DSS, INC. - Quarter Report: 2005 September (Form 10-Q)

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     Much of our efforts in the first half of 2005 were spent on working with Boise to launch Boise Beware. We educated and trained the Boise employees about our technology, and developed, in cooperation with Boise personnel, a purchase order and manufacturing process including outlining the distribution and warehouse functions. We also used a third-party printer to meet initial demand and to build our inventories of the paper which Boise has arranged to sell at OfficeMax and CopyMax stores throughout the United States as well as to its corporate clients.

     Currently, our Safety Paper is manufactured and stored for us by a third-party printer which has sufficient capacity to meet our foreseeable demand for Safety Paper. During the third quarter of 2005, sales of Safety Paper slowed as compared to the second quarter of 2005 primarily due to a seasonality factor and that our paper distributor, Boise, was still in an initial set-up mode. During the quarter, their inventories were sufficient to supply direct retail paper sales. We believe that the “Boise Beware” product line will experience continued growth due to the continued sales efforts of Boise in North America.

     We intend to further increase our revenues by expanding the market for our “AuthentiGuard” safety paper internationally and expect to benefit from new distribution agreements outside of North America. In addition, we are seeking to increase revenues and increase gross profit margins by developing manufacturing capabilities through strategic mergers and acquisitions that will allow us to service larger and a wider range of potential customers while eliminating a layer of costs by reducing our reliance on third party printers.

     Concurrent with the completion of the patent consolidation phase of our business, we are concentrating more of our efforts and resources towards growing our technology licensing business. We continue to reinforce our existing industry relationships and we are active in introducing our organization and technologies to various industries and government agencies in the United States and internationally. In addition, we expanded our service personnel to assure our current and future customers of our ability to provide future support for their post sale service requirements. Our sales initiative is focused on major national and international corporations that have a long-term need for our anti-counterfeiting technologies.

     During 2005, we have also begun to expand our marketing efforts to the end-user of custom secure documents. Whereas in the past, we typically sought to license our technology to the printer of the end-user, we have determined that significant advantages exist in the market if we are able to own the end-user relationship from the design phase through the production phase. By utilizing our patented technologies, the company has the ability to create, design and manufacture one of a kind unique, proprietary secure documents. Therefore, we have shifted our focus to utilize more of our internal printing capabilities towards the custom security document market. In addition, we are actively seeking strategic acquisition candidates in the various printing manufacturing categories. We are in merger and acquisition discussions with several interested companies in the packaging, ID card, digital printing and checks and forms industries. We are also in discussions with one of the world’s largest media electronics companies for a technology cross licensing agreement or a possible merger and or acquisition with one of their subsidiary operations. All of these discussions are at preliminary stages and there is no guarantee that any transactions will be concluded.

      We are also developing a new line of security which employs new technology for use with documents requiring a very high level of security such as vital records to be considered for distribution by Boise or other strategic partners in the paper distribution industry. These efforts continued during the first nine months of 2005 and included the processing of several new US and International patent applications. During 2005, we have invested over 18% of our revenue towards research and development. These advanced technologies protect, as well as identify, documents as originals or counterfeits. Large security printers and packaging companies are testing our technology and we anticipate that our technologies will be embedded on pharmaceutical packaging, consumer product packaging, checks and currencies.

          We also believe that some of our technologies are being used on an un-authorized basis. By aggressively defending our intellectual property rights, we believe that we will be able to secure a potentially significant amount of additional and ongoing revenue by securing licensing agreements with those persons, companies or governments that we believe are infringing our patents. We also anticipate that we may be required to commence litigation in some cases and that we will need to spend a significant amount of money and time on these matters. During the first nine months of 2005, we have incurred approximately $250,000 in legal fees, paid for by shares of our common stock, related to a case we filed against the European Central Bank for infringement of our European Patent 455750B1. We capitalize these costs into the cost of our patents and expense them if it is determined that the defense will be unsuccessful. We anticipate that we will continue to incur significant legal costs associated with this case, of which the majority will be paid for by shares of our common stock.

