SOCKET MOBILE, INC. - Quarter Report: 2019 September (Form 10-Q)

NOTES TO CONDENSED FINANCIAL STATEMENTS (Unaudited)

September 30, 2019

Leases

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842), which requires a lessee to recognize a liability representing future lease payments and a right-of-use asset representing its right to use the underlying asset for the lease term. For operating leases, a lessee is required to recognize at inception a right-of-use asset and a lease liability equal to the net present value of the lease payments, with lease expense recognized over the lease term on a straight-line basis. For leases with a term of twelve months or less, ASU 2016-02 allows a reporting entity to make an accounting policy election to not recognize a right-of-use asset and a lease liability, and to recognize lease expense on a straight-line basis. ASU No. 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, with early adoption permitted. Entities are required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements. The Company adopted ASU 2016-02 effective January 1, 2019, which had no impact on the Company’s Statements of Operations. The most significant impact was the recognition of right-of-use assets and liabilities for the operating lease. Adoption of the standard required the Company to restate the reported results in its earliest comparable period, January 1, 2018, including the recognition of additional operating lease right-of-use assets and liabilities. As a result, there was an increase in assets and corresponding liabilities of approximately $1.57 million on January 1, 2018. At September 30, 2019, the balances of right-of-use assets and liabilities for the operating lease are approximately $1.02 million and $1.23 million, respectively, compared to approximately $1.27 million and $1.51 million, respectively, at December 31, 2018.

Recently Issued Financial Accounting Standards

In July 2019, the FASB issued ASU 2019-07, “Codification Updates to SEC Sections — Amendments to SEC Paragraphs Pursuant to SEC Final Rule Releases No. 33-10532, Disclosure Update and Simplification, and Nos. 33-10231 and 33-10442, Investment Company Reporting Modernization and Miscellaneous Updates (SEC Update)” (“ASU 2019-07”). ASU 2019-07 aligns the guidance in various SEC sections of the Codification with the requirements of certain SEC final rules. ASU 2019-07 is effective immediately. The adoption of ASU 2019-07 did not have a material impact on the Company’s financial statements.

From time to time, new accounting pronouncements are issued by the FASB or other standards setting bodies that are adopted by the Company as of the specified effective date. Unless otherwise discussed, management believes that the impact of recently issued standards that are not yet effective will not have a material impact on the Company’s financial position, results of operations or cash flows upon adoption.

SOCKET MOBILE, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS (Unaudited)

September 30, 2019

NOTE 3 — Inventories

Inventories consist principally of raw materials and sub-assemblies, which are stated at the lower of cost (first-in, first-out) or market. Inventories at September 30, 2019 and December 31, 2018 were as follows:

NOTE 4 — Bank Financing Arrangements

On January 31, 2018, the Company entered into an Amended and Restated Business Financing Agreement (the “Third Financing Agreement”) with Western Alliance Bank (the “Bank), that provides for a $2.5 million revolving line of credit and a $4.0 million term loan that the Company may use to repurchase shares of common stock. Pursuant to the revolving line of credit, the Company is permitted to borrow up to the lesser of $2.5 million or 80% of eligible accounts receivables. Amounts outstanding under the line of credit bear interest at the “U.S. Prime Rate” published by the Wall Street Journal plus 0.75%. Interest is payable monthly on the line of credit, and the principal is due upon the maturity date of January 31, 2020. Amounts outstanding under the term loan bear interest at the “U.S. Prime Rate” published by the Wall Street Journal plus 1.75%. The loans are secured by all of our present and future assets, including intellectual property and general intangibles. The Financing Agreement contains customary affirmative and negative covenants, including covenants that limit or restrict the Company’s ability to, among other things, grant liens, make investments, incur indebtedness, merge or consolidate, dispose of assets, make acquisitions, pay dividends or make distributions, repurchase stock, enter into transactions with affiliates and enter into restrictive agreements, in each case subject to customary exceptions for a credit facility of this size and type.

The Financing Agreement also contains customary events of default including, among others, payment defaults, breaches of covenants, bankruptcy and insolvency events, cross defaults with certain material indebtedness, judgment defaults, and breaches of representations and warranties. Upon an event of default, the Bank may declare all or a portion of the Company’s outstanding obligations payable to be immediately due and payable and exercise other rights and remedies provided for under the Financing Agreement. During the existence of an event of default, interest on the obligations could be increased.

On March 1, 2018, the Company received proceeds of $4.0 million under the provisions of the term loan for a common stock repurchase. On March 9, 2018, the Company completed a tender offer to purchase and retire 1,250,000 shares of common stock from multiple investors at a purchase price of $3.90 per share, for an aggregate cost of approximately $4.9 million, excluding fees and expenses relating to the tender offer.

SOCKET MOBILE, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS (Unaudited)

September 30, 2019

On April 12, 2018, the Company advised the Bank that its operating results for the quarter ended March 31, 2018 were not expected to be in compliance with two financial covenants, the first a Fixed

Charge Coverage Ratio and the second a Total Funded Debt to EBITDA ratio. The Company reported the non-compliance in its Form 10-Q for the quarter ended March 31, 2018. The Bank verbally agreed to forbear the events of default subject to further modification of the Financing Agreement. The Company subsequently paid down the term loan from $4.0 million at March 31, 2018 to $1.0 million at June 30, 2018. The paydowns were made from its cash and revolving lines of credit.

