10-Q 1 auxilio10q09302011.htm 10-Q auxilio10q09302011.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
__________________
 
FORM 10-Q
__________________
 
(Mark One)
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2011
 
[  ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from _______ to _______
 
Commission file number 000-27507
__________________
 
AUXILIO, INC.
(Exact name of registrant as specified in its charter)
__________________
 
Nevada
(State or other jurisdiction of
incorporation or organization)
88-0350448
(I.R.S. Employer
Identification No.)
26300 La Alameda, Suite 100
Mission Viejo, California  92691
(Address of principal executive offices, zip code)
(949) 614-0700
(Registrant’s telephone number, including area code)
__________________

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ No o
 
Indicated by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes þ No o
 
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.
 
Large accelerated filer o   Accelerated filer  o   Non-accelerated filer o  Smaller reporting company þ
 
Indicate by check mark whether the registrant is a shell company (as defined by Section 12b-2 of the Exchange Act).  Yes oNo þ.
 
The number of shares of the issuer’s common stock, $0.001 par value, outstanding as of November 14, 2011 was 19,449,783.
 

 
 

 

FORM 10-Q
TABLE OF CONTENTS
 
 


 
ITEM 1.        FINANCIAL STATEMENTS.
 
AUXILIO, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
 
   
SEPTEMBER 30, 2011
   
DECEMBER 31, 2010
 
   
(unaudited)
       
ASSETS
 
Current assets:
           
Cash and cash equivalents
  $ 2,054,989     $ 2,249,907  
Accounts receivable, net
    2,899,928       1,160,251  
Supplies
    726,652       687,845  
Prepaid and other current assets
    75,760       331,483  
Total current assets
    5,757,329       4,429,486  
                 
Property and equipment, net
    185,020       234,975  
Deposits
    28,013       28,013  
Loan acquisition costs
    248,502       -  
Goodwill
    1,517,017       1,517,017  
Total assets
  $ 7,735,881     $ 6,209,491  
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
Current liabilities:
               
Accounts payable and accrued expenses
  $ 3,328,985     $ 2,538,828  
Accrued compensation and benefits
    645,630       772,532  
Deferred revenue
    371,467       255,802  
Current portion of capital lease obligations
    53,709       41,776  
Total current liabilities
    4,399,791       3,608,938  
                 
Long-term liabilities:
               
Convertible notes payable, net of discount of $399,500
    1,450,500       -  
Derivative warrant liability
    151,000       -  
Derivative additional investment rights liability
    243,000       -  
Capital lease obligations, noncurrent
    60,103       79,524  
Total long-term liabilities
    1,904,603       79,524  
                 
Commitments and contingencies
               
                 
Stockholders’ equity:
               
Common stock, par value at $0.001, 33,333,333 shares authorized, 19,403,318 and 19,336,651 shares issued and outstanding at September 30, 2011 and December 31, 2010, respectively
    19,405       19,338  
Additional paid-in capital
    20,809,119       20,417,584  
Accumulated deficit
    (19,397,037 )     (17,915,893 )
Total stockholders’ equity
    1,431,487       2,521,029  
Total liabilities and stockholders’ equity
  $ 7,735,881     $ 6,209,491  
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
 


 
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
 
   
Three Months
   
Nine Months
 
   
Ended September 30,
   
Ended September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Revenues
  $ 6,674,003     $ 3,970,654     $ 16,160,897     $ 11,257,127  
Cost of revenues
    5,403,700       3,135,217       13,762,040       8,588,800  
                                 
Gross profit
    1,270,303       835,437       2,398,857       2,668,327  
                                 
Operating expenses:
                               
Sales and marketing
    559,227       378,654       1,384,633       1,015,921  
General and administrative expenses
    722,468       633,744       2,451,121       2,173,041  
                                 
Total operating expenses
    1,281,695       1,012,398       3,835,754       3,188,962  
                                 
Loss from operations
    (11,392 )     (176,961 )     (1,436,897 )     (520,635 )
                                 
Other income (expense):
                               
Interest expense
    (65,930 )     (2,384 )     (72,458 )     (3,949 )
Interest income
    995       456       1,611       604  
Change in fair value of derivative liabilities
    29,000       -       29,000       -  
                                 
Total other income (expense)
    (35,935 )     (1,928 )     (41,847 )     (3,345 )
                                 
Loss before provision for income taxes
    (47,327 )     (178,889 )     (1,478,744 )     (523,980 )
                                 
Income tax expense
    -       -       (2,400 )     (2,400 )
                                 
Net loss
  $ (47,327 )   $ (178,889 )   $ (1,481,144 )   $ (526,380 )
                                 
Net loss per share:
                               
Basic
  $ (.00 )   $ (.01 )   $ (.08 )   $ (.03 )
Diluted
  $ (.00 )   $ (.01 )   $ (.08 )   $ (.03 )
                                 
Number of weighted average shares:
                               
Basic
    19,395,259       19,278,595       19,356,187       19,189,188  
Diluted
    19,395,259       19,278,595       19,356,187       19,189,188  

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

 
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
NINE MONTHS ENDED SEPTEMBER 30, 2011
(UNAUDITED)
 
   
Common Stock
                   
   
Shares
   
Amount
   
Additional
Paid-in Capital
   
Accumulated Deficit
   
Total Stockholders’ Equity
 
Balance at December 31, 2010
    19,336,651     $ 19,338     $ 20,417,584     $ (17,915,893 )   $ 2,521,029  
Stock compensation expense for options and warrants granted to employees and consultants
    -       -       228,165       -       228,165  
Restricted stock granted for marketing services
    66,667       67       71,870       -       71,937  
Warrants issued as loan acquisition costs related to convertible notes payable
    -       -       91,500       -       91,500  
Net loss
            -       -       (1,481,144 )     (1,481,144 )
Balance at September 30, 2011
    19,403,318     $ 19,405     $ 20,809,119     $ (19,397,037 )   $ 1,431,487  
 
The accompanying notes are an integral part of these condensed consolidated financial statements.



 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
   
Nine months ended September 30,
 
   
2011
   
2010
 
Cash flows from operating activities:
           
Net loss
  $ (1,481,144 )   $ (526,380 )
Adjustments to reconcile net loss to net cash used for operating activities:
               
Depreciation
    97,229       216,514  
Stock compensation expense for warrants and options issued to employees and consultants
    228,165       210,633  
Fair value of restricted stock granted for marketing services
    71,937       90,161  
Change in fair value of derivative liabilities
    (29,000 )     -  
Interest expense related to accretion of debt discount costs
    23,500       -  
Interest expense related to amortization of loan acquisition costs
    14,618       -  
                 
Changes in operating assets and liabilities:
               
Accounts receivable
    (1,739,677 )     (325,925 )
Supplies
    (38,807 )     44,367  
Prepaid and other current assets
    255,723       (83,452 )
Deposits
    -       15,779  
Accounts payable and accrued expenses
    790,157       (33,497 )
Accrued compensation and benefits
    (126,902 )     (78,928 )
Deferred revenue
    115,665       (68,874 )
Net cash (used for) operating activities
    (1,818,536 )     (539,602 )
                 
Cash flows from investing activities:
               
Purchases of property and equipment
    (19,242 )     (88,240 )
Net cash (used for) investing activities
    (19,242 )     (88,240 )
                 
Cash flows from financing activities:
               
Net proceeds from issuance of common stock
    -       161,450  
Proceeds from convertible notes payable
    1,850,000       -  
Acquisition fees paid for convertible notes payable
    (171,620 )     -  
Payments on capital leases
    (35,520 )     (9,716 )
Net cash provided by financing activities
    1,642,860       151,734  
                 
Net decrease in cash and cash equivalents
    (194,918 )     (476,108 )
Cash and cash equivalents, beginning of period
    2,249,907       1,781,586  
Cash and cash equivalents, end of period
  $ 2,054,989     $ 1,305,478  
                 
Supplemental disclosure of cash flow information:
               
Interest paid
  $ 9,653     $ 3,949  
Income taxes paid
  $ 1,117     $ -  
Property and equipment acquired through capital leases
  $ 28,032     $ 75,253  
Warrants issued as loan acquisition costs related to convertible notes payable
  $ 91,500     $ -  

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

 
NINE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010
(UNAUDITED)
 
1.           BASIS OF PRESENTATION
 
The accompanying unaudited condensed consolidated financial statements of Auxilio, Inc. and its subsidiaries (“the Company”) have been prepared in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”) for interim financial statements pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”).  Accordingly, these financial statements do not include all of the information and notes required by GAAP for complete financial statements.  These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010, as filed with the SEC on March 30, 2011.
 
