FRANKLIN WIRELESS CORP 10-K

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and related notes included elsewhere in this report. This report contains certain forward-looking statements relating to future events or our future financial performance. These statements are subject to risks and uncertainties which could cause actual results to differ materially from those discussed in this report. You are cautioned not to place undue reliance on this information which speaks only as of the date of this report. We are not obligated to publicly update this information, whether as a result of new information, future events or otherwise, except to the extent we are required to do so in connection with our obligation to file reports with the SEC. For a discussion of the important risks to our business and future operating performance, see the discussion under the caption “Item 1A. Risk Factors” and under the caption “Factors That May Influence Future Results of Operations” below. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report might not occur. 8 BUSINESS OVERVIEW We are a leading provider of intelligent wireless solutions including mobile hotspots, routers, trackers, and other devices. Our designs integrate innovative hardware and software enabling machine-to-machine (M2M) applications and the Internet of Things (IoT). Our M2M and IoT solutions include embedded modules, modems and gateways built to deliver reliable always-on connectivity supporting a broad spectrum of applications based on 5G/4G wireless technology. We have a majority ownership position in FTI, a research and development company located in Seoul, South Korea. FTI primarily provides design and development services to us for our wireless products. Our products are generally marketed and sold directly to wireless operators, and indirectly through strategic partners and distributors. Our global customer base extends primarily from the United States to countries in the Middle East and Africa ("EMEA") and Asia. FACTORS THAT MAY INFLUENCE FUTURE RESULTS OF OPERATIONS We believe that our revenue growth will be influenced largely by (1) the successful maintenance of our existing customers, (2) the rate of increase in demand for wireless data products, (3) customer acceptance for our new products, (4) new customer relationships and contracts, and (5) our ability to meet customers’ demands. We have entered into and expect to continue to enter into new customer relationships and contracts for the supply of our products, and this may require significant demands on our resources, resulting in increased operating, selling, and marketing expenses associated with such new customers. CRITICAL ACCOUNTING POLICIES Revenue Recognition In April 2016, the FASB issued Accounting Standards Update No. 2016-10, Revenue from Contracts with Customers (Topic 606) (ASU 2016-10), which amends and adds clarity to certain aspects of the guidance set forth in the upcoming revenue standard (ASU 2014-09) related to identifying performance obligations and licensing. In May 2016, the FASB issued Accounting Standards Update No. 2016-11, Revenue Recognition (Topic 605), which amends and rescinds certain revenue recognition guidance previously released within ASU 2014-09. In May 2016 the FASB issued Accounting Standards Update No. 2016-12, Revenue from Contracts with Customers (Topic 606) (ASU 2016-12), which provides narrow scope improvements and practical expedients related to ASU 2014-09. Through June 30, 2018, we recognized revenue in accordance with Accounting Standards Codification ("ASC") 605, “Revenue Recognition,” when persuasive evidence of an arrangement exists, the price is fixed or determinable, collection is reasonably assured, and delivery of products has occurred or services have been rendered. Accordingly, we recognized revenues from product sales upon shipment of the products to the customers or when the products are received by the customers in accordance with shipping or delivery terms. We provided a warranty for one year from the shipment or delivery date, which was covered by our vendors pursuant to purchase agreements. Any net warranty related expenditures made by us have historically not been material. Under our sales return policy, customers may generally return products that are under warranty for repair or replacement. On July 1, 2018, we adopted ASU 2014-09 using the modified retrospective method applied to those contracts that were not completed or substantially complete as of June 30, 2018. Results for the reporting period beginning after July 1, 2018 are presented under Topic 606, while prior period amounts have not been adjusted and continue to be reported in accordance with our historic accounting under Topic 605. We recorded no change in retained earnings as of July 1, 2018 as a result of the cumulative impact of adopting Topic 606. 