(EDGAR Online via COMTEX) -- Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of financial condition and results of operations should be read in conjunction with our financial statements and related notes appearing elsewhere in this annual report. In addition to historical information, the following discussion and analysis includes forward looking statements that involve risks, uncertainties and assumptions. Our actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of a variety of factors, including those discussed in "Risk Factors" and elsewhere in this annual report. See the discussion under "Forward Looking Statements" beginning on page 1 of this annual report.
We are engaged in the design, manufacture, marketing and sale of augmented reality wearable display devices also referred to as head mounted displays (or HMDs, but also known as Video Eyewear or near-eye displays), in the form of Smart Glasses and Augmented Reality (AR) glasses. Our AR wearable display devices are worn like eyeglasses or attach to a head worn mount. These devices typically include cameras, sensors, and a computer that enable the user to view, record and interact with video and digital content, such as computer data, the Internet, social media or entertainment applications. Our wearable display products integrate micro-display technology with our advanced optics to produce compact high-resolution display engines, less than half an inch diagonally, which when viewed through our smart glasses products create virtual images that appear comparable in size to that of a computer monitor or a large-screen television.
With respect to our Smart Glasses and AR products, we are focused on the enterprise, industrial, commercial, and to a lesser degree the consumer markets. All of the mobile display and mobile electronics markets in which we compete have been subject to rapid technological change over the last decade including the rapid adoption of tablets, larger screen sizes and display resolutions along with declining prices on mobile phones and other computing devices, and as a result we must continue to improve our products' performance and lower our costs. We believe our intellectual property portfolio gives us a leadership position in micro-display projection engines, waveguides, ergonomics, packaging, and optical systems.
Critical Accounting Policies and Significant Developments and Estimates
The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements and related notes appearing elsewhere in this annual report. The preparation of these statements in conformity with generally accepted accounting principles requires the appropriate application of certain accounting policies, many of which require us to make estimates and assumptions about future events and their impact on amounts reported in our consolidated financial statements, including the statement of operations, balance sheet, cash flow and related notes. We continually evaluate our estimates used in the preparation of our consolidated financial statements, including those related to revenue recognition, bad debts, inventories, warranty reserves, product warranty, carrying value of long-lived assets, derivatives, valuation of stock compensation awards, and income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about carrying values of assets and liabilities that are not apparent from other sources. Since we cannot determine future events and their impact with certainty, the actual results may differ from our estimates. Such differences could be material to the consolidated financial statements.
We believe that our application of accounting policies, and the estimates inherently required therein, are reasonable. We periodically reevaluate these accounting policies and estimates and make adjustments when facts and circumstances dictate a change. Historically, we have found our application of accounting policies to be appropriate, and actual results have not differed materially from those determined using necessary estimates.
Our accounting policies are more fully described in the notes to our consolidated financial statements included in this annual report on Form 10-K. The critical accounting policies, judgments and estimates that we believe have the most significant effect on our financial statements are:
� Valuation of inventories;
� Software development costs;
Valuation of Inventories
Inventory is stated at the lower of cost or net realizable value, with cost determined on a weighted average first-in, first-out method. Inventory includes purchased parts and components, work in process and finished goods. Provisions for excess, obsolete or slow-moving inventory are recorded after periodic evaluation of historical sales, current economic trends, forecasted sales, estimated product life cycles and estimated inventory levels. Purchasing practices, electronic component obsolescence, accuracy of sales and production forecasts, introduction of new products, product life cycles, product support and foreign regulations governing hazardous materials are factors that contribute to inventory valuation risks. Exposure to inventory valuation risks is managed by maintaining safety stocks, minimum purchase lots, managing product and end-of-life issues brought on by aging components or new product introductions, and by utilizing certain inventory minimization strategies such as vendor-managed inventories. The accounting estimate related to valuation of inventories is considered a "critical accounting estimate" because it is susceptible to changes from period-to-period due to the requirement for management to make estimates relative to each of the underlying factors, ranging from purchasing to sales, production, and after-sale support. If actual demand, market conditions or product life cycles differ from estimates, inventory adjustments to lower market values would result in a reduction to the carrying value of inventory, an increase in inventory write-offs and a decrease to gross margins. The Company wrote down to net realizable value all of its component inventory parts related to its M300 and M300XL Smart Glasses products, resulting from the decision to end their production as they are at a disadvantaged selling position against our newer, improved M400 introduced in the fall of 2019. The total net realizable value write-down recorded at December 31, 2019 was $3,153,028. In addition, the Company recorded an additional obsolescence provision of $1,419,631 related to its legacy M300 finished goods on hand as of December 31, 2019. The write-down and provision totaled $4,572,659 for the year ended and as of December 31, 2019. These provisions were included in Cost of Sales on the Consolidated Statements of Operations.
