(EDGAR Online via COMTEX) -- Item 7. Management's Discussion and Analysis of Financial Condition, Results of Operations and Critical Accounting Policies.
The following commentary should be read in conjunction with the Consolidated Financial Statements and related notes thereto contained in Part IV of this Annual Report on Form 10-K. This discussion contains forward-looking statements based on current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under Item 1A.,"Risk Factors ," included in Part I of this Annual Report on Form 10-K.
We are a leading U.S. provider of ultra-rugged mobile phones and accessories designed specifically for task workers physically engaged in their work environments, often in mission-critical roles. We currently sell our ruggedized mobile phones and accessories to three of the four largest wireless carriers in the United States-AT&T, Sprint and Verizon-as well as the three largest wireless carriers in Canada-Bell, Rogers and Telus Mobility. Our phones and accessories connect workers with voice, data, and workflow applications in two end-markets: industrial enterprise and public sector.
We generate revenues from sales of our (i) mobile phones, (ii) industrial-grade accessories and (iii) beginning in 2019, cloud-based software and application services. We sell our mobile phones and accessories primarily to wireless carriers in both the United States and Canada, who then resell our products in conjunction with network services to end customers.
Our first mobile device was introduced and began shipping in low volumes in 2006, primarily in Europe, and in increasing volumes in 2012 in Canada through Bell. In late 2012, we first shipped to U.S. wireless carriers, AT&T and Sprint, but between 2012 and 2017, we had (i) only one or two mobile phones in our product portfolio being sold at any one time, (ii) only a handful of wireless carriers selling such phones and (iii) such phones being sold generally as a non-stocked product. In 2018, three of the four largest U.S. wireless carriers and the three largest Canadian wireless carriers certified certain of our products and decided to stock our entire next generation product portfolio, for the first time in our history, resulting in our revenues increasing by more than 100% from the year ended December 31, 2017 to the year ended December 31, 2019. Revenues have decreased from $135.7 million for the year ended December 31, 2018 to $116.3 million for the year ended December 31, 2019. In 2019, we sold approximately 320,300 mobile phones to wireless carriers with approximately 29% and 28% sold to AT&T and Verizon, respectively, compared to a total of approximately 287,500 to wireless carriers in 2018. In addition to acceptance by these large wireless carriers of our product portfolio, expanded adoption of our mobile phones was driven by increases in awareness over the past several years following sales and marketing efforts directed at wireless carriers, new product launches and the increased focus by carriers, such as AT&T and Verizon on dedicated public safety networks, including FirstNet. We expect to continue unit sales volumes with these wireless carriers and anticipate launching additional products starting in 2020 following customization and certification processes. In March 2019 and April 2019, we launched commercial sales of our XP3 mobile phone on the Sprint network and AT&T network (including FirstNet), respectively, in each case following technical acceptance by the applicable wireless carrier.
Because our U.S. sales channel is primarily comprised of large wireless carriers, the number of customers that we sell to is limited. For the year ended December 31, 2019, approximately 87% of our revenues came from this channel and 66% came from our top four channel partner customers. For the year ended December 31, 2019, our smartphones accounted for approximately 50% of our revenues and our feature phones accounted for approximately 45% of our revenues. To help control and manage the quality, cost and reliability of our supply chain, we directly manage the procurement of all final assembly materials used in our products, which include LCDs, housings, camera modules and antennas. In addition, we complete the final assembly of our devices in our Shenzhen, China facility.
To continue to develop differentiated products to attract and retain customers, we have made significant investments in research and development. While the hardware design of our devices remains generally the same for all wireless carriers, each product must be configured specifically to conform to the requirements of each carrier's network, resulting in higher development expenses as the number of wireless carriers we sell through increases. In addition to the unique configurations, we must go through a technical acceptance process for each device at each wireless carrier before it can be stocked. The acceptance process for each device at each wireless carrier has historically cost up to $1.2 million. Since this task tends to be cyclical in nature, we employ third- party experts on a carrier-by-carrier and product-by-product basis to assist with this acceptance process.
