10-Q 1 form10-q.htm

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2018

 

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

 

For the transition period from ______________to _______________ .

 

001-32146

 

Commission file number

 

 

 

DOCUMENT SECURITY SYSTEMS, INC.

 

(Exact name of registrant as specified in its charter)

 

New York   16-1229730

(State or other Jurisdiction of

incorporation- or Organization)

  

(IRS Employer

Identification No.)

 

200 Canal View Boulevard, Suite 300

Rochester, NY 14623

 

(Address of principal executive offices)

 

(585) 325-3610

 

(Registrant’s telephone number, including area code)

 

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

 

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

 

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

 

Large accelerated filer [  ] Accelerated filer [  ] Non-accelerated filer (Do not check if a smaller reporting company) [  ]

Smaller reporting company [X] Emerging growth company [  ]  

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [  ]

 

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

 

As of November 14, 2018, there were 16,813,613 shares of the registrant’s common stock, $0.02 par value, outstanding.

 

 

 

   
 

 

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

 

PART I   FINANCIAL INFORMATION  
Item 1   Financial Statements 3
    Condensed Consolidated Balance Sheets as of September 30, 2018 (Unaudited) and December 31, 2017 3
    Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the three and nine months ended September 30, 2018 and 2017 (Unaudited) 4
    Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2018 and 2017 (Unaudited) 5
    Notes to Interim Condensed Consolidated Financial Statements (Unaudited) 6
Item 2   Management’s Discussion and Analysis of Financial Condition and Results of Operations 22
Item 4   Controls and Procedures 26
       
PART II   OTHER INFORMATION  

Item 1

  

Legal Proceedings

 27
Item 1A   Risk Factors 27
Item 2   Unregistered Sales of Equity Securities and Use of Proceeds 27
Item 3   Defaults upon Senior Securities 27
Item 4   Mine Safety Disclosures 27
Item 5   Other Information 28

Item 6

  

Exhibits

 28
Signatures 29

 

 2 
 

 

PART I – FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS

 

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

As of

 

   September 30, 2018   December 31, 2017 
  (unaudited)     
ASSETS        
Current assets:          
Cash  $2,051,800   $4,188,623 
Restricted cash   6,180    256,005 
Accounts receivable, net of $50,000 allowance for doubtful accounts    1,917,576    2,025,284 
Inventory   1,942,575    1,651,246 
Prepaid expenses and other current assets   309,755    261,324 
Total current assets   6,227,886    8,382,482 
           
Property, plant and equipment, net   4,736,113    4,805,640 
Investment   484,930    484,930 
Other assets   90,320    83,376 
Goodwill   2,453,597    2,453,597 
Other intangible assets, net   842,385    1,220,752 
           
Total assets  $14,835,231   $17,430,777 
           
LIABILITIES AND STOCKHOLDERS’ EQUITY          
           
Current liabilities:          
Accounts payable  $1,491,058   $728,652 
Accrued expenses and deferred revenue   831,689    1,105,718 
Other current liabilities   2,295,681    2,953,629 
Short-term debt   -    3,645,760 
Current portion of long-term debt, net   796,734    966,506 
           
Total current liabilities   5,415,162    9,400,265 
           
Long-term debt, net   1,354,264    1,734,171 
Other long-term liabilities   582,653    1,384,500 
Deferred tax liability, net   125,982    125,982 
           
Commitments and contingencies (Note 8)          
           
Stockholders’ equity          
Common stock, $.02 par value; 200,000,000 shares authorized, 16,813,613 shares issued and outstanding (16,599,327 on December 31, 2017)   336,272    331,987 
Additional paid-in capital   107,024,040    106,633,708 
Subscription receivable, net   -    (300,000)
Accumulated other comprehensive loss   (5,675)   (23,069)
Accumulated deficit   (99,997,467)   (101,856,767)
Total stockholders’ equity   7,357,170    4,785,859 
           
Total liabilities and stockholders’ equity  $14,835,231   $17,430,777 

 

See accompanying notes to the condensed consolidated financial statements.

 

 3 
 

 

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

Consolidated Statements of Operations and Comprehensive Income (Loss)

(unaudited)

 

   For the Three Months Ended
September 30,		   For the Nine Months Ended
September 30,		 
   2018   2017   2018   2017 
                 
Revenue:                    
Printed products  $3,783,779   $3,767,334   $11,432,038   $11,552,955 
Technology sales, services and licensing   310,511    431,356    1,126,867    1,276,489 
                     
Total revenue   4,094,290    4,198,690    12,558,905    12,829,444 
                     
Costs and expenses:                    
Cost of revenue, exclusive of depreciation and amortization   2,551,782    2,400,883    7,889,844    7,380,134 
Selling, general and administrative (including stock based compensation)   1,610,831    1,619,066    5,195,495    4,835,079 
Depreciation and amortization   310,330    352,040    1,002,813    1,041,789 
                     
Total costs and expenses   4,472,943    4,371,989    14,088,152    13,257,002 
                     
Operating loss   (378,653)   (173,299)   (1,529,247)   (427,558)
                     
Other income (expense):                    
Interest income   2,308    -    8,415    - 
Interest expense   (29,554)   (58,164)   (112,460)   (170,565)
Amortization of deferred financing costs and debt discount   (6,168)   (40,854)   (40,067)   (113,286)
Gain on extinguishment of liabilities, net   -    -    3,532,659    - 
Income (loss) before income taxes   (412,067)   (272,317)   1,859,300    (711,409)
                     
Income tax expense   -    4,734    -    14,208 
                     
Net income (loss)  $(412,067)  $(277,051)  $1,859,300   $(725,617)
                     
Other comprehensive income (loss):                    
Foreign currency translation adjustment   (5,088)   -    (5,088)   - 
Interest rate swap gain (loss)   (4,458)   3,943    17,394    9,792 
                     
Comprehensive income (loss):  $(421,613)  $(273,108)  $1,871,606   $(715,825)
                     
Income (loss) per common share:                    
Basic  $(0.02)  $(0.02)  $0.11   $(0.05)
Diluted  $(0.02)  $(0.02)  $0.11   $(0.05)
                     
Shares used in computing income (loss) per common share:                    
Basic   16,767,992    14,087,849    16,662,907    13,793,946 
Diluted   16,767,992    14,087,849    16,930,812    13,793,946 

 

See accompanying notes to condensed consolidated financial statements.

 

 4 
 

 

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

For the Nine Months Ended September 30,

(unaudited)

 

   2018   2017 
         
Cash flows from operating activities:          
Net income (loss)  $1,859,300   $(725,617)
Adjustments to reconcile net income (loss) to net cash used by operating activities:          
Depreciation and amortization   1,002,813    1,041,789 
Stock based compensation   106,617    203,111 
Paid in-kind interest   12,000    54,000 
Change in deferred tax provision   -    14,211 
Amortization of deferred financing costs and debt discount   40,067    113,286 
Gain on extinguishment of liabilities, net   (3,532,659)   - 
Decrease (increase) in assets:          
Accounts receivable   107,708    91,976 
Inventory   (291,329)   (706,735)
Prepaid expenses and other current assets   (55,374)   70,838 
Increase (decrease) in liabilities:          
Accounts payable   762,404    (506,749)
Accrued expenses   (394,170)   (268,082)
Other liabilities   (1,141,929)   (599,620)
Net cash used by operating activities   (1,524,552)   (1,217,592)
           
Cash flows from investing activities:          
Purchase of property, plant and equipment   (526,251)   (438,350)
Purchase of intangible assets   (45,471)   (4,903)
Net cash used by investing activities   (571,722)   (443,253)
           
Cash flows from financing activities:          
Payments of long-term debt   (966,077)   (612,419)
Borrowings from equipment line of credit   87,703    - 
Issuances of common stock, net of issuance costs   300,000    783,094 
Subscription receivable, net   288,000    - 
Net cash (used) provided by financing activities   (290,374)   170,675 
           
Net decrease in cash   (2,386,648)   (1,490,170)
Cash and restricted cash at beginning of period   4,444,628    6,049,347 
           
Cash and restricted cash at end of period  $2,057,980   $4,559,177 

 

See accompanying notes to the condensed consolidated financial statements.

 

 5 
 

 

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

 

1.Basis of Presentation and Significant Accounting Policies

 

Document Security Systems, Inc. (the “Company”), through two of its subsidiaries, Premier Packaging Corporation and Plastic Printing Professionals, Inc., which operates under the assumed name of DSS Plastics Group, operates in the security and commercial printing, packaging and plastic ID markets. The Company develops, markets, manufactures and sells paper and plastic products designed to protect valuable information from unauthorized scanning, copying, and digital imaging. The Company’s subsidiary, DSS Digital Inc., which operates under the assumed name of DSS Digital Group, develops, markets and sells digital product authentication solutions and digital information services. The Company and its subsidiary, DSS Technology Management, Inc., also acquires intellectual property (“IP”) assets for the purpose of monetizing these assets through a variety of value-enhancing initiatives, including, but not limited to, investments in the development and commercialization of patented technologies, licensing, strategic partnerships and commercial litigation. In addition, in January 2018, the Company commenced international operations with its wholly owned subsidiary, DSS International Inc., in its Hong Kong office.

 

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

 

Interim results are not necessarily indicative of results expected for the full year. For further information regarding the Company’s accounting policies, refer to the audited consolidated financial statements and footnotes thereto included in the Company’s Form 10-K for the fiscal year ended December 31, 2017.

 

Principles of Consolidation - The consolidated financial statements include the accounts of Document Security Systems and its subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.

 

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

 

Restricted Cash – As of September 30, 2018, cash of $6,180 ($256,005 – December 31, 2017) is restricted by a third-party co-investor to payments of costs and expenses associated with one of the Company’s IP monetization programs. For purposes of the statement of cash flow, cash and restricted cash are combined. The break out of these amounts by period are as follows:

 

   September 30, 2018   December 31, 2017   September 30, 2017   December 31, 2016 
Cash  $2,051,800   $4,188,623   $4,223,005   $5,871,738 
Restricted Cash   6,180    256,005    336,172    177,609 
Total  $2,057,980   $4,444,628   $4,559,177   $6,049,347 

 

Investment – In accordance with ASC 325-20, the Company records its investment in common stock of Singapore eDevelopment Limited at cost as the fair market value of the investment is not readily determinable. The Company evaluates investment for indications of impairment at least annually.

 

 6 
 

 

Fair Value of Financial Instruments - Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Fair Value Measurement Topic of the FASB ASC establishes a three-tier fair value hierarchy which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers include:

 

● Level 1, defined as observable inputs such as quoted prices for identical instruments in active markets;
   
● Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and
   
● Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.

