Financial Condition and Results of Operations

Cautionary Statement for Purposes of the "Safe Harbor" Provisions of the Private Securities Litigation Reform Act of 1995

Some of the information in this Quarterly Report on Form 10-Q contains forward-looking statements that involve substantial risks and uncertainties. You can identify these statements by forward-looking words such as "may," "will," "expect," "anticipate," "believe," "estimate," "continue" and similar words. You should read statements that contain these words carefully because they: (1) discuss our future expectations; (2) contain projections of our future operating results or financial condition; or (3) state other "forward-looking" information. However, we may not be able to predict future events accurately. The risk factors listed in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2019, as well as any cautionary language in this Quarterly Report on Form 10-Q, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. You should be aware that the occurrence of any of the events described in these risk factors and elsewhere in this Quarterly Report on Form 10-Q could materially and adversely affect our business.





Summary of Operations

We are primarily engaged in the development and sale of biometrics products, solutions and services. Our software products are used in government and commercial systems and applications and fulfill a broad range of functions critical to secure biometric enrollment, authentication, identification and transactions. Principal government applications of biometrics systems include border control, visa applicant screening, law enforcement, national defense, intelligence, secure credentialing, access control, and background checks. Principal commercial applications include: i) user enrollment and authentication used for login to mobile devices, computers, networks, and software programs; ii) user authentication for financial transactions and purchases (online and in-person); iii) physical access control to buildings; and iv) identity proofing of prospective employees and customers. We sell our biometrics software products and services globally through a multifaceted distribution strategy using systems integrators, OEMs, VARs, partners, and directly to end user customers. We also derive a portion of our revenue from the sale of imaging software licenses to OEMs and systems integrators that incorporate our software into medical imaging products and medical systems.

Due to the COVID-19 pandemic we have been unable to: (i) conduct face-to-face meetings with customers and prospective customers, (ii) present in-person demonstrations of our software solutions, (iii) attend trade shows and conferences which typically generate future sales opportunities or (iv) meet with prospective strategic partners . We believe that these effects caused by the COVID-19 pandemic will likely have an adverse impact on our revenue over the next several quarters.

Summary of Financial Results

We use revenue and results of operations to summarize financial results as we believe these measurements are the most meaningful way to understand our operating performance.

Revenue and operating loss for the three months ended March 31, 2020 were $3.5 million and $1.3 million, respectively. These results compared to revenue of $3.7 million and operating loss of $44,000 for the three months ended March 31, 2019. Lower revenue in the current three month period was primarily due to lower services revenue that was partially offset by higher biometrics software license revenue. Higher operating loss in the current three month period was primarily due to lower revenue and higher operating expenses.

These and all other financial results are discussed in more detail in the results of operations section that follows.





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Results of Operations

Software licenses. Software licenses consist of revenue from the sale of biometrics and imaging software products. Sales of software products depend on our ability to win proposals to supply software for biometrics systems projects either directly to end user customers or indirectly through channel partners.

Software license revenue increased 28% from $1.5 million in the three months ended March 31, 2019 to $2.0 million in the same three month period in 2020. As a percentage of total revenue, software license revenue increased from 41% in the first quarter of 2019 to 56% in the current year quarter. The dollar increase in software license revenue was due to a $0.4 million increase in biometrics software license sales. The reasons for the changes in biometrics and imaging software license sales were:

i) Biometrics software licenses - Biometrics software license sales were $1.75


    million in the first quarter of 2020 versus $1.34 million in the same quarter
    last year. The dollar increase was primarily due to higher software license
    sales to a direct government customer, and to a lesser extent higher revenue
    from our commercial customers.

ii) Imaging software licenses - Imaging software license sales were $217,000 in

the first quarter of 2020 versus $193,000 in the same quarter last year. The

dollar increase was primarily due to slightly higher imaging software license

sales to our imaging customers.

As described in the strategy section of our Form 10-K for the year ended December 31, 2019, our market strategy is to continue to focus on our legacy government biometrics markets and expand into new commercial biometrics markets. We are unable to predict future revenue from commercial markets as these are emerging markets.

Software maintenance. Software maintenance consists of revenue from the sale of software maintenance contracts. Software maintenance contracts entitle customers to receive software support and software updates, if and when they become available, during the term of the contract.

