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EX-31.2 - EXHIBIT 31.2 - DOCUMENT SECURITY SYSTEMS INCv318521_ex31-2.htm

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

SQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended
June 30, 2012

 

£ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

 

For the transition period from________________________to________________________.

 

001-32146

 

 

Commission file number

 

Y:\TQData\VINEYARD\Live Jobs\2012\08 Aug\06 Aug\Shift III\v318521 - Document Security Systems, Inc\Draft\03-Production

 

DOCUMENT SECURITY SYSTEMS, INC.

 

 (Exact name of registrant as specified in its charter)

 

New York   16-1229730
(State or other Jurisdiction of incorporation- or Organization)   (IRS Employer Identification No.)

 

28 Main Street East, Suite 1525

Rochester, NY 14614

 

(Address of principal executive offices)

 

(585) 325-3610

 

(Registrant's telephone number, including area code)

  

Indicate by check mark whether the registrant:

(1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files) Yes x No ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer (Do not check if a smaller reporting company) ¨
Smaller reporting company x    

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)
Yes ¨ No x

 

As of August 12, 2012, there were 20,872,316 shares of the registrant’s common stock, $0.02 par value, outstanding.

 

 
 

 

 

DOCUMENT SECURITY SYSTEMS, INC.
FORM 10-Q
TABLE OF CONTENTS

 

PART I FINANCIAL INFORMATION  
Item 1 Financial Statements  
  Consolidated Balance Sheets as of June 30, 2012 (Unaudited) and December  31, 2011  (Audited) 3
  Consolidated Statements of Operations and Comprehensive Loss for the three and six months ended June 30, 2012 and 2011  (Unaudited) 4
  Consolidated Statements of Cash Flows for the six months ended June 30, 2012 and 2011 (Unaudited) 5
  Notes to Interim Consolidated Financial Statements (Unaudited) 6
Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 15
Item 4 Controls and Procedures 20
     
PART II OTHER INFORMATION  
Item 1 Legal Proceedings 22
Item 2 Unregistered Sales of Equity Securities and Use of Proceeds 22
Item 3 Defaults upon Senior Securities 22
Item 4 Mine Safety Disclosures 22
Item 5 Other Information 22
Item 6 Exhibits 22
Signatures    

 

2
 

PART I – FINANCIAL INFORMATION

 

ITEM 1 - FINANCIAL STATEMENTS

 

DOCUMENT SECURITY SYSTEMS, INC.  AND SUBSIDIARIES

Consolidated Balance Sheets

As of

 

   June 30, 2012   December 31, 2011 
   (unaudited)     
ASSETS          
           
Current assets:          
Cash  $1,517,916   $717,679 
Accounts receivable, net of allowance of  $76,000 ($76,000- 2011)   1,647,923    1,595,750 
Inventory   752,271    783,442 
Prepaid expenses and other current assets   344,331    95,399 
Total current assets   4,262,441    3,192,270 
           
Property, plant and equipment, net   3,886,779    4,019,829 
Other assets   234,057    244,356 
Goodwill   3,322,799    3,322,799 
Other intangible assets, net   1,997,935    2,043,212 
           
Total assets  $13,704,011   $12,822,466 
           
LIABILITIES AND STOCKHOLDERS' EQUITY          
           
Current liabilities:          
Accounts payable  $1,602,897   $1,666,963 
Accrued expenses and other current liabilities   971,343    1,142,629 
Revolving lines of credit   767,894    763,736 
Short-term loan from related party   -    150,000 
Current portion of long-term debt   333,083    460,598 
Current portion of capital lease obligations   44,077    88,172 
           
Total current liabilities   3,719,294    4,272,098 
           
Long-term debt, net of unamortized discount of $66,000 ($88,000-2011)   2,203,736    2,819,783 
Interest rate swap hedging liabilities   133,180    110,688 
Capital lease obligations   -    11,133 
Deferred tax liability   118,201    108,727 
Commitments and contingencies (see Note 6)          
           
Stockholders' equity          
Common stock, $.02 par value;  200,000,000 shares authorized, 20,711,026 shares issued and outstanding (19,513,132 in 2011)   414,220    390,262 
Additional paid-in capital   52,492,069    48,395,241 
Accumulated other comprehensive loss   (133,180)   (110,688)
Accumulated deficit   (45,243,509)   (43,174,778)
           
Total stockholders' equity   7,529,600    5,500,037 
           
Total liabilities and stockholders' equity  $13,704,011   $12,822,466 

 

See accompanying notes

 

3
 

 

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

 

Consolidated Statements of Operations and Comprehensive Loss

 

(Unaudited)

 

   For The Three Months Ended June 30,   For The Six Months Ended June 30, 
   2012   2011   2012   2011 
Revenue                    
Printing  $852,115   $789,232   $1,521,743   $1,510,996 
Packaging   1,574,450    1,183,249    3,669,845    2,219,651 
Plastic IDs and cards   799,188    636,727    1,479,370    1,329,706 
Licensing and digital solutions   433,635    266,319    831,251    500,415 
                     
Total revenue   3,659,388    2,875,527    7,502,209    5,560,768 
                     
Costs of revenue                    
Printing   632,512    754,032    1,139,220    1,384,095 
Packaging   1,200,617    919,681    2,831,099    1,637,968 
Plastic IDs and cards   429,842    374,718    829,713    777,147 
Licensing and digital solutions   61,821    19,099    117,012    19,099 
                     
Total costs of revenue   2,324,792    2,067,530    4,917,044    3,818,309 
                     
Gross profit   1,334,596    807,997    2,585,165    1,742,459 
                     
Operating expenses:                    
Selling, general and administrative   1,959,622    1,720,621    3,757,932    3,235,875 
Research and development   223,436    73,818    371,133    125,111 
Amortization of intangibles   76,026    62,076    152,052    134,040 
                     
Operating expenses   2,259,084    1,856,515    4,281,117    3,495,026 
                     
Operating loss   (924,488)   (1,048,518)   (1,695,952)   (1,752,567)
                     
Other income (expense):                    
Change in fair value of derivative liability   -    -    -    360,922 
Interest expense   (54,673)   (59,225)   (125,605)   (109,179)
Amortizaton of note discount   (11,058)   -    (237,700)   - 
                   
Loss before income taxes   (990,219)   (1,107,743)   (2,059,257)   (1,500,824)
                     
Income tax expense   4,737    4,737    9,474    9,474 
Net loss  $(994,956)  $(1,112,480)  $(2,068,731)  $(1,510,298)
                     
Other comprehensive loss:                    
Interest rate swap (loss) gain   (45,134)   -    (22,492)   3,678 
                     
Comprehensive loss  $(1,040,090)  $(1,112,480)  $(2,091,223)  $(1,506,620)
                     
Net loss per share -basic and diluted:  $(0.05)  $(0.06)  $(0.10)  $(0.08)
                     
Weighted average common shares outstanding, basic and diluted   20,711,026    19,420,780    20,391,926    19,416,786 

 

See accompanying notes

 

4
 

 

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

For the Six months Ended June 30,

(Unaudited)

 

   2012   2011 
Cash flows from operating activities:          
Net loss  $(2,068,731)  $(1,510,298)
Adjustments to reconcile net loss to net cash used by operating activities:          
Depreciation and amortization   390,884    351,548 
Stock based compensation   331,526    201,543 
Amortization of note discount   237,700    - 
Change in fair value of derivative liability   -    (360,922)
(Increase) decrease in assets:          
Accounts receivable   (52,173)   773,970 
Inventory   31,171    (315,331)
Prepaid expenses and other assets   (73,469)   34,760 
Decrease in liabilities:          
Accounts payable   (64,066)   (610,130)
Accrued expenses and other liabilities   (161,812)   (457,137)
Net cash (used) provided by operating activities   (1,428,970)   (1,891,997)
           
Cash flows from investing activities:          
Purchase of property, plant and equipment   (105,782)   (4,509)
Purchase of other intangible assets   (106,775)   (24,472)
Acquisition of business   -    61,995 
Net cash (used) provided by investing activities   (212,557)   33,014 
           
Cash flows from financing activities:          
Net (payments) borrowings on revolving lines of credit   4,158    (349,911)
Payment of short-term loan from related party   (150,000)   - 
Payments of long-term debt   (185,835)   (150,000)
Payments of capital lease obligations   (55,228)   (55,204)
Issuance of common stock, net of issuance costs   2,828,669    (160,315)
           
Net cash provided (used) by financing activities   2,441,764    (715,430)
           
Net increase (decrease) in cash   800,237    (2,574,413)
Cash beginning of period   717,679    4,086,574 
           
Cash end of period  $1,517,916   $1,512,161 

 

See accompanying notes.