 

The carrying amounts reported in the balance sheet of cash, accounts receivable, prepaids, accounts payable and accrued expenses approximate fair value because of the immediate or short-term maturity of these financial instruments. The fair value of revolving credit lines, promissory notes and long-term debt approximates their carrying value as the stated or discounted rates of the debt reflect recent market conditions. Derivative instruments, as discussed below, are recorded as assets and liabilities at estimated fair value based on available market information.

 

Derivative Instruments - The Company maintains an overall interest rate risk management strategy that incorporates the use of interest rate swap contracts to minimize significant fluctuations in earnings that are caused by interest rate volatility. The Company has an interest rate swap that changes variable rates into fixed rates on one Citizens Bank term loan relating to the Company’s subsidiary, Premier Packaging. This swap qualifies as a Level 2 fair value financial instrument. This swap agreement is not held for trading purposes and the Company does not intend to sell this derivative swap financial instrument. The Company records the interest swap agreement on the balance sheet at fair value because the agreement qualifies as a cash flow hedge under accounting principles generally accepted in the United States of America. Gains and losses on these instruments are recorded in other comprehensive loss until the underlying transaction is recorded in earnings. When the hedged item is realized, gains or losses are reclassified from accumulated other comprehensive loss (“AOCI”) to the consolidated statement of operations on the same line item as the underlying transaction. The valuations of the interest rate swaps have been derived from proprietary models of Citizens Bank, N.A. based upon recognized financial principles and reasonable estimates about relevant future market conditions and may reflect certain other financial factors such as anticipated profit or hedging, transactional, and other costs. The notional amounts of the swaps decrease over the life of the agreements. The Company is exposed to a credit loss in the event of nonperformance by the counter parties to the interest rate swap agreements. However, the Company does not anticipate non-performance by the counter parties. The cumulative net loss attributable to this cash flow hedge recorded in accumulated other comprehensive loss and other liabilities as of September 30, 2018 was approximately $1,000 ($23,000 - December 31, 2017).

 

As of September 30, 2018, the Company has an interest rate swap agreement for its debt with RBS Citizens, N.A. (“Citizens Bank”) (see Note 6) which changes a variable rate into a fixed rate on a term loan as follows:

 

Amount   Amount   Cost   Date
$880,374    5.26%   5.87%  August 30, 2021

 

Impairment of Long-Lived Assets and Goodwill - Long-lived and intangible assets and goodwill are assessed for potential impairment whenever events or changes in circumstances indicate that full recoverability of net asset balances through future cash flows is in question. Goodwill and indefinite-lived intangible assets are assessed at least annually, but also whenever events or changes in circumstances indicate the carrying values may not be recoverable. Factors that could trigger an impairment review, include (a) significant underperformance relative to historical or projected future operating results; (b) significant changes in the manner of or use of the acquired assets or the strategy for the Company’s overall business; (c) significant negative industry or economic trends; (d) significant decline in the Company’s stock price for a sustained period; and (e) a decline in the Company’s market capitalization below net book value.

 

Contingent Legal Expenses - Contingent legal fees associated with our commercial litigation involving our IP are expensed in the consolidated statements of operations in the period that the related revenues are recognized. In instances where there are no recoveries from potential infringers, no contingent legal fees are paid; however, the Company may be liable for certain out of pocket legal costs incurred pursuant to the underlying legal services agreement that will be paid out from the proceeds from settlements or licenses that arise pursuant to an enforcement action, which will be expensed as legal fees in the period in which the payment of such fees is probable. Any unamortized patent acquisition costs will be expensed in the period in which a conclusion is reached in an enforcement action that does not yield future royalties potential.

 

 7 
 

 

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

 

As of September 30, 2018, and 2017, there were 2,212,773 and 3,297,759 respectively, of common stock share equivalents potentially issuable by the Company pursuant to existing options, warrants, and restricted stock agreements, that could potentially dilute basic earnings per share in the future. For the nine months ended September 30, 2018, based on the average market price of the Company’s common stock during that period of $1.37, 267,905 common stock equivalents were added to the basic shares outstanding to calculate dilutive earnings per share. For the three months ended September 30, 2018, common stock equivalents were excluded from the calculation of diluted earnings per share as the company had a net loss, since their inclusion would have been anti-dilutive. Common stock equivalents were also excluded from the calculation of diluted earnings per share for 2017 periods presented in which the Company had a net loss, since their inclusion would have been anti-dilutive.

 

Concentration of Credit Risk - The Company maintains its cash in bank deposit accounts, which at times may exceed federally insured limits. The Company believes it is not exposed to any significant credit risk as a result of any non-performance by the financial institutions.

 

During the nine months ended September 30, 2018, two customers accounted for 24.8% and 14.7%, respectively, of the Company’s consolidated revenue and accounted for 22% and 6.6%, respectively, of the Company’s accounts receivable balance as of September 30, 2018. During the nine months ended September 30, 2017, these two customers accounted for 25% and 15%, respectively, of the Company’s consolidated revenue and accounted for 17% and 11%, respectively, of the Company’s accounts receivable balance as of September 30, 2017. The risk with respect to accounts receivables is mitigated by credit evaluations the Company performs on its customers, the short duration of its payment terms for most of its customer contracts and by the diversification of its customer base.

 

Income Taxes - The Company has approximately $42.3M in federal net operating loss carryforwards (“NOLs”) available to reduce future taxable income, which will expire at various dates from 2022 through 2036. As these NOL’s were generated prior to the enactment of H.R. 1 (“Tax Cuts and Jobs Act” or “TCJA”) they are eligible to fully offset taxable income. While the company generated taxable income due to the extinguishment of certain liabilities, it is not expected to reoccur. Therefore, due to the uncertainty as to the Company’s ability to generate sufficient taxable income in the future and utilize the NOLs before they expire, the Company has maintained a full valuation allowance against its deferred tax assets accordingly.

 

Reclassifications - Certain prior year amounts have been reclassified to conform to the current year presentation. All common share and per share figures are presented on a post one-for-four reverse stock split basis.

 

Recently Adopted Accounting Pronouncements – In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09 (Topic 606) “Revenue from Contracts with Customer” related to revenue from contracts with customers. Under this standard, revenue is recognized when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for those goods or services. The updated standard will replace most existing revenue recognition guidance under GAAP and permits the use of either the retrospective or cumulative effect transition method. Topic 606 is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. The Company adopted Topic 606 effective January 1, 2018. Topic 606 did not have a material impact on the Company’s Consolidated Financial Statements.

 

In January 2016, the FASB issued ASU No. 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities.” ASU 2016-01 requires that most equity investments be measured at fair value, with subsequent changes in fair value recognized in net income. Entities will no longer be able to use the cost method of accounting for equity securities. However, for equity investments without readily determinable fair values, entities may elect a measurement alternative that will allow those investments to be recorded at cost, less impairment, and adjusted for subsequent observable price changes. Upon adoption, entities must record a cumulative-effect adjustment to the balance sheet as of the beginning of the first reporting period in which the standard is adopted. The guidance on equity securities without readily determinable fair values will be applied prospectively to all equity investments that exist as of the date of the adoption of the standard. The pronouncement also impacts financial liabilities under the fair value option and the presentation and disclosure requirements for financial instruments. This pronouncement is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017, and early adoption is not permitted. The Company adopted this new accounting standard during the three months ended March 31, 2018. ASU 2016-01 did not have a material impact on the Company’s Consolidated Financial Statements.

 

 8 
 

 

In August 2016, the FASB issued ASU 2016-15, “Classification of Certain Cash Receipts and Cash Payments”, which clarifies the treatment of several types of cash receipts and payments for which there was diversity in practice. This update is effective for annual periods beginning after December 15, 2017, and interim periods within those fiscal years, with early adoption permitted, including adoption in an interim period. The Company adopted this standard during the three months ended March 31, 2018. The adoption did not have a material impact on the Company’s Consolidated Financial Statements.

 

In November 2016, the FASB issued ASU 2016-18, “Statement of Cash Flows”, regarding the presentation of restricted cash on the statement of cash flows. The standards update requires that the reconciliation of the beginning and end of period cash amounts shown in the statement of cash flows include restricted cash. When restricted cash is presented separately from cash and cash equivalents on the balance sheet, a reconciliation is required between the amounts presented on the statement of cash flows and the balance sheet. Also, the new guidance requires the disclosure of information about the nature of the restrictions. The Company adopted the standard as of January 1, 2018 on a retrospective basis, wherein the statement of cash flow of each period presented was adjusted to reflect the effects of applying the new guidance.

 

In May 2017, the FASB issued ASU 2017-09, “Compensation – Stock Compensation (Topic 718) – Scope of Modification Accounting”, which provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in Topic 718. ASU 2017-09 is effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years, and early adoption is permitted, including in an interim period. ASU 2017-09 is to be applied on a prospective basis to an award modified on or after the adoption date. The Company adopted this standard during the quarter ended March 31, 2018. The new accounting standard did not have a material impact on the Company’s Consolidated Financial Statements.

 

Recent Accounting Pronouncements – In February 2016, the FASB issued ASU 2016-02, “Leases”, which requires that lease arrangements longer than 12 months result in an entity recognizing an asset and liability. ASU 2016-02 is effective for interim and annual periods beginning after December 15, 2018, and early adoption is permitted. The Company has elected not to adopt this standard in advance of its required effective date. The Company anticipates the adoption of the standard will result in the recognition of additional assets and corresponding liabilities related to its leases of office and production space, but has not quantified these amounts at this time. The Company plans to adopt the standard effective January 1, 2019.

 

In January 2017, the FASB issued ASU 2017-04, “Intangibles – Goodwill and Other (Topic 350) – Simplifying the Test for Goodwill Impairment”, which eliminates the two-step process that required identification of potential impairment and a separate measure of the actual impairment. The annual assessment of goodwill impairment will be determined by using the difference between the carrying amount and the fair value of the reporting unit. The standards update are effective for goodwill impairment tests in fiscal years beginning after December 15, 2019. The Company is currently assessing the impact that adopting this new accounting standard will have on its Consolidated Financial Statements.

 

In February 2018, the FASB issued ASU 2018-03, “Technical Corrections and Improvements to Financial Instruments (Subtopic 825-10) – Recognition and Measurement of Financial Assets and Financial Liabilities”. This update was issued to clarify certain narrow aspects of guidance concerning the recognition of financial assets and liabilities established in ASU No. 2016-01, “Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities”. This includes an amendment to clarify that an entity measuring an equity security using the measurement alternative may change its measurement approach to a fair valuation method in accordance with Topic 820, Fair Value Measurement, through an irrevocable election that would apply to that security and all identical or similar investments of the same issued. The update is effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years beginning after June 15, 2018. The Company is currently assessing the impact that adopting this new accounting standard will have on its Consolidated Financial Statements. The adoption of this standard is not expected to have a material impact on the Company’s Consolidated Financial Statements.

