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OFFON

IMAGE SENSING SYSTEMS, INC.

(ISNS)
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IMAGE SENSING : Management's Discussion and Analysis of Financial Condition and Results of Operations (form 10-Q)

05/03/2021 | 04:23pm EDT

Overview

General. We are a leading provider of above-ground detection products and solutions for the intelligent transportation systems ("ITS") industry. Our family of products, which we market as Autoscope® video or video products ("Autoscope"), RTMS® radar or radar products ("RTMS"), and IntellitraffiQ® or iQ products, provides end users with the tools needed to optimize traffic flow and enhance driver safety. Our technology analyzes signals from sophisticated sensors and transmits the information to management systems and controllers or directly to users. Our products provide end users with complete solutions for the intersection and transportation markets.

Our technology is a process in which software, rather than humans, examines outputs from various types of sophisticated sensors to determine what is happening in a field of view. In the ITS industry, this process is a critical component of managing congestion and traffic flow. In many cities, it is not possible to build roads, bridges and highways quickly enough to accommodate the increasing congestion levels. On average, United States commuters lose 99 hours a year in congestion, which costs motorists $88 billion a year in time, an average of $1,377 per driver (per INRIX 2019 Global Traffic scorecard). We believe this growing use of vehicles will make our ITS solutions increasingly necessary to complement existing and new roadway infrastructure to manage traffic flow and optimize throughput.

We believe our solutions are technically superior to those of our competitors because they have a higher level of accuracy, limit the occurrence of false detection, are generally easier to install with lower costs of ownership, work effectively in a multitude of light and weather conditions, and provide end users the ability to manage inputs from a variety of sensors for a number of tasks. It is our view that the technical advantages of our products make our solutions well suited for use in ITS markets.

We believe the strength of our distribution channels positions us to increase the penetration of our technology­driven solutions in the marketplace. We market our Autoscope video products in the United States, Mexico, Canada and the Caribbean through exclusive agreements with Econolite Control Products, Inc. ("Econolite"), which we believe is the leading distributor of ITS intersection control products in these markets.

We market the RTMS radar systems to a network of distributors globally. On a limited basis, we may sell directly to the end user. We market our Autoscope video products outside the United States, Mexico, Canada and the Caribbean through a combination of distribution and direct sales channels through our office in Spain. Our end users primarily include governmental agencies and municipalities.

The following discussion of period-to-period changes and trends in financial statement results under "Management's Discussion and Analysis of Financial Condition and Results of Operations" aligns with the financial statement presentation discussed above.

Trends and Challenges in Our Business

We believe the expected growth in our business can be attributed primarily to the following global trends:

   º worsening traffic caused by increased numbers of vehicles in metropolitan
     areas without corresponding expansions of road infrastructure and the need
     to automate safety, security and access applications for automobiles and
     trucks, which has increased demand for our products;
   º advances in information technology, which have made our products easier to
     market, implement and integrate;
   º the continued funding allocations for centralized traffic management
     services and automated enforcement schemes, which have increased the
     ability of our primary end users to implement our products; and
   º general increases in the cost effectiveness of electronics, which make our
     products more affordable for end users.

We believe our continued growth primarily depends upon:

   º continued adoption and governmental funding of ITS and other automated
     applications for traffic control, safety and enforcement in developed
     countries;
   º a propensity by traffic engineers to implement lower cost technology-based
     solutions rather than civil engineering solutions such as widening
     roadways;
   º countries in the developing world adopting above-ground detection
     technology, such as video or radar, instead of in-pavement loop technology
     to manage traffic; and

   º our ability to develop new products that provide increasingly accurate
     information and enhance the end users' ability to cost-effectively manage
     traffic and environmental issues.

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Because the majority of our end users are governmental entities, we are faced with challenges related to potential delays in purchasing decisions by those entities and changes in budgetary constraints. These contingencies could result in significant fluctuations in our revenue among periods. The ongoing economic environment in Europe and the United States and the COVID-19 pandemic declared in March 2020 are further adding to the unpredictability of purchasing decisions, creating more delays than usual and decreasing governmental budgets, and they are likely to continue to affect our revenue.