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     As mentioned above, our company also generates revenue from our commercial printing operations and our Internet company, Legalstore.com, which supplies legal supplies and customized legal documents to the legal profession. The principal purpose of these non-core operations is to provide a testing ground for our products and to offset research and development costs associated with the development of our technologies. We intend to continue to pursue profitable growth for these businesses.

Results of Operations for the Three and Nine Months Ended September 30, 2005

     The following discussion and analysis provides information that our management believes is relevant to an assessment and understanding of our results of operations and financial condition. The discussion should be read in conjunction with the financial statements and footnotes in this quarterly report and in our annual report on Form 10-KSB for the year ended December 31, 2004.

Summary		Three Months Ended September 30,2005					Nine Months Ended September 30,2005
		$			% change vs. 3 months ended Sept. 30, 2004		$			% change vs. 9 months ended Sept. 30, 2004
Sales, net			373,000		5	%		1,297,000		26	%
Costs of sales			187,000		-17	%		672,000		5	%
Gross profit			186,000		42	%		625,000		60	%
Total operating expenses			888,000		71	%		2,461,000		59	%
Loss before other income (expense)
and income taxes			(702,000	)	81	%		(1,836,000	)	58	%
Other income (expense):
Interest income			30,000		131	%		67,000		52	%
Interest expense			(6,000	)	50	%		(21,000	)	31	%
Loss before income taxes			(678,000	)	79	%		(1,790,000	)	58	%
Income taxes			-		-100	%		5,000		-10	%
Net loss			(678,000	)	77	%		(1,795,000	)	58	%

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Sales		Three Months Ended September 30,2005					Nine Months Ended September 30,2005
		$			% change vs. 3 months ended Sept. 30, 2004		$			% change vs. 9 months ended Sept. 30, 2004
Sales, net
Document Security		$	137,000		132	%	$	553,000		191	%
Printing			114,000		-35	%		364,000		-25	%
Legal supplies			122,000		2	%		380,000		6	%
Total Revenue			373,000		5	%		1,297,000		26	%

     Document Security

     Document security sales increased 132% for third quarter and 191% for the first nine months of 2005. The increases during the quarter are primarily the result of increases in sales of custom security documents for our customers. The increases the first nine months of 2005 also reflect the early orders under our distribution and marketing contract with Boise. While we still consider these sales to be nominal, we believe that the early results are indicative of the potential for our safety paper products. However, we also are aware that our safety paper products are still a relatively new and there can be no assurance that we will continue to receive orders at a pace higher or lower then the initial product rollout. During the third quarter of 2005, we began to more aggressively target the custom security market by offering custom design and manufacturing services to the end-user market for security documents.

     To date, licensing revenue has been insignificant. We are currently in the process of presenting and testing our technology with multiple printers, corporations and government agencies, however, we have not entered into any definitive licensing agreements with any parties. We are also in the contract negotiation stage with several clients which should conclude in 2005 or early 2006. We believe that the nature of our technology and the typical length and breadth of licensing agreements that we seek to enter into with our customers creates a sales cycle of six to twelve months. In addition, during the third quarter of 2005, we began to limit our licensing business to only large or strategic customers.

      Printing and legal supplies

     We view sales from our commercial printing business segment to be essentially a means of having access to a working research and development facility and to be able to offset the costs of our research. During the quarter ended September 30, 2005, we experienced a 35% decline in our sales to external commercial printing customers primarily due to three factors. First, during the quarter, we utilized a larger amount of our printing capacity for custom security print orders which have a higher profit margin than traditional commercial print orders. Second, results were adversely affected by a large, one-time order from a customer in 2004 that did not occur in the 2005 period. Third, we experienced a decline in business from one significant customer which we believe will be made up in the fourth quarter of 2005.

     Revenue from our legal supplies business continued to grow during the third quarter and the first nine months of 2005. We view our legal supplies business segment as a non-core part of our company and have attempted to simplify its operation by emphasizing e-commerce sales. Although the sales of this segment appear to be significant as to our total sales, we do not expect that to be true in the future. The division continues to increase its revenue by seeking to grow its customer base in a cost effective manner.