 

 9 
 

 

In August 2018, the SEC adopted the final rule under SEC Release No. 33-10532, Disclosure Update and Simplification, amending certain disclosure requirements that were redundant, duplicative, overlapping, outdated or superseded. In addition, the amendments expanded the disclosure requirements on the analysis of stockholders’ equity for interim financial statements. Under the amendments, an analysis of changes in each caption of stockholders’ equity presented in the balance sheet must be provided in a note or separate statement. The analysis should present a reconciliation of the beginning balance to the ending balance of each period for which a statement of comprehensive income is required to be filed. This final rule is effective on November 5, 2018 and expected to be included in the Form 10-Q for the 3 months ended March 31, 2019. The Company is in the process of evaluating the impact of the final rule on its consolidated financial statements.

 

2. Revenue

 

Effective January 1, 2018, the Company adopted Topic 606 using the modified retrospective approach and applied the guidance to those contracts which were not completed as of January 1, 2018. Adoption of Topic 606 did not impact the timing of revenue recognition in the Company’s Consolidated Financial Statements for the current or prior interim or annual periods. Accordingly, no adjustments have been made to opening retained earnings or prior period amounts.

 

Revenue Recognition

 

The Company sells printed products including packaging printing and fabrication, commercial and security printing and plastic cards and badges, including cards and badges integrated with technology such as RFID and smart chips. The Company also provides information technology services and digital authentication products and services to its customers. The Company recognizes its products and services revenue based on when the title passes to the customer or when the service is completed and accepted by the customer. Revenue is measured as the amount of consideration the Company expects to receive in exchange for shipped product or service provided. Sales and other taxes billed and collected from customers are excluded from revenue. Customers, including distributors, do not have a general right of return. The Company also derives revenue from royalties from third parties which are typically based on licensees’ net sales of products that utilize the Company’s technology, or on a per item usage of the technology on the customers’ printed products. The Company recognizes license revenue at the time it is reported by the licensee. From time to time, the Company generates license revenues through litigation settlements. For these, the Company recognizes revenue upon the execution of the agreement, when collectability is reasonably assured, or upon receipt of the minimum upfront fee for term agreement renewals, and when all other revenue recognition criteria have been met.

 

As of September 30, 2018, the Company had no unsatisfied performance obligations for contracts with an original expected duration of greater than one year. Pursuant to Topic 606, the Company has applied the practical expedient with respect to disclosure of the deferral and future expected timing of revenue recognition for transaction price allocated to remaining performance obligations. The Company elected the practical expedient allowing it to not recognize as a contract asset the commission paid to its salesforce on the sale of its products as an incremental cost of obtaining a contract with a customer but rather recognize such commission as expense when incurred as the amortization period of the asset that the Company would have otherwise recognized is one year or less.

 

Accounts Receivable

 

The Company extends credit to its customers in the normal course of business. The Company performs ongoing credit evaluations and generally do not require collateral. Payment terms are generally 30 days but up to net 60 for certain customers. Trade accounts receivable are recorded at their invoiced amounts, net of allowance for doubtful accounts. The Company evaluates the adequacy of its allowance for doubtful accounts quarterly. Accounts outstanding for longer than contractual payment terms are considered past due and are reviewed for collectability. Receivable balances are written off when collection is deemed unlikely.

 

Sales Commissions

 

Sales commissions are expensed as incurred for contracts with an expected duration of one year or less. There were no sales commissions capitalized as of September 30, 2018.

 

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Shipping and Handling Costs

 

Costs incurred by the Company related to shipping and handling are included in cost of products sold. Amounts charged to customers pertaining to these costs are reflected as revenue.

 

See Note 11 for disaggregated revenue information.

 

3. Inventory

 

Inventory consisted of the following:

 

   Inventory 
   September 30, 2018   December 31, 2017 
         
Finished Goods  $1,281,853   $965,757 
WIP   248,749    383,270 
Raw Materials   411,973    302,219 
           
   $1,942,575   $1,651,246 

 

4. Related Party Investment

 

On September 12, 2017, the Company and Hengfai Business Development Pte Ltd. (“HBD”) entered into a Securities Exchange Agreement whereby the Company agreed to issue and sell to HBD 683,000 shares of its common stock, which had a market value on that date of $484,930, in exchange for 21,196,552 ordinary shares which was 1.92% of the total outstanding common stock of SED as of December 31, 2017, and an existing three-year warrant to purchase up to 105,982,759 of ordinary shares at an exercise price of SGD$0.040 (US$0.0298) per share of Singapore eDevelopment Limited (“SED”), a company incorporated in Singapore and publicly-listed on the Singapore Exchange Limited. The SED shares and warrants were owned by HBD. One of the directors of the Company, Mr. Heng Fai Ambrose Chan, who also serves as the Chief Executive Officer of the Company’s subsidiary, DSS International Inc., is a related party to each of HBD and SED. The shares and warrants are restricted for two years after the agreement date. At the time of the investment, the cost of the investment was determined to be the fair value of the Company’s common stock issued in the transaction, which was determined to have the most readily determinable fair value. As of December 31, 2017, the Company performed its annual assessment of impairment for the SED shares and warrant. In making this assessment, the Company determined, that the SED shares, which trade on the Singapore Stock Exchange, had a market value of $900,112 and the warrant had an aggregate intrinsic value of approximately $1,343,000 based on a share price of SGD $0.057 (US$ 0.042) as of December 31, 2017. However, the Company determined that these values did not represent a readily determinable fair value due to a potential lack of liquidity of the SED shares and warrants due to a low average trading volume of the SED shares and the effect of the time restriction on the ability of the Company to sell the shares until September 17, 2019. In 2018, the Company adopted ASU No. 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities.” In accordance with ASU No. 2016-01, the Company noted that the SED share price had changed but such change, evaluated under the practicability election of ASU 2016-01, did not affect the Company’s determination that this observable price change would cause the Company to change its determination that the investment cost was the most readily determinable fair value or that such price change was an indicator of impairment. As of September 30, 2018, the SED shares had a market value of $724,330 and the warrant had an aggregate intrinsic value of approximately $539,420 based on a share price of SGD $0.047 (US$ 0.034).

 

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5. Intangible Assets

 

Intangible assets are comprised of the following:

 

      September 30, 2018   December 31, 2017 
   Useful Life  Gross Carrying Amount   Accumulated Amortization   Net Carrying Amount   Gross Carrying Amount   Accumulated Amortization   Net Carrying Amount 
                            
Acquired intangibles - customer lists and non-compete agreements  5-10 years   2,301,300    1,900,658    400,642    1,997,300    1,810,750    186,550 
Acquired intangibles - patents and patent rights      500,000    500,000    -    3,155,000    2,603,942    551,058 
Patent application costs  Varied (1)   1,168,155    726,412    441,743    1,148,017    664,873    483,144 
      $3,969,455   $3,127,070   $842,385   $6,300,317   $5,079,565   $1,220,752 

 

(1)Patent application costs are amortized over their expected useful life which is generally the remaining legal life of the patent. As of September 30, 2018, the weighted average remaining useful life of these assets in service was approximately 7 years.

 

Intangible asset amortization expense for the nine months ended September 30, 2018 amounted to $407,034 ($513,881- September 30, 2017).

 

On June 26, 2018, the Company entered into an agreement with Fortress Credit Co LLC (“Fortress”), which among other things transferred to Fortress all of the remaining economic rights to certain of the Company’s semi-conductor related patents (See Note 6). As a result, the Company wrote-off these patents which had an aggregated gross cost of $2,655,000 and a net unamortized carrying amount of $295,470 on the agreement date.

 

On July 31, 2018, the Company entered into a Non-Compete Letter Agreement (the “Agreement”) with its former President and Chief Executive Officer of its wholly owned subsidiary, Premier Packaging Corporation. The Agreement called for payments of $16,000 per month, for a period of 19 months, as consideration for the two-year non-competition and non-solicitation restrictive covenants. The Company recorded the aggregate cost of the Agreement of $304,000 as an intangible asset to be amortized over the 24-month period commencing August 1, 2018.

 

6. Short-Term and Long-Term Debt

 

Revolving Credit Lines - The Company’s subsidiary Premier Packaging Corporation (“Premier Packaging”) has a revolving credit line with Citizens Bank (“Citizens”) of up to $800,000 that bears interest at 1 Month LIBOR plus 3.75% (5.86% as of September 30, 2018) and expired on July 26, 2018. As of September 30, 2018, and December 31, 2017, the revolving line had a balance of $0.

 

On July 26, 2017, Premier Packaging entered into a Loan Agreement and accompanying Term Note Non-Revolving Line of Credit Agreement with Citizens pursuant to which Citizens agreed to lend up to $1,200,000 to permit Premier Packaging to purchase equipment from time to time that it may need for use in its business. As of September 30, 2018, and December 31, 2017, the revolving line had a balance of $0.

 

On December 1, 2017, the Company’s subsidiary Plastic Printing Professionals entered into a Loan Agreement and accompanying Term Note Non-Revolving Line of Credit Agreement with Citizens pursuant to which Citizens agreed to lend up to $800,000 to enable Plastic Printing Professionals to purchase equipment from time to time that it may need for use in its business. Advances may be made under this Equipment Acquisition Line of Credit, from time to time, from December 1, 2017 until December 1, 2018. The aggregate principal balance outstanding under the Equipment Acquisition Line of Credit bears interest at 2% above the LIBOR Advantage Rate (as defined in the agreement) (4.11% at September 30, 2018) until converted. Effective on conversion, the interest rate payable on the aggregate principal balance outstanding shall be adjusted to a fixed rate equal to 2% above Citizens’ cost of funds as determined by Citizens. Prior to conversion, interest on the outstanding principal is payable in arrears monthly. After conversion, the aggregate principal balance may be repaid in (i) up to 84 installments comprised of principal and interest for new equipment or (ii) up to 60 installments comprised of principal and interest for used equipment. An initial advance was made under the Equipment Acquisition Line of Credit on December 1, 2017, in the amount of $522,000, to fund the purchase of a used 6-color commercial press. As of September 30, 2018, the balance of the equipment line was $609,703 ($522,000 at December 31, 2017). As of the date of this report, the Company had not yet converted the $609,703 into a term note.

