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, 2021, 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. In December 2021, we acquired 100% of the outstanding shares of FortressID in exchange for $2.5 million in cash. Additionally, the purchase consideration includes a contingent consideration arrangement wherein the seller is entitled to cash payments of up to $4.0M based on revenue targets in 2022 and 2023. The fair value of the contingent consideration was determined to be $0.9M at December 31, 2021 and June 30, 2022 and is included in the purchase price consideration. The acquisition of FortressID, expands the Company’s offerings around identity proofing, enhancing its onboarding, verification and authentication offerings to directly address financial compliance requirements and enable organizations to mitigate risk and curtail increasing fraud. 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, 2022 were $4.2 million and $1.4 million, respectively. These results compared to revenue of $4.3 million and operating loss of $1.5 million for the three months ended June 30, 2021. The slight decrease in revenue in the current three month period was primarily due to a decrease in services and other revenue. Lower operating loss in the current three month period was due to slightly lower operating expenses, which was partially offset by a decrease in services and other revenue. Revenue and operating loss for the six months ended June 30, 2022, were $8.9 million and $2.6 million, respectively. These results compared to revenue of $8.7 million and operating loss of $3.0 million for the six months ended June 30, 2021. The slight increase in revenue in the current six month period was primarily due to increases in software license revenue and software maintenance revenue, which were partially offset by lower services and other revenue. Lower operating loss in the current six month period was primarily due to the slight increase in revenue. These and all other financial results are discussed in more detail in the results of operations section that follows. 20 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 17% from $1.7 million in the three months ended June 30, 2021 to $2.0 million in the same three month period in 2022. As a percentage of total revenue, software license revenue increased from 40% in the second quarter of 2021 to 48% in the current year quarter. The $0.3 million increase in software license revenue was due primarily to an increase in license sales related to our license contracts with fixed amounts. Software license revenue increased 14% from $4.1 million in the six months ended June 30, 2021 to $4.6 million in the same six month period in 2022. As a percentage of total revenue, software license revenue increased from 47% in the first six months of 2021 to 52% in the first six months of the current year. The $0.5 million increase in software license revenue was due primarily to an increase in subscription-based contracts. 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 3% and was $1.8 million in the three months ended June 30, 2021 and 2022. As a percentage of total revenue, software maintenance revenue increased from 41% in the current quarter of 2021 to 43% in the current year quarter. Software maintenance revenue increased 5% from $3.3 million in the six months ended June 30, 2021 to $3.5 million in the same six month period in 2022. As a percentage of total revenue, software maintenance revenue increased from 38% in the first six months of 2021 to 39% in the first six months of the current year. For the three and six month period ended June 30, 2022, the increase in software maintenance revenue was primarily due to software maintenance renewals related to license contracts with fixed amounts. 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 decreased from $0.8 million in the three months ended June30, 2021 to $0.4 million in the same three month period in 2022. As a percentage of total revenue, services and other revenue decreased from 18% in the second quarter of 2021 to 9% in the current year second quarter. Services and other revenue decreased from $1.3 million in the six months ended June 30, 2021 to $0.8 million in the same six month period in 2022. As a percentage of total revenue, services revenue decreased from 15% in the first six months of 2021 to 9% in the first six months of the current year. For the three and six month periods ended June 30, 2022, the decrease in services and other revenue was primarily due to less services performed by us with system integrators resulting in lower services revenue in the current year period. 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. 21 Cost of services and other revenue was $0 . 3 million in the three months ended June 30, 2021 and 2022 . Cost of services and other revenue as a percentage of services and other revenue in creased from 40 % in the current quarter of 202 1 to 81 % in the current year quarter . Cost of services and other revenue decreased $0.1 million from $0.7 million in the six months ended June 30, 2021 to $0.6 million in the six months ended June 30, 2022. Cost of sales as a percentage of services and other revenue increased from 54% in the first six months of 2021 to 79% in the first six months of the current year. The increase in cost of services and other revenue as a percentage of services and other revenue was primarily due to lower service and other revenue resulting from less active contracts with services during the 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 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, 2022 2021 2022 2021 Research and development expense $ 2,229 $ 2,364 $ 4,653 $ 4,760 Cost of sales 324 309 $ 638 692 Total engineering costs $ 2,553 $ 2,673 $ 5,291 $ 5,452 Total engineering costs were $2.7 million in the three months ended June 30, 2021 and $2.6 million for the same period in 2022. As a percentage of total revenue, total engineering costs decreased from 63% in 2021 to 60% in 2022. Total engineering costs were $5.5 million in the six months ended June 30, 2021 and $5.4 million for the same period in 2022. As a percentage of total revenue, research and total engineering costs decreased from 63% in 2021 to 59% in 2022. As the table immediately above indicates, total engineering costs in the three and six months ended June 30, 2022, decreased slightly by $0.1 million compared to the corresponding periods last year. The spending decrease for the three and six months ended June 30, 2022, compared to the same prior year periods was primarily due to lower employee costs 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. 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 slightly 6% from $1.5 million in the three months ended June 30, 2021 to $1.4 million in the same three month period of 2022. As a percentage of total revenue, selling and marketing expense decreased from 35% in the second quarter of 2021 to 33% in the corresponding period in 2022. 22 Selling and marketing expense was $ 3.2 million in the six months ended June 30, 202 1 and 2022. As a percentage of total revenue, selling and marketing expense was 3 6% in the first six months of 202 1 and 2022 . We expect to expand our sales and marketing force 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 were relatively consistent at $1.6 million in the three months ended June 30, 2021 and 2022. As a percentage of total revenue, general and administrative was 38% in the second quarter of 2021 and 2022. General and administrative expense were relatively consistent at $3.1 million in the six months ended June 30, 2021 and 2022. As a percentage of total revenue, general and administrative was 35% in the six months ended 2021 and 2022. We expect general and administrative expense to increase in absolute dollars, but to decrease as a percentage of net revenues and to fluctuate depending on specific activities in a period. Income taxes . We had no income tax benefit for the three and six months ended June 30, 2022 and 2021. 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 estimated loss would result in a refundable federal tax credit of approximately $1.4 million and an increase in research credit carryforwards previously utilized. The federal tax credit can be refunded in the future, as we decided to carry back the loss reported on the filed 2020 tax return. Upon filing our the 2020, we have reclassified the federal tax credit as a current receivable. Due to the recent loss history, continued investments in the Company, and our future projections of income, we will benefit from the 2020 loss to the extent of the available tax refund and will maintain a full valuation allowance on all other deferred tax assets, including any increase in research credit carryforward resulting from a potential carryback. We maintained a full valuation allowance against our net deferred tax assets as of June 30, 2022 and December 31, 2021. Liquidity and Capital Resources At June 30, 2022, we had cash and cash equivalents of $25.0 million, which represented a decrease of $5.0 million from December 31, 2021. The decrease in cash and cash equivalents was primarily due to the following factors: Cash used in operations was $2.6 million in the first six months of 2022. Cash used in operations was primarily the result of $2.6 million of net loss and $1.2 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 used in investing activities was $2.5 million in the first six months of 2022, which primarily consisted of our investment in Note Receivable. Cash provided by in financing activities was $0.1 million in the first six months of 2022, which primarily consisted of proceeds from issuance of common stock as part of our employee stock purchase plan. 23 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 additional external financing. 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. 24