The unaudited condensed consolidated financial statements included herein reflect all adjustments (which include only normal, recurring adjustments) that are, in the opinion of management, necessary to state fairly the financial position and results of operations of the Company as of and for the periods presented.  The results for such periods are not necessarily indicative of the results to be expected for the full year.
 
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  As a result, actual results could differ from those estimates.
 
The financial services industry and the U.S. economy as a whole have been experiencing a period of substantial turmoil and uncertainty characterized by unprecedented intervention by the United States federal government and the failure, bankruptcy, or sale of various financial and other institutions.  The impact of these events on our business and the severity of the current economic crisis is uncertain.  It is possible that the current crisis in the global credit markets, the financial services industry and the U.S. economy may adversely affect our business, vendors and prospects as well as our liquidity and financial condition.  As a result, no assurances can be given as to the Company’s ability to increase its customer base and generate positive cash flows.  Although the Company has been able to raise additional working capital through convertible note agreements and private placement offerings of its common stock, the Company may not be able to continue this practice in the future nor may the Company be able to obtain additional working capital through other debt or equity financings.  In the event that sufficient capital cannot be obtained, the Company may be forced to significantly reduce operating expenses to a point that would be detrimental to the Company’s business operations and business development activities.  These courses of action may be detrimental to the Company’s business prospects and result in material changes to its operations and financial position.  In the event that any future financing should take the form of the sale of equity securities, the current equity holders may experience dilution of their investments.
 
The accompanying financial statements include the accounts of the Company and its wholly owned subsidiaries.  All intercompany balances and transactions have been eliminated.
 
The Company has performed an evaluation of subsequent events through the date of filing these financial statements with the SEC.
 
2.           RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
 
In September 2009, the FASB issued authoritative guidance (ASU 2009-13) regarding multiple-deliverable revenue arrangements that address how to separate deliverables and how to measure and allocate consideration to one or more units of accounting.  Specifically, the guidance requires that consideration be allocated among multiple deliverables based on relative selling prices.  The guidance establishes a selling price hierarchy of (1) vendor-specific objective evidence, (2) third-party evidence and (3) estimated selling price.  This guidance is effective for annual periods beginning after June 15, 2010. The Company adopted this guidance effective January 1, 2011. Adoption resulted in no significant effect on its consolidated financial position and results of operations.
 


 
From time to time, new accounting pronouncements are issued by the FASB that we adopt as of the specified effective date.  Unless otherwise discussed in these financial statements and notes or in the financial statements and notes included in our Annual Report on Form 10-K for the year ended December 31, 2010, we believe the impact of any other recently issued standards that are not yet effective are either not applicable to us at this time or will not have a material impact on our consolidated financial statements upon adoption.
 
3.           OPTIONS AND WARRANTS
 
Below is a summary of Auxilio stock option and warrant activity during the nine-month period ended September 30, 2011:
 
Options
 
Shares
   
Weighted Average Exercise Price
   
Weighted Average Remaining Term
in Years
   
Aggregate
Intrinsic Value
 
Outstanding at December 31, 2010
    5,218,909     $ 1.01              
Granted
    558,500       0.88              
Exercised
    -       -              
Cancelled
    (360,507 )     0.61              
Outstanding at September 30, 2011
    5,416,902     $ 1.02       6.40     $ 292,130  
Exercisable at September 30, 2011
    3,729,235     $ 1.07       5.27     $ 253,148  
                                 
Warrants
 
Shares
   
Weighted Average Exercise Price
   
Weighted Average Remaining Term
in Years
   
Aggregate
Intrinsic Value
 
Outstanding at December 31, 2010
    3,362,708     $ 1.36                  
Granted
    869,800       1.40                  
Exercised
    -       -                  
Cancelled
    (250,000 )     0.55                  
Outstanding at September 30, 2011
    3,982,508     $ 1.40       2.96     $ 188,417  
Exercisable at September 30, 2011
    2,007,508     $ 1.39       2.96     $ 150,733  

During the nine months ended September 30, 2011, the Company granted a total of 558,500 options to its employees and directors to purchase shares of the Company’s common stock at an exercise price range of $0.71 to $1.01 per share.  The exercise price for these options equals the fair value of the Company’s stock on the grant date.  The options have graded vesting annually over three years starting in January 2011 through September 2011.  The fair value of the options was determined using the Black-Scholes option-pricing model.  The assumptions used to calculate the fair value are as follows:  (i) risk-free interest rate of 0.08% to 0.19%; (ii) estimated volatility of 80.95% to 85.78%; (iii) dividend yield of 0.0%; and (iv) expected life of the options of three years.
 
 On April 1, 2011, the Company granted 300,000 warrants to its CEO to purchase shares of the Company’s common stock at an exercise price of $0.94 per share, which exercise price equals the fair value of the Company’s stock on the grant date. The fair value of the warrants was determined using the Black-Scholes option-pricing model.  The warrants have graded vesting annually over three years.  The fair value of the warrants was determined using the Black-Scholes option-pricing model.  The assumptions used to calculate the fair value are as follows:  (i) risk-free interest rate of 0.11%; (ii) estimated volatility of 81.36%; (iii) dividend yield of 0.0%; and (iv) expected life of the warrants of three years.
 
In November 2008, the Company entered into a five year joint marketing agreement with Sodexo Operations, LLC, (“Sodexo”) to provide Auxilio’s document services to Sodexo’s healthcare customer base in the United States.  Sodexo will invest in sales and marketing resources and assist the Company with marketing their document services to Sodexo’s US healthcare customer base of more than 1,600 hospitals.  Under the terms of the agreement the Company expects to provide Sodexo with warrants to purchase up to two million shares of the
 


 
Company’s common stock at a price of $1.50 per share.  The first 150,000 warrants vested in June 2009.  An additional 175,000 vested in July 2010 upon the signing of a new customer contract.  The balance of the warrants will vest in increments of between 75,000 and 500,000 shares dependent on the size and number of the new customer contracts that the Company enters into as a direct result of this agreement.  The expense associated with these performance based warrants will be recognized when they are earned.
 
On July 29, 2011, the company closed on a private offering of secured convertible notes and warrants, wherein warrants for 370,000 shares of common stock were issued to the note holders and a warrant for 199,800 shares of common stock were issued to the placement broker.  Please see Notes 7 and 8 below for further information on these warrants.
 
For the three and nine months ended September 30, 2011 and 2010, stock-based compensation expense recognized in the statement of operations was as follows:
 
   
Three Months
Ended September 30,
   
Nine months
Ended September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Cost of revenues
  $ (16,362 )   $ 32,920     $ 57,789     $ 85,483  
Sales and marketing
    7,077       10,199       16,937       6,224  
General and administrative expense
    45,457       36,799       153,439       118,926  
Total stock based compensation expense
  $ 36,172     $ 79,918     $ 228,165     $ 210,633  

4.           RESTRICTED STOCK
 
On May 11, 2011, the Company amended the joint marketing agreement with Sodexo.  Under the revised agreement, Sodexo will provide additional sales and marketing resources and will expand the marketing effort directed towards existing or potential Sodexo hospital clients.  The term of the agreement is extended to December 31, 2014.  Upon signing the amended agreement, the Company granted 200,000 shares of restricted stock to Sodexo.  These shares vest as follows:  66,667 immediately, 66,667 on May 11, 2013 and 66,666 on May 11, 2014.  The immediately vested shares resulted in a charge to marketing expense of $54,667.  The cost of the remaining shares will be recognized over the vesting periods using the current market price of the stock at each periodic reporting date.  For the nine months ended September 30, 2011, the cost recognized for these unvested shares totaled $17,270.  Sodexo will be granted additional restricted stock for new sales resulting from these efforts.  In addition, Sodexo will receive a quarterly commission based on actual revenues derived from these new accounts over the life of the contract along with an annual marketing fee based on  total revenues received by the Company, excluding for certain existing accounts.  Through September 30, 2011, no additional restricted stock has been granted.
 