Key Financial Terms and Metrics

Revenue. We derive revenue from two sources: (1) royalties received from Econolite for sales of the Autoscope video systems in the United States, Mexico, Canada and the Caribbean and (2) revenue received from the direct sales of our RTMS radar systems and our Autoscope video systems in Europe and Asia. Autoscope video royalties are calculated using a profit sharing model in which the gross profits on sales of product made through Econolite are shared equally with Econolite. This royalty arrangement has the benefit of decreasing our cost of revenues and our selling, marketing and product support expenses because these costs and expenses are borne primarily by Econolite. Although this royalty model has a positive impact on our gross margin, it also negatively impacts our total revenue, which would be higher if all the sales made by Econolite were made directly by us. The royalty arrangement is exclusive under the long-term Manufacturing, Distributing and Technology Agreement dated as of June 11, 1991, as amended (the "Econolite Agreement"), between the Company and Econolite.

Cost of Revenue. Software amortization is the sole cost of revenue related to royalties, as virtually all manufacturing, warranty and related costs are incurred by Econolite. Cost of revenue related to product sales consists primarily of the amount charged by our third party contractors to manufacture hardware products, whose costs are influenced mainly by the cost of electronic components. The cost of revenue also includes logistics costs, estimated expenses for product warranties, and inventory obsolescence. The key metric that we follow is achieving certain gross margin percentages on product sales by operating segment.

Operating Expenses. Our operating expenses fall into three categories: (1) selling, marketing and product support; (2) general and administrative; and (3) research and development. Selling, marketing and product support expenses consist of various costs related to sales and support of our products, including salaries, benefits and commissions paid to our personnel; commissions paid to third parties; travel, trade show and advertising costs; second-tier technical support for Econolite; and general product support, where applicable. General and administrative expenses consist of certain corporate and administrative functions that support the development and sales of our products and provide an infrastructure to support future growth. These expenses include management, supervisory and staff salaries and benefits; legal and auditing fees; travel; rent; and costs associated with being a public company, such as board of director fees, listing fees and annual reporting expenses. Research and development expenses consist mainly of salaries and benefits for our engineers and third party costs for consulting and prototyping. We measure all operating expenses against our annually approved budget, which is developed with achieving a certain operating margin as a key focus. We also include any restructuring costs in operating expenses.

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Non-GAAP Operating Measures. We provide certain non-GAAP financial information as supplemental information to financial measures calculated and presented in accordance with GAAP (Generally Accepted Accounting Principles in the United States). This non-GAAP information excludes the impact of depreciating fixed assets and amortizing intangible assets, and it may exclude other non-recurring items. Management believes that this presentation facilitates the comparison of our current operating results to historical operating results. Management uses this non-GAAP information to evaluate short-term and long-term operating trends in our core operations. Non-GAAP information is not prepared in accordance with GAAP and should not be considered a substitute for or an alternative to GAAP financial measures and may not be computed the same as similarly titled measures used by other companies.

Reconciliations of GAAP income from operations to non-GAAP income from operations are as follows (in thousands):


                                                   Three-Month Period Ended
                                                           March 31,
                                                        2021                2020

Income (loss) from operations                $        411                 $ (275 )
Adjustments to reconcile to non-GAAP income
Amortization of intangible assets                     187                    174
Depreciation                                           40                     50
Non-GAAP income (loss) from operations       $        638                 $  (51 )




Seasonality. Our quarterly revenues and operating results have varied significantly in the past due to the seasonality of our business. Our first quarter generally is the weakest due to weather conditions that make roadway construction more difficult in parts of North America, Europe and northern Asia. We expect such seasonality to continue for the foreseeable future. Additionally, our international revenues regularly contain individually significant sales. This can result in significant variations of revenue between periods. Accordingly, we believe that quarter-to-quarter comparisons of our financial results should not be relied upon as an indication of our future performance. No assurance can be given that we will be able to achieve or maintain profitability on a quarterly or annual basis in the future.

