IMAGEWARE SYSTEMS INC - Quarter Report: 2006 September (Form 10-Q)

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x                              QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2006

o                                 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT

For the transition period from         to

Commission file number 001-15757

IMAGEWARE SYSTEMS, INC.

(Exact Name of Registrant as Specified in Its Charter)

 

10883 Thornmint Road

San Diego, CA 92127

(Address of Principal Executive Offices)

 

(858) 673-8600

(Registrant’s Telephone Number, Including Area Code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of  “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-12 of the Exchange Act).  Yes o  No x

The number of shares of Common Stock, with $0.01 par value, outstanding on November 17, 2006 was 13,621,941.

IMAGEWARE SYSTEMS, INC. INDEX

PART I.	FINANCIAL INFORMATION
	ITEM 1.	FINANCIAL STATEMENTS (UNAUDITED)
		Condensed Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005
		Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2006 and 2005
		Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005
		Condensed Consolidated Statements of Comprehensive Income (Loss) for the three and nine months ended September 30, 2006 and 2005
		Notes to Condensed Consolidated Financial Statements
	ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	ITEM 3.	Quantitative and Qualitative Disclosures About Market Risk
	ITEM 4.	Controls and Procedures
PART II.	OTHER INFORMATION
	ITEM 1A.	Risk Factors
	ITEM 6.	Exhibits
SIGNATURES

 

2

PART I

FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

IMAGEWARE SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

(In Thousands, except share data)

		September 30, 2006			December 31, 2005
		(Unaudited)
ASSETS
Current Assets:
Cash		$	276		$	741
Accounts receivable, net of allowance for doubtful accounts of $477 (unaudited) and $478 at September 30, 2006 and December 31, 2005, respectively		967			1,340
Costs and estimated earnings in excess of billings on uncompleted contract		322			—
Inventory		91			208
Other current assets		294			219
Total Current Assets		1,950			2,508
Property and equipment, net		362			424
Other assets		779			738
Intangible assets, net of accumulated amortization		145			218
Goodwill		3,416			3,416
Total Assets		$	6,652		$	7,304
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
Accounts payable		$	1,511		$	690
Deferred revenue		1,635			1,084
Accrued expenses		1,054			1,035
Notes payable to third parties, net of discount		1,144			—
Total Current Liabilities		5,344			2,809
Pension obligation		1,199			1,130
Total Liabilities		6,543			3,939
Shareholders’ equity:
Preferred stock, $.01 par value, 4,000,000 shares authorized; 750,000 shares designated as Series B convertible redeemable preferred stock, 389,400 shares issued, and 239,400 (unaudited) and 249,400 shares outstanding at September 30, 2006 and December 31, 2005, respectively; liquidation preference $598,500 (unaudited) and $623,500 at September 30, 2006 and December 31, 2005, respectively		2			2
Common stock, $.01 par value, 50,000,000 shares authorized; 13,628,645 (unaudited) and 13,554,366 shares issued at September 30, 2006 and December 31, 2005, respectively, and 13,621,941 (unaudited) and 13,547,662 shares outstanding at September 30, 2006 and December 31, 2005, respectively		135			134
Additional paid in capital		68,954			67,650
Treasury stock, at cost - 6,704 shares		(64		)	(64		)
Accumulated other comprehensive income		(132		)	(35		)
Accumulated deficit		(68,786		)	(64,322		)
Total Shareholders’ equity		109			3,365
Total Liabilities and Shareholders’ Equity		$	6,652		$	7,304

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

3

---

IMAGEWARE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

(UNAUDITED)

		THREE MONTHS ENDED SEPTEMBER 30,						NINE MONTHS ENDED SEPTEMBER 30,
		2006			2005			2006			2005
Revenues:
Product		$	1,635		$	1,981		$	6,276		$	5,744
Maintenance		617			524			1,683			1,545
		2,252			2,505			7,959			7,289
Cost of revenues:
Product		501			613			1,695			2,068
Maintenance		213			255			718			750
Gross profit		1,538			1,637			5,546			4,471
Operating expenses:
General & administrative		1,176			1,162			3,587			3,524
Sales and marketing		989			955			3,095			2,719
Research & development		926			855			2,825			2,342
Depreciation and amortization		59			147			248			460
		3,150			3,119			9,755			9,045
Loss from operations		(1,612		)	(1,482		)	(4,209		)	(4,574		)
Interest expense (income), net		156			(31		)	339			(42		)
Other income, net		(5		)	(86		)	(111		)	(135		)
Loss from continuing operations before income taxes		(1,763		)	(1,365		)	(4,437		)	(4,397		)
Income tax expense (benefit)		—			—			—			—
Loss from continuing operations		(1,763		)	(1,365		)	(4,437		)	(4,397		)
Discontinued operations:
Gain from operations of discontinued Digital Imaging Asia Component (including gain on disposal of $233 in 2005)		—			—			—			223
Income tax benefit (expense)		—			—			—			—
Gain on discontinued operations		—			—			—			223
Net loss		$	(1,763	)	$	(1,365	)	$	(4,437	)	$	(4,174	)
Basic and diluted loss per common share - see note 3		$	(0.13	)	$	(0.10	)	$	(0.33	)	$	(0.34	)
Weighted-average shares (basic and diluted)		13,604,692			13,209,856			13,574,835			12,456,194

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

4

---

IMAGEWARE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(UNAUDITED)