On June 4, 2018, the Company entered into the Fourth Amended and Restated Business Financing Agreement with the Bank. The Bank recognized the repayment of the outstanding term loan balance to $1.0 million by June 30, 2018. The remaining balance is repayable in 24 equal monthly installments. The Bank permanently waived the defaults resulting from March 31, 2018 results when paydown of the term loan balance to $1.0 million by June 30, 2018 was achieved.

On July 30, 2018, the Company entered into the Fifth Amended and Restated Business Financing Agreement with the Bank. The Company was required to maintain daily cash plus available credit at or above 90% of the outstanding principal balance of the term loan until the Asset Coverage Ratio is at 1.25 to 1.0. The minimum Asset Coverage Ratio increased to 1.25 to 1.0 from December 31, 2018 onwards.

On June 14, 2019, the Company entered into the Sixth Amended and Restated Business Financing Agreement with the Bank. The Bank waived the default which occurred for the month ended April 30, 2019 when the Company’s Asset Coverage Ratio was 1.13 to 1.00, instead of the required 1.25 to 1.00. The Bank also increased the Eligible Receivable threshold for Ingram Micro from 50% to 60% of domestic receivables, and from 35% to 50% of all receivables (including both domestic and foreign receivables).

The Asset Coverage Ratio was 1.88 to 1.00 on September 30, 2019. During the three months and nine months ended September 30, 2019, total repayments of the term loan was $125,000 and $375,000. During the nine months ended September 30, 2019, total amount borrowed under the domestic and international lines was $13,038,000 and the total repayments was $12,925,817. At September 30, 2019, the total borrowing capacity was approximately $237,000. Amounts outstanding under the term loan and bank credit facilities at September 30, 2019 are as follows:

SOCKET MOBILE, INC. 

NOTES TO CONDENSED FINANCIAL STATEMENTS (Unaudited)

September 30, 2019

Interest expense on the term loan for three and nine months ended September 30, 2019 was $9,031 and $38,225, respectively. Interest expense on the amounts drawn under the Company’s bank credit lines during the three and nine months ended September 30, 2019 was $16,633 and $45,310. Accrued interest payable related to the amounts outstanding under the term loan and bank credit facilities at September 30, 2019 was $15,877.

NOTE 5 — Segment Information and Concentrations

Segment Information

The Company operates in the mobile barcode scanning and RFID/NFC data capture market. Mobile scanning typically consists of using mobile devices such as smartphones or tablets, with mobile scanning peripherals for data collection, and third-party vertical applications software. The Company distributes its products in the United States and foreign countries primarily through distributors and resellers. The Company markets its products primarily through application developers whose applications are designed to work with Company’s products. Revenues by geographic area for three and nine months ended September 30, 2019 and 2018 were as follows:

Export revenues are attributable to countries based on the location of the Company’s customers. The Company does not hold long-lived assets in foreign locations.

Major Customers

Customers who accounted for at least 10% of the Company’s total revenues for the three and nine-month periods ended September 30, 2019 and 2018 were:

_____________

* Customer accounted for less than 10% of total revenues for the period

SOCKET MOBILE, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS (Unaudited)

September 30, 2019

Concentration of Credit Risk

Financial instruments that potentially subject the Company to significant concentrations of credit risk include cash, cash equivalents and accounts receivable. The Company invests its cash in demand deposit accounts in banks. To date, the Company has not experienced losses on the investments. The Company’s trade accounts receivables are primarily with distributors. The Company performs ongoing credit evaluations of its customers’ financial condition but generally requires no collateral. Reserves are maintained for potential credit losses, and such losses have been within management’s expectations. Customers who accounted for at least 10% of the Company’s accounts receivable balances at September 30, 2019 and December 31, 2018 were as follows:

_____________

* Customer accounted for less than 10% of total accounts receivable balances for the period

Concentration of Suppliers

Several of the Company’s component parts are produced by a sole or limited number of suppliers. Shortages could occur in these essential materials due to increased demand, or to an interruption of supply. Suppliers may choose to restrict credit terms or require advance payments causing delays in the procurement of essential materials. If the Company were unable to procure certain of such materials, it could have a material adverse effect upon its results. At September 30, 2019, 36% of the Company’s accounts payable balances were concentrated in the top three suppliers. For the three months ended September 30, 2019, top three suppliers accounted for 53% of the inventory purchases.

NOTE 6 — Stock-Based Compensation

The Company recognizes the compensation cost in the financial statements for all stock-based awards to employees, including grants of stock options and restricted stock units, based on the fair value of the awards as of the date that the awards are issued. Compensation cost for stock-based awards is recognized on a straight-line basis over the vesting period.

The fair values of stock options are generally determined using a binomial lattice valuation model which incorporates assumptions about expected volatility, risk-free interest rate, dividend yield, and expected life. On February 15, 2019, 165,600 shares were granted to executive officers, selected employees and consultants as stock option refresher grants.