 

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Long-Term Debt - On May 24, 2013, the Company entered into a promissory note in the principal sum of $850,000 to purchase three printing presses that were previously leased by the Company’s wholly-owned subsidiary, Secuprint Inc., and carries an interest rate of 9% per annum. The note is secured by the assets of Company’s wholly-owned subsidiary, Secuprint Inc. Interest is payable quarterly, in arrears. The Company also issued the lender as additional consideration a five-year warrant to purchase up to 60,000 shares of the Company’s common stock at an exercise price of $3.00 per share. The warrant was valued at approximately $69,000 using the Black-Scholes-Merton option pricing model with a volatility of 60.0%, a risk-free rate of return of 0.89% and zero dividend and forfeiture estimates. In conjunction with the issuance of the warrants, the Company recorded a discount on debt of approximately $69,000 that was amortized over the original term of the note. The note was set to mature on May 24, 2014, but its maturity date was extended on May 2, 2014 to May 24, 2015 by the lender. In exchange for the extension, the Company also issued the lender as additional consideration a five-year warrant to purchase up to 40,000 shares of the Company’s common stock at an exercise price of $1.50 per share. The warrant was valued at approximately $29,000 using the Black-Scholes-Merton option pricing model with a volatility of 70.0%, a risk-free rate of return of 1.53% and zero dividend and forfeiture estimates. In conjunction with the issuance of the warrants, the Company recorded expense for modification of debt of approximately $29,000. On February 23, 2015, the Company entered into Promissory Note Amendment No. 2 to extend the maturity date to May 31, 2016 and to institute principal payments in the amount of $15,000 per month plus interest through the extended maturity date, and a balloon payment of $610,000 due on the extended maturity date. On April 12, 2016, the Company entered Promissory Note Amendment No. 3 to extend the maturity date to May 31, 2017 and change the balloon payment to $430,000 due on the extended maturity date. On May 31, 2017, the Company entered into Convertible Promissory Note Amendment No. 4 to extend the maturity date to December 31, 2018 at which point the note is scheduled to be paid in full. In exchange for the extension, the Company issued the lender as additional consideration 18,000 shares of the Company’s common stock which had a fair value of $17,640. As of September 30, 2018, the balance of the term loan was $105,000 ($325,000 at December 31, 2017).

 

Term Loan Debt - On July 19, 2013, Premier Packaging entered into an equipment loan with People’s Capital and Leasing Corp. (“People’s Capital”) for a printing press. The loan is secured by the printing press. The loan was for $1,303,900, repayable over a 60-month period which commenced when the equipment was placed in service in January 2014. The loan bears interest at 4.84% and is payable in equal monthly installments of $24,511. As of September 30, 2018, the loan had a balance of $72,943 ($286,560 at December 31, 2017).

 

On April 28, 2015, Premier Packaging entered into a term note with Citizens for $525,000, repayable over a 60-month period. The loan bears interest at 3.62% and is payable in equal monthly installments of $9,591 until April 28, 2020. Premier Packaging used the proceeds of the term note to acquire a HP Indigo 7800 Digital press. The loan is secured by the printing press. As of September 30, 2018, the loan had a balance of $176,781 ($257,007 at December 31, 2017).

 

Promissory Notes - On August 30, 2011, Premier Packaging purchased the packaging plant it occupies in Victor, New York, for $1,500,000, which was partially financed with a $1,200,000 promissory note obtained from Citizens Bank (“Promissory Note”). The Promissory Note calls for monthly payments of principal and interest in the amount of $7,658, with interest calculated as 1 Month LIBOR plus 3.15% (5.26% at September 30, 2018). Concurrently with the transaction, the Company entered into an interest rate swap agreement to lock into a 5.87% effective interest rate for the life of the loan (see Note 1. “Derivative Instruments”). The Promissory Note matures in August 2021 at which time a balloon payment of the remaining principal balance will be due. As of September 30, 2018, the Promissory Note had a balance of $880,374 ($915,107 at December 31, 2017).

 

On December 6, 2013, Premier Packaging entered into a Construction to Permanent Loan with Citizens Bank for up to $450,000 that was converted into a promissory note upon the completion and acceptance of building improvements to the Company’s packaging plant in Victor, New York. In May 2014, the Company converted the loan into a $450,000 note payable in monthly installments over a 5-year period of $2,500 plus interest calculated at a variable rate of 1 Month LIBOR plus 3.15% (5.26% at September 30, 2018), which payments commenced on July 1, 2014. The note matures in July 2019 at which time a balloon payment of the remaining principal balance of $300,000 is due. As of September 30, 2018, the note had a balance of $322,500 ($345,000 – December 31, 2017).

 

The Citizens credit facilities to each of the Company’s subsidiaries, Premier Packaging and Plastic Printing Professionals, contain various covenants including fixed charge coverage ratio, tangible net worth and current ratio covenants which are tested annually at December 31. For the year ended December 31, 2017, both Premier Packaging and Plastic Printing Professionals were in compliance with the annual covenants.

 

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Other Debt - On February 13, 2014, the Company’s subsidiary, DSS Technology Management, Inc. (“DSS Technology Management” or “DSSTM”), entered into an Investment Agreement (the “Agreement”) dated February 13, 2014 (the “Effective Date”) with Fortress Credit Co LLC, as collateral agent (the “Collateral Agent” or “Fortress”), and certain investors (the “Investors”), pursuant to which DSSTM contracted to receive a series of advances up to $4,500,000 (collectively, the “Advances”). Under the terms of the Agreement, on the Effective Date, DSSTM issued and sold a promissory note in the amount of $1,791,000, fixed return equity interests in the amount of $199,000, and contingent equity interests in the amount of $10,000, to each of the Investors, and in return received $2,000,000 in proceeds. To secure the Advances, DSSTM placed a lien in favor of the Investors on ten semi-conductor patents (the “Patents”) and assigned to the Investors certain funds recoverable from successful patent litigation involving these Patents, including settlement payments, license fees and royalties on the Patents. DSSTM is a plaintiff in various ongoing patent infringement lawsuits involving certain of the Patents.

 

On March 27, 2014, DSSTM received an additional $1,000,000 under the Agreement comprised of a promissory note for $900,000 and fixed and contingent equity interests of $100,000. On September 5, 2014, DSSTM received the remaining $1,500,000 under the Agreement comprised of a promissory note for $1,350,000 and fixed and contingent return interests of $150,000. On May 23, 2016, DSSTM remitted $495,000 in proceeds received from the sale of patent assets (Note 5) to Fortress under the terms of the Agreement. On September 20, 2016, DSSTM remitted $125,250 in proceeds received from a settlement to Fortress as repayment of the note principal balance under the terms of the Agreement.

 

The Agreement defined certain events as Events of Default, one of which is the failure by DSSTM, on or before the second anniversary of the Effective Date, to make payments to the Investors equal to the outstanding Advances. On February 13, 2016, being the second anniversary date of the Effective Date, DSSTM had failed to make these payments and was therefore in default of the Agreement. On December 2, 2016, the parties entered into a First Amendment to Investment Agreement and Certain Other Documents (the “Amendment”). The purpose of the Amendment was to vacate DSSTM’s ongoing non-payment default under the Agreement, and to amend certain provisions of the Agreement.

 

The Agreement also was amended to add expenses in the amount of $150,000 to DSSTM’s payment obligation, payable on the Maturity Date. This amount was recorded as debt issuance costs and was being amortized on a straight-line basis through the amended maturity date of February 13, 2018. The Amendment added a provision whereby DSSTM was required to deposit $300,000 on or before March 2, 2017 and (ii) a further sum of $300,000 on or before March 2, 2018, into a deposit account (collectively, the “Deposit”). The March 2, 2017 and March 2, 2018 deposits were made in a timely manner. The Deposit funds were restricted to pay certain expenses, consisting of out-of-pocket expenses incurred in connection with certain existing patent litigation matters and other patent litigation matters which may occur after the Amendment Effective Date (the “Qualified Expenses”). In the Event of Default, the Investors would apply the then remaining Deposit to the then outstanding Obligations, if any.

 

Additionally per the Amendment, DSSTM agreed to pay to the Investors an amount equal to 25% of any amounts received by DSSTM for any and all types of monetization activities related to certain of its patents covering systems and methods of using low power wireless peripheral devices (collectively, “BlueTooth Patents”), but only until the Investors have received payments under the Agreement totaling the sum of (i) the Capitalized Expenses plus (ii) payments of principal and interest on the Notes totaling the sum of (x) $4,500,000 (consisting of the previously made Advances) plus (y) additional amounts, if any, advanced by the Investors pursuant to the Agreement. In addition to the monetization interest granted the Investors in the BlueTooth Patents, DSSTM also granted the Collateral Agent and the Investors a security interest in certain of DSSTM’s unencumbered semiconductor patents to further collateralize the amounts owed under the Agreement.

 

As of February 13, 2018, DSSTM had made aggregate principal payments of $794,283 on the notes. On February 13, 2018, the Maturity Date, DSS Technology Management defaulted by failing to pay the investors an amount equal to (x) two times the aggregate amount of all advances made by the investors as of such date plus (y) the Capitalized Expenses. The sole recourse available to the investors under the Agreement, as amended, was the establishment of a special purpose entity controlled by the investors which would take ownership of the collateral consisting of the patents covered under the amended Agreement. Each of the investors and the collateral agent had contractually agreed that they would not, individually or collectively, seek to enforce any monetary judgment with respect to or against any assets of the Company other than the patents and the monetization payments and the remaining deposit. On June 26, 2018, the parties agreed that the amounts due under the Agreement having an aggregate remaining balance of $3,714,129 as of the Maturity Date, are discharged, without the assignment to the Investors of any of the collateral that secured the repayment under the Agreement. In addition, the Company confirmed its obligation to pay the Investors $345,000 that remained from an aggregate of $600,000 that had been deposited and restricted to cover expenses related to the IP monetization activities. Furthermore, the parties agreed that in the event there are any future recoveries by DSSTM with respect to monetization activities relating to the collateralized patents or applicable proceed rights set forth in the Agreement, the contractual payment provisions of the original Agreement will apply, and the Investors will be entitled to receive payment of such proceeds. As a result of this agreement, the Company paid $345,000 from restricted cash and recorded a gain of extinguishment of liabilities of $3,372,129 to reflect the discharge of the notes, wrote off contingent equity interests of $459,000 eliminated by the agreement, and wrote-off the underlying patents which had an aggregated gross cost of $2,655,000 and a net unamortized carrying amount of $295,470 on the agreement date, all of which resulted in the a net gain on the extinguishment of liabilities of $3,532,659 recorded in the three months ending June 30, 2018.

