Form 10-Q for APPLIED DNA SCIENCES INC
10-Aug-2015
Quarterly Report
Item 2. - Management's Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion should be read in conjunction with our Unaudited Condensed Consolidated Financial Statements and Notes thereto, included elsewhere within this report. The Quarterly Report contains forward-looking statements, including statements using terminology such as "can", "may", "believe", "designed to", "will", "expect", "plan", "anticipate", "estimate", "potential" or "continue", or the negative thereof or other comparable terminology regarding beliefs, plans, expectations or intentions regarding the future. You should read statements that contain these words carefully because they:
? discuss our future expectations;
? contain projections of our future results of operations or of our financial condition; and
? state other "forward-looking" information.
We believe it is important to communicate our expectations. However, forward looking statements involve risks and uncertainties and our actual results and the timing of certain events could differ materially from those discussed in forward-looking statements as a result of certain factors, including those set forth under "Risk Factors," "Business" and elsewhere in our Annual Report on Form 10-K, as amended, for the fiscal year ended September 30, 2014. All forward-looking statements and risk factors included in this document are made as of the date hereof, based on information available to us as of the date thereof, and we assume no obligations to update any forward-looking statement or risk factor, unless we are required to do so by law.
Introduction
Using biotechnology as a forensic foundation, we provide botanical-DNA based security and authentication solutions and services that can help protect products, brands, entire supply chains, and intellectual property of companies, governments and consumers from theft, counterfeiting, fraud, and diversion. Whether working in supply chain security, brand protection or law enforcement applications, it is our goal to help establish secure flourishing environments that foster quality, integrity and success. With secure taggants, high-resolution DNA authentication, and comprehensive reporting, our botanical DNA-based technologies are designed to deliver what we believe to be the greatest levels of security, deterrence and legal recourse strength.
SigNature? DNA. SigNature DNA is our platform ingredient, at the core of all our security solutions. From application to application, the vehicle which carries SigNature DNA is custom designed to suit the application. Exhaustive development efforts have yielded a flexible and durable marker with all the accuracy provided by nature. SigNature DNA is based on full, double stranded plant DNA, and provides forensic power and protection for a wide array of applications. Highly secure, robust, and durable, SigNature DNA markers are an ingredient that can be used to fortify brand protection efforts; mark, track and convict criminals; and strengthen supply chain security. Custom DNA sequences can be embedded into a wide range of host carriers including ink, varnish, thread, laminates and metal coatings. These items can then be tested for the presence of SigNature DNA markers through optical screening or a forensic level authentication. Hundreds of millions of SigNature DNA marks now exist in the public domain on items ranging from consumer product packaging to microcircuits to guitars. We believe that no marks have ever been copied.
SigNature DNA, SigNature? T DNA, fiberTyping?, DNAnet?, Sentry, digitalDNA?, and SmokeCloak? DNA, our principal anti-counterfeiting and product authentication solutions and our Counterfeit Prevention Authentication Program can be used in numerous industries, including, but not limited to microcircuits and other electronics, cyber security, cash-in-transit (transport and storage of banknotes), textiles and apparel, automotive, printing and packaging, homeland security, law enforcement and home asset marking, identity cards and other secure documents, industrial materials, agrochemicals, pharmaceuticals, consumer products, food and beverage, sports memorabilia, fine wine, and art and collectibles.
SigNature T DNA and fiberTyping. There is one common thread that runs through the global textile industry: success breeds counterfeiting and diversion. SigNature T botanical DNA markers are used for brand protection efforts and raw material source compliance programs. In situations where natural fibers like cotton or wool are utilized, we can isolate and type inherent DNA, making it possible to verify the presence of specified materials. This fiberTyping process provides DNA verification to help manufacturers, retailers and brand owners ensure quality, safety and compliance of their products.
DNAnet.Recognizing that DNA-based evidence is the cornerstone of the modern era of law enforcement, we have created what we believe to be an effective crime fighting tool: DNAnet, a botanical DNA marker that can be used to definitively link evidence and offenders to specific crime scenes and help return stolen or lost property to its rightful owner. As the crime is investigated, the fluorescing DNA mark can assist police in linking the offender and stolen items to a specific crime scene, creating a greater ability to identify and convict.