5.           NET (LOSS) PER SHARE
 
Basic net loss per share is calculated using the weighted average number of shares of the Company’s common stock issued and outstanding during a certain period, and is calculated by dividing the net loss by the weighted average number of shares of the Company’s common stock issued and outstanding during such period.  Diluted net loss per share is calculated using the weighted average number of common and potentially dilutive common shares outstanding during the period, using the as-if converted method for secured convertible notes, and the treasury stock method for options and warrants.  Options, warrants and convertible notes were not included in the computation of diluted net loss per share because inclusion would have been anti-dilutive.
 



 
The following table sets forth the computation of basic and diluted net (loss) per share:
 
   
Three Months Ended September 30,
   
Nine months ended September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Numerator:
                       
Net loss
  $ (47,327 )   $ (178,889 )   $ (1,481,144 )   $ (526,380 )
Denominator:
                               
Denominator for basic calculation weighted average shares
    19,395,259       19,278,595       19,336,651       19,189,188  
Dilutive common stock equivalents:
                               
Options and warrants
    -       -       -       -  
Denominator for diluted calculation weighted average shares
    19,359,259       19,278,595       19,336,651       19,189,188  
                                 
Net loss per share:
                               
Basic net loss per share
  $ (.00 )   $ (.01 )   $ (.08 )   $ (.03 )
Diluted net loss per share
  $ (.00 )   $ (.01 )   $ (.08 )   $ (.03 )

6.           ACCOUNTS RECEIVABLE
 
A summary as of September 30, 2011 is as follows:
 
Trade receivable
  $ 3,270,884  
Customer advances
    (370,956 )
Allowance for doubtful accounts
    -  
Total accounts receivable
  $ 2,899,928  

7.           CONVERTIBLE NOTES PAYABLE
 
Effective July 29, 2011, the Company closed on a private offering of secured convertible notes and warrants (“Units”) for gross proceeds of $1,850,000.  Each of the Units consists of (i) a $5,000 secured convertible promissory note (each a “Note” and collectively “Notes”) and (ii) a warrant (each a “Warrant” and collectively “Warrants”) to purchase 1,000 shares of the Company’s common stock at $1.50 per share.  The Notes mature July 29, 2014 and are secured by the Company’s tangible and intangible assets.  The Notes accrue interest at a rate of eight percent (8%) per annum, compounded annually, and the interest on the outstanding balance of the Notes is payable no later than thirty (30) days following the close of each calendar quarter.  The Notes are convertible into 1,850,000 shares of Common Stock.  The Warrants expire April 29, 2016 and are exercisable to purchase up to 370,000 shares of common stock.  The Company additionally granted piggyback registration rights to the investors in this offering.  Several members of the Board of Directors of the Company, including John Pace, Michael Joyce, Mark St. Clare and Michael Vanderhoof participated in the offering.
 
The Company may call the Notes for prepayment (“Call Option”)  if (a) the Company’s common stock closes at or above $2.00 per share for 20 consecutive days; and (b) the Company’s common stock has had daily trading volume at or above 100,000 shares for the same 20 consecutive days.  Investors shall have 60 days from the date on which the Company calls the Notes to convert the Notes; thereafter any outstanding Notes may be prepaid by the Company.
 
At any time prior to the maturity date, the holders of the Notes may elect to convert all or part of the unpaid principal amount of the Notes and any unpaid interest accrued thereon, into shares of common stock.  The conversion price shall be $1.00 per share of Common Stock, subject to adjustment upon the occurrence of certain capital events.  If (a) there is any transaction, or a series of transactions, that results, directly or indirectly, in the transfer of 100% of the Company including, without limitation, any sale of stock, sale of assets, sale of membership interests, merger or consolidation, reorganization, recapitalization or restructuring, tender or exchange offer, negotiated purchase or leveraged buyout, and (b) the per share price of the Company’s common stock in such transaction equals or exceeds $1.00, then the Notes will be automatically converted into Company common stock.
 


 
The Note agreement provides the note holders with certain dilution protections.  If (a) by July 29, 2012, the Company completes an additional round of debt financing with new investors (“New Debt”) and (b) the New Debt contains more favorable interest rate, payment frequency, amortization, conversion price, warrant coverage and registration rights terms to the New Debt holders than the Notes, then the holder of Notes shall have the option to exchange the Notes for an equal principal amount of new notes with the same terms as the New Debt (the “Exchange Feature”).  The Exchange Feature does not provide for fixed terms for the associated Warrants or can allow for an adjustment to the conversion rate of the Notes.
 
The Company allocated the proceeds in connection with ASC Topic 470-25.  Due to the existence of the Exchange Feature, the warrants were determined to not be indexed to its own underlying stock and therefore did not qualify for equity classification. Therefore the proceeds allocated to the warrants were determined to be a derivate liability and measured at fair value.
 
The conversion rights and the Call Option held by the Company, or the “Additional Investment Rights”, are embedded derivatives of the host debt contract. The potential variability of the conversion rate and the terms of the Call Option, due to the existence of the Exchange Feature, also caused the Additional Investment Rights to not qualify for equity classification.  Under the accounting guidance for multiple embedded derivatives, the Company combined these rights into one embedded derivative and allocated proceeds from the offering to the bundled derivative. Accordingly, the bundled Additional Investment Rights are accounted for as a derivative liability to be measured at fair value.  The Company allocated $1,427,000 to the convertible notes payable, $166,000 to the derivative Warrant liability and $257,000 to the derivative Additional Investments Rights liability.  The debt discount of $423,000 will be amortized as interest expense over the term of the convertible notes payable.  The valuation methodologies for the fair values of the Derivative Warrant Liability and the Derivative Additional Investment Rights Liability are described in Note 8 below.
 
Interest charges associated with the convertible notes payable, including amortization of the discounts and loan acquisition costs totaled $62,784 through September 30, 2011.
 
The Company also agreed to pay Cambria Capital, LLC a placement fee of $149,850 in sales commissions, reimbursement for costs associated with the placement of the Units and issue a Warrant to purchase up to 199,800 shares of Common Stock exercisable at a price of $1.50 per share.  Cambria Capital, LLC is an affiliate of Michael Vanderhoof, a member of the Board of Directors of the Company.  The engagement of Cambria Capital, LLC, the payment of the placement fee and the issuance of the Warrant to Cambria Capital, LLC were approved by a majority of the disinterested members of the Board of Directors.  The Company additionally granted piggyback registration rights to Cambria Capital, LLC in this offering that are the same as those afforded to the investors in the offering.
 
8.           DERIVATIVE LIABILITIES
 
The Company’s derivative liability instruments have been measured at fair value using the Black-Scholes model. The Company evaluated the use of other valuation models and determined that given the fact pattern these methods were not anticipated to be materially different than the amounts calculated using the Black-Scholes model. This determination was based on management’s belief that the likelihood of another round of financing prior to the expiration of the Exchange Feature is remote, and another round of financing with terms more favorable to new investors is even more remote. If another round of financing were to occur, management believes that the Company’s need for an additional round of financing by July 2012 would most likely be driven by significant growth in the Company’s business. This growth would likely result in more favorable terms to the Company, thus rendering the instruments subject to the Exchange Feature with nominal value.  As a result, the Company believes that the Black-Scholes model was an appropriate method for valuing the warrants and additional investment rights subject to the Exchange Feature.
 


 
Derivative Warrant Liability
 
The Company has warrants outstanding with potentially variable terms that could allow for the reduction in the exercise price of the warrants in the event the Company, prior to July 29, 2012, completes an additional round of debt financing with new investors that calls for better economic terms.  The Company accounted for these warrants in accordance with FASB ASC Topic 815.
 
The Company recognizes all of its warrants subject to the Exchange Feature as a derivative liability in its consolidated balance sheet.  The derivative liability is revalued at each reporting period and changes in fair value are recognized currently in the consolidated statements of operations.  The initial recognition and subsequent changes in fair value of the derivative liability have no effect on the Company’s cash flows.
 
