product sales $ 68 $ 33 Sales and marketing 512 409 Research and development 160 342 General and administrative 1,764 2,007 $ 2,504 $ 2,791 Sales and Marketing Expenses. Sales and marketing expenses were relatively constant at $8.5 million during the first half of fiscal 2013 and 2012.

Research and Development Expenses. Research and development expenses decreased to $3.2 million during the first half of fiscal 2013 compared to $4.6 million during the first half of fiscal 2012. The decrease of approximately $1.4 million, or 30.4%, was primarily a result of (i) a decrease of $0.6 million in employee and related expenses associated with a decrease in average headcount, (ii) a decrease of $0.6 million in development expense as a result of a lower level of new product development expenses from the prior year, and (iii) a decrease of $0.2 million in share-based compensation expense.

18 -------------------------------------------------------------------------------- Table of Contents General and Administrative Expenses. General and administrative expenses decreased to $5.6 million during the first half of fiscal 2013 compared to $6.1 million for the first half of fiscal 2012. The decrease of approximately $0.5 million, or 8.2%, was primarily a result of a decrease of $0.4 million in employee and related expenses associated with a decrease in average headcount, and a decrease of $0.2 million in share-based compensation expense. These decreases were offset by an increase in outside contractor expense, principally for financial and accounting services.

Other Income (Expense), net. During the first half of fiscal 2013, we incurred other income (expense), net, of $0.2 million of expense compared to $0.2 million of income during the first half of fiscal 2012. The change of approximately $0.4 million was due to $0.2 million in realized foreign currency exchange losses during the first half of fiscal 2013 compared to $0.2 million in realized foreign currency gains in the first half of fiscal 2012 due to currency fluctuations.

Liquidity and Capital Resources At December 31, 2012, we had a cash balance of $3.2 million, compared to $10.5 million at June 30, 2012. In the first half of fiscal 2013, we incurred a net loss of $9.1 million. Our credit facility provides for an up to $8.0 million secured revolving loan and may be used to fund our working capital and our general business requirements. At December 31, 2012, we had a balance of $3.5 million recorded as current debt, and a remaining external borrowing capacity of $1.0 million. Cash management and preservation continue to be a top priority. We expect to incur negative operating cash flows through the fourth quarter of fiscal 2013 as we continue to reshape our business model and further improve operational efficiencies.

As of December 31, 2012, we had negative working capital of $2.7 million, reflecting a decrease in current assets of $10.1 million and an increase in current liabilities of $0.1 million, compared to June 30, 2012. The decrease in current assets is primarily attributable to cash used in operating activities, and a $1.5 million decrease in accounts receivable due to lower sales volumes primarily in our taped-based products sold in EMEA. The increase in current liabilities is primarily attributable to a $3.5 million increase in current debt related to the maturity date of our credit facility, offset by a $2.7 million decrease in accounts payable and accrued liabilities related to operating activities, and a $0.8 million decrease in our stock appreciation rights valuation liability.

Management has projected that cash on hand and available borrowings under its credit facility, combined with issuing new debt or equity securities, will be sufficient to allow us to continue operations for the next 12 months.

Significant changes from our current forecasts, including but not limited to: (i) shortfalls from projected sales levels, (ii) unexpected increases in product costs, (iii) increases in operating costs, and/or (iv) changes in the historical timing of collecting accounts receivable could have a material adverse impact on our liquidity. This could force us to make further reductions in spending, extend payment terms with suppliers, liquidate assets where possible, and/or suspend or curtail planned programs. Any of these actions could materially harm our business, results of operations and future prospects.

On February 13, 2013, we completed a private placement of $13.25 million convertible promissory notes, or the Notes. The Notes are scheduled to mature in February 2017 and bear interest at a rate of 8% per annum payable semi-annually.

We may, subject to certain limitations, pay interest in cash or in shares of common stock, at our option beginning the quarter ending June 30, 2013. The Notes are convertible into shares of common stock at an initial conversion price of $1.30 per share. We have also granted certain registration rights to the Note purchasers. The Notes are secured by a pledge of 65% of the stock of each of our foreign subsidiaries.

On February 13, 2013, in a private placement transaction, we entered into an agreement to sell an aggregate of 1,020,409 shares of our common stock to an institutional investor for a total issuance price of approximately $1.0 million and net proceeds of approximately $0.9 million. The purchase price for one share of our common stock was $0.98. We expect to close this transaction on February 19, 2013.

19 -------------------------------------------------------------------------------- Table of Contents As a result of our recurring losses from operations and negative cash flows, the report from our independent registered public accounting firm regarding our consolidated financial statements for the year ended June 30, 2012 includes an explanatory paragraph expressing substantial doubt about our ability to continue as a going concern.

During the first half of fiscal 2013, we used cash in operating activities of $6.4 million, compared to $5.4 million in the first half of fiscal 2012. The use of cash during the first half of fiscal 2013 was primarily a result of our net loss of $9.1 million offset by $3.1 million in non-cash items, which were share-based compensation, depreciation and amortization. In addition, we had decreases in accounts receivable, inventory, accounts payable, and accrued liabilities due to lower sales.

We used cash in investing activities of $0.7 million during the first half of fiscal 2013, compared to $0.4 million in the first half of fiscal 2012. During the first half of fiscal 2013 and 2012, capital expenditures totaled $0.7 million and $0.4 million, respectively. In the first half of fiscal 2013 such expenditures were associated with the implementation of a new enterprise resource planning system, and equipment to support new product introductions. In the first half of fiscal 2012 such expenditures were associated with machinery and equipment to support new product introductions.

We used cash in financing activities of $0.3 million during the first half of fiscal 2013, compared to $3.3 million cash generated during the first half of fiscal 2012. During the first half of fiscal 2013, we paid $0.4 million for taxes for net settlement of restricted stock units, and received $145,000 from the exercise of stock options and ESPP purchases. During the first half of fiscal 2012, we borrowed $3.5 million on our credit facility and received $0.2 million from the exercise of warrants and stock options offset by $0.4 million paid for taxes for net settlement of restricted stock units Inflation Inflation has not had a significant impact on our operations during the periods presented. Historically, we have been able to pass on to our customers increases in raw material prices caused by inflation. If at any time we cannot pass on such increases, our margins could suffer.

Off-Balance Sheet Arrangements We have no off-balance sheet arrangements or significant guarantees to third parties that are not fully recorded in our consolidated condensed balance sheet or fully disclosed in the notes to our consolidated condensed financial statements.

Recently Issued Accounting Pronouncements See Note 9 to our consolidated condensed financial statements for information about recent accounting pronouncements.

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

Market risk represents the risk of loss that may impact our financial position, results of operations or cash flows due to adverse changes in financial and commodity market prices and rates. We are exposed to market risk from changes in foreign currency exchange rates as measured against the U.S. dollar. These exposures are directly related to our normal operating and funding activities.

Historically, we have not used derivative instruments or engaged in hedging activities.

Foreign Currency Risk. We conduct business on a global basis and essentially all of our products sold in international markets are denominated in U.S. dollars.

Historically, export sales have represented a significant portion of our sales and are expected to continue to represent a significant portion of sales. Our wholly-owned subsidiaries in the United Kingdom, France and Germany incur costs that are denominated in local currencies. As exchange rates vary, these results may vary from expectations when translated into U.S. dollars, which could adversely impact overall expected results. The effect of exchange rate fluctuations on our results of operations during the first half of fiscal 2013 and 2012 resulted in a loss of $0.2 million and a gain of $0.2 million, respectively.

20 -------------------------------------------------------------------------------- Table of Contents

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