VERITEC INC - Quarter Report: 2008 September (Form 10-Q)

The Exclusive License Agreement provides that all expenses related to the enforcement and licensing of the patents will be the responsibility of VData. The Company and VData share the net proceeds arising from the enforcement or licensing of the patents.

Infringement revenue has been the primary source of revenue for the Company in recent periods. Patents 4,924,078 and 5,612,524, which were the subject of the infringement claims, are currently being reexamined by the U.S. Patent and Trademark Office. United States District Court for the District of Minnesota recently ruled that the 5,612,524 patent was invalid and unenforceable. The Company plans to appeal this decision. As a result of these actions, infringement revenue from patents 4,924,078 and 5,612,524 has ceased.

D. SIGNIFICANT ACCOUNTING POLICIES

Revenue Recognition:

The Company accounts for revenue recognition in accordance with SEC Staff Accounting Bulletin (SAB) No. 101 “Revenue Recognition in Financial Statements” and related amendments. Revenues for the Company are classified into four separate products; license revenue (Veritec’s Multi-Dimensional matrix symbology), hardware revenue, and identification card revenue (license and other) and infringement revenue. Revenues from licenses, hardware and identification cards are recognized when the product is shipped and all required payment terms have been completed. The process typically begins for license and hardware revenue with a customer purchase order detailing its hardware specifications so the Company can import its software into the customer’s hardware. Once importation is completed, if the customer only wishes to purchase a license, the Company typically transmits the software to the customer via the internet. Revenue is recognized at that point. If the customer requests both license and hardware products, once the software is imported into the hardware and the process is complete, the product is shipped and revenue is recognized at time of shipment. Once the software and/or hardware are either shipped or transmitted, the customers do not have a right of refusal or return. Under some conditions, the customers remit payment prior to the Company having completed importation of the software. In these instances, the Company delays revenue recognition and reflects the prepayments as customer deposits.

The process for identification cards begins when a customer requests, via the internet, an identification card. The card is reviewed for design and placement of the data, printed and packaged for shipment. At the time the identification cards are shipped and the customer has met the required payment terms, the revenue is recognized.

The Company receives infringement revenue under an Exclusive License Agreement with VData. The Exclusive License Agreement with VData provides that all expenses related to the enforcement and licensing of the patents is the responsibility of VData. The Company and VData share the net proceeds arising from enforcement or licensing of the patents. As a result, all infringement revenue is recognized at the time it is received. None of the infringement revenue is refundable to any party once received.

Patent Costs:

The patent application costs are capitalized and, when approved, will be amortized over its estimated useful life. If not approved, or if considered impaired, these costs will be written off when deemed impaired.

Income Taxes:

The Company’s adoption, on July 1, 2007, of Financial Accounting Standards Board (FASB) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes (as amended)”, did not have a significant impact on the Company’s consolidated financial position, results of operations, and cash flows.

E. NET LOSS PER COMMON SHARE

Basic net loss per common share is computed by dividing the loss available to common stockholders by the weighted-average number of common shares outstanding. Diluted net loss per common share, in addition to the weighted-average number of common shares outstanding determined for basic net loss per common share, includes potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock.

The weighted average shares outstanding were 15,115,088 and 15,096,827 for the three months ended September 30, 2008 and 2007, respectively. Potentially dilutive instruments include stock options, preferred stock and stock bonus/compensation (Note F). For the three months ended September 30, 2008, stock options (296,749 common shares) and preferred stock (10,000 common shares) were antidilutive and, therefore, were not included in the computation of diluted net loss per common share. For the three months ended September 30, 2007, stock options (195,666 common shares), preferred stock (10,000 common shares) and unpaid stock bonus/compensation were antidilutive and, therefore, were not included in the computation of diluted net loss per common share.

F. STOCK-BASED COMPENSATION

The Company has agreements with certain employees and consultants that provide for five years of annual grants of options, on each employment anniversary date, to purchase shares of the Company’s common stock. The option price is determined based on the market price on the date of the grant for some of the employees and market price on the date of grant for the others, the options vest one year from date of grant, and the options expire five years after vesting. At September 30, 2008, the Company has commitments under these agreements to grant options to acquire 20,000 shares of the Company’s common stock for each fiscal year for 2009 through 2011 and 10,000 shares for fiscal year 2012, totaling 70,000 shares.

