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[February 14, 2013]
DYNASIL CORP OF AMERICA - 10-K/A - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Edgar Glimpses Via Acquire Media NewsEdge) The following management's discussion and analysis should be read in conjunction with our financial statements and the notes thereto appearing elsewhere inthis Form 10-K.
Overview Beginning with this annual report, the Company is divided into four reporting segments to more clearly delineate our main operating activities Below is a summary of these segments: · Contract Research: The Contract Research segment consists of the Radiation Monitoring Devices, Inc. ("RMD") business unit, which is among the largest small business participants in U.S. government-funded research.
· Optics: The Optics segment encompasses four business units (our original optics business ("Dynasil Fused Silica"), Optometrics, Hilger Crystal, and Evaporated Metal Films ("EMF")) that manufacture commercial products, including optical crystals for sensing in the security and medical imaging markets, as well as optical components, optical coatings and optical materials for scientific instrumentation and other applications.
· Instruments: The Instruments segment consists of Dynasil Products (formerly known as RMD Instruments), which manufactures precision instrumentation for medical and commercial applications.
· Biomedical: The Biomedical segment consists of a single business unit, Dynasil Biomedical Corporation ("Dynasil Biomedical"), a medical technology incubator, developing disruptive technologies for a wide spectrum of applications, including hematology, hypothermic core cooling and tissue sealants.
For information about our financial segments and geographical information about our operating revenues and assets, see Note 16 to the Consolidated Financial Statements included in this Report. A complete description of our strategy is included in Item 1 of this Form 10-K.
Our markets are characterized by rapidly changing technology and the needs of our customers change and evolve regularly. Accordingly, our success depends on our ability to develop services and products that address these changing needs and to provide the people and technology needed to deliver these services and products. To remain competitive, we must consistently provide superior service, technology and performance on a cost-effective basis to our customers. Our business performance also is influenced by a variety of other factors including, but not limited to, economic conditions, U.S. Government spending on research and development programs, the availability of Research & Experimentation tax credits, competition, regulatory requirements and insurance costs. Further information on certain risks to our Company is located in Item 1a of this Form 10-K.
Fiscal 2012 Financial Overview On December 31, 2012, the Company announced it is in default of certain financial covenants set forth in the terms of its outstanding indebtedness with respect to its fiscal year ended September 30, 2012. The Company continues to be current with all principal and interest payments due on all its outstanding indebtedness and management expects to continue discussions with its lenders to address the financial covenant situation. Under the default condition, our lenders have the ability to require immediate payment of all indebtedness under our loan agreements. While the lenders have not exercised this right, their ability to require immediate payment has caused all of our outstanding indebtedness to be accelerated to current classification on our consolidated financial statements. Given the uncertainty created by the defaults under the Company's outstanding indebtedness, the Company's independent registered public accounting firm has included a "going concern" qualification in its audit opinion for the year ended September 30, 2012.
The Company has recently taken and will continue to take actions to improve its liquidity, including the implementation of a number of initiatives designed to conserve cash, optimize profitability and right-size the cost structure ofits various businesses.
3 The Company has retained Argus Management Corporation and Mirus Capital as financial advisors to assist it in evaluating strategic and restructuring alternatives, including the potential sale of product lines and/or a Company division. While the Company is actively considering such strategic alternatives, there can be no assurances that any such transaction will occur, or, if a transaction is completed, it will be on terms favorable to the Company.
In fiscal year 2012, we achieved nominal revenue growth but incurred higher expenses than in fiscal 2011. Revenues grew 2.0% from $47.0 million to $47.9 million, offset by a combination of higher-than-expected research and development costs and increased Selling, General & Administrative (SG&A) expenses. During the year we made significant investments within the Instruments segment on upgrades to the segment's two main product lines, specifically, the new hand-held lead paint analyzer, the LPXpro™, and the new wireless medical probe used in cancer surgery, the Navigator 2.0™ gamma counter. Though development of these products has been completed, they have not yet received the required regulatory approvals and additional changes, therefore, may become necessary. As a result of the higher-than-expected costs and delays in product launches, the Company determined that there was a decline in the fair value of business operation, and we recorded a non-cash goodwill impairment charge of $2.3 million for the period ended September 30, 2012 relating to our Instruments segment. Additionally, the Company incurred a large non-recurring increase in SG&A expenses. The increase stemmed from the Company's internal review of the cash application, billing and internal controls at RMD. The Company conducted this review at the direction of the Audit Committee of the Board of Directors.
The Company incurred approximately $466,000 in SG&A expenses associated with the review. As a result of the review, which has been satisfactorily completed, the Company has adopted certain improved practices and internal controls. We do not anticipate additional expenses for this matter.
As a result of the foregoing, our loss from operations for fiscal 2012 was $3.7 million, compared with income from operations of $2.3 million in fiscal 2011.
The net loss for fiscal 2012 was $4.3 million, or $0.29 per share, compared with net income of $1.35 million, or $0.08 per share, in 2011.
During the year, we pursued several growth initiatives, including: · dual mode nuclear detector technology (which generated its first revenue in 2012); · biomedical technologies within the Dynasil Biomedical business unit, concentrating on hematology, hypothermic core cooling and tissue sealants; · patent portfolio, which we expanded during the year primarily within the Contract Research segment.
