DIGITAL ALLY : Management's Discussion and Analysis of Financial Condition and Results of Operation. (form 10-K)

April 06, 2020 at 06:46 am EDT

This Report contains forward-looking statements within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934. The words "believe," "expect," "anticipate," "intend," "estimate,"
"may," "should," "could," "will," "plan," "future," "continue," and other
expressions that are predictions of or indicate future events and trends and
that do not relate to historical matters identify forward-looking statements.
These forward-looking statements are based largely on our expectations or
forecasts of future events, can be affected by inaccurate assumptions, and are
subject to various business risks and known and unknown uncertainties, a number
of which are beyond our control. Therefore, actual results could differ
materially from the forward-looking statements contained in this document, and
readers are cautioned not to place undue reliance on such forward-looking
statements.



We undertake no obligation to publicly update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise.
A wide variety of factors could cause or contribute to such differences and
could adversely impact revenues, profitability, cash flows and capital needs.
There can be no assurance that the forward-looking statements contained in this
document will, in fact, transpire or prove to be accurate.



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Factors that could cause or contribute to our actual results differing
materially from those discussed herein or for our stock price to be adversely
affected include, but are not limited to: (1) our losses in recent years,
including fiscal 2019 and 2018; (2) economic and other risks for our business
from the effects of the COVID-19 pandemic, including the impacts on our
law-enforcement and commercial customers, suppliers and employees and on our
ability to raise capital as required; (3) our ability to increase revenues,
increase our margins and return to consistent profitability in the current
economic and competitive environment; (4) our operation in developing markets
and uncertainty as to market acceptance of our technology and new products; (5)
the availability of funding from federal, state and local governments to
facilitate the budgets of law enforcement agencies, including the timing, amount
and restrictions on such funding; (6) our ability to deliver our new product
offerings as scheduled in 2020, such as the EVO-HD, have such new products
perform as planned or advertised and whether they will help increase our
revenues; (7) whether we will be able to increase the sales, domestically and
internationally, for our products in the future; (8) our ability to maintain or
expand our share of the market for our products in the domestic and
international markets in which we compete, including increasing our
international revenues; (9) our ability to produce our products in a
cost-effective manner; (10) competition from larger, more established companies
with far greater economic and human resources; (11) our ability to attract and
retain quality employees; (12) risks related to dealing with governmental
entities as customers; (13) our expenditure of significant resources in
anticipation of sales due to our lengthy sales cycle and the potential to
receive no revenue in return; (14) characterization of our market by new
products and rapid technological change; (15) our dependence on sales of our
EVO-HD, DVM-800, FirstVU HD and DVM-250 products; (16) potential that
stockholders may lose all or part of their investment if we are unable to
compete in our markets and return to profitability; (17) defects in our products
that could impair our ability to sell our products or could result in litigation
and other significant costs; (18) our dependence on key personnel; (19) our
reliance on third-party distributors and sales representatives for part of our
marketing capability; (20) our dependence on a few manufacturers and suppliers
for components of our products and our dependence on domestic and foreign
manufacturers for certain of our products; (21) our ability to protect
technology through patents and to protect our proprietary technology and
information as trade secrets and through other similar means; (22) our ability
to generate more recurring cloud and service revenues; (23) risks related to our
license arrangements; (24) our revenues and operating results may fluctuate
unexpectedly from quarter to quarter; (25) sufficient voting power by coalitions
of a few of our larger stockholders, including directors and officers, to make
corporate governance decisions that could have significant effect on us and the
other stockholders; (26) sale of substantial amounts of our common stock that
may have a depressive effect on the market price of the outstanding shares of
our common stock; (27) possible issuance of common stock subject to options and
warrants that may dilute the interest of stockholders; (28) our nonpayment of
dividends and lack of plans to pay dividends in the future; (29) future sale of
a substantial number of shares of our common stock that could depress the
trading price of our common stock, lower our value and make it more difficult
for us to raise capital; (30) our additional securities available for issuance,
which, if issued, could adversely affect the rights of the holders of our common
stock; (31) our stock price is likely to be highly volatile due to a number of
factors, including a relatively limited public float; (32) whether the
litigation against Axon will achieve its intended objectives and result in
monetary recoveries for us; (33) whether the USPTO rulings will curtail,
eliminate or otherwise have an effect on the actions of Axon and other
competitors respecting us, our products and customers; and (34) whether our
patented VuLink technology is becoming the de-facto "standard" for agencies
engaged in deploying state-of-the-art body-worn and in-car camera systems and
will increase our revenues; (36) whether such technology will have a significant
impact on our revenues in the long-term; (37) whether we will be able to meet
the standards for continued listing on NASDAQ; and (38) indemnification of


our
officers and directors.

