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

U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

 

Commission file number 001-15757

 

IMAGEWARE SYSTEMS, INC.

(Exact Name of Small Business Issuer as Specified in Its Charter)

 

 

10883 Thornmint Road
San Diego, CA 92127

(Address of Principal Executive Offices)

 

(858) 673-8600

(Issuer’s Telephone Number, Including Area Code)

 

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 ý  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):

 

o Large accelerated filer

o Accelerated filer

ý Non-accelerated filer

 

Indicate by check mark whether the registrant is a shell company (as defined  in Rule 12b-2 of the Exchange Act).
Yes  o No ý

 

The number of shares of Common Stock, with $0.01 par value, outstanding on May 12, 2006 was 13,547,662.

 

Transitional Small Business Disclosure Format (check one) Yes o  No ý

 

 

IMAGEWARE SYSTEMS, INC. INDEX

 

PART I.	FINANCIAL INFORMATION
	ITEM 1.	Financial Statements (Unaudited)
		Condensed Consolidated Balance Sheets as of March 31, 2006 and December 31, 2005
		Condensed Consolidated Statements of Operations for the three months ended March 31, 2006 and 2005
		Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2006 and 2005
		Condensed Consolidated Statements of Comprehensive Income (Loss) for the three months ended March 31, 2006 and 2005
		Notes to Condensed Consolidated Financial Statements
	ITEM 2.	Management’s Discussion and Analysis or Plan of Operation
	ITEM 3.	Quantitive and Qualitive Disclosures About Market Risk
	ITEM 4.	Controls and Procedures
PART II.	OTHER INFORMATION
	ITEM 1A.		Risk Factors
	ITEM 6.		Exhibits and Reports on Form 8-K
SIGNATURES

 

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PART I

FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

IMAGEWARE SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In Thousands, except share data)

 

		March 31, 2006			December 31, 2005
		(Unaudited)
ASSETS
Current Assets:
Cash		$	1,298		$	741
Accounts receivable, net		1,765			1,340
Inventory		192			208
Other current assets		332			219
Total Current Assets		3,587			2,508
Property and equipment, net		428			424
Other assets		762			738
Intangible assets, net of accumulated amortization		153			218
Goodwill		3,416			3,416
Total Assets		$	8,346		$	7,304
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
Accounts payable		$	994		$	690
Deferred revenue		1,372			1,084
Accrued expenses		1,053			1,035
Notes payable to third parties, net of discount		1,149			—
Total Current Liabilities		4,568			2,809
Pension obligation		1,152			1,130
Total Liabilities		5,720			3,939
Shareholders’ equity:
Preferred stock, $.01 par value, authorized 4,000,000 shares Series B convertible redeemable preferred stock, designated 750,000 shares, 389,400 shares issued, and 249,400 shares outstanding at March 31, 2006 and December 31, 2005, liquidation preference $623,500 at March 31, 2006 and December 31, 2005		2			2
Common stock, $.01 par value, 50,000,000 shares authorized, 13,554,366 shares issued and 13,547,662 shares outstanding at March 31, 2006 and December 31, 2005, respectively		134			134
Additional paid in capital		68,305			67,650
Treasury stock, at cost - 6,704 shares		(64		)	(64		)
Accumulated other comprehensive income		(82		)	(35		)
Accumulated deficit		(65,669		)	(64,322		)
Total shareholders’ equity		2,626			3,365
Total Liabilities and Shareholders’ Equity		$	8,346		$	7,304

 

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

 

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IMAGEWARE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except share and per share amounts)

(UNAUDITED)

 