Carrying Value of Long-Lived Assets
If facts and circumstances indicate that a long-lived asset, including a products' mold tooling and equipment, may be impaired, the carrying value is reviewed in accordance with FASB ASC Topic 360-10 Accounting for the Impairment or Disposal of Long-Lived Assets. If this review indicates that the carrying value of the asset will not be recovered as determined based on projected undiscounted cash flows related to the asset over its remaining life, the carrying value of the asset is reduced to its estimated fair value. Impairment losses are dependent on a number of factors such as general economic trends and major technology advances, and thus could be significantly different than historical results. No impairment charges on tooling and equipment were recorded in 2019, 2018 or 2017.
We perform a valuation of our patents and trademark assets when events or circumstances indicate their carrying amounts may be unrecoverable. There was no impairment charge recorded in 2019, 2018 or 2017. The value of the remaining intellectual property, such as patents and trademarks, were valued (net of accumulated amortization) at $1,294,675 as of December 31, 2019, because management believes that its value is recoverable.
Software Development Costs
The Company capitalizes the costs of obtaining and developing its software once technological feasibility has been determined by management. Such costs are accumulated and capitalized. These projects could take several years to complete. The capitalized costs are then amortized over 3 to 5 years on a straight-line basis. Unsuccessful or discontinued software projects are written off and expensed in the fiscal period where the application is abandoned or discontinued. The unamortized software development costs remaining were valued (net of accumulated amortization) at $100,000 as of December 31, 2019, because management believes that its value is recoverable.
The Company adopted the new guidance on Revenue from Contracts with Customers under FASB ASC Topic 606, "Revenue from Contracts with Customers", as of January 1, 2018. Refer to Note 2 for further discussion on the impact of this adoption. Product sales represent the majority of the Company's revenue. The Company recognizes revenue from these product sales as performance obligations are satisfied and transfer of control to the customer has occurred, typically upon physical shipment. Revenue is recognized in the amount that the Company expects to receive in exchange from the sale of our products. FOB shipping point is our standard shipping terms and revenue is recognized as our products ship to customers, as control is transferred at that point in time. All of our standard products sales include a 30-day money back guarantee and expected returns are estimated at each reporting period date and a portion of revenue is deferred for all estimated returns. As of December 31, 2019, deferred revenue associated with our expected returns was immaterial. The Company collects and remits sales taxes in certain jurisdictions and reports revenue net of any associated sales taxes.
Revenue from any engineering consulting and other services is recognized at the time the services are rendered. The Company accounts for its longer-term development contracts, which to date have all been firm fixed-priced contracts, on the percentage-of-completion method, whereby income is recognized as work on contracts progresses, but estimated losses on contracts in progress are charged to operations immediately. The percentage-of-completion is determined using the cost-to-cost method. To date, all such contracts have been less than one calendar year in duration.
Warranty obligations are generally incurred in connection with the sale of our products. The warranty period for these products is generally one year except in certain European countries where it can be two years for some consumer-focused products. Warranty costs are accrued, to the extent that they are not recoverable from third-party manufacturers, for the estimated cost to repair or replace products for the balance of the warranty periods. We provide for the costs of expected future warranty claims at the time of product shipment or over-builds to cover replacements. The adequacy of the provision is assessed at each quarter end and is based on historical experience of warranty claims and costs. The costs incurred to provide for these warranty obligations are estimated and recorded as an accrued liability at the time of sale. Future warranty costs are estimated based on historical performance rates and related costs to repair given products. The accounting estimate related to product warranty is considered a "critical accounting estimate" because judgment is exercised in determining future estimated warranty costs. Should actual performance rates or repair costs differ from estimates, revision to the estimated warranty liability would be required.
