AWARE INC /MA/ 10-Q

ITEM 2: Management’s Discussion and Analysis o f Financial Condition and Results of Operations Cautionary Statement for Purposes of the “Safe Harbor” Provisions of the Private Securities Litigation Reform Act of 1995 Some of the information in this Quarterly Report on Form 10-Q contains forward‑looking statements that involve substantial risks and uncertainties. You can identify these statements by forward‑looking words such as “may,” “will,” “expect,” “anticipate,” “believe,” “estimate,” “continue” and similar words. You should read statements that contain these words carefully because they: (1) discuss our future expectations; (2) contain projections of our future operating results or financial condition; or (3) state other “forward‑looking” information. However, we may not be able to predict future events accurately. The risk factors listed in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2023, as well as any cautionary language in this Quarterly Report on Form 10-Q, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward‑looking statements. You should be aware that the occurrence of any of the events described in these risk factors and elsewhere in this Quarterly Report on Form 10-Q could materially and adversely affect our business. Summary of Operations We are primarily engaged in the development and sale of biometrics products, solutions and services. Our software products are used in government and commercial systems and applications and fulfill a broad range of functions critical to secure biometric enrollment, authentication, identification and transactions. Principal government applications of biometrics systems include border control, visa applicant screening, law enforcement, national defense, intelligence, secure credentialing, access control, and background checks. Principal commercial applications include: i) user enrollment and authentication used for login to mobile devices, computers, networks, and software programs; ii) user authentication for financial transactions and purchases (online and in-person); iii) physical access control to buildings; and iv) identity proofing of prospective employees and customers. We sell our biometrics software products and services globally through a multifaceted distribution strategy using systems integrators, OEMs, VARs, partners, and directly to end user customers. We also derive a portion of our revenue from the sale of imaging software licenses to OEMs and systems integrators that incorporate our software into medical imaging products and medical systems. On October 30, 2024 we announced, Robert Eckel, our Chief Executive Officer and a member of our Board of Directors, will resign from this positions effective as of December 31, 2024. In anticipation of that transition we have engaged an executive strategic advisor to work with the Board and our management to evaluate our market position and sales strategy and provide strategic recommendations. In addition, we have engaged an executive search firm to assist in the identification of Mr. Eckel’s successor. We anticipate that we will recognize approximately $0.9 million of general and administrative expenses during the fourth quarter of 2024 related to this transition. Summary of Financial Results We use revenue and results of operations to summarize financial results as we believe these measurements are the most meaningful way to understand our operating performance. Revenue and operating loss for the three months ended September 30 2024 were $3.8 million and $1.5 million, respectively. These results compared to revenue of $6.4 million and operating income of $0.7 million for the three months ended September 30, 2023. The shift from operating income to an operating loss in the current three month period was primarily due to a $2.6 million decrease in revenue along with the impact of a gain of $0.8 million we recorded related to an adjustment in the fair value of contingent acquisition payment related to our Fortr3ssID acquisition in December 2021 in the three months ended September 30, 2023. These were partially offset by $0.3 million decrease in operating expenses resulting cost-control measures we implemented in the second half of 2023 and the first quarter of 2024, including a reduction of approximately ten percent of our headcount across all departments. Revenue and operating loss for the nine months ended September 30 2024 were $12.6 million and $4.1 million, respectively. These results compared to revenue of $13.9 million and operating loss of $4.1 million for the nine months ended September 30, 2023. Operating loss in the current nine month was impacted primarily by a $1.3 million decrease in revenue, which was partially offset by a $1.2 million decrease in operating expenses resulting from cost-control measures we implemented in the second half of 2023 and the first quarter of 2024, 17 including a reduction of approximately ten percent of our headcount across all departments. During the three months ended September 30, 2023, we recorded a gain of $0.8 related to an adjustment in the fair value of contingent acquisition payment related to our Fortr3ssID acquisition in December 2021. These and all other financial results are discussed in more detail in the results