ITEM 1B:
UNRESOLVED STAFF COMMENTS
Not applicable.
Quatech’s principal place of business is located at 5675 Hudson Industrial Parkway, Hudson, Ohio 44236 where the company leases approximately 17,100 square feet of combined office, warehousing and product assembly space. Quatech has leased the space through April 2014. Quatech has sublet 4,911 square feet of manufacturing space in this facility to one of its contract manufacturers. The sublease is on an open end basis.
We are subject to various legal proceedings and threatened legal proceedings from time to time as part of our business. We are not currently party to any legal proceedings, the adverse outcome of which, individually or in the aggregate, we believe would have a material adverse effect on our business, financial condition and results of operations or for which damages would exceed 10% of the current assets of the Company. However, any potential litigation, regardless of its merits, could result in substantial costs to us and divert management’s attention from our operations. Such diversions could have an adverse impact on our business, results of operations and financial condition.
PART II
ITEM 5:
ITEM 5:
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our Common Stock trades on the OTC Markets Group, Inc. quotation and trading system under the symbol “OTCQB:DPAC.” Some financial Web sites may report DPAC Technologies Corp. under the symbol DPAC.PK The following table sets forth the high and low closing sale prices on the Nasdaq Small Cap Market as reported by The Nasdaq Stock Market.
Holders
There were approximately 196 shareholders of record as of March 22, 2011. Development Capital Ventures, LP, holds approximately 59% of the common shares outstanding at March 22, 2011.
Dividends
We have not paid dividends on our common stock in either of the past two fiscal years. We do not expect to pay any dividends on our common stock in the foreseeable future. There are currently contractual arrangements in our loan agreements and other restrictions that preclude our ability to pay dividends.
Not applicable
ITEM 7:
ITEM 7:
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and notes to those statements included elsewhere in this Report. This discussion contains certain forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. Our actual results could differ materially from those discussed here. The cautionary statements made in this Report should be read as being applicable to all forward-looking statements wherever they appear. Numerous important factors, risks and uncertainties affect our operations and could cause actual results to differ materially from those expressed or implied by these or any other forward-looking statements made by us or on our behalf. Factors that could cause or contribute to such differences include those discussed in “Risk Factors,” as well as those discussed elsewhere herein. We undertake no obligation to publicly release the result of any revisions to these forward-looking statements that may be required to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.
Period-to-period comparisons of our financial results are not necessarily meaningful and should not be relied upon as indications of future performance. It is likely that from time to time our operating results will be below the expectations of some investors and not above the expectations of enough investors. In such events, the market price of our Common Stock would be adversely affected, in some proportion, and perhaps disproportionately. We ourselves have difficulties forecasting, and there are numerous risks and uncertainties concerning, the timing of our customers’ initiating their production orders and the amounts of such orders, fluctuating market demand for and declines in the selling prices of similar products, decreases or increases in the costs of the components, uncertain market acceptance, our competitors, delays, or other problems with new products, software, manufacturing, inefficiencies, cost overruns, fixed overhead costs, competition from new wireless products using 802.11 with newer technology, and challenges managing production from overseas suppliers, among other factors, each of which will make it more difficult for us to meet expectations.
Successful implementation of the Airborne wireless products and new product lines will require, among other things, best-in-class designs, exceptional customer service and patience. Also timing of revenue may be affected by the length of time it may take our customers in designing our Airborne product into their product lines and introducing their products. In addition, our revenues are ultimately limited by the success of our customers’ products in relation to their competition.
Fluctuations in Operating Results
The primary factors that may in the future create material fluctuations in our results of operations include the following: timing and amount of shipments, changes in the mix of products sold, any inability to procure required components, whether new customer orders are for immediate or deferred delivery, the sizes and timing of investments in new technologies or product lines, a partial or complete loss of any principal customer, any addition of a significant new customer, a reduction in orders or delays in orders from a customer, excess product inventory accumulation by a customer, and other factors.
The need for continued significant operating expenditures for research and development, software and firmware enhancements, ongoing customer service and support, and administration, among other factors, will make it difficult for us to reduce our operating expenses in any particular period, even if our expectations for net sales for that period are not met. Therefore, our fixed overhead may negatively impact our operating results.
Critical Accounting Policies and Estimates
We prepare our financial statements in conformity with accounting principles generally accepted in the United States of America. As such, we are required to make certain estimates, judgments and assumptions that we believe to be reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. In order to aid you in fully understanding and evaluating our reported financial results, the significant accounting policies which we believe to be the most subjective and critical include the following:
Revenue Recognition
The majority of our revenue is derived from the sales of products. We recognize product revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectibility is probable and there are no post-delivery obligations other than warranty. Revenue is recognized from the sale of products at the point of passage of title, which is at the time of shipment to customers, including OEMs, distributors and other strategic end user customers. Revenue recognition is deferred in all instances when the earnings process is incomplete, such as sales to certain customers that may have certain rights of return and price protection provisions. Revenue on sales to distributors where a right of return exists is recognized upon “sell-through,” when products are shipped from the distributor to the distributor’s customer. Revenue related to those products in our distribution channel at the end of each reporting period which has not sold-through is deferred. Quatech also offers marketing incentives to certain customers. These incentives are incurred based on the level of expenses the customers incur and are charged to operations as expenses in the same period.
Accounts Receivable
We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. The amount of our reserves is based on historical experience and our analysis of the accounts receivable balances outstanding. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required which would result in an additional general and administrative expense in the period such determination was made. While such credit losses have historically been 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, which could adversely affect our operating results.