 

5
 

 

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2012
(Unaudited)

 

1.     Basis of Presentation and Significant Accounting Policies

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 8.03 of Regulation S-X for smaller reporting companies. Accordingly, these statements do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, the accompanying balance sheets and related interim statements of operations and comprehensive loss and cash flows include all adjustments, consisting only of normal recurring items necessary for their fair presentation in accordance with U.S. generally accepted accounting principles. All significant intercompany transactions have been eliminated in consolidation.

 

Interim results are not necessarily indicative of results expected for a full year. For further information regarding Document Security Systems, Inc.’s (the “Company”) accounting policies, refer to the audited consolidated financial statements and footnotes thereto included in the Company's Form 10-K for the fiscal year ended December 31, 2011.

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States (U.S. GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates and assumptions. In preparing these financial statements, the Company has evaluated events and transactions for potential recognition or disclosure.

 

Earnings Per Common Share - The Company presents basic and diluted earnings per share. Basic earnings per share reflect the actual weighted average of shares issued and outstanding during the period. Diluted earnings per share are computed including the number of additional shares that would have been outstanding if dilutive potential shares had been issued. In a loss year, the calculation for basic and diluted earnings per share is considered to be the same, as the impact of potential common shares is anti-dilutive.

 

As of June 30, 2012 and 2011, there were up to 4,225,691 and 3,281,705, respectively, of shares potentially issuable under convertible debt agreements, options, warrants, restricted stock agreements and employment agreements that could potentially dilute basic earnings per share in the future. These shares were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive to the Company’s losses in the respective periods.

 

Concentration of Credit Risk - The Company maintains its cash in bank deposit accounts, which at times may exceed federally insured limits.  The Company believes it is not exposed to any significant credit risk as a result of any non-performance by the financial institutions. During the six months ended June 30, 2012 and 2011, one customer accounted for 24% and 16%, respectively, of the Company’s consolidated revenue. As of June 30, 2012 and 2011, this customer accounted for 22% and 20%, respectively, of the Company’s trade accounts receivable balance. The risk with respect to trade receivables is mitigated by credit evaluations we perform on our customers, the short duration of our payment terms for the significant majority of our customer contracts and by the diversification of our customer base.

 

Conventional Convertible Debt -When the convertible feature of the conventional convertible debt provides for a rate of conversion that is below market value, this feature is characterized as a beneficial conversion feature (“BCF"). Prior to the determination of the BCF, the proceeds from the debt instrument are first allocated between the convertible debt and any detachable free standing instruments that are included, such as common stock warrants. The Company records a BCF as a debt discount pursuant to FASB ASC Topic 470-20. In those circumstances, the convertible debt will be recorded net of the discount related to the BCF. We amortize the discount to interest expense over the life of the debt using the effective interest method.

 

6
 

 

Derivative Instruments - The Company maintains an overall interest rate risk management strategy that incorporates the use of interest rate swap contracts to minimize significant fluctuations in earnings that are caused by interest rate volatility. The Company has two interest rate swaps that change variable rates into fixed rates on a term loan and promissory note with RBS Citizens, N.A. These swaps qualify as Level 2 fair value financial instruments. These swap agreements are not held for trading purposes and the Company does not intend to sell the derivative swap financial instruments. The Company records the interest swap agreements on the balance sheet at fair value because the agreements qualify as cash flow hedges under accounting principles generally accepted in the United States of America. Gains and losses on these instruments are recorded in other comprehensive income (loss) until the underlying transaction is recorded in earnings. When the hedged item is realized, gains or losses are reclassified from accumulated other comprehensive income (loss) (AOCI) to the Consolidated Statement of Operations on the same line item as the underlying transaction. The valuations of the interest rate swaps have been derived from proprietary models of the bank based upon recognized financial principles and reasonable estimates about relevant future market conditions and may reflect certain other financial factors such as anticipated profit or hedging, transactional, and other costs. The notional amounts of the swaps decrease over the life of the agreements. The Company is exposed to a credit loss in the event of nonperformance by the counter parties to the interest rate swap agreements. However, the Company does not anticipate non-performance by the counter parties. The fair value of interest rate swap hedging liabilities as of June 30, 2012 amounted to $133,180 ($110,688 - December 31, 2011) and the net loss attributable to this cash flow hedge recorded during the six months ended June 30, 2012 amounted to $22,492 ($3,678 gain - 2011).

 

Reclassifications - Certain prior year amounts have been reclassified to conform to the current year presentation.

 

Recent Accounting Pronouncements - In May 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.  This update results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and IFRS.  ASU 2011-04 is required to be applied prospectively in interim and annual periods beginning after December 15, 2011.   The adoption of ASU 2011-04 did not have a material impact on the consolidated financial statements.

 

In September 2011 the FASB issued ASU No. 2011-08, Intangibles – Goodwill and Other (Topic 350), Testing Goodwill for Impairment to allow entities an option to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under that option, an entity no longer would be required to calculate the fair value of a reporting unit unless the entity determines, based on that qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. The amendments in this update are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The adoption of ASU 2011-08 did not have a material impact on the consolidated financial statements.

 

In June 2011 the Financial Accounting Standards Board issued Accounting Standards Update No. 2011-05, Presentation of Comprehensive Income. This standard eliminates the option to report other comprehensive income and its components in the statement of changes in equity. The Company may elect to present items of net income and other comprehensive income in one continuous statement or in two consecutive statements. Each component of net income and each component of other comprehensive income, together with totals for comprehensive income and its two parts – net income and other comprehensive income – would need to be displayed under either alternative, and the statements would need to be presented with equal prominence as the other primary financial statements. This standard does not change 1) the items that constitute net income and other comprehensive income, 2) when an item of other comprehensive income must be reclassified to net income, or 3) the computation for earnings per share, which will continue to be based on net income. The adoption of ASU 2011-05 did not have a material impact on the consolidated financial statements. In December 2011, the FASB issued ASU 2011-12, “Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.” This update indefinitely defers the provision of ASU 2011-05, “Presentation of Comprehensive Income,” that required entities to present reclassification adjustments out of accumulated other comprehensive income by component in the statement of operations. The effective date for this update follows the ASU 2011-05, which is fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company is currently evaluating the impact of adopting ASU 2011-12 will have on the consolidated financial statements.

 

In December 2011, the FASB issued ASU 2011-11, “Disclosures About Offsetting Assets and Liabilities.” This update creates new disclosure requirements about the nature of an entity’s rights of offsetting and related arrangements associated with its financial instruments and derivative instruments. The disclosure requirements in this update are effective for annual reporting periods, and interim periods within those years, beginning on or after January 1, 2013. The Company is currently evaluating the impact this update will have on its disclosures.

 

7
 

 

2. Inventory

 

Inventory consisted of the following:

 

   June 30,   December 31, 
   2012   2011 
         
Finished Goods  $360,269   $421,965 
Work in process   138,332    73,669 
Raw Materials   253,670    287,808 
           
   $752,271   $783,442 

 

3.     Other Intangible Assets         

 

Other intangible assets include patent application costs, which consist of costs associated with the application, acquisition and defense of the Company’s patents, contractual rights to patents and trade secrets associated with the Company’s technologies, customer lists and non-compete agreements obtained as a result of acquisitions. The Company’s patents and trade secrets are for document anti-counterfeiting and anti-scanning technologies and processes that form the basis of the Company’s document security business. Patent application costs are capitalized and amortized over the estimated useful life of the patent, which generally approximates its legal life. External legal costs incurred to defend the Company’s patents are capitalized to the extent of an evident increase in the value of the patents and an expected successful outcome. Patent defense costs are expensed at the point when it is determined that the outcome is expected to be unsuccessful. The Company capitalizes the cost of an appeal until it is determined that the appeal will be unsuccessful. The Company’s capitalized patent defense costs expenses are analyzed for impairment based on the expected eventual outcome of the legal action and recoverability of proceeds or added economic value of the patent in excess of the costs. Legal actions related to the same patent defense case are unified into one asset group for the purposes on the impairment analysis. Intangible asset amortization expense is classified as an operating expense. The Company believes that the decision to incur patent costs is discretionary as the associated products or services can be sold prior to or during the application process. The Company accounts for other intangible amortization as an operating expense, unless the underlying asset is directly associated with the production or delivery of a product. Costs incurred to renew or extend the term of recognized intangible assets, including patent annuities and fees, are expensed as incurred. To date, the amount of related amortization expense for other intangible assets directly attributable to revenue recognized is not material.

