10-K 1 iss150864_10k.htm FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 2014

Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
     
  FORM 10-K  
     
(Mark one)
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2014
 
or
   
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ____________ to ____________
 
Commission file number: 0-26056
     
 
Image Sensing Systems, Inc.
(Exact name of registrant as specified in its charter)
 
Minnesota   41-1519168
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)
     
500 Spruce Tree Centre, 1600 University Avenue West,
St. Paul, MN 
  55104
(Address of principal executive offices)    (Zip Code)
                                                                               
(651) 603-7700
(Registrant’s telephone number, including area code)
 
Not applicable.
(Former name, former address and former fiscal year, if changed since last report)
 
Securities registered pursuant to Section 12(b) of the Act:
 
Title of each class   Name of each exchange on which registered
Common Stock, $0.01 par value    The NASDAQ Capital Market
Preferred Stock Purchase Rights   The NASDAQ Capital Market
     
 
Securities registered pursuant to Section 12(g) of the Act:  None.
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes No
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes No
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or Section 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 No
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes No
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
 
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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
     
  Large accelerated filer Accelerated filer
  Non-accelerated filer    Smaller reporting company
  (Do not check if a smaller reporting company.)  
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes No
 
As of June 30, 2014, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $11,325,392 based on the closing sale price as reported on The NASDAQ Capital Market. The number of shares outstanding of the registrant’s $0.01 par value common stock as of February 28, 2015 was 4,995,963 shares.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Document
 
Parts Into Which Incorporated
Proxy Statement for the 2015 Annual Meeting of Shareholders (Proxy Statement)
 
Part III
 


 
 

 

 
TABLE OF CONTENTS
       
   
1
 
1
 
7
 
15
 
16
 
16
 
16
   
17
 
17
 
18
 
19
 
26
 
27
 
47
 
47
 
47
   
48
 
48
 
48
 
48
 
48
 
48
   
49
 
49
 
53
 
54
 
i

 

Table of Contents

 
Item 1.  Business
             
Business
 
Image Sensing Systems, Inc. (referred to in this Annual Report on Form 10-K as “we,” “us,” “our” and the “Company”) develops and markets video and radar processing products for use in traffic, security, police and parking applications such as intersection control, highway, bridge and tunnel traffic management, venue security, entry control, license plate recognition and traffic data collection.
 
We are a leading provider of software-based products and solutions for the intelligent transportation systems (“ITS”) industry and adjacent security and law enforcement markets. Our family of products, which we market as Autoscope® video (video or video products), RTMS® radar (radar or radar products) and automatic license plate recognition (“LPR”), provides end users with the tools needed to optimize traffic flow, enhance driver safety and address security/surveillance concerns. Our technology analyzes signals from sophisticated sensors and transmits the information to management systems and controllers or directly to users. Our software solutions, which we market as CitySync®, provide end users with complete solutions of our hardware and software for the law enforcement, security, transportation and parking markets.
 
Our technology is a process in which software rather than humans examines outputs from various types of sophisticated sensors to determine what is happening in a field of view. In the ITS industry, this process is a critical component of managing congestion and traffic flow. In many cities, it is not possible to build roads, bridges and highways quickly enough to accommodate the increasing congestion levels. On average, United States commuters spend 38 hours a year stuck in traffic and congestion costs motorists $818 each in 2011 and wasted 19 gallons of fuel. We believe this growing use of vehicles will make our ITS solutions increasingly necessary to complement existing and new roadway infrastructure to manage traffic flow and optimize throughput.
 
We believe our solutions are technically superior to those of our competitors because they have a higher level of accuracy, limit the occurrence of false detection, are generally easier to install with lower costs of ownership, work effectively in a multitude of light and weather conditions, and provide end users the ability to manage inputs from a variety of sensors for a number of tasks. It is our view that the technical advantages of our products make our solutions well suited for use in ITS as well as adjacent security and parking markets.
 
We believe the strength of our distribution channels positions us to increase the penetration of our technology-driven solutions in the marketplace. We market our Autoscope video products in the United States, Mexico, Canada and the Caribbean through exclusive agreements with Econolite Control Products, Inc. (“Econolite”), which we believe is the leading distributor of ITS intersection control products in these markets.
 
We market our Autoscope video, RTMS radar and LPR products outside of the United States, Mexico, Canada and the Caribbean through a combination of distribution and direct sales channels, including our wholly-owned subsidiaries in the United Kingdom. Our end users primarily include governmental agencies and municipalities, and, as of December 31, 2014, we had sold over 160,000 units in more than 60 countries.
 
Industry Overview
 
The Intelligent Transportation Systems Market.  ITS encompasses a broad range of information processing and control electronics technologies that, when integrated into roadway infrastructure, help monitor and manage traffic flow, reduce congestion and enhance driver safety. The ITS market has been built around the detection of conditions that impact the proper operation of roadway infrastructure. ITS applications include a wide array of traffic management systems, such as traffic signal control, tolling and variable messaging signs. ITS technologies include video vehicle detection, inductive loop detection, sensing technologies (such as radars), floating cellular data, computational technologies and wireless communications.
 
In traffic management applications, vehicle detection products are used for automated vehicle detection and are a primary data source upon which ITS solutions are built. Traditionally, automated vehicle detection is performed using inductive wire loops buried in the pavement. However, in-pavement loop detectors are costly to install, difficult to maintain, expensive to repair and not capable of either wide-area vehicle detection without installations of multiple loops or recognizing license plate numbers.
 
1

 

Table of Contents

 

 
Above-ground detection solutions for ITS offer several advantages to in-pavement loop detectors. Above-ground detection solutions tend to have a lower total cost of ownership than in-pavement loop detectors because above-ground solutions are non-destructive to road surfaces, do not require closing roadways to install or repair, and are capable of wide-area vehicle detection with a single device, thus enabling one input device to do the work of many in-pavement loops. Due to their location above-ground, these solutions have no exposure to the wear and tear associated with expanding and contracting pavement and generally less exposure to the vibration and compaction caused by traffic. Furthermore, in the event of malfunction or product failure, above-ground detection solutions can be serviced and repaired without shutting down the roadway. Each of these factors results in greater up-time and increased reliability of above-ground detection solutions compared to in-pavement loop detectors. These technology solutions also offer a broader set of detection capabilities and a wider field of view than in-pavement loop detectors. In addition, a single unit video- or radar-based system can detect and measure a variety of parameters, including vehicle presence, counts, speed, length, time occupancy, headway and flow rate as well as environmental factors and obstructions to the roadway. An equivalent installation using loops would require many installations per lane.
 
We believe our Autoscope video and RTMS radar products are competitive with and can take market share from in-pavement loop detectors. Based on our determination, the U.S. ITS above-ground detection market sales in 2014 were approximately $100 million and the worldwide ITS above-ground detection market was approximately $200 million.  We believe that we are the leader in the U.S. above-ground detection market in terms of sales volume, and we estimate that U.S. sales of in-pavement loop detectors that our Autoscope video and RTMS radar products can supplant were approximately $100 million in 2014.
 
Our CitySync solutions combine hardware and software to provide a complete offering.  As part of our CitySync solutions, we have dedicated research and development time to creating our CitySync initiative called “Safe Cities,” which helps communities improve safety and efficiency.  We are investing thought leadership into this initiative by investigating new ways to combine leading-edge above-ground detection technology, radar, and “Big Data” collection and analysis to give law enforcement, security, parking and traffic management professionals more precise and accurate information. With increased real-time reaction capabilities and in-depth analytics, these professionals will be able to make more confident and proactive decisions that will streamline operations and improve safety.
 
We believe that several trends are driving the growth in ITS and adjacent market segments:
 
Proliferation of Traffic. In many countries, there has been a surge in the number of vehicles on roadways. Due to the growth of emerging economies and elevated standards of living, more people desire and are able to afford automobiles. The number of vehicles utilizing the world’s roadway infrastructure is growing at a quicker pace than new roads, bridges and highways are being constructed. The population of the United States grew by about 22%, or 70 million, from 1990 to 2014, while highway miles have increased by approximately 4% in the same period. Overall, the growth in roadway infrastructure is failing to match the surge in the number of vehicles using it. Above-ground detection based traffic management and control systems address the problem by monitoring high traffic areas and analyzing data that can be used to mitigate traffic problems.
 
The Demographics of Urbanization. Accelerated worldwide urbanization drives the creation and expansion of middle classes and produces heightened demand for automobiles. Currently, there are at least 400 cities in the world with over 1 million people. Because automobiles can be introduced to a metropolitan area faster than roadway infrastructure can be constructed, the result is continuously worsening traffic. Expanding the roadway infrastructure is slow and costly to implement, and often environmentally undesirable, so government agencies are increasingly turning to technology-based congestion solutions that optimize performance and throughput of existing and new roadway infrastructure. Detection is the requisite common denominator for any technology-based solution.
 
The Melding of Large City Service Domains. Large cities require a wide range of service domains, including traffic, security/surveillance and environmental protection. These cities are increasingly turning to centralized management of these service domains, employing a command and control model that requires sharing and integrating data across service domains to operate effectively and lower total cost – so called “Safe Cities” initiatives. For example, data collected for the traffic management service domain is relevant to all of the other service domains. This means that each sensor can supply information to multiple domain services. In turn, the sharing of detection information across service domains should increase the level of sophistication required to process and interpret that information.  Additionally, above-ground detection products are more capable of performing certain complicated tasks than humans.  This makes the concepts of “rich sensing” and “instrumenting the city” through above-ground detection solutions cost effective, which we believe will result in the extensive proliferation of sophisticated sensors and detection devices.
 
The non-ITS LPR Market.  In addition to ITS, LPR is widely used for applications in security, police and parking, among others.  We believe the sum of these world-wide markets is significant and currently is in excess of $350 million for their LPR components.  We also believe the competitive landscape is fragmented, with no dominant market share for any one competitor.
 
Parking.  Both public and private parking facilities have recently undergone a significant period of automation where human attendants have been replaced by machines that control access.  LPR is employed in numerous parking functions, including automatic entrance/exit, open spot locator assistance, lost vehicle location, theft avoidance and related security aspects.
 
2

 

Table of Contents

 

 
Security.  LPR is used in security applications world-wide for border crossings, airports and venues such as convention centers and sports arenas.  Additionally, private industry uses LPR to help control entrances at high value locations, such as power plants.  Homeland security and counter-terrorism activities benefit from LPR as part of the solution.
 
Police. Law enforcement has adopted LPR for a variety of applications.  Police may use LPR to gather information on a stopped vehicle in a faster, automated fashion.  LPR can scan for vehicles of interest from a fixed position or from a moving police vehicle, looking for stolen cars or for automobiles of individuals with arrest warrants outstanding.  Police also use license plate data to analyze information to get the evidence they need to apprehend and convict criminals.
 
Solutions for Adjacent Markets. We believe that the adjacent markets of ITS, security/surveillance and parking management are converging, and that this convergence will accelerate as above-ground detection systems become more cost-effective now that a single sensor can be used for multiple purposes. Because the technologies involved are closely related, our sensor technology can be adapted to or is already capable of addressing these adjacent markets.
 
Our Competitive Strengths
 
We are a leading provider of software-based detection products and solutions for the ITS industry and related security and law enforcement markets. We have the following competitive strengths that we expect will continue to enhance our leadership position:
 
Leading Proprietary Technologies. Over the last two decades, we have developed or acquired a proprietary portfolio of complex software algorithms and applications that we have continuously enhanced and refined. These algorithms, which include our advanced signal processing technologies, allow our video and radar detection and LPR products to capture and analyze objects in diverse weather and lighting conditions and to balance the accuracy of positive detection and the avoidance of false detections. Due to the strength of our proprietary technologies, we believe we command premium pricing. Above-ground detection technologies similar to ours are also difficult to develop and refine in a commercially viable manner. We therefore should be well positioned to quickly introduce next-generation products to market.
 
Proven Ability to Develop, Enhance and Market New Products. We are continually developing and enhancing our product offerings. Over the last two decades, we have demonstrated our ability to lead the market with new products and product enhancements. For example, the Autoscope Solo system was the first fully integrated color camera, zoom lens and machine vision processor in the above-ground detection market. Electronic Integrated Systems, Inc. (“EIS”), from which we purchased our radar product line, was one of the first companies to introduce radar-based technology solutions for ITS applications, and we continue to lead the market with technology enhancements and new products, such as RTMS radar.  Additionally, the CitySync system we acquired from Image Sensing Systems UK Limited (“ISS UK”), formerly known as CitySync Limited, was the first in the LPR market to capture multiple license plates in the same lane with a standard configuration.  Our CitySync solution offering includes a web-based traffic management database and reporting software for providing rich data analytics in real-time.  Furthermore, our radar product, RTMS Sx-300, is an example of development driven by the voice of our customers.  We have developed a high quality radar detection solution with increased reliability and longevity. We have successfully collaborated with our long-term channel partners to market these products. We believe that developing, enhancing and marketing new products with our partners can translate into strong organic revenue growth and high levels of profitability.
 
Leading Distribution Channel. We have maintained a relationship with Econolite for the exclusive manufacture and distribution of our Autoscope video products in the United States, Mexico, Canada and the Caribbean since 1991. We believe that Econolite is the leading distributor of ITS control products in North America and the Caribbean. This relationship enhances our ability to commercialize and market new products and allows us to focus more resources on developing advanced signal processing software algorithms.
 
Broad Product Portfolio. Our product portfolio leverages our core software-based algorithms to enable end users to detect and monitor objects in a designated field of view. We believe that our family of Autoscope video, RTMS radar and LPR products allows us to offer a broad product portfolio that meets the needs of our end users. Additionally, our intention is to use our broad product portfolio to offer hybrid products that satisfy traffic and security/surveillance requirements.
 
Experienced Management Team and Engineering Staff.  Our management team and engineering staff are highly experienced in the ITS and software industries. Additionally, the continuity of our engineering staff should allow the uninterrupted development of new or improved products.
 