The revaluation of these warrants at the end of the reporting period resulted in the recognition of a $15,000 gain within the Company’s consolidated statements of operations for the three and nine months ended September 30, 2011, under the caption “Change in fair value of derivative liabilities”.  The fair value of these warrants at September 30, 2011 was $151,000, which is reported on the consolidated balance sheet under the caption “Derivative Warrant Liability”.
 
Fair Value Assumptions Used in Accounting for Derivative Warrant Liability
 
The Company has determined its derivative warrant liability to be a Level 3 fair value measurement.  The fair value as of July 29, 2011 and September 30, 2011 required the data inputs listed in the table below:
 
   
July 29, 2011
 
September 30, 2011
Exercise price
  $ 1.50   $ 1.50  
Term (years)
    4.75     4.75  
Risk-free interest rate
    1.35%     0.96%  
Estimated volatility
    82%     82%  
Dividend rate
    -0-     -0-  
Stock price
  $ 0.85   $ 0.80  

Derivative Additional Investment Rights Liability
 
The Company has Additional Investment Rights outstanding with  terms that could allow for more beneficial consideration to the note holders in the event the Company, prior to July 29, 2012, completes an additional round of debt financing with new investors that calls for better economic terms.  The Company accounted for these Additional Investment Rights in accordance with FASB ASC Topic 815.
 
The Company recognizes all of its Additional Investment Rights subject to the Exchange Feature as derivative liabilities in its consolidated balance sheet.  The derivative liability is revalued at each reporting period and changes in fair value are recognized in the consolidated statements of operations.  The initial recognition and subsequent changes in fair value of the derivative Additional Investment Rights liability have no effect on the Company’s cash flows.
 
The revaluation of the Additional Investment Rights at each reporting period resulted in the recognition of a $14,000 gain within the Company’s consolidated statements of operations for the three and nine months ended September 30, 2011, under the caption “Change in fair value of derivative liabilities”.  The fair value of the Additional Investments Rights at September 30, 2011 was $243,000, which is reported on the consolidated balance sheet under the caption “Derivative Additional Investment Rights Liability”.
 


 
Fair Value Assumptions Used in Accounting for Derivative Additional Investment Rights Liability
 
The Company has determined its derivative additional investment rights liability to be a Level 3 fair value measurement.  The fair value as of July 29, 2011 and September 30, 2011 required the data inputs listed in the table below:
 
   
July 29, 2011
 
September 30, 2011
Conversion price (range)
  $ 1.00-$2.00   $ 1.00-$2.00
Term (years)
    3.00     2.83
Risk-free interest rate
    0.55%     0.42%
Estimated volatility
    82%     82%
Dividend rate
    -0-     -0-
Stock price
  $ 0.85   $ 0.80

9.           EMPLOYMENT AGREEMENTS
 
On August 5, 2009, the Board of Directors appointed Mr. Joseph J. Flynn as President and Chief Executive Officer (“CEO”) effective August 31, 2009.  Mr. Flynn has served as a member of the Board of Directors since 2003.  He previously held the position of President and CEO for the Company from 2003 to 2006, having resigned to take a position as the Vice President of the Sport Group for the Nielsen Company.  In connection with his appointment as President and CEO, the Company and Mr. Flynn entered into an Executive Employment Agreement, effective as of August 31, 2009 (the “Flynn Employment Agreement”).  The Flynn Employment Agreement provides that Mr. Flynn will be employed by the Company as President and CEO, for an initial term beginning on August 31, 2009 and ending on December 31, 2011, at an initial base salary of $250,000, up to $100,000 per year incentive compensation and options for 250,000 shares as more specifically set forth in the Flynn Employment Agreement.  Upon termination of Mr. Flynn’s employment by the Company other than for cause or by Mr. Flynn for good reason, the Company shall continue paying Mr. Flynn’s salary for six months and accelerate the vesting of Company options and/or warrants issued to Mr. Flynn.
 
The Compensation Committee set Mr. Flynn’s base salary at $261,250 for the fiscal year ending December 31, 2011.  Mr. Flynn may also earn up to $100,000 in annual bonus, with 33.33% payout for closing six new customer contracts before the end of 2011, 33.33% for hitting revenue targets and 33.33% payout for achieving gross margin targets.  In addition, Mr. Flynn will participate in a bonus and option pool that will be allocated at the Board’s discretion based on obtaining new contracts.  Specifically, for every new contract beyond six contracts in 2011, a pool of $25,000 and 25,000 options would be granted with a strike price for the options on the day they are earned, the date in which the contracts are signed and delivered.
 
On April 2, 2010, the Company entered into an employment agreement with Mr. Paul T. Anthony, Chief Financial Officer (“CFO”) of the Company since 2004, to the serve as Executive Vice President (“EVP”) and CFO.  As EVP and CFO, Mr. Anthony, the Company CFO since 2005 continues to report to the CEO and has duties and responsibilities assigned by the CEO.  The employment agreement was effective January 1, 2010, has a term of two years, and provides for an annual base salary of $203,500.  The agreement will automatically renew for subsequent twelve month terms unless either party provides advance written notice to the other that such party does not wish to renew the agreement for a subsequent twelve months.  Mr. Anthony also receives the customary employee benefits paid by the Company.  Mr. Anthony is also entitled to receive a bonus of up to $60,000 per year, the achievement of which is based on Company performance metrics.  The Company may terminate Mr. Anthony’s employment under this agreement without cause at any time on thirty days advance written notice, at which time Mr. Anthony would receive severance pay for six months and be fully vested in all options and warrants granted to date.
 
The CEO set Mr. Anthony’s base salary at $212,658 for the fiscal year ending December 31, 2011.  Mr. Anthony may also earn up to $60,000 in annual bonus, with 33.33% payout for closing six new customer contracts before the end of 2011, 33.33% for hitting revenue targets and 33.33% payout for achieving gross margin targets.  In addition, Mr. Anthony will participate in a bonus and option pool that will be allocated at the Board’s discretion based on obtaining new contracts. Specifically, for every new contract beyond six contracts in 2011, a pool of $25,000 and 25,000 options would be granted with a strike price for the options on the day they are earned, the date in which the contracts are signed and delivered.
 


 
10.           CONCENTRATIONS
 
Cash Concentrations
 
At times, cash balances held in financial institutions are in excess of federally insured limits.  Management performs periodic evaluations of the relative credit standing of financial institutions and limits the amount of risk by selecting financial institutions with a strong credit standing.
 
Major Customers
 
The Company’s two largest customers accounted for approximately 40% of the Company’s revenues for the nine months ended September 30, 2011.  Accounts receivable for these customers totaled approximately $107,000 as of September 30, 2011 which is 4% of the Company’s accounts receivable balance.  The Company’s five largest customers accounted for approximately 83% of the Company’s revenues for the nine months ended September 30, 2010.
 
11.           SEGMENT REPORTING
 
The Company has adopted ASC 280, “Segment Reporting”.  Since the Company operates in one business segment based on the Company’s integration and management strategies, segment disclosure has not been presented.
 
12.           GOODWILL
 
The Company performed an impairment test of goodwill as of December 31, 2010, determining that its estimated fair value based on its market capitalization was greater than the Company’s carrying amount including goodwill.  The Company did not perform step 2 because the fair value was greater than the carrying amount.
 
Although the Company has experienced a net loss for the nine months ended September 30, 2011, these losses were a direct result of operating expenses related to improved sales efforts that recently resulted in Auxilio closing seven new recurring revenue contracts.  As a result, management did not feel it was necessary to perform an interim impairment test.
 
 
The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q.  This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Section 27A of the Securities Act, and is subject to the safe harbors created by those sections.  Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “may,” “will” and variations of these words or similar expressions are intended to identify forward-looking statements.  In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements.  These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict.  Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors.  We undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements.
 



 
Due to possible uncertainties and risks, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Quarterly Report, which speak only as of the date of this Quarterly Report, or to make predictions about future performance based solely on historical financial performance.  We disclaim any obligation to update forward-looking statements contained in this Quarterly Report.
 