Additional Sonim Subsidiary
On August 21, 2019, Sonim Technologies (Canada), Inc. was incorporated, a fully owned subsidiary of the Company, to aide with sales and post sales services. During the year ended December 31, 2019, immaterial fees were incurred in the set-up of the subsidiary.
Restructuring and Reduction in Force
In September 2019, the Board of Directors approved, and management commenced and completed, a restructuring plan to reduce operating costs and better align its workforce with the needs of its business. Under the plan, the Company reduced its workforce by 16 employees. Affected employees are eligible to receive severance and COBRA reimbursement payments. In connection with the restructuring, the Company accrued $0.7 million in aggregate restructuring charges related to one-time termination severance payments and other employee-related costs. $0.2 million of the cash payments related to the personnel-related restructuring charges were paid during the second half of 2019, with the remaining $0.5 million to be paid by the second quarter of 2020. The Company may also incur additional costs not currently contemplated due to events that may occur as a result of, or that are associated, with the workforce reductions.
Departure of Certain Officers; Appointment of Certain Officers; and Compensatory Arrangements of Certain Officers
On September 9, 2019, the Company and Mr. James Walker determined that Mr. Walker would cease serving as the Company's Chief Financial Officer. Mr. Walker was deemed eligible to receive certain severance benefits following his last day of employment pursuant to, and subject to the conditions set forth in, his existing agreements with the Company, all of which have been previously publicly disclosed, as well as extension of his post-separation option exercise period to January 17, 2020.
On September 10, 2019, the Company entered into an employment agreement with Robert Tirva, which was amended on December 18, 2019, which governs the terms of Mr. Tirva's employment as the Company's Chief Financial Officer. In this role, Mr. Tirva will serve as the Company's principal financial officer and principal accounting officer.
On October 29, 2019, the Company and Mr. Robert Plaschke agreed that Mr. Plaschke will cease serving as the Company's Chief Executive Officer. In connection with Mr. Plaschke's transition, the Company entered into a Transition and Separation Agreement with Mr. Plaschke pursuant to which he will serve as a Senior Advisor to the Board until April 30, 2020.
On October 29, 2019, the Company entered into an employment agreement with Thomas W. Wilkinson, which governs the terms of Mr. Wilkinson's employment as the Company's Chief Executive Officer and member of the board.
Initial Public Offering
On May 9, 2019, our registration statement on Form S-1 (File No. 333-230887) related to our initial public offering ("IPO") was declared effective by the SEC, and our common stock began trading on The Nasdaq Stock Market LLC ("Nasdaq") on May 10, 2019. Our IPO closed on May 14, 2019. As a result, our consolidated financial statements as of December 31, 2019 reflects the impact of our IPO.
Key Metrics We review a variety of key financial metrics to help us evaluate growth trends, establish budgets, measure the effectiveness of our business strategies and assess operational efficiencies. In addition to our financial results determined in accordance with U.S. GAAP, we believe the following non-GAAP and operational measures are useful in evaluating our performance related metrics. Year Ended December 31, 2019 2018 (in thousands) Smartphones 102 160 Feature Phones 257 151 Total Units Sold 359 311 Adjusted EBITDA $ (12,355 ) $ 6,931 Adjusted Covenant EBITDA $ (11,812 ) $ 7,480
Our smartphones include the XP6, XP7, and XP8 models. The number of smartphone units sold during the year ended December 31, 2019 compared to the year ended December 31, 2018 decreased by 36%, primarily due to a slower than expected sales of our XP8 product at several carriers.
Our feature phones include the XP3, XP5, and XP5s models. The number of feature phone units sold during the year ended December 31, 2019 compared to the year ended December 31, 2018 increased by 70%, primarily due to increased demand for the XP5s from several carriers and the introduction of our newest feature phone, the XP3.