3

 

Table of Contents

 

 
Our Growth Strategy
 
As part of our growth strategy, we seek to:
 
Enhance and Extend Our Technology Leadership in ITS. We believe we have established ourselves as a leading provider of technology in the ITS market segment. We believe that we continue to have an opportunity to accelerate our growth. We plan to do this by improving the accuracy and functionality of our products and opportunistically expanding our product offering into adjacent markets, as well as expanding our portfolio and channels through licensing. Having developed and introduced a hybrid product, we expect to take advantage of our technical leadership in ITS and further differentiate us from our competitors.
 
Expand LPR Markets. We believe that the LPR market is poised for growth.  Further, we believe that our financial strength, distribution channels and customer base will add to our ability to grow Autoscope LPR-related revenue.
 
Expand into Adjacent Markets. Our core skill is the implementation of software-based above-ground detection products and solutions. Over the past two decades, we have been developing and refining our complex signal processing software algorithms. We should be able to effectively utilize our core software skills more broadly as markets, including security/surveillance and parking systems, converge. We believe that a driver of this convergence is that above-ground detection systems will become more cost-effective when a single sensor can be used for multiple purposes. As a result, our objective is to become the leading supplier of critical detection components to third party management systems, particularly those that exploit the convergence of traffic, security/surveillance and parking management systems. To do this, we are integrating this concept into our long-range engineering development road-map and will evaluate the use of technology licensing and channel strategies that support this vision.
 
Increase the Scope of Our Distribution and Direct Sales. We have made substantial investments in product adjustments to tailor our solutions to the differing needs of our international end users and in new product acquisitions for both domestic and international markets. We have also invested in sales and marketing expansion, with a focus on our European subsidiaries. Markets in Eastern Europe, the Asia/Pacific region, the Middle East, Africa and South America, which have historically lagged North America and Western Europe in their use of above-ground detection, have recently begun to increase the adoption of detection technology in their traffic, security/surveillance and parking systems. We intend to continue to refine our product offerings through engineering development and technology licensing to take advantage of the accelerated pace of the adoption of above-ground detection throughout the developing world.
 
Our Products and Solutions
 
Our vehicle and traffic detection products are critical components of many ITS and adjacent security and law enforcement applications. Our Autoscope video systems and RTMS radar systems convert sensory input collected by video cameras and radar units into vehicle detection and traffic data used to operate, monitor and improve the efficiency of roadway infrastructure. Our Autoscope LPR systems use video sensors in the visible and infrared spectrums to read license or number plates for security, police and parking applications.  At the core of each product line are proprietary digital signal processing algorithms and sophisticated embedded software that analyze sensory input and deliver actionable data to integrated applications. We invested approximately $5.7 million, $5.0 million and $4.1 million on research and development in 2014, 2013 and 2012, respectively, to develop and enhance our product technology. Our digital signal processing software algorithms represent a foundation on which support for additional sensory inputs such as acoustic, chemical, smoke, weather and vibration sensors may be added in the future. A diagram displaying our fundamental product architecture is shown below.
 
4

 

Table of Contents

 

 
The Image Sensing Product Architecture
 
(FLOW CHART)
 
Autoscope Video. Our Autoscope video system processes video input from a traffic scene in real time and extracts the required traffic data, including vehicle presence, bicycle presence/differentiation, counts, speed, length, time occupancy (percent of time the detection zone is occupied), average headway (time interval between vehicles) and flow rate (vehicles per hour per lane). Autoscope supports a variety of standard video cameras or can be purchased with an integrated video camera. For intersections, the system communicates with the intersection signal controller, which changes the traffic lights based on the data provided. In highway applications, the system gathers vehicle count and flow rates and detects anomalous incidents, such as stopped vehicles. In any application, the data may also be transmitted to a traffic management center via the internet or other standard communication means and processed in real time to assist in traffic management and stored for later analysis for traffic planning purposes.
 
The Autoscope system comes in two varieties.  Autoscope Encore is our integrated unit with a color zoom camera and a machine vision processing computer contained in a compact housing that is our leading offering in the North American market.  Autoscope RackVision is our card only machine vision processing computer that is located in an intersection signal controller, control hub, incident management center or traffic management center that receives video from a separate camera. The RackVision and its variants are our top selling Autoscope products in international markets. Autoscope products offer digital MPEG-4 video streaming, high speed Ethernet interface, web browser maintenance and data and video over power line communications.
 
Autoscope Radar. Our Autoscope radar systems use radar to measure vehicle presence, volume, occupancy, speed and classification information for roadway monitoring applications. Data is transmitted to a central computer at a traffic management center via standard communication means, including wireless. Data can be processed in real time to assist in traffic management and stored for later analysis for traffic planning purposes.
 
Autoscope radar is an integrated radar transmitter/receiver and special purpose computer contained in a compact, self-contained unit. The unit is typically situated on roadway poles and side-fired, making it especially well-suited for highway detection applications.
 
Autoscope LPR. Our LPR systems process video information gathered from the visible and infrared spectrum to perform LPR for ITS, security, police and parking applications.  Data is transmitted to other integrated systems or stored in onboard vehicle systems for later processing. Data can be processed to assist in traffic and parking management, real-time law enforcement and traffic alerts and stored for later analysis for traffic, security and commercial purposes.
 
At the core of each Autoscope LPR system is the Autoscope Base software suite, which runs the LPR algorithms and related processes, including communications.  Autoscope Base operates with both non-proprietary and proprietary cameras.  We offer a range of proprietary analog, high definition and intelligent cameras for both fixed and mobile systems.
 
5

 

Table of Contents

 

 
CitySync. Our CitySync solutions provide the end user with a complete package including hardware and software.  CitySync solutions are currently positioned around our LPR technology and platform.  These solutions combine intelligent cameras with our market specific software packages that we believe offer our end users complete LPR solutions.  The Rapid Plate Recognition technology reads a license plate numerous times and uses multiple advanced methods for both optical character recognition and plate finding for each plate read.  The speed of our solutions allows us the capability to read hundreds of plates simultaneously.  We believe our CitySync solutions provide the highest accuracy for the markets we serve.  We believe in the development of our CitySync solutions and will continue to grow and enhance these solutions into all of our markets.
 
Distribution, Sales and Marketing
 
We market and sell our products globally. As of December 31, 2014, we had supplied systems for more than 160,000 units in more than 60 countries. Together with our partners, we offer a combination of high-performance detection technology and experienced local support. Our end users primarily consist of federal, state, city and county departments of transportation, port, highway, tunnel and other transportation authorities, law enforcement agencies and parking facility operators. The decision-makers within these entities typically are traffic planners and engineers, who in turn often rely on consulting firms that perform planning and feasibility studies. Our products sometimes are sold directly to system integrators or other suppliers of systems and services who are operating under subcontracts in connection with major road construction contracts.
 
Sales of Autoscope Video in the United States, Mexico, Canada and the Caribbean. We have granted Econolite an exclusive right to manufacture, market and distribute the Autoscope video system in the United States, Mexico, Canada and the Caribbean. The agreement with Econolite grants it a first refusal right that arises when we make a proposal to Econolite to extend the license to additional products in the United States, Mexico, Canada and the Caribbean and a first negotiation right that arises when we make a proposal to Econolite to include rights corresponding to Econolite’s rights under our current agreements in countries not in these territories. Econolite provides the marketing and technical support needed for its sales in these territories. Econolite pays us a royalty on the revenue derived from its sales of the Autoscope system. We cooperate in marketing Autoscope video products with Econolite for the United States, Mexico, Canada and the Caribbean and provide second-tier technical support. We have the right to terminate our agreements with Econolite if it does not meet minimum annual sales levels or if Econolite fails to make payments as required by the agreements. In 2008, the term of the original agreement with Econolite, as amended, was extended to 2031. The agreements can be terminated by either party upon three years’ notice.
 
Sales of RTMS Radar and Autoscope LPR in North America, the Caribbean and Latin America. We market the RTMS radar and Autoscope LPR systems to a network of distributors covering countries in North America, the Caribbean and Latin America. On a limited basis, we sell directly to the end user.  We provide technical support to these distributors from our various North American locations.
 
Sales in Europe, Asia, the Middle East and Africa. We market our Autoscope video, radar and LPR lines of products to a network of distributors covering countries in Europe, the Middle East, Africa and Asia through our wholly-owned subsidiaries that have offices in Europe and Asia. On a limited basis, we sell directly to the end user. Technical support to these distributors is provided by our wholly-owned subsidiaries in Europe, with second-tier support provided by our engineering groups.  From time to time, we may grant exclusive rights to Econolite for markets outside of our significant markets for certain jurisdictions or product sales based on facts and circumstances related to the opportunities.
 
Competition
 
We compete with companies that develop, manufacture and sell traffic management devices using video and radar sensing technologies as well as other above-ground detection technologies based on laser, infrared and acoustic sensors. For ITS applications, we also compete with providers of in-pavement loop detectors and estimate that more than 70% of the traffic management systems currently in use in the U.S. use in-pavement loop detectors. For competition with other above-ground detection products, we typically compete on performance and functionality, and to a lesser extent on price. When competing against providers of loop detectors, we compete principally on ease of installation and the total cost of ownership over a multi-year period, and to a lesser extent on functionality.
 
Among the companies that provide direct competition to Autoscope video worldwide are FLIR Systems, Inc., Signal Group Inc. (Semex), Iteris, Inc. and Citilog S.A. Among the companies that provide direct competition to RTMS radar worldwide are Wavetronix, LLC, MS Sedco Inc., Smartmicro Sensors GmbH and Xtralis, LLC. Among the companies that provide direct competition to Autoscope LPR worldwide are 3M Company, Perceptics LLC, Genetec Inc., Vigilant Solutions and Elsag Datamat S.p.A. All of these companies have working installations of their systems in the U.S. and other parts of the world. To our knowledge, Autoscope video and RTMS radar have the largest number of installations as compared to their direct competitors. In addition, there are smaller local companies providing direct competition in specific markets throughout the world. We are aware that these and other companies will continue to develop technologies for use in traffic management, security, police and parking applications. One or more of these technologies could in the future provide increased competition for our systems.
 
6

 

Table of Contents

 

 
Other potential competitors of which we are aware include Siemens AG, Cognex Corp., Augusta Technologie AG, Matsushita Electric Industrial Co., Ltd. (Panasonic), Sumitomo Corporation and Omron Electronics LLC. These companies have machine vision or radar capabilities and have substantially more financial, technological, marketing, personnel and research and development resources than we have.
 
Manufacturing
 
Autoscope video products for sale under the Econolite license agreement are manufactured through agreements with Econolite and Wireless Technology, Inc. Econolite is responsible for setting warranty terms and must provide all service required under this warranty. In Europe and Asia, we engage contract manufacturers to manufacture the Autoscope family of products.
 
Until January 2012, we engaged contract manufacturers to produce subassemblies for our radar products based on our designs. These subassemblies were then shipped to our facilities in Toronto, where we performed final assembly, testing and calibration and packaging of finished units for shipment.  We also performed warranty and post-warranty repairs of radar units in Toronto.  Beginning in July 2014, we engaged Wireless Technology, Inc. to manufacture our radar products and perform warranty and post-warranty repairs of radar units.
 
Autoscope LPR products are manufactured through contract manufacturers in the United Kingdom and the United States.
 
We typically provide a two-year warranty on our products.
 
Most of the hardware components used to manufacture our products are standard electronics components that are available from multiple sources. Although some of the components used in our products are obtained from single-source suppliers, we believe other component vendors are available should the necessity arise.  The European Parliament has enacted a directive for the restriction of the use of certain hazardous substances in electrical and electronic equipment (“RoHS”).  To our knowledge, our contract manufacturing and component vendors in Europe and Asia comply with the European directive on RoHS.
 
Intellectual Property
 
To protect our rights to our proprietary know-how, technology and other intellectual property, it is our policy to require all employees and consultants to sign confidentiality agreements that prohibit the disclosure of confidential information to any third parties. These agreements also require disclosure and assignment to us of any discoveries and inventions made by employees and consultants while they are devoted to our business activities. We also rely on trade secret, copyright and trademark laws to protect our intellectual property.  We have also entered into exclusive and non-exclusive license and confidentiality agreements relating to our own and third-party technologies. We aggressively protect our processes, products, and strategies as proprietary trade secrets. Our efforts to protect intellectual property and avoid disputes over proprietary rights include ongoing review of third-party patents and patent applications.
 
Environmental Matters
 
We believe our operations are in compliance with all applicable environmental regulations within the jurisdictions in which we operate.
 
Employees
 
As of December 31, 2014, we had 109 employees, consisting of 67 employees in North America, 35 employees in Europe and 7 employees in Asia. None of our employees are represented by a union.
 
Item 1A. Risk Factors
 
Information Regarding Forward-Looking Statements
 
This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange of 1934, as amended. Forward-looking statements represent our expectations or beliefs concerning future events and can be identified by the use of forward-looking words such as “believes,” “may,” “will,” “should,” “intends,” “plans,” “estimates,” or “anticipates” or other comparable terminology. Forward-looking statements are subject to risks and uncertainties that may cause our actual results to differ materially from the results discussed in the forward-looking statements. Some factors that might cause these differences include the factors listed below. Although we have attempted to list these factors comprehensively, we wish to caution investors that other factors may prove to be important in the future and may affect our operating results. New factors may emerge from time to time, and it is not possible to predict all of these factors, nor can we assess the effect each factor or combination of factors may have on our business.
 
7

 

Table of Contents

 

 
We further caution you not to unduly rely on any forward-looking statements because they reflect our views only as of the date the statements were made. We undertake no obligation to publicly update or revise any forward-looking statements whether as a result of new information, future events or otherwise.
 
If governmental entities elect not to use our products due to budgetary constraints, project delays or other reasons, our revenue may fluctuate severely or be substantially diminished.
 
Our products are sold primarily to governmental entities. We expect that we will continue to rely substantially on revenue and royalties from sales of our systems to governmental entities. In addition to normal business risks, it often takes considerable time before governmental initiated projects are developed to the point at which a purchase of our systems would be made, and a purchase of our products also may be subject to a time-consuming approval process. Additionally, governmental budgets and plans may change without warning. Other risks of selling to governmental entities include dependence on appropriations and administrative allocation of funds, changes in governmental procurement legislation and regulations and other policies that may reflect political developments, significant changes in contract scheduling, competitive bidding and qualification requirements, performance bond requirements, intense competition for government business and termination of purchase decisions for the convenience of the governmental entity. Substantial delays in purchase decisions by governmental entities, or governmental budgetary constraints, could cause our revenue and income to drop substantially or to fluctuate significantly between fiscal periods.
 