A summary of outstanding stock options is as follows:

		Number
		of				Weighted — Average
		Shares				Exercise Price
Outstanding at June 30, 2008			267,749			$	0.82
Granted			10,000			$	0.14
Outstanding at September 30, 2008			277,749			$	0.80

The weighted-average remaining contractual life of stock options outstanding at September 30, 2008 is 4.6 years.

The weighted-average fair value of options granted for the three months ended September 30, 2008 and 2007 was $0.14 and $0.50, respectively. Stock-based compensation expense was $1,171 and $9,766 during the three months ended September 30, 2008 and 2007, respectively. As of September 30, 2008, there was $2,211 of unrecognized compensation costs related to stock options. These costs are expected to be recognized over the next three quarters.

The Board of Directors had authorized the Chief Executive Officer to issue up to 1,000,000 shares of the Company’s common stock in the form of options or stock bonuses to employees and consultants. At September 30, 2008, stock and stock options totaling 399,249 have been committed under this authorization.

G. OTHER SIGNIFICANT EVENTS

In November 2006, the Company entered into an agreement with a manufacturing company to design and develop a line of readers to overcome the Company’s dependence on outside suppliers. In Phase One of the project, a proto-type cell phone reader designed by the manufacturing company was evaluated and accepted. Phase Two of the project requires the manufacturing company to design and manufacture four individual proto-type models of readers that work with Matrix Symbologies. The agreement required a deposit of $30,000 and payments of $30,000 for each of the four defined milestones with the total project cost not to exceed $150,000. The project is continuing to progress but at this time no estimate as to the completion date has been determined. To date the Company has made the required deposit of $30,000, a $20,000 advance and accrued another $50,000 for a total cost of $100,000 against the maximum expenditure of $150,000. Payments under this agreement are recorded as research and development expense as the service is provided.

In August 2007, the Company entered into an agreement with a consultant to purchase certain intellectual property. The agreement requires the Company to make a $25,000 payment once it has been proven that the intellectual property is patentable. It also requires the Company to issue 60,000 shares of the Company’s common stock to the consultant once one or more patents have been issued. At September 30, 2008, the intellectual property information has been submitted to the Company’s patent attorney and is being reviewed for patentability.

H. RECENTLY ISSUED ACCOUNTING STANDARD

In September 2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 157, “Fair Value Measurements (as amended)”, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosure about fair value measurements. SFAS No. 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value, and therefore, does not expand the use of fair value in any new circumstances. SFAS No. 157 will be effective for the Company beginning fiscal year 2009. In February 2008, the FASB issued FASB Staff Position No. FAS 157-2, Effective Date of FASB Statement No. 157. This FSP permits the delayed application of SFAS No. 157 for all non-recurring fair value measurement of non-financial assets and non-financial liabilities until fiscal years beginning after November 15, 2008. Management is currently evaluating the impact SFAS No. 157 will have on the consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities (as amended), Including an Amendment of FASB Statement No. 115,” which permits entities to measure eligible financial assets, financial liabilities and firm commitments at fair value, on an instrument-by-instrument basis, that are otherwise not permitted to be accounted for at fair value under other generally accepted accounting principles. The fair value measurement election is irrevocable and subsequent changes in fair value must be recorded in earnings. SFAS No. 159 will be effective for the Company beginning fiscal year 2009. Management is currently evaluating if it will elect the fair value option for any of the Company’s eligible financial instruments.

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

Results of Operations — June 30, 2008 compared to June 30, 2007

We had a net loss of $50,474 for the three months ended September 30, 2008 compared to a net loss of $446,030 for the three months ended September 30, 2007.

License and other revenues are derived from our Product Identification systems sold principally to customers in the LCD monitor industry.

For the three months ended September 30, 2008, license and other revenue was $432,532 compared to $70,214 for the three months ended September 30, 2007, an increase of $362,318. The license and other revenue increase are attributable to growth of the demand for LCD screens. Revenues from the LCD market remain unpredictable as they are generated when customers open new production facilities or update production equipment; however, for now the Company continues to experience demand for product identification product licenses in the LCD industry. The majority of the increase is a result of one customer purchasing a large quantity of our Vericode^® for product identification and one customer using our expertise to port our technology into their reader during the three months ended September 30, 2008.