 

Other intangible assets are comprised of the following:

      June 30, 2012   December 31, 2011 
   Useful Life   Gross Carrying
Amount
   Accumulated
Amortizaton
   Net Carrying
Amount
   Gross Carrying
Amount
   Accumulated
Amortizaton
   Net Carrying
Amount
 
Acquired intangibles   5 -10 years   $2,405,300   $1,121,813   $1,283,487   $2,405,300   $999,761   $1,405,539 
Patent application costs   Varied (1)    949,920    235,472    714,448    843,145    205,472    637,673 
       $3,355,220   $1,357,285   $1,997,935   $3,248,445   $1,205,233   $2,043,212 

 

(1)- patent rights are amortized over their expected useful life which is generally the legal life of the patent. As of June 30, 2012, the weighted average remaining useful life of these assets in service was approximately 12 years.

 

Amortization expense for the six months ended June 30, 2012 amounted to $152,052 ($134,040 – 2011). Approximate expected amortization for each of the five succeeding fiscal years is as follows:

 

2013  $295,000 
2014  $295,000 
2015  $210,000 
2016  $176,000 
2017  $163,000 

 

8
 

 

4.    Short-Term and Long-Term Debt

 

Revolving Credit Lines - The Company entered into a credit facility agreement with RBS Citizens, N.A. (“Citizens Bank”) in connection with the Company’s acquisition of Premier Packaging (“Premier”). As amended on July 26, 2011, the credit facility agreement provides Premier with a revolving credit line of up to $1,000,000.  The revolving line bears interest at one-month LIBOR plus 3.75% (3.99% as of June 30, 2012) and matures on May 31, 2013. As of June 30, 2012, the revolving line had a balance of $696,319 ($669,785 - December 31, 2011).

 

On May 12, 2011, in conjunction with the Company’s acquisition of ExtraDev, Inc. (“ExtraDev”), the Company assumed revolving credit lines and open credit card accounts totaling approximately $239,000, comprised of a $100,000 revolving line of credit with a bank at 4.75% with an outstanding balance of $63,000, a $100,000 revolving line of credit with a bank at 8.09% with an outstanding balance of $86,000, and various credits cards with an aggregate outstanding balance of approximately $90,000. All of the credit lines are secured by personal guarantees of the former ExtraDev owners. The line of credit with the $86,000 balance was paid in full during the year ended December 31, 2011 and the line of credit was closed. As of June 30, 2012, the balance of the revolving line of credit at 4.5% was $40,593 and outstanding balances on credit cards were $30,982, $71,575 in aggregate ($93,951 - December 31, 2011).

 

Short-Term Loan from Related Party - The Company issued a promissory note (the “DSS Note”) to Bzdick Properties, LLC (“Bzdick Properties”) in connection with the purchase of the Premier real estate, totaling $150,000. One of the members of Bzdick Properties is Robert Bzdick, who also serves as a director and chief operating officer of the Company. The DSS Note accrued interest at a rate of 9.5% per annum and permitted prepayment of principal without penalty. The DSS Note called for interest only payments during its term with a balloon payment due at the scheduled maturity date of March 31, 2012. The DSS Note was secured by a guaranty agreement running from Premier to Bzdick Properties and was subordinated to the Citizens Bank loan documents. The DSS Note was paid off in full on March 23, 2012 ($150,000 - December 31, 2011). Interest expense on the short-term loan from related party amounted to $3,240 for the six months ended June 30, 2012.

 

Long-Term Debt - On December 30, 2011, the Company issued a $575,000 convertible note in order to refinance a traditional note payable that now matures on December 29, 2013, and carries an interest rate of 10% per annum. Interest is payable quarterly, in arrears. The convertible note can be converted at any time during the term at Lender’s option into a total of 260,180 shares of the Company’s common stock at a conversion price of $2.21 per share. In conjunction with the issuance of the convertible note, the Company determined a beneficial conversion feature existed amounting to approximately $88,000, which was recorded as a debt discount and will be amortized over the term of the note. The note is secured by all of the assets (excluding assets leased) of Secuprint, Inc., is subject to various events of default, and had a balance of $575,000 as of June 30, 2012 ($575,000 - December 31, 2011).

 

On February 12, 2010, in conjunction with the credit facility agreement with Citizens Bank, the Company entered into a term loan with Citizens Bank for $1,500,000.    As amended on July 26, 2011, the term loan now requires monthly principal payments of $25,000 through maturity of February 2015. Interest accrues at 1 Month LIBOR plus 3.75% (3.99% at June 30, 2012).  The Company entered into an interest rate swap agreement to lock into a 5.7% effective interest over the remaining life of the amended term loan. As of June 30, 2012, the balance of the term loan was $800,000 ($950,000 - December 31, 2011).

 

On June 29, 2011, the Company and Plastic Printing Professionals, Inc. (“P3”), a wholly owned subsidiary of the Company, entered into a Commercial Term Note (the “Note”) with Neil Neuman (“Neuman”) whereby the Company borrowed $650,000 from Neuman. The Note called for monthly payments of $13,585, an interest rate of 6.5% per annum, a term of forty-eight months and a final balloon payment of $100,000 on August 1, 2015. The proceeds from the Note were used to pay in full all sums owed by the Company under a Related Party Credit Agreement executed between the Company and Fagenson & Co., Inc., as agent for certain lenders, including Neuman, dated January 4, 2008. Upon such payment the Credit Agreement between the Company and Fagenson & Co., Inc. was terminated in its entirety. As of December 31, 2011, the Note had a balance of $599,462. On February 29, 2012, the Company entered into a Purchase, Amendment and Escrow Agreement (the “Purchase Agreement”) with Barry Honig (“Honig”), Neil Neuman (“Neuman”) and Grushko & Mittman, P.C. The Purchase Agreement provided, among other things, for the sale of the Note to Honig for a purchase price of $578,396, which was the outstanding principal balance on February 29, 2012. In connection with the sale and transfer of the Note to Honig, the Company agreed to amend certain terms of the Note pursuant to an allonge entered into on February 29, 2012 (the “Allonge”). Under the Purchase Agreement any security interest in the Note terminated at the closing of the purchase of the Note; accordingly, Honig did not possess a security interest in any assets of the Company as a result of his purchase of the Note. Pursuant to the Allonge, the maturity date of the Note was extended to July 1, 2013. Honig had the right to convert the principal and any interest due under the Note into shares of the Company’s common stock at a conversion price of $3.30 per share, subject to adjustment upon certain corporate events as set forth in the Allonge. In conjunction with this conversion option, the Company recorded a beneficial conversion feature of approximately $216,000, which was recorded as a discount to the debt.

 

9
 

 

During the first fiscal quarter of 2012, Honing exercised the conversion option on the Note. Pursuant to the conversion, the Company issued an aggregate of 175,710 shares of its common stock to Honig for full payment of Note and accrued interest amounting to $579,843. In conjunction with the conversion, the Company recorded a note discount amortization expense of the entire $216,000 of remaining unamortized debt discount expense during the first fiscal quarter of 2012.

 

Promissory Note - On August 30, 2011, the Company’s wholly owned subsidiary Premier purchased the packaging plant it occupies in Victor, New York for $1,500,000, which was partially financed with a $1,200,000 promissory note obtained by Premier from Citizens Bank (“Promissory Note”). The Promissory Note calls for monthly payments of principal and interest in the amount of $7,658, which includes interest, calculated as 1 month LIBOR plus 3.15% (3.39% at June 30, 2012). Concurrently with the transaction, the Company entered into an interest rate swap agreement to lock into a 5.865% effective interest rate for the life of the loan.  The Promissory Note matures in August 2021 at which time a balloon payment of the remaining principal balance of $919,677 is due. As of June 30, 2012, the Promissory Note had a balance of $1,182,022 ($1,192,914 - December 31, 2011).