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Gross Profit			Three Months Ended September 30,2005				Nine Months Ended September 30,2005
		$			% change vs. 3 months ended Sept. 30, 2004		$			% change vs. 9 months ended Sept. 30, 2004
Gross profit
Document Security			66,000		214	%		259,000		232	%
Printing			60,000		-19	%		183,000		13	%
Legal supplies			60,000		67	%		183,000		21	%
Total gross profit			186,000		42	%		625,000		60	%

		Three Months Ended September 30,2005				Nine Months Ended September 30,2005
				% change vs. 3 months ended Sept. 30, 2004				% change vs. 9 months ended Sept. 30, 2004
Gross profit percentage:
Document Security		48	%	35	%	47	%	14	%
Printing		53	%	25	%	50	%	50	%
Legal supplies		49	%	64	%	48	%	14	%
Total gross profit percentage		50	%	35	%	48	%	27	%

     Document Security

     The 214% increase in gross profit in the third quarter of 2005 when compared to the third quarter of 2004 is the result of increased volumes of custom security print orders versus prior year amounts. The gross profit percentage increase reflects the improvements in inventory management and pricing gained by larger order quantities which the Company is able to make as its sales increase.

     Printing and legal supplies

Gross profits from our printing and legal supplies operations support our document security business. While gross profits declined on a dollar basis due to the revenue variances described above, printing gross profit percentages have increased for both periods presented generally as the result of improvements in the customer mix as the sales declines described above were generally to commercial printing and copying customers which had lower than average profit margins associated with them.

     Legal supplies gross profit margins in the third quarter of 2005 as compared to the third quarter in 2004 increased primarily due to a change in product mix resulting in a greater percentage of wholesale sales versus drop shipment sales. We generally generate higher gross margins on products that we purchase on a wholesale basis and resell to our customers versus products that we sell as a dealer for a larger legal supply company.

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Expenses
Operating expenses

		Three Months Ended September 30,2005					Nine Months Ended September 30,2005
		$			% change vs. 3 months ended Sept. 30, 2004		$			% change vs. 9 months ended Sept. 30, 2004
Selling, general and administrative expenses:
Compensation			260,000		79	%		724,000		75	%
Professional Fees			156,000		64	%		490,000		114	%
Sales and marketing			125,000		54	%		351,000		33	%
Depreciation and amortization			23,000		188	%		117,000		388	%
Other			110,000		41	%		269,000		3	%
Research and development			79,000		-26	%		240,000		-19	%
Amortization of intangibles			135,000		2600	%		270,000		335	%
Total operating expenses			888,000		71	%		2,461,000		59	%

     Selling, General and Administrative

     Our selling, general and administrative costs have increased as we have increased the size of our organization to a level that we feel necessary to execute our business plan. Increases in compensation costs are primarily due to the additions in sales, service and finance personnel. As mentioned above, we increased our sales and service departments to coincide with our national and international sales initiative and to improve our post sale support capabilities. Our addition in finance internalizes our finance and corporate governance capabilities and is expected to be partially offset by decrease in professional fees.

     Professional fees have primarily increased due to increases in legal, accounting, investor and public relation costs and consulting fees. Legal costs are associated with general corporate fees and legal fees in connection with the litigation referred to below in Part II –Legal Proceedings. These legal costs do not include legal costs associated with the application and defense of our patents which the company capitalizes and amortizes over the expected life of the patent. Consulting fees are primarily directed towards efforts to help the Company develop contacts and market opportunities with government and large multinational corporations.

     Sales and marketing expense increases include increases in travel costs associated with greater participation in trade shows as well as an increase in potential customer site visits. We expect that sales and marketing expenses will continue to fluctuate as we incur costs incidental with our sales volume.

     Depreciation expense has increased primarily due to leasehold improvements incurred during the last quarter of 2004 for our new corporate headquarters as well as additional computers and office equipment associated with our increase in personnel levels.

     Other expenses are primarily rent, supplies, and insurance costs that have not significantly fluctuated since 2004, except for the timing of certain office expenses and employee hiring costs which the company experience in the third quarter of 2005 but not in the third quarter of 2004.

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     Research and Development

     We continue to invest in research and development to improve our existing technologies and develop new technologies that will enhance our position in the document security market. Research and development costs consists primarily of compensation costs for our chief technology officer and third party subcontracting costs incurred to test our technologies on equipment that we do not have access to internally. These costs have decreased in both periods of 2005 primarily due to a reduction in subcontracting costs. We expect that our research and development costs will continue at current levels for the foreseeable future as we continue to research new technologies and different uses of our current technologies.