A majority of our gross profit has been generated from sales of our Autoscope family of products, and if we do not maintain the market for these products, our business will be harmed.
 
Historically, a majority of our gross profit has been generated from sales of, or royalties from the sales of, Autoscope products. Gross profit from Autoscope sales accounted for approximately 67% of our gross profit in 2014, 71% in 2013 and 77% in 2012. We anticipate that gross profit from the sale of Autoscope systems will continue to account for a substantial portion of our gross profit for the foreseeable future. As such, any significant decline in sales of our Autoscope system would have a material adverse impact on our business, financial condition and results of operations.
 
If Econolite’s sales volume decreases or if it fails to pay royalties to us in a timely manner or at all, our financial results will suffer.
 
We have agreements with Econolite under which Econolite is the exclusive distributor of the Autoscope® video system in the United States, Mexico, Canada and the Caribbean.  From July 24, 2012 until July 14, 2014, our Autoscope® radar products were sold by Econolite in these geographic areas under the same arrangement. Our current agreements grant Econolite a first refusal right that arises when we make a proposal to Econolite to extend the license to additional products in the United States, Mexico, Canada and the Caribbean. In addition, the agreements grant Econolite a first negotiation right that arises when we make a proposal to Econolite to include rights corresponding to Econolite’s rights under our current agreements in countries not in these territories. In exchange for its rights under the agreements, Econolite pays us royalties for sales of the Autoscope® video system and, from July 24, 2012 until July 14, 2014, the Autoscope® radar products. Since 2002, a substantial portion of our revenue has consisted of royalties resulting from sales made by Econolite, including 44% in 2014, 44% in 2013 and 50% in 2012. Econolite’s account receivable represented 32% of our accounts receivable at December 31, 2014 and 26% of our accounts receivable at December 31, 2013. We expect that Econolite will continue to account for a significant portion of our revenue for the foreseeable future. Any decrease in Econolite’s sales volume could significantly reduce our royalty revenue and adversely impact earnings. A failure by Econolite to make royalty payments to us in a timely manner or at all will harm our financial condition. In addition, we believe sales of our products are a material part of Econolite’s business, and any significant decrease in Econolite’s sales of the other products it sells could harm Econolite, which could have a material adverse effect on our business and prospects.
 
As a result of our continuing review of our business, we may have to undertake further restructuring plans that would require additional charges, including incurring facility exit and restructuring charges.
 
We continue to evaluate our business, which may result in restructuring activities. We may choose to divest certain business operations based on management’s assessment of their strategic value to our business, consolidate or close certain facilities or outsource certain functions. Decisions to eliminate or limit certain business operations in the future could involve the expenditure of capital, consumption of management resources, realization of losses, transition and wind-up expenses, reduction in workforce, impairment of assets, facility consolidation and the elimination of revenues along with associated costs, any of which could cause our operating results to decline and may fail to yield the expected benefits.
 
The features and functions in our products have not been as widely utilized as traditional products offered by our competitors, and the failure of our end users to accept the features and functions in our products could adversely affect our business and growth prospects.
 
Video and radar technologies have not been utilized in the traffic management industry as extensively as other more traditional technologies, mainly in-pavement loop detectors. Our financial success and growth prospects depend on the continued development of the market for advanced technology solutions for traffic detection and management and the acceptance of our current Autoscope® video, Autoscope® radar and LPR systems and also future systems we may develop as reliable, cost-effective alternatives to traditional vehicle detection systems. We cannot assure you that we will be able to utilize our technology profitably in other products or markets. If our end users do not continue to increase their acceptance of the features and functions provided by our current systems or other systems we may develop in the future, our business and growth prospects could be adversely affected.
 
8

 

Table of Contents

 

 
Existing and future laws, ordinances and regulations and constitutional provisions protecting privacy rights could negatively affect the acceptance and sale of our video and LPR products and systems and have a negative effect on our financial condition and results of operations.
 
The use of video and LPR products and systems has been challenged, limited and banned under existing laws, ordinances and regulations and constitutional provisions protecting privacy rights.  In addition, governments and governmental agencies have stopped or suspended their use of LPR systems.  For example, Maine, New Jersey and Virginia have laws limiting the use of LPR systems; New Hampshire bans their use; legislation has been proposed in many states, including Minnesota, limiting their use or the use of data collected by LPR systems; and the Boston Police Department has indefinitely halted its use of LPR systems.  In addition, laws, ordinances, regulations and constitutional provisions may be adopted in the future to limit the use of video and LPR products and systems.  These existing and new laws, ordinances, regulations and constitutional provisions could negatively affect the acceptance and sale of our video and LPR products and systems and thus have a negative effect on our financial condition and results of operations.
 
Our operating costs tend to be fixed, while our revenue tends to be seasonal, thereby resulting in operating results that fluctuate from quarter to quarter.
 
Our expense levels are based in part on our product development efforts and our expectations regarding future revenues and, in the short-term, are generally fixed. Our quarterly revenues, however, have varied significantly in the past, with our first quarter historically being the weakest due to weather conditions in parts of North America, Europe and Asia that make roadway construction more difficult. Additionally, our international revenues have a significant large project component, resulting in a varying revenue stream. We expect the seasonality of our revenue and the fixed nature of our operating costs to continue in the foreseeable future. Therefore, we may be unable to adjust our spending in a timely manner to compensate for any unexpected revenue shortfall. As a result, if anticipated revenues in any quarter do not occur or are delayed, our operating results for the quarter would be disproportionately affected. Operating results also may fluctuate due to factors such as the demand for our products; product life cycle; the development, introduction and acceptance of new products and product enhancements by us or our competitors; changes in the mix of distribution channels through which our products are offered; changes in the level of operating expenses; end user order deferrals in anticipation of new products; competitive conditions in the industry; and economic conditions generally. No assurance can be given that we will be able to achieve or maintain profitability on a quarterly or annual basis in the future.
 
Increased competition may make it difficult for us to acquire and retain end users. If we are unsuccessful in developing new applications and product enhancements, our products may become noncompetitive or obsolete.
 
Competition in the areas of ITS, security and parking management is continuing to grow. Some of the companies that may compete with us in the business of developing and implementing traffic control and related security systems have substantially more financial, technological, marketing, personnel and research and development resources than we have. Therefore, they may be able to respond more quickly than we can to new or changing opportunities, technologies, standards or end user requirements. If we are unable to compete successfully with these companies, the market share for our products will decrease, and competitive pressures may seriously harm our business.
 
Additionally, the market for vehicle detection and LPR is continuously seeking more advanced technological solutions to problems. Technologies such as embedded loop detectors, pressure plates, pneumatic tubes, radars, lasers, magnetometers, acoustics and microwaves that have been used as traffic sensing devices in the past are being enhanced for use in the traffic management industry, and new technologies may be developed. We are aware of several companies that are developing traffic management devices using machine vision technology or other advanced technology. Floating vehicle and/or radio frequency identification (RFID) tagged license plate initiatives are under consideration and may be implemented. We expect to face increasingly competitive product developments, applications and enhancements. New technologies or applications in traffic control systems from other companies or the development of new and emerging technologies and applications, including vehicle-to-vehicle (VTV) communications, mobile applications, and new algorithms or sensor technologies, may provide our end users with alternatives to our products and could render our solutions noncompetitive or obsolete. If we are unable to increase the number of our applications and develop and commercialize product enhancements and applications in a timely and cost-effective manner that respond to changing technology and satisfy the needs of our end users, our business and financial results will suffer.
 
9

 

Table of Contents

 

 
We may not achieve our growth plans for the expansion of our business.
 
In addition to market penetration, our long-term success depends on our ability to expand our business through new product development, mergers and acquisitions, and/or geographic expansion.
 
New product development requires that we maintain our ability to improve existing products, continue to bring innovative products to market in a timely fashion, and adapt products to the needs and standards of current and potential customers. Our products and services may become less competitive or eclipsed by technologies to which we do not have access or which render our solutions obsolete.
 
Geographic expansion will be primarily outside of the U.S. and hence will be disproportionately subject to the risks of international operations discussed in this Annual Report on Form 10-K.
 
Mergers and acquisitions will be accompanied by risks which may include:
 
 
difficulties identifying suitable acquisition candidates at acceptable costs;
 
unavailability of capital to conduct acquisitions;
 
failure to achieve the financial and strategic goals for the acquired and combined businesses;
 
difficulty assimilating the operations and personnel of the acquired businesses;
 
disruption of ongoing business and distraction of management from the ongoing business;
 
dilution of existing shareholders and earnings per share;
 
unanticipated, undisclosed or inaccurately assessed liabilities, legal risks and costs; and
 
difficulties retaining our key vendors, customers or employees or those of the acquired business.
 
In addition, acquisitions of businesses having a significant presence outside the U.S. will increase our exposure to the risks of international operations discussed in this Annual Report on Form 10-K.
 
Our dependence on third parties for manufacturing and marketing our products may prevent us from meeting customers’ needs in a timely manner.
 
We do not have, and do not intend to develop in the near future, internal capabilities to manufacture our products. We have entered into agreements with Econolite and Wireless Technology, Inc. (“WTI”) to manufacture the Autoscope system, the Autoscope® radar products and related products for sales in the United States, Mexico, Canada and the Caribbean. We have arrangements with Hansatech EMS Limited (“Hansatech”) in the United Kingdom to manufacture our LPR systems.  We work with suppliers, most of whom are overseas, to manufacture the rest of our products.  We also need to comply with the European Union’s regulatory RoHS directive restricting the use of certain hazardous substances in electrical and electronic equipment. If Econolite, WTI, Hansatech or our other suppliers are unable to manufacture our products in the future, we may be unable to identify other manufacturers able to meet product and quality demands in a timely manner or at all. Our inability to find suitable manufacturers for our products could result in delays or reductions in product shipments, which in turn may harm our business reputation and results of operations. In addition, we have granted Econolite the exclusive right to market the Autoscope® video system and related products in the United States, Mexico, Canada and the Caribbean. Consequently, our revenue depends to a significant extent on Econolite’s marketing efforts. Econolite’s inability to effectively market the Autoscope® video system, or the disruption or termination of that relationship could result in reduced revenue and market share for our products.
 
We and our third party manufacturers obtain some of the components of our products from a single source, and an interruption in the supply of those components may prevent us from meeting customers’ needs in a timely manner and could therefore reduce our sales.
 
Although substantially all of the hardware components incorporated into our products are standard electronics components that are available from multiple sources, we and our third party manufacturers obtain some of the components from a single source. The loss or interruption of any of these supply sources could force us or our manufacturers to identify new suppliers, which could increase our costs, reduce our sales and profitability, or harm our customer relations by delaying product deliveries.
 
Regulations related to the use of conflict-free minerals may increase our costs and cause us to incur additional expenses.
 
The Dodd-Frank Wall Street Reform and Consumer Protection Act contains provisions to improve the transparency and accountability of the use by public companies in their products of minerals mined in certain countries and to prevent the sourcing of such “conflict” minerals.  As a result, the Securities and Exchange Commission enacted annual disclosure and reporting requirements for public companies who use these minerals in their products, which apply to us.  Under the final rules, we are required to conduct due diligence to determine the source of any conflict minerals used in our products.  We filed our first conflict minerals report on Form SD with the Securities and Exchange Commission May 29, 2014, and we are required to file our next conflict minerals report on or before June 1, 2015.  Although we expect to file the required report on a timely basis, our supply chain is broad-based and complex, and we may not be able to easily verify the origins for all minerals used in our products.  To the extent that any information furnished to us by our suppliers is inaccurate or inadequate, we could face reputational and enforcement risks.  In addition, the conflict mineral rules could reduce the number of suppliers who provide components and products containing conflict-free minerals and thus could disrupt our supply chain or that of our manufacturers and increase the cost of the components used in manufacturing our products and the costs of our products to us.  Any increased costs and expenses could have a material adverse impact on our financial condition and results of operations.
 
10

 

Table of Contents

 

 
Some of our products are covered by our warranties and, if the cost of fulfilling these warranties exceeds our warranty allowance, it could adversely affect our financial condition and results of operations.
 
Unanticipated warranty and other costs for defective products could adversely affect our financial condition and results of operations and our reputation.  We generally provide a two-year warranty on our product sales.  These warranties require us to repair or replace faulty products, among other customary warranty provisions.  Although we monitor our warranty claims and provide an allowance for estimated warranty costs, unanticipated claims in excess of the allowance could have a material adverse impact on our financial condition and results of operations. Additionally, we rely on our third party manufacturers to fulfill our warranty repair obligations to our customers.  Adverse changes in these parties’ abilities to perform these repairs could cause a delay in repairs or require us to source other parties to perform the repairs and could adversely affect impact our financial condition and results of operations.  In addition, the need to repair or replace products with design or manufacturing defects could adversely affect our reputation.
 
We may face increased competition if we fail to adequately protect our intellectual property rights, and any efforts to protect our intellectual property rights may result in costly litigation.
 
Our success depends in large measure on the protection of our proprietary technology rights. We rely on trade secret, copyright and trademark laws, confidentiality agreements with employees and third parties, and patents, all of which offer only limited protection.  We cannot assure you that the scope of these protective measures will exclude competitors or provide a competitive advantages to us. We also cannot assure you that we will become aware of all instances in which others develop similar products, duplicate any of our products, or reverse engineer or misappropriate our proprietary technology. If our proprietary technology is misappropriated, our business and financial results could be adversely affected. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. In addition, we may be the subject of lawsuits by others who claim we violate their intellectual property rights.
 
Intellectual property litigation is very costly and could result in substantial expense and diversions of our resources, either of which could adversely affect our business and financial condition and results of operations. In addition, there may be no effective legal recourse against infringement of our intellectual property by third parties, whether due to limitations on enforcement of rights in foreign jurisdictions or as a result of other factors.
 