Stock-Based Compensation Expense
Our Board of Directors approves grants of stock awards and options to employees to purchase our common stock. Stock-based compensation expense is recorded based upon the estimated fair value of the stock option or stock award at the date of grant. The Company uses the Black-Scholes Merton option pricing model to estimate the fair value of stock options granted pursuant to ASC Topic 718. The application of this pricing model involves assumptions that are judgmental and sensitive in the determination of compensation expense. The fair market value of our common stock on the date of each option grant is determined based on the most recent quoted sales price on our primary trading stock exchange, currently the NASDAQ Capital Market.
We have historically incurred domestic operating losses from both a financial reporting and tax return standpoint. Accordingly, we provide deferred income tax assets and liabilities based on the estimated future tax effects of differences between the financial and tax bases of assets and liabilities based upon currently enacted tax laws. Any future recorded value of our deferred tax assets will be dependent upon our ability to generate taxable income in the jurisdictions in which we operate. These assets consist primarily of credit carry-forwards and net operating loss carry-forwards and the future tax effects of temporary differences between balances recorded for financial statement purposes and for tax return purposes. A valuation allowance is established for deferred tax assets in amounts for which realization is not considered more likely than not to occur. The accounting estimate related to income taxes is considered a "critical accounting estimate" because judgment is exercised in estimating future taxable income, including prudent and feasible tax planning strategies, and in assessing the need for any valuation allowance. To date, we have determined a 100% valuation allowance is required and accordingly no deferred tax asset has been reflected in our consolidated financial statements. In the event that it should be determined that all or part of a deferred tax asset in the future is more likely than not to be realized, an adjustment (reduction) of the valuation allowance would increase income to be recognized in the period such determination was made.
In addition, the calculation of our deferred taxes involves dealing with uncertainties in the application of complex tax regulations. As a result, we recognize liabilities for uncertain tax positions based on the two-step process prescribed within the interpretation. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step requires us to estimate and measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement. It is inherently difficult and subjective to estimate such amounts, as this requires us to determine the probability of various possible outcomes. We re-evaluate these uncertain tax positions on a quarterly basis. This evaluation is based on factors including, but not limited to, changes in facts or circumstances, changes in tax law, effectively settled issues under audit and new audit activity. Such a change in recognition or measurement would result in the recognition of a tax benefit or an additional charge to the tax provision in the period. The Company currently has no uncertain tax positions.
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.
Recent Accounting Pronouncements
Refer to Note 1
Results of Operations for Fiscal Years Ended December 31, 2019 and December 31, 2018
The following table compares the Company's consolidated statements of operations data for the years ended December 31, 2019 and 2018.