 

Term Note - On October 8, 2010, the Company amended the Credit Facility Agreement with Citizens Bank to add a Standby Term Loan Note pursuant to which Citizens Bank will provide Premier with up to $450,000 towards the funding of eligible equipment purchases. In October 2011, the Standby Term Loan Note was converted into a Term Note payable in monthly installments of $887 plus interest over 5 years. As of June 30, 2012, the balance under this Term Note was $46,143 ($51,467 - December 31, 2011).

 

All of the Citizens Bank credit facilities are secured by all of the assets of the Company’s subsidiary, Premier Packaging Corporation, and are also secured through cross guarantees by the Company and two of its other wholly owned subsidiaries, P3 and Secuprint.

 

Under the Citizens Bank credit facilities, the Company’s subsidiary, Premier Packaging Corporation is subject to various covenants including fixed charge coverage ratio, tangible net worth and current ratio covenants. In June 2012, Premier Packaging was notified that it was not in compliance with certain financial covenants as of December 31, 2011 and March 31, 2012, including a failure to maintain the required fixed charge coverage ratio and a disallowance of transfers from Premier Packaging to one of the Company’s subsidiaries. In August 2012, the Company received a waiver as of December 31, 2011 and March 31, 2012 from Citizens Bank, relating to the above-mentioned financial covenants. Premier Packaging was in compliance with the covenants as of June 30, 2012.

 

5.     Stockholders’ Equity

 

Stock Issued in Private Placements - On February 13, 2012, the Company completed the sale of $3,000,000 of investment units (the “Units”) in a private placement. A total of 30 Units were sold, at a price of $100,000 per Unit. Each Unit consisted of (i) 32,258 shares of the Company’s common stock, and (ii) a five-year warrant to purchase up to 16,129 shares of the Company’s common stock at an exercise price of $3.10 per share. The private placement resulted in aggregate cash proceeds to the Company of $3,000,000. In connection with the private placement, the Company paid a placement agent fee of $210,000 and issued to the placement agent a five-year warrant to purchase up to an aggregate of 58,064 shares of Common Stock at an exercise price of $3.10. The placement agent warrant had a fair value of $177,000.

  

Stock Warrants - On February 20, 2012, the Company and ipCapital Group, Inc. (“ipCapital”) entered into an engagement letter (the “ipCapital Engagement Letter”) for the provision of certain IP strategic consulting services by ipCapital for the 2012 calendar year (the “Services”). The managing director and 42% owner of ipCapital, John Cronin, is also a director of the Company. Fees will range from $240,000 to $365,000 for services provided in 2012. In addition the Company issued ipCapital a five-year warrant (the “Warrant”) to purchase up to 100,000 shares of the Company’s common stock at an exercise price of $4.62 per share (the “Warrant Stock”). The Warrant vests and becomes exercisable to the extent of 33 1/3 percent of the Warrant Stock upon each of the first, second and third anniversary dates, respectively, of the Issuance Date. The warrant is valued using the Black Scholes option pricing model at each reporting period through the earlier of the completion of services or the expiration of the service term. The warrant was valued at $178,468 as of June 30, 2012. In addition, on February 20, 2012, the Company entered into a second consulting arrangement with ipCapital (the “ipCapital Consulting Agreement”) for which ipCapital will provide strategic advice to the Company’s senior management team on the development of the Company’s Digital Group infrastructure and cloud computing business strategy. The ipCapital Consulting Agreement has a three year term. As ipCapital’s sole source of compensation under the ipCapital Consulting Agreement, the Company issued ipCapital a five-year warrant (the “Consulting Warrant”) to purchase up to 200,000 shares of the Company’s common stock at an exercise price of $4.50 per share (the “Consulting Warrant Stock”). The Consulting Warrant vests and becomes exercisable to the extent of 33 1/3 percent of the Consulting Warrant Stock upon each of the first, second and third anniversary dates, respectively, of the Consulting Warrant Issuance Date. The warrant is valued using the Black Scholes option pricing model at each reporting period through the requisite service period, in this case the vesting period. The warrant was valued at $362,592 as of June 30, 2012.

 

10
 

 

Also, on February 20, 2012, the Company entered into consulting arrangement with Century Media Group for the provision of investor relations services. As compensation Century Media Group will receive a fee of $10,000 per month for the one year term, plus the Company issued Century Media Group a 14-month warrant (the “Century Media Warrant”) to purchase up to 250,000 shares of the Company’s common stock at exercise prices of $4.50, $4.75, $5.00, $5.25 and $6.00 for each 50,000 shares subject to the Century Media Warrant. The Century Media Warrant vested in full on the date of issuance. The Company calculated the fair value of the warrant at approximately $248,000, using the Black Scholes-Merton option pricing model. Expense for consulting services will be recorded over the 12-month service term.

 

During the six months ended June 30, 2012, a total of 54,444 shares of common stock were issued upon the exercise of warrants in exchange for aggregate proceeds of approximately $109,000.

 

Restricted Stock - During the six months ended June 30, 2012, the Company granted two restricted stock awards to an employee. The first award grants the employee 30,000 shares of common stock that vest ratably over four years and has a grant date fair value of $101,400. Expense related to the first grant is being recorded on a straight-line basis as shares vest. The second award grants the employee 100,000 shares of common stock that vest in four tranches upon reaching net sales goals. The grant date fair value of the second award amounted to $338,000. As of June 30, 2012, no expense was recorded for the second award as vesting was determined to be remote.

 

Stock Options - The Company records stock-based payment expense related to these options based on the grant date fair value in accordance with FASB ASC 718. During the six months ended June 30, 2012, the Company issued options to purchase up to an aggregate of 40,000 shares of its common stock to its non-executive board members at an exercise price of $2.55 per share. The fair value of these options amounted to approximately $40,000 determined by utilizing the Black Scholes Merton option pricing model.

 

Stock-Based Compensation - Stock-based compensation includes expense charges for all stock-based awards to employees, directors and consultants. Such awards include option grants, warrant grants, and restricted stock awards. During the six months ended June 30, 2012, the Company had stock compensation expense of approximately $332,000 or $0.02 per share ($202,000; $0.01 per share - 2011).

 

As of June 30, 2012, there was approximately $992,000 of total unrecognized compensation costs (excluding $932,000 that vest upon the occurrence of certain events) related to options and restricted stock granted under the Company’s stock option plans, which the Company expects to recognize over the weighted average period of one year.

 

Stock Option Plans - During the second quarter of 2012, a proposal to increase the number of shares under the 2004 Employee Stock Option Plan from 1,700,000 to 3,400,000 and a proposal to increase the number of shares under the 2004 Non-Executive Director Stock Option Plan from 200,000 to 500,000 was approved by the Company’s stockholders.

 

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6.     Commitments and Contingencies

 

Legal Matters - On August 1, 2005, the Company commenced a suit in the European Court of First Instance in Luxembourg against the ECB alleging patent infringement by the ECB and claimed unspecified damages (the “ECB Litigation”). The Company brought the suit in the European Court of First Instance in Luxembourg.   The Company alleged that all Euro banknotes in circulation infringe the Company European Patent 0 455 750B1 which covers a method of incorporating an anti-counterfeiting feature into banknotes or similar security documents to protect against forgeries by digital scanning and copying devices.  The Court of First Instance in Luxembourg ruled on September 5, 2007 that it does not have jurisdiction to rule on the patent infringement claim. In 2006, the Company received notices that the ECB had filed separate claims in each of the United Kingdom, The Netherlands, Belgium, Italy, France, Spain, Germany, Austria and Luxembourg courts seeking the invalidation of the Patent.  Proceedings were commenced before each of the national courts seeking revocation and declarations of invalidity of the Patent. On August 20, 2008, the Company entered into an agreement with Trebuchet Capital Partners, LLC (“Trebuchet”) under which Trebuchet agreed to pay substantially all of the litigation costs associated with validity proceedings in eight European countries relating to the Patent. The Company provided Trebuchet with the sole and exclusive right to manage infringement litigation relating to the Patent in Europe, including the right to initiate litigation in the name of the Company, Trebuchet or both and to choose whom and where to sue, subject to certain limitations set forth in the Trebuchet Agreement. In consideration for Trebuchet's funding obligations, the Company assigned and transferred a 49% interest in the Company's rights, title and interest in the Patent to Trebuchet which allows Trebuchet to have a separate and distinct interest in and share of the Patent, along with the right to sue and recover in litigation, settlement or otherwise and to collect royalties or other payments under or on account of the Patent. In addition, the Company and Trebuchet agreed to equally share all proceeds generated from litigation relating to the Patent, including judgments and licenses or other arrangements entered into in settlement of any such litigation. On July 7, 2011, Trebuchet and the Company entered into a series of related agreements wherein Trebuchet effectively ended its ongoing participation in the ECB litigation, except for its continuing involvement in the final settlement of fees that may become payable as a result of the infringement case in The Netherlands described below. The original agreement with Trebuchet, executed in August 2008, will remain in full force and effect, in its entirety, until Trebuchet makes any and all final payments that may become due in The Netherlands infringement case.

