Form 10KSB for ELECTRONIC SENSOR TECHNOLOGY, INC
2-Apr-2007
Annual Report
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS.
You should read the following discussion and analysis of our financial
condition and results of operations together with the financial statements and
the related notes appearing in this annual report.
CRITICAL ACCOUNTING POLICIES
Electronic Sensor Technology records revenue from direct sales of products
to end-users when the products are shipped, collection of the purchase price is
probable and Electronic Sensor Technology has no significant further
obligations to the customer. Costs of remaining insignificant obligations of
Electronic Sensor Technology, if any, are accrued as costs of revenue at the
time of revenue recognition. Cash payments received in advance of product
shipment or service revenue are recorded as deferred revenue.
The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the financial
statements and the recorded amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Electronic Sensor Technology reviews long-lived assets, such as property and
equipment, to be held and used or disposed of, for impairment whenever events
or changes in circumstances indicate that the carrying amount of an asset may
not be recoverable. If the sum of the expected cash flows, undiscounted and
without interest, is less than the carrying amount of the asset, an impairment
loss is recognized as the amount by which the carrying amount of the asset
exceeds its fair value. At December 31, 2006 no assets were impaired.
We account for liquidated damages during 2006 and 2005 pursuant to Emerging
Issue Task Force ("EITF")05-04, View C, "The Effect of a
Liquidated Damages Clause on a Freestanding Financial Instrument Subject to
EITF Issue No. 00-19, "Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in, a Company's Own Stock". In
December 2006, FASB issued FASB Staff Position No. EITF 00-19-2
"Accounting for Registration Payment Arrangements" ("FSP
00-19-2"), which superseded EITF 05-04. FSP 00-19-2 provides that the
contingent obligation to make future payments or otherwise transfer
consideration under a registration payment arrangement, should be separately
recognized and measured in accordance with FASB Statement No.5,
"Accounting for Contingencies". The registration statement payment
arrangement should be recognized and measured as a separate unit of account
from the financial instrument(s) subject to that arrangement. If the transfer
of consideration under a registration payment arrangement is probable and can
be reasonably estimated at inception, such contingent liability is included in
the allocation of proceeds from the related financing instrument. Pursuant to
EITF 05-04, View C, the liquidated damages paid in cash or stock are accounted for
as a separate derivative, which requires a periodical valuation of its fair
value and a corresponding recognition of liabilities associated with such
derivative. FSP00-19-2 did not have an impact on our accounting of the
liquidated damages.
We registered all shares underlying the convertible debentures as well as
all shares underlying the warrants related to the convertible debentures on
November 21, 2006, and December 21, 2006, respectively.
We account for embedded conversion features and freestanding warrants
pursuant to SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities", which requires a periodic valuation of their fair
value and a corresponding recognition of liabilities associated with such
derivatives. The recognition of derivative liabilities related to the issuance
of shares of common stock is applied first to the proceeds of such issuance, at
the date of issuance, and the excess of derivative liabilities over the
proceeds is recognized as other expense in the accompanying consolidated
financial statements. The recognition of derivative liabilities related to the
issuance of convertible debt is applied first to the proceeds of such issuance
as a debt discount, at the date of issuance, and the excess of derivative liabilities
over the proceeds is recognized as other expense in the accompanying
consolidated financial statements. Any subsequent increase or decrease in the
fair value of the derivative liabilities, which are measured at the balance
sheet date, are recognized as other expense or other income, respectively.
Accounts receivable are reported at net realizable value. We have
established an allowance for doubtful accounts based upon factors pertaining to
the credit risk of specific customers, historical trends, and other
information. Delinquent accounts are written-off when it is determined that the
amounts are uncollectible.
Inventories are stated at the lower of cost or market, cost determined by
the first-in, first-out (FIFO) method. The company writes down its inventory
for estimated obsolescence or unmarketable inventory using the difference
between the cost of inventory and the estimated market value based upon
assumptions about future demand and market conditions.
We are required to estimate our income taxes in each of the jurisdictions in
which we operate as part of the process of preparing our consolidated financial
statements. SFAS No. 109, "Accounting for Income Taxes", requires a
valuation allowance to reduce the deferred tax assets reported if, based on the
weight of the evidence, it is not more likely than not that some portion or all
of the deferred tax assets will be realized. Management reviews deferred tax
assets periodically for recoverability and makes estimates and judgments
regarding the expected geographic sources of taxable income, gains from
investments, as well as tax planning strategies in assessing the need for a
valuation allowance. We determined that a valuation allowance of approximately
$2,000,000 relating to net operating loss carryovers was necessary to reduce
our deferred tax assets to the amount that will more likely than not be
realized. As a result, at December 31, 2006, the company has no net deferred
tax assets. If the estimates and assumptions used in our determination change
in the future, we could be required to revise our estimates of the valuation
allowances against our deferred tax assets and adjust our provisions for
additional income taxes. In the ordinary course of global business, there are
transactions for which the ultimate tax outcome is uncertain, thus judgment is
required in determining the worldwide provision for income taxes. We provide
for income taxes on transactions based on our estimate of the probable
liability. We adjust our provision as appropriate for changes that impact our
underlying judgments. Changes that impact provision estimates include such
items as jurisdictional interpretations on tax filing positions based on the
results of tax audits and general tax authority rulings.