of operations section that follows. Results of Operations Software licenses. Software licenses consist of revenue from the sale of biometrics and imaging software products. Sales of software products depend on our ability to win proposals to supply software for biometrics systems projects either directly to end user customers or indirectly through channel partners. Software license revenue decreased 73% from $4.4 million in the three months ended September 30, 2023 to $1.2 million for the three months ended September 30, 2024. As a percentage of total revenue, software license revenue decreased from 69% in the third quarter of 2023 to 31% in the current year quarter. The $3.2 million decrease in software license revenue was due primarily to a decrease in perpetual licenses sales including the impact of $2.9 million of license revenue related to a government contract recognized in the three months ended September 30, 2023. Software license revenue decreased 32% from $7.5 million in the nine months ended September 30, 2023 to $5.1 million for the nine months ended September 30, 2024. As a percentage of total revenue, software license revenue decreased from 54% in the nine months ended September 30, 2023 to 41% in the current year period. The $2.4 million decrease in software license revenue was due primarily to a decrease in perpetual licenses sales including the impact of $2.9 million of license revenue related to a government contract recognized in the three months ended September 30, 2023 and partially offset by $0.3 million increase in license revenue related to subscription contracts. Software license sales have historically fluctuated, and we expect software license revenue to continue to fluctuate since these sales are based on the timing of projects with our customers and partners. Our market strategy is to continue to focus on our legacy government biometrics markets and expand into new commercial biometrics markets. We are unable to predict future revenue from commercial markets as these are emerging markets. Software maintenance . Software maintenance consists of revenue from the sale of software maintenance contracts. Software maintenance contracts entitle customers to receive software support and software updates, if and when they become available, during the term of the contract. Software maintenance revenue increased 19% from $1.9 million in the three months ended September 30, 2023 to $2.3 million in the three months ended September 30, 2024. As a percentage of total revenue, software maintenance revenue increased from 30% in the third quarter of 2023 to 59% in the current year third quarter. For the three month period ended September 30, 2024, the increase in software maintenance revenue was primarily due to expansion of our customer base that has purchased and is actively using our perpetual software licenses. Software maintenance revenue increased 20% from $5.5 million in the nine months ended September 30, 2023 to $6.6 million in the in the nine month period ended September 30, 2024. As a percentage of total revenue, software maintenance revenue increased from 40% in the first nine months of 2023 to 52% in the current year period. For the nine month period ended September 30, 2024, the increase in software maintenance revenue was primarily due to software maintenance related to our sales of perpetual software licenses. Services and other revenue . Services revenue consists of fees we charge to perform software development, integration, installation, and customization services. Similar to software license revenue, services revenue depends on our ability to win biometrics systems projects either directly with end user customers or in conjunction with channel partners. Other revenue consists of hardware fees that are included with some of our software licenses. Services and other revenue increased from $0.1 million in the three months ended September 30, 2024 to $0.4 million in the three months ended September 30, 2024. As a percentage of total revenue, services and other revenue increased from 2% in the third quarter of 2023 to 11% in the current year quarter. 18 Services and other revenue increased 5% from $0.8 million in the nine months ended September 30, 2023 to $0.9 million in the nine months ended September 30, 2024. As a percentage of total revenue, services and other revenue increased from 6% in the nine months ended September 30, 2023 to 7% in the current year period. Services and other revenue fluctuate dependent on when we commence new projects and when we complete projects that were started in previous periods. Cost of services and other revenue. Cost of services and other revenue consists primarily of engineering costs to perform customer services projects and other third-party costs that are included with some of our software licenses. Such costs primarily include: i) engineering salaries, stock-based compensation, fringe benefits, and facilities; ii) engineering consultants and contractors; iii) software license fees; and iv) hardware costs. Cost of services and other revenue decreased 34% from $0.4 million in the three months ended September 30, 2023 to $0.3 million the three months ended September 30, 2024. Cost of services and other revenue as a percentage of total