Sentry. Sentry intruder tagging systems help to expand and strengthen any security effort by providing a means of directly linking criminals to crimes. Each unit is designed to be unique to each store, warehouse, or sting operation, allowing the police and prosecutors to link criminals to the crimes. In the event of a crime, the fleeing offender is sprayed with an indelible, fluorescing DNA taggant. As the crime is investigated, the fluorescing DNA mark can assist police in linking the offender and stolen items to a specific crime scene, creating a greater ability to identify and convict.Whether deployed as an offender spray or fog in a retail location or a degradation dye in cash handling boxes, DNA markers facilitate conviction, and establish a heightened level of deterrence. While any commercial/retail establishment could benefit from the addition of a Sentry system, ideal areas of use include: banks, ATMs, pharmacies, jewelry stores, convenience stores, pawn brokers and gun shops.
digitalDNA. digitalDNA is a security solution that utilizes the flexibility of mobile communications, the instant accessibility of secure, cloud-based data, and the certainty of DNA to make item tracking and authentication fast, easy and definitive, while providing the opportunity to create a new customer interface. digitalDNA begins with a DNA-secured form of the QR ("quick read") code or other two dimensional code. A unique identification code is created for each article, and represented in an easy-to-read QR style barcode. The product uses forensic authentication of a botanical DNA marker, embedded within a secure QR code, and physically included within the ink used to digitally print the code. Should there ever be a question about the validity of a digitalDNA code, a laboratory-based analysis can be conducted to determine authenticity. Scanning bar code item numbers on marked goods enables individuals to post or access information about a product such as its geo-location, original image or associated documentation. Consumers may take advantage of marketing information supplied by brand owners.
The secure cloud application also offers back-end features including DNA custody management, forensic sample submission, CODA (certificate of DNA authentication) issuance, customer account administration, order placement, status tracking and reporting, and online training. The cloud-based platform is designed to be customizable for the particular attributes of each customer's business and conforms to strict security standards for ISO, PCI, and Federal Information Processing Standards. This digitalDNA platform is designed as the data management and reporting hub for devices for DNA on-site authentication and optical mark in-field validation. Market-specific configurations have been demonstrated to businesses in textiles supply chain, printing/publishing, art and collectibles and law enforcement.
SmokeCloak DNA. When deployed in pharmacies, banks, commercial or retail locations, SmokeCloak DNA helps protect staff, customers and assets. A thick and disorienting fog wards off offenders and deposits a unique, location-specific DNA marker on skin, clothing and stolen items. The combination of fog and DNA technologies has no negative side effects and provides a strong crime fighting and loss prevention tool.
Counterfeit Prevention Authentication Program. Our turnkey program for electronics, military, commercial, and aerospace contractors called the Counterfeit Prevention Authentication Program ("CPA" Program) empowers end-users to verify the originality or provenance of parts which have been marked by their suppliers with our SigNature DNA Markers.
Plan of Operations
General
To date, the substantial portion of our revenues have been generated from sales of our SigNature DNA platform and fiberTyping, our principal anti-counterfeiting and product authentication solutions. We expect to continue to grow revenues from sales of our SigNature DNA platform ingredient, including our Signature T DNA, fibertyping, DNAnet, Sentry, digitalDNA, and SmokeCloakDNA offerings and the Counterfeit Prevention Authentication Program. We have limited sources of liquidity. We have developed or are currently attempting to develop business in the following target markets: microcircuits and other electronics, cash-in-transit (transport and storage of banknotes), textiles and apparel, automotive, printing and packaging, homeland security, law enforcement and home asset marking, identity cards and other secure documents, industrial materials, agrochemical, pharmaceuticals, consumer products, food and beverage, sports memorabilia, fine wine, and art and collectibles. Our developments in the textile and apparel authentication, semiconductor authentication, and cash-in-transit have contributed to the increase in our revenues. We intend to pursue both domestic and international sales opportunities in each of these vertical markets.