PLAN OF OPERATIONS
Over the course of the next 12 months, we intend to execute our business
plan and focus our business development efforts in the following key areas:
o By diversifying our product offerings to enhance the usefulness of our
solutions for customers who will have already adopted one or more products;
o By enhancing our product lines and developing new products to attract new
customers; and
o By developing partnering relationships with wide-ranging sales and
distribution channel leaders already serving our vertical market space in a way
that assists them in developing new revenue streams and opportunities through
improved technical and sales support and customer services.
RESULTS OF OPERATIONS
FISCAL YEAR ENDED DECEMBER 31, 2006 COMPARED TO FISCAL YEAR ENDED DECEMBER 31, 2005 The following table sets forth certain items included in our Income Statements (see Financial Statements and Notes) for the periods indicated: Year Ended December 31, Variation $ Variation % -------------------------------- 2006 vs 2006 vs 2006 2005 2005 2005 -------------- -------------- -------------- -------------- In $ REVENUES $ 2,180,208 $ 2,122,349 57,859 2.7% COST OF SALES 1,085,056 1,302,602 (217,546) (16.7%) -------------- -------------- -------------- --------------- GROSS PROFIT 1,095,152 819,747 275,405 33.6% OPERATING EXPENSES: Research and development 833,791 260,125 573,666 220.5% Selling 822,954 653,092 169,862 26.0% Compensation 655,045 466,421 188,624 40.4% General and administrative 1,200,800 1,522,451 (321,651) (21.1%) -------------- -------------- -------------- --------------- TOTAL OPERATING EXPENSES 3,512,590 2,902,089 610,501 21.0% -------------- -------------- -------------- --------------- LOSS FROM OPERATIONS (2,417,438) (2,082,342) (335,096) (16.1%) OTHER INCOME AND EXPENSE: Other income - derivative liabilities 2,414,605 7,577,929 (5,163,324) (68.1%) Other expense - derivative liabilities 0 (2,401,358) 2,401,358 100.0% Other income 2,140 2,140 NM** Gain (loss) on sale of property and equipment (1,615) 9,287 (10,902) (117.4%) Interest expense (2,809,682) (324,540) (2,485,142) (765.7%) -------------- -------------- -------------- --------------- TOTAL OTHER INCOME (EXPENSE) (394,552) 4,861,318 (5,255,870) (108.1%) -------------- -------------- -------------- --------------- NET INCOME LOSS $ (2,811,990) $ 2,778,976 (5,590,966) (201.2%) ============== ============== -------------- --------------- |
**NM = not meaningful.
The following table sets forth, as a percentage of revenues, certain items
included in our Income Statements (see Financial Statements and Notes) for the
periods indicated:
Year Ended December 31, ---------------------- 2006 2005 ---------- ---------- As a % of revenues REVENUES 100% 100% COST OF SALES 49% 61% GROSS PROFIT 51% 39% OPERATING EXPENSES 161% 136% LOSS FROM OPERATIONS (110%) (97%) OTHER INCOME AND EXPENSE (18%) 229% NET INCOME (LOSS) (128%) 132% |
Revenues primarily consist of the sale of our zNose products. Revenues in 2006
were better than 2005 due to slightly higher sales volume. Product revenues
increased approximately 2.5% over 2005 as a result of a greater number of zNose
units shipped, 58 units versus 56 units. Product support sales improved 8% over
2005 primarily due to greater revenues generated from training and technical
support.
Cost of Sales primarily consists of manufacturing costs and licensing fees.
Cost of sales as a percentage of revenues improved from 61% in 2005 to 49% in
2006. The improvement was due to sales mix in which lower cost products
accounted for a larger percentage of sales in 2006 than in 2005. There were
also some additional production efficiencies achieved through refinement of the
production process.
Research and development expenses primarily consist of salaries and related
benefits, material and supplies associated with our efforts in developing and
enhancing our products. The increase in our research and development expenses
during 2006 is primarily attributable to an increase in salaries and related
benefits resulting from the hiring of personnel whose time is devoted to the
development and enhancement of our products.
Selling expenses primarily consist of salaries, commissions and related
benefits associated with our selling and marketing efforts. The increase in
selling expenses during 2006 when compared to 2005 is attributable to an
increase in personnel on the marketing staff as well as greater expenditures
for advertising, promotion and attendance at trade shows.
Compensation expenses primarily consist of salaries and related benefits of
our general and administrative personnel. The increase in compensation expenses
during 2006 when compared to 2005 is primarily attributable to payment of
severance to the former President and Chief Executive Officer of the company
and an increase in personnel to support the growth of our operations.
General and administrative expenses for 2006 were 21% less than 2005. The
improvement of approximately $322,000 resulted primarily from non-recurring professional
fees associated with the company's reverse merger in 2005. The improvement was
offset by an increase in personnel to support the company's growth.