		Nine Months Ended September 30,
		2006			2005
Cash flows from operating activities
Net loss		$	(4,437	)	$	(4,174	)
Adjustments to reconcile net loss to net cash used in operating activities
Depreciation and amortization		248			462
Gain on sale of subsidiary		—			(233		)
Non cash interest and amortization of debt discount and debt issuance costs		284			—
Stock based compensation		912			209
Provision for losses on accounts receivable		14			—
Change in assets and liabilities
Accounts receivable, net		359			2
Costs and estimated earnings in excess of billings on uncompleted contracts		(322		)	—
Inventory		117			244
Other current assets		(35		)	(15		)
Intangible and other assets		(68		)	41
Accounts payable		821			(499		)
Accrued expenses		(7		)	(464		)
Deferred revenue		551			105
Contract costs		—			(424		)
Pension obligation		69			(28		)
Total adjustments		2,943			(600		)
Net cash used in operating activities		(1,494		)	(4,774		)
Cash flows from investing activities
Purchase of property and equipment		(113		)	(244		)
Proceeds from sale of subsidiary net of cash sold and direct transaction costs		—			1,209
Net cash provided by (used in) investing activities		(113		)	965
Cash flows from financing activities
Repayment of notes payable		(215		)	(17		)
Proceeds from issuance of notes payable with warrants		1,550			—
Debt issuance costs		(98		)	—
Proceeds from issuance of common stock, net of issuance costs					3,234
Proceeds from exercised stock options		—			63
Dividends paid		(26		)	(26		)
Net cash provided by financing activities		1,211			3,254
Effect of exchange rate changes on cash		(69		)	(127		)
Net decrease in cash		(465		)	(682		)
Cash at beginning of period		741			2,912
Cash at end of period		$	276		$	2,230
Supplemental disclosure of cash flow information:
Cash paid for interest		$	35		$	—
Summary of non-cash investing and financing activities:
Exchange of common shares for marketable equity securities		$	—		$	231

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

5

---

IMAGEWARE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(IN THOUSANDS)

(UNAUDITED)

		THREE MONTHS ENDED SEPTEMBER 30,						NINE MONTHS ENDED SEPTEMBER 30,
		2006			2005			2006			2005
Net loss		$	(1,763	)	$	(1,365	)	$	(4,437	)	$	(4,174	)
Other comprehensive income (loss):
Unrealized loss on securities:
Unrealized holding gain (losses) arising during the period		(28		)	15			(28		)	(113		)
Foreign currency translation adjustment		(35		)	(1		)	(69		)	(126		)
Comprehensive loss		$	(1,826	)	$	(1,351	)	$	(4,534	)	$	(4,413	)

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

6

IMAGEWARE SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1.  DESCRIPTION OF BUSINESS AND OPERATIONS

ImageWare Systems, Inc. (the “Company”), formerly known as ImageWare Software, Inc., utilizes identity management technology to provide stand alone, networked and web-based software solutions for secure credentials, biometrics, law enforcement and professional photography.

Basis of Presentation

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

The accompanying condensed consolidated unaudited financial statements of ImageWare have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for annual financial statements and should be read in conjunction with the consolidated financial statements for the year ended December 31, 2005, and notes thereto included in the Company’s Annual Report on Form 10-KSB, filed with the SEC on April 17, 2006, as amended on May 1, 2006. In the opinion of management, the accompanying condensed consolidated financial statements contain all adjustments, consisting only of adjustments of a normal recurring nature, necessary for a fair presentation of the Company’s financial position as of September 30, 2006, and its results of operations for the periods presented. These condensed consolidated unaudited financial statements are not necessarily indicative of the results to be expected for the entire year.

Going Concern

As reflected in the accompanying condensed consolidated financial statements, the Company has continuing losses and negative cash flows from operations. These matters raise doubt about the Company’s ability to continue as a going concern.

New financing will be required to fund working capital and operations should the Company be unable to generate positive cash flow from operations in the near future. The Company is exploring the possible sale of equity securities and/or debt financing, and believes that additional financing will be available under terms and conditions that are acceptable to the Company. However, there can be no assurance that additional financing will be available. In the event financing is not available in the time frame required, the Company will be forced to reduce its rate of growth, if any, reduce operating expenses, curtail sales and marketing activities and reschedule research and development projects. In addition, the Company might be required to sell certain of its assets or license its technologies to others. These actions, while necessary for the continuance of operations during a time of cash constraints and a shortage of working capital, could adversely affect the Company’s business.

As a result of the Company’s continuing losses and negative cash flows from operations, the Company currently does not meet certain listing standards of the American Stock Exchange (AMEX) Company Guide.  As a result, the Company may be considered for suspension or delisting from AMEX.  During May 2006, we received notification from AMEX that we were not in compliance with certain sections of the AMEX Company Guide.  To maintain an AMEX listing, we were required to submit a plan to AMEX which demonstrates our ability to regain compliance with the continued listing standards within a maximum of 18 months.  We submitted our plan to AMEX during June 2006.  The Listing Qualifications Department of AMEX evaluated our plan and in September 2006 notified us that we had made a reasonable demonstration in the plan of an ability to regain compliance with the continued listing standards by the end of the plan periods which AMEX determined to be Novembeer 15, 2006 for Section 1003(a)(iv) of the AMEX Company Guide and November 30, 2007 for Sections 1003(a)(i), 10033(a)(ii) and 1003(a)(iii) of the AMEX Company Guide.   Accordingly,  in September 2006, AMEX notified us that they would continue the listing of the Company subject to us making a public announcement disclosing the fact that we are not in compliance with the continued listing standards of the Exchange and that our listing is being continued pursuant to an extension and our providing certain supporting documentation of key elements of our plan.  We made the required public announcement and provided the requested information.  We are subject to periodic review to determine if we

7

---

are making progress consistent with the plan0.  Failure to make progress consistent with the plan or regain compliance with the continued listing standards by the end of the applicable extension periods could result in the AMEX initiating delisting proceedings pursuant to Section 1009 of the AMEX Company Guide.  There is no assurance that we will make progress consistent with the plan, or that we will be able to continue our listing on AMEX. 

In view of the matters described in the preceding paragraphs, recoverability of a major portion of the recorded asset amounts shown in the accompanying condensed consolidated balance sheets is dependent upon continued operations of the Company, which, in turn, is dependent upon the Company’s ability to continue to raise capital and generate positive cash flows from operations. The condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or amounts and classifications of liabilities that might be necessary should the Company be unable to continue its existence.

The Company operates in markets that are emerging and highly competitive. There is no assurance that the Company will operate at a profit in the future.

Recently Issued Accounting Standards

In July 2006, Financial Accounting Standards Board Interpretation (FIN) No. 48 “Accounting for Uncertainty in Income Taxes-an Interpretation of FASB No. 109,” was issued.  FIN No. 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, and disclosure requirements for uncertain tax positions.  FIN No. 48 is effective for years beginning after December 15, 2006.  The adoption of FIN No. 48 is not expected to have a material impact on the Company’s financial position, cash flows, or results of operations.