Adjusted EBITDA and Adjusted Covenant EBITDA
We define Adjusted EBITDA as net income (loss) adjusted to exclude the impact of stock-based compensation expense, depreciation and amortization, interest expense, income taxes, change in fair value of warrant liability and one-time restructuring costs. We define Adjusted Covenant EBITDA as Adjusted EBITDA further adjusted to exclude the impact of exchange rate changes. Adjusted EBITDA and Adjusted Covenant EBITDA are useful financial metrics in assessing our operating performance from period to period by excluding certain items that we believe are not representative of our core business, such as certain material non-cash items and other adjustments such as stock-based compensation and changes in the fair value of the warrant liability. We use Adjusted Covenant EBITDA to periodically assess compliance with certain covenants and other provisions under our East West Bank Loan Agreement.
We believe that Adjusted EBITDA and Adjusted Covenant EBITDA, viewed in addition to, and not in lieu of, our reported GAAP results, provide useful information to investors regarding our performance and overall results of operations for various reasons, including:
non-cash equity grants made to employees at a certain price do not necessarily reflect the performance of our business at such time, and as such, stock-based compensation expense is not a key measure of our operating performance; and
costs associated with certain events, such as changes in fair value of warrant liability and restructuring costs, are not considered a key measure of our operating performance.
We use Adjusted EBITDA and Adjusted Covenant EBITDA:
as a measure of operating performance;
for planning purposes, including the preparation of budgets and forecasts;
to allocate resources to enhance the financial performance of our business;
to evaluate the effectiveness of our business strategies;
to periodically assess compliance with certain covenants and other provisions under the EWB Loan Agreement;
in communications with our board of directors concerning our financial performance; and
as a consideration in determining compensation for certain key employees.
Adjusted EBITDA and Adjusted Covenant EBITDA have limitations as analytical tools, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. Some of these limitations include:
they do not reflect all cash expenditures, future requirements for capital expenditures or contractual commitments;
they do not reflect changes in, or cash requirements for, working capital needs;
they do not reflect interest expense on our debt or the cash requirements necessary to service interest or principal payments; and
other companies in our industry may define and/or calculate these metrics differently than we do, limiting their usefulness as comparative measures.
Set forth below is a reconciliation from net income (loss) to Adjusted EBITDA and Adjusted Covenant EBITDA for the respective periods:
2019 2018 (in thousands) Net income (loss) $ (25,834 ) $ 1,277 Depreciation and amortization 3,525 1,850 Stock-based compensation 6,308 252 Interest expense 1,522 1,828 Change in fair value of warrant liability(1) - 970 Income taxes 1,388 754 Restructuring costs 736 - Adjusted EBITDA (12,355 ) 6,931 Exchange rates 543 549 Adjusted Covenant EBITDA $ (11,812 ) $ 7,480
(1) Prior to the conversion of each share of our then outstanding preferred stock to one share of our common stock effected in November 2018. (including the conversion of preferred stock issuable upon exercise of warrants), the fair value of outstanding warrants to purchase preferred stock was subject to periodic remeasurement, and any change in fair value was recognized as a change in fair value of warrant liability.
Factors Affecting Our Results of Operations
We believe that the growth and future success of our business depend on many factors. While these factors present significant opportunities for our business, they also pose important challenges that we must successfully address in order to improve our results of operations.
Research and Development
We believe that our performance is significantly dependent on the investments we make in research and development and that we must continue to develop and introduce innovative new products on a two to three-year cycle. While the hardware design of our devices is generally the same for all wireless carriers, each device must be configured to conform to the requirements of each wireless carrier's network, resulting in higher development expenses as the number of wireless carriers we sell through increases. In addition to the design and configuration costs, each device must undergo a multi-month technical approval process at each carrier before it can be certified to be stocked at each carrier. The approval process for each device for each carrier has historically cost between $1-2 million. Prior to commencement of development of a product for certification, we generally do not receive any purchase orders or commitments. Following a carrier's review of product concepts, we may receive a product award letter from that carrier to move forward with the development and certification process, at which time we may begin receiving advance purchase orders or commitments. Since the timing of when we seek technical approval with our wireless carriers tends to be cyclical in nature, quarter-over-quarter expenditures may vary significantly depending on the number of approvals in process during the quarter. If we fail to innovate and enhance our product offerings, our brand, market position and revenues may be adversely affected. If our research and development efforts are not successful, we will not recover these investments that we make.