 

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7. Other Liabilities

 

On November 14, 2016, the Company entered into a Proceeds Investment Agreement (the “Agreement”) with Brickell Key Investments LP (“BKI”). Pursuant to the Agreement, BKI financed an aggregate of $13,500,000 in a patent purchase and monetization program to be implemented and managed by the Company (the “Financing”). Pursuant to the Agreement. $3,000,000 of the Financing was used to cover the Company’s purchase of a portfolio of U.S. and foreign LED patents and a license from Intellectual Discovery Co., Ltd., a Korean company (collectively, the “LED Patent Portfolio”), resulting in a basis in these assets of $0. A total of $6,000,000 of the Financing was directed by BKI to attorneys to cover anticipated attorneys’ fees and out-of-pocket expenses for legal proceedings that may transpire relating to enforcement of the LED Patent Portfolio. This amount is not included in the Company’s financial statements as the Company has no control over these funds, which are segregated and escrowed in the attorneys’ trust account.

 

In addition, on November 14, 2016, the Company received $4,500,000 of the Financing, which was required to be used by the Company to pay for the defense of Inter Partes Review or other similar proceedings that may be filed from time to time by defendants with the U.S. Patent & Trademark Office relating to the LED Patent Portfolio, with excess amounts available for general working capital needs. As of September 30, 2018, an aggregate of approximately $2,385,000 is recorded as other liabilities by the Company, of which approximately $1,919,000 is classified as short-term. Of this amount, the Company allocated $2,500,000 which it subsequently adjusted to $1,500,000 for the payment of estimated future Inter Partes Review costs. The Company will reduce this liability as it pays legal and other expenses related to the Inter Partes Review matters involving the LED Patent Portfolio as incurred. The remaining $1,216,000 in other liabilities is allocated to working capital, which the Company is amortizing on a pro-rata basis over the expected remaining life of the monetization period of the LED Patent Portfolio through November 30, 2019. For this amount, the Company reduced the liability with an offset to selling, general and administrative costs by $47,500 per month from January 2017 through July 2017, $80,000 per month for the remainder of 2017 through March 2018, and $86,500 per month for the remainder of 2018. During the nine months ended September 30, 2018, there was approximately $300,000 of Inter Partes Review costs and an aggregate of $761,000 was recorded as a reduction of the liability allocated to working capital.

 

On July 8, 2013, the Company’s subsidiary, DSSTM, purchased two patents for $500,000 covering certain methods and processes related to Bluetooth devices. In conjunction with the patent purchases, DSSTM entered into a Proceed Right Agreement with certain investors pursuant to which DSSTM initially received $250,000 of a total of $750,000 which it will ultimately receive thereunder, subject to certain payment milestones, in exchange for 40% of the proceeds which it receives, if any, from the use, sale or licensing of the two patents. As of September 30, 2018, the Company had received an aggregate of $650,000 ($650,000 in 2017) from the investors pursuant to the agreement of which approximately $376,000 was in current liabilities in the consolidated balance sheets ($432,000 as of December 31, 2017). The Company reduces the liability as it pays legal and other expenses related to its litigation involving the Bluetooth patents, for which the amount is available to be used for 50% of all such expenses.

 

As described in Note 6, on February 13, 2014, DSSTM entered into an Investment Agreement with Fortress. Pursuant to this agreement, an aggregate of $459,000 of fixed and contingent equity interests received are recorded in current liabilities. The liabilities under the agreement matured on February 13, 2018. Per the agreement, the Investors have the right to take ownership of the patents as settlement of the liabilities upon maturity. On June 26, 2018, the parties entered into an agreement (see Note 6 “Other Debt”) which among other things eliminated the Company’s obligation for the fixed and contingent equity interests under the agreement.

 

8. Commitments and Contingencies

 

On November 26, 2013, DSSTM filed suit against Apple, Inc. (“Apple”) in the United States District Court for the Eastern District of Texas, for patent infringement (the “Apple Litigation”). The complaint alleges infringement by Apple of DSSTM’s patents that relate to systems and methods of using low power wireless peripheral devices. DSSTM is seeking a judgment for infringement, injunctive relief, and compensatory damages from Apple. On October 28, 2014, the case was stayed by the District Court pending a determination of Apple’s motion to transfer the case to the Northern District of California. On November 7, 2014, Apple’s motion to transfer the case to the Northern District of California was granted. On December 30, 2014, Apple filed two Inter Partes Review (“IPR”) petitions with the Patent Trial and Appeal Board (“PTAB”) for review of the patents at issue in the case. The PTAB instituted the IPRs on June 25, 2015. The California District Court then stayed the case pending the outcome of those IPR proceedings. Oral arguments of the IPRs took place on March 15, 2016, and on June 17, 2016, PTAB ruled in favor of Apple on both IPR petitions. DSSTM then filed an appeal with the U.S. Court of Appeals for the Federal Circuit (the “Federal Circuit”) seeking reversal of the PTAB decisions. Oral arguments for the appeal were held on August 9, 2017. On March 23, 2018, the Federal Circuit reversed the PTAB, finding that the PTAB erred when it found the claims of U.S. Patent No. 6,128,290 to be unpatentable. The Federal Circuit affirmed its decision on July 12, 2018, when it denied Apple’s petition for panel rehearing of the Federal Circuit’s Opinion and Judgment issued on March 23, 2018. On July 27, 2018, the District Court judge lifted the Stay resuming the litigation. The patent assets underlying this matter had no carrying value as of the date of the PTAB decision and therefore, there were no impairment considerations because of that earlier PTAB decision.

 

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On February 16, 2015, DSSTM filed suit in the United States District Court, Eastern District of Texas, against defendants Intel Corporation, Dell, Inc., GameStop Corp., Conn’s Inc., Conn Appliances, Inc., NEC Corporation of America, Wal-Mart Stores, Inc., Wal-Mart Stores Texas, LLC, and AT&T, Inc. The complaint alleges patent infringement and seeks judgment for infringement of two of DSSTM’s patents, injunctive relief and money damages. On December 9, 2015, Intel filed IPR petitions with PTAB for review of the patents at issue in the case. Intel’s IPRs were instituted by PTAB on June 8, 2016. On June 1, 2017, the PTAB ruled in favor of Intel for all the challenged claims. On July 28, 2017, DSSTM filed a notice of appeal of the PTAB’s decision relating to U.S. Patent 6,784,552 with the Federal Circuit. Oral arguments for the appeal are scheduled for December 6, 2018. The Intel litigation has been stayed by the District Court pending final determination of the IPR proceedings.

 

On July 16, 2015, DSSTM filed three separate lawsuits in the United States District Court for the Eastern District of Texas alleging infringement of certain of its semiconductor patents. The defendants are SK Hynix et al., Samsung Electronics et al., and Qualcomm Incorporated. Each respective complaint alleges patent infringement and seeks judgment for infringement, injunctive relief and money damages. On November 12, 2015, SK Hynix filed an IPR petition with PTAB for review of the patent at issue in their case. SK Hynix’s IPR was instituted by the PTAB on May 11, 2016. On August 16, 2016, DSSTM and SK Hynix entered into a confidential settlement agreement ending the litigation between them. The pending SK Hynix IPR was then terminated by mutual agreement of the parties on August 31, 2016. On March 18, 2016, Samsung also filed an IPR petition, which was instituted by the PTAB. On September 20, 2017, PTAB ruled in favor of Samsung for all the challenged claims relating to U.S. Patent 6,784,552. DSSTM then appealed this PTAB ruling to the Federal Circuit on November 17, 2017. The Federal Circuit joined this appeal with the Intel appeal effective on December 7, 2017. The appeal is still pending as of the date of this Report. Qualcomm filed its IPR proceeding on July 1, 2016, which was then later joined with Intel’s IPRs in August 2016 by PTAB. On June 1, 2017, the PTAB ruled in favor of Intel/Qualcomm for all the challenged claims. On July 28, 2017, DSSTM filed a notice of appeal of the PTAB’s decision relating to U.S. Patent 6,784,552 with the Federal Circuit. As indicated above, this joint appeal is still pending as of the date of this Report.

 

On April 13, 2017, the Company filed a patent infringement lawsuit against Seoul Semiconductor Co., Ltd. and Seoul Semiconductor, Inc. (collectively, “Seoul Semiconductor”) in the United States District Court for the Eastern District of Texas, alleging infringement of certain of the Company’s Light-Emitting Diode (“LED”) patents. The Company is seeking a judgement for infringement of the patents along with other relief including, but not limited to, money damages, costs and disbursements. On June 7, 2017, the Company refiled its patent infringement complaint against Seoul Semiconductor in the United States District Court for the Central District of California, Southern Division. The case is currently pending. On December 3, 2017, Seoul Semiconductor filed an IPR challenging the validity of certain claims of U.S. Patent No. 6,949,771. This IPR was instituted by the PTAB on June 7, 2018. On December 21, 2017, Seoul Semiconductor filed an IPR challenging the validity of certain claims of U.S. Patent No. 7,256,486. This IPR was instituted by the PTAB on June 21, 2018. On January 25, 2018, Seoul Semiconductor filed an IPR challenging the validity of certain claims of U.S. Patent No. 7,524,087. This IPR was instituted by the PTAB on July 27, 2018. These challenged patents are the patents that are the subject matter of the infringement lawsuit which is still pending as of the date of this Report.

 

On April 13, 2017, the Company filed a patent infringement lawsuit against Everlight Electronics Co., Ltd. and Everlight Americas, Inc. (collectively, “Everlight”) in the United States District Court for the Eastern District of Texas, alleging infringement of certain of the Company’s LED patents. The Company is seeking a judgement for infringement of the patents along with other relief including, but not limited to, money damages, costs and disbursements. On June 8, 2017, the Company refiled its patent infringement complaint against Everlight in the United States District Court for the Central District of California. The case is currently pending as of the date of this Report. On June 8, 2018, Everlight filed IPR petitions challenging the validity of claims under U.S. Patent Nos. 7256486 and 7524087. On June 12, 2018, Everlight filed an IPR petition challenging the validity of claims under U.S. Patent No. 6949771, and on June 15, 2018, filed an IPR petition challenging the validity of claims under U.S. Patent No 7919787. These challenged patents are the patents that are the subject matter of the infringement lawsuit.

 

 16 
 

 

On April 13, 2017, the Company filed a patent infringement lawsuit against Cree, Inc. (“Cree”) in the United States District Court for the Eastern District of Texas, alleging infringement of certain of the Company’s LED patents. The Company is seeking a judgement for infringement of the patents along with other relief including, but not limited to, money damages, costs and disbursements. On June 8, 2017, the Company refiled its patent infringement complaint against Cree in the United States District Court for the Central District of California, and thereafter filed a first amended complaint for patent infringement against Cree in that same court on July 14, 2017. The case is currently pending as of the date of this Report. On June 6, 2018, Cree filed an IPR petition challenging the validity of claims under U.S. Patent No. 7256486. On June 7, 2018, Cree filed IPR petitions challenging the validity of claims under U.S. Patent Nos. 7524087 and 6949771. These challenged patents are the patents that are the subject matter of the infringement lawsuit.