9 Contracts with Customers Revenue for sales of products and services is derived from contracts with customers. The products and services promised in contracts primarily consist of hot spot routers. Contracts with each customer generally state the terms of the sale, including the description, quantity and price of each product or service. Payment terms are stated in the contract, primarily in the form of a purchase order. Since the customer typically agrees to a stated rate and price in the purchase order that does not vary over the life of the contract, the majority of our contracts do not contain variable consideration. We establish a provision for estimated warranty and returns. Using historical averages, that provision for the year ended June 30, 2020 was not material. Disaggregation of Revenue In accordance with Topic 606, we disaggregate revenue from contracts with customers into geographical regions and by the timing of when goods and services are transferred. We determined that disaggregating revenue into these categories meets the disclosure objective in Topic 606, which is to depict how the nature, amount, timing and uncertainty of revenue and cash flows are affected by regional economic factors. Contract Balances We perform our obligations under a contract with a customer by transferring products in exchange for consideration from the customer. We typically invoice our customers as soon as control of an asset is transferred, and a receivable is established. We, however, recognize a contract liability when a customer prepays for goods and/or services, or we have not delivered goods under the contract since we have not yet transferred control of the goods and/or services. The balances of our trade receivables are as follows: June 30, 2020 June 30, 2019 Accounts Receivable $ 15,973,537 $ 4,138,469 The balance of contract assets was immaterial as we did not have a significant amount of un-invoiced receivables in the periods ended June 30, 2020 and June 30, 2019. Our contract liabilities, which are included in accrued liabilities on our balance sheet, are as follows: June 30, 2020 June 30, 2019 Undelivered products $ 140,000 $ 140,000 Performance Obligations A performance obligation is a promise in a contract to transfer a distinct good or service to the customer and is the unit of measurement in Topic 606. At contract inception, we assess the products and services promised in our contracts with customers. We then identify performance obligations to transfer distinct products or services to the customer. To identify performance obligations, we consider all the products or services promised in the contract regardless of whether they are explicitly stated or are implied by customary business practices. Our performance obligations are satisfied at a point in time. Revenue from products transferred to customers at a single point in time accounted for 99% of net sales for the year ended June 30, 2020. Revenue for non-recurring engineering projects is based on the percentage completion of a project and accounted for 1% of net sales for the year ended June 30, 2020. Most of our revenue that is recognized at a point in time is for the sale of hot-spot router products. Revenue from these contracts is recognized when the customer can direct the use of and obtain substantially all of the benefits from the product, which generally coincides with title transfer at completion of the shipping process. 10 As of June 30, 2020, our contracts do not contain any unsatisfied performance obligations, except for undelivered products. Capitalized Product Development Costs ASC Topic 350, “Intangibles - Goodwill and Other” includes software that is part of a product or process to be sold to a customer and shall be accounted for under Subtopic 985-20. Our products contain embedded software internally developed by FTI which is an integral part of these products because it allows the various components of the products to communicate with each other and the products are clearly unable to function without this coding. The costs of product development that are capitalized once technological feasibility is determined (noted as Technology in progress in the Intangible Assets table, in Note 2 to Notes to Consolidated Financial Statements) include certifications, licenses, payroll, employee benefits, and other headcount-related expenses associated with product development. We determine that technological feasibility for our products is reached after all high-risk development issues have been resolved. Once the products are available for general release to our customers, we cease capitalizing the product development costs and any additional costs, if any, are expensed. The capitalized product development costs are amortized on a product-by-product basis using the straight-line amortization. The amortization begins when the products are available for general release to our customers. As of June 30, 2020, and June 30, 2019, capitalized product development costs in progress were $140,193 and $465,352, respectively, and these amounts are included in intangible assets in our consolidated balance sheets. During the year ended June 30, 2020, we incurred $343,360 in capitalized product development costs, and such amounts are primarily comprised of certifications and licenses. All costs incurred before technological feasibility is reached are expensed and included in our consolidated statements of comprehensive income (loss). Income Taxes Deferred income tax assets and liabilities are recorded for differences between the financial statement and tax basis of the assets and liabilities that will result in taxable or deductible amounts in the future based on enacted laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. As of June 30, 2020, we have federal and state net operating loss carryforwards of approximately $1.2 million and no state net operating loss carryforwards. Under the Tax Cuts and Jobs Act (the “Act”), which was signed into