RACOM SYSTEMS INC (NASDAQ:RCOM) files SEC Form 10QSB
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
GENERAL
Investors should carefully consider the following information as well as other
information contained in this Report before making an investment in the Common
Stock. Information contained in this Report contains "forward-looking
statements" which can be identified by the use of forward-looking terminology
such as "believes," "expects," "may," "should" or "anticipates" or the negative
thereof or other variations thereon or comparable terminology, or by discussions
of strategy. No assurance can be given that the future results covered by the
forward-looking statements will be achieved. The following matters constitute
cautionary statements identifying important factors with respect to such
forward-looking statements, including certain risks and uncertainties, that
could cause actual results to vary materially from the future results covered in
such forward-looking statements. Other factors could also cause actual results
to vary materially from the future results covered in such forward-looking
statements.
The Company is a leading developer and marketer of contactless smart card
systems ("Smart Card(s)") used primarily in electronic commerce. Generally the
size of a credit card, Smart Cards are used in a number of consumer applications
including (i) access to restricted areas (replacing keys and identification
cards), (ii) public transportation fare collection (replacing bus tokens, taxi
cab charge cards, airline or railway tickets and the like), (iii) point of sale
purchases (replacing cash or credit cards at cafeterias, newsstands and related
point of sale locations where speed of purchase is important), and (iv)
miscellaneous small monetary transactions (replacing coins and cash at parking
lots, in vending machines and public telephones, etc.). Smart Card technology is
also used in industrial applications by attaching a "tag" containing the Smart
Card technology to the manufactured product in order to track the product from
the assembly line through quality control, warehousing, inventory control,
distribution and warranty.
The Company's Smart Cards are both "contactless" and "batteryless" and therefore
do not require the use of a magnetic stripe or insertion into a terminal as is
required by contacted cards ("Contacted Card(s)"), such as credit cards and ATM
cards. Contacted Cards in use today are typically limited to storing information
as opposed to "intelligent" Smart Cards, which have processing capabilities
similar to that of a personal computer. The Company's Smart Card System
involves direct wireless radio frequency communications and magnetic induction
between a chip in the Smart Card and a terminal. Moreover, the Company's
contactless Smart Card Systems do not require insertion in a terminal or the use
of a keypad and therefore may be used by all members of the population
regardless of age or physical ability and in both indoor and outdoor locations.
The Company believes it was the first to successfully develop and introduce
contactless Smart Cards using FRAM technology and batteryless, radio frequency
("RF") communications. The Company has primarily relied on its licensed FRAM
technology for the memory component of the Smart Cards. Although the FRAM
memory demonstrates quantifiable benefits by improving processing speeds and
reliability over competing memory technologies, it is not currently being
produced in sufficient volumes by a significant number of manufacturers to
achieve competitive costs. Complementary to its FRAM technology, the Company
also utilizes Electronically Erasable Programmable Read-Only Memory ("EEPROM")
technology in its Smart Card Systems, allowing the Company to offer higher
volume Smart Cards at a more competitive price.
The Company principally generates revenues from licensing, fee based custom
product development projects and sale of its Smart Card systems. In the future,
the Company anticipates that a substantial portion of its revenues will be
generated from custom product development projects, the sale of its Smart Card
systems and services. If the Company is unable to continually replace larger
custom product development projects as these projects are completed, its
operations will be adversely affected. Custom product development projects are
billed in stages based on certain agreed upon performance milestones.
Accordingly, financial results for any calendar quarter may fluctuate widely
depending on the stage of a project or the amount of licensing payments in a
particular quarter.