The Company is actively exploring commercialization opportunities in thin film digital x-rays, sensors for nondestructive testing and radiation dosimeters based on technologies developed at RMD. No determination has been made as to the Company's entry into these market segments.
4 Results of Operations Results of Operations for the Fiscal Year Ended September 30, 2012 Contract Research Optics Instruments Biomedical Total Revenue 24,270,675 17,456,436 6,054,752 105,287 47,887,150 Gross Profit 8,859,780 7,125,962 3,436,542 83,459 19,505,743 SG&A 9,523,642 5,548,421 4,915,723 939,149 20,926,935 Impairment of goodwill - - 2,284,499 - 2,284,499 Operating Income (Loss) (663,862 ) 1,577,541 (3,763,680 ) (855,690 ) (3,705,691 ) GM % 36.5 % 40.8 % 56.8 % 79.3 % 40.7 % Depreciation and Amortization 237,623 796,847 575,246 60,003 1,669,719 Capital expenditures 348,314 462,445 207,454 - 1,018,213 Intangibles, Net 366,853 960,821 5,135,634 239,997 6,703,305 Goodwill 4,938,625 1,300,463 4,015,072 - 10,254,160 Total Assets 12,870,151 11,588,145 12,537,403 469,729 37,465,428 Results of Operations for the Fiscal Year Ended September 30, 2011 Contract Research Optics Instruments Biomedical Total Revenue 24,874,088 15,839,205 6,238,373 - 46,951,666 Gross Profit 10,339,990 6,391,291 3,018,950 - 19,750,231 SG&A Costs 9,149,838 5,178,590 2,639,944 495,201 17,463,573 Operating Income (Loss) 1,190,152 1,212,700 379,007 (495,201 ) 2,286,658 GM % 41.6 % 40.4 % 48.4 % 0.0 % 42.1 % Depreciation and Amortization 147,687 581,464 503,922 - 1,233,073 Capital expenditures 284,098 915,978 343,186 - 1,543,262 Intangibles, Net 456,367 1,096,773 5,613,366 300,000 7,466,506 Goodwill 4,938,625 1,283,775 6,299,571 - 12,521,971 Total Assets 10,447,842 14,683,407 15,363,526 371,808 40,866,583 Revenue Revenues for the fiscal year ended September 30, 2012 were $47,887,150. This represents an increase of 2.0% over revenues for the fiscal year ended September 30, 2011 of $46,951,666. Contract Research revenues declined by 2.4% as a result of lower billable costs. The contract revenue backlog for contract research continues to be strong and is approximately $36 million and contains about 42% SBIR grants as of September 30, 2012. The Company is actively pursuing alternative funding avenues to further reduce the percentage of work through the SBIR program. This includes contract research for commercial businesses rather than governmental agencies.
Revenues in the Optics segment increased by 10.2% to $17.5 million in fiscal 2012. New customers and new product growth initiatives continue to be pursued throughout this segment.
Revenues in the Instruments segment declined by 2.9% to $6.1 million in fiscal year 2012. We believe that customers have delayed purchases of our existing products in anticipation of the availability of the newly refreshed products which are not yet approved by the necessary regulatory agencies.
The Biomedical segment achieved its first revenues of $105,287, primarily through a technology development contract with the Mayo Clinic.
Gross Profit Gross profit for fiscal year 2012 declined by 1.2% to $19,505,743 from the prior year amount of $19,750,231. Gross profit as a percentage of sales declined to 40.7% from 42.1% at September 30, 2011 as a result of lower gross margin in the Contract Research segment and mix changes between the segments.
5 Gross profit dollars declined by 14.3% for the Contract Research segment. Gross profit as a percentage of sales declined to 36.5% from 41.6%, due to losses incurred to complete contracts and costs incurred in excess of provisional contract rates. This decline in gross profit for Contract Research was offset by improvements in other segments. The Optics segment's gross margin stayed relatively steady at 40.8% from 40.4%. The Instruments segment's gross margin improved to 56.8% from 48.4% as a result of additional revenues derived, in part, from re-activating the radioactive source in our installed base of lead paint analyzer ("LPA") products. The LPA units contain a tiny radioactive source which must be periodically refreshed. Instruments also sold three RadCam units during the year at high margin. A RadCam unit is a radiation detector married with a camera to provide a visual display of radioactive locations. Finally, the Biomedical segment had its first revenues, with small costs of goods sold.Selling, General & Administrative ("SG&A") Expenses SG&A expenses increased by $3.5 million to $20,926,935 or 43.7% of sales, for fiscal year 2012, from $17,463,573 or 37.2% of sales for fiscal year 2011. All segments experienced SG&A increases at various levels. All segments shared in higher costs at the corporate level. Corporate level costs are allocated to each operating business unit. The main higher cost at the corporate level related to the Company initiating an internal review of the billing and accounting practices and internal controls at its RMD division. The Company conducted this review at the direction of the Audit Committee of the Board of Directors. The Company incurred a total of approximately $466,000 of such expenses, all of which are reflected in the fiscal year ended September 30, 2012. This investigation has been satisfactorily completed and, as a result, the Company has adopted certain improved practices and internal controls, and does not anticipate additional expenses for this matter.