SOCKET MOBILE, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS (Unaudited)

September 30, 2019

On February 15, 2019, the Company also granted 116,050 restricted stock units (“RSUs”) to employees. Each RSU represents the right to receive one share of the Company’s common stock upon vesting. The fair value of these RSUs was calculated based upon the Company’s closing stock price on the date of grant. These RSUs are with service-based vesting provisions and vest over four years: 15% on February 15, 2020, 20% on February 15, 2021, 25% on February 15, 2022, and 40% on February 15, 2023. The shares are issued in the name of each employee but held in an escrow account by the Company’s transfer agent, American Stock Transfer & Trust. As they vest, the shares will be issued to the individual either electronically or as certificates as instructed by the individual.  Each individual has voting rights while shares are unvested.  The share totals are included in primary earnings per share. The expense of these RSUs is recognized on a straight-line basis over the vesting period.

On August 30, 2019 the Company completed a one-time tender offer to exchange 331,314 shares granted under its 2004 Equity Incentive Plan in year 2010 to the current employees, executive officers, and directors of the Company. All surrendered options were cancelled effective as of the expiration of the Exchange Offer on August 30, 2019. The Company granted new options to purchase an aggregate of 331,314 shares of the Company’s common stock pursuant to the terms of the Exchange Offer and the Company’s 2004 Equity Incentive Plan. The new options were priced at the closing market price of $2.32 on August 30, 2019 with a monthly vesting over 4 years and a new 10-year expiration date of August 30, 2029. The Company’s stockholders approved the implementation of this stock option exchange program at its 2019 annual meeting of stockholders on May 22, 2019.

Total stock-based compensation expense for the three months and nine months ended September 30, 2019, was $133,008 and $392,008, respectively.

NOTE 7 — Net Income (Loss) Per Share Applicable to Common Stockholders

The following table sets forth the computation of basic and diluted net income (loss) per share:

In the three and nine months ended September 30, 2019, 2,128,547 and 2,189,372, respectively, stock options were excluded in the calculation of diluted net loss per share because their effect would be anti-dilutive. In the three and nine months ended September 30, 2018, 2,358,059 stock options were excluded in the calculation of diluted net loss per share because their effect would be anti-dilutive.

SOCKET MOBILE, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS (Unaudited)

September 30, 2019

NOTE 8 — Income Taxes

The Tax Cuts and Jobs Act of 2017, effective on January 1, 2018, eliminates alternative minimum taxes and lowers the U.S. federal corporate income tax from 34% to 21%. In the three and nine months ended September 30, 2019, the Company recorded deferred tax expenses of $37,449 and $85,030, respectively. In the same periods a year ago, the Company recorded income tax benefits of $17,582 and $151,216, respectively, with the expectation of a return to profitable operating results and full utilization of the Company’s Net Operating Loss carryforwards.

In Q3 2019, the Company also recorded a tax refund of $27,838 resulted of AMT paid in the prior years.

NOTE 9 — Commitments and Contingencies

Operating Lease Obligations

The Company leases office space under a non-cancelable operating lease that provides the Company approximately 37,100 square feet in Newark, California. The lease agreement expires on June 30, 2022.

Monthly base rent increases four percent per year annually on July 1^st of each year. The Company recognizes operating lease expense on a straight-line basis over the lease term. The operating lease expense was $103,208 and $309,625 for the three and nine-month periods ended September 30, 2019 and 2018, respectively.

Cash payments included in the measurement of our operating lease liabilities were $117,268 and $342,785 for the three and nine-month periods ended September 30, 2019, respectively, compared to $112,758 and $329,601, respectively, for the same periods a year ago.

Future minimum lease payments under the operating lease at September 30, 2019 are as shown below:

SOCKET MOBILE, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS (Unaudited)

September 30, 2019

Financing Lease Obligations

The new standard, ASU 2016-02 classifies lessee leases into two types, operating and finance. The Company leases certain of its equipment under finance leases. These leases are collateralized by their underlying assets. At September 30, 2019 and December 31, 2018, equipment with a cost of $100,584 was subject to such financing arrangements. The accumulated depreciation of the assets associated with the financing leases as of September 30, 2019 and December 31, 2018, amounted to $88,565 and $76,546 respectively.

Future minimum payments under financing lease and equipment financing arrangements as of September 30, 2019 are as follows:

Purchase Commitments

As of September 30, 2019, the Company has non-cancelable purchase commitments for inventory to be used in the ordinary course of business of approximately $3,758,000.

Legal Matters

The Company is subject to disputes, claims, requests for indemnification and lawsuits arising in the ordinary course of business. Under the indemnification provisions of the Company’s customer agreements, the Company routinely agrees to indemnify and defend its customers against infringement of any patent, trademark, copyright, trade secrets, or other intellectual property rights arising from customers’ legal use of the Company’s products or services. The exposure to the Company under these indemnification provisions is generally limited to the total amount paid for the indemnified products. However, certain indemnification provisions potentially expose the Company to losses in excess of the aggregate amount received from the customer. To date, there have been no claims against the Company by its customers pertaining to such indemnification provisions, and no amounts have been recorded. The Company is currently not a party to any material legal proceedings.

SOCKET MOBILE, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS (Unaudited)

September 30, 2019

NOTE 10 — Subsequent Events

The Company has evaluated events from September 30, 2019 through the date the financial statements were issued. Except as disclosed below, there were no subsequent events that need disclosure.