     Amortization of intangibles

     Commencing in the second quarter of 2005, we began to amortize the costs associated with the patents that we acquired in 2005. As described above, we consolidated our patent portfolio with the purchase of legal and economic ownership rights to several patents in the first quarter of 2005. We are amortizing these costs over the weighed average expected life of the patents that we purchased which is approximately 9 years. This non-cash expense will continue to be a significant component of our operating expenses during the amortization period. In addition, we expect to capitalize additional costs associated with the application and defense of our patents which will increase the amortization expense that we will incur in future periods.

Other income and expense

		Three Months Ended September 30,2005					Nine Months Ended September 30,2005
		$			% change vs. 3 months ended Sept. 30, 2004		$			% change vs. 9 months ended Sept. 30, 2004
Other income (expense):			30,000		131	%		67,000		52	%
Interest income			(6,000	)	50	%		(21,000	)	31	%
Interest expense			24,000		167	%		46,000		64	%

     Our other income and expense is comprised of interest income, which we derive from our cash savings and interest expense which we incur on our debt and capitalized lease obligations. Interest income has increased due to increase in our rate of return compared to the same periods of 2004. Our interest expense has increased due to the addition of several capitalized leases in the last quarter of 2004. We expect that our interest income will decrease as we use cash in operations. We expect interest expense to be stable.

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Net loss

		Three Months Ended September 30,2005					Nine Months Ended September 30,2005
		$			% change vs. 3 months ended Sept. 30, 2004		$			% change vs. 9 months ended Sept. 30, 2004
Net loss			(678,000	)	77	%		(1,795,000	)	59	%

     During the three and nine months ended September 30, 2005 we continued to experience a net loss. While we have experienced growth in our net sales and our gross profit, these increases have not offset our increases in our operating expense, especially a significant increase in amortization of intangibles expense that has resulted from the investments we have made in our patent assets.

Loss per share
	Three Months Ended							Nine Months Ended
	September 30, 2005				September 30, 2004			September 30, 2005			September 30, 2004
Net loss		$	(678,406	)	$	(381,821	)	$	(1,794,594	)	$	(1,129,239	)
Net loss per share, basic and
diluted		$	(0.05	)	$	(0.04	)		(0.15	)		(0.10	)
Weighted average common
shares outstanding, basic and
diluted			12,285,046			10,908,607			11,856,517			10,885,137

     Our basic loss per share has increased due to the increased dollar value of our loss partially offset by an increase in the weighted average common shares outstanding in both periods of 2005 compared to 2004. Our shares have increased as we have used our common shares for an acquisition and to purchase patent assets. In addition, we have issued shares as the result of exercises of warrants by some of our investors as well as to pay certain legal fees. The “basic net loss per share” is computed by dividing the net loss, by the weighted average common shares outstanding.

LIQUIDITY AND CAPITAL RESOURCES

The Company’s cash flows and other key indicators of liquidity are summarized as follows:

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	Nine Months Ended
	September 30, 2005 (unaudited)				September 30, 2004 (unaudited)			% Change
Operating activities cash flows		$	(1,217,000	)	$	(1,218,000	)	0	%
Investing activities cash flows:			(269,000	)		(426,000	)	37	%
Financing activities cash flows			2,548,000			(33,000	)	7821	%
Working capital			3,518,000			2,627,000		34	%
Current ratio			6.84	x		5.87	x	17	%

     During the first nine months of 2005, we continued to use cash for operations at a rate consistent with the same period of 2004. Our operating cash flow loss during the first nine months of 2005 was primarily the result of our operating loss and our use of cash for insurance pre-payments and to increase our inventory levels. While our net loss has increased from 2004 levels, our cash flow has remained consistent due to the fact that our 2005 results are primarily negatively impacted by a large increase in non-cash depreciation and amortization expenses.