In September 2006, the FASB issued Statement of Financial Accounting Standard 157 “Fair Value Measurements” (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. FAS 157 applies under other accounting pronouncements that require or permit fair value measurements. Accordingly, FAS 157 does not require any new fair value measurements. However, for some entities, the application of FAS 157 will change current practice. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We have not yet determined the impact of FAS 157 on our consolidated financial position, results of operations, cash flows or financial statement disclosures.

In September 2006, the FASB issued Statement of Financial Accounting Standard 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“FAS 158”). FAS 158 requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur through comprehensive income. It also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions. Under FAS 158, the requirement to initially recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures is effective for us as of the end of our first fiscal year ending after December 15, 2006. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for us for our first fiscal year ending after December 15, 2008. We have not yet determined the impact of FAS 158 on our consolidated financial position, results of operations, cash flows or financial statement disclosures.

In September 2006, the SEC staff issued Staff Accounting Bulletin, or SAB, No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements”, (“ SAB 108”). SAB 108 provides guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of determining whether the current year’s financial statements are materially misstated. SAB 108 is effective for fiscal years ending after November 15, 2006. We will initially apply the provisions of SAB 108 in connection with the preparation of our annual financial statements for the year ending December 31, 2006. We have evaluated the potential impact that SAB 108 may have on our financial statements and do not believe the impact of the application of this guidance will be material.

Reclassifications

Certain reclassifications have been made to the prior period balances in order to conform to the current period presentation.

NOTE 2. STOCK BASED COMPENSATION

At September 30, 2006, the Company had three stock-based compensation plans for employees and nonemployee directors which authorize the granting of various equity-based incentives including stock options and restricted stock.

Prior to January 1, 2006, the Company accounted for the measurement and recognition of stock-based compensation under the provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations,

8

---

 

permitted under Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation” (SFAS No. 123). As a result, employee stock option based compensation was included as a pro forma disclosure in the Notes to the Company’s financial statements for prior year periods.

Prior to the adoption of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment”, (SFAS No. 123(R)), the Company provided the disclosures required under SFAS No. 123. The pro forma effect on net income and net income per share as if the fair value of stock-based compensation had been recognized as compensation expense for the three and nine month periods ending September 30, 2005 was as follows:

		Three Months Ended September 30,			Nine Months Ended September 30,
(In thousands, except per share data)		2005			2005
Net Loss:
As reported		$	(1,365	)	$	(4,174	)
Stock-based compensation included in net loss		$	70		$	209
Stock-based employee compensation under fair value based method		$	(196	)	$	(480	)
Pro forma net loss		$	(1,491	)	$	(4,445	)
Basic loss per common share:
As reported		$	(0.10	)	$	(0.34	)
Pro forma		$	(0.11	)	$	(0.36	)

 

On January 1, 2006, the Company adopted the provisions of SFAS 123(R) using the modified prospective transition method.  SFAS 123(R) requires companies to measure and recognized the cost of employee services received in exchange for awards of equity instruments based on the grant date fair value of those awards. For share option instruments issued subsequent to the adoption of SFAS 123(R), compensation cost is recognized ratably using the straight-line attribution method over the expected vesting period. For equity options issued prior to the adoption of SFAS 123(R), compensation cost is recognized using a graded vesting attribution method. In addition, pursuant to SFAS 123(R), we are required to estimate the amount of expected forfeitures when calculating compensation costs, instead of accounting for forfeitures as incurred, which was our previous method. Prior periods are not restated under this transition method. Options previously awarded and classified as equity instruments continue to maintain their equity classification under SFAS 123(R).

The effect of recording stock-based compensation for the three and nine months ended September 30, 2006 was as follows:

		Three Months Ended September 30,			Nine Months Ended September 30,
(In thousands, except per share data)		2006			2006
Stock-based compensation expense by type of award:
Employee stock options		$	143		$	607
Restricted stock grants		$	102		$	305
Total employee stock based compensation		$	245		$	912
Tax effect on stock-based compensation		—			—
Tax effect on net income		—			—
Stock-based compensation included in net loss		$	245		$	912
Effect on loss per common share:
Basic		$	(0.02	)	$	(0.07	)
Diluted		$	(0.02	)	$	(0.07	)

 

Prior to adopting SFAS No. 123(R), the Company presented all excess tax benefits, if any, resulting from the exercise of stock options as operating cash flows in the Statement of Cash Flows. SFAS No. 123(R) requires cash flows resulting from excess tax benefits to be classified as a financing activity. Excess tax benefits are realized from tax deductions for exercised options in excess of the deferred tax asset attributable to stock compensation costs for such options. The Company did not record any excess tax benefits as a result of adopting SFAS 123(R) in the three and nine months ended

9

---

September 30, 2006 because the Company is currently providing a full valuation on future tax benefits realized in the United States until it can sustain a level of profitability that demonstrates its ability to utilize the assets.

SFAS No. 123(R) requires the use of a valuation model to calculate the fair value of stock-based awards. For the three and nine months ended September 30, 2006, the Company has elected to use the Black-Sholes option-pricing model, which incorporates various assumptions including volatility, expected life, and interest rates. The Company is required to make various assumptions in the application of the Black-Sholes option pricing model. The Company has determined that the best measure of expected volatility is based on the historical weekly volatility of the Company’s common stock. Historical volatility factors utilized in the Company’s Black-Sholes computations range from 83.5% to 98.5%. The Company has elected to estimate the expected life of an award based upon the SEC approved “simplified method” noted under the provisions of Staff Accounting Bulletin No. 107. Under this formula, the expected term is equal to: ((weighted-average vesting term + original contractual term)/2). The expected term used by the Company as computed by this method range from 3.5 years to 6.1 years. The interest rate used is the risk free interest rate and is based upon U. S. Treasury rates appropriate for the expected term. Interest rates used in the Company’s Black-Sholes calculations range from 2.7% to 4.6%. Dividend yield is zero as we do not expect to declare any dividends on our common shares in the foreseeable future.