Cost of Goods Sold

Cost of sales for the three months ended September 30, 2008, totaled $63,596 and for the three months ended September 30, 2007, cost of sales were $30,887, an increase of $32,709. Charges of $28,875 for a designated site and maintenance services of a computer database to store information in conjunction with our Independent Sales Organization (ISO) license, purchased in December 2006, accounted for 45% and 93% of the total cost of goods sold for the three month periods ended September 30, 2008 and 2007, respectively. The remaining amount for the three months ended September 30, 2008 was a result of establishing a reserve for potential obsolescence of $3,000 and $31,721 for the cost of the licenses sold during the quarter and inventory used for testing and customer demonstrations. The remaining amount for the three months ended September 30, 2007 was for the cost of the licenses sold during the quarter.

Operating Expenses

Research and development expense for the three months ended September 30, 2008 totaled $99,095 versus $139,963 for the three months ended September 30, 2007. The decrease of $40,868 was principally the result of reduced consultant and project costs totaling $54,300 for the three months ended September 30, 2008 and an increase of $11,772 in engineering payroll due to increases and the hiring of higher quality engineers. For the three months ended September 30, 2008, the Company has been focusing on one major engineering project. Thereby eliminating a demand for additional outside engineering consultants and providing cost savings to the Company.

Sales and marketing expense for the three months ended September 30, 2008 were $37,146 compared to $51,052 for the three months ended September 30, 2007, a decrease of $13,906. For the three months ended September 30, 2008, the Company had no sales staff, accounting for $25,748 of cost savings compared to the same three month period ended September 30, 2007. The Company, for the three months ended September 30, 2008, paid out commissions of $13,033 compared to $608 for the three month period ended September 30, 2007.

General and administrative expenses for the three months ended September 30, 2008 were $284,230 compared to $303,884 for the three months ended September 30, 2007, a decrease of $19,654 over the three months ended September 30, 2007. The decrease was the result of some expenditures for the three months ended September 30, 2007 that did not occur in the three months ended September 30, 2008. Rent expense was lower by $7,400 due to the Company not renting two housing units for guests for the three months ended September 30, 2008, the Company reducing outside accounting fees by $20,890, and the reduction of amortization expense by $8,333. The Company did see increases of $11,328 for Directors and Officers insurance and $8,750 for outside consultants for the three months ended September 30, 2008. The Company acquired the Directors and Officers insurance so as to attract Board Members and the outside consultants were used to formulate a plan to allow Veritec to meet its compliance issues for SOX 404.

Other Income (Expense)

Interest income for the three months ended September 30, 2008 was $1,061 compared to $8,557 for the three months ended September 30, 2007 a decrease of $7,496. The decrease was a result of the Company’s need for cash to fund the operations, thus drawing down cash reserves and in so doing earning less interest.

Liquidity

For the three months ended September 30, 2008 and 2007, the Company had not received any cash from infringement revenue through its relationship with VData. The patents (4,924,078 and 5,612,524), which were the subject of the infringement claims, are currently being reexamined by the U.S. Patent and Trademark Office. United States District Court for the District of Minnesota recently ruled that the 5,612,524 patent was invalid and unenforceable. The Company plans to appeal this decision. As a result of these actions, infringement revenue from patents 4,924,078 and 5,612,524 has ceased.

At September 30, 2008, the Company has $313,896 and $20,605 of cash and working capital, respectively. The Company believes its cash and forecasted cash flow from operations will not be sufficient to continue operations through fiscal 2009. The Company believes it will require additional funds to continue its operations through fiscal 2009 and continue to develop its existing and future projects by obtaining investment funds, generating sufficient sales revenue, implementing dramatic cost reductions or any combination thereof. There is no assurance that the Company can be successful in raising such funds, generating the necessary sales or reducing major costs.

Commitments and Contractual Obligations

The Company has one annual lease commitment of $37,800 for the corporate office building, which is leased from Ms. Tran, that expires June 30, 2012. The commitment is for the corporate offices at 2445 Winnetka Avenue North, Golden Valley, Minnesota. The total amount of the 4-year lease commitment is $151,200.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements.

Critical Accounting Policies

Stock-Based Compensation:

The Company accounts for stock-based compensation under Statement of Financial Accounting Standards (SFAS) No. 123(R), “Share-Based Payment” using the modified prospective application method. SFAS No. 123(R) requires the cost of employee compensation paid with equity instruments to be measured based on grant-date fair values and recognized over the vesting period.