     During the first nine months of 2005, our investing activities used cash for investments in software, equipment and patents of $269,000, which was 37% less than the use of cash for investment during the first nine months of 2004. During 2005, we have been able to use our common stock to pay for investments in patents and contractual rights which we may not have otherwise been able to had we been required to pay in cash. The use of equity for our investments has allowed us to retain cash needed for operations during the early stages of our business without sacrificing the investments needed to secure our competitiveness in the future.

     Also during the first nine months of 2005, our financing activities resulted in cash inflows primarily from the issuance of our common stock to warrant holders who have exercised their right to buy our stock at prices ranging from $2.00 to $5.00. The proceeds from these investors support our operations. Since entering the document security business, we have funded a significant portion of our cash needs by issuing our securities.

     At September 30, 2005, we had cash and cash equivalents of approximately $3,720,000 along with restricted cash of $249,000. Our restricted cash is held as collateral for our current and long-term debt obligation which was approximately $230,000 at September 30, 2005. Our working capital as of September 30, 2005 was approximately $3,518,000 which was $891,000 or 34% higher than working capital at September 30, 2004. Our ability to improve our working capital position was based on our ability to use our securities to obtain funding and make investments in patent assets. Our working capital position is expected to deteriorate as long as we continue to lose money from operations. In order to support our existing and proposed operations, we may need additional financing. Although we have outstanding warrants to purchase our common stock with exercise prices below the current market price, there is no assurance that all or any of the warrants will be exercised. If the warrants are not exercised, we may be required to raise additional funds by borrowing or selling stock to meet our cash needs, and there is no guarantee that we will be able to raise such additional funds.

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ITEM 3 - CONTROLS AND PROCEDURES

     Evaluation of Disclosure Controls and Procedures. Our management, with the participation of our principal executive officer and principal accounting officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of the end of the period covered by this Quarterly Report on Form 10-QSB. Based on that evaluation, our principal executive officer and principal accounting officer have concluded that as of that date, our disclosure controls and procedures were designed to ensure that information required to be disclosed in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported with the time periods specified in applicable SEC rules and forms and were effective.

     In addition, there have been no changes in our internal controls or in other factors that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

PART II
OTHER INFORMATION

ITEM 1 - LEGAL PROCEEDINGS

     There were no significant developments during the first nine months of 2005 in connection with our intellectual property litigation against Adler Technologies and Andrew McTagger. This litigation commenced by us in January 2003, is described in our Form 10-KSB Annual Report for the year ended December 31, 2004. The case is in the late stage of discovery and it is still too soon to determine how the various issues raised by the lawsuit will be resolved. There can be no assurance that we will be successful in our suit against Adler and McTagger or that Adler’s counterclaims will not be upheld. If Adler is successful in all of its counterclaims, we may be adversely affected in our ability to market certain technology.

     We have been named as a defendant in a lawsuit entitled Frank LaLoggia v. Document Security Systems, Inc. (Index No. 05/8307 New York State Supreme Court, Monroe County) in which the plaintiff alleges that he is owed compensation in the amount of 3,000,000 shares of the Company’s Common Stock for services allegedly provided to the Company. The complaint asserts that the Company owes the shares as a result of efforts made by Mr. Frank LaLoggia under a movie consulting agreement dating from 1996. Management believes that the plaintiff has received all compensation which was due to him in relation to the former movie business. The Company believes that even if the plaintiff was owed any compensation for services, the number of shares would be determined on a post reverse stock split basis, which was effected several years ago (resulting in a claim for 15,000 shares). Management believes that the claims, which relate to the former movie production business of the Company when it was named New Sky Communications, Inc. and was operated by different senior management, are without merit and subject to valid defenses. The Company intends to vigorously defend this action and has asserted against the plaintiff counterclaims for money damages up to $800,000 arising out of and related to his conduct under that same agreement. The complaint was filed on July 26, 2005 and is currently in the discovery stage. There can be no assurance that we will be successful in our defense or in our counterclaims.

     On August 1, 2005 we commenced a suit against the European Central Bank alleging patent infringement by the European Central Bank and have claimed unspecified damages. The suit was brought by us in European Court of First Instance in Luxembourg. The Company alleges that all Euro banknotes in circulation infringe its European Patent 455750B1, which covers a method of incorporating an anti-counterfeiting feature into banknotes or similar security documents to protect against forgeries by digital scanning and copying devices. We are currently awaiting their defense.