We have not applied for patent protection in all countries in which we market and sell our products. Consequently, our proprietary rights in the technology underlying our systems in countries other than the U.S. will be protected only to the extent that trade secret, copyright or other non-patent protection is available and to the extent we are able to enforce our rights. The laws of other countries in which we market our products may afford little or no effective protection of our proprietary technology, which could harm our business.
 
We plan to continue introducing new products and technologies and may not realize the degree or timing of benefits we initially anticipated, which could adversely affect our business and results of operations.
 
We regularly invest substantial amounts in research and development efforts that pursue advancements in a range of technologies, products and services. Our ability to realize the anticipated benefits of these advancements depends on a variety of factors, including meeting development, production, certification and regulatory approval schedules; the execution of internal and external performance plans; the availability of supplier-produced parts and materials; the performance of suppliers and vendors; achieving cost efficiencies; the validation of innovative technologies; and the level of end user interest in new technologies and products. These factors involve significant risks and uncertainties. We may encounter difficulties in developing and producing these new products and may not realize the degree or timing of benefits initially anticipated. In particular, we cannot predict with certainty whether, when or in what quantities our current or potential end users will have a demand for products currently in development or pending release. Moreover, as new products are announced, sales of current products may decrease as end users delay making purchases until such new products are available. Any of the foregoing could adversely affect our business and results of operations.
 
11

 

Table of Contents

 

 
Our business could be adversely affected by product liability and commercial litigation.
 
Our products or services may be claimed to cause or contribute to personal injury or property damage to our customers’ employees or facilities. Additionally, we are, at times, involved in commercial disputes with third parties, such as customers, distributors, vendors and others. The ensuing claims may arise singularly, in groups of related claims, or in class actions involving multiple claimants. Such claims and litigation are frequently expensive and time-consuming to resolve and may result in substantial liability to us, which liability and related costs and expenses may not be recoverable through insurance or any other forms of reimbursement.
 
Our business could be affected by various legal and regulatory compliance risks, including those involving antitrust, environmental, anti-bribery or anti-corruption laws and regulations.
 
We are subject to various legal and regulatory requirements and risks in the U.S. and other countries in which we have facilities or sell our products involving compliance with antitrust, environmental, anti-bribery and anti-corruption laws and regulations, including the U.S. Foreign Corrupt Practices Act and the U.K. Anti-Bribery Act. Although we have internal policies and procedures with the intention of assuring compliance with these laws and regulations, our employees, contractors, agents and licensees involved in our international sales may take actions in violation of such policies. For more information, see the discussion in Note 15 of our Notes to Consolidated Financial Statements contained elsewhere in this Annual Report on Form 10-K. Any future adverse development, ruling or settlement could result in charges that could have an adverse effect on our results of operations or cash flows.
 
We price certain of our products at a premium compared to other technologies. As such, we may not be able to quickly respond to emerging low-cost competitors, and our inability to do so could adversely affect revenue and profitability.
 
We price certain of our products at a premium as compared to products using less sophisticated technologies. As the technological sophistication of our competitors and the size of the market increase, competing low-cost developers of machine vision products for traffic are likely to emerge and grow stronger. If end users prefer low-cost alternatives over our products, our revenue and profitability could be adversely affected.
 
Our revenue could be adversely affected by the emergence of local competitors and local biases in international markets.
 
Our experience indicates that local officials that purchase traffic management products in the international markets we serve favor products that are developed and manufactured locally. As local competitors to our products emerge, local biases could erode our revenue in Europe and Asia and adversely affect our sales and revenue in those markets.
 
Our failure to predict technological convergence could harm our business and could reduce our sales.
 
Within our product families, we currently utilize only certain detection technologies available in the ITS field. If we fail to predict convergence of technology preferences in the market for ITS, or fail to identify and acquire complementary businesses or products that broaden our current product offerings, we may not capture certain segments of the market, which could harm our business and reduce our sales.
 
We sell our products internationally and are subject to various risks relating to such international activities, which could harm our international sales and profitability.
 
Sales outside of the United States, including export sales from our U.S. business locations, accounted for approximately 42% of our total revenue in 2014. By doing business in international markets, we are exposed to risks separate and distinct from those we face in our U.S. operations. Our international business may be adversely affected by changing political and economic conditions in foreign countries. Additionally, fluctuations in currency exchange rates could affect demand for our products or otherwise negatively affect profitability. Engaging in international business inherently involves a number of other difficulties and risks, including:
 
 
export restrictions and controls relating to technology;
 
 
pricing pressure that we may experience internationally;
 
 
exposure to the risk of currency value fluctuations, where payment for products is denominated in a currency other than U.S. dollars;
 
 
variability in the U.S. dollar value of foreign currency-denominated assets, earnings and cash flows;
 
 
required compliance with existing and new foreign regulatory requirements and laws;
 
 
laws and business practices favoring local companies;
 
 
longer payment cycles;
 
12

 

Table of Contents

 

 
 
difficulty of enforcing agreements, including patent and trademarks, and collecting receivables through foreign legal systems;
 
 
disputes with parties outside of the U.S., which may be more difficult, expensive and time-consuming to resolve than disputes with parties located in the U.S.;
 
 
political and economic instability, including volatility in the economic environment of the European Union caused by the ongoing sovereign debt crisis in Europe;
 
 
tax rates in certain foreign countries that exceed those in the U.S. and the imposition of withholding requirements on foreign earnings;
 
 
higher danger of terrorist activity, war or civil unrest compared to domestic operations;
 
 
difficulties and costs of staffing and managing foreign operations; and
 
 
difficulties in enforcing intellectual property rights.
 
Our exposure to each of these risks may increase our costs, lengthen our sales cycle and require significant management attention. One or more of these factors may harm our business.
 
Our inability to comply with European and Asian regulatory restrictions over hazardous substances and electronic waste could restrict product sales in those markets and reduce profitability in the future.
 
The European Union’s Waste Electrical and Electronic Equipment (“WEEE”) directive makes producers of electrical goods financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. This directive must be enacted and implemented by individual European Union governments, and certain producers will be financially responsible under the WEEE legislation. This may impose requirements on us, which, if we are unable to meet them, could adversely affect our ability to market our products in European Union countries, and our sales revenues and profitability would suffer as a consequence. In addition, the European Parliament has enacted a directive for the restriction of the use of certain hazardous substances in electrical and electronic equipment.  This RoHS legislation restricts the use of such substances as mercury, lead, cadmium and hexavalent cadmium. If we are unable to have our products manufactured in compliance with the RoHS directive, we would be unable to market our products in European Union countries, and our revenues and profitability would suffer. In addition, various Asian governments could adopt their own versions of environment-friendly electronic regulations similar to the European directives, RoHS and WEEE. This could require new and unanticipated manufacturing changes, product testing and certification requirements, thereby increasing cost, delaying sales and lowering revenue and profitability.
 
Our inability to manage growth effectively could seriously harm our business.
 
Growth and expansion of our business could significantly strain our capital resources as well as the time and abilities of our management personnel. Our ability to manage growth effectively will require continued improvement of our operational, financial and management systems and the successful training, motivation and management of our employees. If we are unable to manage growth successfully, our business and operating results will suffer.
 
Our business operations will be severely disrupted if we lose key personnel or if we fail to attract and retain qualified personnel.
 
Our technology depends upon the knowledge, experience and skills of our key management and scientific and technical personnel. Additionally, our ability to continue technological developments and to market our products, and thereby develop a competitive edge in the marketplace, depends in large part on our ability to attract and retain qualified scientific and technical personnel. Competition for qualified personnel is intense, and we cannot assure you that we will be able to attract and retain the individuals we need, especially if our business expands and requires us to employ additional personnel. In addition, the loss of personnel or our failure to hire additional personnel could materially and adversely affect our business, operating results and ability to expand. The loss of key personnel, or our inability to hire and retain qualified personnel, would harm our business.
 
13

 

Table of Contents

 

 
We may not be successful in integrating acquired companies into our business, which could materially and adversely affect our financial condition and operating results.
 
Part of our business strategy has been to acquire or invest in companies, products or technologies that complement our current products, enhance our market coverage or technical capabilities or offer growth opportunities. For any acquisition, a significant amount of management’s time and financial resources may be required to complete the acquisition and integrate the acquired business into our existing operations. Even with this investment of management time and financial resources, an acquisition may not produce the revenue, earnings or business synergies anticipated. Acquisitions involve numerous other risks, including the assumption of unanticipated operating problems or legal liabilities; problems integrating the purchased operations, technologies or products; the diversion of management’s attention from our core businesses; restrictions on the manner in which we may use purchased companies or assets imposed by acquisition agreements; adverse effects on existing business relationships with suppliers and customers; incorrect estimates made in the accounting for acquisitions and amortization of acquired intangible assets that would reduce future reported earnings (such as goodwill impairments); ensuring acquired companies’ compliance with the requirements of the U.S. federal securities laws and accounting rules; and the potential loss of customers or key employees of acquired businesses. We cannot assure you that any acquisitions, investments, strategic alliances or joint ventures will be completed or integrated in a timely manner or achieve anticipated synergies, will be structured or financed in a way that will enhance our business or creditworthiness, or will meet our strategic objectives or otherwise be successful.
 
We may be required to recognize impairment charges for long-lived assets.
 
As of December 31, 2014, the net carrying value of long-lived assets (property and equipment, deferred tax assets and other intangible assets) totaled approximately $4.9 million. In accordance with generally accepted accounting principles, we periodically assess these assets to determine if they are impaired. Significant negative industry or economic trends, a significant and sustained decline in our stock price, disruptions to our businesses, significant unexpected or planned changes in our use of assets, divestitures and market capitalization declines may result in impairments to our goodwill and other long-lived assets.  Future impairment charges could significantly affect our results of operations in the periods recognized.
 
Our stock is thinly traded and our stock price is volatile.
 
Our common stock is thinly traded, with 4,513,436 shares of our 4,995,963 outstanding shares held by non-affiliates as of February 28, 2015. Based on the trading history of our common stock and the nature of the market for publicly traded securities of companies in evolving high-tech industries, we believe there are several factors that have caused and are likely to continue to cause the market price of our common stock to fluctuate substantially. The fluctuations may occur on a day-to-day basis or over a longer period of time. Factors that may cause fluctuations in our stock price include announcements of large orders obtained by us or our competitors, substantial cutbacks in government funding of highway projects or of the potential availability of alternative technologies for use in traffic control and safety, quarterly fluctuations in our financial results or the financial results of our competitors, consolidation among our competitors, fluctuations in stock market prices and volumes, and the volatility of the stock market.
 
Difficult and volatile conditions in the capital, credit and commodities markets and in the overall economy could continue to adversely affect our financial position, results of operations and cash flows, and we do not know if these conditions will improve in the near future.
 
Our financial position, results of operations and cash flows could continue to be adversely affected by difficult conditions and significant volatility in the capital, credit and commodities markets and in the overall worldwide economy. Although certain economic conditions in the United States have improved, economic growth has been slow and uneven and may not be sustained. During economic downturns, governmental entities in particular, which constitute most of our end users, reduce or delay their purchase of our products, which has had and may continue to have an adverse effect on our business. Any uncertainty about the federal budget in the U.S. could have a negative effect on the U.S. and global economy. The continuing impact that these factors might have on us and our business is uncertain and cannot be estimated at this time. Current economic conditions have accentuated each of these risks and magnified their potential effect on us and our business. The difficult conditions in these markets and the overall economy affect our business in a number of ways. For example:
 
 
Although we believe we have sufficient liquidity under our financing arrangements to run our business, under extreme market conditions, there can be no assurance that such funds would be available or sufficient, and, in such a case, we may not be able to successfully obtain additional financing on favorable terms, or at all.
 
 
Continuing market volatility has exerted downward pressure on our stock price, which could make it more difficult or unfavorable for us to raise additional capital in the future.
 
 
Economic conditions could result in customers in our markets continuing to experience financial difficulties, including limited liquidity and their inability to obtain financing or electing to limit spending because of the economy which may result, for example, in customers’ inability to pay us at all or on a timely basis and in declining tax revenue for our customers that are governmental entities, which in turn could result in decreased sales and earnings for us.
 
We do not know if market conditions or the state of the overall economy will improve in the near future, when improvement will occur or if any improvement will benefit our market segment.
 
14

 

Table of Contents

 

 
Our articles of incorporation and bylaws and Minnesota law may inhibit a takeover that shareholders consider favorable.
 
Provisions of our articles of incorporation and bylaws and applicable provisions of Minnesota law may delay or discourage transactions involving an actual or potential change in our control or change in our management, including transactions in which shareholders might otherwise receive a premium for their shares or transactions that our shareholders might otherwise deem to be in their best interests. These provisions:
 
 
permit our board of directors to issue up to 5,000,000 shares of preferred stock with any rights, preferences and privileges as it may designate, including the right to approve an acquisition or other change in our control;
 
 
provide that the authorized number of directors may be increased by resolution of the board of directors;
 
 
provide that all vacancies, including newly-created directorships, may, except as otherwise required by law, be filled by the affirmative vote of a majority of directors then in office, even if less than a quorum; and
 
 
eliminate cumulative voting rights, therefore allowing the holders of a majority of the shares of common stock entitled to vote in any election of directors to elect all of the directors standing for election, if they should so choose.
 
Section 302A.671 of the Minnesota Business Corporation Act (“MBCA”) generally limits the voting rights of a shareholder acquiring a substantial percentage of our voting shares in an attempted takeover or otherwise becoming a substantial shareholder of our company unless holders of a majority of the voting power of all outstanding shares and the disinterested shares approve full voting rights for the substantial shareholder. Section 302A.673 of the MBCA generally limits our ability to engage in any business combination with certain persons who own 10% or more of our outstanding voting stock or any of our associates or affiliates who at any time in the past four years have owned 10% or more of our outstanding voting stock. These provisions of the MBCA may have the effect of entrenching our management team and may deprive shareholders of the opportunity to sell their shares to potential acquirers at a premium over prevailing prices. This potential inability to obtain a control premium could reduce the price of our common stock.
 