Segments. We currently operate in two reportable segments: Intersection and Highway. Autoscope video is our machine-vision product line, and revenue consists of royalties (all of which are received from Econolite), as well as a portion of international product sales. Video products are normally sold in the Intersection segment. RTMS and IntellitraffiQ are our radar product lines, and revenue consists of sales to external customers. Radar products are normally sold in the Highway segment. As a result of business model changes and modifications in how we manage our business, we may reevaluate our segment definitions in the future.

The following table sets forth selected unaudited financial information for each of our reportable segments (in thousands):

                                               Three Months Ended March 31,
                                     Intersection        Highway            Total
                                    2021     2020     2021     2020     2021     2020

Revenue                            $ 1,892  $ 2,250  $ 1,087  $   909  $ 2,979  $ 3,159
Gross profit                         1,724    2,069      549      467    2,273    2,536

Amortization of intangible assets 92 92 95 82 187 174 Intangible assets

                    1,407    1,651    1,690    2,071    3,097    3,722



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Results of Operations

The following table sets forth, for the periods indicated, certain statements of operations data as a percent of total revenue and gross profit on product sales and royalties as a percentage of product sales and royalties, respectively.

                                          Three-Month Periods Ended
                                                  March 31,
                                         2021                      2020
Product sales                              39.0 %                  33.2 %
Royalties                                  61.0                    66.8
Total revenue                             100.0                   100.0
Gross profit - product sales               47.3                    49.4
Gross profit - royalties                   94.9                    95.6
Selling, general and administrative        45.9                    60.4
Research and development                   16.6                    28.6
Income (loss) from operations              13.8                    (8.7 )
Other income, net                          31.1                       -
Income tax expense (benefit)                6.9                    (5.2 )
Net income (loss)                          38.0                    (3.5 )


Total revenue decreased to $3.0 million in the first three months of 2021, from $3.2 million in the same period in 2020, a decrease of 5.7%. Royalty income decreased to $1.8 million in the first three months of 2021 from $2.1 million in the first three months of 2020, a decrease of 13.9%. Product sales increased to $1.2 million in the first three months of 2021 from $1.1 million in the first three months of 2020, an increase of 10.8%.

Revenue for the Intersection segment decreased to $1.9 million in the first three months of 2021 from $2.3 million in the first three months of 2020, a decrease of 15.9%. Revenue for the Highway segment increased to $1.1 million in the first three months of 2021 from $0.9 million in the first three months of 2020, an increase of 19.6%.

Gross margin percent for product sales decreased to 47.3% in the first three months of 2021 from 49.4% in the first three months of 2020. Product sales gross profit increased $31,000, or 6.0%, in the three months ended March 31, 2021 compared to the prior year period. The decrease in product gross margin percent was primarily the result of a reduction in the warranty reserve in the first quarter of 2020.

Gross margin percent for royalty sales for the three months ended March 31, 2021 decreased to 94.9% from 95.6% in the same period in 2020. Gross profit from royalties decreased $294,000, or 14.6%, in the first quarter of 2021 compared to the prior year period. The decrease in royalty gross margin percent was due to lower royalty revenues while software amortization expense remained substantially the same.

Selling, general and administrative expense was $1.4 million, or 45.9% of total revenue, in the first three months of 2021 compared to $1.9 million, or 60.4% of total revenue, in the first three months of 2020. A portion of the expense in the first three months of 2020 consisted of expenses for legal and outside consulting costs related to the efforts around exploring strategic alternatives to maximize shareholder value that we announced in January 2020. In light of current market conditions, including the effects of the COVID-19 pandemic, the strategic review process has been terminated.

Research and development expense decreased to $496,000, or 16.6% of total revenue, in the three-month period ended March 31, 2021, from $902,000, or 28.6% of total revenue, in the three-month period ended March 31, 2020. The decrease was due to higher capitalized software development costs in the three-month period ended March 31, 2021 of $123,000 compared to capitalized software costs of $22,000 for the same period in 2020. After normalizing for software development costs, overall research and development expenditures decreased in the three-month period ended March 31, 2021 compared to the same period in the prior year due to lower headcount.

The Company recognized other income of $931,000 for the forgiveness of the Paycheck Protection Program loan and accrued interest during the first quarter.

There was $205,000 of income tax expense and $164,000 of income tax benefit recorded in the three-months ended March 31, 2021 and 2020, respectively.