Inventories
We value our inventory at the lower of the actual cost to purchase and/or manufacture or the current estimated market value of the inventory. We regularly review inventory quantities on hand and record a provision for excess and obsolete inventory based primarily on our estimated forecast of product demand and production requirements for the next twelve months. We additionally consider additional facts and circumstances in order to determine whether any condition exists that would confirm or deny the need for recording a write-down. A significant increase in the demand for our products could result in a short-term increase in the cost of inventory purchases while a significant decrease in demand could result in an increase in the amount of excess inventory quantities on hand. Additionally, our estimates of future product demand may prove to be inaccurate, in which case we may have understated or overstated the provision required for excess and obsolete inventory. In the future, if our inventory is determined to be overvalued, we would be required to recognize such costs in our cost of goods sold at the time of such determination. Likewise, if our inventory is determined to be undervalued, we may have over-reported our costs of goods sold in previous periods and would be required to recognize such additional operating income at the time of sale of the related inventory. Therefore, although we make every effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and our reported operating results.
Property, Plant and Equipment
The Company periodically reviews the recoverability of its long-lived assets. The Company also reviews these assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of these assets is determined by comparing the forecasted undiscounted future net cash flows from the operations to which the assets relate, based on management’s best estimates using appropriate assumptions and projections at the time, to the carrying amount of the assets. If the carrying value is determined not to be recoverable from future operating cash flows, the asset is deemed impaired and an impairment loss is recognized equal to the amount by which the carrying amount exceeds the estimated fair value of the asset.
Capitalized Developed Software
Certain software development costs are capitalized after a product becomes technologically feasible and before its general release to customers. Significant judgment is required in determining when a product becomes “technologically feasible.” Capitalized development costs are then amortized over the product’s estimated life beginning upon general release of the product. Periodically, we compare a product’s unamortized capitalized cost to the product’s net realizable value. To the extent unamortized capitalized cost exceeds net realizable value based on the product’s estimated future gross revenues (reduced by the estimated future costs of completing and selling the product) the excess is written off. This analysis requires us to estimate future gross revenues associated with certain products and the future costs of completing and selling certain products. Changes in these estimates could result in write-offs of capitalized software costs.
Goodwill and Indefinite Lived Intangibles
We review the recoverability of the carrying value of goodwill and intangibles on an annual basis at December 31st or more frequently when an event occurs or circumstances change to indicate that an impairment of goodwill or intangibles has possibly occurred. Since we operate in a single business segment as a single business unit, the determination of whether any potential impairment of goodwill exists is based on a comparison of the fair value of the entire Company to its carrying value. In estimating the fair value of the entire Company, the Market Approach and Income Approach are the methodologies deemed the most reliable and are the primary methods used for our impairment analysis, with the income approach weighted 60% and the market approached weighted 40%. The valuation analysis is dependent upon a number of various factors including estimates of forecasted revenues and costs, appropriate discount rates and other variables. The first step of the goodwill impairment test consists of comparing the carrying value of the reporting unit to its fair value. If the fair value of the entire Company is determined to be less than the carrying value of the Company, we would be required to take the second step of the goodwill impairment test to measure the amount of impairment loss, if any, and to record such impairment loss for our goodwill. Based on our impairment testing as of December 31, 2010, the fair value of our single reporting unit exceeded its carrying value by approximately $995,000, which management believes to be substantial and not indicative of potential impairment. As the total of the company’s fair value exceeded the carrying value of net assets, it passed the first step of the impairment test and, accordingly, the second step was not required to be performed. Recording an impairment charge for goodwill could have a material adverse impact on our operating results for the period in which such charge was recorded.
Deferred Taxes
Deferred tax assets and liabilities are determined based on temporary differences between financial reporting and tax bases of assets and liabilities and are measured using enacted tax rates and laws that will be in effect when the differences are expected to reverse. The Company records a valuation allowance against deferred tax assets when it is more likely than not that such assets will not be realized. During the years ended December 31, 2010 and 2009, the Company recorded a full valuation allowance associated with its net deferred tax assets.
The Company records an estimated income tax liability to recognize the amount of income taxes payable or refundable for the current year and deferred income tax liabilities and assets for the future tax consequences of events that have been recognized in our financial statements or income tax returns. Judgment is required in estimating the future income tax consequences of events that have been recognized in the Company’s financial statements or the income tax returns. The Company estimates and provides an allowance for deferred tax assets based on estimated realization of the asset utilizing information related to historical taxable income and projected taxable income.
Included in total deferred tax assets, the Company has an income tax carryforward for federal net operating losses. The cumulative federal net operating loss carryforward of approximately $12,308,000 expires through 2030; however, as a result of the merger between Quatech, Inc. and DPAC Technologies Corp, a substantial portion of DPAC’s federal net operating loss carryforward is subject to the provisions of Sec. 382 of the Internal Revenue Code (IRC), and therefore, is not available for immediate benefit to the company. The realization of the Company’s deferred tax assets, including this federal net operating loss, and the related valuation allowance are significant estimates requiring assumptions regarding the sufficiency of future taxable income to realize the future tax deduction from the reversal of deferred tax assets and the net operating loss prior to their expiration. The valuation allowance has been provided based upon the Company’s assessment of future realizability of certain deferred tax assets, as it is more likely than not that sufficient taxable income will not be generated to realize these temporary differences. The net increase in the valuation allowance was $252,201 for 2010 and $419,790 for 2009. The amount of the corresponding valuation allowance could change significantly in the near term if estimates of future taxable income are changed.
The Company adheres to the provisions of ASC 740, “Income Taxes”. ASC 740 prescribes a recognition threshold that a tax position is required to meet before being recognized in the financial statements, and provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure, and transition issues. It is the Company’s practice to recognize penalties and/or interest related to income tax matters in interest and penalties expense.