 

On March 26, 2007, the High Court of Justice, Chancery Division, Patents Court in London, England ruled that the Patent was deemed invalid in the United Kingdom, and on March 19, 2008 this decision was upheld on appeal.   On March 27, 2007 the Bundespatentgericht of the Federal Republic of Germany ruled that the German part of the Patent was valid, having considered the English Court’s decision.  However, on July 6, 2010, the Company was notified that the German Court had reversed the ruling on appeal and the Patent was deemed invalid in Germany. On January 9, 2008 the French Court held that the Patent was invalid in France and on March 10, 2010, this decision was upheld on appeal.   On March 12, 2008 the Dutch Court ruled that the Patent was valid in the Netherlands.   However, on December 21, 2010 the Dutch Court reversed the ruling on appeal and the Patent was deemed invalid in the Netherlands. On November 3, 2009, the Belgium Court held that the Patent was invalid in Belgium. On November 17, 2009, the Austrian Court held that the Patent was invalid in Austria.   On March 24, 2010 the Spanish Court ruled that the Patent was valid. The decision is being appealed by the ECB. In July 2010, the Company was notified that the Italian Court deemed the patent invalid. The decision was not appealed.

 

During the course of the litigation, the losing party in certain jurisdictions was responsible for the other party’s legal fees. As of June 30, 2012, the Company has recorded as accrued liabilities of approximately €132,000 ($165,000) for the Germany case and approximately €175,000 ($218,750) for the Netherlands case for such fees. In addition, the ECB formally requested the Company to pay attorneys and court fees for the Court of First Instance case in Luxembourg in the amount of €93,752 ($117,000) as of June 30, 2012, which, unless the amount is settled will be subject to an assessment procedure that has not been initiated. The Company will accrue the assessed amount, if any, as soon as it is reasonably estimable.

 

On February 18, 2010, Trebuchet, on behalf of the Company, filed an infringement suit in the Netherlands against the ECB and two security printing entities with manufacturing operations in the Netherlands, Joh. Enschede Banknotes B.V and Koninklijke Joh. Enschede B.V.  Upon determination on December 21, 2010, that the patent was invalid in the Netherlands, the infringement case was terminated by Trebuchet. Trebuchet is responsible for costs reimbursement associated with the case, if any, when determined by the Dutch Court.

 

On October 24, 2011 the Company initiated a law suit against Coupons.com Incorporated (“Coupons.com”). The suit was filed in the United States District Court, Western District of New York, located in Rochester, New York. Coupons.com is a Delaware corporation having its principal place of business located in Mountain View, California. In the Coupons.com suit, the Company alleges breach of contract, misappropriation of trade secrets, unfair competition and unjust enrichment, and is seeking in excess of $10 million in money damages from Coupons.com for those claims.

 

In addition to the foregoing, we are subject to other legal proceedings that have arisen in the ordinary course of business and have not been finally adjudicated. Although there can be no assurance in this regard, in the opinion of management, none of the legal proceedings to which we are a party, whether discussed herein or otherwise, will have a material adverse effect on our results of operations, cash flows or our financial condition.

 

Contingent Litigation Payments – Pursuant to an agreement made in December 2004, the Company is required to share the economic benefit derived from settlements, licenses or subsequent business arrangements that the Company obtains from any infringer of patents formerly owned by the Wicker Family.  For infringement matters involving certain U.S. patents, the Company will be required to disburse 30% of the settlement proceeds.  For infringement matters involving certain foreign patents, the Company will be required to disburse 14% of the settlement proceeds.  These payments do not apply to licenses or royalties to patents that the Company has developed or obtained from persons other than the Wicker Family. In addition, in May 2005, the Company made an agreement with its legal counsel in charge of the Company’s litigation with the European Central Bank which called for a $150,000 contingent payment to the legal counsel upon a successful ruling or settlement on the Company’s behalf in that litigation. As of June 30, 2012, there has been no settlement amounts related to these agreements.

 

12
 

 

On October 21, 2011, the Company entered into a contingency legal fee agreement with Nixon Peabody LLP (the “Contingency Agreement”), in connection with its law suit against Coupons.com. Under the Contingency Agreement, the Company would pay Nixon Peabody LLP 33 1/3% of any settlements or damages awards collected from Coupons.com in connection with the suit. Under the Contingency Agreement, the Company is responsible for payment of out-of-pocket charges and disbursements of Nixon Peabody LLP necessarily accrued during the prosecution of the suit.

 

Contingent Purchase Price -In December, 2008, the Company acquired substantially all of the assets of DPI of Rochester, LLC in which the Company guaranteed up to $50,000 to certain parties depending on whether certain conditions occurred within five years of the acquisition.   As of June 30, 2012, the Company considers the likelihood that the payment will be required as remote.

 

7. Supplemental Cash Flow Information

 

Supplemental cash flow information for the six months ended June 30, 2012 and 2011 is approximately as follows:

 

   2012   2011 
         
Cash paid for interest  $126,000   $228,000 
           
Non-cash investing and financing activities:          
Beneficial conversion feature issued with convertible debt  $216,000   $- 
Conversion of debt and accrued interest to equity  $580,000   $- 
Warrant issued for prepaid consulting services  $248,000   $- 
Loss from change in fair value of interest rate swap derivative  $22,000   $- 
Equity issued for acquisition  $-   $274,000 
Refinance of related party revolving line of credit and accrued interest  $-   $650,000 
Retirement of derivative warrant liability  $-   $3,506,000 

 

8.     Segment Information

 

The Company's businesses are organized, managed and internally reported as four operating segments.   In the second quarter of 2011, the Company acquired ExtraDev for its DSS Digital Group and the Company launched a new corporate identity and logo, along with a new website that grouped the Company under four distinct divisions. In conjunction with this, the Company determined that an expansion of its segment reporting to align with the new internal structure was appropriate. A summary of the four reportable segments follows:

 

DSS Printing Licenses security printing technologies and manufactures and sells secure documents such as vital records, transcripts, safety paper, secure coupons, voter ballots, event tickets, among others.   In addition, sells general commercial printing services utilizing digital and offset printing capabilities.
   
DSS Plastics Manufactures and sells secure and non-secure plastic printed products such as ID cards, event badges and passes, and loyalty and gift cards, among others.    Plastic cards include RFID chips, magnetic strips with variable data, and high quality graphics with overt and covert security features.
   
DSS Packaging Manufactures and sells secure and non-secure custom paperboard packaging serving clients in the pharmaceutical, beverage, photo packaging, toy, specialty foods and direct marketing industries, among others.  
   
DSS Digital Develops, installs, hosts and services IT services including remote server and application hosting, cloud computing, secure document systems, back-up and disaster recovery services and customer program development services.