Contract Research SG&A increased to 39.2% of sales in fiscal 2012 from 36.8% of sales in the prior year. This segment has incurred the costs for the previously disclosed severance agreement with the former President of RMD in the amount of $325,000. Costs were also incurred to increase resources to better handle internal processes and internal control matters.
SG&A within the Optics segment increased $369,831, and the margin declined slightly to 31.8% of sales in fiscal 2012 from 32.7% in the prior year.
The Instruments segment incurred the greatest increase in SG&A costs, increasing $2,275,779 over prior year to 81.2% of sales in fiscal 2012 compared to 42.3% of sales in prior year. This segment has two main product lines: a hand-held lead paint analyzer and a medical gamma probe used primarily in breast cancer treatment. Both product lines were in need of revitalization with new features and functionality to maintain their positions in the marketplace. The Company spent $1.3 million on research and development on the products and significant monies on sales and marketing efforts in advance of the new product launches.
Administrative staff was also increased in anticipation of future higher volume.
As of this date, the updated products, the new hand-held lead paint analyzer, LPXpro™, and the new wireless medical probe, the Navigator 2.0™, are awaiting regulatory approval so that they can be sold in the marketplace. Recent sales of existing products have suffered as a result. Steps have been taken to reduce costs while awaiting the regulatory approvals. These include downsizing the administrative staff - including replacement of the general manager for the segment - and reducing the scheduled hours of the production staff. Regulatory approvals are expected imminently, but the timing is yet unknown. There can be no assurance when or if the regulatory approvals will be obtained and additional delays could lead to a further deterioration of product revenues. At September 30, 2012, the Company recorded an impairment of goodwill in the amount of $2,284,499 associated with the Instruments segment.
Finally, we have a full year of costs from the Biomedical segment in fiscal year 2012 as compared to only six months of costs in fiscal year 2011. SG&A costs were $939,149 compared to $495,201 in fiscal 2011. These costs were incurred to advance the development of the three main technologies: hematology, hypothermic core cooling and tissue sealants. While we believe these technologies are progressing favorably, they remain in the early stages of development and there can be no assurance that we will be able to successfully bring any of them to market. In order to advance further development activities, we are exploring the availability of outside financing, including through a sale, licensing or joint venture involving one or more technologies, though we may not be able to secure any such financing arrangement on favorable terms or at all.
6 Net Interest Expense Net interest expense decreased slightly to $639,096 in fiscal 2012 from $641,815 in fiscal 2011. There were offsetting components to the change. First, the Company continued to make regular payments of principal to Sovereign Bank, N.A.
("Sovereign" or the "Bank") under the Loan and Security Agreement, dated July 7, 2010, as amended on April 1, 2011, April 12, 2012, and June 29, 2012 (the "Term Loan and the Acquisition Line of Credit"). With these periodic payments, debt was reduced by $1,860,678 during the year ended September 30, 2012. Offsetting this reduction in interest-bearing debt was new borrowings from Massachusetts Capital Resources Company on July 31, 2012 in the amount of $3.0 million.
Proceeds of this borrowing were used to repurchase shares pursuant to the exercise of a contractual put right by a stockholder, in the amount of $1,857,546 with the remainder used for general working capital purposes. The new borrowings are subordinated to Sovereign's senior debt. The new borrowingscarry an interest rate of 10%.
Income Tax Expense Total income tax expense decreased from a tax provision of $293,000 in fiscal 2011 to a tax benefit of ($41,000) in fiscal 2012. There were offsetting components to the net decrease. First, income (loss) before the provision for income taxes decreased significantly resulting in a reduction of current tax due for federal and state purposes as compared to the prior year. This decrease was offset by a full valuation allowance on the U.S. net deferred tax assets recorded during fiscal 2012. Additionally, the current year tax benefit from research and experimentation credits is lower as the federal research and experimentation credit is not extended as of September 30, 2012.
Net Income The Company had a net loss of $4,303,766 for the year ended September 30, 2012 compared to net income of $1,351,645 for the fiscal year ended September 30, 2011. Lower operating results from higher costs, goodwill impairment and the valuation allowance on tax assets due to the going concern opinion all contributed to the current year loss.
7 Liquidity and Capital Resources Liquidity Overview On December 31, 2012, the Company announced it is in default of the financial covenants set forth in the terms of its outstanding indebtedness at September 30, 2012. These covenants require the Company to maintain specified ratios of earnings before interest, taxes, depreciation and amortization (EBITDA) to fixed charges and to total/senior debt. The Company continues to be current with all principal and interest payments due on all its outstanding indebtedness and management expects to continue discussions with its lenders to address the financial covenant situation.
These financial covenant defaults give the lenders the right to accelerate the maturity of the indebtedness outstanding and foreclose on any security interest.
Furthermore, Sovereign Bank, N.A, the Company's senior lender, may, at its option, impose a default interest rate with respect to the senior debt outstanding, which is 5% higher than the rate otherwise in effect. To date, the lenders have not taken any such actions. However, the Company cannot predict when or whether a resolution of this situation will be achieved.
As of September 30, 2012, the Company had total indebtedness outstanding of approximately $12.0 million, consisting of approximately $9.0 million of senior debt owed to Sovereign Bank and approximately $3.0 million of subordinated debt owed to Massachusetts Capital Resources Company. The Company's indebtedness is secured by substantially all the accounts and assets of the Company and is guaranteed by its subsidiaries.