As reflected in the Company's Financial Statements, the Company has generated
substantial operating losses since inception and has yet to generate substantial
revenues to fund its operations. To date, the Company has completed a series of
smaller scale projects; however, the Company has not yet completed a significant
number of larger projects, and as a result, it is uncertain whether the Company
will be able to successfully market and sell its Smart Card products in
sufficient quantities and at sufficient prices and volumes to fund its
operations. During 1997, the Company experienced significant cash flow deficits
and liquidity shortages and funded its operations primarily through licensing
transactions and proceeds from the sale of its Common Stock. During the six
months ended June 30, 1998, the Company's operating revenues have been generated
primarily from a licensing transaction. The Company anticipates that increased
operating revenues for the balance of 1998 will be achieved through a
combination of product sales, custom product development projects and the sale
of non-exclusive licenses.
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 1998 COMPARED TO THE
THREE MONTHS ENDED JUNE 30, 1997
Revenues. Revenues increased 70.0% to $572,783 for the three months ended June
30, 1998 ("Second Quarter 1998"), from $336,815 for the three months ended June
30, 1997 ("Second Quarter 1997").
Product Sales. Product sales decreased 40.3% to $72,783 for Second Quarter
1998, from $121,922 for Second Quarter 1997. To date, the Company has
completed a series of projects, many of which are small scale "pilot"
projects, but may have the potential for implementation on a larger scale.
In some cases, these demonstration projects are "rolled out" for full scale
implementation, however the demonstration phase often takes six to twelve
months or longer. Product sales in the current quarter included approximately
$7,000 of sales of product to Racom Japan ("RJ"), of which the Company owns
19.9%, as compared to approximately $47,000 for the Second Quarter in 1997.
License Revenues. License revenues increased 132.7% to $500,000 for Second
Quarter 1998, from $214,893 for Second Quarter 1997. In Second Quarter
1997, license revenues included the recognition of deferred revenues on a
license from RJ for the manufacture and sale of FRAM based radio frequency
products in Japan of $199,010, pursuant to the reduction in ownership of RJ
to 22.8%. The increase in license revenues reflects the execution of the
licensing contract with Hitachi, Ltd. which closed in January 1998, and
under which the Company received and recognized the final initial license
fee payment in May 1998.
COST OF REVENUES AND GROSS MARGIN. As a percentage of revenues, gross margin
increased to 93.0% in Second Quarter 1998, from 61.8% for Second Quarter 1997.
Product Costs. The Company has not generated significant margin on product
sales in part because of competition with Contacted Cards which typically
are sold at a lower price than the Company's Smart Cards. Currently,
production volumes of the Company's products may not be sufficient to cover
manufacturing costs which are included in Cost of Revenues. Due to an
increase in availability of FRAM memory chips resulting in lower component
costs, and the use of EEPROM memory chips which are already available at
lower component costs, the Company expects to be able to lower its prices
while improving gross margin. The Company anticipates that cost
efficiencies will allow the Company to compete more effectively with
Contacted Card products and to build sales volume for its Smart Cards.
License revenues. In both periods presented, gross margin is primarily a
result of license revenues which have no direct cost of revenues.
Research and Development Expenses ("R&D"). R&D decreased $83,533 from $300,852
in Second Quarter 1997 to $217,319 in Second Quarter 1998. The decrease is
primarily due to the Company focusing on its internal engineering resources and
not utilizing the services of contractors in new product development projects
during Second Quarter 1998. During November 1997, a group of engineers
responsible for a specific project left the Company upon completion of the
project. Additional engineers with skills necessary to complete new product
development were hired. In Second Quarter 1997, the Company incurred
approximately $40,000 on outside engineering contractors for software and
hardware development and approximately $35,000 on contract services to develop
card packaging for its Smart Card products.
General and Administrative Expenses ("G&A"). G&A increased $6,339 from $296,557
in Second Quarter 1997 to $302,896 in Second Quarter 1998. While G&A decreased
its overall personnel expenses due to the resignation of Richard L. Horton,
President and CEO, the Company incurred $25,000 on a total contract of $37,500,
of recruiting fees for a new President and CEO.
Sales and Marketing Expenses. Sales and marketing expenses decreased $57,538
from $278,149 in Second Quarter 1997 to $220,611 in Second Quarter 1998. Travel
expenses decreased approximately $8,000 between the Second Quarter periods.