Software maintenance revenue was $1.4 million for both the three months ended March 31, 2019 and 2020. As a percentage of total revenue, software maintenance revenue increased from 36% in the first quarter of 2019 to 39% in the current year quarter.

Services. Services consist of fees we charge to perform software development, integration, installation, and customization services. Similar to software license revenue, services revenue depends on our ability to win biometrics systems projects either directly with end user customers or in conjunction with channel partners. Services revenue will fluctuate when we commence new projects and/or when we complete projects that were started in previous periods.

Services revenue decreased from $0.8 million in the three months ended March 31, 2019 to $0.2 million in the same three month period in 2020. As a percentage of total revenue, services revenue decreased from 23% in the first quarter of 2019 to 5% in the current year quarter.

For the three month period ended March 31, 2020, the dollar decrease in services revenue was primarily due to lower services revenue in the current year quarter related to the software license agreement we entered into with a systems integrator in the second quarter of 2018 for a large project, and to a lesser extent lower service revenue due to fewer service projects.

We expect our development effort on this large project to continue for approximately one more quarter.

Services backlog was $0.4 million as of March 31, 2020.

Cost of services. Cost of services consists of engineering costs to perform customer services projects. Such costs primarily include: i) engineering salaries, stock-based compensation, fringe benefits, and facilities; and ii) engineering consultants and contractors.





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Cost of services decreased 67% from $518,000 in the three months ended March 31, 2019 to $170,000 in the same three month period in 2020. Cost of services as a percentage of services increased from 62% in the first quarter of 2019 to 91% in the current year quarter, which means that gross margins decreased from 38% to 9%. The dollar decrease in cost of services was primarily due to lower services revenue in the first quarter of 2020.

Research and development expense. Research and development expense consists of costs for: i) engineering personnel, including salaries, stock-based compensation, fringe benefits, and facilities; ii) engineering consultants and contractors, and iii) other engineering expenses such as supplies, equipment depreciation, dues and memberships and travel. Engineering costs incurred to develop our technology and products are classified as research and development expense. As described in the cost of services section, engineering costs incurred to provide engineering services for customer projects are classified as cost of services, and are not included in research and development expense.

The classification of total engineering costs to research and development expense and cost of services was (in thousands):





                                     Three Months Ended
                                          March 31,
                                      2020          2019

Research and development expense   $    2,272      $ 1,760
Cost of services                          170          518
   Total engineering costs         $    2,442      $ 2,278

Research and development expense increased 29% from $1.8 million in the three months ended March 31, 2019 to $2.3 million in 2020. As a percentage of total revenue, research and development expense increased from 47% in 2019 to 65% in 2020.

As the table immediately above indicates, total engineering costs in the first quarter of 2020 increased by $164,000 compared to the same period last year. The spending increase was primarily due to higher employee costs due to higher headcount, higher recruiting costs and to a lesser extent higher other costs. The increase was partially offset by lower spending on third-party development costs with third-party vendors we engaged to assist in our software development.

We anticipate that we will continue to focus our future research and development activities on enhancing our existing products and developing new products with our internal resources.

Selling and marketing expense. Selling and marketing expense primarily consists of costs for: i) sales and marketing personnel, including salaries, sales commissions, stock-based compensation, fringe benefits, travel, and facilities; and ii) advertising and promotion expenses.

Sales and marketing expense increased 56% from $0.8 million in the three months ended March 31, 2019 to $1.3 million in the same three month period of 2020. As a percentage of total revenue, sales and marketing expense increased from 22% in the first quarter of 2019 to 37% in the corresponding period in 2020. The dollar increase in sales and marketing expense was primarily due to higher employee costs due to higher headcount and to a lesser extent higher spending on sales agents, and higher other costs, including engagement of a third- party marketing firm. The increase was partially offset by lower sales commissions.

General and administrative expense. General and administrative expense consists primarily of costs for: i) officers, directors and administrative personnel, including salaries, bonuses, director compensation, stock-based compensation, fringe benefits, and facilities; ii) professional fees, including legal and audit fees; iii) public company expenses; and iv) other administrative expenses, such as insurance costs and bad debt provisions.

General and administrative expense increased 58% from $0.7 million in the three months ended March 31, 2019 to $1.1 million in the same three month period in 2020. As a percentage of total revenue, general and administrative expense increased from 19% in the first quarter of 2019 to 32% in the corresponding period in 2020. The increase in general and administrative expense was primarily due to: i) higher employee costs due to higher headcount; ii) higher legal fees; iii) higher recruiting fees; and iv) higher stock-based compensation expense.