law on December 22, 2017, the federal net operating loss recognized on or after January 1, 2018 will carry forward indefinitely. The federal net operating loss of $1.2 million, which was recognized on or before December 31, 2017, will expire through 2035, and the federal net operating loss recognized on or after January 1, 2018, which will carry forward indefinitely, is 0. The utilization of net operating loss carryforwards may be subject to limitations under provisions of the Internal Revenue Code Section 382 and similar state provisions. Under the provision of ASC 740 “Application of the Uncertain Tax Position Provisions” related to accounting for uncertain tax positions, which prescribes a recognition threshold and measurement process for recording in the financial statements, uncertain tax positions taken or expected to be taken in a tax return, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. Tax benefits of an uncertain tax position will not be recognized if it has less than a 50% likelihood of being sustained based on technical merits. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS Refer to NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES in the Consolidated Financial Statements. 11 RESULTS OF OPERATIONS The following table sets forth, for the years ended June 30, 2020, 2019, and 2018, our statements of operations including data expressed as a percentage of sales: 2020 2019 2018 (as a percentage of sales) Net sales 100.0% 100.0% 100.0% Cost of goods sold 80.7% 84.3% 82.7% Gross profit 19.3% 15.7% 17.3% Operating expenses 9.9% 21.5% 26.2% Income (loss) from operations 9.4% (5.8% ) (8.9% ) Other income (expense), net 0.3% 0.6% 1.1% Net income (loss) before income taxes 9.7% (5.2% ) (7.8% ) Income tax provision (benefit) 1.8% (1.2% ) (0.6% ) Net income (loss) 7.9% (4.0% ) (7.2% ) Less: non-controlling interest in net income (loss) of subsidiary 0.5% (0.5% ) (0.2% ) Net income (loss) attributable to Parent Company stockholders 7.4% (3.5% ) (7.0% ) YEAR ENDED JUNE 30, 2020 COMPARED TO YEAR ENDED JUNE 30, 2019 NET SALES - Net sales increased by $38,603,398, or 105.9%, to $75,072,298 for the year ended June 30, 2020 from $36,468,900 for the corresponding period of 2019. For the year ended June 30, 2020, net sales by geographic regions, consisting of the United States, EMEA (Europe, the Middle East and Africa) and Asia were $74,839,778 (99.7% of net sales), $0 (0.0% of net sales), and $232,520 (0.3% of net sales), respectively. For the year ended June 30, 2019, net sales by geographic regions, consisting of the United States, EMEA (Europe, the Middle East and Africa) and Asia were $36,217,387 (99.3% of net sales), $224,427 (0.6% of net sales) and $27,086 (0.1% of net sales), respectively. Net sales in the United States increased by $38,622,391, or 106.6%, to $74,839,778 for the year ended June 30, 2020, from $36,217,387 for the corresponding period of 2019. The increase in net sales in the United States resulted primarily from increased demand for wireless connectivity due to people working and attending school remotely. High volume sales to school districts rapidly rolling out remote learning programs was a significant driver for increased sales through our primary customers during the Covid-19 Pandemic period. Net sales also increased due to a newly launched product and the timing of orders placed by a new carrier customer, from which a significant portion of our revenue was derived. (46% of our consolidated net sales for the year ended June 30, 2020). Net sales in EMEA decreased by $224,427, or 100.0%, to $0 for the year ended June 30, 2020, from $224,427 for the corresponding period of 2019. The decrease in net sales was due to the discontinued orders for a product placed by a carrier customer in Africa compared to the corresponding period of 2019. Net sales in Asia increased by $205,434, or 105.9%, to $232,520 for the year ended June 30, 2020, from $27,086 for the corresponding period of 2019. The increase in net sales was primarily due to product development service revenue generated by FTI, which typically varies from period to period. GROSS PROFIT - Gross profit increased by $8,784,996, or 153.1%, to $14,524,485 for the year ended June 30, 2020, from $5,739,489 for the corresponding period of 2019. The gross profit in terms of net sales percentage was 19.3% for the year ended June 30, 2020, compared to 15.7% for the corresponding period of 2019. The increase in gross profit was primarily due to the change in net sales as described above. The increase in gross profit and gross profit in terms of net sales percentage was primarily due to a newly launched product, with a higher selling price, as well as the product development service revenues generated by Franklin and FTI, which involve lower costs of goods sold. 12 OPERATING EXPENSES - Operating expenses decreased by $400,585, or 5.1%, to $7,446,361 for the year ended June 30, 2020, from $7,846,946 for the corresponding period of 2019. Selling, general, and administrative decreased by $1,191,506 to $3,699,859 for the year ended June 30, 2020, from $4,891,365. The decrease in selling, general, and administrative was primarily due to the decreased payroll expense for employees involved in selling, general, and administrative by approximately $700,000 as well as the significant decrease in shipping and handling costs within selling, general, and administrative costs by $497,298, resulting from the positively restructured shipping terms with a major vendor despite the increased volume of product shipments. Research and development increased by $790,921 to $3,746,502 for the year ended June 30, 2020, from $2,955,581. The increase in research and development was primarily due to the increased reimbursement in payroll expense for employees involved in research and development. OTHER INCOME, NET - Other income, net increased by $15,810, or 7.71%, to $220,764 for the year ended June 30, 2020, from $204,954 for the corresponding period of 2019. The increase was primarily due to the increased interest income earned from money market accounts and certificates of deposit, as well as the gain from appreciation on favorable foreign currency change, which is partially offset by the decreased product development funding received by FTI from a government entity. YEAR ENDED JUNE 30, 2019 COMPARED TO YEAR ENDED JUNE 30, 2018 NET SALES - Net sales increased by $6,403,067, or 21.3%, to $36,468,900 for the year ended June 30, 2019 from $30,065,833 for the corresponding period of 2018. For the year ended June 30, 2019, net sales by geographic regions, consisting of the United States, South America and the Caribbean, EMEA (Europe, the Middle East and Africa) and Asia were $36,217,387 (99.3% of net sales), $0 (0.0% of net sales), $224,427 (0.6% of net sales) and $27,086 (0.1% of net sales), respectively. Net sales in the United States increased by $6,982,376, or 23.9%, to $36,217,387 for the year ended June 30, 2019, from $29,235,011 for the corresponding period of 2018. The increase in net sales was primarily due to the average of 46% increased product demand from four major carrier customers, which was increased by the favorable effect of sales that fluctuate significantly from period to period due to timing of orders placed by several customers. Net sales in the South American and Caribbean regions decreased by $238,970, or 100%, to $0 for the year ended June 30, 2019, from $238,970 for the corresponding period of 2018. The decrease was primarily due to the general nature of sales in these regions, which often fluctuate significantly from period to period due to timing of orders placed by a relatively small number of customers. Net sales in EMEA decreased by $111,418, or 33.2%, to $224,427 for the year ended June 30, 2019, from $335,845 for the corresponding period of 2018. The decrease in net sales was due to the discontinued orders of a product placed by a carrier customer in Africa. Net sales in Asia decreased by $228,921, or 89.4%, to $27,086 for the year ended June 30, 2019, from $256,007 for the corresponding period of 2018. The decrease in net sales was primarily due to lower component sales generated by FTI, which typically vary from period to period in connection with its customers’ production schedule. GROSS PROFIT - Gross profit increased by $547,775, or 10.6%, to $5,739,489 for the year ended June 30, 2019, from $5,191,714 for the corresponding period of 2018. The gross profit in terms of net sales percentage was 15.7% for the year ended June 30, 2019, compared to 17.3% for the corresponding period of 2018. The increase in gross profit was primarily due to the change in net sales as described above. The decrease in gross profit in terms of net sales percentage was primarily due to variations in customer and product mix, competitive selling prices and product costs which generally vary from period to period and region to region. OPERATING EXPENSES - Operating expenses decreased by $36,638, or 0.5%, to $7,846,946 for the year ended June 30, 2019, from $7,883,584 for the corresponding period of 2018. For the year ended June 30, 2019, operating expenses consisted of selling, general, and administrative costs of $4,891,365 and research and development costs of $2,955,581, respectively. Selling, general, and administrative costs increased by $379,797, or 8.4%, to $4,891,365 for the year ended June 30, 2019, from $4,511,568 for the corresponding period of 2018. The increase in selling, general, and administrative costs was primarily due to the increase in delivery charges by $325,303 due to the increased sales. Research and development costs decreased by $416,435, or 12.3%, to $2,955,581 for the year ended June 30, 2019, from $3,372,016 for the corresponding period of 2018. The decrease in research and development costs was primarily due to the decrease in research and development payroll expense and the related expenses from a cost reduction effort especially for the early portion of fiscal 2019, as well as increased capitalized product development cost. 13 OTHER INCOME, NET - Other income, net decreased by $127,368, or 38.33%, to $204,954 for the year ended June 30, 2019, from $332,322 for the corresponding period of 2018. The decrease was primarily due to the decreased product development funding received by FTI from a government entity as the periods of the associated projects expired, which is partially offset by the increased interest income earned from the newly opened money market accounts and the certificates of deposit. LIQUIDITY AND CAPITAL RESOURCES Our historical operating results, capital resources and financial position, in combination with current projections and estimates, were considered in management's plan and intentions to fund our operations over a reasonable period of time, which we define as the twelve-month