On October 23, 2019, The Board of Directors unanimously approved the appointment of Ivan Lazarev to serve as an independent director until the next annual meeting. Mr. Lazarev was granted a stock option of 5,542 shares vesting monthly over 19 months commencing October 23, 2019. The Board also appointed independent director Bill Parnell, the chairmanship of the Compensation Committee. Mr. Parnell was granted a supplemental stock option of 1,000 shares vesting over 19 months commencing October 23, 2019 to reflect his board committee leadership role.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These statements include statements forecasting our future financial condition and results, our future operating activities, market acceptance of our products, expectations for general market growth of mobile computing devices, growth in demand for our data capture products, expansion of the markets that we serve, expansion of the distribution channels for our products, and the timing of the introduction and availability of new products, as well as other forecasts discussed under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Words such as “may,” “will,” “predicts,” “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” variations of such words, and similar expressions are intended to identify such forward-looking statements. Such forward-looking statements are based on current expectations, estimates, and projections about our industry, management’s beliefs, and assumptions made by management. These forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties, and assumptions that are difficult to predict; therefore, actual results and outcomes may differ materially from what is expressed or forecasted in any such forward looking statements. Factors that could cause actual results and outcomes to differ materially include, but are not limited to: volatility in the world economy generally and in the markets we serve in particular; the risk of delays in the availability of our products due to technological, market or financial factors including the availability of product components and necessary working capital; our ability to successfully develop, introduce and market future products; our ability to effectively manage and contain our operating costs; the availability of third-party hardware and software that our products are intended to work with; product delays associated with new model introductions and product changeovers by the makers of products that our products are intended to work with; continued growth in demand for barcode scanners; market acceptance of emerging standards such as RFID/Near Field Communications and of our related data capture products; the ability of our strategic relationships to benefit our business as expected; our ability to enter into additional distribution relationships; or other factors described in this Form 10-Q including “Item 1A. Risk Factors” and recent Form 8-K and Form 10-K reports filed with the Securities and Exchange Commission. We assume no obligation to update such forward-looking statements or to update the reasons why actual results could differ materially from those anticipated in such forward-looking statements.

You should read the following discussion in conjunction with the interim condensed financial statements and notes included elsewhere in this report, the Company’s annual financial statements in form 10-K, and other information contained in other reports and documents filed from time to time with the Securities and Exchange Commission.

The Company and its products

We are a leading innovator of data capture and delivery solutions for enhanced productivity in workforce mobilization. Our products are incorporated into mobile applications used in point of sale (POS), enterprise mobility (field workers), asset tracking, manufacturing process and quality control, transportation and logistics (goods tracking and movement), event management (ticketing, entry, access control, and identification), medical and education. Our primary products are cordless data capture devices incorporating barcode scanning or RFID/Near Field Communications (NFC) technologies that connect over Bluetooth. All products work with applications running on smartphones, mobile computers and tablets using operating systems from Apple® (iOS), Google (Android™) and Microsoft® (Windows®). Our Capture SDK, an essential part of the products we offer, allows mobile application developers to seamlessly integrate our data capture devices into their workflow, improving end user experiences and productivity. Our products are marketed by the application developers or the resellers of their applications as part of that solution. The number of our registered developers for data capture applications continues to grow.

Standard companion cordless barcode scanners. Our SocketScan® 700 Series barcode scanners include 1D linear imaging (S700), 1D laser (S730), 2D (S740 and S760) barcode scanners, available in five vivid colors: blue, green, red, white and yellow. S740 reads all common 1D, stacked, 2D and postal codes. In addition to 1D and 2D barcodes, S760 scans DotCode and most international travel IDs and passports.

Durable companion cordless barcode scanners. Our DuraScan® 700 Series Linear Barcode Scanner (D700), Laser Barcode Scanner (D730) and Universal Barcode Scanner (D740, D750, D760, D790), are designed to be durable barcode scanners with IP54-rated outer casing to withstand tougher environments. Universal Barcode Scanners (D740, D750, D760, D790) read all common 1D, stacked, 2D and postal codes. D740 is priced competitively with a 1D barcode scanner, making D740 the affordable 2D option available in the market. D760 includes MRZ (machine readable support zone) support, making it capable of scanning passports, visas, and other travel documents. D790 is designed to read DPM (Direct Part Marking) codes.

Attachable cordless barcode scanners. Our SocketScan 800 Series cordless barcode scanners, 1D linear imaging (S800) and 2D (S840, S860) are attachable to smartphones, tablets and other mobile devices with an easily detachable clip or DuraSled, creating a one-handed solution. In Q3, we rebranded and repositioned our Scanning Sled as DuraSled to eliminate the confusion caused by the previously marketed DuraCase. DuraSled enables both devices to be used and charged simultaneously and protects from common drops or bumps. Newly introduced DuraSled models support iPhone 10 and 11. S860 includes MRZ (machine readable support zone) support, making it capable of scanning DotCode, passports, visas, and other travel documents in addition to barcodes. SocketScan 800 Series scanners may be used stand-alone as well.

Contactless RFID/NFC reader writer. Our contactless product line includes the D600 Contactless Reader/Writer and S550 Token Exchange. The D600, an ergonomically handheld model with IP54-rated outer casing, can read and write many different types of electronic SmartTags or transfer data with near field communication. The S550 Token Exchange facilitates tap-and-go NFC user experiences with mobile wallets and consumer engagements, applicable for payment applications, contactless passes, identifications, ticketing and others which leverage the exchange of electronic “tokens”. These tokens can be exchanged via NFC enabled devices. Many smartphones support NFC communications and are expected to enable third party applications to transfer tokens utilizing NFC. S550 is currently available to developers and is scheduled to be launched in Q1 2020.