Recently Issued Accounting Standards
In January 2009, the Securities and Exchange Commission (“SEC”) issued Release No. 33-9002, “Interactive Data to Improve Financial Reporting.” The final rule requires companies to provide their financial statements and financial statement schedules to the SEC and on their corporate websites in interactive data format using the eXtensible Business Reporting Language (“XBRL”). The rule was adopted by the SEC to improve the ability of financial statement users to access and analyze financial data. The SEC adopted a phase-in schedule indicating when registrants must furnish interactive data. Under this schedule, the Company will be required to submit filings with financial statement information using XBRL commencing with its June 30, 2011 quarterly report on Form 10-Q. The Company is currently evaluating the impact of XBRL reporting on its financial reporting process.
In October 2009, the FASB amended revenue recognition guidance for arrangements with multiple deliverables. The guidance eliminates the residual method of revenue recognition and allows the use of management’s best estimate of selling price for individual elements of an arrangement when vendor specific objective evidence (“VSOE”), vendor objective evidence (“VOE”) or third-party evidence (“TPE”) is unavailable. This guidance should be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. Full retrospective application of the guidance is optional. The Company does not expect the impact of adopting this guidance to have a material effect on its financial statements.
In April 2010, the FASB issued Accounting Standards Update 2010-13 (ASU 2010-13), “Compensation-Stock Compensation (Topic 718).” ASU 2010-13 provides amendments to ASC Topic 718 to clarify that an employee share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity securities trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity. The amendments in ASU 2010-13 are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The provisions of ASU 2010-13 are not expected to have a material effect on the financial position, results of operations or cash flows of the Company.
In December 2010, the FASB issued an Accounting Standards Update 2010-28(“ASU 2010-28”), “Intangibles-Goodwill and Other (Topic 350)”. ASU 2010-28 amends ASC Topic 350. ASU 2010-28 clarifies the requirement to test for impairment of goodwill. ASC Topic 350 requires that goodwill be tested for impairment if the carrying amount of a reporting unit exceeds its fair value. Under ASU 2010-28, when the carrying amount of a reporting unit is zero or negative an entity must assume that it is more likely than not that a goodwill impairment exists, perform an additional test to determine whether goodwill has been impaired and calculate the amount of that impairment. The modifications to ASC Topic 350 resulting from the issuance of ASU 2010-28 are effective for fiscal years beginning after December 15, 2010 and interim periods within those years. Early adoption is not permitted. The provisions of ASU 2010-28 are not expected to have a material effect on the financial position, results of operations or cash flows of the Company.
Introduction/Business Overview
DPAC, through its wholly-owned subsidiary, Quatech, designs, manufactures, and sells device connectivity and device networking solutions for a broad market. Quatech sells its products through a global network of distributors, system integrators, value added resellers, and original equipment manufacturers (“OEM”).
Quatech products can be categorized into two broad product lines:
Our Device Connectivity products include:
•
Multi-port serial boards that add ports to desktop computers to allow for the connection of multiple peripherals with standard interfaces. These products are used in a variety of industries including banking, transportation management, kiosks, satellite communications, and retail point of sale.
•
Mobile products that add ports for laptop and handheld computers. These products include multi-port serial adapters, parallel port adapters, and Bluetooth products.
•
USB to Serial products that add standard serial ports to any computing environment through a USB port. These products address the need to add connectivity through a solution that is external to the computer. These products are used in several markets including retail point of sale and kiosks.
Our Device Networking products include:
•
Serial device server products that connect peripherals to a local area network through a standard TCP/IP interface. This product line was introduced in 2003 and was extended in 2004 through the introduction of product models that connect to the local area network through a wireless 802.11b interface.
•
Industrial rated, embedded wireless modules that enable OEM customers to add standard 802.11 connectivity capabilities to their products. These modules address the needs of a number of industries including transportation, telematics, warehouse and logistic, and point of sale.
Results of Operations
The following table summarizes DPAC’s results of operations as a percentage of net sales for the two years ended December 31, 2010 and 2009:
Net Sales
Net sales for the year ended December 31, 2010 of $7,847,000 increased by $1,040,000 or 15% compared to net sales for the year ended December 31, 2009. Net sales related to the Company’s Device Connectivity products increased $19,000 or 1%, and net sales related to the Company’s Device Networking products, including the Airborne wireless product line, increased by $1,021,000, or 36% from the prior year. The increase in revenues for the Device Networking product line is the result of improved product shipments to end customers by our OEM customers and increased penetration into new applications for our products.
Gross Profit
Gross profit increased by $354,000 or 13% to $3,153,000 in 2010 from $2,799,000 in 2009 due to the increase in net sales. Gross profit as a percentage of sales decreased to 40% for 2010 from 41% in 2009. The decrease in gross profit percentage is due to the write-down of inventory of $166,000 in the current year partially offset by fixed operating expenses being spread over a higher revenue base resulting in fixed expenses representing a smaller percentage of cost of goods sold.
Sales and Marketing
Sales and marketing expenses of $783,000 decreased by $42,000 or by 5% as compared to 2009. The decrease is due primarily to a decrease in salaries and related expenses of $71,000, offset by an increase in representative commissions of $19,000 and advertising Internet search engine costs of $10,000.
Research and Development
Research and development expenses of $733,000 for 2010 decreased by $42,000, or 5%, as compared to 2009. The decrease is due to a decrease in personnel and consulting costs incurred, including benefits and travel related costs, of $73,000. These reductions were partially offset by software developments costs incurred of $29,000 being capitalized in 2009 and no costs being capitalized in 2010. The Company will continue to invest in research and development to expand and develop new wireless products. See “Forward-Looking Statements.”
General and Administrative Expense
General and administrative expenses incurred for 2010 of $1,111,000 decreased by $136,000 or 11% from the prior year. The decrease was due primarily to decreases in salaries and benefits of $39,000, non-cash compensation expense related to stock options of $51,000, business and Directors and Officers insurance premiums of $35,000 and depreciation expense of $18,000. These reductions were partly off-set by small increases in other expense items.