A summary of the activity under the Company’s stock option plans for the nine months ended September 30, 2006 is as follows:

		Options		Weighted- Average Exercise Price			Weighted- Average Remaining Contractual Term (Years)
Balance at December 31, 2005		1,474,093		$	2.68		8.20
Granted		363,000		$	1.90		9.41
Forfeited		(181,629	)	$	3.08		6.03
Exercised		—		$	—		—
Balance at September 30, 2006		1,655,464		$	2.46		8.03

 

Options exercisable at September 30, 2006 totaled 788,081 at a weighted-average price of $2.68, with a remaining weighted average contractual term of approximately 7.1 years.

The weighted-average grant date fair value of options granted during the three and nine months ended September 30, 2006 was $1.23 and $1.38, respectively.

The following table sets forth a summary of the status and changes of the Company’s unvested shares related to its stock option plans as of and during the nine months ended September 30, 2006:

		Options		Weighted- Average Grant Date Fair Value Per Share
Balance at December 31, 2005		849,930		$	1.82
Granted		363,000		$	1.38
Vested		(279,209	)	$	1.78
Forfeited		(63,445	)	$	1.95
Balance at September 30, 2006		870,276		$	1.65

 

At September 30, 2006, the total remaining unrecognized compensation cost related to unvested stock options amounted to approximately $817,074, which will be amortized over the weighted-average remaining requisite service period of 1.87 years.

10

---

 

NOTE 3.  NET LOSS PER COMMON SHARE

Basic loss per common share is calculated by dividing net loss available to common shareholders for the period by the weighted-average number of common shares outstanding during the period. Diluted earnings per common share is calculated by dividing net loss available to common shareholders for the period by the weighted-average number of common shares outstanding during the period, adjusted to include, if dilutive, potential dilutive shares consisting of convertible preferred stock, stock options and warrants, calculated using the treasury stock method. During the periods ended September 30, 2006 and 2005, the Company has excluded the following securities from the calculation of diluted loss per share, as their effect would have been antidilutive due to the Company’s net loss:

Potential Dilutive Securities:		Number of Common Shares Convertible into at September 30, 2006		Number of Common Shares Convertible into at September 30, 2005
Convertible preferred stock		45,384		47,280
Stock options		793,741		589,577
Warrants		4,680,805		4,469,578

 

The following table sets forth the computation of basic and diluted loss per share for the three and nine month periods ended September 30, 2006 and 2005 (amounts in thousands except share and per share amounts):

		THREE MONTHS ENDED SEPTEMBER 30,						NINE MONTHS ENDED SEPTEMBER 30,
		2006			2005			2006			2005
Numerator — loss from continuing operations:
Net loss from continuing operations		$	(1,763	)	$	(1,365	)	$	(4,437	)	$	(4,397	)
Less Series B preferred dividends		(13		)	(13		)	(40		)	(40		)
Net loss from continuing operations available to common shareholders		$	(1,776	)	$	(1,378	)	$	(4,477	)	$	(4,437	)
Numerator — gain (loss) from discontinued operations:
Net gain (loss) discontinued operations		—			—			—			223
Denominator
Weighted-average shares outstanding		13,604,692			13,209,856			13,574,835			12,456,194
Basic and diluted loss per share:
Loss from continuing operations		$	(0.13	)	$	(0.10	)	$	(0.33	)	$	(0.36	)
Discontinued operations		—			—			—			0.02
Net loss per share		$	(0.13	)	$	(0.10	)	$	(0.33	)	$	(0.34	)

 

NOTE 4.  SEGMENT INFORMATION

The Company is comprised of three reportable segments: Law Enforcement, Identification and Digital Photography. The Law Enforcement segment develops, sells and supports identity management technology used to create booking and investigative software used by law enforcement and public safety agencies to manage criminal history records and investigate crime. The Identification segment develops, sells and supports software and designs systems which utilize identity management technology in the production of smart and secure identification systems and documents. The Digital Photography segment develops digital imaging software for photographic purposes.

Corporate assets are comprised primarily of cash and other assets providing benefits to all business segments.

There are no significant intersegment transactions.

The table below summarizes information about reportable segments for the three and nine months ended September 30, 2006 and 2005:

11

---

 

		THREE MONTHS ENDED SEPTEMBER 30,						NINE MONTHS ENDED SEPTEMBER 30,
		2006			2005			2006			2005
		(in thousands) (unaudited)						(in thousands) (unuadited)
Net Revenue:
Law Enforcement		$	746		$	719		$	2,821		$	2,326
Identification		1,431			1,123			4,987			4,144
Digital Photography		75			163			151			319
Corporate		—			500			—			500
Total consolidated net sales		$	2,252		$	2,505		$	7,959		$	7,289
Operating loss:
Law Enforcement		$	(523	)	$	(971	)	$	(1,357	)	$	(2,547	)
Identification		(975		)	(903		)	(2,506		)	(2,031		)
Digital Photography		(114		)	(108		)	(346		)	(496		)
Corporate		—			500			—			500
Other unallocated amounts:
Interest expense (income)		156			(31		)	339			(42		)
Other expense (income)		(5		)	(86		)	(111		)	(135		)
Income (loss) before taxes		$	(1,763	)	$	(1,365	)	$	(4,437	)	$	(4,397	)

 

		September 30, 2006
		(in thousands)
Total Assets by Segment:
Law Enforcement		$	460
Identification		5,330
Digital Photography		40
Total assets for reportable segments		5,830
Corporate		822
Total consolidated assets		$	6,652

 

NOTE 5. CONTRACT COSTS

The Company recognizes sales and cost of sales on long-term, fixed price contracts involving significant amounts of customization using the percentage of completion method based on costs incurred to date compared to total estimated costs at completion.  Such amounts are included in the accompanying Balance Sheets at September 30, 2006 and December 31, 2005 under the caption “Costs and estimated earnings in excess of billings on uncompleted contract.”