Readers should carefully review the risk factors described below under the heading “Risk Factors”  and in other documents we file from time to time with the SEC, including our Form 10-K for the fiscal year ended December 31, 2010.  Our filings with the SEC, including our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those filings, pursuant to Sections 13(a) and 15(d) of the Exchange Act, are available free of charge at www.auxilioinc.com, when such reports are available at the SEC web site.
 
OVERVIEW
 
Prior to March 2004, Auxilio, then operating under the name PeopleView, Inc., developed, marketed and supported web based assessment and reporting tools and provided consulting services that enabled companies to manage their Human Capital Management needs in real-time.  In March 2004, Auxilio decided to change its business strategy and sold the PeopleView business to Workstream, Inc. (“Workstream”).  Following completion of the sale of PeopleView, Inc. to Workstream, the Company focused its business strategy on providing outsourced image management services to healthcare facilities.
 
To facilitate this strategy, Auxilio, in April 2004, acquired Alan Mayo & Associates, dba The Mayo Group (“The Mayo Group” or “TMG”), a provider of integration strategies and outsourced services for document image management in healthcare facilities.  It was this acquisition that formed the basis of Auxilio’s current operations.
 
Auxilio now provides total outsourced document managed services and related financial and business processes exclusively for major healthcare facilities.  Our proprietary services and unique processes assist hospitals, and health systems with strategic direction and services that reduce print related expenses, increase operational efficiencies and improve the productivity of their staff.  Auxilio’s analysts, consultants and resident hospital teams work with senior hospital financial management and IT department heads to determine the best possible long term strategy for managing the millions of documents produced by their facilities on an annual basis.  Auxilio’s print management programs help our clients achieve measurable savings and a fully outsourced print management process.  Auxilio’s target market includes medium to large hospitals and healthcare systems which include multiple hospitals.
 
Our common stock currently trades on the OTC Bulletin Board under the stock symbol “AUXO”.
 
Where appropriate, references to “Auxilio,” the “Company,” “we,” “us” or “our” include Auxilio, Inc. and Auxilio Solutions, Inc.
 
APPLICATION OF CRITICAL ACCOUNTING POLICIES
 
Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”).  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosure of contingent assets and liabilities.  We evaluate these estimates on an on-going basis, including those estimates related to revenue recognition, customer programs and incentives, product returns, bad debts, inventories, investments, intangible assets, income taxes, contingencies and litigation.  We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances.  The results of these estimates form the basis for our judgments about the carrying values of assets and liabilities which are not readily apparent from other sources.  As a result, actual results may differ from these estimates under different assumptions or conditions.
 



 
We consider the following accounting policies to be most important to the portrayal of our financial condition and those that require the most subjective judgment:
 
Revenue recognition
 
Revenues from equipment sales transactions are deemed earned when the equipment is delivered and accepted by the customer.  For equipment that is to be placed at the customer’s location at a future date, revenue is deferred until that equipment is actually placed.  Service and supply revenue is earned monthly during the term of the various contracts, as services and supplies are provided.
 
Deferred revenue
 
We enter into arrangements that include multiple deliverables, which typically consist of the sale of equipment and a support services contract.  We account for each element within an arrangement with multiple deliverables as separate units of accounting.  Revenue is allocated to each unit of accounting under the guidance of FASB ASC Topic 605-25, Multiple-Deliverable Revenue Arrangements which provides criteria for separating consideration in multiple-deliverable arrangements by establishing a selling price hierarchy for determining the selling price of a deliverable.  The selling price used for each deliverable is based on vendor-specific objective evidence if available, third-party evidence if vendor-specific objective evidence is not available, or estimated selling price if neither vendor-specific objective evidence nor third-party evidence is available.  A vendor is required to determine its best estimate of selling price in a manner that is consistent with that used to determine the price to sell the deliverable on a standalone basis.  The updated guidance does not permit the residual method of allocation and requires that arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method, which allocates any discount in the overall arrangement proportionally to each deliverable based on its relative selling price.
 
Accounts receivable valuation and related reserves
 
We estimate the losses that may result from that portion of our accounts receivable that may not be collectible as a result of the inability of our customers to make required payments.  Management specifically analyzes customer concentration, customer credit-worthiness, current economic trends and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts.  We review past due accounts on a monthly basis and record an allowance for doubtful accounts where we deem appropriate.
 
New customer implementation costs
 
We ordinarily incur additional costs to implement our services for new customers.  These costs are comprised primarily of additional labor and support.  These costs are expensed as incurred, and have a negative impact on our statements of operations and cash flows during the implementation phase.
 
Impairment of intangible assets
 
The Company performs an impairment test of goodwill at least annually or on an interim basis if any triggering events occur that would merit another test.  The impairment test compares the Company’s estimate of its fair value based on its market capitalization to the Company’s carrying amount including goodwill.  To date, the Company has not had to perform step 2 of the impairment test because the fair value has exceeded the carrying amount.
 
Stock-based compensation
 
The Company recognizes stock-based compensation as an expense in accordance with ASC Topic 718 “Share-Based Payments” (“ASC 718”) and values the equity securities based on the fair value of the security on the date of grant.  Stock option awards are valued using the Black-Scholes option-pricing model.  The Black-Scholes option valuation model was developed for estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Because option valuation models require the use of subjective assumptions, changes in these assumptions can materially affect the fair value of the options.
 


 
Income taxes
 
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial reporting requirements and those imposed under federal and state tax laws.  Deferred taxes are provided for timing differences in the recognition of revenue and expenses for income tax and financial reporting purposes and are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.  Deferred income tax expense represents the change during the period in the deferred tax assets and liabilities.  The components of the deferred tax assets and liabilities are individually classified as current and non-current based on their characteristics.  Realization of the deferred tax asset is dependent on generating sufficient taxable income in future years.  Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.
 
Derivative Liabilities
 
The Company’s derivative warrants and additional investment rights liabilities are measured at fair value using the Black-Scholes valuation model which takes into account, as of the measurement date, factors including the current exercise price, the term of the instrument, the current price of the underlying stock and its expected volatility, expected dividends on the stock and the risk-free interest rate for the term of the item. These derivative liabilities are revalued at each reporting period and changes in fair value are recognized currently in the consolidated statements of operations under the caption “Change in fair value of derivative liabilities.”
 
You should refer to our Annual Report on Form 10-K filed on March 30, 2011 for a complete discussion of our critical accounting policies.
 
RESULTS OF OPERATIONS
 
For the Three Months Ended September 30, 2011 Compared to the Three Months Ended September 30, 2010
 
Revenue
 
Revenue increased by $2,703,349 to $6,674,003 for the three months ended September 30, 2011, as compared to the same period in 2010.  The increase is a result of the addition of seven new recurring revenue contracts between October 2010 and July 2011.  Meanwhile we have maintained all our current customers, though we have negotiated lower rates for some of them.  Equipment sales for the three months ended September 30, 2011 were approximately $1,200,000 as compared to approximately $480,000 for the same period in 2010.  The increase is due primarily to an $800,000 equipment placement at one customer.
 
Cost of Revenue
 
Cost of revenue consists of print related equipment, parts, supplies and salaries and expenses of field services personnel.  Cost of revenue was $5,403,700 for the three months ended September 30, 2011, as compared to $3,135,217 for the same period in 2010.  The increase in the cost of revenue for the first quarter of 2011 is attributed primarily to the addition of seven new recurring revenue contracts between October 2010 and July 2011.  During 2011 we incurred approximately $500,000 in additional labor costs in connection with the support and operation of new customers.  Service and supply costs increased by approximately $900,000 primarily as a result of our new customers, but partially offset by a reduction in our per unit supplies costs in 2011.  We cannot be sure this trend of lower per unit supply costs will continue.  Equipment costs, which includes equipment provided under the recurring service contracts and equipment sold, increased by approximately $900,000 in 2011, primarily as a result of an equipment placement at one customer.
 



 
We expect higher cost of revenues at the start of our engagement with most new customers.  In addition to the costs associated with implementing our services, we absorb our new customer’s legacy contracts with third-party vendors.  As we implement our programs we strive to improve upon these legacy contracts thus reducing costs over the term of the contract.  Given that expiration dates of and the amount of savings are specific to each such vendor arrangement, we cannot predict our anticipated profit margins as these legacy contracts come up for renewal.  We anticipate this trend to continue but anticipate overall increase in cost of revenues sold as a result of the expansion of our customer base.
 