Amortization Expense
Amortization expense of $538,000 for 2010 is comprised of the amortization of purchased intangible assets acquired in the Merger on February 28, 2006 being amortized over 5 years of $490,000, amortization of internally developed software being capitalized over 5 years of $38,000, and amortization of the customer list acquired in the SocketSerial acquisition of $10,000.
Interest Expense
The Company incurred interest and financing costs of $641,000 in 2010 as compared to $580,000 incurred in 2009. The following non-cash charges are included in interest expense during 2010: accretion of participation and success fees of $35,000, amortization of deferred financing costs of $47,000, and amortization of the discount for warrants of $13,000. The following non-cash charges are included in interest expense during 2009: accretion of participation fees of $46,000, amortization of deferred financing costs of $50,000, and amortization of the discount for warrants of $13,000.
Fair Value Adjustment of Put Warrant Liability.
For 2010, the Company recorded a net charge to earnings of $10,600 related to the adjustment of the liability for the put warrant compared to a net gain of $15,800 for 2009. The Company is required to adjust the put warrant liability to its fair value through earnings at the end of each reporting period. At December 31, 2010, based on the Company’s common stock average share price of $0.017, the Company calculated the fair value of the put warrants to be $110,900. The actual settlement amount of the put warrant liability could differ materially from the value determined based on the Company’s stock price.
Income Taxes
The Company recognizes deferred tax assets and liabilities based on the differences between the financial statement carrying values and the tax bases of assets and liabilities. A full valuation allowance was recorded against the Company’s related deferred tax assets for 2010 and 2009. The Company recorded no income tax provision for 2010 or 2009.
DPAC regularly reviews its deferred tax assets for recoverability and establishes a valuation allowance based on historical taxable income, projected future taxable income, and the expected timing of the reversals of existing temporary differences. To the extent that recovery is not believed to be more likely than not, a valuation allowance is established. Recent net operating losses represent sufficiently negative evidence to require a continued valuation allowance against the net deferred tax assets. This valuation allowance will be evaluated periodically and could be reversed partially or totally if business results have sufficiently improved to support realization of our deferred tax assets.
LIQUIDITY AND CAPITAL RESOURCES
The Company incurred a net loss of $665,000 for 2010 and ended the year with a cash balance of $48,000 and a deficit in working capital of $1.4 million. The Company incurred a net loss of $1.1 Million for 2009 and ended the year with a cash balance of $18,000 and a deficit in working capital of $1.3 million.
Although the Company has reported net losses in recent periods, a significant portion of our operating expenses are non-cash. For the year ended December 31, 2010, non-cash operating expenses included depreciation and amortization of $684,000, write-down of inventory of $166,000, non-cash compensation for stock options of $68,000, and non-cash interest expense of $95,000. During 2009, non-cash operating expenses included depreciation and amortization of $595,000, write-down of inventory of $48,000, non-cash compensation for stock options of $119,000, and non-cash interest expense of $108,000.
In the third quarter of 2008, the Company took actions to reduce its cash operating expenses to align its cost structure with the then current economic conditions and a downturn in the Company’s revenue levels. These reductions resulted in annualized operating cost savings of approximately $600,000. Additionally, during the first quarter of 2009, the Company consummated an agreement with one of its contract manufacturers and sold certain equipment and inventory, sublet a portion of its facility to the manufacturer, and will further engage the manufacturer to produce more of the Company’s products. This transaction provided $150,000 in cash.
In the third quarter of 2009, the Company implemented additional cost reduction measures by reducing headcount by 3 individuals and implementing a salary reduction program for all employees of 10%. These measures are expected to result in annual operating costs reductions of approximately $400,000.
On September 30, 2009, the Company acquired the SocketSerial product line in a non-cash transaction for the Company. Management believes that margins generated from future revenues of this product line will help enable the Company to achieve a cash flow break even from operations.
Net cash provided by operating activities for 2010 was $122,000 as compared to net cash used of $4,000 for 2009. The net loss of $665,000 incurred in 2010 was offset by non-cash items, including depreciation and amortization, provision for excess inventory, non-cash compensation expense, accretion of success fees and amortization of deferred financing costs, totaling $1.0 million. Cash was used to pay down accounts payable by $386,000, and fund increases in accounts receivable of $31,000. A decrease in inventories of $13,000 and in prepaid expenses of $39,000, and an increase in other accrued liabilities of $132,000 contributed to cash.
Net cash used in investing activities in 2010 of $70,000 was for the property acquisitions. Net cash provided by investing activities of $124,000 for 2009 consisted of cash received from the sale of assets of $190,000 and partially offset by property additions of $37,000 and capitalized developed software of $29,000.
Net cash used in financing activities for 2010 was $22,000 as compared to $112,000 used during 2009. Cash used in the current year consisted of principal repayments on the Ohio Development loan of $31,000, principal repayments on subordinated debt of $35,000, payment of preferred stock dividends of $18,000 and financing costs incurred of $13,000, partially offset by net borrowings under our revolving credit facility of $75,000. Cash used in 2009 consisted of principal repayments on the Ohio Development loan of $104,000, principal repayments on subordinated debt of $20,000, and financing costs incurred of $20,000, partially offset by proceeds from the issuance of preferred stock of $35,000.
The Company operates at leased premises in Hudson, Ohio which are adequate for the Company’s needs for the near term.
The Company does not expect acquiring more than $100,000 in capital equipment during fiscal year 2011.