Critical Accounting Policies
Financial Reporting Release No. 60, published by the SEC, recommends that all companies include a discussion of critical accounting policies used in the preparation of their financial statements. While all these significant accounting policies impact our financial condition and results of operations, we view certain of these policies as critical. Policies determined to be critical are those policies that have the most significant impact on our consolidated financial statements and require management to use a greater degree of judgment and estimates. Actual results may differ from those estimates.
We believe that given current facts and circumstances, it is unlikely that applying any other reasonable judgments or estimate methodologies would cause a material effect on our condensed consolidated results of operations, financial position or liquidity for the periods presented in this report.
The accounting policies identified as critical are as follows:
? Revenue recognition;
? Equity based compensation; and
? Fair value of financial instruments
Revenue Recognition
We recognize revenue in accordance with Accounting Standards Codification ("ASC") 605, Revenue Recognition ("ASC 605"). ASC 605 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred and/or service has been performed; (3) the selling price is fixed and determinable; and (4) collectability is reasonably assured. Determination of criteria (3) and (4) are based on management's judgments regarding the fixed nature of the selling prices of the products delivered or services provided and the collectability of those amounts. Provisions for allowances and other adjustments are provided for in the same period the related sales are recorded. We defer any revenue for which the product has not been delivered, service has not been provided, or is subject to refund until such time that we and the customer jointly determine that the product has been delivered, the service has been provided, or no refund will be required. At June 30, 2015 and September 30, 2014, we recorded deferred revenue of $204,863 and $583,362, respectively.
Revenue arrangements with multiple components are divided into separate units of accounting if certain criteria are met, including whether the delivered component has stand-alone value to the customer. Consideration received is allocated among the separate units of accounting based on their respective selling prices. The selling price for each unit is based on vendor-specific objective evidence, or VSOE, if available, third party evidence if VSOE is not available, or estimated selling price if neither VSOE nor third party is available. The applicable revenue recognition criteria are then applied to each of the units.
Revenue for government contract awards, which supports our development efforts on specific projects, is recognized as milestones are achieved as per the contract. We recognized revenue of approximately $657,708 and $1,919,031 from these contract awards during the three and nine month periods ended June 30, 2015, respectively, and $0 and $50,000 for the three and nine month periods ended June 30, 2014, respectively.
Equity Based Compensation
We follow ASC subtopic 718, Compensation ("ASC 718") which requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their fair values.
We account for stock based compensation awards issued to non-employees for services, as prescribed by ASC 718-10, at either the fair value of the services rendered or the instruments issued in exchange for such services, whichever is more readily determinable, using the measurement date guidelines enumerated in ASC 505-50.
Fair Value of Financial Instruments
The valuation techniques utilized are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect internal market assumptions. These two types of inputs create the following fair value hierarchy:
Level 1 - Quoted prices in active markets for identical assets or liabilities.
Level 2 - Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the related asset or liabilities.
Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of assets or liabilities.
The Company utilizes observable market inputs (quoted market prices) when measuring fair value whenever possible.
For fair value measurements categorized within Level 3 of the fair value hierarchy, the Company's accounting and finance department, who report to the Chief Financial Officer, determine its valuation policies and procedures. The development and determination of the unobservable inputs for Level 3 fair value measurements and fair value calculations are the responsibility of the Company's accounting and finance department and are approved by the Chief Financial Officer.
Use of Estimates
In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenue and expenses during the reporting period. Actual results could differ from those estimates.
Comparison of Results of Operations for the Three Month Periods Ended June 30, 2015 and 2014
Revenues
For the three month periods ended June 30, 2015 and 2014, we generated $2,267,671 and $841,197, respectively, in revenues. The increase in revenues in the three month period ended June 30, 2015 of $1,426,474 or 170% was primarily from an increase in revenue related to sales to the textile industry for protecting cotton supply chains of $1,200,000 and revenue from government contract awards of approximately $658,000. These increases were offset by a decrease in revenue from suppliers of the United States DefenseLogistics Agency ("DLA") due to the consolidation of these individual contracts to one contract with DLA.