Costs and estimated billings on uncompleted contracts and related amounts billed as of September 30, 2006 and December 31, 2005 are as follows:

($ in thousands)		September 30,  2006			December 31,  2005
Costs incurred on uncompleted contract		$	157		$	—
Estimated earnings		165			—
		322			—
Less: Billings to date		—			—
		$	322		$	—

 

 

12

NOTE 6. NOTES PAYABLE

In March 2006, the Company completed a secured debt financing in the aggregate amount of $1,550,000, with net proceeds to Company approximating $1,452,000. The Company issued a series of secured promissory notes aggregating $1,550,000 which bear interest at 8% per annum, with interest compounded monthly and payable quarterly. The principal balance becomes due in one year or earlier upon the occurrence of the following contractually defined events: (i) payments received by the Company in connection with contracts with Grupo Inffinix and Argus Solutions or any affiliate thereof, or any extension, renewal or amendment of such contracts; or (ii) payments made against any new contract signed by the Company which contract amount is in excess of $1,500,000; or (iii) the receipt by the Company of proceeds from the sale of equity or equity-linked securities by the Company; or (iv) receipt of proceeds from the issuance by the Company of any type of debt instruments, including lines of credit. In addition, the Company may prepay the notes in whole or in part upon five days prior written notice.

As a condition to the loan, the Company entered into a security agreement whereby the Company granted a security interest in all of the Company’s goods and equipment, inventory, contract rights and general intangibles, accounts or other obligations owing to the Company, and cash deposit accounts and other investment property to secure payment of the note.

As a condition to the loan, the Company also issued warrants to purchase 387,500 shares of the Company’s common stock. Such warrants have a 5-year term and an exercise price $2.30 per share. Common shares underlying the warrants have piggyback registration rights and cashless exercise after 12 months from closing date if there is no effective registration statement covering the underlying shares.

The Company recorded the secured debt financing net of a discount equal to the fair value allocated to the warrants using the relative fair value method of approximately $419,000. The Company estimated the fair value of the warrants using the Black-Sholes option pricing model and the following assumptions: term of 5 years, a risk free interest rate of 4.52%, a dividend yield of 0%, and volatility of 82%.  During the three and nine months ended September 30, 2006, the Company recorded approximately $105,000 and $227,000 respectively in debt discount amortization which is included as a component of net interest expense in the Company’s Condensed Consolidated Statement of Operations.

NOTE 7. COMMON STOCK

During the three months ended September 30, 2006, the Company issued 18,096 shares of its common stock pursuant to stock-based compensation agreements with certain employees and issued 1,895 shares of its common stock pursuant to the conversion of 10,000 shares of Series B Preferred Stock.

NOTE 8. SUBSEQUENT EVENT

On November 14, 2006, the Company entered into a Securities Purchase Agreement with certain accredited investors (the "Investors") pursuant to which the Company sold to the Investors an aggregate of 2,300 shares of the Company’s Series C 8% Convertible Preferred Stock (the "Series C") at a stated value of $1,000 per share for aggregate gross proceeds of $2,300,000, and issued to the Investors warrants (the "Investor Warrants") to purchase up to an aggregate of 115,000 shares of common stock of the Company with an exercise price of $1.575 per share (the "Financing"). In connection with the Financing, the Company issued to a placement agent and its affiliates warrants to purchase an aggregate of 40,000 shares of common stock of the Company with exercise prices of $1.575 per share (the "Placement Agent Warrants" and, together with the Investor Warrants, the "Warrants"). In connection with the Financing, the Company also entered into a registration rights agreement (the "Registration Rights Agreement") with certain of the Investors, and has agreed to enter into the Registration Rights Agreement with the remaining Investors, pursuant to which the Company has agreed to file a registration statement with the Securities and Exchange Commission covering the resale of certain shares of common stock into which the Series C are convertible as well as the shares of common stock issuable upon exercise of the Placement Agent Warrants. The material terms of the Securities Purchase Agreement, the Registration Rights Agreement, the Warrants and the transactions contemplated thereby were described in the Company’s Form 8-K filed on November 20, 2006 (incorporated by reference into this Report).

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. All forward-looking statements included in this report are based on information available to us as of the date hereof and we assume no obligation to update any forward-looking statements. Forward-looking statements involve known or unknown risks, uncertainties and other factors, which may cause our actual results, performance or achievements, or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include but are not limited to those items discussed under “Risk Factors” beginning on page 24 and elsewhere in this Quarterly Report.

The following discussion of the financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements included elsewhere within this Quarterly Report. Fluctuations in annual and quarterly results may occur as a result of factors affecting demand for our products such as the timing of new product introductions by us and by our competitors and our customers’ political and budgetary constraints. Due to such fluctuations, historical results and percentage relationships are not necessarily indicative of the operating results for any future period.

13

---

OVERVIEW

ImageWare Systems, Inc. utilizes identity management technology to develop software used to create booking and investigative software, smart and secure identification systems and documents, and software for professional photographers. Our software systems and associated hardware enable our customers to quickly capture, archive, search, retrieve and share digital photographs and associated text records. The following management’s discussion and analysis is based primarily upon our Law Enforcement, Identification and Digital Photography products.

CRITICAL ACCOUNTING ESTIMATES

The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principals generally accepted in the United States of America, or U.S. GAAP. The preparation of these financial statements in accordance with U.S. GAAP requires us to utilize accounting policies and make certain estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingencies as of the date of the financial statements and the reported amounts of revenue and expenses during a fiscal period. The SEC considers an accounting policy to be critical if it is important to a company’s financial condition and results of operations, and if it requires significant judgment and estimates on the part of management in its application. Although we believe that our judgments and estimates are appropriate and correct, actual results may differ from those estimates.

The following are our critical accounting policies because we believe they are both important to the portrayal of our financial condition and results of operations and require critical management judgments and estimates about matters that are uncertain. If actual results or events differ materially from those contemplated by us in making these estimates, our reported financial condition and results of operations for future periods could be materially affected.

Revenue Recognition

Our revenue recognition policy is significant because our revenue is a key component of our consolidated results of operations. We recognize revenue from the following major revenue sources:

·      Long-term fixed-price contracts involving significant customization

·      Fixed-price contracts involving minimal customization

·      Software licensing

·      Sales of computer hardware and identification media

·      Postcontract customer support (PCS)

The Company’s revenue recognition policies are consistent with U. S. GAAP including Statements of Position 97-2 “Software Revenue Recognition” and 98-9 “Modification of SOP 97-2, Software Revenue Recognition With Respect to Certain Transactions”, Securities and Exchange Commission Staff Accounting Bulletin 104 , Emerging Issues Task Force Issue 00-21 “Revenue Arrangements with Multiple Deliverables”, and Emerging Issues Task Force Issue 03-05 “Applicability of AICPA Statement of Position 97-2 to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software”. Accordingly, the Company recognizes revenue when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the fee is fixed or determinable, and collectibility is reasonable assured.