 

On July 13, 2017, the Company filed a patent infringement lawsuit against Osram GMBH, Osram OPTO Semiconductors GMBH & Co., and Osram Sylvania Inc. (collectively, “Osram”) in the United States District Court for the Central District of California, alleging infringement of certain of the Company’s LED patents. DSS is seeking a judgment for infringement of the patents along with other relief including, but not limited to, money damages, costs and disbursements. On February 21, 2018, the Company and Osram executed a confidential settlement agreement ending the litigation between them.

 

On August 15, 2017, the Company filed a patent infringement lawsuit against Lite-On, Inc., and Lite-On Technology Corporation (collectively, “Lite-On”) in the United States District Court for the Central District of California, alleging infringement of certain of the Company’s LED patents. The Company is seeking a judgement for infringement of the patents along with other relief including, but not limited to, money damages, costs and disbursements. The case is currently pending as of the date of this Report.

 

On December 7, 2017, the Company filed a patent infringement lawsuit against Nichia Corporation and Nichia America Corporation (collectively, “Nichia”) in the United States District Court for the Central District of California, alleging infringement of certain of the Company’s LED patents. The Company is seeking a judgement for infringement of the patents along with other relief including, but not limited to, money damages, costs and disbursements. The case is currently pending as of the date of this Report. On May 10, 2018, Nichia filed an IPR petition challenging the validity of claims under U.S. Patent No. 7919787. On May 11, 2018, Nichia filed an IPR petition challenging the validity of claims under U.S. Patent No. 7652297. On May 25, 2018, Nichia filed an IPR petition challenging the validity of claims under U.S. Patent No. 7524087. On May 29, 2018, Nichia filed an IPR petition challenging the validity of claims under U.S. Patent No. 6949771. On May 30, 2018, Nichia filed an IPR petition challenging the validity of claims under U.S. Patent No. 7256486. These challenged patents are the patents that are the subject matter of the infringement lawsuit.

 

In addition to the foregoing, we may become subject to other legal proceedings that arise in the ordinary course of business and have not been finally adjudicated. Adverse decisions in any of the foregoing may have a material adverse effect on our results of operations, cash flows or our financial condition. The Company accrues for potential litigation losses when a loss is probable and estimable.

 

Contingent Litigation Payments – The Company retains the services of professional service providers, including law firms that specialize in intellectual property licensing, enforcement and patent law. These service providers are often retained on an hourly, monthly, project, contingent or a blended fee basis. In contingency fee arrangements, a portion of the legal fee is based on predetermined milestones or the Company’s actual collection of funds. The Company accrues contingent fees when it is probable that the milestones will be achieved, and the fees can be reasonably estimated. As of September 30, 2018, and December 31, 2017, the Company had not accrued any contingent legal fees pursuant to these arrangements.

 

Contingent Payments – The Company is party to certain agreements with funding partners who have rights to portions of intellectual property monetization proceeds that the Company receives. As of September 30, 2018, and December 31, 2017, there are no contingent payments due.

 

9. Stockholders’ Equity

 

Stock Options - During the nine months ended September 30, 2018, the Company issued an aggregate of 405,000 options to purchase the Company’s common stock at between $1.30 and $1.55 per share with a term of five years to employees at its technology, corporate and printed products divisions, as well as independent board members. The options granted during the three months ended June 30, 2018 vest pro-ratably as follows: 1/3 on the grant date, 1/3 on the first anniversary of the grant date and 1/3 on the second anniversary of the grant date as long as the employee is employed or direct is active on such dates. The options granted during the three months ended September 30, 2018 vest pro-ratably as follows: 1/3 on the first anniversary of the grant date, 1/3 on the second anniversary of the grant date and 1/3 on the third anniversary of the grant date. The options had an aggregate estimated fair value on the grant date of approximately $335,000 using the Black-Scholes-Merton option pricing model with a volatility of 98.1% - 98.2%, a risk-free rate of return of 2.67% - 2.96% and zero dividend and forfeiture estimates.

 

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Sales of Equity - On August 30, 2017, the Company sold 1,200,000 shares of unregistered common stock and five-year warrants to purchase up to an aggregate of 240,000 additional shares of the Company’s common stock at an exercise price of $1.00 to a total of two related party accredited investors for an aggregate purchase price of $900,000, of which $300,000 was recorded as a subscription receivable as of December 31, 2017 in the stockholders equity section. On March 29, 2018, the Company received the payment of the $300,000 subscription receivable from the investor, which is presented net of $12,000 of financing costs.

 

On July 3, 2018, the Company sold 214,286 shares of its common stock, par value $0.02 per share, to a related party accredited investor, Heng Fai Holdings Limited. The purchase price was $1.40 per share, for total proceeds of $300,000.

 

Stock-Based Payments and Compensation - The Company records stock-based payment expense related to options and warrants based on the grant date fair value in accordance with FASB ASC 718. Stock-based compensation includes expense charges for all stock-based awards to employees, directors and consultants. Such awards include option grants, warrant grants, and restricted stock awards. During the nine months ended September 30, 2018, the Company had stock compensation expense of approximately $107,000 or less than $0.01 basic and diluted earnings per share ($203,000; $0.01 basic and diluted earnings per share for the corresponding nine months ended September 30, 2017).

 

10. Supplemental Cash Flow Information

 

The following table summarizes supplemental cash flows for the nine-month periods ended September 30, 2018 and 2017:

 

Supplemental Cash Information        
   2018   2017 
         
Cash paid for interest  $100,000   $127,000 
           
Non-cash investing and financing activities:          
Gain from change in fair value of interest rate swap derivatives  $17,000   $10,000 
Commons Stock issued for investment        485,000 
Elimination of contingent liabilities through agreement   459,000    - 
Purchase of intangible assets to be paid in installments   304,000    - 

 

11. Segment Information

 

The Company’s businesses are organized, managed and internally reported as five operating segments. Two of these operating segments, Packaging and Printing, and Plastics are engaged in the printing and production of paper, cardboard and plastic documents with a wide range of features, including the Company’s patented technologies and trade secrets designed for the protection of documents against unauthorized duplication and altering. The three other operating segments, DSS Digital Group, DSS Technology Management, and DSS International, which was added in 2018, are engaged in various aspects of developing, acquiring, selling and licensing technology assets and are grouped into one reportable segment called Technology.

 

Approximate information concerning the Company’s operations by reportable segment for the three and nine months ended September 30, 2018 and 2017 is as follows. The Company relies on intersegment cooperation and management does not represent that these segments, if operated independently, would report the results contained herein.

 

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Three Months Ended September 30, 2018  Packaging and Printing   Plastics   Technology   Corporate   Total 
                     
Revenue  $2,736,000   $1,048,000   $310,000   $-   $4,094,000 
Depreciation and amortization   227,000    60,000    22,000    1,000    310,000 
Interest expense   (20,000)   (6,000)   -    (4,000)   (30,000)
Stock based compensation   1,000    -    15,000    4,000    20,000 
Net Income (loss)   96,000    72,000    (427,000)   (153,000)   (412,000)

 

Three Months Ended September 30, 2017  Packaging and Printing   Plastics   Technology   Corporate   Total 
                     
Revenue  $2,719,000   $1,049,000   $431,000   $-   $4,199,000 
Depreciation and amortization   169,000    30,000    152,000    1,000    352,000 
Interest expense   (28,000)   -    (17,000)   (13,000)   (58,000)
Stock based compensation   -    -    1,000    11,000    12,000 
Net Income (loss)   304,000    53,000    (397,000)   (237,000)   (277,000)

 

Nine Months Ended September 30, 2018  Packaging and Printing   Plastics   Technology   Corporate   Total 
                     
Revenue  $8,483,000   $2,949,000   $1,127,000   $-   $12,559,000 
Depreciation and amortization   561,000    119,000    322,000    1,000    1,003,000 
Interest expense   (66,000)   (17,000)   (12,000)   (17,000)   (112,000)
Stock based compensation   2,000    -    82,000    23,000    107,000 
Net Income (loss)   378,000    63,000    2,092,000    (674,000)   1,859,000 
Identifiable assets   9,381,000    3,141,000    830,000    1,483,000    14,835,000 

 

Nine Months Ended September 30, 2017  Packaging and Printing   Plastics   Technology   Corporate   Total 
                     
Revenue  $8,122,000   $3,431,000   $1,276,000   $-   $12,829,000 
Depreciation and amortization   487,000    91,000    462,000    2,000    1,042,000 
Interest Expense   (83,000)   -    (44,000)   (44,000)   (171,000)
Stock based compensation   -    -    38,000    165,000    203,000 
Net Income (loss)   812,000    372,000    (967,000)   (943,000)   (726,000)
Identifiable assets   9,143,000    2,450,000    1,642,000    4,200,000    17,435,000 

 

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The following tables disaggregate our business segment revenues by major source.

 

Printed Products Revenue Information:

 

   Total 
Three months ended September 30, 2018    
Packaging Printing and Fabrication  $2,482,000 
Commercial and Security Printing   253,000 
Technology Integrated Plastic Cards and Badges   409,000  
Plastic Cards, Badges and Accessories   640,000 
Total Printed Products  $3,784,000 
      
Three months ended September 30, 2017     
Packaging Printing and Fabrication  $2,469,000 
Commercial and Security Printing   250,000 
Technology Integrated Plastic Cards and Badges   528,000  
Plastic Cards, Badges and Accessories   522,000 
Total Printed Products  $3,769,000 
      
Nine months ended September 30, 2018     
Packaging Printing and Fabrication  $7,592,000 
Commercial and Security Printing   891,000 
Technology Integrated Plastic Cards and Badges   915,000  
Plastic Cards, Badges and Accessories   2,034,000 
Total Printed Products  $11,432,000 
      
Nine months ended September 30, 2017     
Packaging Printing and Fabrication  $7,334,000 
Commercial and Security Printing   788,000 
Technology Integrated Plastic Cards and Badges   1,421,000  
Plastic Cards, Badges and Accessories   2,012,000 
Total Printed Products  $11,555,000 

 

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Technology Sales, Services and Licensing Revenue Information:

 

   Total 
Three months ended September 30, 2018    
Information Technology Sales and Services  $61,000 
Digital Authentication Products and Services   143,000 
Royalties from Licensees   107,000 
Total Technology Sales, Services and Licensing  $311,000 
      
Three months ended September 30, 2017     
Information Technology Sales and Services  $103,000 
Digital Authentication Products and Services   150,000 
Royalties from Licensees   178,000 
Total Technology Sales, Services and Licensing  $431,000 
      