		THREE MONTHS ENDED March 31,
		2006			2005
Revenues:
Product		$	2,298		$	2,315
Maintenance		511			495
		2,809			2,810
Cost of revenues:
Product		527			845
Maintenance		281			268
Gross profit		2,001			1,697
Operating expenses:
General & administrative		1,238			1,083
Sales and marketing		1,093			941
Research & development		934			691
Depreciation and amortization		125			159
		3,390			2,874
Loss from operations		(1,389		)	(1,177		)
Interest (income) expense, net		26			(6		)
Other income, net		(69		)	(44		)
Loss from continuing operations before income taxes		(1,346		)	(1,127		)
Income tax expense (benefit)		—			—
Loss from continuing operations		(1,346		)	(1,127		)
Discontinued operations:
Gain (loss) from operations of discontinued Digital Imaging Asia Pacific Component (including gain on disposal of $233 in 2005)		—			223
Income tax benefit (expense)		—			—
Gain (loss) on discontinued operations		—			223
Net loss		$	(1,346	)	$	(904	)
Basic and diluted (loss) per common share - see note 2
Loss from continuing operations		$	(0.10	)	$	(0.10	)
Discontinued operations		$	—		0.02
Net loss per common share		$	(0.10	)	$	(0.08	)
Weighted-average shares (basic and diluted)		13,547,662			12,036,104

 

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

 

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IMAGEWARE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)

(UNAUDITED)

 

		Three Months Ended March 31,
		2006			2005
Cash flows from operating activities
Net loss		$	(1,346	)	$	(904	)
Adjustments to reconcile net loss to net cash used by operating activities
Depreciation and amortization		125			161
Gain on sale of subsidiary		—			(233		)
Non cash interest and amortization of debt discount and debt issuance costs		25			—
Stock-based compensation		338			70
Change in assets and liabilities
Accounts receivable, net		(425		)	(173		)
Inventory		16			14
Other current assets		(24		)	(43		)
Intangible and other assets		(24		)	21
Accounts payable		304			(223		)
Accrued expenses		(83		)	(317		)
Deferred revenue		289			22
Contract costs		—			(416		)
Pension obligation		21			(12		)
Total adjustments		562			(1,129		)
Net cash used by operating activities		(784		)	(2,033		)
Cash flows from investing activities
Purchase of property and equipment		(64		)	(109		)
Proceeds from sale of subsidiary net of cash sold and direct transaction costs		—			1,209
Net cash provided (used) by investing activities		(64		)	1,100
Cash flows from financing activities
Repayment of notes payable		—			(9		)
Proceeds from issuance of notes payable with warrants		1,550			—
Proceeds from exercised stock options		—			37
Debt issuance costs		(98		)	—
Net cash provided by financing activities		1,452			28
Effect of exchange rate changes on cash		(47		)	(79		)
Net increase (decrease) in cash		557			(984		)
Cash at beginning of period		741			2,912
Cash at end of period		$	1,298		$	1,928
Supplemental disclosure of cash flow information:
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.

 

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IMAGEWARE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(In thousands)

(UNAUDITED)

 

		THREE MONTHS ENDED MARCH 31,
		2006			2005
Net loss		$	(1,346	)	$	(904	)
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustment		(47		)	(79		)
Comprehensive loss		$	(1,393	)	$	(1,035	)

 

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

 

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IMAGEWARE SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Three Months Ended March 31, 2006

(Unaudited)

 

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. 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 March 31, 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 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.

 

In view of the matters described in the preceding paragraph, recoverability of a major portion of the recorded asset amounts shown in the accompanying consolidated balance sheet 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 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.

 

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Recently Issued Accounting Standards

 

In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets, an amendment of FASB Statements No. 140 (SFAS 156). SFAS 156 requires that servicing assets and servicing liabilities be recognized at fair value, if practicable, when the Company enters into a servicing agreement. This accounting standard will be effective for the Company beginning January 1, 2007. SFAS 156 is not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

 

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 March 31, 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, permitted under Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation (SFAS 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 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 for the first fiscal quarter of 2005 was as follows:

 

 

		Three Months Ended March 31,
(In thousands, except per share data)		2005
Net Loss:
As reported		$	(904	)
Stock-based compensation included in net loss		70
Stock based employee compensation under fair value based method		(131		)
Pro forma net loss		$	(965	)
Basic loss per common share:
As reported		$	(0.08	)
Pro forma		$	(0.09	)

 

On January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment”, (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 first quarter of fiscal 2006 was as follows:

 

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		Three Months Ended March 31,
(In thousands, except per share data)		2006
Stock-based compensation expense by type of award:
Employee stock options		$	236
Restricted stock grants		102
Total employee stock based compensation		338
Tax effect on stock-based compensation		—
Tax effect on net income		—
Stock-based compensation include in net loss		$	338
Effect on loss per common share:
Basic		$	0.03
Diluted		$	0.03

 

Prior to adopting SFAS No. 123(R), the Company presented all excess tax benefits, it 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 months ended March 31, 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 months ended March 31, 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 in the foreseeable future.