We recognize revenue and profit as work progresses on long-term, fixed-price contracts involving significant amount of hardware and software customization using the percentage of completion method based on costs incurred to date compared to total estimated costs at completion. Revenue from contracts for which we cannot reliably estimate total costs or there are not significant amounts of customization are recognized upon completion. Determining when a contract should be accounted for using the percentage of completion method involves judgment. Critical items that are considered in this process are the degree of customization and related labor hours necessary to complete the required work as well as ongoing estimates of the future labor hours needed to complete the contract. We also generate non-recurring revenue from the licensing of our software. Software license revenue is recognized upon the execution of a license agreement, upon deliverance, fees are fixed and determinable, collectibility is probable and when all other significant obligations have been fulfilled. We also generate

14

---

revenue from the sale of computer hardware and identification media. Revenue for these items is recognized upon delivery of these products to the customer. Our revenue from periodic maintenance agreements is generally recognized ratably over the respective maintenance periods provided no significant obligations remain and collectibility of the related receivable is probable.

Allowance for Doubtful Accounts

Our management must make estimates of the uncollectibility of our accounts receivables. Management specifically analyzes accounts receivable and analyzes historical bad debts, customer concentrations, customer creditworthiness, current economic trends, the age of the accounts receivable balances, and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Our accounts receivables balance was approximately $1,444,000 and our allowance for doubtful accounts was approximately $477,000 as of September 30, 2006.

Valuation Of Goodwill And Other Intangible Assets

We assess impairment of goodwill and identifiable intangible assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

·              Significant underperformance relative to historical or expected future operating results;

·              Significant changes in the manner of our use of the acquired assets or the strategy of our overall business;

·              Significant negative industry or economic trends;

When we determine that the carrying value of goodwill and other intangible assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure any impairment based upon fair value methodologies. Goodwill and other net intangible assets amounted to approximately $3,561,000 as of September 30, 2006.

In 2002, Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” became effective, and as a result we ceased to amortize goodwill. In lieu of amortization, we performed an initial impairment review of our goodwill in June 2002 and an annual impairment review thereafter in the fourth quarter of our fiscal year. Completion of our initial impairment test indicated there was no goodwill impairment. We also performed our annual impairment review as of December 31, 2004 and 2005, based upon our 2005 and 2006 operating plans, respectively. This annual impairment review indicated there was goodwill impairment in our Digital Photography segment as of December 31, 2005, and accordingly, we have recorded an impairment loss in the 2005 Consolidated Statement of Operations. Both of these tests were conducted by determining and comparing the fair value of our reporting units, as defined in SFAS 142, to the reporting unit’s carrying value as of that date. Our reporting units are Law Enforcement, Identification and Digital Photography. We determined that as of September 30, 2006 there were no indicators of potential impairment. There are many management assumptions and estimates underlying the determination of an impairment loss, and estimates using different, but reasonable, assumptions could produce significantly different results. Significant assumptions include estimates of future levels of revenues and operating expenses. Therefore, the timing and recognition of impairment losses by us in the future, if any, may be highly dependent upon our estimates and assumptions. There can be no assurance that goodwill impairment will not occur in the future.

We account for long-lived assets in accordance with the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”  This statement requires that long-lived assets and certain identifiable intangible assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount which the carrying amount of the assets exceeds the fair value of the assets. Fair value is determined based on discounted cash flows or appraised values, depending upon the nature of the asset. Assets to be disposed of are reported at the lower of the carrying amount of fair value less costs to sell. In 2005, we recorded an impairment charge of approximately $253,000 related to our intangible asset for certain trademark and tradenames carried in our Identification segment. This loss reflects the amount by which the carrying value of this asset exceeded its estimated fair value determined by the assets’ future discounted cash flows. The impairment loss is recorded as a component of “Operating expenses” in the Statement of Operations for 2005. We determined that as of September 30, 2006 there were no indicators of potential impairment. There are many management assumptions and estimates underlying the

15

---

determination of an impairment loss, and estimates using different, but reasonable, assumptions could produce significantly different results. Significant assumptions include estimates of future levels of revenues and operating expenses. Therefore, the timing and recognition of impairment losses by us in the future, if any, may be highly dependent upon our estimates and assumptions. There can be no assurance that intangible asset impairment will not occur in the future.

Stock-Based Compensation

Upon adoption of SFAS 123R on January 1, 2006, we began estimating the value of employee stock options on the date of grant using the Black-Scholes model. Prior to the adoption of SFAS 123R, the value of each employee stock option was estimated on the date of grant using the Black-Scholes model for the purpose of the pro forma financial disclosure in accordance with SFAS 123. The determination of fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to the expected stock price volatility over the term of the awards and the actual and projected employee stock option exercise behaviors. The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination behavior. We calculated our expected volatility assumption required in the Black-Scholes model based on the historical volatility of our stock. As of January 1, 2006 we have adopted the modified prospective transition method and its effect is included in our three and nine month financial statements for the period ended September 30, 2006.

RESULTS OF OPERATIONS

THREE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005.

		THREE MONTHS ENDED SEPTEMBER 30,
Net Product Revenues		2006			2005			$ Change			% Change
(dollars in thousands)
Product revenues:
Law Enforcement		$	232		$	225		$	7		3	%
Percentage of total net product revenue		14		%	11		%
Identification		$	1,328		$	1,106		$	222		20	%
Percentage of total net product revenue		81		%	56		%
Digital Photography		$	75		$	150		$	(75	)	(50	)%
Percentage of total net product revenue		5		%	8		%
Patent Licensing		—			500			(500		)	(100	)%
Percentage of total net product revenue		0		%	25		%
Total net product revenues		$	1,635		$	1,981		$	(346	)	(17	)%

 

The increase in our Law Enforcement product revenues is due to the deployment of our Crime Capture System to law enforcement agencies.  We believe that continued incidents of terrorism has created heightened interest in the ability of law enforcement and other government agencies to be able to efficiently retrieve, analyze and share information from their respective criminal databases.  We anticipate that these factors will increase the overall demand for our law enforcement products and software; however, we cannot predict the timing of the shift in demand.