The causes for the covenant violations are lower revenue and higher than expected expenses in the Company's Dynasil Products and RMD divisions during the fiscal quarter ended September 30, 2012, combined with the continued investment in Dynasil Biomedical Corp. and the Company's Dual Mode nuclear detection initiative. In addition, the Company incurred a significant, non-recurring charge of approximately $466,000 to its selling, general and administrative expenses during that quarter related to costs incurred as a result of a review, under the direction of the Audit Committee of the Board, of certain cash application processes and billing practices of the RMD division. This investigation has been completed and has resulted in modifications in the division's practices and internal controls. The Company does not anticipate additional expenses for this matter.
Because of the uncertainty of any resolution of the covenant violations and possibility of an acceleration of the indebtedness by the lenders, the Company has reclassified all of its outstanding indebtedness to current classification in the financial statements for the year ended September 30, 2012 filed herewith. As a result, the Company's independent registered public accountants, McGladrey LLP, has included a "going concern" qualification in its audit opinion with respect to such financial statements.
The Company has recently taken and will continue to take actions to improve its liquidity, including the implementation of a number of initiatives designed to conserve cash, optimize profitability and right-size the cost structure of its various businesses. The Company has retained Argus Management Corporation and Mirus Capital as financial advisors to assist it in evaluating strategic and restructuring alternatives, including the potential sale of product lines and/or a Company division. While the Company is actively considering such strategic alternatives, there can be no assurances that any such transaction will occur, or, if a transaction is completed, it will be on terms favorable to the Company.
Net cash as of September 30, 2012 was $3,414,880 which was a decrease of $1,064,960 as compared to $4,479,840 at September 30, 2011. The Company does not currently have cash available to satisfy its obligations under its indebtedness if it were to be accelerated or payment demanded. If the Company is not able to resolve its current defaults under its outstanding indebtedness and improve its liquidity through the actions described above, it may not have sufficient liquidity to meet its anticipated cash needs for the next twelve months.
8 Net cash provided by operating activities Net cash provided by operating activities was $693,054 for fiscal year 2012 versus $3,892,646 for fiscal year 2011. Fiscal year 2012 net loss was $4,303,766. There were non-cash expenses contained in the net loss which included stock compensation expense of $935,396, depreciation and amortization expense of $1,669,719 and the impairment of goodwill was $2,284,499. These major non-cash items totaled $4,889,614. Net changes in assets totaled $1,695,234.
This included $986,133 in an increase in accounts receivable, net of unbilled accounts receivable. Days Sales Outstanding ("DSO") increased to 63.3 days at September 30, 2012 from a record low of 46.1 days at September 30, 2011.
Contract Research, the largest business segment, experienced an increase in DSO from prior year results of 35.8 days to 67.0 days at September 30, 2012.
Expected improvements have yet to materialize and we continue efforts to streamline processes and improve collections. We do not believe that these internal procedural matters will ultimately affect the collectability of these receivables and accordingly, we have not made any increase in allowance for doubtful accounts for these receivables. DSO for the Optics segment was 50.9 days at September 30, 2012 compared with 49.5 days for the period in the prior year. The Instruments segment's DSO was 80.4 days at September 30, 2012 compared with a prior year DSO of 91.1 days. This segment has a portion of its revenues through distributors who usually have extended terms beyond net 30 days.
Finally, the Biomedical segment has little revenue and a measure of DSO is not meaningful. Increases in assets were partially offset by net changes in liabilities of $1,503,514 for accounts payable, accrued expenses and deferred revenue.
Cash flows used in investing activities Cash flows used in investing activities were $1,018,213 for fiscal 2012 compared with $1,843,262 for fiscal 2011. All expenditures in 2012 were made to purchase machinery and equipment and to invest in leasehold improvements. Fiscal year 2011 included $300,000 to acquire biomedical technologies by the newly created Dynasil Biomedical Corp. In fiscal 2012, the Contract Research segment used $348,314, primarily for leasehold improvements. The Optics segment used $462,445, primarily for replacement machinery and equipment. The Instruments segment used $207,454, primarily for machinery and equipment used in research, development and engineering. Biomedical had no capital expenditures. There are currently plans for capital expenditures of $1,511,000 during fiscal year 2013, depending on the availability of cash and/or financing. Due to the uncertainty with respect to the Company's long-term financing arrangements, the Company is not able to determine whether financing will be available to fund these capital expenditures.
Cash flows from financing activities Cash flows from financing activities used $711,701 of cash in fiscal 2012 and used $1,803,411 of cash in fiscal 2011. Fiscal 2012 included new financing in the amount of $3,000,000 under a Note Purchase Agreement with Massachusetts Capital Resource Company ("MCRC"). The Company used $1,857,546 of the financing proceeds to repurchase shares of common stock pursuant to a put right exercised by Dr. Gerald Entine, a former owner of RMD and RMD Instruments, which required the repurchase of a total of 928,773 shares of Dynasil common stock held by Dr.
Entine and certain affiliates (collectively "Entine") for an aggregate purchase price of $1,857,546. This put right originated from the Company's acquisition of RMD and RMD Instruments in July 2008 and is set forth in the Asset Purchase Agreement dated July 1, 2008 by and among the Company, RMD Instruments Corp., RMD Instruments, LLC and Entine. Transaction costs for the new financing used $56,600 in cash.