Current Trends and Recent Developments for the Company





Overview



We supply technology-based products utilizing our portable digital video and
audio recording capabilities, for the law enforcement and security industries
and for the commercial fleet and mass transit markets. We have the ability to
integrate electronic, radio, computer, mechanical, and multi-media technologies
to create unique solutions to our customers' requests. Our products include the
DVM-800 and DVM-800 Lite, in-car digital video mirror systems for law
enforcement; the FirstVU and the FirstVU HD, body-worn cameras, our patented and
revolutionary VuLink product, which integrates our body-worn cameras with our
in-car systems by providing hands-free automatic activation, for both law
enforcement and commercial markets; the DVM-250 and DVM-250 Plus, a commercial
line of digital video mirrors that serve as "event recorders" for the commercial
fleet and mass transit markets; and FleetVU and VuLink, our cloud-based evidence
management systems. We introduced the EVO-HD product in late June 2019 and began
full-scale deployments in the third quarter 2019. It is designed and built on a
new and highly advanced technology platform that will become the platform for a
new family of in-car video solution products for the law enforcement and
commercial markets. We believe that the launch of these new products will help
to reinvigorate our in-car and body-worn systems revenues while diversifying and
broadening the market for our product offerings.



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We experienced operating losses for all quarters during 2019 and 2018 except for
the second quarter 2019 which was aided by a patent litigation settlement. The
following is a summary of our recent operating results on a quarterly basis:

For the Three Months Ended:


                  December 31,        September 30,         June 30,         March 31,        December 31,        September 30,         June 30,         March 31,
                      2019                2019                2019              2019              2018                2018                2018              2018
Total revenue     $   2,420,437      $     2,923,148      $  2,546,983      $  2,550,796      $   2,378,287      $     2,878,059      $  3,563,550      $  2,471,513
Gross profit            (88,185 )          1,188,262           950,812         1,181,740             56,658            1,177,289         1,618,467         1,109,394
Gross profit
margin
percentage                 (3.6 )%              40.7 %            37.3 %%           46.3 %              2.3 %               40.9 %            45.4 %            44.9 %
Total selling,
general and
administrative
expenses              3,145,633            3,468,709        (1,616,830 )       4,267,898          5,292,374            3,087,005         3,055,776         3,082,710
Operating loss       (3,233,819 )         (2,280,447 )       2,567,643        (3,086,158 )       (5,235,716 )         (1,909,716 )      (1,437,309 )      (1,973,316 )
Operating loss
percentage               (133.6 )%             (78.0 )%          100.8 %          (121.0 )%          (220.1 )%             (66.4 )%          (40.3 )%          (79.8 )%
Net loss          $  (3,426,984 )    $    (2,985,825 )    $   (387,730 )    $ (3,205,174 )    $  (5,327,849 )    $    (4,665,580 )    $ (2,962,890 )    $ (2,588,232 )

Our business is subject to substantial fluctuations on a quarterly basis as
reflected in the significant variations in revenues and operating results in the
above table. These variations result from various factors, including but not
limited to: (1) the timing of large individual orders; (2) the traction gained
by products, such as the recently released EVO HD; (3) production, quality and
other supply chain issues affecting our cost of goods sold; (4) unusual
increases in operating expenses, such as the timing of trade shows and
stock-based and bonus compensation; (5) the timing of patent infringement
litigation settlements, such as the $6.0 settlement we obtained from WatchGuard
during the second quarter 2019 and (5) ongoing patent and other litigation and
related expenses respecting outstanding lawsuits. We reported an operating loss
of $3,233,819 on revenues of $2,420,437 for fourth quarter 2019. The income
recognized in the second quarter 2019 ended a series of quarterly losses
resulting from competitive pressures, supply chain problems, increases in
inventory reserves as our current product suite ages, product quality control
issues, product warranty issues, infringement of our patents by direct
competitors such as Axon that reduced our revenues, and litigation expenses
relating to the patent infringement.

The factors and trends affecting our recent performance include:

? On May 13, 2019 we reached a resolution of the pending patent infringement

litigation with WatchGuard and executed a settlement agreement that resulted

in the dismissal of this case. As part of the settlement agreement, we

received a one-time $6,000,000 payment and granted WatchGuard a perpetual

covenant to not sue WatchGuard if its products incorporate agreed-upon

modified recording functionality. Additionally, we granted it license to the

'292 Patent and '452 Patent through December 31, 2023. As part of the

settlement, the parties agree that WatchGuard made no admission that it

infringed any of our patents. See Note 12, "Contingencies" for the details

respecting the settlement.