Years Ended December 31, % Increase 2019 2018 Dollar Change (Decrease) Sales: Sales of Products $ 5,997,453 $ 7,692,102 $ (1,694,649 ) (22 )% Sales of Engineering Services 673,151 402,266 270,885 67 % Total Sales 6,670,604 8,094,368 (1,423,764 ) (18 )% Cost of Sales: Cost of Sales - Products Sold 6,334,333 6,072,476 261,857 4 % Cost of Sales - Inventory Reserve for Obsolescence 4,572,659 - 4,572,659 NM Cost of Sales - Engineering Services 171,733 253,610 (81,877 ) (32 )% Total Cost of Sales 11,078,725 6,326,086 4,752,639 75 % Gross Profit (Loss) (exclusive of depreciation shown separately below) (4,408,121 ) 1,768,282 (6,176,403 ) (349 )% Gross Profit (Loss) % (66 )% 22 % Operating Expenses: Research and Development 8,900,837 10,378,728 (1,477,891 ) (14 )% Selling and Marketing 4,215,611 4,822,639 (607,028 ) (13 )% General and Administrative 6,600,092 6,973,238 (373,146 ) (5 )% Depreciation and Amortization 2,441,581 1,469,664 971,917 66 % Impairment of Software Development Cost - 196,223 (196,223 ) (100 )% Loss (Gain) on Inventory Revaluation and Product Discontinuance - (211,416 ) 211,416 (100 )% Loss from Operations (26,566,242 ) (21,860,794 ) (4,705,448 ) 22 % Other Income (Expense): Investment Income 252,416 191,755 60,661 32 % Other Taxes (110,269 ) (57,917 ) (52,352 ) 90 % Foreign Exchange Loss (52,275 ) (60,380 ) 8,105 (13 )% Loss on Asset Disposal - (55,172 ) 55,172 (100 )% Gain on Derivative Valuation - (13,873 ) 13,873 (100 )% Interest Expense - (19,332 ) 19,332 (100 )% Total Other Income (Expense), Net 89,872 (14,919 ) 104,791 (702 )% Net Loss $ (26,476,370 ) $ (21,875,713 ) $ (4,600,657 ) 21 %
Sales. There was an overall decrease in product sales for the year ended December 31, 2019 from those in 2018 of $1,694,649 or 22%. The following table reflects the major components of our sales:
% Increase 2019 % of Sales 2018 % of Sales Dollar Change (Decrease) Sales of Smart Glasses $ 4,798,910 72 % $ 5,940,108 73 % $ (1,141,198 ) (19 )% Sales of OEM Products 951,570 14 % 994,500 12 % (42,930 ) (4 )% Sales of Video Eyewear - 0 % 452,460 6 % (452,460 ) (100 )% Sales of Waveguides & Display Engines 152,499 2 % 185,400 2 % (32,901 ) (18 )% Sales Freight out 94,474 2 % 119,634 2 % (25,160 ) (21 )% Sales of Engineering Services 673,151 10 % 402,266 5 % 270,885 67 % Total Sales $ 6,670,604 100 % $ 8,094,368 100 % $ (1,423,764 ) (18 )%
Sales of Smart Glasses decreased to $4,798,910, or a 19% decline, as compared to 2018. The decrease was driven by reduced sales of our enterprise Smart Glasses products caused by (i) large deliveries of approximately $859,000 to AMA XpertEye Inc. in June 2018 and $573,000 to SATS Ltd. in September 2018 as compared to 2019 when we had no such large single customer shipments; (ii) price reductions in the third quarter of 30% and 33% on our existing Blade and M300XL products commencing in June 2019, respectively; (iii) with the launch of the M400 Early Adaptors Program (EAP),Vuzix customers received an M300XL upon initial order and payment and were shipped a M400 as they became available, both at a 28% reduced retail price; and (iv) customer order deferrals of follow-on orders while they await the production and delivery of the new and more powerful M400 Smart Glasses for Enterprise, which were first made available in late September 2019. Offsetting these decreases were sales of the new Blade Smart Glasses which represented approximately 38% of Smart Glasses revenues for the year ended December 31, 2019, despite a summer sale with a 30% reduced retail price for the months of July and August supplanted by a 20% price decrease for the balance of 2019. There were no sales of Video Eyewear in the 2019 period as the product was discontinued in September 2018. Sales of Waveguides and Display Engines for the year ended December 31, 2019 were $152,499 versus $185,400 in 2018.
Sales of engineering services for the year ended December 31, 2019 increased $270,885 to $673,151 as compared to $402,266 in 2018. The revenue recognized in 2019 for engineering services was a result of two waveguide development projects which commenced in the second quarter of 2019 and were completed in the fourth quarter of 2019.