 

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Approximate information concerning the Company’s operations by reportable segment for the three and six months ended June 30, 2012 and 2011 is as follows. The Company relies on intersegment cooperation and management does not represent that these segments, if operated independently, would report the results contained herein:

   

Three months ended June 30, 2012  DSS Printing   DSS Plastics   DSS
Packaging
   DSS Digital   Corporate   Total 
                         
Revenues from external customers  $1,056,000   $799,000   $1,574,000   $230,000   -   $3,659,000 
Revenue from other operating segments   135,000    -    79,000    -     -    214,000 
Depreciation and amortization   37,000    44,000    97,000    19,000    1,000    198,000 
Net income (loss)   (72,000)   43,000    (35,000)   (74,000)   (857,000)   (995,000)

 

Three months ended June 30, 2011  DSS Printing   DSS Plastics   DSS
Packaging
   DSS Digital   Corporate   Total 
                         
Revenues from external customers  $960,000   $637,000   $1,183,000   $96,000   -   2,876,000 
Revenue from other operating segments   119,000    -    -    -    -    119,000 
Depreciation and amortization   35,000    44,000    86,000    5,000    1,000    171,000 
Net loss   (576,000)   (6,000)   (99,000)   (23,000)   (408,000)   (1,112,000)

 

Six months ended June 30, 2012  DSS Printing   DSS Plastics   DSS
Packaging
   DSS Digital   Corporate   Total 
                         
Revenues from external customers  $1,873,000   $1,479,000   $3,670,000   $480,000   $-   $7,502,000 
Revenue from other operating segments   278,000    -    79,000    -    -    357,000 
Depreciation and amortization   74,000    88,000    194,000    33,000    2,000    391,000 
Net income (loss)   (252,000)   9,000    33,000    (107,000)   (1,752,000)   (2,069,000)
Identifiable assets   2,274,000    2,092,000    7,225,000    935,000    1,178,000    13,704,000 

 

Six months ended June 30, 2011  DSS Printing   DSS Plastics   DSS
Packaging
   DSS Digital   Corporate   Total 
                         
Revenues from external customers  $1,915,000   $1,330,000   2,220,000   96,000   -   5,561,000 
Revenue from other operating segments   389,000    -    -    -    -    389,000 
Depreciation and amortization   74,000    99,000    173,000    5,000    1,000    352,000 
Net income (loss)   (864,000)   21,000    (171,000)   (23,000)   (473,000)   (1,510,000)
Identifiable assets   2,124,000    2,122,000    5,766,000    761,000    1,350,000    12,123,000 

  

9.     Subsequent Events

 

Facility Operating Lease - In July 2012, the Company entered into an amended facility lease at its current location that will accommodate the Company corporate offices as well as the Digital division. The commencement date of the amended lease will be October 1, 2012, until such time, the Company will continue to lease space for its corporate offices and Digital division on a month to month basis. The amended facility lease will expire September 30, 2015, and future lease payments are expected to be approximately $39,000 in 2012, $157,000 in 2013, $169,000 in 2014 and $133,000 in 2015.

 

Warrant Exercise -In July 2012, the Company received $500,000 as the result of the exercise of warrants by certain holders that resulted in the issuance of an aggregate of 161,290 shares of the Company’s common stock.

 

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ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

FORWARD-LOOKING STATEMENTS

 

Certain statements contained herein constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “1995 Reform Act”). Document Security Systems, Inc. desires to avail itself of certain “safe harbor” provisions of the 1995 Reform Act and is therefore including this special note to enable us to do so. Except for the historical information contained herein, this report contains forward-looking statements (identified by the words "estimate," "project," "anticipate," "plan," "expect," "intend," "believe," "hope," "strategy" and similar expressions), which are based on our current expectations and speak only as of the date made. These forward-looking statements are subject to various risks, uncertainties and factors that could cause actual results to differ materially from the results anticipated in the forward-looking statements, including, without limitation, those contained in our Annual Report on Form 10-K for the year ended December 31, 2011, and as follows:

 

·Our limited operating history with our business model.

·The inability to adequately protect our intellectual property.

·Intellectual property infringement or other claims presently unknown to us, which could be filed against us, or against our customers or our intellectual property, which could be costly to defend and result in our loss of significant rights.

·The failure of our products and services to achieve market acceptance.

·Changes in document security technology and standards could render our applications and services obsolete.

·The inability to compete in our market, especially against established industry competitors with greater market presence and financial resources.

·The inability to meet our growth strategy of acquiring complementary businesses and assets and expanding our existing operations to include manufacturing capabilities.

 

Overview

 

Document Security Systems, Inc. (referred to in this report as “Document Security Systems”, “Document Security,” “DSS,” “we,” “us,” “our” or “Company”) was formed in New York in 1984 and, in 2002, chose to strategically focus on becoming a developer and marketer of secure technologies. We specialize in fraud and counterfeit protection for all forms of printed documents and digital information. The Company holds numerous patents for optical deterrent technologies that provide protection of printed information from unauthorized scanning and copying. We operate three production facilities including a security and commercial printing facility, a packaging facility and a plastic card facility where we produce secure and non-secure documents for our customers. We license our anti-counterfeiting technologies to printers and brand-owners. In addition, we have a digital division which provides cloud computing services for its customers, including disaster recovery, back-up and data security services.

 

Prior to 2006, the Company’s primary revenue source in its document security division was derived from the licensing of its technology. In 2006, the Company began a series of acquisitions designed to expand its ability to produce its products for end-user customers. In 2006, we acquired Plastic Printing Professionals, Inc., a privately held plastic cards manufacturer located in the San Francisco, California area, referred to herein as the DSS Plastics Group. In 2008, we acquired substantially all of the assets of DPI of Rochester, LLC, a privately held commercial printer located in Rochester, New York, referred to herein as Secuprint or DSS Printing Group. In 2010, the Company acquired Premier Packaging Corporation (“Premier Packaging”), a privately held packaging company located in the Rochester, New York area. Premier Packaging is also referred to herein as the DSS Packaging Group.

 

In May 2011, we acquired all of the capital stock of ExtraDev, Inc. (“ExtraDev”), a privately held information technology and cloud computing company located in the Rochester, New York area. ExtraDev is also referred to herein as the DSS Digital Group.

 

In 2011, we rebranded as “DSS” and now do business in four operating segments as follows:

 

DSS Printing Group -Provides secure and commercial printing services for end-user customers along with technical support for the Company’s technology licensees. The division produces a wide array of printed materials such as security paper, vital records, prescription paper, birth certificates, receipts, manuals, identification materials, entertainment tickets, secure coupons, parts tracking forms, brochures, direct mailing pieces, catalogs, and business cards. The division also provides the basis of research and development for the Company’s security printing technologies.

 

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DSS Plastics Group -Manufactures laminated and surface printed cards which can include magnetic stripes, bar codes, holograms, signature panels, invisible ink, micro fine printing, guilloche patterns, Biometric, Radio Frequency Identification (RFID) and watermarks for printed plastic documents such as ID cards, event badges, and driver’s licenses.

 

DSS Packaging Group -Produces custom paperboard packaging serving clients in the pharmaceutical, beverage, photo packaging, toy, specialty foods and direct marketing industries, among others. The division incorporates our security technologies into printed packaging to help companies prevent or deter brand and product counterfeiting.

 

DSS Digital Group -Provides data center centric solutions to businesses and governments delivered via the “cloud”. This division is also developing proprietary digital data security technologies based on the Company’s optical deterrent technologies.  

 

Approximate Results of Operations for the Three Months and Six Months Ended June 30, 2012 Compared to the Three and Six Months Ended June 30, 2011

 

The discussion should be read in conjunction with the financial statements and footnotes in this quarterly report and in our Annual Report on Form 10-K for the year ended December 31, 2011.

 

Revenue

 

   Three Months Ended
June 30, 2012
   Three Months Ended
June 30, 2011
   % change   Six Months Ended
June 30, 2012
   Six Months Ended
June 30, 2011
   %
change
 
Revenue                              
Printing  $852,000   $789,000    8%  $1,522,000   $1,511,000    1%
Packaging   1,574,000    1,183,000    33%   3,670,000    2,220,000    65%
Plastic IDs and cards   799,000    637,000    25%   1,479,000    1,330,000    11%
Licensing and digital solutions   434,000    266,000    63%   831,000    500,000    66%
                               
Total Revenue  $3,659,000   $2,875,000    27%  $7,502,000   $5,561,000    35%

 

For the three months ended June 30, 2012, revenue was $3.7 million which was 27% greater than revenue for the three months ended June 30, 2011. The revenue increase was primarily due to increases in packaging and plastics revenues. The Company’s packaging group saw increased order activity from its two largest customers during the quarter while the Company’s plastics group benefited from a general increase in orders from its overall customer base along with increase orders for its newer products for RFID and smart card applications. In addition, the Company’s technology license and digital solutions sales increased 63% due to a full quarter of revenues in 2012 from the Company’s ExtraDev cloud computing subsidiary, which was acquired in May of 2011.