Nine months ended September 30, 2018     
Information Technology Sales and Services  $269,000 
Digital Authentication Products and Services   494,000 
Royalties from Licensees   364,000 
Total Technology Sales, Services and Licensing  $1,127,000 
      
Nine months ended September 30, 2017     
Information Technology Sales and Services  $354,000 
Digital Authentication Products and Services   404,000 
Royalties from Licensees   518,000 
Total Technology Sales, Services and Licensing  $1,276,000 

 

11. Subsequent Events

 

On October 24, 2018, the Company, Global eMacMall Limited, a privately-owned company incorporated in Hong Kong (“GEMM”), and Li Kin Pong, the sole-stockholder and owner of GEMM and a resident of Hong Kong, entered into a Sale and Purchase Agreement (the “Agreement”) whereby the Company will acquire 51% of the outstanding common shares of GEMM (the “GEMM Acquisition”). GEMM is a holding company which serves as a platform for the provision of construction equipment and special purpose vehicles through sales and leasing arrangements, primarily in Asia. Pursuant to the Agreement, the Company will issue 3,200,000 shares of its common stock and $1,121,000 by way of cash or in promissory notes, as determined by Company in its sole discretion in exchange for 51% of the outstanding shares of GEMM. Furthermore if the net earnings of GEMM in calendar year 2018 is less than $1,300,000, then the Purchase Price will be reduced by the amount of the short-fall of the net earnings for calendar year 2018 multiplied by a price to earnings ratio of 7, and a corresponding adjustment will be made to the remaining balance owed in cash or under any existing promissory note. Closing of the GEMM Acquisition is anticipated to occur within 60 days following the date of the Agreement, subject to customary closing conditions, as well as (i) the completion to the satisfaction of Company of a due diligence review of GEMM, and (ii) additional listing approval by the NYSE American LLC exchange of the DSS Shares to be issued.

 

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

 

FORWARD-LOOKING STATEMENTS

 

Certain statements contained herein constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “1995 Reform Act”). Document Security Systems, Inc. desires to avail itself of certain “safe harbor” provisions of the 1995 Reform Act and is therefore including this special note to enable us to do so. Except for the historical information contained herein, this report contains forward-looking statements (identified by the words “estimate”, “project”, “anticipate”, “plan”, “expect”, “intend”, “believe”, “hope”, “strategy” and similar expressions), which are based on our current expectations and speak only as of the date made. These forward-looking statements are subject to various risks, uncertainties and factors, as set forth in the Risk Factors section of our Annual Report on Form 10-K for the year ended December 31, 2017, that could cause actual results to differ materially from the results anticipated in the forward-looking statements.

 

Overview

 

Document Security Systems, Inc. (referred to in this report as “Document Security Systems”, “DSS”, “we”, “us”, “our” or “Company”) has strategically focused its core business efforts on developing and selling anti-counterfeiting technologies and solutions. We emphasize fraud and counterfeit prevention for all forms of printed documents and digital information. The Company holds numerous patents for optical deterrent technologies that provide protection of printed information from unauthorized scanning and copying. We operate two production facilities, consisting of a combined security printing and packaging facility and a plastic card facility where we produce secure and non-secure documents for our customers. We license our anti-counterfeiting technologies to printers and brand-owners. In addition, we have a digital division which provides cloud computing services for our customers, including disaster recovery, back-up and data security services. In 2013, the Company expanded its business focus by merging with DSS Technology Management, Inc., formerly known as Lexington Technology Group, Inc., which acquires intellectual property assets and interests in companies owning intellectual property assets for the purpose of monetizing these assets through a variety of value-enhancing initiatives, including, but not limited to, investments in the development and commercialization of patented technologies, licensing, strategic partnerships and commercial litigation.

 

We do business in five operating segments as follows:

 

DSS Packaging and Printing Group - Produces custom paperboard packaging serving clients in the pharmaceutical, beverage, photo packaging, toy, specialty foods and direct marketing industries, among others. The group also provides secure and commercial printing services for end-user customers along with technical support for our technology licensees. The division produces a wide array of printed materials such as security paper, vital records, prescription paper, birth certificates, receipts, manuals, identification materials, entertainment tickets, secure coupons, parts tracking forms, brochures, direct mailing pieces, catalogs, business cards, etc. The division also provides resources and production equipment resources for our ongoing research and development of security printing and related technologies.

 

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

 

DSS Digital Group - Develops and markets digital authentication solutions, including AuthentiGuard, a smartphone-based application system that integrates traditional printed optical deterrent technologies with proprietary digital data security-based solutions for brand protection and product diversion prevention.

 

DSS and DSS Technology Management - Acquires or internally develops patented technology or intellectual property assets (or interests therein), with the purpose of monetizing these assets through a variety of value-enhancing initiatives, including, but not limited to, investments in the development and commercialization of patented technologies, licensing, strategic partnerships and commercial litigation. As previously reported by the Company, both the Company and its wholly-owned subsidiary, DSS Technology Management, currently maintain active patent infringement lawsuits against numerous defendants, including, but not limited to, cases against Apple, Inc., Seoul Semiconductor Co., Ltd. et. al., Everlight Electronics Co., Ltd. et. al., Cree, Inc., Lite-On, Inc. et. al. and Nichia Corporation et. al.

 

DSS International - Assists in development and marketing of the Company’s digital authentication products in the Hong Kong market.

 

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Results of Operations for the Three and Nine Months Ended September 30, 2018 as compared to the Three and Nine Months Ended September 30, 2017

 

This discussion should be read in conjunction with the financial statements and footnotes contained in this Quarterly Report and in our Annual Report on Form 10-K for the year ended December 31, 2017.

 

Revenue

 

  

Three Months Ended

September 30, 2018

  

Three Months Ended

September 30, 2017

   % change  

Nine Months Ended

September 30, 2018

  

Nine Months Ended

September 30, 2017

   % change 
Revenue                              
Printed products  $3,784,000   $3,767,000    0%  $11,432,000   $11,553,000    -1%
Technology sales, services and licensing   310,000    432,000    -28%   1,127,000    1,276,000    -12%
                               
Total revenue  $4,094,000   $4,199,000    -3%  $12,559,000   $12,829,000    -2%

 

For the three months ended September 30, 2018, total revenue was approximately $4.1 million, a decrease of 3% from the corresponding three months ended September 30, 2017. Revenues from the sale of printed products were relatively flat during the three months ended September 30, 2018, as compared to the same period in 2017. Technology sales, services and licensing revenue decreased 28% during the three months ended September 30, 2018 as compared to the same period in 2017, primarily due to declines in licensing royalties and general IT services. Revenues for the nine months ended September 30, 2018 decreased from $12.8 million to $12.6, representing a decline of 2%. Printed products revenues for the nine months ended September 30, 2018 were down by 1% as compared to the same period in 2017, primarily due to a decline in sales for commercial printing and technology integrated plastic cards and badges, while Technology sales, services and licensing revenue decreased by 12%, primarily resulting from a decline in general IT services and royalty licensing revenues.

 

Costs and expenses

 

   Three Months Ended September 30, 2018   Three Months Ended September 30, 2017   % change   Nine Months Ended September 30, 2018   Nine Months Ended September 30, 2017   % change 
Costs and expenses                              
Costs of goods sold, exclusive of depreciation and amortization  $2,552,000   $2,401,000    6%  $7,890,000   $7,380,000    7%
Sales, general and administrative compensation   795,000    920,000    -14%   2,616,000    2,659,000    -2%
Depreciation and amortization   310,000    352,000    -12%   1,003,000    1,042,000    -4%
Professional fees   243,000    198,000    23%   828,000    556,000    49%
Stock based compensation   20,000    12,000    67%   107,000    203,000    -47%
Sales and marketing   137,000    117,000    17%   351,000    292,000    20%
Rent and utilities   173,000    167,000    4%   488,000    462,000    6%
Other operating expenses   241,000    205,000    18%   698,000    561,000    24%
Research and development   2,000    -    N/A    107,000    102,000    5%
                               
Total costs and expenses  $4,473,000   $4,372,000    2%  $14,088,000   $13,257,000    6%

 

 

Costs of goods sold, exclusive of depreciation and amortization includes all direct costs of printed products revenues, including materials, direct labor, transportation and manufacturing facility costs. In addition, this category includes all direct costs associated with technology sales, services and licensing including hardware and software that are resold, and fees paid to inventors or others as a result of technology licenses or settlements, if any. Costs of goods sold increased by 6% during the three months ended September 30, 2018 as compared to the same period in 2017, primarily due to a general increase in material costs as a percentage of the printed products groups’ total direct costs and an increase of outside services used by our packaging division. For the nine months ended September 30, 2018, costs of goods sold increased by 7% as compared to the same period in 2017 for the same reasons as stated for the three months ended September 30, 2018.

 

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Sales, general and administrative compensation costs, excluding stock-based compensation, decreased 14% and 2%, respectively, during the three and nine months ended September 30, 2018, as compared to the same periods in 2017, primarily due to the reduction of senior management headcount and a reduction in commissions and bonus compensation expense.

 

Depreciation and amortization include the depreciation of machinery and equipment used for production, depreciation of office equipment and building and leasehold improvements, amortization of software, and amortization of acquired intangible assets such as customer lists, trademarks, non-compete agreements and patents, and internally developed patent assets. For the three and nine months ended September 30, 2018, depreciation and amortization expense decreased 12% and 4%, respectively, as compared to the same periods in 2017, primarily due to the write-off of the semiconductor patents during the nine months ended September 30, 2018 (Note 5).

 

Professional fees increased 23% and 49%, respectively, during the three and nine months ended September 30, 2018, as compared to the same periods in 2017, as a result of increases in new consulting services for DSS International and increases in legal services for patent litigation.

 

Stock-based compensation includes expense charges for all stock-based awards to employees, directors and consultants. Such awards include option grants, warrant grants, and restricted stock awards. Stock-based compensation increased 67% during the three months ended September 30, 2018, as compared to the same period in 2017, due to the costs of stock options granted to various employees during the third quarter of 2018. For the nine months ended September 30, 2018, stock-based compensation decreased by 47%, as compared to the same period in 2017, due to a decline in stock options granted to employees.

 

Sales and marketing costs, which include internet and trade publication advertising, travel and entertainment costs, sales-broker commissions, and trade show participation expenses increased 17% and 20%, respectively, during the three and nine months ended September 30, 2018 as compared to the three and nine months ended September 30, 2017, resulting from increases in trade show and travel and entertainment costs for the Company.

 

Rent and utilities increased by 4% and 6%, respectively, during the three and nine months ended September 30, 2018, as compared to the same periods in 2017, primarily due to an increase in rental costs at the Company’s plastics division.