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Patent related income. We entered into an arrangement with an unaffiliated third party in 2010 under which we assigned certain patents in return for royalties on proceeds from patent monetization efforts by the third party. The third party has engaged in various patent monetization activities, including enforcement, litigation and licensing. In the three months ended March 31, 2020, there was no revenue from this arrangement. In the three months ended March 31, 2019, the third party reported and we recorded $49,000 of income from this arrangement We continue to have a contractual relationship with this third party. However, we are unable to predict how much more income we might receive from this arrangement, if any, because we do not know whether any patent monetization efforts by the third party will be successful.

Interest income. Interest income decreased 46% from $275,000 in the three months ended March 31, 2019 to $148,000 in the same three month period in 2020. For the three month period, the dollar decrease in interest income was primarily due to lower interest rates within our money market accounts and to a lesser extent lower cash and cash equivalents balances.

Income taxes. Income tax benefit was $0.1 million for the three months ended March 31, 2020. Income tax benefit for the three month period ended March 31, 2020 was based on the U.S. statutory rate of 21%, increased by state income taxes, and reduced by permanent adjustments and research tax credits.

The Coronavirus Aid, Relief and Economic Security Act (CARES Act) was signed into law on March 27, 2020. The Act contained specific relief and stimulus measures including allowing net operating losses originating in 2018 through 2020 to be carried back five years to offset taxable income in the carryback period.

Separately, the enactment of the Tax Cut and Jobs Act in 2017 allowed taxpayers to claim a refund for alternative minimum tax credits over a period of years. The CARES Act enacted during the quarter allows for the entire amount of the credit to be refunded in 2020.

We have reviewed the impact of the CARES Act enactment on the income tax provision and have determined that, as a result of the net operating loss carryback provision, we can obtain a tax benefit if we were to carry back the forecasted 2020 net operating loss to the five year carryback period.

The carryback of the estimated loss would result in a refundable alternative minimum tax credit of approximately $736,000 and an increase in research credit carryforwards previously utilized. The alternative minimum tax credit can be refunded in the future, if we decide to carry back the loss reported on the filed 2020 tax return instead of electing to carry the loss forward. Due to the recent loss history and continued uncertainty surrounding our future projections of income, we will benefit from the current year loss to the extent of the available tax refund and will maintain a full valuation allowance on all other deferred tax assets, including any increase in research credit carryforward resulting from a potential carryback.

As of the end of the period, we have not made a determination on whether to elect to carry forward the 2020 operating loss, however, the alternative minimum tax refund potential on carryback represents a minimum tax benefit we can obtain from the estimated 2020 loss. We can realize a tax benefit to the extent of the carryback refund potential as it is considered a source of income against which to utilize the 2020 estimated loss.

The total estimated benefit of the alternative minimum tax refund of $736,000 is included in our projection of our annual effective rate and results in a year to date benefit of approximately $146,000 as of March 31, 2020. We recorded the year to date tax benefit as a long term tax receivable.





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Liquidity and Capital Resources

At March 31, 2020, we had cash and cash equivalents of $46.9 million, which represented a decrease of $0.9 million from December 31, 2019. The decrease in cash and cash equivalents was primarily due to the following factors:

Cash used in operations was $0.5 million in the first three months of 2020. Cash used in operations was primarily the result of $1.1 million of net loss that was partially offset by $0.3 million of changes in assets and liabilities, and the add back of $0.2 million of non-cash items primarily for depreciation, amortization and stock-based compensation.

Cash used in investing activities was $0.3 million in the first three months of 2020. This cash usage consisted of purchases of property and equipment.

Cash used in financing activities was $50,000 in the first three months of 2020. Financing activity cash usage was the result of $50,000 used to pay income taxes for employees who surrendered shares in connection with stock grants.

While we cannot assure you that we will not require additional financing, or that such financing will be available to us, we believe that our cash and cash equivalents will be sufficient to fund our operations for at least the next twelve months.

Recently Adopted Accounting Pronouncements

See Note J to our Consolidated Financial Statements in Item 1.





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                                    ITEM 4:

                            Controls and Procedures

Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective.

There were no changes in our internal control over financial reporting during the quarter ended March 31, 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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