As discussed in the financial footnotes to the Financial Statements and Supplementary Data, the Company has in place a senior revolving credit facility with Fifth Third Bank, a Loan Agreement with the State of Ohio and a subordinated note with Canal Mezzanine Partners (each of the State of Ohio loan and the subordinated note with Canal are subordinated to the interests of Fifth Third Bank). In March of 2011, the Company entered into a Fourth Amendment to Credit Agreement extending the maturity date of its Bank revolving credit facility to May 31, 2011.
As of December 31, 2010, we were not in compliance with certain of our bank financial covenants, which included purchasing assets in excess of $100,000.00 from Socket Mobile, Inc. through the assistance of Development Capital Venture, L.P. without the express written consent of the bank. These defaults were waived by Fifth Third Bank by agreement (entered into in March, 2011), but any other events of default were not waived. Each of the loan agreements with Canal Mezzanine Partners and the State of Ohio provide for cross-default of such loans in the event the Company defaults on a material agreement (such as the Bank credit facility) under certain terms. Further, each of the loan agreements provide for restrictive covenants, including the incurrence of additional indebtedness and certain equity financings, which restrict the Company’s ability to access other sources of liquidity, absent refinancing all of the existing indebtedness. The Company is currently talking to a number of other potential lenders with the intent of replacing the bank line of credit with a new facility; however, we have not at this time received a commitment from another source that could replace the Bank line in its entirety. The Bank line currently is set to mature in May, 2011. Additionally, the Canal Mezzanine and State of Ohio loan agreements contain provisions that accelerate the maturity and repayment of outstanding borrowings upon the acceleration of the Bank debt.
At December 31, 2010, the Company was not in compliance with certain financial covenants associated with the Canal Mezzanine debt; however, subsequent to year end, the covenant was modified such allowing the Company to be in compliance. The Company expects to be able to remain in compliance with the modified covenant at least through the remainder of 2011.
The report of the independent registered public accounting firm included an explanatory paragraph regarding certain conditions that raise substantial doubt about our ability to continue as a going concern. These conditions include the inherent uncertainty in refinancing our bank line of credit, which matures on May 31, 2011 as well as continuing operating losses and deficits in our working capital balances. Our ability to continue as a going concern is dependent upon our ability to maintain positive cash flows from operations and to refinance or extend our line of credit. We believe that the steps we have taken, including the acquisition of a product line and the reduction of our operating expenses as described above will enable us to achieve positive cash flows from operations. Additionally, the Company experienced an increase in the rate of new orders during 2010, resulting in a 15% increase in net sales for 2010 compared to 2009, and a 23% increase in the size of its backlog of firm orders from $540,000 at December 31, 2009 to $664,000 at December 31, 2010. There can be no assurance that we will be successful in achieving any of these steps, and there can be no assurance that additional financing will be available on acceptable terms, if at all, and any such terms may be dilutive to existing stockholders. Our inability to secure and maintain the necessary liquidity will have a material adverse effect on our financial condition and results of operations. If we are unable to secure the necessary capital for our business, we may need to suspend some or all of our current operations. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of assets and liabilities that may result from the outcome of this uncertainty. If we continue to achieve revenue growth and maintain positive cash flows from operations, we anticipate requirements for cash will include funding of higher receivable and inventory balances.
Off-Balance Sheet Arrangements
Our off-balance sheet arrangements consist primarily of conventional operating leases, purchase commitments and other commitments arising in the normal course of business, as further discussed below under “Contractual Obligations and Commercial Commitments.” As of December 31, 2010, we did not have any other relationships with unconsolidated entities or financial partners, such as entities often referred to as structured finance, special purpose entities or variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Contractual Obligations and Commercial Commitments
We incur various contractual obligations and commercial commitments in our normal course of business. Such obligations and commitments consist primarily of the following:
Debt Payment Obligations
The Company has a significant amount of borrowings and has the following amounts of aggregate long term debt repayments maturing as of December 31st in future years of $320,000 in 2011, $125,000 in 2012, and $3,039,000 in 2013.
Operating Lease Obligations
As of December 31, 2010, we have operating leases for our facilities with future minimum payments of $520,000 extending through March 31, 2014.
Purchase Commitments with Contract Manufacturers
We generally issue purchase orders to our contract manufacturers with delivery dates from four to sixteen weeks from the purchase order date. In addition, we regularly provide such contract manufacturers with rolling six-month forecasts of material and finished goods requirements for planning and long-lead time parts procurement purposes only. We are committed to accept delivery of materials pursuant to our purchase orders subject to various contract provisions which allow us to delay receipt of such orders or cancel orders beyond certain agreed lead times. Such cancellations may or may not result in cancellation costs payable by us. In the past, we have been required to take delivery of materials from our suppliers that were in excess of our requirements and we have previously recognized charges and expenses related to such excess material. If we are unable to adequately manage our contract manufacturers and adjust such commitments for changes in demand, we may incur additional inventory expenses related to excess and obsolete inventory. Such expenses could have a material adverse effect on our business, financial condition and results of operations.
Other Purchase Commitments
We also incur various purchase obligations with other vendors and suppliers for the purchase of inventory, as well as other goods and services, in the normal course of business. These obligations are generally evidenced by purchase orders with delivery dates from four to six weeks from the purchase order date, and in certain cases, supply agreements that contain the terms and conditions associated with these purchase arrangements. We are committed to accept delivery of such materials pursuant to such purchase orders subject to various contract provisions which allow us to delay receipt of such orders or cancel orders beyond certain agreed lead times. Such cancellations may or may not result in cancellation costs payable by us. In the past, we have been required to take delivery of materials from our suppliers that were in excess of our requirements and we have previously recognized charges and expenses related to such excess material. If we are not able to adequately manage our supply chain and adjust such commitments for changes in demand, we may incur additional inventory expenses related to excess and obsolete inventory. Such expenses could have a material adverse effect on our business, financial condition and results of operations.