Sales and Marketing
 
Sales and marketing expenses include salaries, commissions and expenses for sales and marketing personnel, travel and entertainment, and other selling and marketing costs.  Sales and marketing expenses were $559,227 for the three months ended September 30, 2011, as compared to $378,654 for the same period in 2010.  The headcount of the sales team increased from four to eight employees thus increasing payroll by approximately $70,000.  Sales commissions increased by approximately $90,000 due to additional sales contracts signed in 2011.
 
General and Administrative
 
General and administrative expenses include personnel costs for finance, administration, information systems, and general management, as well as facilities expenses, professional fees, legal expenses and other administrative costs.  General and administrative expenses increased by $88,724 to $722,468 for the three months ended September 30, 2011, as compared to $633,744 for the same period in 2010.  Salary expense increased approximately $70,000 in the third quarter of 2011 primarily due to job transfers of two employees to administrative roles from operations and adding an accounting manager.
 
Other Income (Expense)
 
Interest expense for the three months ended September 30, 2011 was $65,930, compared to $2,384 for the same period in 2010.  The increase is a result of the convertible debt borrowing consummated in July 2011.  Interest income is derived from short-term interest-bearing securities and money market accounts.  Interest income for the three months ended September 30, 2011 was $995, as compared to $456 for the same period in 2010, primarily due to nominal interest rates for invested cash.  The change in fair value of derivative liabilities was a result of a convertible debt offering which first occurred in 2011, thus there was no similar activity in 2010.
 
Income Tax Expense
 
There was no income tax expense for the three months ended September 30, 2011 or 2010.
 
For the Nine months ended September 30, 2011 Compared to the Nine months ended September 30, 2010
 
Revenue
 
Revenue increased $4,903,770 to $16,160,897 for the nine months ended September 30, 2011, as compared to the same period in 2010.  The increase is a result of the addition of seven new recurring revenue contracts between October 2010 and July 2011.  Meanwhile we have maintained all our current customers, though we have negotiated lower rates for some of them.  Equipment sales for the nine months ended September 30, 2011 were approximately $1,400,000 as compared to approximately $600,000 for the same period in 2010.  The increase is due primarily to an $800,000 equipment placement at one customer.
 
Cost of Revenue
 
Cost of revenue consists of print related equipment, parts, supplies and salaries and expenses of field services personnel.  Cost of revenue increased $5,173,240 to $13,762,040 for the nine months ended September 30,
 


2011, as compared to $8,588,800 for the same period in 2010.  The increase in the cost of revenue for 2011 is attributed primarily to the addition of seven new recurring revenue contracts between October 2010 and July 2011.  During 2011 we incurred approximately $1,660,000 in additional staffing and approximately $110,000 in additional travel related costs in connection with the support and operation of new customers.  Service and supply costs increased by approximately $2,370,000 primarily as a result of our new customers, but partially offset by a reduction in our per unit supplies costs in 2011.  We cannot be sure this trend of lower per unit supply costs will continue.  Equipment costs, which includes equipment provided under the recurring service contracts and equipment sold, increased by approximately $1,050,000 in 2011, primarily as a result of an equipment placement at one customer.
 
We expect higher cost of revenues at the start of our engagement with most new customers.  In addition to the costs associated with implementing our services, we absorb our new customer’s legacy contracts with third-party vendors.  As we implement our programs we strive to improve upon these legacy contracts thus reduce costs over the term of the contract.  We anticipate this trend to continue but anticipate overall increase in cost revenues sold as a result of the expansion of our customer base.
 
Sales and Marketing
 
Sales and marketing expenses include salaries, commissions and expenses for sales and marketing personnel, travel and entertainment, and other selling and marketing costs.  Sales and marketing expenses were $1,384,633 for the nine months ended September 30, 2011, as compared to $1,015,921 for the same period in 2010.  Included in sales and marketing costs for the nine months ended September 30, 2011 is a charge of approximately $70,000 in connection with restricted stock granted to Sodexo for marketing services under a joint marketing agreement.  There is no similar charge in 2010.  The headcount of the sales team increased from four to eight employees during 2011 thus increasing payroll by approximately $130,000.  The increased sales effort also caused travel expenses to increase approximately $90,000 during 2011.  Sales commissions increased by approximately $70,000 due to additional sales contracts signed in 2011.
 
General and Administrative
 
General and administrative expenses include personnel costs for finance, administration, information systems, and general management, as well as facilities expenses, professional fees, legal expenses and other administrative costs.  General and administrative expenses increased by $278,080 to $2,451,121 for the nine months ended September 30, 2011, as compared to $2,173,041 for the same period in 2010.  Salary expense increased approximately $60,000 in 2011 primarily due to job transfers of two employees to administrative roles from operations and adding an accounting manager.  Legal fees in 2011 increased approximately $100,000 in connection with statutory filings and drafting our stock option plan.  Investor relations fees paid increased to $170,000 in 2011 from $50,000 in 2010.  Other consulting fees in 2011 include approximately $170,000 paid to prepare operational training manuals, while 2010 consulting fees included approximately $50,000 paid for an organizational assessment.  Depreciation expense decreased approximately $120,000 in 2011 as certain fixed assets became fully depreciated in the fourth quarter of 2010.
 
Other Income (Expense)
 
Interest expense for the nine months ended September 30, 2011 was $72,458, compared to $3,949 for the same period in 2010.  The increase is a result of the convertible debt borrowing consummated in July 2011.  Interest income is primarily derived from short-term interest-bearing securities and money market accounts.  Interest income for the nine months ended September 30, 2011 was $1,611, as compared to $604 for the same period in 2010, primarily due to nominal interest rates for invested cash.  The change in fair value of derivative liabilities was a result of a convertible debt offering which first occurred in 2011, thus there was no similar activity in 2010.
 


 
Income Tax Expense
 
Income tax expense for the nine months ended September 30, 2011 of $2,400 represents the minimum amount due for state filing purposes.  Income tax expense for the nine months ended September 30, 2010 of $2,400 also represents the minimum amount due for state filing purposes.
 
LIQUIDITY AND CAPITAL RESOURCES
 
As of September 30, 2011, our cash and cash equivalents were $2,054,989 and our working capital was $1,357,538.  Our principal cash requirements are for operating expenses, including equipment, supplies, employee costs, and capital expenditures and funding of the operations.  Our primary sources of cash are service and equipment sale revenues, convertible debt offerings, exercising of warrants and the sale of common stock.
 
During the nine months ended September 30, 2011, our cash used for operating activities amounted to $1,818,536, as compared to cash used for operating activities of $539,602 for the same period in 2010.  The difference in cash from operating activities was primarily due to the costs incurred to implement our new recurring revenue contracts, more aggressive sales and marketing effort to obtain new clients and legal and consulting fees in connection with the development of operational training tools, statutory filings, the drafting and adoption of the new stock incentive plan and investor relations.
 
We have and expect to continue to close additional recurring revenue contracts to new customers throughout 2011.  Since we expect higher cost of revenues at the start of our engagement with most new customers, we may seek additional financing, which may include debt and/or equity financing or funding through third party agreements.  In July 2011, we closed on a private offering of secured convertible notes and warrants with gross proceeds of $1,850,000.  There can be no assurance that any additional financing will be available on acceptable terms, if at all.  Any equity financing may result in dilution to existing stockholders and any debt financing may include restrictive covenants.  Management believes that cash generated from debt and/or equity financing arrangements along with funds from operations will be sufficient to sustain our business operations over the next twelve months.
 