 

Other operating expenses consist primarily of equipment maintenance and repairs, office supplies, IT support, bad debt expense and insurance costs. Other operating expenses increased by 18% and 24%, respectively, during the three and nine months ended September 30, 2018, as compared to the same periods in 2017, primarily as the result of increases in dues and subscriptions, equipment expenses, and bank fees.

 

Research and development costs consist primarily of compensation costs for research personnel, third-party research costs, and consulting costs. During the three months ended September 30, 2018, research and development costs were approximately $2,000 as compared to no research and development costs for the three months ended September 30, 2017. For the nine months ended September 30, 2018, research and development costs increased 5% primarily due to development costs related to the development of proprietary block chain solutions for DSS International.

 

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Other Income and Expense

 

   Three Months
Ended
September 30,
2018		   Three Months
Ended
September 30,
2017		   %
change		   Nine Months
Ended
September 30,
2018		   Nine Months
Ended
September 30,
2017		   %
change		 
                         
Other income and expense                              
Interest income  $2,000   $-    NA   $8,000   $-    NA 
Interest expense   (30,000)   (58,000)   -48%   (112,000)   (171,000)   -35%
Amortized debt discount   (6,000)   (41,000)   -85%   (40,000)   (113,000)   -65%
Gain on extinguishment of liabilities, net   -    -    0%   3,533,000    -    N/A 
Total other income and expense  $(34,000)  $(99,000)   -66%  $3,389,000   $(284,000)   -1293%

 

The company recognized interest income on the money market account, in the amount of $8,000 during the nine months ended September 30, 2018.

 

Interest expense decreased 48% and 35%, respectively, during the three and nine months ended September 30, 2018, as compared to the same periods in 2017, due to a decrease in the total debt carried by the Company in 2018 as compared to 2017.

 

Amortized debt discount decreased 85% and 65%, respectively, during the three and nine months ended September 30, 2018, as compared to the same period in 2017, due to a decrease in the total debt carried by the Company in 2018 as compared to 2017.

 

Gain on extinguishment of liabilities, net -On June 26, 2018, the Company reached an agreement with one of its third-party IP monetization co-investors that, among other things, discharged the amounts recorded as liabilities by the Company under an agreement executed in 2014. As a result of this agreement, the Company recorded a gain of extinguishment of liabilities of $3,714,129 to reflect the discharge of the notes, a write down of other current labilities of $114,000 to reflect the elimination the contingent equity interests of $459,000 offset by the repayment of the $345,000 restricted cash, and the Company wrote-off the value of the underlying patents which had a net book value of $295,470, all of which resulted in the a net gain on the extinguishment of liabilities of $3,532,659 recorded in the period ended June 30, 2018.

 

Net Income (Loss)

 

   Three Months Ended September 30, 2018   Three Months Ended September 30, 2017   % change   Nine Months Ended September 30, 2018   Nine Months Ended September 30, 2017   % change 
                         
Net income (loss)  $(413,000)  $(277,000)   49%  $1,860,000   $(726,000)   -356%
                               
Income (loss) per common share:                              
Basic  $(0.02)  $(0.02)   0%  $0.11   $(0.05)   -320%
Diluted  $(0.02)  $(0.02)   0%  $0.11   $(0.05)   -320%
                               
Shares used in computing income (loss) per common share:                              
Basic   16,767,992    14,087,849    19%   16,662,907    13,793,946    21%
Diluted   16,767,992    14,087,849    19%   16,930,812    13,793,946    23%

 

For the three months ended September 30, 2018, the Company recorded net loss of approximately $412,000, as compared to a net loss of $277,000 during the same period in 2017. During the nine months ended September 30, 2018, the company recorded net income of $1.9 million, primarily due to the impact of net gain from extinguishment of liabilities of approximately $3.5 million which occurred during the second quarter of 2018, offset by operating losses incurred during the same period. The increases in operating losses incurred during the three and nine months ended September 30, 2018 as compared to the same periods in 2017 primarily reflect the combined impact of a decline in revenues, especially technology-based revenues which carry higher gross margins, coupled with an increase in professional fees and an increase in costs associated with the Company’s expansion into Asia in 2018.

 

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LIQUIDITY AND CAPITAL RESOURCES

 

As of September 30, 2018, the Company had cash of $2,051,800 and restricted cash of $6,180.

 

Operating Cash Flow – During the nine months ended September 30, 2018, the Company used approximately $1.5 million of cash for operations as compared to the $1.2 million in cash used for operations during the nine months ended September 30, 2017.

 

Investing Cash Flow – During the nine months ended September 30, 2018, the Company expended approximately $526,000 on equipment for its packaging and plastic card operations, $32,000 for non-compete agreement installment payments, and approximately $20,000 for patent applications.

 

Financing Cash Flows - During the nine months ended September 30, 2018, the Company made aggregate principal payments for long-term debt of approximately $966,000, which included a one-time payment of $345,000 as part of a final settlement of one debt agreement. In addition, the Company also received proceeds of approximately $288,000 from the collection of a subscription receivable, $88,000 in borrowings from the equipment line of credit for the plastics group, and $300,000 from the sale of the Company’s common stock.

 

Future Capital Needs -As of September 30, 2018, the Company had cash of approximately $2,051,000 and $800,000 available to its packaging division under a revolving credit line. The Company believes that its current cash resources and credit line resources provide it with sufficient resources to fund its operations and meet its obligations for at least the next twelve months, provided that the Company achieves or substantially achieves the key factors of its business plan over the next twelve months, including but not limited to (i) increasing sales of the Company’s digital products, especially of its AuthentiGuard products; (ii) continuing to decrease legal and professional expenses for the Company’s intellectual property monetization business; and (iii) continuing to generate operating profits from the Company’s packaging and plastic printing operations. In the absence of any of these, we will likely need to raise capital of approximately $500,000 to $1,000,000 to fund our operations for the twelve months. The Company believes that it will be able to raise additional equity and/or debt funding if necessary to fund working capital requirements not met by its current cash and credit resources. The Company has been able to obtain equity and/or debt-based financing in the past, including most recently when the Company raised gross proceeds of $1,050,000 in September 2017 and an $300,000 in July 2018 from the sale of its equity. However, there is no assurance the Company will be able to raise sufficient funds in the future if necessary to do so.

 

Off-Balance Sheet Arrangements

 

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

 

Critical Accounting Policies and Estimates

 

As of September 30, 2018, our critical accounting policies and estimates have not changed materially from those set forth in our Annual Report on Form 10-K for the year ended December 31, 2017. Refer to Note 2 of the Notes to Consolidated Condensed Financial Statements included in this report for the Company’s Critical accounting policies with respect to revenue recognition. For a complete discussion of the Company’s other critical accounting policies, refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

 

ITEM 4 - CONTROLS AND PROCEDURES

 

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures for the quarter ended September 30, 2018, pursuant to Rule 13a-15(e) and Rule 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on this evaluation and on the material weakness disclosed in our Annual Report on Form 10-K for the year ended December 31, 2017 which remained as of September 30, 2018, our principal executive officer and principal financial officer concluded that as of September 30, 2018, our disclosure controls and procedures were not effective to ensure that information required to be disclosed by us in reports filed or submitted under the Exchange Act is being recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that our disclosure controls are not effectively designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is being accumulated and communicated to management, including our principal executive officer and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

 

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Plan for Remediation of Material Weaknesses

 

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

 

Changes in Internal Control over Financial Reporting

 

There have been no changes to our internal controls over financial reporting as defined in Rule 13a-15(f) and Rule 15d-15(f) of the Exchange Act during the third quarter of 2018 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

 

PART II
OTHER INFORMATION

 

ITEM 1 - LEGAL PROCEEDINGS

 

As previously reported in our Form 10-Q for the second quarter of 2018, on March 23, 2018, in connection with the pending patent infringement litigation matter between the Company’s wholly-owned subsidiary, DSS Technology Management, Inc. (“DSSTM”) and defendant Apple, Inc. (“Apple”) in the U.S. District Court for the Northern District of California (the “District Court”), the U.S. Court of Appeals for the Federal Circuit (the “Federal Circuit”) entered judgment in favor of DSSTM reversing a previous ruling made by the Patent Trial and Appeal Board (the “PTAB”), which was favorable to defendant Apple, finding that PTAB erred when it found certain claims of DSSTM’s U.S. Patent No. 6,128,290 to be unpatentable. The Federal Circuit affirmed its decision on July 12, 2018, when it denied Apple’s petition for panel rehearing of the Federal Circuit’s Opinion and Judgement issued on March 23, 2018. On July 27, 2018, the District Court judge lifted the Stay resuming the litigation.

 

ITEM 1A - RISK FACTORS

 

There have been no material changes to the discussion of risk factors previously disclosed in our most recently filed Annual Report on Form 10-K for the year ended December 31, 2017.

 

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

 

As previously reported in our Form 10-Q for the second quarter of 2018, on July 3, 2018, the Company closed the sale of 214,286 shares of its common stock, par value $0.02 per share, to a related party accredited investor, Heng Fai Holdings Limited. The purchase price was $1.40 per share, for total proceeds of $300,000. The common stock sold in this transaction has not been registered under the Securities Act of 1933, as amended (the “Securities Act”), and was sold in reliance upon the exemption from registration contained in Section 4(a)(2) of the Securities Act.

 

ITEM 3 - DEFAULTS UPON SENIOR SECURITIES

 

None.

 

ITEM 4 – MINE SAFETY DISCLOSURES

 

None.

 

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ITEM 5 - OTHER INFORMATION

 

None.

 

ITEM 6 – EXHIBITS

 

Exhibit Number  

Exhibit Description

     
31.1   Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer.*
31.2   Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer.*
32.1   Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes Oxley Act of 2002.*
32.2   Certification of Chief Financial Officer as required by 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes Oxley Act of 2002.*
101.INS   XBRL Instance Document*
101.SCH   XBRL Taxonomy Extension Schema Document*
101.CAL   XBRL Taxonomy Extension Calculation Linkbase Document*
101.DEF   XBRL Taxonomy Extension Definition Linkbase Document*
101.LAB   XBRL Taxonomy Extension Label Linkbase Document*
101.PRE   XBRL Taxonomy Extension Presentation Linkbase Document*

 

*Filed herewith.

 

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SIGNATURES

 

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

 

  DOCUMENT SECURITY SYSTEMS, INC.
     
November 14, 2018 By: /s/ Jeffrey Ronaldi
    Jeffrey Ronaldi
   

Chief Executive Officer (Principal Executive Officer)

     
November 14, 2018 By: /s/ Philip Jones
    Philip Jones
    Chief Financial Officer (Principal Financial and Accounting Officer)

 

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