In addition, in June 2013, we adopted a shareholder rights plan and declared a dividend to our shareholders of one preferred share purchase right for each outstanding share of common stock. Generally, the shareholder rights plan provides that if a person or group acquires 20% or more of our outstanding shares of common stock, subject to certain exceptions and under certain circumstances, the rights may be exchanged by us for common stock or the holders of the rights, other than the acquiring person or group, could acquire additional shares of our capital stock at a discount of the then current market price. Such exchanges or exercise of rights could cause substantial dilution to a particular acquirer and discourage the acquirer from pursuing our company. The mere existence of a shareholder rights plan often delays or makes a merger, tender offer or other acquisition more difficult to complete.
 
We can issue shares of preferred stock without shareholder approval, which could adversely affect the rights of common shareholders.
 
Our articles of incorporation permit our board of directors to establish the rights, privileges, preferences and restrictions, including voting rights, of future series of our preferred stock and to issue such stock without approval from our shareholders. The rights of holders of our common stock may suffer as a result of the rights granted to holders of preferred stock that may be issued in the future. In addition, we could issue preferred stock to prevent a change in control of our company, depriving common shareholders of an opportunity to sell their stock at a price in excess of the prevailing market price.
 
We do not intend to declare cash dividends on our stock in the foreseeable future.
 
We currently intend to retain all future earnings for the operation and expansion of our business and, therefore, do not anticipate declaring or paying cash dividends on our common stock in the foreseeable future. Any payment of cash dividends on our common stock will be at the discretion of our board of directors and will depend upon our operating results, earnings, current and anticipated cash needs, capital requirements, financial condition, future prospects, any contractual restrictions and any other factors deemed relevant by our board of directors. Therefore, shareholders should not expect to receive dividend income from shares of our common stock.
 
      
None.
 
15

 

Table of Contents

 

 
                
We currently lease and occupy approximately 26,775 square feet in St. Paul, Minnesota for our headquarters. In February 2014, we entered into an amendment to the lease for our headquarters which expanded the leased space from approximately 20,000 square feet to approximately 26,775 square feet, extended the term of the lease to July 2020, and gave us the right to further extend the term of the lease for one additional five-year term. In November 2014 our office in suburban north London, United Kingdom moved to a new leased facility, which occupies approximately 6,400 square feet. The term of this lease is to November 2024. We also lease smaller facilities in Canada, Hong Kong, China, Germany, Spain and Romania.
 
We believe that our current space is generally adequate to meet our current expected needs, and we do not intend to lease significantly more space in 2015.
 
                
We are involved in legal actions and claims relating to various matters.  Although we are unable to predict the ultimate outcome of these legal actions and claims, it is the opinion of management that the disposition of these matters, taken as a whole, will not have a material adverse effect on our Consolidated Financial Statements.
 
                
Not applicable.
 
16

 

Table of Contents

 

 
 
 
Market Information
 
Our common stock is traded on The NASDAQ Capital Market under the symbol “ISNS.” The quarterly high and low sales prices for our common stock for our last two fiscal years are set forth below.
                            
   
2014
 
2013
 
Quarter
 
High
 
Low
 
High
 
Low
 
                           
First
 
$
5.99
 
$
4.74
 
$
6.00
  $ 4.29  
Second
   
5.37
   
3.16
   
7.70
   
4.62
 
Third
   
9.94
   
2.10
   
8.28
   
6.50
 
Fourth
   
4.13
   
1.89
   
7.39
   
4.78
 
 
Shareholders
 
As of February 28, 2015, there were 19 holders of record of our common stock. The number of holders of record is based upon the actual number of holders registered at such date and does not include holders of shares in “street names” or persons, partnerships, associates, corporations, or other entities identified in security position listings maintained by depositories.
 
Dividends
 
We have never declared or paid a cash dividend on our common stock. We currently intend to retain earnings for use in the operation and expansion of our business, and, consequently, we do not anticipate paying any dividends in the foreseeable future.
 
Debt Covenants
 
Our credit agreement includes certain financial covenants, including minimum debt service ratios, minimum cash flow coverage ratios, and other financial measures. These financial covenants may restrict our ability to pay dividends and purchase outstanding shares of common stock. At December 31, 2014 and December 31, 2013, we were in compliance with these financial covenants. Information on our debt agreements is included in Item 7 of this Annual Report on Form 10-K.
 
17

 

Table of Contents

 

 
Selected Financial Data
 
The following table sets forth selected consolidated financial data for each of the five fiscal years ended December 31, 2014. The statement of income and balance sheet data for the years ended and as of December 31, 2014, 2013, 2012, 2011 and 2010 are derived from our audited Consolidated Financial Statements. The following information should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and with our Consolidated Financial Statements and the related notes thereto included elsewhere in this Annual Report on Form 10-K.
                                         
   
2014
   
2013
   
2012
   
2011
   
2010
 
         
(in thousands, except per share data)
       
Consolidated Statement of Operations Data:
                             
Revenue:
                             
Product sales
 
$
12,806
   
$
14,692
   
$
12,564
   
$
17,475
   
$
19,162
 
Royalties
   
10,247
     
11,598
     
12,399
     
13,046
     
12,519
 
     
23,053
     
26,290
     
24,963
     
30,521
     
31,681
 
Cost of revenue:
                                       
Product sales
   
8,041
     
9,889
     
6,706
     
8,769
     
7,799
 
Restructuring
   
     
     
     
448
     
 
     
8,041
     
9,889
     
6,706
     
9,217
     
7,799
 
Gross profit
   
15,012
     
16,401
     
18,257
     
21,304
     
23,882
 
                                         
Operating expenses:
                                       
Selling, marketing and product support
   
9,543
     
11,768
     
7,289
     
10,609
     
9,807
 
General and administrative
   
6,185
     
6,290
     
5,167
     
6,315
     
4,372
 
Research and development
   
5,734
     
5,036
     
4,135
     
4,424
     
3,630
 
Amortization of intangible assets
   
1,558
     
1,554
     
1,622
     
     
 
Impairment
   
1,017
     
     
     
1,650
     
1,218
 
Restructuring
   
770
     
     
430
     
287
     
 
Investigation matter
   
152
     
3,723
     
     
     
 
Goodwill impairment
   
     
     
3,175
     
11,685
     
 
Acquisition related expenses (income)
   
     
     
     
(618
)
   
817
 
     
24,959
     
28,371
     
21,818
     
34,352
     
19,844
 
Income (loss) from operations
   
(9,947
)
   
(11,970
)
   
(3,561
)
   
(13,048
)
   
4,038
 
                                         
Other income (expense), net
   
70
     
6
     
29
     
9
     
(123
)
Income (loss) before income taxes
   
(9,877
)
   
(11,964
)
   
(3,532
)
   
(13,039
)
   
3,915
 
Income tax expense (benefit)
   
(174
)
   
3,937
     
(180
)
   
(3,022
)
   
910
 
Net income (loss)
 
$
(9,703
)
 
$
(15,901
)
 
$
(3,352
)
 
$
(10,017
)
 
$
3,005
 
                                         
Net income (loss) per share:
                                       
Basic
 
$
(1.95
)
 
$
(3.21
)
 
$
(0.69
)
 
$
(2.07
)
 
$
0.66
 
Diluted
 
$
(1.95
)
 
$
(3.21
)
 
$
(0.69
)
 
$
(2.07
)
 
$
0.64
 
                                         
Weighted average number of common shares outstanding:
                                       
Basic
   
4,983
     
4,955
     
4,886
     
4,834
     
4,555
 
Diluted
   
4,983
     
4,955
     
4,886
     
4,834
     
4,667
 
                                         
Consolidated Balance Sheet Data:
                                       
Total assets
 
$
14,890
   
$
24,385
   
$
38,536
   
$
41,254
   
$
54,356
 
Total shareholders’ equity
   
8,320
     
18,514
     
33,980
     
36,326
     
46,021
 
 
18

 

Table of Contents

 

 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
                 
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the Selected Financial Data and our financial statements and the accompanying notes included elsewhere in this Annual Report on Form 10-K. Our actual results could differ materially from those anticipated in the forward-looking statements included in this discussion as a result of certain factors, including, but not limited to, those discussed in “Risk Factors” included elsewhere in this Annual Report on Form 10-K.
 
General. We provide software based computer enabled detection (“CED”) products and solutions that use advanced signal processing software algorithms to detect and monitor objects in a designated field of view. Our technology analyzes signals from a sophisticated sensor and passes the information along to management systems, controllers or directly to users. Our core products, the Autoscope® Video Vehicle Detection System, Autoscope® Radar Detection System and Autoscope® License Plate Recognition (“LPR”) System, operate using our proprietary application software in conjunction with video cameras or radar and commonly available electronic components. Our systems are used by traffic managers primarily to improve the flow of vehicle traffic and to enhance safety at intersections, main thoroughfares, freeways and tunnels and by parking and toll managers and law enforcement officials to read license plates for various safety, security, access and enforcement LPR applications.
 
Autoscope® video systems are sold to distributors and end users of traffic management products in the United States, Mexico, Canada and the Caribbean by Econolite Control Products, Inc. (“Econolite”), our exclusive licensee in these regions. We sell LPR systems to distributors and end users in the United States, Canada and Mexico. We sell all of our systems to distributors and end users in Europe and Asia through our subsidiaries. The majority of our sales are to end users that are funded by government agencies responsible for traffic management or traffic law enforcement.
 
Autoscope® Radar Business Model Change. From July 24, 2012 until July 14, 2014, our Autoscope® radar systems also were sold by Econolite in the United States, Mexico, Canada and the Caribbean under the same arrangement as Econolite sold our Autoscope® video systems. Effective July 14, 2014, the marketing, manufacturing and distribution of the Autoscope® radar product line in these regions transitioned from Econolite to the Company.
 
Trends and Challenges in Our Business
 
We believe the expected growth in our business can be attributed primarily to the following global trends:
 
 
worsening traffic caused by increased numbers of vehicles in metropolitan areas without corresponding expansions of road infrastructure and the need to automate safety, security and access applications for automobiles and trucks, which has increased demand for our products;
 
 
advances in information technology, which have made our products easier to market and implement;
 
 
the continued funding allocations for centralized traffic management services and automated enforcement schemes, which have increased the ability of our primary end users to implement our products; and
 
 
general increases in the cost-effectiveness of electronics, which make our products more affordable for end users.
 
We believe our continued growth primarily depends upon:
 
 
continued adoption and governmental funding of intelligent transportation systems (“ITS”) and other automated applications for traffic control, safety and enforcement in developed countries;
 
 
a propensity by traffic engineers to implement lower cost technology-based solutions rather than civil engineering solutions such as widening roadways;
 
 
countries in the developing world adopting above-ground detection technology, such as video or radar, instead of in-pavement loop technology to manage traffic;
 
 
the adoption of automatic LPR for law enforcement and homeland security applications in metropolitan areas;
 
 
the use of CED to provide solutions to security/surveillance and environmental issues associated with increasing automobile use in metropolitan areas; and
 
19

 

Table of Contents

 

 
 
our ability to develop new products, such as hybrid CED devices incorporating, for example, radar and video technologies, that provide increasingly accurate information and enhance the end users’ ability to cost-effectively manage traffic, security/surveillance and environmental issues.
 
Because the majority of our end users are governmental entities, we are faced with challenges related to potential delays in purchase decisions by those entities and changes in budgetary constraints. These contingencies could result in significant fluctuations in our revenue between periods. The ongoing economic environment in Europe and the United States is further adding to the unpredictability of purchase decisions, creating more delays than usual and decreasing governmental budgets, and it is likely to continue to affect our revenue.
 
Key Financial Terms and Metrics
 
Revenue. We derive revenue from two sources: (1) royalties received from Econolite for sales of the Autoscope® video and Autoscope® radar (from 2012 until July 14, 2014) systems in the United States, Mexico, Canada and the Caribbean and (2) revenue received from the direct sales of our Autoscope® radar (before 2012 and after July 14, 2014) and LPR systems in the United States, Mexico, Canada and the Caribbean and all of our systems in Europe and Asia.  On July 14, 2014, we announced the transfer of North American marketing and manufacturing of the Autoscope® radar product line from Econolite to Image Sensing Systems, ending our royalty agreement for radar sales. Autoscope® video royalties are calculated using a profit sharing model where the gross profits on sales of product made through Econolite are shared equally with Econolite.  This royalty arrangement has the benefit of decreasing our cost of revenues and our selling, marketing and product support expenses because these costs and expenses are borne primarily by Econolite. Although this royalty model has a positive impact on our gross margin, it also negatively impacts our total revenue, which would be higher if all the sales made by Econolite were made directly by us. The royalty arrangement is exclusive under a long-term agreement.
 
Cost of Revenue. There is no cost of revenue related to royalties, as virtually all manufacturing, warranty and related costs are incurred by Econolite. Cost of revenue related to product sales consists primarily of the amount charged by our third party contractors to manufacture hardware platforms, which is influenced mainly by the cost of electronic components. The cost of revenue also includes logistics costs, estimated expenses for product warranties, restructuring costs and inventory reserves. The key metric that we follow is achieving certain gross margin percentages on product sales by geographic region and to a lesser extent by product line.
 
Operating Expenses. Our operating expenses fall into three categories: (1) selling, marketing and product support; (2) general and administrative; and (3) research and development. Selling, marketing and product support expenses consist of various costs related to sales and support of our products, including salaries, benefits and commissions paid to our personnel; commissions paid to third parties; travel, trade show and advertising costs; second-tier technical support for Econolite; and general product support, where applicable. General and administrative expenses consist of certain corporate and administrative functions that support the development and sales of our products and provide an infrastructure to support future growth. These expenses include management, supervisory and staff salaries and benefits, legal and auditing fees, travel, rent and costs associated with being a public company, such as board of director fees, listing fees and annual reporting expenses. Research and development expenses consist mainly of salaries and benefits for our engineers and third party costs for consulting and prototyping. We measure all operating expenses against our annually approved budget, which is developed with achieving a certain operating margin as a key focus. Also included in operating expenses are restructuring costs and non-cash expense for intangible asset amortization.
 