revenue increased from 2% in the third quarter of 2023 to 11% in the current year third quarter. Cost of services and other revenue decreased 21% from $1.0 million in the nine months ended September 30, 2023 to $0.8 million in the current year period. Cost of services and other revenue as a percentage of total revenue decreased from 7% in the nine months ended September 30, 2023 to 6% in the current year period. Gross margins on services and other revenue are a function of: i) the nature of the projects; ii) the level of engineering difficulty and labor hours required to complete project tasks; and iii) how much we were able to charge. We expect that gross margins on services and other revenue will continue to fluctuate in future periods based on the nature, complexity, and pricing of future projects. Research and development expense. Research and development expense consists of costs for: i) engineering personnel, including salaries, stock-based compensation, fringe benefits, and facilities; ii) engineering consultants and contractors, and iii) other engineering expenses such as supplies, equipment depreciation, dues and memberships and travel. Engineering costs incurred to develop our technology and products are classified as research and development expense. As described in the cost of services section, engineering costs incurred to provide engineering services for customer projects are classified as cost of services and other revenue, and are not included in research and development expense. The classification of total engineering costs to research and development expense and cost of services and other revenue was (in thousands): Three Months Ended September 30, Nine Months Ended September 30, 2024 2023 2024 2023 Research and development expense $ 1,873 $ 2,264 $ 5,922 $ 6,909 Cost of services and other revenue 270 410 817 1,033 Total engineering costs $ 2,143 $ 2,674 $ 6,739 $ 7,942 Total engineering costs decreased 20% from $2.7 million in the three months ended September 30, 2023 to $2.1 million in the three months ended September 30, 2024. As a percentage of total revenue, total engineering costs increased from 42% in the three months ended September 30, 2023 to 56% in the same current year quarter. Total engineering costs decreased 15% from $7.9 million in the nine months ended September 30, 2023 to $6.7 million in the nine months ended September 30, 2024. As a percentage of total revenue, total engineering costs decreased from 57% in the nine months ended September 30, 2023 to 54% in the same current year period. The spending decreases for the three and nine months ended September 30, 2024 compared to the same prior year periods were primarily due to decreased headcount. We anticipate that we will continue to focus our future research and development activities on enhancing our existing products and developing new products with our growing internal resources. 19 Selling and marketing expense. Selling and marketing expense primarily consists of costs for: i) sales and marketing personnel, including salaries, sales commissions, stock-based compensation, fringe benefits, travel, and facilities; and ii) advertising and promotion expenses. Selling and marketing expense decreased 15% from $2.2 million in the three months ended September 30, 2023 to $1.9 million in the same three month period of 2024. As a percentage of total revenue, selling and marketing expense increased from 34% in the third quarter of 2023 to 48% in the corresponding period in 2024. Selling and marketing expense decreased 5% from $6.1 million in the nine months ended September 30, 2023 to $5.8 million in the same nine month period of 2024. As a percentage of total revenue, selling and marketing expense increased from 44% in the nine months ended September 30, 2023 to 46% in the corresponding period in 2024. The spending decreases for the three and nine months ended September 30, 2024, compared to the same prior year periods were primarily due to one time savings related to the reversal of accrued bonus expense as a result of the departure of our chief revenue officer in September 2024. We may expand our sales force and marketing efforts to address additional opportunities. General and administrative expense. General and administrative expense consists primarily of costs for: i) officers, directors and administrative personnel, including salaries, bonuses, director compensation, stock-based compensation, fringe benefits, and facilities; ii) professional fees, including legal and audit fees; iii) public company expenses; and iv) other administrative expenses, such as insurance costs and bad debt provisions. General and administrative expense decreased 18% from $2.2 million for the three months ended September 30, 2023 to $1.9 million for the three months ended September 30, 2024. As a percentage of total revenue, general and administrative was 25% in the third quarter of 2023 and 34% in the corresponding period of 2024. General and administrative expense decreased 13% from $4.7 million for the nine months ended September 30, 2023 to $4.1 million for the nine months ended September 30, 2024. As a percentage of total revenue, general and administrative was 34% in the nine months ended September 30, 2024 and 32% in the corresponding