 

A summary of the activity under the Company’s stock option plans for the three months ended March 31, 2006 is as follows:

 

		Options		Weighted-  Average Exercise Price			Weighted- Average Remaining Contractual Term
Balance at December 31, 2005		1,474,093		$	2.68		8.31
Granted		314,000		$	1.92		9.84
Forfeited		(138,629	)	$	3.28		5.04
Exercised		—		$	—		—
Balance at March 31, 2006		1,649,464		$	2.77		8.49

 

Options exercisable at March 31, 2006 totaled 540,901 at a weighted-average price of $2.75, with a remaining weighted average contractual term of approximately 7.2 years.

 

The weighted-average grant date fair value of options granted during the three months ended March 31, 2006 was $1.40.

 

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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 three months ended March 31, 2006:

 

		Options		Weighted- Average Grant Date Fair Value Per Share
Balance at December 31, 2005		849,930		$	1.83
Granted		314,000		$	1.40
Vested		(30,367	)	$	1.97
Forfeited		(25,000	)	$	1.92
Balance at March 31, 2006		1,108,563		$	1.72

 

At March 31, 2006, the total remaining unrecognized compensation cost related to unvested stock options amounted to approximately $937,000, which will be amortized over the weighted-average remaining requisite service period of 2.6 years.

 

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

 

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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 March 31, 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 March 31, 2006		Number of Common Shares Convertible into at March 31, 2005
Convertible preferred stock		47,280		47,280
Stock options		1,352,175		914,483
Warrants		4,469,578		5,824,863

 

The following table sets forth the computation of basic and diluted loss per share for the three months ended March 31, 2006 and 2005 (amounts in thousands except share and per share amounts):

 

		THREE MONTHS ENDED MARCH 31,
		2006			2005
Numerator – loss from continuing operations:
Net loss from continuing operations		$	(1,346	)	$	(1,127	)
Less Series B preferred dividends		(13		)	(13		)
Net loss from continuing operations available to common shareholders		$	(1,359	)	$	(1,140	)
Numerator – gain from discontinued operations
Net gain from discontinued operations		—			223
.
Denominator
Weighted-average shares outstanding		13,547,662			12,036,104
Basic and diluted loss per share:
Continuing operations		$	(0.10	)	$	(0.09	)
Discontinued operations		—			0.02
Net loss per share		(0.10		)	(0.07		)

 

NOTE 4. SEGMENT INFORMATION

 

Prior to its acquisition of G & A, Castleworks and E-Focus, the Company operated in one business segment. With its acquisition of G & A, Castleworks and E-Focus, the Company is now comprised of three reportable segments: Law Enforcement, Identification and Digital Photography. The Law Enforcement segment develops, sells and supports a suite of modular software products and designs systems 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 digital imaging in the production of photo identification cards, documents and identification badging systems. The Digital Photography segment develops digital imaging software for photographic purposes.

 

Due to the Company’s integrated operations, the use of allocations in the determination of business segment information is necessary for certain financial information not discretely captured.

 

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

 

There are no inter-segment transactions.

 

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The table below summarizes information about reportable segments for the three months ended March 31, 2006 and 2005:

 

		THREE MONTHS ENDED March 31,
		2006			2005
		(in thousands)
Net Revenue:
Law Enforcement		$	1,090		$	919
Identification		1,675			1,799
Digital Photography		44			92
Total consolidated net sales		$	2,809		$	2,810
Operating profit (loss):
Law Enforcement		$	(469	)	$	(744	)
Identification		(822		)	(240		)
Digital Photography		(98		)	(193		)
Other unallocated amounts:
Interest expense (income)		26			(6		)
Other income		(69		)	(44		)
Income (loss) from continuing operations before taxes		$	(1,346	)	$	(1,127	)

 

		March 31, 2006
		(in thousands)
Total Assets by Segment:
Law Enforcement		$	605
Identification		5,987
Digital Photography		60
Total assets for reportable segments		6,652
Corporate		1,694
Total consolidated assets		$	8,346

 

NOTE 5. 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 terms and an exercise price $2.30 per share. Common shares underlying the warrants

 

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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 months ended March 31, 2006, the Company recorded approximately $18,000 in debt discount amortization which is included as a component of net interest expense in the Company’s Condensed Consolidated Statement of Operations.