16

---

Identification revenues generated by our San Diego and Canadian offices increased approximately $444,000 or 50% for the three months ended September 30, 2006 as compared to the corresponding period in 2005.  This increase in revenue is reflective of increased sales of our Biometric Engine and Identification software products in project-oriented work and revenues generated by our IWS Desktop Security products (released in the fourth quarter of 2005), offset by decreases in products sold through our distribution channel.  Identification revenues generated by our German sales office decreased approximately $222,000.  This decrease is reflective of our decision to reorganize our German sales office by closing our existing facility in order to reduce operating expenses.  We intend to pursue project sales opportunities in areas serviced by this office through geographically dedicated sales personnel.  We are of the opinion that foreign markets formerly served by this office will embrace our identification and biometric solutions for large-scale high-end installations.

We continue to be of the opinion that government agencies and private entities will react to heightened security concerns resulting from acts of terrorism by re-evaluating and upgrading their ability to positively identify and track their citizens, employees, consultants and visitors. We anticipate that these factors will increase overall demand for our identification products; however, we cannot predict the timing of the shift in demand.

We feel that we are well positioned for participation in one or more large-scale domestic or international projects which will enable our company to achieve significant product revenue growth in our Identification segment.  In the past twelve months we have retooled our identification products to enable customization for large project applications, added the biometric engine for incorporation into large scale biometric installations and reoriented our organization to direct our resources and capabilities toward establishing a foothold in the market for large-scale secure identification solutions.

The decrease in Digital Photography product revenues is due to lower sales of boxed software during the three months ended September 30, 2006 as compared to the comparable period of 2005.  While we devoted substantial research and development resources upgrading our suite of Digital Photography product offerings in 2005 and 2006, we anticipate that because of changing market dynamics and competitive pressures, product revenues for our Digital Photography segment will not reach 2005 levels.

Our backlog of product orders as of September 30, 2006 was approximately $1,047,000.  At September 30, 2006, we also had maintenance and support backlog of approximately $1,402,000 under existing maintenance agreements.  Product revenue is typically recognized within a three to six month time period depending upon the required degree of customization, if any.  Historically, we have experienced a very minimal risk of order cancellation.  Our revenue from maintenance agreements is generally recognized ratably over the respective maintenance periods provided no significant obligations remain and collectibility of the related receivable is probable.

		THREE MONTHS ENDED SEPTEMBER 30,
Maintenance Revenues		2006			2005			$ Change			% Change
(dollars in thousands)
Maintenance revenues:
Law Enforcement		$	514		$	494		$	20		4	%
Percentage of total net maintenance revenue		83		%	94		%
Identification		$	103		$	17		$	86		506	%
Percentage of total net maintenance revenue		17		%	3		%
Digital Photography		$	—		$	13		$	(13	)	(100	)%
Percentage of total net maintenance revenue		0		%	3		%
Total net maintenance revenues		$	617		$	524		$	93		18	%

 

The increase in Law Enforcement maintenance revenues is due to the expansion of our installed base in the Law Enforcement market.

The increase in Identification maintenance revenues is due to software maintenance on domestic identification projects.

17

---

Our decrease in Digital Photography maintenance revenues as compared to the corresponding period in 2005 is reflective of the expiration of software maintenance on custom contract programming projects.

		THREE MONTHS ENDED SEPTEMBER 30,
Cost of Product Revenues:		2006			2005			$ Change			% Change
(dollars in thousands)
Cost of Product Revenues:
Law Enforcement		$	165		$	137		$	28		20	%
Percentage of Law Enforcement product revenue		71		%	61		%
Identification		$	333		$	470		$	(137	)	(29	)%
Percentage of Identification product revenue		25		%	43		%
Digital Photography		$	3		$	6		$	(3	)	(50	)%
Percentage of Digital Photography product revenue		4		%	4		%
Patent Licensing		—			—
Percentage of Patent Licensing product revenue		0		%	0		%
Total net product revenues		$	501		$	613		$	(112	)	(18	)%
Percentage of total product revenues		31		%	31		%

 

The increase in the cost of product revenues for our Law Enforcement segment as a percentage of Law Enforcement product revenues is due primarily to higher fixed costs offset by a product mix with slightly higher percentages of software only solutions for the three months ended September 30, 2006 as compared to the corresponding period in 2005.  Costs of products can vary as a percentage of product revenue from period to period depending upon product mix and the hardware content, print media consumable content and software content included in systems installed during a given period.

The decrease in the cost of product revenues for our Identification segment as a percentage of Identification product revenue is reflective of higher domestic Identification revenues containing software only solutions.   For the three months ended September 30, 2006, software and royalties comprised approximately 88% of Identification product revenues as compared to approximately 77% for the corresponding period in 2005.  Costs of products can vary as a percentage of product revenue from period to period depending upon product mix and the hardware content, print media consumable content and software content included in systems installed during a given period.

		THREE MONTHS ENDED SEPTEMBER 30,
Maintenance cost of revenues		2006			2005			$ Change			% Change
(dollars in thousands)
Maintenance cost of revenues:
Law Enforcement		$	199		$	236		$	(37	)	(16	)%
Percentage of Law Enforcement maintenance revenue		39		%	48		%
Identification		$	14		$	19		$	(5	)	(26	)%
Percentage of Identification maintenance revenue		14		%	112		%
Digital Photography		$	—		$	—		$	—		N/A
Percentage of Digital Photography maintenance revenue		—		%	—		%	—
Total net maintenance revenues		$	213		$	255		$	(42	)	(16	)%
Percentage of total maintenance revenues		35		%	49		%

 

Cost of maintenance revenues as a percentage of maintenance revenues decreased due primarily to higher maintenance revenues to absorb fixed maintenance costs.  The dollar decrease during the three months ended September 30, 2006 as compared to the corresponding period in 2005 is reflective of a higher percentage of our maintenance revenues being generated from maintenance coverage on software only solutions which typicaly have lower maintenance costs than solution comprised on both software and hardware.