period ending June 30, 2020. For purposes of liquidity disclosures, we assess the likelihood that we have sufficient available working capital and other principal sources of liquidity to fund our operating activities and obligations as they become due. Our principal source of liquidity as of June 30, 2020 consisted of cash and cash equivalents as well as short-term investments of $33,543,562. We believe we have sufficient available capital to cover our existing operations and obligations through at least June 30, 2020. Our long-term future cash requirements will depend on numerous factors, including our revenue base, profit margins, product development activities, market acceptance of our products, future expansion plans and ability to control costs. If we are unable to achieve our current business plan or secure additional funding that may be required, we would need to curtail our operations or take other similar actions outside the ordinary course of business in order to continue to operate as a going concern. OPERATING ACTIVITIES – Net cash provided by operating activities for year ended June 30, 2020 and 2019 was $22,004,304 and $775,090, respectively. The $22,004,304 in net cash provided by operating activities for the year ended June 30, 2020 was primarily due to the increase in accounts payable of $36,410,741, caused by a sudden increase in Wi-Fi hotspot production, as well as our operating results (net loss adjusted for depreciation, amortization and other non-cash charges), which were partially offset by an increase in accounts receivable of $11,855,351 as well as the increase in inventory of $10,730,663. The $775,090 in net cash provided by operating activities for the year ended June 30, 2019 was primarily due to the decrease in accounts receivable of $3,852,985 as well as the decrease in inventory of $304,813, which was partially offset by the decrease in accounts payable of $1,937,071. INVESTING ACTIVITIES – Net cash used in investing activities for the years ended June 30, 2020 and 2019 was $794,969 and $6,250,710, respectively. The $794,969 in net cash used in investing activities for the year ended June 30, 2020 was primarily due to the purchases of capitalized product development, intangible asset, and property and equipment of $343,360, $193,171 and $181,746, respectively, as well as the payments for additional shares of a subsidiary of $75,000. The $6,250,710 in net cash used in investing activities for the year ended June 30, 2019 was primarily due to the payments for purchase of short-term investments of $5,380,226 and additional shares of the subsidiary of $234,330 as well as the purchases of capitalized product development, intangible assets, and property and equipment of $465,352, $70,034, and $100,768, respectively. 14 FINANCING ACTIVITIES – Net cash provided by financing activities for the years ended June 30, 2020 and 2019 was $520,428 and $0, respectively. The $520,418 in net cash provided by financing activities for the years ended June 30, 2020 was due to the cash received from a loan under the Payroll Protection Program and the exercise of stock options of $487,300 and $33,128, respectively. OFF-BALANCE SHEET ARRANGEMENTS None. CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS The following table summarizes our contractual obligations and commitments as of June 30, 2020, and the effect such obligations could have on our liquidity and cash flow in future periods: Payments Due by June 30, 2021 2022 2023 2024 Total Leases $ 429,846 $ 351,362 $ 321,930 $ 160,965 $ 1,264,103 LEASES Refer to ITEM 2. PROPERTIES. FUTURE LIQUIDITY AND CAPITAL REQUIREMENTS For the next twelve months, we may require in excess of $5 million for capital expenditures, software licenses and for testing and certifying new products. We believe we will be able to fund our future cash requirements for operations from our cash available, operating cash flows, bank lines of credit and issuance of equity securities. We believe these sources of funds will be sufficient to continue our operations and planned capital expenditures. However, we will be required to raise additional debt or equity capital if we are unable to generate sufficient cash flow from operations to fund the expansion of our sales and to satisfy the related working capital requirements for the next twelve months. Our ability to satisfy such obligations also depends upon our future performance, which in turn is subject to general economic conditions and regional risks, and to financial, business and other factors affecting our operations, including factors beyond our control. See Item 1A, “Risk Factors” included in this report. If we are unable to generate sufficient cash flow from operations to meet our obligations and commitments, we will be required to raise additional debt or equity capital. Additionally, we may be required to sell material assets or operations or delay or forego expansion opportunities. We might not be able to effect these alternative strategies to raise funds including credit lines and loans, on satisfactory terms, if at all. 15 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not applicable. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and the supplementary financial information required by this Item and included in this report are listed in the Index to Financial Statements beginning on page F-1. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None.