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION.

 

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 22 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.

 

OVERVIEW

 

ImageWare Systems, Inc. utilizes its 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 judgement and estimates on the part of management in its application. Although we believe that our judgements 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 judgements 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

 

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•                  Software licensing

•                  Sales of computer hardware and identification media

•                  Postcontract customer support (PCS)

 

We recognize 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 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 $1,765,000, net of allowance for doubtful accounts of approximately $475,000 as of March 31, 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 $3,569,000 as of March 31, 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 will perform 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  March 31, 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.

 

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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  March 31, 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 intangible asset impairment will not occur in the future.

 

Stock-Based Compensation

 

Upon adoptions 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 first quarter 2006 financial statements.

 

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RESULTS OF OPERATIONS

 

THREE MONTHS ENDED MARCH 31, 2006 AND 2005.

 

		THREE MONTHS ENDED MARCH 31,
Net Product Revenues		2006			2005			$ Change			% Change
(dollars in thousands)
Product revenues:
Law Enforcement		$	612		$	328		$	284		87	%
Percentage of total net product revenue		27		%	14		%
Identification		$	1,642		$	1,905		$	(263	)	(14	)%
Percentage of total net product revenue		71		%	82		%
Digital Photography		$	44		$	82		$	(38	)	(46	)%
Percentage of total net product revenue		2		%	4		%
Total net product revenues		$	2,298		$	2,315		$	(17	)	(1	)%

 

The increase in our Law Enforcement 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.

 

Domestically, Identification revenues decreased approximately $280,000 or 16% for the three months ended March 31, 2006 as compared to the corresponding period in 2005. This decrease in domestic revenue is reflective of a decrease in project-oriented work. Internationally, our Identification revenues increased approximately $17,000. 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 us 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 March 31, 2006 as compared to the comparable period of 2005.

 

Our backlog of product orders as of March 31, 2006 was approximately $1,177,000. At March 31, 2006, we also had maintenance and support backlog of approximately $1,164,000 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.

 

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		THREE MONTHS ENDED MARCH 31,
Maintenance Revenues		2006			2005			$ Change			% Change
(dollars in thousands)
Maintenance revenues:
Law Enforcement		$	478		$	478		$	—		0	%
Percentage of total net maintenance revenue		94		%	96		%
Identification		$	33		$	5		$	28		556	%
Percentage of total net maintenance revenue		6		%	1		%
Digital Photography		$	—		$	12		$	(12	)	(100	)%
Percentage of total net maintenance revenue		0		%	3		%
Total net maintenance revenues		$	511		$	495		$	16		3	%

 

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

 

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

 

		THREE MONTHS ENDED MARCH 31,
Cost of Product Revenues:		2006			2005			$ Change			% Change
(dollars in thousands)
Cost of Product Revenues:
Law Enforcement		$	263		$	193		$	70		37	%
Percentage of Law Enforcement product revenue		43		%	59		%
Identification		$	262		$	650		$	(388	)	(60	)%
Percentage of Identification product revenue		16		%	34		%
Digital Photography		$	2		$	2		$	0		0	%
Percentage of Digital Photography product revenue		4		%	3		%
Total net product revenues		$	527		$	845		$	(318	)	(38	)%
Percentage of total product revenues		23		%	37		%

 

Overall cost of product revenues as a percentage of product revenues decreased primarily due to higher sales of software only solutions in the three months ended March 31, 2006 than the comparable period in 2005 which had higher sales of hardware and consumables (which have higher costs than software only solutions). This change in product resulted in  lower cost of sales as a percentage of product revenues.