Inflation
Management believes that inflation has not had a significant impact on the price of our products, the cost of our materials, or our operating results for either of the two years ended December 31, 2010.
ITEM 7A:
ITEM 7A:
QUANTITIVE AND QUALITIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
ITEM 8:
ITEM 8:
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Financial Statements of the Company with related Notes and Report of Independent Registered Public Accounting Firm are attached hereto commencing at page F-l.
ITEM 9:
ITEM 9:
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A:
ITEM 9A:
CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
The Company’s Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the fiscal year ending December 31, 2010 covered by this Annual Report on Form 10-K. Our disclosure controls and procedures are intended to ensure that the information we are required to disclose in the reports that we file or submit under the Securities Exchange Act of 1934 is (i) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (ii) accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as the principal executive and financial officers, respectively, to allow timely decisions regarding required disclosures. Based upon such evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures were effective as required under Rules 13a-15(e) and 15d-15(e) under the Exchange Act.
Management’s Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) of the Company. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.
The Company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management, under the supervision of the Company’s Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of internal control over financial reporting based on the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2010 under the criteria set forth in the Internal Control-Integrated Framework.
Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within DPAC have been detected.
This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to the permanent deferral by the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.
Changes in Internal Control Over Financial Reporting
No change in the Company’s internal control over financial reporting occurred during the quarter ended December 31, 2010, that materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
None.
PART III
ITEM 10:
ITEM 10:
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
DIRECTORS
The following table sets forth certain information regarding our directors as of December 31, 2010:
Position with Company (in addition to Director) and Principal Occupations during the Past Five Years
Samuel W. Tishler, Chairman of our Board of Directors, is an independent consultant, retired in 2003 as vice president for Corporate Development for Acterna Corporation, a manufacturer of telecommunications test equipment, and is an experienced strategic planning and venture investment professional. He was a vice president of Arthur D. Little Enterprises, Inc. from 1977 to 1986 and a founder of Arthur D. Little Ventures. He also was a vice president of Raytheon Ventures from 1987 to 1994, and in that capacity was responsible for its venture capital portfolio. Mr. Tishler has also served on many of the Boards of venture-backed companies, including Viewlogic Systems and Kloss Video Corporation.
Mr. Tishler’s broad strategic planning background includes the early development of technology concepts from planning to development and execution. This strategic background and experience with smaller companies allow him to provide significant leadership to the Board of Directors and the Company, as a smaller reporting company.
Steven D. Runkel is our Chief Executive Officer (CEO) and President, and has served in that role since February, 2006. From July, 2000 until February, 2006 he was Quatech, Inc.’s CEO and President. Quatech, Inc. and DPAC merged in February of 2006. From May of 1999 until July 2000, he was a Sr. Practice Director for Oracle Corporation with a focus on Customer Relationship Management (CRM) system implementations. From April 1995 to April 1999 he served in a number of executive management positions for Innovative Systems Inc., a CRM software and services company. These positions included President and Chief Operating Officer from June 1997 to April 1999. Prior to joining Innovative Systems, Mr. Runkel held leadership positions at Formtek, Inc. and Harris Corporation. Mr. Runkel has a BS from Pennsylvania State University.
The company believes that Mr. Runkel’s background in customer relationship management is critical to DPAC’s core business strategy of service and support to its customers.
Dennis R. Leibel has served as a Director of the Company since February 2006 and chairs the Audit Committee. Mr. Leibel is a private investor and a retired financial and legal executive. Mr. Leibel also serves on the Board of Directors of Microsemi Corporation, where he is Chairman, and was formerly a member of the Board of Directors of Commerce Energy Group, Inc. until 2008. Mr. Leibel holds a B.S. degree in accounting, a Juris Doctor degree and an L.L.M. degree.
Mr. Leibel’s experience both in financial matters and as a practicing attorney are significant benefits to DPAC as a smaller reporting company.
William Roberts’ is a 30 year veteran in retailing. He currently is Chairman, Belk Northern Division, a division of Belk Inc. Belk is a $4 billion private retail chain based out of Charlotte, NC. Prior to Belk, Mr. Roberts held various merchandising positions with May Department Stores and Macy’s.
Mr. Roberts experience in the retailing and merchandising fields benefit the company insofar as its core business (as described above) primarily relates to establishing strong relationships with its customers.
Mark Chapman is CEO of EDX wireless LLC, a privately held developer of wireless network planning software. Previously, he was Senior Vice President and General Manager at Comarco Inc (NASDAQ: CMRO), and President of Ascom Inc, a division of Ascom (ASCN.SW), a Swiss provider of wireless network test equipment which acquired Comarco’s WTS division in Jan 2009. Prior roles included acting Vice President of Business Development for WiSpry, a venture funded fabless semiconductor company targeting broadband and wireless communications, as well as various consulting assignments. From 2001 to 2003, Mr. Chapman served as President and CEO of Ditrans Corp, a developer of Digital Transceiver products. Mr. Chapman’s prior experience also includes various management, sales and marketing positions at Rockwell Semiconductor (now Conexant) where he had responsibility for various modem products and later wireless data products. Mr. Chapman received a BSEE with first class honors from Robert Gordon’s University, Aberdeen, Scotland.
Mr. Chapman’s technical background and wide ranging experience in industries similar to DPAC’s represent knowledge, skills and experience that are highly beneficial to the company.