Software Developer Kit (Capture SDK). Our Software Developer Kit (Capture SDK) supports all our data capture devices with a single installation, making it easy for a developer to integrate our data capture capabilities into their application. Installing our data capture software enables their customers to choose any of our products that work best for them. Our Capture SDK enables the developer to modify captured data, control the placement of the barcoded or RFID data in their application, and control the feedback to the user that the transaction and transmission was successfully completed. Our Capture SDK also supports the built-in camera in a customer’s smartphone or tablet to be used for occasional or lower volume data collection requirements. The Capture SDK uses tools integrated with software build environments such as CocoaPods, Maven and NuGet, adds support for high level frameworks such as Xamarin, Cordova and Java, and adds other features to make it easier for developers to integrate our data capture software into their applications.

Service. Our products are warranted for one year and we offer SocketCare extended warranty programs for up to five years including repair or replacement due to accidental breakage. We also repair or replace products that are beyond their warranty period.

We design our own products and are responsible for all associated test equipment. Many of our components are made by third party contract manufacturers. We perform final product assembly, test, packaging and distribute our products worldwide at and from our Newark, California facility. We offer our products through two-tier distribution enabling customers to purchase from large numbers of on-line resellers and through online stores around the world including application developers who resell their own products along with our data capture products. We believe growth in mobile applications and the mobile workforce are resulting from technical advances in mobile technologies, cost reductions in mobile devices and the growing adoption by businesses of mobile applications for smartphones and tablets, building a growing demand for our products. Our data capture products address the need for speed and accuracy by today’s mobile workers and by the systems supporting those workers, thereby enhancing their productivity and allowing them to exploit time sensitive opportunities and improve customer satisfaction.

Revenues

Total revenues for the three and nine months ended September 30, 2019 were $5.0 million and $14.7 million, respectively, an increase of 20% and 19%, respectively, from revenues of $4.1 million and $12.3 million, respectively, in the comparable periods one year ago.

Mobile point of sale (mPOS) applications continued to be our primary growth driver in Q3 2019. Comparted to the same quarter a year ago, sales in Japan benefitted greatly from a government incentive program that provided rebates to small businesses upgrading to an on-line POS system. Increased sales in Europe were primarily driven by an iPad-based solution deployment. Sales in America remained unchanged.

Cost of Sales and Gross Margins

 Cost of sales primarily consists of the costs to manufacture our products, including the costs of materials, contract manufacturing, shipping costs, personnel and related expenses including stock-based compensation, equipment and facility expenses, warranty costs and inventory excess and obsolete provisions.

The factors that impact our gross margins are the cost of materials, the mix of products and the extent to which we are able to efficiently utilize our manufacturing capacity. Our gross margins on sales for the three and nine-month periods ended September 30, 2019 were 52.9% and 52.3%, respectively compared to 52.6% and 51.8%, respectively, for the corresponding periods a year ago.

Research and Development Expense

Research and development expenses consist of the personnel and related expenses including stock-based compensation of our research and development teams, and materials and supplies, consulting services, third party testing services and equipment and facility expenses related to our research and development activities. All research and development costs are expensed as incurred. 

Research and development expense in the three and nine months ended September 30, 2019 were $1,015,052 and $2,906,271, an increase of 15% and 6% compared to expenses of $884,497 and $2,748,310 in the corresponding periods a year ago. Increase in the level of research and development expense was primarily due to increase in compensation and benefits including stock-based compensation expense as result of an increase in annual salaries and headcount additions to facilitate product development and meet more complex requirements of today’s products. We expect research and development expense to increase slightly for the remainder of the year.

Sales and Marketing Expense

Sales and marketing expenses consist primarily of salaries and stock-based compensation for our sales and marketing personnel, fees for sales consultants, fees for professional services, marketing programs, advertising costs and travel expenses.

Sales and marketing expense in the three and nine months ended September 30, 2019 were $785,295 and $2,312,305, an increase of 6% and 5% compared to the expense of $738,804 and $2,210,499 in the corresponding periods a year ago.  The increase was primarily due to an increase in compensation and benefits including stock-based compensation expense as a result of an increase in annual salaries. Sales and marketing expense for Q4 2019 is expected to remain flat.

General and Administrative Expense

General and administrative expenses consist primarily of general corporate costs, including personnel expenses, financial reporting, corporate governance and compliance and outside legal, audit and tax fees.

General and administrative expense in the three and nine months ended September 30, 2019 were $706,485 and $2,052,882, an increase of 21% and 10% compared to the expense of $584,256 and $1,874,069 in the corresponding periods a year ago. The increase was primarily due to the legal expenses associated with the document preparation for the one-time tender offer to exchange 331,314 shares granted in year 2010 to our current employees, officers and directors.

Interest Expense, Net of Interest Income

 Interest expense represents interest expense on our term loans, lines of credit and equipment lease financing obligations. Interest income reflects interest earned on cash balances. Interest income was nominal reflecting low average cash balances combined with low average rates of return.

Interest expense, net of interest income, in the three and nine months ended September 30, 2019 was approximately $25,600 and $83,400, respectively, compared to $31,919 and $99,819, respectively, in the same periods one year ago. Interest expense in 2019 was primarily related to interest on bank term loan and credit line facilities (see “NOTE 4 — Bank Financing Arrangements” for more information). Average outstanding balance of bank term loan and credit lines during Q3 2019 was $1.58 million. Interest expense in 2018 was primarily related to interest on the term loan borrowed for repurchase of our common stock and credit line facilities. Average outstanding balance of bank term loan and credit lines during the Q3 2018 was $1.67 million.