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ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

     During the quarter ended March 31, 2005, the Company issued an aggregate of 541,460 shares of its common stock for the various legal ownership and economic interests in certain technology (patents and trade secrets) from 40 persons and entities who previously obtained these rights from the Wicker Family. The value of the shares of common stock was determined based upon the closing price of the shares of the Company’s common stock on the American Stock Exchange on February 15, 2005 ($7.25 per share) The total aggregate fair value of the acquisition of the interests from the interest holders was $3,925,585. The shares issued in the transaction are “restricted securities” within the meaning of Rule 144 of the Securities Act of 1933. We relied upon the exemption from registration under the Securities Act of 1933 provided by Section 4(2) thereof in connection with the issuance of the securities. We filed a registration statement with the Securities and Exchange Commission to register for resale 20% of the shares that were received by each Interest Holder, which was declared effective on August 9, 2005.

     During the quarter ended September 30, 2005, we issued 83,705 shares of our common stock pursuant to the exercise of our common stock purchase warrants. Net proceeds from the exercise of the warrants were approximately $332,000. Of the shares issued upon the exercise of warrants, 35,933 were issued at $5.00 per share for proceeds of $180,000, and 31,665 were issued at $4.80 per share for proceeds of $152,000. In addition, 16,107 shares were issued as a result of cashless exercise provisions of warrant agreements issued as part of our 2003 private placement of common stock and warrants. Pursuant to these cashless exercises, 19,068 warrants were cancelled. The proceeds were used to fund general operations. The shares issued pursuant to the exercise of the warrants have been registered with the Securities and Exchange Commission under an effective Form S-3. We relied upon the exemption from registration under the Securities Act of 1933 provided by Section 4(2) thereof in connection with the issuance of the securities

     On August 26, 2005, the Company agreed to issue 150,000 restricted shares to Strategic Resource Advisory Services, (“SRAS”), a subsidiary of IDT Corporation, in exchange for the payment of substantially all of the Company’s legal expenses that it will incur during the Company’s lawsuit with the European Central Bank. IDT Corporation is a related party to a member of the Company’s Board of Directors. The Company expects to issue the shares during its fiscal fourth quarter, and the shares will not be registered under the Securities Act of 1933.

     On September 9, 2005, the Company purchased Secured Document Systems (“SDS”) for 62,654 shares of its common stock. The value of the shares of common stock was determined based upon the closing price of the shares of the Company’s common stock on the American Stock Exchange on September 9, 2005 of $8.26 per share. SDS is an entity that holds various economic rights to several of the Company’s patents which it had previously obtained from the Wicker Family. The shares issued in the transaction were not registered under the Securities Act of 1933.

     We did not purchase any shares of our capital stock during the nine months ended September 30, 2005.

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ITEM 3 - DEFAULTS UPON SENIOR SECURITIES

     None

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     No matters were submitted to a vote of our security holders during the fiscal quarter ended September 30, 2005. We anticipate holding a meeting of shareholders in the fourth quarter of 2005.

ITEM 5 - OTHER INFORMATION

     None

ITEM 6 - EXHIBITS

     (a) Exhibits

	Item 31.1     Certifications of Chief Executive Officer Pursuant to Section 302of the Sarbanes Oxley Act
	Item 31.2     Certifications of Principal Accounting Officer Pursuant to Section302 of the Sarbanes Oxley Act
	Item 32.1     Certification of Chief Executive Officer Pursuant to Section 906of the Sarbanes Oxley Act
	Item 32.2     Certification of principal Accounting Officer Pursuant to Section906 of the Sarbanes Oxley Act

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SIGNATURES

     In accordance with the requirements of the Exchange Act, the registrant caused this report on Form 10-QSB to be signed on its behalf by the undersigned, thereunto duly authorized.

 

	DOCUMENT SECURITY SYSTEMS, INC.
November 14, 2005	By:	/s/ Patrick White
		Patrick White
		President, Chief Executive Officer and Acting Chief Financial Officer
November 14, 2005	By:	/s/ Philip Jones
		Philip Jones
		Controller/Principal Accounting Officer

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