AWARE INC /MA/ 10-Q

ITEM 2: Management’s Discussion and Analysis of 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, 2020, 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. Due to the COVID-19 pandemic we have been unable to: (i) conduct face-to-face meetings with customers and prospective customers, (ii) present in-person demonstrations of our software solutions, (iii) attend trade shows and conferences which typically generate future sales opportunities or (iv) meet with prospective strategic partners. We believe that these effects caused by the COVID-19 pandemic adversely impacted our revenue in 2020 and the three and six months ended June 30, 2021 and will likely have an adverse impact on our revenue over the next several quarters. 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 June 30, 2021 were $4.3 million and $1.5 million, respectively. These results compared to revenue of $1.9 million and operating loss of $3.7 million for the three months ended June 30, 2020. The increase in revenue in the current three month period was primarily due to increase in software license revenue. Lower operating loss in the current three month period was primarily due to the increase in revenue, which was partially offset by increased operating expenses. Revenue and operating loss for the six months ended June 30, 2021 were $8.7 million and $3.0 million, respectively. These results compared to revenue of $5.4 million and operating loss of $5.0 million for the three months ended June 30, 2020. The increase in revenue in the current six month period was primarily due to an increase in software license revenue. Lower operating loss in the current six month period was primarily due to the increase in revenue, which was partially offset by an increased operating expenses related to our increased headcount in sales and engineering resources that are driving growth in new product areas. These and all other financial results are discussed in more detail in the results of operations section that follows. 18 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 increased 321 % from $0.4 million in the three months ended June 30, 2020 to $1.7 million in the same three month period in 2021. As a percentage of total revenue, software license revenue increased from 22% in the second quarter of 2020 to 40% in the second quarter of the current year. The $1.3 million increase in software license revenue was due primarily to an increase in license sales related to our fixed amount contracts. Software license revenue increased 72 % from $2.4 million in the six months ended June 30, 2020 to $4.1 million in the same six month period in 2021. As a percentage of total revenue, software license revenue increased from 44% in the first six months of 2020 to 47% in the first six months of the current year. The $1.7 million increase in software license revenue was due primarily to an increase in subscription-based contracts of $0.9 million, a $0.5 increase in license sales related to our fixed amount contracts and $0.3 million of revenue related to sales of AFIX products as a result of our acquisition of AFIX products in the fourth quarter of 2020. As described in the strategy section of our Form 10-K for the year ended December 31, 2020, 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 28% from $1.4 million in the three months ended June 30, 2020 to $1.8 million in the same three month period in 2021. As a percentage of total revenue, software maintenance revenue decreased from 73% in the second quarter of 2020 to 41% in the current year quarter. Software maintenance revenue increased 21% from $2.7 million in the six months ended June 30, 2020 to $3.3 million in the same six month period in 2021. As a percentage of total revenue, software maintenance revenue decreased from 51% in the first six months of 2020 to 38% in the first six months of the current year. For the three and six month periods ended June 30, 2021, the dollar increase in software maintenance revenue was primarily due to software maintenance revenue related to our acquisition of AFIX in the fourth quarter of 2020. 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 will fluctuate when we commence new projects and/or when we complete projects that were started in previous periods. Services and other revenue increased from $0.1 million in the three months ended June 30, 2020 to $0.8 million in the same three month period in 2021. As a percentage of total revenue, services revenue increased from 5% in the second quarter of 2020 to 18% in the second quarter of the current year. Services and other revenue increased from $0.3 million in the six months ended June 30, 2020 to $1.3 million in the same six month period in 2021. As a percentage of total revenue, services revenue increased from 5% in the first six months of 2020 to 15% in the first six months of the current yea. For the three and six month period ended June 30, 2021, the dollar increase in services and other revenue was primarily due to higher services revenue in the current year period related to higher services revenue from services customers. Cost of sales. Cost of sales consists 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 19 salaries, stock-based compensation, fringe benefits, and facilities; ii) engineering consultants and contractors ; iii) software license fees; and iv) hardware costs . Cost of sales increased from $0.2 million in the three months ended June 30, 2020 to $0.3 million in the same three month period in 2021. Cost of sales as a percentage of services revenue decreased from 165% in the second quarter of 2020 to 40% in the second quarter of the current year. Cost of sales increased from $0.3 million in the six months ended June 30, 2020 to $0.7 million in the same six month period in 2021. Cost of sales as a percentage of services revenue decreased from 116% in the first six month s of 2020 to 54% in the first six months of the current year. The increase in cost of services expense was primarily due to third party software and hardware costs related to a project from our AFIX product line as well as higher service and other revenue resulting from higher active contracts with services during the period. 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 sales, and are not included in research and development expense. The classification of total engineering costs to research and development expense and cost of sales was (in thousands): Three Months Ended June 30, Six Months Ended June 30, 2021 2020 2021 2020 Research and development expense $ 2,364 $ 2,422 $ 4,760 $ 4,694 Cost of services 309 164 692 334 Total engineering costs $ 2,673 $ 2,586 $ 5,452 $ 5,028 Total engineering costs were $2.6 million in the three months ended June 30, 2020 and $2.7 million for the same period in 2021. As a percentage of total revenue, total engineering costs decreased from 137% in 2020 to 63% in 2021. Total engineering costs were $5.0 million in the six months ended June 30, 2020 and $5.5 million for the same period in 2021. As a percentage of total revenue, research and total engineering costs decreased from 93% in 2020 to 63% in 2021. As the table immediately above indicates, total engineering costs in the three months ended June 30, 2021 increased by $0.1 million compared to the same period last year and by $0.4 million in six months ended June 30, 2021 compared to the same period in 2020. The spending increase for the three and six months ended June 30, 2021 compared to the same prior year periods was primarily due to higher employee costs due to increased headcount. These increases were partially offset by a decrease in spending on third-party development costs. Lower spending on third-party development costs was primarily due to a decrease in spending with a third-party software development vendor. 