Non-GAAP Operating Measure.  We provide certain non-GAAP financial information as supplemental information to financial measures calculated and presented in accordance with GAAP (Generally Accepted Accounting Principles in the United States). This non-GAAP information excludes the impact of amortizing intangible assets and may exclude other non-recurring items.  Management believes that this presentation facilitates the comparison of our current operating results to historical operating results. Management uses this non-GAAP information to evaluate short-term and long-term operating trends in our core operations. Non-GAAP information is not prepared in accordance with GAAP and should not be considered a substitute for or an alternative to GAAP financial measures and may not be computed the same as similarly titled measures used by other companies.
 
20

 

Table of Contents

 

 
The table below reconciles Non-GAAP Income (Loss) from Operations, which is a non-GAAP financial measure, to comparable GAAP financial measures:
                         
   
Year Ended December 31,
 
   
2014
   
2013
   
2012
 
                   
Loss from operations
 
$
(9,947
)
 
$
(11,970
)
 
$
(3,561
)
Adjustments to reconcile to non-GAAP net loss
                       
Amortization of intangible assets
   
1,558
     
1,554
     
1,622
 
Impairment
   
1,017
     
     
 
Restructuring
   
770
     
     
430
 
Investigation matter
   
152
     
3,723
     
 
Goodwill impairment
   
     
     
3,175
 
Non-GAAP net income (loss)
 
$
(6,450
)
 
$
(6,693
)
 
$
1,666
 
 
Seasonality. Our quarterly revenues and operating results have varied significantly in the past due to the seasonality of our business. Our first quarter generally is the weakest due to weather conditions that make roadway construction more difficult in parts of North America, Europe and northern Asia. We expect such seasonality to continue for the foreseeable future. Additionally, our international revenues regularly contain individually significant sales. This can result in significant variations of revenue between periods. Accordingly, we believe that quarter-to-quarter comparisons of our financial results should not be relied upon as an indication of our future performance. No assurance can be given that we will be able to achieve or maintain profitability on a quarterly or annual basis in the future.
 
Segments. We currently operate in three reportable segments: Intersection, Highway and LPR. Autoscope® video is our machine-vision product line, and revenue consists of royalties (all of which are received from Econolite), as well as a portion of international product sales. Video products are normally sold in the Intersection segment. The Autoscope® radar is our radar product line, and revenue consists of sales to external customers. Radar products are normally sold in the Highway segment. Autoscope® license plate recognition is our LPR product line.  All segment revenues are derived from external customers. As a result of business model changes and modifications in how we manage our business, we may reevaluate our segment definitions in the future.
 
The following tables set forth selected unaudited financial information for each of our reportable segments (in thousands):
                                 
   
For the year ended December 31, 2014
 
   
Intersection
   
Highway
   
LPR
   
Total
 
Revenue
 
$
11,357
   
$
6,786
   
$
4,910
   
$
23,053
 
Gross profit
   
10,305
     
3,255
     
1,452
     
15,012
 
Amortization of intangible assets
   
     
488
     
1,070
     
1,558
 
Intangible assets
   
     
454
     
3,533
     
3,987
 
                                 
   
For the year ended December 31, 2013
 
   
Intersection
   
Highway
   
LPR
   
Total
 
                                 
Revenue
 
$
13,428
   
$
6,414
   
$
6,448
   
$
26,290
 
Gross profit
   
11,559
     
1,862
     
2,980
     
16,401
 
Amortization of intangible assets
   
     
488
     
1,066
     
1,554
 
Intangible assets
   
     
942
     
5,521
     
6,463
 
                                 
   
For the year ended December 31, 2012
 
   
Intersection
   
Highway
   
LPR
   
Total
 
                                 
Revenue
 
$
16,031
   
$
4,118
   
$
4,814
   
$
24,963
 
Gross profit
   
14,010
     
1,798
     
2,449
     
18,257
 
Goodwill impairment
   
     
1,372
     
1,803
     
3,175
 
Amortization of intangible assets
   
     
748
     
874
     
1,622
 
Intangible assets and goodwill
   
     
1,430
     
5,059
     
6,489
 
 
21

 

Table of Contents

 

 
Results of Operations
 
The following table sets forth, for the periods indicated, certain consolidated statements of operations data as a percent of total revenue and gross profit on product sales and royalties as a percentage of international sales and royalties, respectively.
                         
   
Year Ended December 31,
 
   
2014
   
2013
   
2012
 
Product sales
   
55.6
%
   
55.9
%
   
50.3
%
Royalties
   
44.4
     
44.1
     
49.7
 
Total revenue
   
100.0
     
100.0
     
100.0
 
Gross profit - product sales
   
37.2
     
32.7
     
46.6
 
Gross profit - royalties
   
100.0
     
100.0
     
100.0
 
Selling, marketing and product support
   
41.4
     
44.8
     
29.2
 
General and administrative
   
26.8
     
23.9
     
20.7
 
Research and development
   
24.9
     
19.2
     
16.6
 
Amortization of intangible assets
   
6.8
     
5.9
     
6.5
 
Impairment
   
4.4
     
     
 
Restructuring
   
3.3
     
     
1.7
 
Investigation matter
   
0.7
     
14.2
     
 
Goodwill impairment
   
     
     
12.7
 
Loss from operations
   
(43.1
)
   
(45.5
)
   
(14.3
)
Income tax expense (benefit)
   
(0.8
)
   
15.0
     
(0.7
)
 
Year Ended December 31, 2014 Compared to Year Ended December 31, 2013. Total revenue decreased to $23.1 million in 2014 from $26.3 million in 2013, a decrease of 12.3%. In the first quarter of 2014, we implemented restructuring plans to improve our financial performance in Europe, which included the closure of our office in Poland. Excluding Poland revenue of $2.3 million in 2013, revenue for 2014 decreased $1.0 million, a decrease of 4.0%. Royalty income decreased to $10.2 million in 2014 from $11.6 million in 2013, a decrease of 11.6%. The decrease in royalties was the result of a decrease in Autoscope® video system sales under the Econolite agreement and the transition of Autoscope® radar product sales from Econolite to the Company. Autoscope® video royalties were lower in the fiscal year ended December 31, 2014 compared to the fiscal year ended December 31, 2013 as a result of lower unit volume. Product sales decreased to $12.8 million in 2014 from $14.7 million in 2013, a decrease of 12.8%.  The decrease in product sales was mainly due to lower sales volume in Europe, which was partially offset by an increase in Autoscope® radar sales in North America due to the previously discussed radar transition. The decrease in European sales volume was primarily the result of the Polish office closure.
 
Revenue for the Intersection segment decreased to $11.4 million in 2014 from $13.4 million in 2013, a decrease of 15.4%. The decrease in the Intersection segment was mainly due to lower sales volume in Europe and North America.
 
Revenue for the Highway segment increased to $6.8 million in 2014 from $6.4 million in 2013, an increase of 5.8%. The increase in Highway was due to the transition of the North American Highway sales from Econolite to Image Sensing Systems. This transition resulted in the direct sale of products to customers instead of a royalty from Econolite beginning at the transition date of July 14, 2014.
 
Revenue for the LPR segment decreased to $4.9 million in 2014 from $6.4 million in 2013, a decrease of 23.9%.  The decrease in revenue for the LPR segment in 2014 compared to 2013 is due to lower sales volumes in North America and Europe.
 
Gross profit for product sales increased to 37.2% in 2014 from 32.7% in 2013. Gross profit for the LPR product line has historically been lower than gross profit for the Intersection and Highway product lines and therefore the mix of the product lines sold in any given period can result in varying gross profit. Generally, higher sales volumes of Highway or LPR products will reduce gross profit because of fixed manufacturing costs for these products. Additionally, the geographic sales mix of our product sales can influence margins, as product sold in some jurisdictions have lower margins. We anticipate that gross profit for our product sales will be higher in 2015 as compared to 2014, while we expect royalty gross profit will be 100% in 2015.
 
Selling, marketing and product support expense decreased to $9.5 million or 41.4% of total revenue in 2014 from $11.8 million or 44.8% of total revenue in 2013. Our selling, marketing and product support expense decreased mainly due to certain cost reductions, which were partially offset by nonrecurring expenses associated with transitioning the North American radar business from Econolite. Included in these charges are royalties due to Econolite for orders that were received by Econolite but fulfilled by Image Sensing Systems. These royalties to Econolite will end once all such open orders are fulfilled. We anticipate that annual selling, marketing and product support expense will decrease in dollar amount in 2015 as compared to 2014.
 
22

 

Table of Contents

 

 
General and administrative expense decreased slightly to $6.2 million from $6.3 million in 2013, but increased to 26.8% of total revenue in 2014, from 23.9% of total revenue in 2013. General and administrative expenses decreased in 2014 mainly as a result of a decrease in the other professional fees related to the use of outside consultants which were partially offset by severance costs related to the separation from former employees and other normal operating costs. Our direct costs related to the investigation involving our subsidiary in Poland and associated remediation actions were approximately $152,000 for the year ended December 31, 2014 compared to $3.7 million for the year ended December 31, 2013. Please see Note 15 of our Notes to Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for a discussion of the investigation. We anticipate that annual general and administrative expenses will decrease in 2015 as compared to 2014.
 
Research and development expense increased to $5.7 million or 24.9% of total revenue in 2014, from $5.0 million or 19.2% of total revenue in 2013. The increase was mainly related to the increased expenditures on new research and development projects, the acceleration of previously existing projects and other product developments. We anticipate that research and development expense will decrease in dollar amount in 2015 compared to 2014.
 
In performing the ongoing assessment of the recoverability of our software development costs, which is impacted by estimates and assumptions of future revenues and expenses for these software products, as well as other factors such as changes in product technologies, we determined that the capitalized costs were in excess of net realizable value. As a result, during the quarter ended December 31, 2014, we recorded an impairment charge of $867,000 for the full amount of the software development costs.
 
In the first quarter of 2014, the Company implemented restructuring plans to improve our financial performance in Europe.  These plans included the closure of our office in Poland. Because of these actions, restructuring charges of approximately $460,000 were recorded related primarily to the closure of facilities and employee terminations. In the fourth quarter of 2014 the Company implemented restructuring plans to close down our operations in Asia. Because of these actions, restructuring charges of approximately $310,000 were recorded related primarily to the closure of facilities and employee terminations.
 
Amortization of intangibles was $1.6 million in both 2014 and 2013 and reflects the amortization of intangible assets acquired in acquisitions. Assuming there are no changes to our intangible assets, we anticipate amortization expense will be approximately $1.5 million in 2015.
 
Income tax expense of $174,000, or 1.7% of our pretax loss, was recorded for the year ended December 31, 2014, compared to income tax expense of $3.9 million, or 33.3% of pretax loss, for the year ended December 31, 2013. The income tax expense in 2013 was primarily driven by the recognition of a valuation allowance of $8.1 million for the United States and United Kingdom jurisdictions.
 
Year Ended December 31, 2013 Compared to Year Ended December 31, 2012. Total revenue increased to $26.3 million in 2013 from $25.0 million in 2012, an increase of 5.3%. Royalty income decreased to $11.6 million in 2013 from $12.4 million in 2012, a decrease of 6.5%. The decrease in royalties was the result of a decrease in Autoscope® video royalties slightly offset by an increase in Autoscope® radar royalties.  Autoscope® video royalties were lower in 2013 compared to 2012 as a result of lower unit volume.  Product sales increased to $14.7 million in 2013 from $12.6 million in 2012, an increase of 16.9%.  The increase in product sales was mainly due to higher sales volume in Europe and Asia.
 
Revenue for the Intersection segment decreased to $13.4 million in 2013 from $16.0 million in 2012, a decrease of 16.2%. The increase in revenue for the Intersection segment was mainly due to lower sales volume in Europe.
 
Revenue for the Highway segment increased to $6.4 million in 2013 from $4.1 million in 2012, an increase of 55.8%. The increase in revenue for the Highway segment was due mainly to higher sales worldwide.
 
Revenue for the LPR segment increased to $6.4 million in 2013 from $4.8 million in 2012, an increase of 33.9%.  The increase in revenue for the LPR segment in 2013 over 2012 was due to higher sales volumes in North America and Europe.
 
Gross profit for product sales decreased to 32.7% in 2013 from 46.6% in 2012. Gross profit for the LPR product line has historically been lower than gross profit for the Intersection and Highway product lines and therefore the mix of the product lines sold in any given period can result in varying profit. Generally, lower sales volumes of Highway or LPR products will reduce gross profit because of fixed manufacturing costs for these products.
 
Selling, marketing and product support expense increased to $11.8 million or 44.8% of total revenue in 2013 from $7.3 million or 29.2% of total revenue in 2012. Our selling, marketing and product support expense increased mainly due to our investments in additional sales and marketing resources.
 
General and administrative expense increased to $6.3 million or 23.9% of total revenue in 2013 from $5.2 million or 20.7% of total revenue in 2012. General and administrative expenses increased in 2013 mainly as a result of legal and other professional fees related to the investigation and remediation actions described in Note 15 of our Notes to Consolidated Financial Statements set forth elsewhere in this Annual Report on Form 10-K and severance costs related to the separation from former employees.  Our direct costs related to the investigation were approximately $3.7 million for the year ended December 31, 2013 and immaterial in 2012.
 
23

 

Table of Contents

 

 
Research and development expense increased to $5.0 million or 19.2% of total revenue in 2013, from $4.1 million or 16.6% of total revenue in 2012. The increase was mainly related to the increased expenditures on new research and development projects, the acceleration of previously existing projects and other product developments.
 
Amortization of intangibles was $1.6 million in both 2013 and 2012 and reflects the amortization of intangible assets acquired in acquisitions.
 
Income tax expense of $3.9 million, or 33.3% of our pretax loss, was recorded for the year ended December 31, 2013, compared to income tax benefit of $180,000, or 5.4% of pretax loss, for the year ended December 31, 2012. The income tax expense increase was primarily driven by the recognition of a valuation allowance of $8.1 million for the United States and United Kingdom jurisdictions in 2013.
 