Costs and Expenses
Selling, General and Administrative
Selling, general and administrative expenses for the three month period ended June 30, 2015 increased by $560,003 or 19% from $2,948,452 for the three month period ended June 30, 2014 to $3,508,455 for the three month period ended June 30, 2015. The increase is attributable to an increase in stock based compensation expense of $610,855, primarily associated with stock option modifications resulting from the extension of certain stock options offset by a decrease of approximately $210,000 in legal fees as a result of the court's dismissal of the SmartWater Limited litigation against us.
Research and Development
Research and development expenses increased to $310,093 for the three month period ended June 30, 2015 from $266,331 for the three month period ended June 30, 2014, an increase of $43,762 or 16%. This increase is due to development costs incurred in relation to the two government contracts offset by capitalized costs for the development of infield readers.
Depreciation and Amortization
In the three month period ended June 30, 2015, depreciation and amortization increased by $7,915 from $113,424 for the three month period ended June 30, 2014 to $121,339 for the three month period ended June 30, 2014.
Gain on Change in Fair Value of Warrant Liability
Gain from change in fair value of warrant liability during the three month period ended June 30, 2014 was $515,543. This change in fair value related to warrants containing certain reset provisions which required us to classify them as liabilities and mark the warrants to market and record the change in fair value at each reporting period, and upon exercise as a non cash adjustment to our current period operations. As discussed in Note E of the accompanying condensed consolidated financial statements, on November 21, 2014, we repurchased the remaining outstanding Series B Warrants.
Comparison of Results of Operations for the Nine Month Periods Ended June 30, 2015 and 2014
Revenues
For the nine month periods ended June, 30, 2015 and 2014, we generated $5,028,234 and $2,075,698, respectively, in revenues. The increase in revenues of $2,952,536 or 142% was primarily due to an increase in sales from two government contract awards of approximately $1.9 million as well as revenues related to the set up, marking, and authentication of cotton of $1,372,500. These increases were offset by a decrease in revenue from suppliers of the United States Defense Logistics Agency ("DLA") due to the consolidation of these individual contracts to one contract with DLA.
Costs and Expenses
Selling, General and Administrative
Selling, general and administrative expenses for the nine month period ended June 30, 2015 increased by $984,774 or 10% from $10,093,631 for the nine month period ended June 30, 2014 to $11,078,405 for the nine month period ended June 30, 2015. The increase is primarily attributable to an increase in stock based compensation expense of approximately $1,813,000, attributable to grants to employees that vested immediately, as well as stock based compensation expense associated with stock option modifications resulting from the extension of certain stock options, and to a lesser extent, the acceleration of vesting terms. This increase was primarily offset by decreases in legal and consulting expenses. Legal expenses decreased by $783,000 due to the court's dismissal of the SmartWater Limited litigation against us. Consulting fees decreased by $238,000 primarily due to shares of common stock issued to a business strategy consultant in settlement of their fees during the nine month period ended June 30, 2014. The remaining variance is due to increases in payroll offset by decreases in filing fees during the nine month period ended June 30, 2015.
Research and Development
Research and development expenses decreased to $961,745 for the nine month period ended June 30, 2015 from $1,085,416 for the nine month period ended June 30, 2014. The decrease of $123,671 or 11% is attributable to purchases for laboratory equipment associated with the corporate headquarters in the prior year as well as components purchased relating to a pilot program for the marking of cotton during the prior period, which we did not incur during the nine month period ended June 30, 2015. Also, during the nine month period ended June 30, 2015, we started capitalizing the costs for the development of infield readers, which were being expensed during the same period in the prior year.
Depreciation and Amortization
Depreciation and amortization increased by $28,696 from $325,448 for the nine month period ended June 30, 2014 to $354,144 for the nine month period ended June 30, 2015. This increase is related to the depreciation incurred on the fixed asset additions during the period.
Loss from Change in Fair Value of Warrant Liability
Loss from change in fair value of warrant liability during the nine month periods ended June 30, 2015 and 2014 was $2,994,540 and $1,663,316, respectively. These losses relate to warrants containing certain reset provisions which required us to classify them as liabilities and mark the warrants to market and record the change in fair value at each reporting period as a non-cash adjustment to our current period operations. As discussed in Note E of the accompanying condensed consolidated financial statements, on November 21, 2014, we repurchased the remaining outstanding Series B Warrants.