Finally, current year cash of $1,860,678 was used for regularly scheduled payments to Sovereign/Santander Bank under the five year term debt and acquisition line of credit.
Summary of Terms of Outstanding Indebtedness Management expects to continue discussions with its lenders to address the financial covenant defaults as of September 30, 2012 as described above. The following is summary of the terms of the existing loan agreement in place with the Company's senior lender, Sovereign Bank, and the terms of subordinated debt owed to Massachusetts Capital Resources Company.
Sovereign Bank Loan Agreement On June 29, 2012, the Company entered into a letter agreement (the "Waiver Letter") with Sovereign as well as Amendment No. 3 (the "Amendment") to the Loan and Security Agreement, dated July 7, 2010, as amended on April 1, 2011 and April 12, 2012 (the "Original Loan Agreement"). Under the Waiver Letter, the Lender agreed to waive non-compliance by the Company with certain financial covenants under the Original Loan Agreement as of June 30, 2012, subject to the Company's compliance with the terms of the Amendment, including the requirement that the Company would raise, on or before September 30, 2012, at least $2,000,000 in gross proceeds from the sale of its capital stock and/or the incurrence of new indebtedness which is subordinated to the indebtedness in favor of the Lender, on terms and conditions acceptable to the Lender in its sole discretion (the "Required Capital Raise") and applying the proceeds as described below, all of which the Company has successfully completed.
9 The Amendment also made certain other changes to the Original Loan Agreement, including certain financial covenants, limitations on capital expenditures and the termination of the Company's acquisition line of credit, in each case as described in more detail below. The Amendment did not change the interest rates on outstanding indebtedness under the Original Loan Agreement.
The terms of the Amendment are described below: · The Required Capital Raise on or before September 30, 2012 Under the Amendment, the Company agreed with the Lender that the Company would raise, on or before September 30, 2012, at least $2,000,000 in gross proceeds from the sale of its capital stock and/or the incurrence of new indebtedness which is subordinated to the indebtedness in favor of the Lender, on terms and conditions acceptable to the Lender in its sole discretion. As disclosed in the Company's Form 8-K filed on June 8, 2012, the Company has incurred indebtedness in favor of certain entities affiliated with Dr. Gerald Entine (together, "Entine") in the aggregate principal amount of $1,857,546 (the "Entine Indebtedness"). The Company incurred the Entine Indebtedness in satisfaction of its obligation to repurchase certain shares of Dynasil common stock from Entine pursuant to a put right exercised by Entine on February 12, 2012. The proceeds of the Required Capital Raise must first be used to repay all amounts outstanding under the Entine Indebtedness by September 30, 2012, and thereafter for general working capital needs. The Required Capital Raise has been completed as of July 31, 2012 pursuant to the Note Purchase Agreement ("the Agreement") with Massachusetts Capital Resource Company ("MCRC") described below. Pursuant to the terms of the Agreement, the Company issued and sold to MCRC a $3,000,000 subordinated note (the "Subordinated Note") for proceeds of $3,000,000.
· Amendment to Leverage Ratio Covenants For the Consolidated Maximum Leverage Ratio (Consolidated Total Funded Debt to Consolidated EBITDA, as defined in the Amendment), the Amendment (i) revised the required ratio for September 30, 2012 from 3.25x to 4.5x; (ii) revised the required ratio for December 31, 2012 from 3.0x to 4.5x; and (iii) revised the required ratio for March 31, 2013 and for each rolling four quarters thereafter from 3.0x to 4.0x.
The Amendment also includes a new Consolidated Maximum Adjusted Leverage Ratio covenant, which is Consolidated Total Funded Debt (excluding subordinated debt) to Consolidated EBITDA, as defined in the Amendment. The Amendment requires the Company to maintain a Consolidated Maximum Adjusted Leverage Ratio equal to or less than (i) 3.25x to 1.00x for each of the rolling four quarter periods ending on September 30, 2012 and December 31, 2012, and (ii) 3.0x to 1.0x for each rolling four quarter period ending on or after March 31, 2013.
For the purposes of calculating both the Consolidated Maximum Leverage Ratio and the Consolidated Maximum Adjusted Leverage Ratio, Consolidated EBITDA (as defined in the Amendment) will be (i) at September 30, 2012, the actual Consolidated EBITDA for the 3 months then ended times 4; (ii) at December 31, 2012, the actual Consolidated EBITDA for the 6 months then ended times 2; and (iii) at March 31, 2013, the actual Consolidated EBITDA for the 9 months then ended times 4/3 (provided that the add-backs for costs are not annualized). · Amendment to Fixed Charge Coverage Ratio Covenants For the Consolidated Fixed Charge Coverage Ratio, the Amendment (i) revised the required ratio for September 30, 2012 from 1.10x to 1.00x; (ii) revised the required ratio for December 31, 2012 from 1.20x to 1.00x; (iii) revised the required ratio for March 31, 2013 from 1.20x to 1.05x; (iv) revised the required ratio at 6/30/13 from 1.20x to 1.10x; and (v) did not change the required ratio at September 30, 2013 (remained at 1.20x).