James Bole is President and CEO of Almaden Systems LLC, a private information technology consultancy. Prior to founding Almaden Systems, Jim served as Vice President of Products and Services at RNA Networks, and previous to that Vice President of SOA Solutions at Software AG, a German global enterprise software company. Mr. Bole has more than 25 years of entrepreneurial software development and technical management experience in both startups and Fortune 100 companies. From 2001 to September 2006, Mr. Bole was Vice President of Products and Professional Services at Infravio, a venture capital-backed software startup acquired by Software AG/webMethods. Prior to joining Infravio, Mr. Bole held executive positions at Lockheed Martin (NYSE: LMT), Formtek (acquired by Lockheed Martin), and WorkExchange Technologies. Mr. Bole holds a BS in Applied Mathematics/Computer Science from Carnegie Mellon University.
Mr. Bole’s technical background and management experience, both with large enterprises and smaller companies, are highly valuable to the company as a smaller reporting company.
Executive Officers
The following information is provided with respect to DPAC’s current executive officers. Information for Mr. Steven D. Runkel is provided under the heading “Directors” above.
DPAC’s executive officers and their ages as of December 31, 2009 are as follows:
Board of Director Meetings and Committees
During the year ended December 31, 2010, the board of Directors held 4 meetings. All members of the Board of directors hold office until the next Annual Meeting of Stockholders or the election and qualification of their successors. Executive officers serve at the discretion of the Board of Directors.
During the year ended December 31, 2010, each Board of Directors member attended at least 75% of the meetings of the board of Directors and at least 75% of the meetings of the committees on which he served.
We currently have two committees of our Board of Directors: the Audit Committee and the Compensation Committee.
The Audit Committee meets periodically with the company’s management and independent registered public accounting firm to, among other things, review the results of the annual audit and quarterly reviews and discuss the financial statements. The audit committee also hires the independent registered public accounting firm, and receives and considers the accountant’s comments as to controls, adequacy of staff and management performance and procedures. As of the end of 2010 the Audit Committee was composed of Mr. Leibel, Mr. Tishler and Mr. Chapman, all of whom are independent directors. Mr. Leibel is the Chairman of the Audit Committee, and also serves as our “audit committee financial expert”, as defined in Item 407(d)(5)(ii) of Regulation S-K. The Audit Committee operates under a formal charter that governs its duties and conduct.
The compensation committee determines the salaries and incentive compensation of our officers and provides recommendations for the salaries and incentive compensation of our other employees. There are currently two members of the Compensation Committee, Mr. Roberts and Mr. Bole. The compensation committee does not operate under a charter.
The Board of Directors does not maintain a standing nominating committee. The board believes that given its small relative size and familiarity with the company, the costs associated with maintaining such an additional committee are outweighed and that the board and the company would not benefit materially by expending board time and resources with such a formal process. The Board does not have a specific policy as to diversity of the Board. However, with respect to diversity in its deliberations, the Board considers the extent to which potential candidates possess sufficiently beneficial skill sets and characteristics that would contribute to the Board’s overall effectiveness.
Board Leadership Structure. Mr. Tishler serves as our Chairman of the Board of Directors. Mr. Runkel has served as our CEO since the acquisition of Quatech by the company in 2006. The Board believes that the company benefits from having a non-employee chairperson, which affords management greater time resources with which to focus on the core business of the company. The Board does not currently have a designated lead independent director. The Board believes that the appointment of a designated lead independent director is not necessary at this time because of the Company’s small size and because the independent directors play an active role in Board matters.
Board Role in Risk Oversight. The Board administers its risk oversight function directly and through the Audit Committee. The Board and the Audit Committee regularly discuss with management the Company’s major risk exposures, their potential financial impact on the Company, and the steps taken to monitor and control those risks.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934, as amended, requires our officers and directors and those persons who beneficially own more than 10% of our outstanding shares of common stock to file reports of securities ownership and changes in such ownership with the Securities and Exchange Commission. Officers, directors and greater than 10% beneficial owners are also required by rules promulgated by the SEC to furnish us with copies of all Section 16(a) forms they file.
Based solely upon a review of the copies of such forms furnished to us, we believe that during 2010 all Section 16(a) filing requirements applicable to our officers, directors and greater than 10% beneficial owners were complied with.
Code of Ethics for Financial Professionals
Our code of ethics, which we adopted in 2004, will be provided free of charge to anyone upon written request. Request can be made by mail or fax to:
DPAC Technologies Corp.
5675 Hudson Industrial Park
Hudson, Ohio 44236
Fax: 330-655-9020
The following table sets forth compensation for services rendered in all capacities to the Company for each person who served as an executive officer during the year ended December 31, 2010 (the “Named Executive Officers”). No other executive officer of the Company received salary and bonus, which exceeded $100,000 in the aggregate during the year ended December 31, 2010:
Summary Compensation Table
Option Grants
During 2010 the Company issued no stock options.
The following tables contain information concerning the stock option grants to the Company’s Named Executive Officers for the year ended December 31, 2010.
Option Grants in Last Fiscal Year
Outstanding Equity Awards at Year End
Employment Agreements
Effective January 1, 2011, the Company has a written employment agreement with Mr. Runkel that specified a base salary of $225,000 per year, an auto allowance of $750 per month and eligibility to participate in any incentive compensation program of the Company and all other benefit programs generally applicable to the Company’s senior executives. If DPAC terminates Mr. Runkel’s employment for any reason other than for “cause” or if Mr. Runkel terminates his employment for “good reason”, as those terms are defined in the agreement, Mr. Runkel will be entitled to a severance equal to the continuation of his base salary and auto allowance for twelve months from the termination of his employment. In addition, upon such an event, all unvested stock options to purchase Company common stock held by Mr. Runkel, if any, shall become fully vested and may be exercised by him for two years from the date of his termination. The employment agreement terminates on January 30, 2012.