Liquidity and Capital Resources
Our liquidity needs consist of our working capital requirements and research and development expenditure funding. As of June 30, 2015, we had working capital of $11,394,253. For the nine month period ended June 30, 2015, we generated a net cash flow deficit from operating activities of $5,226,713 consisting primarily of our loss of $11,385,102 net with non-cash adjustments of $354,144 in depreciation and amortization charges, $3,531,205 for stock-based compensation, $2,994,540 change in fair value of warrant liability, $980,842 in loss on the conversion of promissory notes, $64,426 in common stock issued for consulting services and $21,750 of bad debt expense. Additionally, we had a net increase in operating assets of $1,334,504 and a net decrease in operating liabilities of $454,014. Cash used in investing activities was $459,471 for the purchase of property, plant and equipment and intangible assets. Cash provided by financing activities was $15,023,466 in net proceeds from the sale of common stock and warrants related to the underwritten public offering offset by the repurchase and cancellation of the remaining Series B Warrants.
The Company has recurring net losses, which have resulted in an accumulated deficit of $211,145,374 as of June 30, 2015. At June 30, 2015 the Company had cash and cash equivalents of $10,730,144. The Company's current capital resources include cash and cash equivalents, accounts receivable and prepaid expenses. Historically, the Company has financed its operations principally from the sale of equity securities. On April 1, 2015, the Company closed on an underwritten public offering of common stock and warrants for gross proceeds of $12.0 million, before deducting underwriting discounts and offering expenses. Subsequently on April 30, 2015, the Company closed on the over-allotment option of the underwritten public offering for additional gross proceeds of $263,950. In addition, on November 20, 2014 the Company closed its underwritten public offering of common stock and warrants for gross proceeds of $9.3 million before deducting underwriting discounts and offering expenses. The Company utilized approximately $4,091,000 of the gross proceeds to repurchase the remaining Series B Warrants from Crede, as discussed in Note E. The Company also raised $2,156,264 in a private placement of common stock and warrants and $1,800,000 in promissory notes during the fiscal year ended September 30, 2014, including $1,000,000 from a related party.
The Company expects to finance operations primarily through cash flows provided by operating activities provided that it will achieve a sufficient level of future revenues. The Company estimates that its cash and cash equivalents are sufficient to fund operations for the next twelve months. The Company will require additional funds to complete the continued development of its products, product manufacturing, and to fund expected additional losses from operations, until revenues are sufficient to cover the Company's operating expenses.
We expect capital expenditures to be less than $980,000 in fiscal 2015. Our primary investments will be in laboratory equipment to support prototyping, manufacturing, our authentication services, and outside services for our detector and reader development.
All of the real property used in our business is leased under operating lease agreements.
Subsequent Events
None.
Product Research and Development
We anticipate spending approximately $1,500,000 for product research and development activities during the next twelve months.
Acquisition of Plant and Equipment and Other Assets
We do not anticipate the sale of any material property, plant or equipment during the next twelve months.
Number of Employees
We currently have forty-nine full-time employees and nine part-time employees, including four in management, eleven in research and development, one in Life Sciences, two in forensics, six in quality assurance/compliance, four in finance and accounting, five in operations, thirteen in sales and marketing, one in human resources, five in shared services, three in information services, one in investor relations, one legal (Intellectual Property) and one in product development. We expect to increase our staffing dedicated to sales, production and formulation. Marketing, salaries, and general overhead will be increased as necessary. However, cost containment measures have been put in place to monitor expenses. In order for us to attract and retain quality personnel, we anticipate we will continue to offer competitive salaries and benefits to future employees. We anticipate that it may become desirable to add additional full and or part time employees to discharge certain critical functions during the next twelve months. This projected increase in personnel is dependent upon our ability to generate revenues and obtain sources of financing. There is no guarantee that we will be successful in raising the funds required or generating revenues sufficient to fund the projected increase in the number of employees. As we continue to expand, we will incur additional costs for personnel. We continue to work with Insperity Inc. to help us manage many of our back-end administrative human resources and payroll responsibilities.
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements.
Inflation
The effect of inflation on our revenue and operating results was not significant.
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