10 The Consolidated Fixed Charge Coverage Ratio is defined as Consolidated EBITDA (as defined in the Amendment) for the applicable period divided by the sum of (a) the Company's consolidated interest expense for such period, plus (b) the aggregate principal amount of scheduled payments on the Company's indebtedness made during such period (excluding any repayment of the Entine Indebtedness), plus (c) the sum of all cash dividends and other cash distributions to the Company's shareholders during such period, plus (d) the sum of all taxes paid in cash by the Company during such period, less (e) up to $75,000 paid to the IRS, to the extent characterized as interest expense, in connection with certain historical tax filings (the "IRS Payments").
For the purposes of calculating the Consolidated Fixed Charge Coverage Ratio, Consolidated EBITDA will be (i) at September 30, 2012, the actual Consolidated EBITDA for the 3 months then ended times 4; (ii) at December 31, 2012, the actual Consolidated EBITDA for the 6 months then ended times 2; and (iii) at March 31, 2013, the actual Consolidated EBITDA for the 9 months then ended times 4/3 (provided that the add-backs for Entine Indebtedness repayment and theIRS Payments are not annualized).
· Restriction on Capital Expenditures For the fiscal year ending September 30, 2012, the Amendment reduced the limitation on the Company's capital expenditures from $3.25 million to $2.25 million and for fiscal years ending September 30, 2013 and for each fiscal year thereafter, the Amendment raised the limitation on the Company's capital expenditures from $2.00 million to $2.25 million.
· Termination of Acquisition Line of Credit The Amendment also accelerated the termination date of the Company's $5 million acquisition line of credit to June 29, 2012, which will prohibit the Company from drawing down the approximately $1 million of previously available undrawn funds.
Note Purchase Agreement - Massachusetts Capital Resource Company ("MCRC") As described above, the Company is currently in financial default under its note purchase agreement with MCRC.
On July 31, 2012, the Company entered into the Agreement with MCRC. Pursuant to the terms of the Agreement, the Company issued and sold to MCRC the $3,000,000 Subordinated Note for proceeds of $3,000,000. The Company has used a portion of the proceeds from the sale of the Subordinated Note to repay the Entine Indebtedness in the aggregate principal amount of $1,857,546 and has agreed to use the balance of the proceeds for working capital purposes.
The Subordinated Note matures on July 31, 2017, unless accelerated pursuant to an event of default, as described below. The Subordinated Note bears interest at the rate of ten percent (10%) per annum, with interest to be payable monthly on the last day of each calendar month in each year, the first such payment to be due and payable on August 31, 2012. Under the terms of the Agreement, beginning on and with September 30, 2015, and on the last day of each calendar month thereafter through and including July 31, 2017, the Company will redeem, without premium, $130,434 in principal amount of the Subordinated Note together with all accrued and unpaid interest then due on the amount redeemed.
Under the terms of the Agreement and a Subordination Agreement dated July 31, 2012, among the Company, the Guarantor Subsidiaries, the Lender and MCRC, MCRC and any successor holder of the Subordinated Note have agreed that the payment of the principal of and interest on the Subordinated Note shall be subordinated in right of payment, to the prior payment in full of all indebtedness of the Company for money borrowed from banks or other institutional lenders at any time outstanding, including money borrowed from the Lender under the Original Loan Agreement.
The Agreement contains customary representations, warranties and covenants, including covenants by the Company limiting additional indebtedness, liens, guaranties, mergers and consolidations, substantial asset sales, investments and loans, sale and leasebacks, transactions with affiliates and fundamental changes. In addition, the Agreement contains financial covenants by the Company (as further defined in the Agreement) that (i) impose a Consolidated Maximum Leverage Ratio (consolidated total funded debt to consolidated EBITDA) equal to or less than (a) 5.0 to 1.0 for each of the rolling four quarter periods ending on September 30, 2012 and December 31, 2012, and (b) 4.5 to 1.0 for each rolling four quarter period ending on or after March 31, 2013, and (ii) require a Consolidated Fixed Charge Coverage Ratio (consolidated EBITDA to consolidated fixed charges) of not less than (a) .75 to 1.00 for each of the rolling four quarter periods ending on September 30, 2012 and December 31, 2012, (b) .8 to 1.0 for each of the rolling four quarter period ending on March 31, 2013 and June 30, 2013, and (c) .95 to 1.00 for each rolling four quarter period ending on or after September 30, 2013.
11 The Agreement also provides for events of default customary for agreements of this type, including, but not limited to, non-payment, breach of covenants, insolvency and defaults on other debt. Upon an event of default, MCRC may elect to declare all obligations (including principal, interest and all others amounts payable) immediately due and payable, which shall occur automatically if the Company becomes insolvent.
"Off Balance Sheet" Arrangements The Company has no "Off Balance Sheet" arrangements.
NEW ACCOUNTING PRONOUNCEMENTS See Note 2, "Summary of Significant Accounting Policies" in the Notes to Consolidated Financial Statements for a full description of recent accounting pronouncements, including the respective dates of adoption or expected adoption and effects on our consolidated financial position, results of operations and cash flows.
CRITICAL ACCOUNTING POLICIES Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America and pursuant to the rules and regulations of the SEC. The preparation of these financial statements 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. We have identified the following as the items that require the most significant judgment and often involve complex estimation: revenue recognition, valuation of long-lived assets, intangible assets and goodwill, estimating allowances for doubtful accounts receivable, stock-based compensation and accounting for income taxes.