18

---

 

		THREE MONTHS ENDED SEPTEMBER 30,
Product gross profit		2006			2005			$ Change			% Change
(dollars in thousands)
Product gross profit
Law Enforcement		$	67		$	87		$	(20	)	(23	)%
Percentage of Law Enforcement product revenue		29		%	39		%
Identification		$	995		$	637		$	358		56	%
Percentage of Identification product revenue		75		%	57		%
Digital Photography		$	72		$	144		$	(72	)	(50	)%
Percentage of Digital Photography product revenue		96		%	96		%
Patent Licensing		—			500			(500		)	100	%
Percentage of Patent Licensing product revenue		0		%	100		%
Total net product revenues		$	1,134		$	1,368		$	(234	)	(17	)%
Percentage of total product revenues		69		%	69		%

 

Total product gross profit decreased due primarily to the 2005 period containing $500,000 of gross profit from patent licensing revenues as compared to no such revenues being generated during the three months ended September 30, 2006.

Law Enforcement gross profit as a percentage of Law Enforcement product revenue decreased due to higher fixed costs, offset by slightly higher percentages of software and royalties in our product mix than the corresponding period of 2005.  Costs of products can vary as a percentage of product revenue from quarter to quarter depending upon product mix and hardware content and print media consumable content included in systems installed during a given period.

Identification gross profit as a percentage of Identification product revenue increased due primarily to increased sales of identification products combined with our product mix containing higher percentages of software (which has lower costs than hardware and consumables) than the comparable period in 2005.  Costs of products can vary as a percentage of product revenue from quarter to quarter depending upon product mix and hardware content and print media consumable content included in systems installed during a given period.

The decrease of $72,000 in gross profit from the Digital Photography product segment is reflective of lower sales of boxed product in the three months ended September 30, 2006, as compared to the corresponding period in 2005.

		THREE MONTHS ENDED SEPTEMBER 30,
Maintenance gross profit		2006			2005			$ Change			% Change
(dollars in thousands)
Maintenance gross profit
Law Enforcement		$	315		$	258		$	57		22	%
Percentage of Law Enforcement maintenance revenue		61		%	52		%
Identification		$	89		$	(2	)	$	91		4,528	%
Percentage of Identification maintenance revenue		86		%	(12		)%
Digital Photography		$	—		$	13		$	(13	)	(100	)%
Percentage of Digital Photography maintenance revenue		—		%	100		%
Total net maintenance revenues		$	404		$	269		$	135		50	%
Percentage of total maintenance revenues		65		%	51		%

 

Gross margins related to maintenance revenues increased due primarily to higher maintenance revenues to absorb fixed maintenance costs.

19

---

               

		THREE MONTHS ENDED SEPTEMBER 30,
Operating expenses		2006			2005			$ Change			% Change
(dollars in thousands)
General & administrative		$	1,176		$	1,162		$	14		1	%
Percentage of total net revenue		52		%	46		%
Sales and marketing		$	989		$	955		$	34		4	%
Percentage of total net revenue		44		%	38		%
Research & development		$	926		$	855		$	71		8	%
Percentage of total net revenue		41		%	34		%
Depreciation and amortization		$	59		$	147		$	(88	)	(60	)%
Percentage of total net revenue		3		%	6		%

 

GENERAL AND ADMINISTRATIVE EXPENSES.  General and administrative expenses are comprised primarily of salaries and other employee-related costs for executive, financial, and other infrastructure personnel. General legal, accounting and consulting services, insurance, occupancy and communication costs are also included with general and administrative expenses.  The increase in such expenses, as a percentage of total net revenues, is reflective of lower net revenues during the three months ended September 30, 2006 as compared to the corresponding period in 2005.  The dollar increase of $14,000 is due primarily to approximately $70,000 in stock-based compensation recorded in the three months ended September 30, 2006 pursuant to the implementation of SFAS 123(R) offset by lower personnel expenses due to reduced headcount combined with reduced costs due to the closure of our sales office in Germany.  We are continuing to focus our efforts on achieving additional future operating efficiencies by reviewing and improving upon existing business processes and evaluating our cost structure. We believe these efforts will allow us to gradually decrease our level of general and administrative expenses expressed as a percentage of total revenues.

SALES AND MARKETING.  Sales and marketing expenses consist primarily of the salaries, commissions, other incentive compensation, employee benefits and travel expenses of our sales force.   The increase in such expenses for the three months ended September 30, 2006 as compared to the corresponding period in 2005 is due primarily to approximately $55,000 in stock-based compensation recorded in the three months ended September 30, 2006 pursuant to the implementation of SFAS 123(R).  We anticipate that this level of expenses for sales and marketing will continue through 2006 as we pursue large project solution opportunities.

RESEARCH AND DEVELOPMENT.  Research and development costs consist primarily of salaries, employee benefits and outside contractors for new product development, product enhancements and custom integration work. Such expenses increased due primarily to the continued development of our Biometric Engine, the development of our Personal Identity Verification (PIV) solution, the web enablement of our CCS product line, development IWS desktop security program and product enhancements to our Digital Photography software product suite utilizing contract programming services in conjunction with internal research and development resources.  Also contributing to the increase is approximately $15,000 in stock-based compensation recorded in the three months ended September 30, 2006 pursuant to the implementation of SFAS 123(R).  Our level of expenditures in research and development reflects our belief that to maintain our competitive position in markets characterized by rapid rates of technological advancement, we must continue to invest significant resources in new systems and software as well as continue to enhance existing products.

DEPRECIATION AND AMORTIZATION.  Depreciation and amortization decreased primarily due to lower amortization of intangible assets due to such assets being fully amortized.

INTEREST EXPENSE (INCOME), NET.  For the three months ended September 30, 2006, we recognized interest income of $4,000 and interest expense of $160,000. For the three months ended September 30, 2005, we recognized interest income of $32,000 and interest expense of $1,000.  Interest expense for the three months ended September 30, 2006 increased due to interest expense incurred on our secured debt financing consummated in March 2006.

20