 

The cost of product revenues for our Law Enforcement segment decreased as a percentage of product revenues due primarily to product mix with a higher percentage of software sales for the three months ended March 31, 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 cost of product revenues for our Identification segment decreased as a percentage of product revenues due primarily to product mix with a higher percentage of software sales for the three months ended March 31, 2006 as compared to the corresponding period in 2005. The dollar decrease in the cost of product revenues related to our Identification segment is reflective of a higher percentage of the sale of software only solutions than the comparable period in 2005. The percentage decrease in Identification cost of revenues as a percentage of Identification revenues from 34% for the three months ended March  31, 2005 to 16% for the corresponding period in 2006 is reflective primarily of higher domestic identification revenues from project-oriented work which included higher percentages of software than the comparable three months ended March 31, 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

 

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software content included in systems installed during a given period.

 

		THREE MONTHS ENDED MARCH 31,
Maintenance cost of revenues		2006			2005			$ Change			% Change
Maintenance cost of revenues:
Law Enforcement		$	266		$	252		$	14		6	%
Percentage of Law Enforcement maintenance revenue		56		%	53		%
Identification		$	15		$	16		$	(1	)	(9	)%
Percentage of Identification maintenance revenue		45		%	339		%
Digital Photography		$	—		$	—		$	—		N/A
Percentage of Digital Photography maintenance revenue		—		%	—		%	—			N/A
Total net maintenance revenues		$	281		$	268		$	13		5	%
Percentage of total maintenance revenues		55		%	54		%

 

The dollar increase in costs of maintenance revenues is reflective of higher costs necessary to service our expanding installed base.

 

		THREE MONTHS ENDED MARCH 31,
Product gross profit (dollars in thousands)		2006			2005			$ Change			% Change
Product gross profit
Law Enforcement		$	348		$	135		$	213		158	%
Percentage of Law Enforcement product revenue		57		%	41		%
Identification		$	1,380		$	1,255		$	125		10	%
Percentage of Identification product revenue		84		%	66		%
Digital Photography		$	43		$	79		$	(37	)	(47	)%
Percentage of Digital Photography product revenue		96		%	97		%
Total net product revenues		$	1,771		$	1,470		$	301		21	%
Percentage of total product revenues		77		%	63		%

 

Total product gross profit as a percentage of product revenues increased despite lower overall product sales due to a higher percentage of total revenues coming from the sales of software only solutions which have lower costs than sales of hardware and consumables.

 

Law Enforcement gross profit as a percentage of Law Enforcement product revenue increased due primarily to our product mix containing higher percentages of software (which have lower costs than hardware and consumable sales) than the comparable period in 2005. Also contributing to this increase is a larger revenue base available to absorb fixed product costs. 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 our product mix containing higher percentages of software only solutions (which have lower costs than sales of 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 $37,000 in gross profit from the Digital Photography product segment is reflective of our lower sales of boxed product in the three months ended March 31, 2006, as compared to the corresponding period in 2005.

 

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		THREE MONTHS ENDED MARCH 31,
Maintenance gross profit		2006			2005			$ Change			% Change
(dollars in thousands)
Maintenance gross profit
Law Enforcement		$	212		$	226		$	(14	)	(6	)%
Percentage of Law Enforcement maintenance revenue		44		%	47		%
Identification		$	18		$	(11	)	$	29		(265	)%
Percentage of Identification maintenance revenue		55		%	(220		)%
Digital Photography		$	0		$	12		$	(12	)	(100	)%
Percentage of Digital Photography maintenance revenue		N/A			100		%
Total net maintenance revenues		$	230		$	227		$	3		1	%
Percentage of total maintenance revenues		45		%	46		%

 

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

 

		THREE MONTHS ENDED MARCH 31,
Operating expenses		2006			2005			$ Change			% Change
(dollars in thousands)
General & administrative		$	1,238		$	1,083		$	155		14	%
Percentage of total net revenue		44		%	39		%
Sales and marketing		$	1,093		$	941		$	152		16	%
Percentage of total net revenue		39		%	33		%
Research & development		$	934		$	691		$	243		35	%
Percentage of total net revenue		33		%	25		%
Depreciation and amortization		$	125		$	159		$	(34	)	(22	)%
Percentage of total net revenue		4		%	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 approximately $115,000 of stock –based compensation expense recorded in 2006 pursuant to the implementation of  SFAS 123(R). 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, as a percentage of total net revenues, is reflective of higher headcount. We anticipate that the 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 accelerated development of our new ImageWare Biometric Engine, the Web enablement of our CCS product line, development of our 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. 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

 

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