Cost of Sales and Gross Profit (Loss). Cost of product revenues and engineering services are comprised of materials, components, labor, warranty costs, freight costs, manufacturing overhead, software royalties, and the non-cash amortization of software development costs related to the production of our products and rendering of engineering services. The following table reflects the components of our cost of goods sold for products:
Component of Cost As % Related As % Related % Increase of Sales 2019 Product Sales 2018 Product Sales Dollar Change (Decrease) Product Cost of Sales $ 3,817,689 64 % $ 3,638,727 47 % $ 178,962 5 % Freight Costs 666,115 11 % 719,062 9 % (52,947 ) (7 )% Manufacturing Overhead 1,744,517 29 % 1,176,681 15 % 567,836 48 % Warranty Costs (119,154 ) -2 % 295,924 4 % (415,078 ) (140 )% Amortization of Software Development Costs 100,000 2 % 100,000 1 % - 0 % Software Royalties 125,166 2 % 142,082 2 % (16,914 ) (12 )% Total Cost of Sales - Products Sold $ 6,334,333 106 % $ 6,072,476 79 % $ 261,857 4 % Gross Profit (Loss) - Before Reserve for Obsolescence $ (336,880 ) (6 )% $ 1,619,626 21 % $ (1,956,506 ) (121 )% Cost of Sales - Inventory Reserve for Obsolescence 4,572,659 NM - NM 4,572,659 NM Gross Profit (Loss) - Products Total $ (4,909,539 ) $ 1,619,626 $ (6,529,167 ) (403 )% Gross Profit - Engineering Services 501,418 148,656 352,762 237 % Total Gross Profit (Loss) $ (4,408,121 ) $ 1,768,282 $ (6,176,403 ) (349 )%
For the year ended December 31, 2019, we reported an overall gross loss from product sales, before inventory obsolescence, of $336,880 as compared to a gross profit of $1,619,626 in the prior year. On a product cost of sales basis only, product direct costs were 64% of sales in the 2019 period as compared to 47% in 2018, the increase resulting from: (i) a 33% standalone retail price reduction on the M300XL commencing in the summer of 2019; (ii) lower margins of approximately 60% on our M300XLs that shipped in the third quarter under our M400 EAP launch; (iii) a 30% summer price reduction and a 20% fall price reduction in the retail price of the Blade; and (iv) lower gross margins earned on the M400 smart glasses included in the M400 EAP program over their normal standalone sales price. Manufacturing overhead costs for 2019, as a percentage of total product sales, increased to 29% for 2019 from 15% in 2018, as we have increased our production floor and warehouse space which we first occupied in November 2018, including related personnel, in anticipation of increased Blade manufacturing and the commencement in late September 2019 of M400 production at our Rochester facility. There was a negative warranty expense, or gain, of $119,154 for the year ended December 31, 2019. This warranty cost reduction resulted from the following contributing factors: (i) lower product sales volume in 2019 versus 2018, and (ii) lower warranty returns realized against previously provisioned amounts.
In addition to its normal Reserve for Obsolescence provision, (i) the Company wrote down to net realizable value all of its component inventory parts related to its M300 and M300XL Smart Glasses products, resulting from the decision to end their production as they are at a disadvantaged selling position against our newer, improved M400 introduced in the fall of 2019. The total net realizable value write-down recorded at December 31, 2019 was $3,153,028, and (ii) the Company recorded an additional obsolescence provision of $1,419,631 related to its legacy M300 finished goods on hand as of December 31, 2019. The write-down and obsolescence provision totaled $4,572,659 for the year ended and as of December 31, 2019. These provisions were included in Cost of Sales on the Consolidated Statements of Operations.
Costs for engineering services for the year ended December 31, 2019 were $171,733 as compared to $253,610 in 2019. The majority of the 2019 period amounts represented the reclassification of our internal R&D wage costs associated with two waveguide development projects. There was a gross profit of $501,418 from engineering services for 2019 versus $148,656 in the 2018.
Research and Development. Our research and development expenses consist primarily of compensation costs for personnel, related stock-based compensation expenses, third-party services, purchase of research supplies and materials, and consulting fees related to research and development. Software development expenses to determine technical feasibility before final development and ongoing maintenance are not capitalized and are included in research and development costs.
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Mar 16, 2020
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