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. 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 increased 27% from $1.2 million in the three months ended June 30, 2020 to $1.5 million in the same three month period of 2021. As a percentage of total revenue, selling and marketing expense decreased from 62% in the second quarter of 2020 to 35% in the corresponding period in 2021. 20 Selling and marketing expense increased 2 8 % from $ 2.5 million in the six months ended June 30, 2020 to $ 3.2 million in the same six month period of 2021. As a percentage of total revenue, selling and marketing expense de creased from 46 % in the first six months of 2020 to 36 % in the corresponding period in 2021. The dollar increase in selling and marketing expense in the three and six months ended June 30, 2021 was primarily due to higher employee costs due to increased headcount and contracted sales agents. 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 10% from $1.8 million in the three months ended June 30, 2020 to $1.6 million in the same three month period in 2021. As a percentage of total revenue, general and administrative expense decreased from 97% in the second quarter of 2020 to 38% in the corresponding period in 2021. The decrease in general and administrative expense was primarily due costs incurred in the second quarter of 2020 related to the COVID-19 pandemic, including turnover of over 50% of our administrative personnel, which did not recur in the corresponding period of 2021, which was partially offset by higher employee related costs of our administrative personnel and professional services in 2021. General and administrative expense increased 4% from $3.0 million in the six months ended June 30, 2020 to $3.1 million in the same six month period in 2021. As a percentage of total revenue, general and administrative expense decreased from 55% in the first six months of 2020 to 35% in the corresponding period in 2021. The decrease in general and administrative expense was primarily due to costs incurred in the second quarter of 2020 related to the COVID-19 pandemic, including turnover of over 50% of our administrative personnel, which did not recur in the corresponding period of 2021, which was partially offset by higher employee related costs of our administrative personnel and professional services in 2021. Interest income. Interest income decreased 95% from $19 thousand in the three months ended June 30, 2020 to $1 thousand in the same three month period in 2021. Interest income decreased 99% from $0.2 million in the six months ended June 30, 2020 to $2 thousand in the same six month period in 2021. For the three and six month period, the decrease in interest income was primarily due to lower interest rates within our money market accounts as a result of the financial markets response to the COVID-19 pandemic. Income taxes . We had no income tax benefit for the three and six months ended June 30, 2021 and $0.5 million and $0.7 million of income tax benefit, respectively, for the three and six months ended June 30, 2020. Income tax benefit was based on the U.S. statutory rate of 21%, increased by state income taxes, and reduced by permanent adjustments and research tax credits. The Coronavirus Aid, Relief and Economic Security Act (CARES Act) was signed into law on March 27, 2020. The Act contained specific relief and stimulus measures including allowing net operating losses originating in 2018 through 2020 to be carried back five years to offset taxable income in the carryback period. Separately, the enactment of the Tax Cut and Jobs Act in 2017 allowed taxpayers to claim a refund for federal tax credits over a period of years. The CARES Act enacted during the first quarter allows for the entire amount of the credit to be refunded. We have reviewed the impact of the CARES Act enactment on the income tax provision and have determined that, as a result of the net operating loss carryback provision, we can obtain a tax benefit if we were to carry back the 2020 net operating loss to the five year carryback period. The carryback of the loss would result in a refundable federal tax credit of approximately $1.5 million and an increase in research credit carryforwards previously utilized. The federal tax credit can be refunded in the future, if we decide to carry back the loss reported on the filed 2020 tax return instead of electing to carry the loss forward. Due to the recent loss history and continued uncertainty surrounding our future projections of income, we will benefit from the current year loss to the extent of the available tax refund and will maintain a 21 full valuation allowance on all other deferred tax assets, including any increase in research credit carryforward resulting from a potential carryback. As of June 30, 2021, we have not made a determination on whether to elect to carry forward the 2020 operating loss, however, the federal tax refund potential on carryback represents a minimum tax benefit we can obtain from the 2020 loss. We can realize a tax benefit to the extent of the carryback refund potential as it is considered a source of income against which to utilize the 2020 loss. We recorded a full valuation allowance against our net deferred tax assets as of June30, 2021. Liquidity and Capital Resources At June 30, 2021, we had cash and cash equivalents of $35.2 million, which represented a decrease of $3.4 million from December 31, 2020. The decrease in cash and cash equivalents was primarily due to the following factors: Cash used in operations was $3.3 million in the first six months of 2021. Cash used in operations was primarily the result of $3.0 million of net loss and $1.3 million of changes in assets and liabilities, which were partially offset by $1.0 million of non-cash items primarily for depreciation, amortization and stock-based compensation. Cash used in investing activities was $21 thousand in the first six months of 2021, which consisted of purchases of property and equipment. Cash used in financing activities was $30 thousand in the first six months of 2021. Financing activity cash usage was primarily the result of paying income taxes for employees who surrendered shares in connection with stock grants which was partially offset by proceeds received in connection with the exercise of stock awards. 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. Recently Adopted Accounting Pronouncements See Note 1 to our Consolidated Financial Statements in Item 1. 22