Personnel expenses also decreased between Second Quarter periods by
approximately $75,000 due to the termination of the V.P. of Transportation and
Banking and the V.P. of Business Development, but increased approximately
$48,000 due to the hiring of a new OEM sales manager, a director of marketing
and the internal transfer of an applications support engineer. Second Quarter
1997 also included approximately $21,000 for printing and trade show expenses.
Equity in Loss of Joint Venture. The Company currently owns 19.9% of RJ. RJ
was formed in 1993 for the purpose of marketing, distributing and supporting the
Company's Smart Card products to be sold in Japan. The Company accounts for its
investment on the cost method. In Second Quarter 1997, the Company owned 22.8%
of RJ and accounted for its investment under the equity method, recognizing its
proportionate share of RJ's losses.
Amortization Expense. The Company's primary asset is a technology license
related to the design and manufacture of its Smart card products. The asset is
amortized over its estimated useful life on a straight line basis.
Other Income (Expense). During Second Quarter 1998 and 1997, the Company earned
$16,807 and $47,177, respectively, in interest income on its cash balances held
primarily in a government obligations fund with an average maturity of less than
90 days.
Net Loss. The Company is a C Corporation under the Internal Revenue Code and for
income tax reporting purposes as of December 31, 1997, has approximately
$13,700,000 of net operating loss carryforwards that expire at various dates
through 2012. The Tax Reform Act of 1986 contains provisions which may limit
the net operating loss carryforwards available to the Company in
any given year if certain events occur, including significant changes in
ownership interests.
RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 1998 COMPARED TO THE SIX
MONTHS ENDED JUNE 30, 1997
Revenues. Revenues increased 169.0% to $1,637,288 for the six months ended June
30, 1998 ("Interim 1998"), from $608,649 for the six months ended June 30, 1997
("Interim 1997").
Product Sales. Product sales decreased 19.4% to $137,288 for Interim 1998,
from $170,391 for Interim 1997. To date, the Company has completed a series
of projects, many of which are small scale "pilot" projects, but may have
the potential for implementation on a larger scale. In some cases, these
demonstration projects are "rolled out" for full scale implementation,
however the demonstration phase often takes six to twelve months or longer.
Product sales in Interim 1998 included approximately $44,000 of sales of
product to RJ, of which the Company owns 19.9%, as compared to
approximately $64,000 for the Second Quarter in 1997.
License Revenues. License revenues increased 242.3% to $1,500,000 for
Interim 1998, from $438,258 for Interim 1997.
Interim 1997 included the recognition of deferred revenues on a license
from RJ for the manufacture and sale of FRAM based radio frequency products
in Japan of $238,242 pursuant to the Company's ownership being reduced to
22.8%.
In 1996, pursuant to the technology license discussed above, RJ entered
into a custom product development project with Fujitsu, Ltd. under which
the Company is entitled to 50% of all sublicense revenue earned by RJ. This
sublicense resulted in the Company recording and receiving sublicense
revenue of $200,016 during Interim 1997.
The increase in license revenues reflects the execution of the licensing
contract with Hitachi, Ltd. which closed in January 1998, and under which
the Company received the first installment of the initial license fee
payment in January 1998 and the final initial license fee payment in May
1998.
COST OF REVENUES AND GROSS MARGIN. As a percentage of revenues, gross margin
increased to 95.4% in Interim 1998, from 59.9% for the same period in 1997.
Product Costs. The Company has not generated significant margin on product
sales in part because of competition with Contacted Cards which typically
are sold at a lower price than the Company's Smart Cards. Currently,
production volumes of the Company's products may not be sufficient to cover
manufacturing costs which are included in Cost of Revenues. Due to an
increase in availability of FRAM memory chips resulting in lower component
costs, and the use of EEPROM memory chips which are already available at
lower component costs, the Company expects to be able to lower its prices
while improving gross margin. The Company anticipates that cost
efficiencies will allow the Company to compete more effectively with
Contacted Card products and to build sales volume for its Smart Cards.