OFF-BALANCE SHEET ARRANGEMENTS
 
Our off-balance sheet arrangements consist primarily of conventional operating leases, purchase commitments and other commitments arising in the normal course of business, as further discussed below under “Contractual Obligations and Commercial Commitments.” As of September 30, 2011, we did not have any other relationships with unconsolidated entities or financial partners, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
 
CONTRACTUAL OBLIGATIONS AND CONTINGENT LIABILITIES AND COMMITMENTS
 
As of September 30, 2011, expected future cash payments related to contractual obligations and commercial commitments were as follows:
 
   
Payments Due by Period
 
   
Total
   
Less than
1 year
   
1-3 years
   
3-5 years
   
More than 5 years
 
Convertible notes
  $ 2,294,000     $ 135,667     $ 2,158,333     $ -     $ -  
Capital leases
    123,187       62,967       60,220       -       -  
Operating leases
    646,915       155,587       323,458       167,870       -  
Total
  $ 3,064,102     $ 354,221     $ 2,542,011     $ 167,870     $ -  




 
As a “smaller reporting company” as defined by Rule 229.10(f)(1), we are not required to provide the information required by this Item 3.
 
ITEM 4.    CONTROLS AND PROCEDURES.
 
We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15(d)-15(e) under the Exchange Act) that are designed to ensure that information required to be disclosed in our reports under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure.
 
We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934), as of the end of the period covered by this Quarterly Report.  Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including each of such officers as appropriate to allow timely decisions regarding required disclosure.
 
No change in our internal control over financial reporting occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
 
 
ITEM 1A.    RISK FACTORS.
 
Investing in our common stock involves a high degree of risk.  You should carefully consider the following risk factors, which have been updated from the disclosure provided under the caption "Risk Factors" included in our Annual Report on Form 10-K for the year ended December 31, 2010, any updates to such risks described in our subsequently filed Quarterly Reports on Form 10-Q, as well as the other information contained in our Annual Report on Form 10-K for the year ended December 31, 2010, our Quarterly Reports on Form 10-Q, and our other filings with the SEC, before investing in our common stock. If any of the described risks actually occur, our business, financial condition, operating results and prospects could suffer. In any such case, the trading price of our common stock could decline, and you might lose all or part of your investment in our common stock. The risks described in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2010 are not the only risks we face. Additional risks that we face and uncertainties not presently known to us or that we currently deem immaterial may also impair our business, financial condition and operating results.
 
WE FACE SUBSTANTIAL COMPETITION FROM BETTER ESTABLISHED COMPANIES THAT MAY HAVE SIGNIFICANTLY GREATER RESOURCES WHICH COULD LEAD TO REDUCED SALES OF OUR PRODUCTS AND SERVICES.
 
The market for our products and services is competitive and is likely to become even more competitive in the future.  Increased competition could result in pricing pressures, reduced sales, reduced margins or the failure of our products and services to achieve or maintain market acceptance, any of which would have a material adverse effect on our business, results of operations and financial condition.  Many of our current and potential competitors enjoy substantial competitive advantages, such as:
 
·  
greater name recognition and larger marketing budgets and resources;
 

 
·  
established marketing relationships and access to larger customer bases;
 
·  
substantially greater financial, technical and other resources; and
 
·  
larger technical and support staffs.
 
As a result, our competitors may be able to respond more quickly than us to new or changing opportunities, technologies, standards or customer requirements.  For all of the foregoing reasons, we may not be able to compete successfully against our current and future competitors.
 
RISKS RELATED TO OUR BUSINESS
 
WE ARE DEPENDENT UPON OUR VENDORS TO CONTINUE SUPPLYING US WITH EQUIPMENT, PARTS, SUPPLIES, AND SERVICES AT COMPARABLE TERMS AND PRICE LEVELS AS OUR BUSINESS GROWS.
 
Our access to equipment, parts, supplies, and services depends upon our relationships with, and our ability to purchase these items on competitive terms from, our principal vendors.  We do not enter into long-term supply contracts with these vendors and we have no current plans to do so in the future.  These vendors are not required to use us to distribute their equipment and are free to change the prices and other terms at which they sell to us.  In addition, we compete with the selling efforts of some of these vendors.  Significant deterioration in relationships with, or in the financial condition of, these significant vendors could have an adverse impact on our ability to sell and lease equipment as well as our ability to provide effective service and technical support.  If one of these vendors terminates or significantly curtails its relationship with us, or if one of these vendors ceases operations, we would be forced to expand our relationships with our existing vendors or seek out new relationships with previously-unused vendors.
 
WE ARE DEPENDENT UPON OUR LARGEST CUSTOMERS.
 
The loss of any key customer could have a material adverse effect upon our financial condition, business, prospects and results of operation.  Our two largest customers represent approximately 40% of our revenues for the nine months ended September 30, 2011.  The loss of these customers may contribute to our inability to operate as a going concern and may require us to obtain additional equity funding or debt financing to continue our operations.  We cannot be certain that we will be able to obtain such additional financing on commercially reasonable terms, or at all.
 
WE MAY BE UNABLE TO RECRUIT AND RETAIN OUR SENIOR MANAGEMENT AND OTHER KEY PERSONNEL ON WHOM WE ARE DEPENDENT.
 
We are highly dependent upon senior management and key personnel, and we do not carry any insurance policies on such persons.  In particular, we are highly dependent upon Joseph J. Flynn, our Chief Executive Officer, and Paul T. Anthony, our Chief Financial Officer.  The loss of any member of our senior management, or our inability to attract, retain and motivate the additional highly-skilled employees and consultants that our business requires, could substantially hurt our business, prospects, financial condition and results of operations.  In addition, we rely on the ability of our management team to work together effectively.  If our management team fails to work together effectively, our business could be harmed.
 
THE MARKET MAY NOT ACCEPT OUR PRODUCTS AND SERVICES AND WE MAY NOT BE ABLE TO CONTINUE OUR BUSINESS OPERATIONS; OR, IF THE MARKET IS RECEPTIVE TO OUR PRODUCTS BUT NOT OUR SERVICES, OUR REVENUES AND PROFITABILITY WILL BE HARMED.
 
Our products and services are targeted to the healthcare market, a market in which there are many competing service providers.  Accordingly, the demand for our products and services is very uncertain.  The market may not accept our products and services. Even if our products and services achieve market acceptance, our products and services may fail to address the market’s requirements adequately.
 


 
In addition, if we are able to sell our products but are unable to provide ongoing services, our revenues and profitability will be harmed.  Our services are integral to the successful deployment of our solutions.  If we do not effectively service and support our customers, our revenues and operating results would be harmed.
 
WE MAY NEED ADDITIONAL CAPITAL IN THE FUTURE AND, IF SUCH CAPITAL IS NOT AVAILABLE ON TERMS ACCEPTABLE TO US OR AVAILABLE TO US AT ALL, WE MAY BE UNABLE TO CONTINUE OUR BUSINESS OPERATIONS.
 
We may need capital in the future to continue our business operations or to expand.  If we need capital, we cannot be certain that it will be available on terms acceptable to us or available to us at all.  In the event we need to raise capital, we may not be able to:
 
·  
develop or enhance our service offerings;
 
·  
take advantage of future opportunities; or
 
·  
respond to customers and competition.
 
If we cannot obtain additional capital and continue or expand our business, we may be unable to effectively compete in our industry.
 
WE MAY NOT BE ABLE TO MAINTAIN OUR CURRENT RATE OF GROWTH AND, AS A RESULT, OUR PROFITABILITY MAY SUFFER.
 
To continue to be successful, we may need to implement additional management information systems, develop further our operating, administrative, financial and accounting systems and controls and maintain close coordination among our executive, finance, marketing, sales and operations organizations.  Any failure to maintain our current rate of growth may result in a decline of our profitability.
 
RISKS RELATED TO THE MARKET FOR OUR SECURITIES
 
BECAUSE THE PUBLIC MARKET FOR SHARES OF OUR COMMON STOCK IS LIMITED, SHAREHOLDERS MAY BE UNABLE TO RESELL THEIR SHARES OF COMMON STOCK.
 
Currently, there is only a limited public market for our Common Stock on the OTCBB and our shareholders may be unable to resell their shares of Common Stock.  Currently, the average daily trading volume of our Common Stock is not significant, and it may be more difficult for you to sell your shares in the future, if at all.
 
The development of an active trading market depends upon the existence of willing buyers and sellers who are able to sell shares of our Common Stock as well as market makers willing to create a market in such shares.  Under these circumstances, the market bid and ask prices for the shares may be significantly influenced by the decisions of the market makers to buy or sell the shares for their own account.  Such decisions of the market makers may be critical for the establishment and maintenance of a liquid public market in our Common Stock.  Market makers are not required to maintain a continuous two-sided market and are free to withdraw quotations at any time.  We cannot assure our stockholders that an active public trading market for our Common Stock will develop or be sustained.
 