Liquidity and Capital Resources
 
At December 31, 2014, we had $2.7 million in cash and cash equivalents, compared to $3.6 million in cash and cash equivalents and $2.6 million in short-term investments at December 31, 2013. Our investment objectives are to preserve principal, maintain liquidity, and achieve the best available return consistent with the primary objectives of safety and liquidity.
 
Net cash used for operating activities was $2.6 million in 2014, compared to cash used of $5.5 million in 2013 and cash provided of $5.9 million in 2012. The primary reason for the decrease in cash in 2014 was operating losses and restructuring costs, partially offset by a reduction in working capital. The primary reasons for the decrease in cash in 2013 was the on-going expenses related to the investigation and investments made in the Company’s product offerings. We anticipate that average receivable collection days in 2015 will be similar to 2014 and that it will not have a material impact on our liquidity.
 
Net cash provided by investing activities was $2.3 million in 2014, compared to cash provided by investing activities of $791,000 in 2013 and cash used in investing activities of $1.4 million in 2012. Our planned additions of property and equipment are discretionary, and we do not expect them to exceed historical levels in 2015.
 
There was no net cash provided by financing activities in 2014, compared to cash provided of $9,000 and $121,000 in 2013 and 2012, respectively.
 
In May 2014, the Company entered into a credit agreement and related documents with Alliance Bank providing for a revolving line of credit for the Company.  The credit agreement and related documents with Alliance Bank (collectively, the “Alliance Credit Agreement”) provide up to a $5.0 million revolving line of credit. Amounts due under the Alliance Credit Agreement bear interest at a fixed annual rate of 3.95%. Any advances are secured by the Company’s inventories, accounts receivable, cash, marketable securities, and equipment. We are subject to certain covenants under the Alliance Credit Agreement. At December 31, 2014, we had no borrowings under the Alliance Credit Agreement, and we were in compliance with all financial covenants. In March 2015, we entered into an agreement with Alliance Bank amending the Alliance Credit Agreement to extend the maturity date from May 2015 to April 1, 2016.
 
Prior to May 12, 2014, we had a revolving line of credit with Associated Bank, National Association (“Associated Bank”) that was initially entered into as of May 1, 2008. We requested, and Associated Bank granted, a termination to the Credit Agreement effective on May 12, 2014 in connection with the revolving line of credit from Alliance Bank described above.
 
We believe that cash and cash equivalents on hand at December 31, 2014, along with the availability of funds under our revolving line of credit and cash provided by operating activities, will satisfy our projected working capital needs, investing activities, and other cash requirements for the foreseeable future.
 
Off-Balance Sheet Arrangements
 
We do not participate in transactions or have relationships or other arrangements with an unconsolidated entity, including special purpose and similar entities or other off-balance sheet arrangements.
 
24

 

Table of Contents

 

 
Critical Accounting Policies
 
Our Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”), which require us to make estimates and assumptions in certain circumstances that affect amounts reported. In preparing these financial statements, management has made its best estimates and judgments of certain amounts, giving due consideration to materiality. We believe that of our significant accounting policies, the following are particularly important to the portrayal of our results of operations and financial position, may require the application of a higher level of judgment by our management, and as a result, are subject to an inherent degree of uncertainty. For further information see Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
 
Revenue Recognition and Allowance for Doubtful Accounts. We are required to comply with a variety of technical accounting requirements in order to achieve consistent and accurate revenue recognition. Royalty income is recognized based on sales shipped or delivered to our customers as reported to us by Econolite. Revenue is recognized when both product ownership and the risk of loss have transferred to the customer and we have no remaining obligations. Allowances for doubtful accounts are estimated by management based on an evaluation of potential losses related to customer receivable balances. We determine the allowance based on historical write-off experience in the industry, regional economic data, and an evaluation of specific customer accounts for risk of loss. We review our allowance for doubtful accounts monthly. Account balances are charged off against the allowance when we believe it is probable the receivable will not be recovered. We do not have any off-balance sheet credit exposure related to our customers. The establishment of this reserve requires the use of judgment and assumptions regarding the potential for losses on receivable balances. Although management considers these balances adequate and proper, changes in economic conditions in specific markets in which we operate could have an effect on reserve balances required.
 
Inventories. We maintain a material amount of inventory to support our engineering and manufacturing operations. This inventory is stated at the lower of cost or market. On a regular basis, we review our inventory and identify that which is excess, slow moving, and obsolete by considering factors such as inventory levels, expected product life, and forecasted sales demand. Any identified excess, slow moving, and obsolete inventory is written down to its market value through a charge to income from operations. It is possible that additional inventory write-down charges may be required in the future if there is a significant decline in demand for our products.
 
Impairment of Long-Lived Assets.  We review the carrying value of long-lived assets or asset groups, such as property and equipment and intangibles subject to amortization, when events or changes in circumstances such as asset utilization, physical change, legal factors, or other matters indicate that the carrying value may not be recoverable. When this review indicates the carrying value of an asset or asset group exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset or asset group, we recognize an asset impairment charge against operations. The amount of the impairment loss recorded is the amount by which the carrying value of the impaired asset or asset group exceeds its fair value.
 
Our impairment loss calculations contain uncertainties because they require management to make assumptions and to apply judgment to identify events or changes in circumstances indicating the carrying value of assets may not be recoverable, estimate future cash flows, estimate asset fair values, and select a discount rate that reflects the risk inherent in future cash flows.  Expected cash flows may not be realized, which could cause long-lived assets to become impaired in future periods and could have a material adverse effect on future results of operations.
 
Warranty Liabilities.  The estimated cost to service warranty and customer service claims is included in cost of sales. This estimate is based on historical trends of warranty claims.  We regularly assess and adjust the estimate of accrued warranty claims by updating claims rates for actual trends and projected claim costs.  Our warranty liability contains uncertainties because our warranty obligations cover an extended period of time. While these liability levels are based on historical warranty experience, they may not reflect the actual claims that will occur over the upcoming warranty period, and additional warranty reserves may be required. A revision of estimated claim rates or the projected cost of materials and freight associated with sending replacement parts to customers could have a material adverse effect on future results of operations.
 
Income Taxes. We record a tax provision for the anticipated tax consequences of the reported results of operations. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those deferred tax assets and liabilities are expected to be realized or settled. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. We believe it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining net realizable value of our deferred tax assets. In the event that all or part of the net deferred tax assets are determined not to be realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on our financial condition and operating results.
 
25

 

Table of Contents

 

 
New and Recently Adopted Accounting Pronouncements
 
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers.” ASU 2014-09 provides new guidance related to how an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In addition, ASU 2014-09 specifies new accounting for costs associated with obtaining or fulfilling contracts with customers and expands the required disclosures related to revenue and cash flows from contracts with customers. This new guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2016, and can be adopted either retrospectively to each prior reporting period presented or as a cumulative-effect adjustment as of the date of adoption, with early application not permitted. We are currently determining our implementation approach and assessing the impact of ASU 2014-09 on the consolidated financial statements.
 
Quantitative and Qualitative Disclosures About Market Risk
                 
Foreign Currency Exchange Risk
 
Approximately 40% of our revenue has historically been derived from shipments to customers outside of the United States, and a large portion of this revenue is denominated in currencies other than the U.S. dollar. Our international subsidiaries have functional currencies other than our U.S. dollar reporting currency and, occasionally, transact business in currencies other than their functional currencies. These non-functional currency transactions expose us to market risk on assets, liabilities and cash flows recognized on these transactions.
 
The strengthening of the U.S. dollar relative to foreign currencies decreases the value of foreign currency-denominated revenue and earnings when translated into U.S. dollars. Conversely, a weakening of the U.S. dollar increases the value of foreign currency-denominated revenue and earnings. A 10% adverse change in foreign currency rates, if we have not properly hedged, could have a material effect on our results of operations or financial position.
 
26

 

Table of Contents

 

 
 
 
IMAGE SENSING SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
                 
   
December 31,
 
   
2014
   
2013
 
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ 2,656     $ 3,564  
Marketable securities
          2,639  
Accounts receivable, net of allowance for doubtful accounts of $516 and $1,173, respectively
    4,219       5,252  
Inventories
    2,234       3,589  
Prepaid expenses and other current assets
    871       1,414  
Total current assets
    9,980       16,458  
                 
Property and equipment:
               
Furniture and fixtures
    620       620  
Leasehold improvements
    556       511  
Equipment
    3,964       3,988  
      5,140       5,119  
Accumulated depreciation
    4,279       4,094  
      861       1,025  
                 
Intangible assets, net
    3,987       6,463  
Deferred income taxes
    62       139  
Other assets
          300  
TOTAL ASSETS
  $ 14,890     $ 24,385  
                 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
  $ 3,315     $ 2,409  
Warranty and other current liabilities
    2,096       1,959  
Accrued compensation
    687       1,202  
Accrued restructuring
    216        
Total current liabilities
    6,314       5,570  
                 
Deferred income taxes
    165       175  
Other long-term liabilities
    91       126  
                 
Shareholders’ equity
               
Preferred stock, $.01 par value; 5,000,000 shares authorized, none issued or outstanding
           
Common stock, $.01 par value; 20,000,000 shares authorized, 4,995,963 and 4,974,847 issued and outstanding, respectively
    49       49  
Additional paid-in capital
    23,547       23,276  
Accumulated other comprehensive income (loss)
    (158 )     604  
Accumulated deficit
    (15,118 )     (5,415 )
Total shareholders’ equity
    8,320       18,514  
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
  $ 14,890     $ 24,385  
 
See accompanying notes to the consolidated financial statements.
 
27

 

Table of Contents

 

 
IMAGE SENSING SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share data)
                         
   
Years ended December 31,
 
   
2014
   
2013
   
2012
 
Revenue:
                 
Product sales
  $ 12,806     $ 14,692     $ 12,564  
Royalties
    10,247       11,598       12,399  
      23,053       26,290       24,963  
Cost of revenue:
                       
Product sales
    8,041       9,889       6,706  
      8,041       9,889       6,706  
Gross profit
    15,012       16,401       18,257  
                         
Operating expenses:
                       
Selling, marketing and product support
    9,543       11,768       7,289  
General and administrative
    6,185       6,290       5,167  
Research and development
    5,734       5,036       4,135  
Amortization of intangible assets
    1,558       1,554       1,622  
Impairment
    1,017              
Restructuring
    770             430  
Investigation matter
    152       3,723        
Goodwill impairment
                3,175  
      24,959       28,371       21,818  
Loss from operations
    (9,947 )     (11,970 )     (3,561 )
                         
Other income, net
    70       6       29  
Loss before income taxes
    (9,877 )     (11,964 )     (3,532 )
Income tax expense (benefit)
    (174 )     3,937       (180 )
Net loss
  $ (9,703 )   $ (15,901 )   $ (3,352 )
Net loss per share:
                       
Basic
  $ (1.95 )   $ (3.21 )   $ (0.69 )
Diluted
  $ (1.95 )   $ (3.21 )   $ (0.69 )
                         
Weighted average number of common shares outstanding:
                       
Basic
    4,983       4,955       4,886  
Diluted
    4,983       4,955       4,886  
 
See accompanying notes to the consolidated financial statements.
 
28

 

Table of Contents

 

 
IMAGE SENSING SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(in thousands)
                         
    Years ended December 31,  
    2014     2013     2012  
Loss before income taxes
  $ (9,703 )   $ (15,901 )   $ (3,352 )
Other comprehensive income (loss):
                       
Foreign currency translation adjustment
    (762 )     214       570  
Comprehensive loss
  $ (10,465 )   $ (15,687 )   $ (2,782 )
                         
See accompanying notes to the consolidated financial statements.
 
29

 

Table of Contents

 

 
IMAGE SENSING SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOW
(in thousands)
                         
   
Years ended December 31,
 
   
2014
   
2013
   
2012
 
Operating activities:
                 
Net loss
  $ (9,703 )   $ (15,901 )   $ (3,352 )
Adjustments to reconcile net loss to net cash provided by (used for) operating activities:
                       
Depreciation
    533       673       727  
Amortization
    1,558       1,554       1,622  
Stock-based compensation
    271       213       244  
Impairment
    1,017              
Goodwill impairment
                3,175  
Loss on disposal of assets
    41              
Tax benefit from disqualifying dispositions
                71  
Deferred income tax expense (benefit)
    (21 )     4,085       (402 )
Changes in operating assets and liabilities:
                       
Accounts receivable, net
    1,033       1,470       2,777  
Inventories
    1,355       896       1,657  
Prepaid expenses and current assets
    533       197       33  
Accounts payable
    906       297       114  
Accrued expenses and other liabilities
    (102 )     999       (727 )
Net cash provided by (used for) operating activities
    (2,579 )     (5,517 )     5,939  
                         
Investing activities:
                       
Sales and maturities of marketable securities
    2,639       7,685       7,303  
Purchases of marketable securities
          (5,507 )     (10,027 )
Purchases of property and equipment
    (495 )     (221 )     (487 )
Proceeds (purchases) of other investments
    150       (300 )      
Capitalized software development costs
          (867 )      
Net cash provided by (used for) investing activities
    2,294       790       (3,211 )
                         
Financing activities:
                       
Proceeds from exercise of stock options
          9       121  
Net cash provided by financing activities
          9       121  
                         
Effect of exchange rate on changes on cash
    (623 )     (52 )     261  
Increase (decrease) in cash and cash equivalents
    (908 )     (4,770 )     3,110  
                         
Cash and cash equivalents at beginning of period
    3,564       8,334       5,224  
Cash and cash equivalents at end of period
  $ 2,656     $ 3,564     $ 8,334  
 
See accompanying notes to the consolidated financial statements.
 