Other income - derivative liabilities primarily consists of the decrease in
the fair value of derivative liabilities between balance sheet dates. The
decrease in other income-derivative liabilities during 2006 when compared to
2005 is primarily attributable to a decrease in the fair value of our stock
between issuance of the derivative contracts and the measurement dates during
2005.
Other expense - derivative liabilities primarily consists of the recognition
of derivative liabilities we issued during 2005. No such derivatives were
issued during 2006.
Interest expense primarily consists of debt discount amortization and
interest on certain debt. The increase in interest expense during 2006 when
compared to 2005 is primarily attributable to the recognition of debt discount
amortization associated with the issuance of convertible debentures in December
2005. In 2005, only one month's debt discount amortization was recognized while
twelve (12) months of debt discount amortization was recorded to interest
expense in 2006.
LIQUIDITY AND CAPITAL RESOURCES
Our cash and cash equivalents amounted to approximately $1.094 million at
December 31, 2006.
During 2006, we used approximately $2.963 million in our operating
activities which is the result of the following:
o A net loss of approximately $2.812 million adjusted for:
o the amortization of debt discount of approximately $2.333 million,
amortization of deferred financing costs of approximately $182,000 and a
decrease in the fair value of the derivative liabilities of approximately
$2.415 million.
o An increase in inventories of approximately $383,000 for materials
required for the production of several new products introduced during the year.
A decrease in accounts receivable and accounts payable and accrued expenses of
approximately $165,000, and $77,000 respectively, due to better collection
efforts and control over expenditures.
During 2006, we used approximately $162,000 in investing activities mostly
for purchase of property and equipment of approximately $129,000.
During 2006, we did not have any financing activities.
The company has a revolving line of credit for borrowings up to $500,000
with East West Bank. The line of credit is collateralized with a certificate of
deposit in the amount of $250,000. Borrowings under this agreement bear
interest at prime. The maturity date of the line of credit is March 31, 2007
and the line of credit is in the process of being renewed with East West Bank.
During 2005, we used approximately $2.945 million in our operating
activities which is the result of the following:
o A net income of approximately $2.779 million adjusted for:
o the recognition of derivative liabilities of approximately $2.401 million
resulting from the issuance of such derivative (convertible debentures and
warrants) and a decrease in the fair value of the derivative liabilities of
approximately $7.578 million.
o An increase in accounts receivables, inventories, and accounts payable and
accrued expenses of approximately $435,000, $459,000, $267,000, respectively,
resulting from increased revenues, increased production to meet the increased
demand for our products and a general increase in our expenses associated with
our growth.
During 2005, we used approximately $1.001 million in investing activities by
purchasing a certificate of deposit of approximately $919,000 to satisfy
collateral requirement of our line of credit and by incurring capital
expenditures of approximately $127,000.
During 2005, we generated approximately $8.140 million in financing
activities by generating proceeds of approximately $7.000 million and $3.812
million from the issuance of our convertible debentures and our shares of
common stock, respectively, offset by the repayment of our line of credit of
approximately $1.969 million and by paying financing costs of approximately $593,000.
Although Electronic Sensor Technology possesses a bank operating line of
credit, there can be no assurance that these proceeds will be adequate for our
capital needs. There can be no assurance that any required or desired financing
will be available through any other bank borrowings, debt, or equity offerings,
or otherwise, on acceptable terms. If future financing requirements are
satisfied through the issuance of equity securities, investors may experience
significant dilution in the net book value per share of common stock. There is
no guarantee that a market will exist for the sale of our shares.
Our primary capital needs are to fund our growth strategy, which includes
expanding our sales and marketing staff for the marketing, advertising and selling
of the zNose(R) family of chemical detection products, increasing distribution
channels both in the U.S. and foreign countries, introducing new products,
improving existing product lines and development of a strong corporate
infrastructure. We do not believe that we will have to incur significant
capital expenditures in the near future in order to meet our growth strategy
goals.
As of December 31, 2006, our cash balance and working capital were
$1,796,223 and $3,215,511, respectively. Our current monthly cash burn rate is
approximately less than $200,000 and we do not anticipate any extraordinary
cash payments that we will have to make in the near future until the first
principal payment of approximately $780,000 is due on the convertible
debentures that we issued on December 7, 2005, which such payment is to be made
on January 1, 2008. Based on our current monthly cash burn rate, the cash
balance in the bank and our sales backlog of approximately $1.750 million; we
believe that we will not require any financing until the first half of 2008.
Accordingly, we believe that we will be able to continue as a going concern for
at least the next twelve months.
SEASONALITY AND QUARTERLY RESULTS
We do not foresee any seasonality to our revenues or our results of
operations.
INFLATION
Although we currently use a limited number of sources for most of the
supplies and services that we use in the manufacturing of our vapor detection
and analysis technology, our raw materials and finished products are sourced
from cost-competitive industries. While prices for our raw materials may vary
significantly based on market trends, we do not foresee any material
inflationary trends for our product sources.
OFF BALANCE SHEET ARRANGEMENTS
We do not have any off-balance sheet arrangements.