Revenue Recognition:

The Company accounts for revenue recognition in accordance with SEC Staff Accounting Bulletin (SAB) No. 101 “Revenue Recognition in Financial Statements” and related amendments. Revenues for the Company are classified into four separate products; license revenue (Veritec’s Multi-Dimensional matrix symbology), hardware revenue, and identification card revenue (collectively, other), and infringement revenue. Revenues from licenses, hardware, and identification cards are recognized when the product is shipped and collection is reasonably assured. The process typically begins for license and hardware revenue with a customer purchase order detailing its hardware specifications so the Company can import its software into the customer’s hardware. Once importation is completed, if the customer only wishes to purchase a license, the Company typically transmits the software to the customer via the Internet. Revenue is recognized at that point. If the customer requests both license and hardware products, once the software is imported into the hardware and the process is complete, the product is shipped and revenue is recognized at time of shipment. Once the software and/or hardware are either shipped or transmitted, the customers do not have a right of refusal or return. Under some conditions, the customers remit payment prior to the Company having completed importation of the software. In these instances, the Company delays revenue recognition and reflects the prepayments as customer deposits.

The process for identification cards begins when a customer requests, via the Internet, an identification card. The card is reviewed for design and placement of the data, printed and packaged for shipment. At the time the identification cards are shipped and collection is reasonably assured, revenue is recognized.

The Company has received infringement revenue under its Exclusive License Agreement with VData LLC (VData). VData is a wholly owned subsidiary of Acacia Research Corporation (NASDAQ: ACTG). The Exclusive License Agreement with VData provides that all expenses related to the enforcement and licensing of the patents is the responsibility of VData. The Company and VData share the net proceeds arising from enforcement or licensing of the patents. As a result, all infringement revenue is recognized at the time it is received. None of the infringement revenue is refundable to any party once received.

ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our financial instruments include cash and cash equivalents. Our cash and cash equivalents are not subject to significant interest rate risk due to the short maturities of these instruments. As of September 30, 2008, the carrying value of our cash and cash equivalents approximated fair value. We have in the past and may in the future obtain marketable debt securities (principally consisting of commercial paper, corporate bonds and government securities) having a weighted average duration of one year or less. Consequently, such securities would not be subject to significant interest rate risk. Our main investment objectives are the preservation of investment capital and the maximization of after-tax returns on our investment portfolio. We do not use derivative instruments for speculative or investment purposes.

ITEM 4 CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

We maintain “disclosure controls and procedures” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer/Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable assurance of achieving the desired objectives, and we necessarily are required to apply our judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures.

Our management, with the participation of our Chief Executive Officer/Chief Financial Officer, have evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. It was concluded that the disclosure controls and procedures were not effective, because certain deficiencies involving internal controls constituted material weaknesses as discussed below. The material weaknesses identified did not result in the restatement of any previously reported financial statements or any other related financial disclosures, nor does management believe that it had any effect on the accuracy of our financial statements for the current reporting period.

Internal Control over Financial Reporting

There have not been any changes in our internal control over financial reporting during the fiscal year to which this report relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II

ITEM 1 LEGAL PROCEEDINGS

Vcode joined with VData as Plaintiffs in patent enforcement litigation filed on October 4, 2005, against Brother Industries, Ltd., Sato Corporation, Toshiba Corporation and US Bank National Association in the United States District Court for the District of Minnesota alleging violations of the Company’s patents. US Bank National Association has entered into a licensing agreement with the Company and the case as to that defendant was dismissed. The remaining defendants, Brother Industries, Ltd., Sato Corporation, and Toshiba Corporation, did not settle but were dismissed from the case without prejudice. VData and the Company must wait for resolution of the patent reexaminations, described below, before re-asserting claims against the remaining defendants.

On March 13, 2006, in response to notices of infringement sent to its customers by VData, Cognex Corporation filed a preemptive action seeking a Declaratory Judgment against VData and the Company in the United States District Court for the District of Minnesota. Amongst other remedies the action seeks a ruling from the court that Vcode’s United States Patent No. 5,612,524 is not enforceable against Cognex Corporation and its customers, that the Company has defamed Cognex and that the Company has engaged in unfair and deceptive business practices in violation of Minnesota law. On December 27, 2006, an answer and affirmative defense was filed to contest the plaintiff’s allegations and claims for damages, injunctive relief, attorney’s fees, and costs. On May 19, 2008, the summary judgment was received ruling in favor of Cognex on three of the four claims. The Court found that the asserted claims of the 5,612,524 patent were invalid, the entire patent unenforceable and denied our motion to dismiss the defamation claim. However the Court did grant our motion to dismiss the Minnesota DTPA (Deceptive Trade Practices Act) claim. Cognex subsequently filed a motion for the Court to declare this an exceptional case and award Cognex its attorney fees. The Company, along with the other defendants, filed an opposition to this motion. No decision has been made by the Court to date on this motion.