New Customer Acquisitions
We are focused on continuing to acquire new customers, both in North America and overseas, to support our long-term growth. Historically, we have been dependent on a small number of wireless carriers distributing our products. We have invested, and expect to continue to invest, in our sales and marketing efforts to drive new customer acquisition. In particular, a key part of our strategy is to further expand the use of our solutions over dedicated LTE networks in the public safety market. We will also continue to invest in and expand our international sales teams. As a result, we expect our sales and marketing costs to increase as we seek to acquire new customers. Sales and marketing investments will often occur in advance of any sales benefits from these activities, and it may be difficult for us to determine if we are efficiently allocating our sales and marketing resources.
Seasonality and New Product Introduction
We have historically experienced lower net revenue in our first quarter compared to other quarters in our fiscal year due to seasonal demand associated with the introduction of new products to our lead customers. New product introductions can significantly impact net revenue, gross profit and operating expenses. The timing of product introductions can also impact our net revenue as our wireless carrier customers prepare for a new product launch, and channel inventory of an older product often declines as the launch of a newer product approaches. Net revenue can also be affected when consumers and distributors anticipate a new product introduction. However, neither historical seasonal patterns nor historical patterns of product or service introductions should be considered reliable indicators of our future pattern of product or service introductions, future net sales or financial performance.
Components of Our Results of Operations
The following describes the line items set forth in our consolidated statements of operations.
Revenues are recognized on the date that the customer receives the products sold. Any discounts, marketing development funds, product returns or other revenue reductions are treated as offsets to revenues, which is presented on a net basis. We have also historically entered into customer agreements with channel partners that include a combination of products and non-recurring engineering services, or NRE services. When a customer agreement includes NRE services which involve significant design modification and customization of the product software that is essential to the functionality of the hardware, revenues are also recognized according to the contractual milestones in the agreements under ASC 605 or when or as control transfers to the customer under ASC 606. If a milestone is deemed non-substantive, we defer, if applicable, and recognize such non-substantive milestones over the estimated period of performance applicable to each agreement on a straight-line basis, as appropriate. All of our revenues are derived from a single segment.
The Company recognizes revenue primarily from the sale of products, including our mobile phones and accessories, and the majority of the Company's contracts include only one performance obligation, namely the delivery of product. A performance obligation is a commitment in a contract to transfer a distinct good or service to the customer and is defined as the unit of account for revenue recognition under ASC 606. The Company also recognizes revenue from other contracts that may include a combination of products and NRE services or from the provision of solely NRE services. Where there is a combination of products and NRE services, the Company accounts for the commitments as individual performance obligations if they are both capable of being distinct and distinct within the context of the contract.
Our customer agreements with channel partners set forth the terms pursuant to which our channel partners purchase our products for distribution on a purchase order basis. While these arrangements are typically long term, they generally do not contain any firm purchase volume commitments. As a result, our channel partners are not contractually obligated to purchase from us any minimum number of products. However, while our channel partners provide us with demand forecasts under these sales arrangements, we are generally required to satisfy any and all purchase orders delivered to us within specified delivery windows, with limited exceptions (such as orders significantly in excess of forecasts). Our sales arrangements also generally include technical performance standards for our mobile phones and accessories sold, which vary by channel partner. If a technical issue with any of our covered products exceeds certain preset failure thresholds for the relevant performance standard or standards, the channel partner typically has the right to cease selling the product, cancel open purchase orders and levy certain monetary penalties. In addition, our channel partners retain sole discretion in which of their stocked products to offer their customers.
We also offer our channel partners channel marketing and other limited promotional incentives, such as sales volume incentives, in exchange for retail price reductions. Under certain of our customer agreements, we may also offer NRE services in the form of third-party design services relating to the design of materials and software licenses used in the manufacturing of our products.