? Revenues decreased in fourth quarter 2019 to $2,420,436 compared to the

previous quarters. The primary reason for the revenue decrease in the fourth

quarter 2019 is that we continue to face increased challenges for our in-car

and body-worn systems as our competitors have released new products with

advanced features and have maintained their product price cuts. We introduced

a new product platform, the EVO-HD, specifically for in-car systems late in

June 2019 to address our competitors' new product features and we experienced

some positive traction in third and fourth quarter 2019. However, we expect

potential customers to review and test the EVO-HD prior to adopting the new

platform for deployment and therefore expect that the rate of adoption of the

new technology will accelerate in 2020. This new product platform utilizes

advanced chipsets that will generate new and highly advanced products for our

law enforcement and commercial customers and we believe will improve product

revenues in future quarters as customers become aware of and commit to the new

EVO-HD. Our law enforcement revenues declined over the prior period due to

price-cutting, willful infringement of our patents and other actions by our

competitors and adverse marketplace effects related to the patent litigation.

For example, one of our competitors introduced a body-camera including cloud

storage free for one year beginning in 2017 and this has continued to pressure


    our revenues in 2019.




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? Our objective is to expand our recurring service revenue to help stabilize our

revenues on a quarterly basis. Revenues from cloud storages have been

increasing in recent quarters and reached approximately $205,714 in Q-4 2019,

an increase of $12,714 (7%) over Q-4 2018. Overall, cloud revenues increased

to approximately $750,000 in 2019 compared to approximately $694,000 for 2018,

an increase of $56,000, or 8%. Additionally, revenues from extended warranties

have also been increasing and were approximately $405,179 for the year ended

December 31, 2019, compared to $301,000 for the prior year period for an

increase of $104,179 (35%). We are pursuing several new market channels that

do not involve our traditional law enforcement and private security customers,

such as our NASCAR affiliation and event security solutions, which we believe

will help expand the appeal of our products and service capabilities to new

commercial markets. If successful, we believe that these new market channels

could yield recurring service revenues for us in the future.

? Recognizing a critical limitation in law enforcement camera technology, during

2014 we pioneered the development of our VuLink ecosystem that provided

intuitive auto-activation functionality as well as coordination between

multiple recording devices. The USPTO granted us multiple patents with claims

covering numerous features, such as automatically activating an officer's

cameras when the light bar is activated or when a data-recording device such

as a smart weapon is activated. Additionally, our patent claims cover

automatic coordination between multiple recording devices. Prior to this

innovation, officers were forced to manually activate each device while

responding to emergency scenarios - a requirement that both decreased the

usefulness of the existing camera systems and diverted officers' attention

during critical moments. We believe law enforcement agencies have recognized

the value of our VuLink technology and that a trend has developed where the

agencies are seeking information on "auto-activation" features in requests for

bids and requests for information involving the procurement process of

body-worn cameras and in-car systems. We believe this trend may result in our

patented VuLink technology becoming the de-facto "standard" for agencies

engaged in deploying state-of-the-art body-worn and in-car camera systems.

However, the willful infringement of our VuLink patent by Axon and others has

substantially and negatively impacted revenues that otherwise would have been

generated by our VuLink system and indirectly our body-worn and in-car

systems. We believe that the results of the current patent litigation with

Axon will largely set the competitive landscape for body-worn and in-car

systems for the foreseeable future. We are seeking other ways to monetize our

VuLink patents, which may include entering into license agreements or supply

and distribution agreements with competitors. We expect that this technology

will have a significant positive impact on our revenues in the long-term,

particularly if we are successful in our prosecution of the patent

infringement litigation pending with Axon, and we can successfully monetize

the underlying patents, although we can make no assurances in this regard.

? We have a multi-year official partnership with NASCAR, naming us "A Preferred

Technology Provider of NASCAR." As part of the relationship, we will provide

cameras that will be mounted in the Monster Energy NASCAR Cup Series garage

throughout the season, bolstering both NASCAR's commitment to safety at every

racetrack, as well as enhancing its officiating process through technology.

Our relationship with NASCAR has yielded many new opportunities with NASCAR

related sponsors. We believe this partnership with NASCAR will demonstrate the

flexibility of our product offerings and help expand the appeal of our

products and service capabilities to new commercial markets.