 

For the first six months of 2012, revenue has increased 35% over the same period in 2011, primarily due to the 65% increase in the Company’s packaging group’s sales along with a 66% increase in revenue from the Company’s technology licensing and digital solutions groups, which was primarily the result of the Company’s acquisition of its ExtraDev cloud computing subsidiary in May of 2011.

 

16
 

 

Cost of Revenue and Gross Profit

 

   Three Months Ended
June 30, 2012
   Three Months Ended
June 30, 2011
   % change   Six Months Ended
June 30, 2012
   Six Months Ended
June 30, 2011
   % change 
                               
Costs of revenue                              
Printing  $632,000   $754,000    -16%  $1,139,000   $1,384,000    -18%
Packaging   1,201,000    920,000    31%   2,831,000    1,638,000    73%
Plastic IDs and cards   430,000    375,000    15%   830,000    777,000    7%
Licensing and digital solutions   62,000    19,000    226%   117,000    19,000    516%
                               
Total cost of revenue   2,325,000    2,068,000    12%   4,917,000    3,818,000    29%
                               
Gross profit                              
Printing   220,000    35,000    526%   383,000    127,000    202%
Packaging   373,000    263,000    42%   839,000    582,000    44%
Plastic IDs and cards   369,000    262,000    41%   649,000    553,000    17%
Licensing and digital solutions   372,000    247,000    51%   714,000    481,000    48%
                               
Total gross profit  $1,334,000   $807,000    65%  $2,585,000   $1,743,000    48%
                               
Gross profit percentage   36%   28%   30%   34%   31%   10%

 

For the three months ended June 30, 2012, gross profit increased 65% to $1,334,000 as compared to the three months ended June 30, 2011. The increase in gross profit was primarily due to the significant increases in gross profits in the Company’s printing group, which benefited from a favorable product sales mix as the Company focused on higher margin projects. Gross profits from licensing and digital solutions sales increased 51% primarily due to the addition of a full quarter of gross profits in 2012 from the Company’s acquisition of ExtraDev in May 2011.

 

For the first six months of 2012, the Company’s gross profit has increased 48% over the same period in 2011. The Company saw a significant increase in gross profits from its printing groups as it has benefited from a lower cost structure and a more favorable product mix. In addition, each of the Company’s packaging and plastics groups realized gross profit gains as a result of their revenue gains. Finally, gross profits from licensing and digital solutions sales increased 48% primarily due to the addition of gross profits from the Company’s acquisition of ExtraDev in May 2011.

 

Operating Expenses

 

   Three Months Ended
June 30, 2012
   Three Months Ended
June 30, 2011
   % change   Six Months Ended
June 30, 2012
   Six Months Ended
June 30, 2011
   % change 
                         
Operating Expenses                              
Sales, general and administrative compensation  $1,046,000   $845,000    24%  $2,111,000   $1,604,000    32%
Professional Fees   187,000    163,000    15%   375,000    364,000    3%
Sales and marketing   83,000    162,000    -49%   165,000    286,000    -42%
Rent and utilities   147,000    188,000    -22%   298,000    354,000    -16%
Other   311,000    231,000    35%   492,000    364,000    35%
    1,774,000    1,589,000    12%   3,441,000    2,972,000    16%
                               
Other Operating Expenses                              
Non-production depreciation and amortization   32,000    31,000    3%   64,000    63,000    2%
Research and development, including research and development costs paid by equity instruments   223,000    74,000    201%   371,000    125,000    197%
Stock based compensation   154,000    101,000    52%   253,000    202,000    25%
Amortization of intangibles   76,000    62,000    23%   152,000    134,000    13%
    485,000    268,000    81%   840,000    524,000    60%
Total Operating Expenses  $2,259,000   $1,857,000    22%  $4,281,000   $3,496,000    22%

 

Sales, general and administrative compensation costs, excluding stock base compensation, increased in 2012 as compared to 2011 primarily due to the addition of employees as a result of the Company’s acquisition of its cloud computing division in May 2011, offset by reductions of personnel in the Company’s printing and packaging divisions.

 

Professional fees during the three and six months ended June 30, 2012 increased from the corresponding 2011 periods due to an increase in intellectual property consulting and investor relations costs, offset by decreases in legal and accounting fees.

 

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Sales and marketing costs during the three and six months ended June 30, 2012 decreased from the corresponding periods of 2011, as the Company significantly decreased its marketing costs, including costs incurred during 2011 to redesign the Company’s logo, websites, sales collateral and trade-show booths, which did not re-occur in 2012.

 

Rent and utilities expenses in 2012 have decreased due to the elimination of rent at the Company’s packaging division as a result of that division’s purchase of its facility in August 2011, offset by an increase in rent due to the Company’s acquisition of ExtraDev in May 2011.

 

Other operating expenses consists primarily of equipment maintenance and repairs, office supplies, IT support, bad debt expense and insurance costs. Other expenses in the second quarter of 2012 increased primarily due to the addition of costs at the Company’s digital division, and a placement agent fee related to the placement of a convertible note and subsequent conversion in March 2012. Other expenses increased in the first six months of 2012 due to a one-time settling of certain accrued liabilities for $56,000 less than originally estimated, which occurred during the first quarter of 2011, and did not re-occur in 2012. Absent this item, other expenses would have only increased by 20% during the first six months of 2012 compared to the first six months of 2011.

 

Research and development costs consist primarily of compensation costs for research personnel, third-party research costs, and consulting costs. During the first six months of 2012, the Company research and development costs, which include stock based compensation costs allocated to research and development costs as a result of warrants issued to ipCapital in February 2012, reflect a plan that the Company initiated in early 2012 to significantly increase its research and development efforts with the goal of increasing its intellectual property portfolio of patents and trade secrets in the security field. The Company expects to continue to see a significant increase in research and develop costs over the next 12 to 18 months which the Company hopes will result in an increase in security product and licensing sales, and an increase in the value of its patent asset portfolio.

 

Stock based compensation includes expense charges for all stock based awards to employees, directors and consultants, except for stock based compensation allocated to research and development. Such awards include option grants, warrant grants, and restricted stock awards. Stock based compensation in the for the three months ended June 30, 2012 increased 52% from the three months ended June 30, 2011, primarily due to the estimated value of warrants issued to the Company’s investor relations provider in February 2012.

 

Amortization of intangibles expense increases in 2012 compared to 2011 are due to the increase in the Company’s other intangible asset basis due to the acquisition of ExtraDev in May 2011.

 

Other Income and Expenses

 

   Three Months Ended
June 30, 2012
   Three Months Ended
June 30, 2011
   % change   Six Months Ended
June 30, 2012
   Six Months Ended
June 30, 2011
   % change 
                         
Other income (expense):                              
Change in fair value of derivative liability  $-   $-    -   $-   $361,000    -100%
Interest expense   (55,000)   (59,000)   -7%   (126,000)   (109,000)   16%
Amortizaton of note discount   (11,000)   -    100%   (238,000)   -    100%
                               
Other income (expense), net  $(66,000)  $(59,000)   12%  $(364,000)  $252,000    -244%

 

Interest expense During the three months ended June 30, 2012, interest expense decreased due to a decrease in debt as the result of the reduction of debt caused by the conversion of approximately $580,000 of debt in March 2012, offset by an increase in interest as a result of the increased debt carried by the Company due to its use of a promissory note to help fund the Company’s acquisition of its packaging facility in August 2011. This increase in interest expense offset a reduction in rent expense included in operating expenses as a result of the building purchase for both three and six month periods ending June 30, 2012 compared to the same periods of 2011.

 

Amortization of note discount On February 29, 2012, the Company entered into a convertible note. The holder of the note had the right to convert the principal and any interest due under the note into shares of the Company’s common stock at a conversion price of $3.30 per share. In conjunction with this conversion option, the Company recorded a beneficial conversion feature of $216,000 which the Company will expense over the term of the note. In March 2012, the holder exercised the conversion option on the note. Pursuant to the conversion, the Company issued an aggregate of 175,710 shares of its common stock to the holder for full payment of note and accrued interest. In conjunction with the conversion, the Company recorded a note discount amortization expense of the entire $216,000 of remaining unamortized debt discount expense during the first quarter of 2012.