OUR STOCK PRICE MAY BE VOLATILE AND OUR COMMON STOCK COULD DECLINE IN VALUE, RESULTING IN LOSS TO OUR SHAREHOLDERS.
 
The market for our Common Stock is volatile, having ranged in the last twelve months from a low of $0.52 to a high of $1.25 on the OTCBB.  The market price for our Common Stock has been, and is likely to continue to be, volatile. The following factors may cause significant fluctuations in the market price of shares of our Common Stock:
 

 
 
·  
fluctuations in our quarterly revenues and earnings or those of our competitors;
 
·  
variations in our operating results compared to levels expected by the investment community;
 
·  
announcements concerning us or our competitors;
 
·  
announcements of technological innovations;
 
·  
sale of shares or short-selling efforts by traders or other investors;
 
·  
market conditions in the industry; and
 
·  
the conditions of the securities markets.
 
The factors discussed above may depress or cause volatility of our share price, regardless of our actual operating results.  In addition, the highly volatile nature of our stock price may cause investment losses for our stockholders.  In the past, securities class action litigation has often been brought against companies following periods of volatility in the market price of their securities.  If securities class action litigation is brought against us, such litigation could result in substantial costs while diverting management’s attention and resources.
 
THERE ARE A LARGE NUMBER OF SHARES OF COMMON STOCK THAT MAY BE ISSUED OR SOLD, AND IF SUCH SHARES ARE ISSUED OR SOLD, THE MARKET PRICE OF OUR COMMON STOCK MAY DECLINE.
 
As of September 30, 2011, approximately 19,403,318 shares of our Common Stock were outstanding.
 
If all warrants and options outstanding as of September 30, 2011 are exercised prior to their expiration, up to approximately 9.4 million additional shares of Common Stock could become freely tradable.  Such sales of substantial amounts of Common Stock in the public market could adversely affect the prevailing market price of our Common Stock and could also make it more difficult for us to raise funds through future offerings of Common Stock.
 
FUTURE SALES OF RESTRICTED STOCK COULD ADVERSELY AFFECT THE PRICE OF OUR COMMON STOCK AND OUR ABILITY TO OBTAIN ADDITIONAL FINANCING.
 
Although our Common Stock is currently quoted on the OTCBB, the volume of trading of our Common Stock and the number of shares in the public float are small.  Sales of a substantial number of shares of our Common Stock into the public market in the future could materially adversely affect the prevailing market price of our Common Stock.  During the year ended December 31, 2009, we sold 1,416,667 shares of our Common Stock to finance our operations.  Such a large “over-hang” of stock eligible for sale in the public market may have the effect of depressing the market price of our Common Stock, and make it difficult for us to obtain debt or equity financing, if we are able to obtain such financing at all.
 
IF OUR COMMON STOCK IS DETERMINED TO BE A “PENNY STOCK,” A BROKER-DEALER MAY FIND IT MORE DIFFICULT TO TRADE OUR COMMON STOCK AND AN INVESTOR MAY FIND IT MORE DIFFICULT TO ACQUIRE OR DISPOSE OF OUR COMMON STOCK IN THE SECONDARY MARKET.
 
Our Common Stock may be subject to the so-called “penny stock” rules.  The SEC has adopted regulations that define a “penny stock” to be any equity security that has a market price per share of less than $5.00, subject to certain exceptions, such as any securities listed on a national securities exchange.  For any transaction involving a “penny stock,” unless exempt, the rules impose additional sales practice requirements on broker-dealers, subject to certain exceptions. If our Common Stock is determined to be a “penny stock,” a broker-dealer may find it more difficult to trade our common stock and an investor may find it more difficult to acquire or dispose of our common stock on the secondary market.
 


 
WE DO NOT INTEND TO PAY DIVIDENDS.
 
We have never declared or paid any cash dividends on our Common Stock.  We do not anticipate paying dividends on our Common Stock in the foreseeable future.  We may not have sufficient funds to legally pay dividends.  Even if funds are legally available to pay dividends, we may nevertheless decide in our sole discretion not to pay dividends and to retain any future earnings to fund growth.
 
OTHER RISKS
 
IT MAY BE DIFFICULT FOR A THIRD PARTY TO ACQUIRE US EVEN IF DOING SO WOULD BE BENEFICIAL TO OUR SHAREHOLDERS.
 
Some provisions of our Articles of Incorporation, as amended, and Bylaws, as well as some provisions of Nevada or California law, may discourage, delay or prevent third parties from acquiring us, even if doing so would be beneficial to our shareholders.
 
AS A PUBLIC COMPANY, WE ARE SUBJECT TO COMPLEX LEGAL AND ACCOUNTING REQUIREMENTS THAT WILL REQUIRE US TO INCUR SIGNIFICANT EXPENSES.
 
As a public company, we are subject to numerous legal and accounting requirements that do not apply to private companies.  The cost of compliance with many of these requirements is material, not only in absolute terms but, more importantly, in relation to the overall scope of the operations of a small company.  The cost of such compliance may prove to be a substantial competitive disadvantage vis-à-vis our privately held and larger public competitors.
 
THE IMPACT OF THE DETERIORATION OF THE GLOBAL CREDIT MARKETS, FINANCIAL SERVICES INDUSTRY AND U.S. ECONOMY MAY CONTINUE TO NEGATIVELY AFFECT OUR BUSINESS AND OUR ABILITY TO OBTAIN CAPITAL, IF NEEDED.
 
The deterioration in the global credit markets, the financial services industry and the U.S. economy as a whole have resulted in a period of substantial turmoil and uncertainty characterized by unprecedented intervention by the United States federal government and the failure, bankruptcy, or sale of various financial and other institutions.  The impact of these events on our business and the severity of the current economic crisis is uncertain.  It is possible that the current crisis in the global credit markets, the financial services industry and the U.S. economy may adversely affect our business, vendors and prospects as well as our liquidity and financial condition.  As a result no assurances can be given as to our ability to increase our customer base and generate positive cash flows.  Although we have been able to raise additional working capital through convertible note agreements and private placement offerings of our common stock, we may not be able to continue this practice in the future or we may not be able to obtain additional working capital through other debt or equity financings.  In the event that sufficient capital cannot be obtained, we may be forced to significantly reduce operating expenses to a point that would be detrimental to our business operations and business development activities.  These courses of action may be detrimental our business prospects and result in material charges to our operations and financial position.  In the event that any future financing should take the form of the sale of equity securities, the current equity holders may experience dilution of their investments.
 
 
None.
 


 
No.
Item
31.1
Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.
31.2
Certification  of the Chief Financial Officer  pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.
32.1*
Certification of the CEO and CFO pursuant to Rule 13a-14(b) and Rule 15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350.
101**
Interactive Data File

* In accordance with Item 601(b)(32)(ii) of Regulation S-K, this exhibit shall not be deemed “filed” for the purposes of Section 18 of the Securities and Exchange Act of 1934 or otherwise subject to the liability of that section, nor shall it be deemed incorporated by reference in any filing under the Securities Act or the Securities Exchange Act of 1934.
 
** Pursuant to Rule 406T of Regulation S-T, this XBRL information will not be deemed “filed” for the purpose of Section 18 of the Securities Exchange Act of 1934 or otherwise subject to the liability of that section, nor will it be deemed filed or made a part of a registration statement or prospectus for purposes of Sections 11 and 12 of the Securities Act of 1933, or otherwise subject to liability under those sections.
 


 
SIGNATURES
 
In accordance with the requirements of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
AUXILIO, INC.
 
       
Date: November 14, 2011
By:
/s/ Joseph J. Flynn  
   
Joseph J. Flynn
 
   
Chief Executive Officer
 
    (Principal Executive Officer)  

     
       
Date: November 14, 2011
By:
/s/ Paul T. Anthony  
   
Paul T. Anthony
 
   
Chief Financial Officer
 
    (Principal Accounting Officer)  
 

 
25