License revenues. In both periods presented, gross margin is primarily a
result of license revenues which have no direct cost of revenues.
Research and Development Expenses ("R&D"). R&D decreased $73,194 from $557,261
in Interim 1997 to $484,067 in Interim 1998. The decrease is primarily due to
changes in the personnel responsible for the product development. In November
1997, a group of engineers responsible for a specific project left the Company
upon completion of the project. Additional engineers with skills necessary to
complete new product development were hired. Overall, these changes resulted in
an increase in personnel expenses for R&D of approximately $36,000.
Additionally, the changes resulted in the Company focusing on its internal
engineering resources and not utilizing the services of contractors in new
product development projects. During Interim 1997, the Company incurred
approximately $70,000 on outside contractors. Further, in Interim 1997 the
Company incurred approximately $35,000 on contract services to develop card
packaging for its Smart Card products.
General and Administrative Expenses ("G&A"). G&A increased $144,766 from
$473,736 in Interim 1997 to $618,502 in Interim 1998. Interim 1998 includes
increasing expenditures approximating $30,000 relating to investor relations
consulting, securities legal and Nasdaq filing expenses incurred after the
Company's initial public offering ("IPO") which was completed on March 12, 1997.
The Company also recognized approximately $17,000 of additional expense relating
to the Directors and Officers Liability Insurance policy which was not effective
until March, 1997, and was renewed in March 1998. Interim 1998 also includes an
increase in consulting and office expenses of approximately $67,000 due to
increased audit fees, mergers & acquisitions research consulting and legal
consulting expenses. Interim 1998 also includes approximately $25,000 of
recruiting expenses incurred in the search for a President and CEO.
Sales and Marketing Expenses. Sales and marketing expenses decreased $22,769
from $489,353 in Interim 1997 to $466,584 in Interim 1998. 1997 Sales &
Marketing expenses for the Second Quarter included a $20,000 recruiting fee for
the hiring of a new Product Manager. Although Sales and Marketing expenses are
comparable between Interim periods, there were various changes in personnel
resulting in an overall increase in expenses, offset by fewer expenses incurred
in general marketing expenses (trade shows, new product literature, etc.).
Equity in Loss of Joint Venture. The Company currently owns 19.9% of RJ. RJ
was formed in 1993 for the purpose of marketing, distributing and supporting the
Company's Smart Card products to be sold in Japan. The Company accounts for its
investment on the cost method. In Interim 1997, the Company owned 22.8%
of RJ and accounted for its investment under the equity method, recognizing its
proportionate share of RJ's losses.
Amortization Expense. The Company's primary asset is a technology license
related to the design and manufacture of its Smart card products. The asset is
amortized over its estimated useful life on a straight line basis.
Other Income (Expense). During Interim 1997, the Company incurred $17,405 and
$40,466 in interest expense on various notes payable to Intag International
Limited ("Intag") and Ramtron and a group of lenders, respectively. The notes
carried interest at 10% and prime plus 2%, respectively. The notes and accrued
interest were paid during Interim 1997 upon completion of the IPO. Interest
expense for Interim 1997 also includes $97,799 related to the amortization of
debt issuance costs associated with a bridge financing completed prior to the
IPO. Interim 1997 also included approximately $20,000 in currency exchange
losses on the sub-licensing transaction completed with RJ. During Interim 1997
and 1998 the Company earned $49,802 and $34,529, respectively, in interest
income on its cash balances held primarily in a government obligations fund with
an average maturity of less than 90 days.
Net Loss. The Company is a C Corporation under the Internal Revenue Code and for
income tax reporting purposes as of December 31, 1997, has approximately
$13,700,000 of net operating loss carryforwards that expire at various dates
through 2012. The Tax Reform Act of 1986 contains provisions which may limit
the net operating loss carryforwards available to the Company in
any given year if certain events occur, including significant changes in
ownership interests.