? Our international revenues decreased to $190,105 (2% of total revenues) during

the year ended December 31, 2019, compared to $362,338 (3% of total revenues)

during the year ended December 31, 2018. Political macro-economic tensions

including illegal immigration and import/export tariffs between the United

States and many countries that have been our customers in the past have made

it a difficult climate for our international sales. The international sales

cycle generally takes longer than domestic business and we continue to provide

bids to a number of international customers. We are actively marketing many of

our products, including but not limited to the EVO-HD, DVM-800, DVM-750,

DVM-500+, FleetVu driver monitoring and management service and the FirstVU HD,

internationally. We saw an uptick in our international sales activity in 2020

as evidenced by the recent award of a contract with the potential of over $4.0

million for our FirstVU HD by a sovereign nation's national police force.

Off-Balance Sheet Arrangements





We do not have any off-balance sheet debt, nor did we have any transactions,
arrangements, obligations (including contingent obligations) or other
relationships with any unconsolidated entities or other persons that may have
material current or future effect on financial conditions, changes in the
financial conditions, results of operations, liquidity, capital expenditures,
capital resources, or significant components of revenue or expenses.

We are a party to operating leases and license agreements that represent commitments for future payments (described in Note 12 to our consolidated financial statements) and we have issued purchase orders in the ordinary course of business that represent commitments to future payments for goods and services.

For the Years Ended December 31, 2019 and 2018





Results of Operations



Summarized immediately below and discussed in more detail in the subsequent
sub-sections is an analysis of our operating results for the years ended
December 31, 2019 and 2018, represented as a percentage of total revenues for
each respective year:



                                                                 Years Ended December 31,
                                                                2019                   2018
Revenue                                                               100 %                  100 %
Cost of revenue                                                        69 %                   65 %

Gross profit                                                           31 %                   35 %
Selling, general and administrative expenses:
Research and development expense                                       19 %                   13 %
Selling, advertising and promotional expense                           35 %                   25 %
Stock-based compensation expense                                       20 %                   20 %
General and administrative expense                                     72 %                   71 %
Patent litigation settlement                                          (57 )%                   - %

Total selling, general and administrative expenses                     89 %                  129 %

Operating loss                                                        (58 )%                 (94 )%
Change in warrant derivative liabilities                                - %                   (3 )%
Change in fair value of secured convertible notes                      (5 )%                   - %
Change in fair value of secured convertible debentures                  - %                  (20 )%
Change in fair value of proceeds investment agreement                 (32 )%                  (1 )%
Loss on extinguishment of secured convertible debentures                - %                   (5 )%
Secured convertible note payable issuance expenses                     (1 )%                  (3 )%
Other income and interest expense, net                                  - %                  (12 )%
Loss before income tax benefit                                        (96 )%                (138 )%
Income tax expense (benefit)                                            - %                    - %

Net loss                                                              (96 )%                (138 )%

Net loss per share information:
Basic                                                      $        (0.87 )       $        (1.93 )
Diluted                                                    $        (0.87 )       $        (1.93 )




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Revenues

Our current product offerings include the following:





  Product                           Description                          Retail Price
EVO-HD         An in-car digital audio/video system which records in
               1080P high definition video and is designed for law
               enforcement and commercial fleet customers. This
               system includes two cameras and can use up to four
               external cameras for a total of four video streams.
               This system includes integrated, patented VuLink
               technology, internal GPS, and an internal Wi-Fi
               Module. The system includes the choice between a
               Wireless Microphone Kit or the option to use the
               FirstVu HD Body Camera as the wireless microphone.
               This system also includes a three-year Advanced
               Exchange Warranty. We offer a cloud storage solution
               to manage the recorded evidence and charge a monthly
               device license fee for our cloud storage.                $         4,795
DVM-750        An in-car digital audio/video system that is
               integrated into a rear-view mirror primarily designed
               for law enforcement customers. We offer local storage
               as well as cloud storage solutions to manage the
               recorded evidence. We charge a monthly storage fee for
               our cloud storage option and a one-time fee for the
               local storage option. This product is being
               discontinued and phased out of our product line but
               the Company is supporting existing customers with new
               products and repair and parts.                           $         2,995
DVM-100        An in-car digital audio/video system that is
               integrated into a rear view mirror primarily designed
               for law enforcement customers. This system uses an
               integrated fixed focus camera. This product is being
               discontinued and phased out of our product line but
               the Company is supporting existing customers with new
               products and repair and parts.                           $         1,895
DVM-400        An in-car digital audio/video system that is
               integrated into a rear view mirror primarily designed
               for law enforcement customers. This system uses an
               external zoom camera. This product is being
               discontinued and phased out of our product line but
               the Company is supporting existing customers with new
               products and repair and parts.                           $         2,795
DVM-250 Plus   An in-car digital audio/video system that is
               integrated into a rear view mirror primarily designed
               for commercial fleet customers. We offer a web-based,
               driver management and monitoring analytics package for
               a monthly service fee that is available for our
               DVM-250 customers.                                       $         1,295
DVM-800        An in-car digital audio/video system which records in
               480P standard definition video that is integrated into
               a rear view mirror primarily designed for law
               enforcement customers. This system can use an internal
               fixed focus camera or two external cameras for a total
               of four video streams. This system also includes the
               Premium Package which has additional warranty. We
               offer local storage as well as cloud storage solutions
               to manage the recorded evidence. We charge a monthly
               storage fee for our cloud storage option and a
               one-time fee for the local storage option.               $         3,995
DVM-800 Lite   An in-car digital audio/video system which records in
               480P standard definition video that is integrated into
               a rear view mirror primarily designed for law                    Various
               enforcement customers. This system can use an internal      prices based
               fixed focus camera or two external cameras for a total                on
               of four video streams. We offer local storage as well      configuration
               as cloud storage solutions to manage the recorded
               evidence. We charge a monthly storage fee for our
               cloud storage option and a one-time fee for the local
               storage option. This system is replacing the DVM-100
               and DVM-400 product offerings and allows the customer
               to configure the system to their needs.
FirstVU HD     A body-worn digital audio/video camera system
               primarily designed for law enforcement customers. We
               also offer a cloud based evidence storage and
               management solution for our FirstVU HD customers for a
               monthly service fee.                                     $           595
VuLink         An in-car device that enables an in-car digital
               audio/video system and a body worn digital audio/video
               camera system to automatically and simultaneously
               start recording.                                         $           495




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We sell our products and services to law enforcement and commercial customers in the following manner:

? Sales to domestic customers are made directly to the end customer (typically a

law enforcement agency or a commercial customer) through our sales force,

comprised of our employees. Revenue is recorded when the product is shipped to

the end customer.

? Sales to international customers are made through independent distributors who

purchase products from us at a wholesale price and sell to the end user

(typically law enforcement agencies or a commercial customer) at a retail

price. The distributor retains the margin as its compensation for its role in

the transaction. The distributor generally maintains product inventory,

customer receivables and all related risks and rewards of ownership. Revenue

is recorded when the product is shipped to the distributor consistent with the


    terms of the distribution agreement.

  ? Repair parts and services for domestic and international customers are
    generally handled by our inside customer service employees. Revenue is

recognized upon shipment of the repair parts and acceptance of the service or


    materials by the end customer.

We may discount our prices on specific orders based upon the size of the order, the specific customer and the competitive landscape.





Revenues for the years ended December 31, 2019 and 2018 were derived from the
following sources:



                                     Years ended December 31,
                                     2019                 2018
DVM-800 and DVM 800HD                      36 %                 45 %
FirstVu HD                                 12 %                 12 %
DVM-250 Plus                               11 %                  7 %
Cloud service revenue                       7 %                  6 %
DVM-750                                     1 %                  4 %
VuLink                                      1 %                  2 %
EVO                                         3 %                  - %
Repair and service                         15 %                 13 %
Accessories and other revenues             14 %                 11 %
                                          100 %                100 %

Product revenues for the years ended December 31, 2019 and 2018 were $7,732,796 and $9,130,911 respectively, a decrease of $1,398,115 (15%), due to the following factors:

? In general, we have experienced pressure on our revenues as our in-car and

body-worn systems are facing increased competition because our competitors

have released new products with advanced features. Additionally, our law

enforcement revenues declined over the prior period due to price-cutting,

willful infringement of our patents and other actions by our competitors,

adverse marketplace effects related to the patent litigation and supply chain

issues. We introduced our EVO-HD late in second quarter 2019 with the goal of

enhancing our product line features to meet these competitive challenges and

we started to see traction in late 2019. We expect customers and potential


    customers to review and test the EVO-HD prior to committing to this new
    product platform, which may have delayed any meaningful positive impact to
    revenues until 2020.




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  ? We shipped five individual orders in excess of $100,000, for a total of
    approximately $951,734 in revenue for the year ended December 31, 2019,
    compared to six individual orders in excess of $100,000, for a total of

approximately $984,450 in revenue for the year ended December 31, 2018. Our

average order size increased to approximately $2,259 in the year ended

December 31, 2019 from $2,075 during the year ended December 31, 2018. For

certain opportunities that involve multiple units and/or multi-year contracts,

we have occasionally discounted our products to gain or retain market share

and revenues.