30

 

Table of Contents

 

 
IMAGE SENSING SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(in thousands, except share data)
                                                 
                     
Accumulated
             
                     
Other
             
               
Additional
   
Comprehensive
             
   
Shares
   
Common
   
Paid-In
   
Income
   
Retained
       
   
Issued
   
Stock
   
Captal
   
(Loss)
   
Earnings
   
Total
 
                                     
Balance at December 31, 2011
    4,910,619     $ 49     $ 22,619     $ (180 )   $ 13,838     $ 36,326  
                                                 
Tax benefit from disqualifying disposition
                71                   71  
Common stock issued for options exercised
    56,000             121                   121  
Stock-based compensation
                244                   244  
Comprehensive loss:
                                               
Foreign currency translation adjustment
                      570             570  
Net loss
                            (3,352 )     (3,352 )
Total comprehensive loss
                                    (2,782 )
Balance at December 31, 2012
    4,966,619     $ 49     $ 23,055     $ 390     $ 10,486     $ 33,980  
                                                 
Stock awards issued
    13,395             75                   75  
Common stock issued for options exercised
    2,333             8                   8  
Acquisition-related shares surrendered
    (7,500 )                              
Stock-based compensation
                138                   138  
Comprehensive loss:
                                               
Foreign currency translation adjustment
                      214             214  
Net loss
                            (15,901 )     (15,901 )
Total comprehensive loss
                                  (15,687 )
Balance at December 31, 2013
    4,974,847     $ 49     $ 23,276     $ 604     $ (5,415 )   $ 18,514  
                                                 
Stock awards issued
    21,116             91                     91  
Stock-based compensation
                180                   180  
Comprehensive loss:
                                               
Foreign currency translation adjustment
                      (762 )           (762 )
Net loss
                            (9,703 )     (9,703 )
Total comprehensive loss
                                  (10,465 )
Balance at December 31, 2014
    4,995,963     $ 49     $ 23,547     $ (158 )   $ (15,118 )   $ 8,320  
                                                 
See accompanying notes to the consolidated financial statements.
 
31

 

Table of Contents

 

 
Notes to Consolidated Financial Statements
 
December 31, 2014
 
1. DESCRIPTION OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES
 
DESCRIPTION OF BUSINESS
 
Image Sensing Systems, Inc. (referred to herein as “we,” the “Company,” “us” and “our”) develops and markets software-based computer enabled detection products for use in traffic, safety, security, police and parking applications. We sell our products primarily to distributors and also receive royalties under a license agreement with a manufacturer/distributor for certain of our products. Our products are used primarily by governmental entities.
 
PRINCIPLES OF CONSOLIDATION
 
The Consolidated Financial Statements include the accounts of Image Sensing Systems, Inc. and its wholly-owned subsidiaries: Image Sensing Systems HK Limited (ISS HK) located in Hong Kong; Image Sensing Systems (Shenzhen) Limited (ISS WOFE) located in China; Image Sensing Systems Holdings Limited (ISS Holdings), Image Sensing Systems Europe Limited (ISS Europe), Image Sensing Systems UK Limited (ISS UK) and Image Sensing Systems England (ISS England) located in the United Kingdom; Image Sensing Systems Europe Limited SP.Z.O.O., (ISS Poland) located in Poland; Image Sensing Systems Spain SLU (ISS Spain) located in Spain; Image Sensing Systems Germany, GmbH (ISS Germany) located in Germany; and ISS Image Sensing Systems Canada Limited (ISS Canada) located in Canada. All significant inter-company transactions and balances have been eliminated in consolidation.
 
REVENUE RECOGNITION
 
We recognize revenue on a sales arrangement when it is realized or realizable and earned, which occurs when all of the following criteria have been met: persuasive evidence of an arrangement exists; delivery and title transfer have occurred or services have been rendered; the sales price is fixed and determinable; collectability is reasonably assured; and all significant obligations to the customer have been fulfilled.
 
Certain sales may contain multiple elements for revenue recognition purposes. We consider each deliverable that provides value to the customer on a standalone basis as a separable element. Separable elements in these arrangements may include the hardware, software, installation services, training and support. We initially allocate consideration to each separable element using the relative selling price method. Selling prices are determined by us based on either vendor-specific objective evidence (“VSOE”) (the actual selling prices of similar products and services sold on a standalone basis) or, in the absence of VSOE, our best estimate of the selling price. Factors considered by us in determining estimated selling prices for applicable elements generally include overall economic conditions, customer demand, costs incurred by us to provide the deliverable, as well as our historical pricing practices. Under these arrangements, revenue associated with each delivered element is recognized in an amount equal to the lesser of the consideration initially allocated to the delivered element or the amount for which payment is not deemed contingent upon future delivery of other elements in the arrangement. Under arrangements where special acceptance protocols exist, installation services and training may not be considered separable. Under those circumstances, revenue for the entire arrangement is recognized upon the completion of installation, training and fulfillment of any other significant obligations specific to the terms of the arrangement. Arrangements that do not contain any separable elements are typically recognized when the products are shipped and title has transferred to the customer.
 
Revenue from arrangements for services such as maintenance, repair, consulting and technical support are recognized either as the service is performed or ratably over the defined contractual period for service maintenance contracts.
 
Econolite Control Products, Inc. (Econolite) is our licensee that sells certain of our products in the United States, Mexico, Canada and the Caribbean. The royalty of approximately 50% of the gross profit on licensed products is recognized when the products are shipped or delivered by Econolite to its customers.
 
We record provisions against sales revenue for estimated returns and allowances in the period when the related revenue is recorded based on historical sales returns and changes in end user demand.
 
Revenue is recorded net of taxes collected from customers that are remitted to governmental authorities, with the collected taxes recorded as current liabilities until remitted to the relevant government authority.
 
32

 

Table of Contents

 

 
SHIPPING AND HANDLING
 
Freight revenue billed to customers is reported within revenue on the Consolidated Statements of Operations, and expenses incurred for shipping products to customers are reported within cost of revenue on the Consolidated Statements of Operations.
 
CASH AND CASH EQUIVALENTS
 
We consider all highly liquid investments with an original maturity of three months or less when purchased to be cash equivalents. Cash equivalents, both inside and outside the United States, are invested in money market funds and bank deposits in local currency denominations. Cash located in foreign banks was $2.0 million and $1.8 million at December 31, 2014 and 2013, respectively. We hold our cash and cash equivalents with financial institutions and, at times, the amounts of our balances may be in excess of insurance limits.
 
MARKETABLE SECURITIES
 
We classify marketable debt securities as available-for-sale investments and these securities are stated at their estimated fair value.  The value of these securities is subject to market and credit volatility during the period these investments are held.
 
ACCOUNTS RECEIVABLE
 
We grant credit to customers in the normal course of business and generally do not require collateral from domestic customers. When deemed appropriate, receivables from customers outside the United States are supported by letters of credit from financial institutions. Management performs on-going credit evaluations of customers. The allowance for doubtful accounts is based on management’s assessment of the collectability of specific customer accounts and includes consideration of the credit worthiness and financial condition of those specific customers. We record an allowance to reduce receivables to the amount that is reasonably believed to be collectible and consider factors such as the financial condition of the customer and the aging of the receivables. If there is a deterioration of a customer’s financial condition, if we become aware of additional information related to the credit worthiness of a customer, or if future actual default rates on trade receivables in general differ from those currently anticipated, we may have to adjust our allowance for doubtful accounts, which would affect earnings in the period the adjustments were made.
 
INVENTORIES
 
Inventories are primarily electronic components and finished goods and are valued at the lower of cost or market determined under the first-in, first-out accounting method.
 
PROPERTY AND EQUIPMENT
 
Property and equipment is stated at cost. Additions, replacements, and improvements are capitalized at cost, while maintenance and repairs are charged to operations as incurred. Depreciation is recorded using the straight-line method over the estimated useful lives of the assets and by accelerated methods for income tax purposes. Leasehold improvements are depreciated over the shorter of the estimated useful lives of the assets or the contractual term of the lease, with consideration of lease renewal options if renewal appears probable. Depreciation is recorded over a three- to seven-year period for financial reporting purposes.
 
INCOME TAXES
 
We record a tax provision for the anticipated tax consequences of the reported results of operations. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those deferred tax assets and liabilities are expected to be realized or settled. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. We believe it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining net realizable value of deferred tax assets. In the event that all or part of the net deferred tax assets are determined not to be realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on our financial condition and operating results. We recognize penalties and interest expense related to unrecognized tax benefits in income tax expense.
 
33

 

Table of Contents

 

 
GOODWILL AND INTANGIBLE ASSETS
 
Goodwill represents the excess of acquisition costs over the fair value of the net assets of businesses acquired. Goodwill is not amortized, but instead tested at least annually for impairment. Goodwill is also tested for impairment as changes in circumstances occur indicating that the carrying value may not be recoverable.
 
Goodwill impairment testing first requires a comparison of the fair value of each reporting unit to the carrying value. If the carrying value of the reporting unit exceeds fair value, goodwill is considered impaired. Impairment testing for indefinite-lived intangible assets requires a comparison between the fair value and the carrying value of the asset. If the carrying value of the asset exceeds its fair value, the asset is reduced to fair value. See Note 4 to the Consolidated Financial Statements for additional information on goodwill.
 
Intangible assets with finite lives are amortized on a straight-line basis over the expected period to be benefited by future cash flows and reviewed for impairment. At both December 31, 2014 and 2013, there were no indefinite-lived intangible assets.
 
We capitalize certain software development costs related to software to be sold, leased, or otherwise marketed. Capitalized software development costs include purchased materials and services and other costs associated with the development of new products and services. Software development costs are expensed as incurred until technological feasibility has been established, at which time future costs incurred are capitalized until the product is available for general release to the public. Based on our product development process, technological feasibility is generally established once product and detailed program designs have been completed, uncertainties related to high-risk development issues have been resolved through coding and testing, and we have established that the necessary skills, hardware, and software technology are available for production of the product.
 
Capitalized software development costs are subject to an ongoing assessment of recoverability, which is impacted by estimates and assumptions of future revenues and expenses for these software products, as well as other factors such as changes in product technologies. Any portion of unamortized capitalized software development costs that are determined to be in excess of net realizable value have been expensed in the period in which such a determination is made. In performing the ongoing assessment of the recoverability of our software development costs, we determined that the capitalized costs were in excess of net realizable value. As a result, we recorded an impairment of $867,000 during the fourth quarter ended December 31, 2014.
 
IMPAIRMENT OF LONG-LIVED ASSETS
 
We review the carrying value of long-lived assets or asset groups, such as property and equipment and intangibles subject to amortization, when events or changes in circumstances such as asset utilization, physical change, legal factors, or other matters indicate that the carrying value may not be recoverable. When this review indicates the carrying value of an asset or asset group exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset or asset group, we recognize an asset impairment charge against operations. The amount of the impairment loss recorded is the amount by which the carrying value of the impaired asset or asset group exceeds its fair value. No such impairment losses were recorded during the years ended December 31, 2014, 2013 or 2012.
 
RESEARCH AND DEVELOPMENT
 
Research and development costs associated with new products are charged to operations in the period incurred.
 
WARRANTIES
 
We generally provide a standard two-year warranty on product sales. We record estimated warranty costs at the time of sale and accrue for specific items at the time that their existence is known and the amounts are determinable. We estimate warranty costs using standard quantitative measures based on historical warranty claim experience and an evaluation of specific customer warranty issues. In addition, warranty provisions are also recognized for certain nonrecurring product claims that are individually significant.
 
FOREIGN CURRENCY
 
The financial position and results of operations of our foreign subsidiaries are measured using local currency as the functional currency. Assets and liabilities are translated using fiscal period-end exchange rates, and statements of operations are translated using average exchange rates applicable to each period, with the resulting translation adjustments recorded as a separate component of shareholders’ equity under “Accumulated other comprehensive loss”. Gains and losses from foreign currency transactions are recognized in the Consolidated Statements of Operations.
 
34

 

Table of Contents

 

 
NET LOSS PER SHARE
 
Basic loss per share excludes dilution and is computed by dividing net loss attributable to common shareholders by the weighted-average number of common shares outstanding during the period. Diluted loss per share includes potentially dilutive common shares consisting of stock options, restricted stock and warrants using the treasury stock method.   Under the treasury stock method, shares associated with certain stock options have been excluded from the diluted weighted average shares outstanding calculation because the exercise of those options would lead to a net reduction in common shares outstanding. As a result, stock options to acquire 354,000, 348,000 and 481,000 weighted common shares have been excluded from the diluted weighted shares outstanding calculation for the years ended December 31, 2014, 2013 and 2012, respectively, because the exercise prices were greater than the average market price of the common shares during the period and were excluded from the calculation of diluted net income per share.
 
USE OF ESTIMATES
 
The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities as of the date of the financial statements, and reported amounts of revenue and expense during the reporting period. Predicting future events is inherently an imprecise activity and, as such, requires the use of judgment. Ultimate results could differ from those estimates. Changes in these estimates will be reflected in the financial statements in future periods.
 
STOCK-BASED COMPENSATION
 
We measure the cost of employee services received in exchange for the award of equity instruments based on the fair value of the award at the date of grant and recognize the cost over the period during which an employee is required to provide services in exchange for the award. Stock options are granted at exercise prices equal to the closing market price of our stock on the day before the date of grant.
 
For purposes of determining estimated fair value of stock-based payment awards, we utilize a Black-Scholes option pricing model, which requires the input of certain assumptions requiring management judgment. Because our employee stock option awards have characteristics significantly different from those of traded options, and because changes in the input assumptions can materially affect fair value estimates, existing models may not provide a reliable single measure of the fair value of employee stock options.  Management will continue to assess the assumptions and methodologies used to calculate estimated fair value of stock-based compensation. Circumstances may change and additional data may become available over time that could result in changes to these assumptions and methodologies and thereby materially impact the fair value determination of future grants of stock-based payment awards. If factors change and we employ different assumptions in future periods, the compensation expense recorded may differ significantly from the stock-based compensation expense recorded in the current period.
 
RECENT ACCOUNTING PRONOUNCEMENTS
 
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers.” ASU 2014-09 provides new guidance related to how an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In addition, ASU 2014-09 specifies new accounting for costs associated with obtaining or fulfilling contracts with customers and expands the required disclosures related to revenue and cash flows from contracts with customers. This new guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2016, and can be adopted either retrospectively to each prior reporting period presented or as a cumulative-effect adjustment as of the date of adoption, with early application not permitted. We are currently determining our implementation approach and assessing the impact of ASU 2014-09 on the consolidated financial statements.