Revenue Recognition Revenue from sales of products is recognized at the time title and the risks and rewards of ownership pass. Revenue from research and development activities is derived generally from the following types of contracts: reimbursement of costs plus fees, fixed price or time and material type contracts. Revenue is recognized when the products are shipped per customers' instructions, the contract has been executed, the contract or sales price is fixed or determinable, delivery of services or products has occurred and the Company's ability to collect the contract price is considered reasonably assured.
Government funded services revenues from cost plus contracts are recognized as costs are incurred on the basis of direct costs plus allowable indirect costs and an allocable portion of the contracts' fixed fees. Revenue from fixed-type contracts is recognized under the percentage of completion method with estimated costs and profits included in contract revenue as work is performed. Revenues from time and materials contracts are recognized as costs are incurred at amounts generally commensurate with billing amounts. Recognition of losses on projects is taken as soon as the loss is reasonably determinable.
The majority of the Company's contract research revenue is derived from the United States government and government related contracts. Such contracts have certain risks which include dependence on future appropriations and administrative allotment of funds and changes in government policies. Costs incurred under United States government contracts are subject to audit. The Company believes that the results of such audits will not have a material adverse effect on its financial position or its results of operations.
12 Goodwill Goodwill and intangible assets which have indefinite lives are subject to annual impairment tests. Goodwill is tested by reviewing the carrying value compared to the fair value at the reporting unit level. Fair value for the reporting unit is derived using the income approach. Under the income approach, fair value is calculated based on the present value of estimated future cash flows.
Assumptions by management are necessary to evaluate the impact of operating and economic changes and to estimate future cash flows. Management's evaluation includes assumptions on future growth rates and cost of capital that are consistent with internal projections and operating plans.
The Company generally performs its annual impairment testing of goodwill during the fourth quarter of its fiscal year, or more frequently if events or changes in circumstances indicate that the assets might be impaired. The Company tests impairment at the reporting unit level using the two-step process. The Company's primary reporting units tested for impairment are RMD, which comprises our Contract Research segment, Dynasil Products (also known as RMD Instruments), which comprises our Instruments segment, and Hilger Crystals, which is a component of the Optics segment.
Step one of the impairment testing compares the carrying value of a reporting unit to its fair value. The carrying value represents the net book value of the net assets of the reporting unit or simply the equity of the reporting unit if the reporting unit is the entire entity. If the fair value of the reporting unit is greater than its carrying value, no impairment has been incurred and no further testing or analysis is necessary. The Company estimates fair value using a discounted cash flow methodology which calculates fair value based on the present value of estimated future cash flows. Estimating future cash flows requires significant judgment and includes making assumptions about projected growth rates, industry-specific factors, working capital requirements, weighted average cost of capital, and current and anticipated operating conditions.
Assumptions by management are necessary to evaluate the impact of operating and economic changes. The Company's evaluation includes assumptions on future growth rates and cost of capital that are consistent with internal projections and operating plans. The use of different assumptions or estimates for future cash flows could produce different results. The Company regularly assesses the estimates based on the actual performance of each reporting unit.
If the carrying value of a reporting unit is greater than its fair value, step two of the impairment testing process is performed to determine the amount of impairment to be recognized. Step two requires the Company to estimate an implied fair value of the reporting unit's goodwill by allocating the fair value of the reporting unit to all of the assets and liabilities other than goodwill.
An impairment then exists if the carrying value of the goodwill is greater than the goodwill's implied fair value. With respect to the Company's annual goodwill impairment testing performed during the fourth quarter of fiscal year 2012, step one of the testing determined the estimated fair value of RMD substantially exceeded its carrying value by more than 20%. The estimated fair value of the Hilger Crystals reporting unit exceeded its carrying value but the carrying value of the Dynasil Products reporting unit exceeded its estimated fair value.
As a conservative measure, the Company undertook step two analyses by performing essentially a new purchase price allocation as of the date of the impairment test for both Hilger Crystals and Dynasil Products. To assist in developing the assumptions and methodologies, the Company uses the services of an independent consulting firm to determine the values of both originally recognized assets and any new assets that may have been unrecognized at the time of the original transaction, but were developed between the acquisition date and the test date.
For Hilger Crystals, the result was confirmation that the new residual value of goodwill is higher than the carrying value. Accordingly, the Company concluded that no impairment had occurred and no further testing was necessary. For Dynasil Products, under step two, the income method was used to allocate the fair values of all of the assets and liabilities of this reporting unit, with the remaining residual fair value allocated to goodwill. As the carrying value of goodwill exceeded the new residual fair value of goodwill, the Company recorded a pre-tax impairment loss of $2,284,499 in the fourth quarter of 2012.
During the fourth quarter of 2011, The Company completed our annual goodwill impairment reviews with no impairments to the carrying values identified. As such, there was no impairment charge during the year ended September 30, 2011.
Impairment of Long-Lived Assets The Company's long-lived assets include property, plant and equipment and intangible assets subject to amortization. The Company evaluates long-lived assets for recoverability whenever events or changes in circumstances indicate that an asset may have been impaired. In evaluating an asset for recoverability, the Company estimates the future cash flow expected to result from the use of the asset and eventual disposition. If the expected future undiscounted cash flow is less than the carrying amount of the asset, an impairment loss, equal to the excess of the carrying amount over the fair value of the asset, is recognized. The Company reviewed its long-lived assets and determined there was no impairment charge during the years ended September 30, 2012 and 2011.