Income Taxes

The Tax Cuts and Jobs Act of 2017, effective on January 1, 2018, eliminates alternative minimum taxes and lowers the U.S. federal corporate income tax rate from 34% to 21%. California corporate net income tax rate is 6.98% after allowing for federal deductibility. In the first nine months of 2019, our stock-based compensation of $392,000 is the primary permanent difference between financial and tax expense which increased our taxable income. We estimated our federal and state effective tax rate to be 36% in 2019. In the three and nine months ended September 30, 2019, we recorded a deferred tax expense of $37,400 and $85,000, respectively. In the three and nine months ended June 30, 2018, we recorded deferred tax benefits of $17,600 and $151,200, respectively, with the expectation of a return to profitable operating results and full utilization of our net operating loss carryforwards. Our deferred tax asset, primarily representing future income tax savings from the application of net operating loss carry forwards, was valued at $5,669,000 at September 30, 2019.

 We have determined that utilization of existing net operating losses against future taxable income is not limited by Section 382 of the Internal Revenue Code. Future ownership changes, however, may limit our ability to fully utilize the existing net operating loss carryforwards against any future taxable income. We will continue to monitor the likelihood to realize the value of deferred tax assets in the future.

Liquidity and Capital Resources

As reflected in our Statements of Cash Flows, net cash provided by operating activities was approximately $507,000 in the first nine months of 2019, compared to net cash provided by operating activities of approximately $612,000 in the comparable period a year ago. We calculate net cash used

in or provided by operating activities by increasing our net income ($225,927 in the first nine months of 2019) or decreasing our net loss ($408,528 in the first nine months of 2018) by the expenses, such as stock-based compensation expense, depreciation, and deferred tax expense, that did not require the use of cash. These amounts totaled $837,527 and $525,229 in the first nine months of 2019 and 2018, respectively. In addition, we report increases in assets and reductions in liabilities as uses of cash and decreases in assets and increases in liabilities as sources of cash, together referred to as changes in operating assets and liabilities.

In the first nine months of 2019, changes in operating assets and liabilities resulted in a net use of cash of approximately $556,000 which was primarily due to increases in accounts receivable driven by the higher shipments in the second half of Q3, the buildup of inventories to accommodate rising sales and prepayments for insurance policies and inventories. The use of cash was partially offset by an increase in accounts payable due to inventory buildup and the timing of vendor payments, an increase in accrued compensation due to improved financial results in 2019 and an increase in stocking levels in our distribution channel driven by higher level sales out.

In the first nine months of 2018, changes in operating assets and liabilities resulted in a net source of cash of $496,000 which resulted from lower inventory levels due to the reduction of component order sizes, a decrease in accounts receivable due to lower overall shipments to our distributors, and an increase in accounts payable due to the timing of vendor payments. The source of cash was partially offset by a decrease of accrued payroll and related expenses.

In the first nine months of 2019 and 2018, we invested approximately $437,000 and $389,000, respectively, in manufacturing tooling costs and computer software development costs.

Net cash used in financing activities was approximately $274,000 in the first nine months of 2019, compared to net cash used of $2.3 million in the comparable period a year ago. Financing activities in the first nine months of 2019 consisted primarily of $375,000 repayment on our term loan, offset by approximately $112,000 borrowed on our bank lines of credit. Financing activities in the first nine months of 2018 consisted primarily of the $5.0 million use of cash related to repurchase of company stock, partially offset by net $958,000 borrowed on our term loan, net $1.53 million borrowed on our bank lines of credit, and $279,000 proceeds from the exercise of stock options.

Contractual Obligations

Our contractual cash obligations at September 30, 2019 are outlined in the table below:

Off-Balance Sheet Arrangements

As of September 30, 2019, we have no off-balance sheet arrangements as defined in Item 303 of Regulation S-K.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to our bank term loan and credit line facilities. Amounts outstanding under the term loan bear interest at lender's prime rate (minimum of 4.25%) plus 1.75%. Our bank credit line facilities of up to $2.5 million have variable interest rates based upon the lender's prime rate (minimum of 4.25%) plus 0.75%, for both the domestic line (up to $2.0 million) and the international line (up to $0.5 million). Accordingly, interest rate increases could increase our interest expense on outstanding term loan and credit line balances. Based on a sensitivity analysis during the three months ended September 30, 2019, an increase of 1% in the interest rate would have increased our third quarter borrowing costs by approximately $3,938.

Foreign Currency Risk

A substantial majority of our revenue, expense and purchasing activities are transacted in U.S. dollars.  However, we require our European distributors to purchase our products in Euros and we pay the expenses of our European employees in Euros and British pounds.  We may enter into selected future purchase commitments with foreign suppliers that may be paid in the local currency of the supplier.  We hedge a significant portion of our European receivables balance denominated in Euros to reduce the foreign currency risk associated with these assets, and we have not been subject to significant losses from material foreign currency fluctuations.  Based on a sensitivity analysis of our net foreign currency denominated assets and expenses at the beginning, during and at the end of the quarter ended September 30, 2019, an adverse change of 10% in exchange rates would have resulted in an decrease in our net income for the third quarter of 2019 of approximately $97,000 if left unprotected.  For the third quarter of 2019, the total net adjustment for the effects of changes in foreign currency on cash balances, collections, payables, and derivatives used to hedge foreign currency risks, was a net loss of $15,900.  We will continue to monitor, assess, and mitigate through hedging activities, our risks related to foreign currency fluctuations.