On April 6, 2006, the U.S. Patent and Trademark Office granted a Third Party Request for an Ex Parte Reexamination of Vcode’s United States Patent No. 5,612,524.  A response on behalf of the Company rebutting the allegations in the Request for Reexamination was filed with the U.S. Patent and Trademark Office. In December 2007, the Company received a determination by the U.S. Patent and Trademark Office stating that some of the claims in the patent were patentable and others were being rejected. The Company submitted a rebuttal against the decision in February 2008. The Company believes that when the final determination occurs, even if the determination is adverse to the patent, it would not be detrimental to the Company’s ability to market its products, but will be detrimental to the collection of licensing fees based upon this patent.

On May 23, 2006, Vcode joined with VData as a Plaintiff in a pending patent enforcement litigation filed against Aetna, Inc., PNY Technologies, Inc., Merchants’ Credit Guide Co. The Allstate Corporation, and American Heritage Life Insurance Company in the United States District Court for the District of Minnesota alleging violations of the Company’s patents. The Allstate Corporation and American Heritage Life Insurance Company have entered into a licensing agreement with the Company and the case as to those defendants has been dismissed. Aetna, Inc., and Merchants’ Credit Guide Co. have filed responsive pleadings in the action. PNY Technologies, Inc. has counterclaimed with allegations of non-infringement, invalidity, and inequitable conduct and is seeking attorney’s fees and costs. Defendant Aetna, Inc. filed a Motion to Dismiss and a Motion for Rule 11 Sanctions. The Court denied both of Aetna’s motions. Defendant Merchant’s Credit Guide Co. filed a Motion to Stay Alternative Motion for Sanctions. The Court granted Merchants’ Motion to Stay and the case is currently stayed pending reexamination of the patents. This case has not been set for trial.

On October 26, 2006, a Third Party Request for an Ex Parte Reexamination of Vcode’s United States Patent No. 4,924,078 was made.  The Company was awaiting a determination from the U.S. Patent and Trademark Office as to whether a grant of the request for reexamination was merited.  On January 17, 2007, the reexamination for United States Patent No. 4,924,078 was ordered. The Company believes that a determination adverse to the patent would not be detrimental to the Company’s ability to market its products, but could be detrimental to the collection of licensing fees based upon this patent.

On April 16, 2007, Vcode and VData filed a patent infringement case in the Eastern District of Texas against Cognex relating to United States Patent No. 5,331,176.  Cognex has counterclaimed for non-infringement and invalidity.  In April 2008, an agreement between the parties was reached to dismiss without prejudice the claim. The agreement has been signed by all parties and fully executed.

Vcode joined with VData as Plaintiffs in patent enforcement litigation filed on August 21, 2007, against Data Logic, Inc., Hand Held Products, Inc. and Siemens Energy and Automation, Inc. in the United States District Court for the District of Texas alleging violations of the Company’s Patent No. 5,331,176. Hand Held Products, Inc. has entered into an agreement with the Company and the case as to that defendant was dismissed. In April 2008, a proposed agreement between the remaining parties was reached to dismiss without prejudice the claim. The agreement is awaiting the signatures of all parties.

ITEM 1A RISK FACTORS

There have been no material changes to our risk factors and uncertainties during the three months ended September 30, 2008. For a discussion of the Risk Factors, refer to the “Risk Factors” section of Item 1 in the Company’s Annual Report on Form 10-K for the period ended June 30, 2008.

ITEM 6 EXHIBITS

31.1				CEO Certification required by Rule 13a14(a)/15d14(a) under the Securities Exchange Act of 1934.
31.2				CFO Certification required by Rule 13a14(a)/15d14(a) under the Securities Exchange Act of 1934.
32.1				Veritec, Inc. Certification of CEO/CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. §1350).

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

VERITEC, INC.
By		/s/ Van Thuy Tran   Van Thuy Tran				November 14, 2008
		Director, Chief Executive Officer
By		/s/ Van Thuy Tran   Van Thuy Tran				November 14, 2008
		Chief Financial Officer

EXHIBIT INDEX

31.1				CEO Certification required by Rule 13a14(a)/15d14(a) under the Securities Exchange Act of 1934.
31.2				CFO Certification required by Rule 13a14(a)/15d14(a) under the Securities Exchange Act of 1934.
32.1				Veritec, Inc. Certification of CEO/CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. §1350).