13 Intangible Assets The Company's intangible assets consist of an acquired customer base of Optometrics, LLC, acquired customer relationships and trade names of Hilger Crystals, customer relationships and trade names of Dynasil Products, acquired backlog and know-how of Radiation Monitoring Devices, Inc., and provisionally patented technologies within Dynasil Biomedical Corp.
Dynasil estimates the fair value of indefinite-lived intangible assets using an income approach, and recognizes an impairment loss when the estimated fair value of the indefinite-lived intangible assets is less than the carrying value.
During the fourth quarter of fiscal year 2012, the Company conducted its annual impairment review of indefinite-lived intangible assets with no impairments to the carrying values identified.
The Company reviews intangible assets with finite lives for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. Recoverability of these intangible assets is assessed based on the undiscounted future cash flows expected to result from the use of the asset. If the undiscounted future cash flows are less than the carrying value, the intangible assets with finite lives are considered to be impaired. The amount of the impairment loss, if any, is measured as the difference between the carrying amount of these assets and the fair value based on a discounted cash flow approach or, when available and appropriate, to comparable market values.
During the fourth quarter of fiscal year 2012, the Company conducted its annual impairment review of definite lived intangible assets with no impairments to the carrying values identified.
During the fourth quarter of 2011, the Company completed its annual intangible asset impairment review with no impairments to the carrying values identified.
As such, no impairment charge was recorded during the year ended September30, 2011.
The Company amortizes its intangible assets with definitive lives over their useful lives, which range from 4 to 15 years, based on the time period the Company expects to receive the economic benefit from these assets.
Convertible Preferred Stock The Company considers the guidance of EITF 98-5, "Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios" and EITF 00-27, "Application of Issue No. 98-5 to Certain Convertible Instruments", codified in FASB ASC Topic 470-20 when accounting for the issuance of convertible preferred stock. The Company's convertible preferred stock, when issued, is generally convertible to common stock at or above the then current market price of the Company's common stock and therefore, will contain no beneficial conversion feature.
Allowance for Doubtful Accounts Receivable We perform ongoing credit evaluations of our customers and adjust credit limits based upon payment history and the customer's current credit worthiness, as determined by our review of their current credit information. We continuously monitor collections and payments from our customers and maintain a provision for estimated credit losses based upon our historical experience and any specific customer collection issues that we have identified. While such credit losses have historically been minimal, within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. A significant change in the liquidity or financial position of any of our significant customers could have a material adverse effect on the collectability of our accounts receivable and our future operating results.
14 Stock-Based Compensation We account for stock-based compensation using fair value. Compensation costs are recognized for stock options granted to employees and directors. Options and warrants granted to employees and non-employees are recorded as an expense over the requisite service period based on the grant date estimated fair value of the grant, determined using the Black-Scholes option pricing model.
Income Taxes As part of the process of preparing our consolidated financial statements, we are required to estimate our income tax provision (benefit) in each of the jurisdictions in which we operate. This process involves estimating our current income tax provision (benefit) together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes.
These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheets. We regularly evaluate our ability to recover the reported amount of our deferred income taxes considering several factors, including our estimate of the likelihood of the Company generating sufficient taxable income in future years during the period over which temporary differences reverse. The Company believes it is more likely than not that these carry-forwards will not be realized and, therefore, a valuation allowance has been applied.
Forward-Looking Statements The statements contained in this Annual Report on Form 10-K which are not historical facts, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements regarding future events and our future results are based on current expectations, estimates, forecasts, and projections and the beliefs and assumptions of our management, including, without limitation, our expectations regarding results of operations, our default under the financial covenants under our loan agreement with Sovereign Bank and Massachusetts Capital Resource Company, the commercialization of our products including our dual mode detectors, our development of new technologies including at Dynasil Biomedical, the adequacy of our current financing sources to fund our current operations, our growth initiatives, our capital expenditures and the strength of our intellectual property portfolio. These forward-looking statements may be identified by the use of words such as "may," "could," "expect," "estimate," "anticipate," "continue" or similar terms, though not all forward-looking statements contain such words. The actual results of the future events described in such forward-looking statements could differ materially from those stated in such forward-looking statements due to a number of important factors. These factors that could cause actual results to differ from those anticipated or predicted include, without limitation, our ability to resolve our current default under our outstanding indebtedness, our ability to develop and commercialize our products, including obtaining regulatory approvals, the size and growth of the potential markets for our products and our ability to serve those markets, the rate and degree of market acceptance of any of our products, our ability to address our material weaknesses in our internal controls, general economic conditions, costs and availability of raw materials and management information systems, our ability to obtain and maintain intellectual property protection for our products, competition, the loss of key management and technical personnel, our ability to obtain timely payment of our invoices to governmental customers, litigation, the effect of governmental regulatory developments, the availability of financing sources, our ability to identify and execute on acquisition opportunities and integrate such acquisitions into our business, and seasonality, as well as the uncertainties set forth in this Annual Report on Form 10-K, including the risk factors contained in Item 1a, and from time to time in the Company's other filings with the Securities and Exchange Commission. The Company disclaims any intention or obligation to update any forward-looking statements, whether as a result of new information, futureevents or otherwise.
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