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary need for capital has been to finance expansion of research
and development of new Smart Card products, sales and marketing of its products
and operations. Annual product revenues growth has been limited due to limited
financial resources and an inability to expand receivables, build inventory and
effectively sell and market Smart Card products.
CASH FLOW
The Company had cash and cash equivalents of $1,198,567 and $1,363,773 as of
December 31, 1997 and June 30, 1998, respectively. During Interim 1998, the
Company's primary source of cash was from the initial license fee payments
received under the Hitachi license agreement, and the sale of 220,000 shares of
common stock to a former employee upon the exercise of employee stock options at
$1.00 per share.
CAPITALIZATION
The Company's capitalization of $2,775,235 as of December 31, 1997 was comprised
entirely of stockholders' equity, as compared to $2,942,736 of stockholders'
equity as of June 30, 1998. The increase is attributable to the sale of 220,000
shares of common stock to a former employee upon the exercise of employee stock
options at $1.00 per share.
Management of the Company intends to fund its remaining 1998 operations through
a combination of product sales, technology sublicensing and possible offerings
of its common stock. There is no assurance that sales of common stock will
occur or that additional proceeds will be received from such offerings. The
Company currently does not have an available source for short-term borrowings.
The Company must also maintain certain requirements in order to be listed on
Nasdaq. These requirements include maintaining a specified level of net
tangible assets, as defined, market capitalization or net income. Additionally,
the Company must maintain a specified level of publicly traded shares, market
value of the publicly traded shares, minimum bid price, number of market makers
and shareholders. As of June 30, 1998 the Company was in compliance with the
Nasdaq listing requirements. However, subsequent to June 30, 1998, the minimum
bid price of the stock was listed below $1.00 for three consecutive days. As of
the date of this report, the Company had not received a delisting notification
from Nasdaq and does not anticipate that it will receive notification as the
Company is currently in compliance with the minimum bid price requirement.
There is no assurance that the Company will continue to meet the Nasdaq listing
requirements.
YEAR 2000
The Company utilizes software and related technologies throughout its business
and relies on many suppliers of services and materials that will be affected by
the date change in the year 2000. The Year 2000 issue exists because many
computer systems and applications currently use two-digit fields to designate a
year. As the century date change occurs, date-sensitive systems will recognize
the year 2000 as 1900, or not at all. This inability to recognize or properly
treat the Year 2000 may cause systems to process critical financial and
operational information incorrectly.
The Company has completed an internal study to determine the full scope and
related costs to insure that the Company's systems continue to meet its internal
needs and those of its customers. The results of the internal study indicate
that its products are not affected by the Year 2000 issue. In addition, the
results of the internal study indicate that certain software utilized by the
Company's internal systems will be affected by the Year 2000 issue, and steps to
upgrade the software have begun. Management believes these amounts are not
significant and such expenditures will continue through the year 1999 as
upgrades become available.
The Company believes that there is a greater risk that its vendors, clients and
strategic partners will be affected by the Year 2000 problem. The Company is
currently unable to assess, and may be unable to accurately determine, the
magnitude of any Year 2000 problems that may reside in the computer and
information systems of its clients, vendors and strategic partners, or the
impact that any such problems could have on the products and services provided
by the Company to such clients. In addition to the internal study, the Company
has begun assessing the existence of any Year 2000 problems that may reside in
the computer systems and products of its vendors, clients and strategic
partners. The Company expects to complete the assessment phase by December 31,
1998. The Company believes, based upon the progress to date, that its suppliers
and strategic partners are either Year 2000 compliant, or are themselves in an
assessment phase. However, there can be no assurance that all such problems will
be resolved. The Company plans to develop a contingency plan as a result of its
findings during this assessment phase. The occurrence of Year 2000 related
failures in the computer and information systems of any of the Company's
significant clients, vendors or strategic partners could have a materially
adverse effect on the business, results of operations and financial condition of
the Company.
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