Cost of Revenues and Gross Profit/Gross Margin
Cost of revenues primarily consists of the following:
Direct costs consist of raw materials, supplies and sub-assemblies used in the production of our products. We purchase all materials and sub-assemblies from our supply chain directly and do all final assembly and testing at our facility in Shenzhen, China. Direct materials represent the majority of our direct manufacturing expenses.
Direct labor costs expended in the final assembly and testing of our products. Labor is charged to each product based on the actual time required to build that specific product.
Other direct costs related to the shipment of the final product to the customer, including such items as shipping costs, royalties on third-party technology included in the product, warranty cost accruals and packaging and handling costs.
Indirect manufacturing expense associated with producing our products, such as rent on production facilities, depreciation on production equipment and tooling, engineering and support salaries and other indirect manufacturing costs.
Amortization of NRE expenses is now part of cost of goods as a result of the adoption of ACS 606 in 2019, using the modified retrospective method.
Gross profit is defined as revenues less cost of revenues. Gross margin is gross profit expressed as a percentage of revenues. We expect that our gross margin may fluctuate from period to period, primarily as a result of changes in average selling price, revenue mix among our devices, and manufacturing costs. In addition, we may reserve against the value at which we carry our inventory based upon the device's lifecycle and conditions in the markets in which we sell.
Our operating expenses consist of the following categories:
Research and development. Research and development expenses consist primarily of personnel-related expenses, including salaries, bonuses, stock-based compensation and employee benefits. Research and development expenses also include the costs of developing new products and supporting existing products. Research and development activities include the design of new products, refinement of existing products and design of test methodologies to ensure compliance with required specifications, as well as all costs associated with achieving technical acceptance with each product at each carrier. All research and development costs are expensed as incurred. We expect our research and development expenses to increase in absolute dollars as we continue to expand our available solutions.
Sales and marketing. Sales expenses consist primarily of personnel-related expenses, including salaries, bonuses, stock-based compensation, commissions to independent sales representatives, travel costs and employee benefits, as well as field support and customer training costs. Marketing expenses include all social media and collateral print media, and brand development expenses. We expect our sales and marketing costs to increase in absolute dollars as we seek to expand our product lines and customer base and increase brand awareness with end customers.
General and administrative. General and administrative expenses consist primarily of personnel-related expenses, including salaries, bonuses, stock-based compensation, travel costs and employee benefits, as well as professional and consulting fees, legal fees, trade shows, depreciation expense and occupancy costs. We expect our general and administrative expenses to increase in absolute dollars as we expand our organization to better support our customers and our anticipated growth. Additionally, these expenses will increase as we establish the necessary infrastructure to operate effectively as a public company.
Income taxes. As part of the process of preparing our consolidated financial statements we are required to estimate our taxes in each of the jurisdictions in which we operate. We account for income taxes in accordance with the asset and liability method. Under this method, deferred tax assets and liabilities are recognized based on temporary differences between the financial reporting and income tax bases of assets and liabilities and the tax effects of operating loss and credit carryforwards using the enacted tax rates expected to apply in the periods of expected settlement. In addition, this method requires a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.
Year Ended December 31, 2019 Compared to Year Ended December 31, 2018
Provision for Income Taxes (in thousands, except percentages) 2019 2018 $ Change % Change Provision for Income Taxes (in thousands, except percentages) Provision for Income Taxes $ 1,388 $ 754 $ 634 84.09 %
We recognized an expense for income taxes of $1.4 million during 2019 as compared to an expense of $0.8 million during 2018. The increase in tax expense in 2019 was primarily due to the Company's increase in earnings in the foreign subsidiaries and uncertain tax position accrual.
Results of Operations Years Ended December 31, 2019 and 2018: See Note 2 - Adoption of ASC 606 was made using the modified retrospective and is not fully comparative in the table below. The following tables present key components of our results of operations for the respective periods (In thousands): . . .
Mar 27, 2020
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