Item 4. Controls and Procedures

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is (i) recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (ii) accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting during the third quarter of 2019 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II

Item 1A. Risk Factors

The risks described in this Quarterly Report on Form 10-Q are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition, and operating results.

We may not maintain ongoing profitability.

To maintain ongoing profitability, we must accomplish numerous objectives, including continued growth in our business, ongoing support to registered developers whose applications support the use of our data capture products, and the development of successful new products. We cannot foresee with any certainty whether we will be able to achieve these objectives in the future. Accordingly, we may not generate sufficient net revenue or manage our expenses sufficiently to maintain ongoing profitability. If we cannot maintain ongoing profitability, we will not be able to support our operations from positive cash flows, and we would use our existing cash to support operating losses. If we are unable to secure the necessary capital to replace that cash, we may need to suspend some or all of our current operations.

We may require additional capital in the future, but that capital may not be available on reasonable terms, if at all, or on terms that would not cause substantial dilution to investors’ stock holdings.

We may need to raise capital to fund our growth or operating losses in future periods. Our forecasts are highly dependent on factors beyond our control, including market acceptance of our products and delays in deployments by businesses of applications that use our data capture products. Even if we maintain profitable operating levels, we may need to raise capital to provide sufficient working capital to fund our growth. If capital requirements vary materially from those currently planned, we may require additional capital sooner than expected. There can be no assurance that such capital will be available in sufficient amounts or on terms acceptable to us, if at all.

If application developers are not successful in their efforts to develop, market and sell their applications into which our software and products are incorporated, we may not achieve our sales projections.

We are dependent upon application developers to integrate our scanning and software products into their applications designed for mobile workers using smartphones, tablets and mobile computers, and to successfully market and sell those application products and solutions into the marketplace. We focus on serving the needs of application developers as sales of our data capture products are application driven. However, these developers may take considerable time to complete development of their applications, may experience delays in their development timelines, may develop competing applications, may be unsuccessful in marketing and selling their application products and solutions to customers, or may experience delays in customer deployments and implementations, which would adversely affect our ability to achieve our revenue projections.

Failure to maintain effective internal controls could have a material adverse effect on our business, operating results and stock price.

We have evaluated and will continue to evaluate our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which requires an annual management assessment of the design and effectiveness of our internal control over financial reporting. If we fail to maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act. Moreover, effective internal controls, particularly those related to revenue recognition, are necessary for us to produce reliable financial reports and are important to helping prevent financial fraud. If we cannot provide reliable financial reports or detect and prevent fraud, our business and operating results could be harmed, investors could lose confidence in our reported financial information, and the trading price of our stock could drop significantly.

Despite security protections, our business records and information system could be hacked by unauthorized personnel

We protect our business records and information from access by unauthorized personnel. We maintain adequate segregation of duties in safeguarding our assets and related records and monitor our systems to detect any attempts to bypass our controls and procedures which we evaluate and update from time to time. We are aware that unauthorized efforts to access our business records and information system with sophisticated tools could bypass our controls and procedures and we remain alert to that possibility.

Global economic conditions may have a negative impact on our business and financial condition in ways that we currently cannot predict and may further limit our ability to raise additional funds.

Global economic conditions may have an impact on our business and our financial condition. We may face significant challenges if global economic growth slows down and conditions in the financial markets worsen. In particular, should these conditions cause our revenues to be materially less than forecast, we may find it necessary to initiate reductions in our expenses and defer product development programs. In addition, our ability to access the capital markets and raise funds required for our operations may be severely restricted at a time when we would like, or need, to do so, which could have an adverse effect on our ability to meet our current and future funding requirements and on our flexibility to react to changing economic and business conditions.

The decision by British voters to exit the European Union (“Brexit”) may negatively impact our financial results and cause realignment of our European and U.K. distribution channels.

Our products sold in Europe are primarily sold online through third party distributors and resellers operating within the European Common Market, some of whom are based in the U.K. and others whom are based outside of the U.K. All distributors within the European Common Market including the U.K. prior to exit may sell our products anywhere within the common market. Our distributors’ customers may purchase our products from any of these distributors. The outcome of Brexit negotiations remain uncertain, but the UK’s exit will likely change the trading relationship between the U.K. and the European Union which could affect the cost of goods imported into and exported from the U.K., could increase currency volatility that could drive a weaker British pound which could cause prices of our products sold in the U.K. to increase or profit margins to decline, may affect the ability of our distributors operating within the U.K. to sell our products into the European Common Market on competitive terms, and may affect the ability of our distributors operating within the European Common Market but outside of the U.K. to sell our products into the U.K. on competitive terms. With a range of outcomes still possible, the impact from Brexit remains uncertain and will depend, in part, on the final outcome of tariff, trade, regulatory and other negotiations.

Our quarterly operating results may fluctuate in future periods, which could cause our stock price to decline.