Consolidated net income was $1.1 million, or $0.21 per basic and diluted share, in the three-month period ended March 31, 2021 compared to a net loss of $(111,000), or $(0.02) per basic and diluted share, in the comparable prior year period.


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Liquidity and Capital Resources

At March 31, 2021, we had $8.2 million in cash and cash equivalents compared to $8.6 million in cash and cash equivalents at December 31, 2020.

Net cash used for operating activities was $186,000 in the first three months of 2021 compared to net cash provided by operating activities of $494,000 in the same period in 2020. The decrease in net cash provided by operating activities in the first three months of 2021 compared to the prior year period is primarily attributed to an increase in accounts receivable and a decrease in accounts payable.

Net cash used for investing activities was $133,000 for the first three months of 2021 compared to net cash used for investing activities of $97,000 in the same period in 2020. The increase of the amount of net cash used for investing activities in the first three months of 2021 compared to the prior year period was primarily the result of higher capitalized internal software development costs compared to the prior year period.

Net cash used for financing activities was $24,000 in the first three months of 2021 compared to $0 in the same period in 2020, due to shares withheld for taxes on the vesting of restricted stock units.

We believe that cash and cash equivalents on hand at March 31, 2021 and cash provided by operating activities will satisfy our projected working capital needs, investing activities, and other cash requirements for at least one year from the date of these financial statements.

Off-Balance Sheet Arrangements

We do not participate in transactions or have relationships or other arrangements with an unconsolidated entity, including special purpose and similar entities, or other off-balance sheet arrangements.

Critical Accounting Policies

Our significant accounting policies are described in Note 1 to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2020. The accounting policies used in preparing our interim Condensed Consolidated Financial Statements as of and for the three months ended March 31, 2021 are set forth elsewhere in this Quarterly Report on Form 10-Q and should be read in conjunction with those described in our Annual Report on Form 10-K and the risk factor set forth in Part II, Item 1A of this Quarterly Report on Form 10-Q.



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Cautionary Statement:

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange of 1934, as amended. Forward-looking statements represent our expectations or beliefs concerning future events and can be identified by the use of forward-looking words such as "expects," "believes," "may," "will," "should," "intends," "plans," "estimates," or "anticipates" or other comparable terminology. Forward-looking statements are subject to risks and uncertainties that may cause our actual results to differ materially from the results described in the forward-looking statements. Factors that might cause such differences include, but are not limited to:

   º our historical dependence on a single product for most of our revenue;
   º budget constraints by governmental entities that purchase our products,
     including constraints caused by declining tax revenue;
   º the continuing ability of Econolite to pay royalties owed;

   º the mix of and margin on the products we sell;
   º our dependence on third parties for manufacturing and marketing our
     products;
   º our dependence on single-source suppliers to meet manufacturing needs;
   º our failure to secure adequate protection for our intellectual property
     rights;
   º our inability to develop new applications and product enhancements;
   º the potential disruptive effect on the markets we serve of new and emerging
     technologies and applications, including vehicle-to-vehicle communications
     and autonomous vehicles;
   º unanticipated delays, costs and expenses inherent in the development and
     marketing of new products;
   º our inability to respond to low-cost local competitors;
   º our inability to properly manage any growth in revenue and/or production
     requirements;
   º the influence over our voting stock by affiliates;
   º our inability to hire and retain key scientific and technical personnel;
   º the effects of legal matters in which we may become involved;
   º our inability to achieve and maintain effective internal controls;
   º our inability to successfully integrate any acquisitions;
   º tariffs and other trade barriers;
   º political and economic instability, including continuing volatility in the
     economic and political environment of the European Union;
   º our inability to comply with international regulatory restrictions over
     hazardous substances and electronic waste; and
   º conditions beyond our control such as war, terrorist attacks, health
     epidemics (including the COVID-19 pandemic caused by the coronavirus) and
     economic recession.

We caution that the forward-looking statements made in this report or in other announcements made by us are further qualified by the risk factors set forth in Item 1A. of our Annual Report on Form 10-K for the fiscal year ended December 31, 2020.


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