period of 2024. The expense decreases for the three and nine months ended September 30, 2024 compared to the same prior year periods were primarily due to the impact of lower headcount. Fluctuations of general and administrative expenses are expected depending on specific activities in a period. Fair value adjustment to contingent acquisition payment. In December 2021, we acquired 100% of the outstanding shares and acquired all of the assets and liabilities of Fortr3ssID for a purchase price of $3.4 million, which consisted of $2.5 million of cash consideration and contingent acquisition payments which were fair valued at $0.9 million at the acquisition date. The maximum contingent acquisition payments at the time of the acquisition was $4.0 million and required cash payments of up to $2.0 million for set revenue targets in 2022 and another $2.0 million for set revenue targets in 2023. No revenue targets were achieved in 2022. The maximum contingent acquisition payment as of September 30, 2023 was $2.0 million. We determined that as of September 30, 2023 there was a remote probability of reaching the revenue targets in 2023 and that the fair value of the contingent acquisition payment was $0 at September 30, 2023. As a result, we recorded a $0.8 million gain in the quarter ended September 30, 2023. Interest Income. Interest income decreased from $0.4 million in the three months ended September 30, 2023 to $0.3 million in three months ended September 30, 2024. Interest income decreased from $1.0 million in the nine months ended September 30, 2023 to $0.9 million in nine months ended September 30, 2024. The dollar decrease in interest income was primarily due to interest income related to an IRS carryback claim that was recognized in the three and nine months ended September 30, 2023. Income taxes . Total income tax expense was $15 thousand and $0 for the three months ended September 30, 2024 and 2023, respectively and $54 thousand and $0 for the nine months ended September 30, 2024 and 2023, 20 respectively. The income tax expense relates to limitations on the usage of net operating loss carryforwards generated in years beginning after December 31, 2017. We are subject to income taxes in the United States, and we use estimates in determining our provisions for income taxes. We account for income taxes using the asset and liability method for accounting and reporting income taxes. Deferred tax assets and liabilities are recognized based on temporary differences between the financial reporting and income tax bases of assets and liabilities using statutory rates. We have evaluated the positive and negative evidence bearing upon our ability to realize our deferred tax assets, which primarily consist of net operating loss carryforwards and research and development tax credits. We considered the history of cumulative net losses, estimated future taxable income and prudent and feasible tax planning strategies and we have concluded that it is more likely than not that we will not realize the benefits of our deferred tax assets. As a result, as of September 30, 2024 and December 31, 2023, we recorded a full valuation allowance against our net deferred tax assets. Liquidity and Capital Resources At September 30, 2024, we had cash, cash equivalents and marketable securities of $27.4 million, which represented a decrease of $3.5 million from December 31, 2023. The decrease in cash, cash equivalents and marketable securities was primarily due to the impact of $3.8 million of cash used in operating activities. Cash used in operations was $3.8 million in the first nine months of 2024. Cash used in operations was primarily the result of $3.2 million of net loss and $1.8 million of changes in assets and liabilities, which were partially offset by $1.2 million of non-cash items primarily for depreciation, amortization and stock-based compensation. Cash provided by investing activities was $5.0 million in the first nine months of 2021, which primarily consisted of net sales of marketable securities. Cash provided by financing activities was $26 thousand in the first nine months of 2021, which consisted of proceeds from issuance of our common stock and partially offset by the paying income taxes for employees who surrendered shares in connection with stock grants. While we cannot assure you that we will not require additional financing, or that such financing will be available to us, we believe that our cash and cash equivalents will be sufficient to fund our operations for at least the next twelve months from the date of this filing and to meet our known long-term cash requirements. Whether these resources are adequate to meet our liquidity needs beyond that period will depend on our future growth, operating results, and the investments needed to support our operations. If we require additional capital resources, we may utilize available funds or seek external financing, which may not be available on terms we find attractive or at all. To date, inflation has not had a material impact on our financial results. There can be no assurance, however, that inflation will not adversely affect our financial results in the future. Recent Accounting Pronouncements See Note 1 to our Consolidated Financial Statements in Item 1.