We expect to experience quarterly fluctuations in operating results in the future. We generally ship orders as received, and as a result we may have little backlog. Quarterly revenues and operating results therefore depend on the volume and timing of orders received during the quarter, which are difficult to forecast. Historically, we have often recognized a substantial portion of our revenue in the last month of the quarter. This subjects us to the risk that even modest delays in orders or in the manufacture of products relating to orders received, may adversely affect our quarterly operating results. Our operating results may also fluctuate due to factors such as:

Because we base our staffing and other operating expenses on anticipated revenues, unanticipated declines or delays in the receipt of orders can cause significant variations in operating results from quarter to quarter. As a result of any of the foregoing factors, or a combination, our results of operations in any given quarter may be below the expectations of public market analysts or investors, in which case the market price of our common stock would be adversely affected.

To maintain the availability of our bank lines of credit we must remain in compliance with the covenants as specified under the terms of the credit agreements and the bank may exercise discretion in making advances to us.

Our credit agreements with our bank requires us to maintain compliance with an asset coverage ratio of no less than 1.25 to 1.0, measured monthly. The agreement contains customary affirmative and negative covenants, including covenants that limit or restrict our ability to, among other things, grant liens, make investments, incur indebtedness, merge or consolidate, dispose of assets, make acquisitions, pay dividends or make distributions, repurchase stock, enter into transactions with affiliates and enter into restrictive agreements, in each case subject to customary exceptions for a credit facility of this size and type. The agreement also contains customary events of default including, among others, payment defaults, breaches of covenants, bankruptcy and insolvency events, cross defaults with certain material indebtedness, judgment defaults, and breaches of representations and warranties. Upon an event of default, our bank may declare all or a portion of our outstanding obligations payable to be immediately due and payable and exercise other rights and remedies provided for under the agreement. During the existence of an event of default, interest on the obligations could be increased. The agreement may be terminated by us or by our bank at any time. Upon such termination, our bank would no longer make advances under the credit agreement and outstanding advances would be repaid as receivables are collected. All advances are at our bank’s discretion and our bank is not obligated to make advances.

Deferred tax assets comprise a significant portion of our assets and are dependent upon future tax profitability to realize the benefits.

We have recorded deferred tax assets on our balance sheet because we believe that it is more likely than not that we will generate sufficient tax profitability in the future to realize the tax savings our deferred tax assets represent. If we do not achieve and maintain sufficient profitability, the tax savings represented by our deferred tax assets may never be realized and we would need to recognize a loss for those deferred tax assets.

Goodwill comprises a significant portion of our assets and may be subject to impairment write-downs in future periods which would substantially increase our losses, make it more difficult to achieve profitability, and could cause our stock price to decline.

We review our goodwill for impairment at least annually as of September 30th, and more often if factors suggest potential impairment. Many factors are considered in evaluating goodwill including our market capitalization, comparable companies within our industry, our estimates of our future performance, and discounted cash flow analysis. Many of these factors are highly subjective and may be negatively impacted by our financial results and market conditions in the future. We may incur goodwill impairment charges in the future and any future write-downs of our goodwill would adversely affect our operating results, make it more difficult to maintain profitability, and as a result the market price of our common stock could be adversely affected.

We may be unable to manufacture our products because we are dependent on a limited number of qualified suppliers for our components.

Several of our component parts are produced by one or a limited number of suppliers. Shortages or delays could occur in these essential components due to an interruption of supply or increased demand in the industry. Suppliers may choose to restrict credit terms or require advance payment causing delays in the procurement of essential materials. If we are unable to procure certain component parts, we could be required to reduce our operations while we seek alternative sources for these components, which could have a material adverse effect on our financial results. To the extent that we acquire extra inventory stocks to protect against possible shortages, we would be exposed to additional risks associated with holding inventory, such as obsolescence, excess quantities, or loss.

If we fail to develop and introduce new products rapidly and successfully, we will not be able to compete effectively, and our ability to generate sufficient revenues will be negatively affected.

The market for our products is prone to rapidly changing technology, evolving industry standards and short product life cycles. If we are unsuccessful at developing and introducing new products and services on a timely basis that include the latest technologies, conform to the newest standards and that are appealing to end users, we will not be able to compete effectively, and our ability to generate significant revenues will be seriously harmed.

The development of new products and services can be very difficult and requires high levels of innovation. The development process is also lengthy and costly. Short product life cycles for smartphones and tablets expose our products to the risk of obsolescence and require frequent new product upgrades and introductions. We will be unable to introduce new products and services into the market on a timely basis and compete successfully, if we fail to:

We cannot be sure that we will have sufficient resources to make adequate investments in research and development or that we will be able to identify trends or make the technological advances necessary to be competitive.

A significant portion of our revenue currently comes from a limited number of distributors, and any decrease in revenue from these distributors could harm our business.

A significant portion of our revenue comes from a limited number of distributors. In the nine months of 2019 and 2018, Ingram Micro Inc. and BlueStar, Inc. together represented approximately 57% and 55%, respectively, of our worldwide revenues. We expect that a significant portion of our revenue will continue to depend on sales to a limited number of distributors. We do not have long-term commitments from our distributors to carry our products, and any of our distributors may from quarter to quarter comprise a significant concentration of our revenues. Any could choose to stop selling some or all of our products at any time, and each of these companies also carries our competitors’ products. If we lose our relationship with any of our significant distributors, we would experience disruption and delays in marketing our products.