 

18
 

 

Change in fair value of derivative liability In late 2010, the Company issued various financial instruments to an investor in connection with a stock purchase agreement, which contained certain provisions that resulted in a derivative liability. On February 18, 2011 the Company entered into certain amendments with the investor for the purpose of modifying the terms of the financial instruments that among other things eliminated the provisions of the warrants that had created the derivative liabilities. As a result, the Company determined the fair value of the derivative liability as of the modification date of February 18, 2011 and recorded the change in fair value of the derivative liability since December 31, 2010 of $360,922 in the statement of operations.

 

Net Loss and Loss per Share

 

   Three Months Ended
June 30, 2012
   Three Months Ended
June 30, 2011
   % change   Six Months Ended
June 30, 2012
   Six Months Ended
June 30, 2011
   % change 
Net loss  $(995,000)  $(1,112,000)   -11%  $(2,069,000)  $(1,510,000)   37%
                               
Net loss per share, basic and diluted  $(0.05)  $(0.06)   -17%  $(0.10)  $(0.08)   25%
                               
Weighted average common shares outstanding, basic and diluted   20,711,026    19,420,780    7%   20,391,926    19,416,786    5%

  

During the three months ended June 30, 2012, the Company had a net loss of $995,000, representing an 11% decrease from the net loss during the three months ended June 30, 2011. The decrease in net loss was primarily due to the 65% increase in gross profit, offset by a 22% increase in operating expenses, which was significantly impacted by a significant increase in research and development costs, including stock based compensation costs.

 

During the six months ended June 30, 2012, the Company had a net loss of $2,069,000 representing a 37% increase from the net loss during the six months ended June 30, 2011. The increase in net loss was primarily due to two items: 1) $227,000 amortization of note discount expense recorded in the first quarter of 2012, and 2) the $361,000 one-time other income recorded in the first quarter of 2011 due to a change in the fair value of a derivative liability. These two items in aggregate amounted to $588,000. Absent these items, net loss during the first six months of 2012 would have decreased approximately 2%.

 

LIQUIDITY AND CAPITAL RESOURCES

 

The Company has historically met its liquidity and capital requirements primarily through the private placement of equity securities and debt financings. As of June 30, 2012, the Company had cash of approximately $1.5 million. In addition, the Company had approximately $304,000 available to its Packaging division and approximately $59,000 available to its Digital division under a revolving credit line.

 

During the first six months of 2012, the Company increased its cash position and reduced its debt by selling shares of its common stock and issuing shares of its common stock pursuant to debt conversions. On February 13, 2012, the Company sold 967,740 shares of common stock for net proceeds of approximately $2,700,000 in a private placement of equity. On February 29, 2012, the Company entered into an agreement whereby an existing commercial term note in the original principal amount of $650,000 was sold and transferred to an investor for a purchase price of $578,396, the outstanding principal at the time of the sale. In connection with the sale and transfer of the commercial term note, the Company agreed to structure the note as a convertible note at a conversion price of $3.30 per share. In March 2012, the holder converted the full amount of the remaining indebtedness under the note, in exchange for 175,710 shares of the Company’s common stock, and the note was retired. In addition, in July 2012, the Company received approximately $500,000 from the exercise of warrants.

  

Operating Cash Flow – During the first six months of 2012, the Company used approximately $1,400,000 of cash for operations, a 26% decrease from our use of cash for operations during the first six months of 2011, which generally reflected the improved condition of the Company’s working capital position entering 2012 as compared to the working capital position of the Company as it entered 2011, along with the impact of non-cash income and expense items on the income statement.

 

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Investing Cash Flow - During the first six months of 2012, the Company spent approximately $106,000 on equipment additions at its packaging and plastic divisions, and paid approximately $107,000 of legal and consulting costs which were capitalized as patent assets.

 

Financing Cash Flows - During the first six months of 2012, the Company raised approximately $2.8 million from the sale of equity in a private placement, as described above, and from the exercise of warrants made by certain holders. In addition, the Company made scheduled debt and capitalized lease payments during the first six months of 2012 of approximately $391,000.

 

Future Capital Needs - As of June 30, 2012, the Company had cash of approximately $1.5 million and in July 2012, the Company received approximately $500,000 from the exercise of warrants. In addition, the Company had approximately $304,000 available to its Packaging division and approximately $59,000 available to its Digital division under revolving credit lines. The Company believes that its current cash, working capital and availability of funds under its credit line resources provide it sufficient resources in order to fund its operations and meet its obligations for at least the next twelve months. However, if expected revenues in the second half of 2012 do not materialize and if the Company cannot generate sufficient cash from its operations in the future, the Company may need to raise additional funds in order to fund its working capital needs and pursue its growth strategy. However, there is no guarantee we will be able to raise such funds if necessary.

 

Off-Balance Sheet Arrangements

 

We do not have any off-balance sheet arrangements that have, or are reasonably likely to have, an effect on our financial condition, financial statements, revenues or expenses.

 

Critical Accounting Policies and Estimates

 

As of June 30, 2012, our critical accounting policies and estimates have not changed materially from those set forth in our Annual Report on Form 10-K for the year ended December 31, 2011.

 

ITEM 4 - CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures

 

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) and Rule 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of June 30, 2012. Based on this evaluation, our principal executive officer and principal financial officer have concluded that, based on the material weaknesses discussed below, our disclosure controls and procedures were not effective to ensure that information required to be disclosed by us in reports filed or submitted under the Securities Exchange Act were recorded, processed, summarized, and reported within time periods specified in the Securities and Exchange Act Commission’s rules and forms and that our disclosure controls are not effectively designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act is accumulated and communicated to management, including our principal executive officer and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

 

In connection with management’s assessment of our internal control over financial reporting described above, management has identified the following material weaknesses in the Company’s internal control over financial reporting as of June 30, 2012.

 

We did not maintain a sufficient complement of qualified accounting personnel and controls associated with segregation of duties. We have two people on staff that perform nearly all aspects of our external financial reporting process, including but not limited to access to the underlying accounting records and systems, the ability to post and record journal entries and responsibility for the preparation of the external financial statements. This creates certain incompatible duties and a lack of review over the financial reporting process that would likely fail to detect errors in spreadsheets, calculations, or assumptions used to compile the financial statements and related disclosures as filed with the Securities and Exchange Commission. Specifically, we determined that our controls over the preparation, review and monitoring of the financial statements were ineffective to provide reasonable assurance that financial disclosures agree with appropriate supporting detail, calculations or other documentation. These control deficiencies could potentially result in a material misstatement to our interim consolidated financial statements that may not be prevented or readily detected.

 

20
 

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Plan for Remediation of Material Weaknesses

 

In response to the identified material weaknesses, management, with oversight from the Company’s audit committee, plans to continue to monitor and review our control environment and to evaluate whether cost effective solutions are available to remedy the identified material weaknesses by expanding the resources available to the financial reporting process.

 

Changes in Internal Control over Financial Reporting

 

There were no changes in our internal controls over the financial reporting during our fiscal quarter ending June 30, 2012 that have materially affected, or are reasonably likely to materially effect, our internal control over financial reporting.

 

21
 

 

PART II
OTHER INFORMATION

 

ITEM 1 - LEGAL PROCEEDINGS

 

None

 

ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

There were no sales of unregistered equity securities which were not previously reported.

 

ITEM 3 - DEFAULTS UPON SENIOR SECURITIES

 

None

 

ITEM 4 – MINE SAFETY DISCLOSURES

 

None

 

ITEM 5 - OTHER INFORMATION

 

None

 

ITEM 6 - EXHIBITS

 

Exhibit Number   Exhibit Description
     
31.1   Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer.*
31.2   Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer.*
32.1   Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes Oxley Act of 2002.*
32.2   Certification of Chief Financial Officer as required by 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes Oxley Act of 2002.*

 

101 **    The following materials from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2012 formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Cash Flows, and (iv) related notes to these financial statements, tagged as blocks of text.

 

*Filed herewith.

 

**Furnished herewith.

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

        DOCUMENT SECURITY SYSTEMS, INC.
         
  August 14, 2012   By: /s/ Patrick White  
        Patrick White
Chief Executive Officer
         
         
  August 14, 2012   By: /s/ Philip Jones  
        Philip Jones
Chief Financial Officer

 

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