Effective January 1, 2011, the Company has a written employment agreement with Mr. Vukadinovich that specified a base salary of $155,000 per year, an auto allowance of $500 per month and eligibility to participate in any incentive compensation program of the Company and all other benefit programs generally applicable to the Company’s senior executives. If DPAC terminates Mr. Vukadinovich’s employment for any reason other than for “cause” or if Mr. Vukadinovich terminates his employment for “good reason”, as those terms are defined in the agreement, Mr. Vukadinovich will be entitled to a severance equal to the continuation of his base salary and auto allowance for six months from the termination of his employment. In addition, upon such an event, all unvested stock options to purchase Company common stock held by Mr. Vukadinovich, if any, shall become fully vested and may be exercised by him for two years from the date of his termination. The employment agreement terminates on January 30, 2012.
Compensation of Directors
The following table sets forth the compensation of the Board for the 2010 fiscal year:
(1)
Mr. Runkel’s compensation is included in the Executive Compensation summary table. Mr. Runkel does not receive any compensation related to being a director of the Company.
(2)
The Company recognized no expense in its consolidated financial statements related to compensation for directors.
Prior to 2009, the Company paid its non-employee directors a cash retainer of $2,000 per quarter. The Chair of the Audit Committee and the Chair of the Compensation Committee were each paid an additional $1,000 and $500 per quarter, respectively. In addition to such retainers, non-employee directors received fees of $1,500 for each Board meeting attended. In addition, non-employee directors received fees of $500 for each Audit Committee or Compensation Committee meeting attended. The Board members are reimbursed their out-of-pocket expenses for attending Board and committee meetings. For 2009 and 2010, the Directors agreed to forgo all cash payments. The Compensation Committee is currently taking under consideration future Director compensation.
Each non-employee director is entitled to be granted annually an option to purchase up to 50,000 shares of the Company’s Common Stock at the fair market value of such shares at the time of such grant. Such option grants have a 10 year life and are immediately exercisable and fully vested at the time of grant. No stock option grants were issued to directors during the 2010 year. On January 10, 2011, the Company issued to its non-employee directors option grants to purchase 200,000 common shares. This included the annual 50,000 share grants plus additional shares in lieu of cash compensation. All options granted had an exercise price of $0.018 per share, the closing stock price on the day of the grant.
ITEM 12:
ITEM 12:
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The following tables sets forth certain information as of January 31, 2011, with respect to ownership of the Company’s Common Stock by each person who is known by the Company to own beneficially 5% or more of the Common Stock, each Named Officer, each director of the Company, each nominee for director, and all executive officers and directors of the Company as a group.
Equity Compensation Plan Information
ITEM 13:
ITEM 13:
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
As previously reported in the company’s current report on Form 8-K (filed with the SEC on October 6, 2009) in connection with the acquisition of the SocketSerial assets reported therein, our majority stockholder Development Capital Ventures, LP (“DCV”) facilitated the purchase of such assets through the purchase of shares of our Series A Preferred Stock for an approximate dollar value of $500,000. Mr. Don Murfin, a former director of DPAC, is also a shareholder, director and officer of DCV’s sole general partner.
ITEM 14:
ITEM 14:
PRINCIPAL ACCOUNTANT FEES AND SERVICES
Maloney + Novotny LLC (“Maloney + Novotny”) served as the company’s independent auditor for the years ended December 31, 2010 and 2009. The following is a summary of the fees billed to the Company by Maloney + Novotny for professional services rendered during the years ended December 31, 2010 and 2009:
Audit fees consist of fees billed for professional services rendered for the audit of the Company’s consolidated financial statements and review of the interim financial statements included in quarterly reports and services that are normally provided in connection with statutory and regulatory filings or engagements.
Our audit committee pre-approves all fees for services to be performed by our principal accountant in accordance with our audit committee charter.
The following documents are filed as part of this Form 10-K:
*
Management compensatory plan or arrangement
(c)
Financial Statement Schedules Excluded from Annual Report: None
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
POWER OF ATTORNEY
The undersigned hereby constitutes and appoints Steven D. Runkel and Stephen J. Vukadinovich, or either of them, his true and lawful attorney-in-fact and agent, with full power of substitution and re-substitution, to sign the report on Form 10-K and any or all amendments thereto and to file the same, with all exhibits thereto, and other documents in connection therewith with the Securities and Exchange Commission, hereby ratifying and confirming all that said attorney-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof in any and all capacities.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
/s/ Samuel W. Tishler
Samuel W. Tishler
Chairman of the Board
April 15, 2011
/s/ Steven D. Runkel
Steven D. Runkel
Chief Executive Officer, Director
(Principal Executive Officer)
April 15, 2011
/s/ William Roberts
William Roberts, Director
April 15, 2011
/s/ Mark Chapman
Mark Chapman, Director
April 15, 2011
/s/ Dennis R. Leibel
Dennis R. Leibel, Director
April 15, 2011
/s/ Jim Bole
Jim Bole, Director
April 15, 2011
/s/ Stephen J. Vukadinovich
Stephen J. Vukadinovich
Chief Financial Officer & Secretary
(Principal Financial and Accounting Officer)
April 15, 2011
DPAC TECHNOLOGIES CORP.
Report of Independent Registered Public Accounting Firm
To the Stockholders and Board of Directors
DPAC Technologies Corp.
Hudson, Ohio
We have audited the accompanying consolidated balance sheets of DPAC Technologies Corp. and subsidiary as of December 31, 2010 and 2009, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company has determined that it is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of DPAC Technologies Corp. and subsidiary as of December 31, 2010 and 2009, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, certain conditions raise substantial doubt about its ability to continue as a going concern. Management’s plans regarding these matters are also described in Note 1. The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty.
MALONEY + NOVOTNY LLC
Cleveland, Ohio
April 15, 2010
DPAC Technologies Corp.
Consolidated Balance Sheets
December 31, 2010 and 2009
See accompanying notes to consolidated financial statements.
DPAC Technologies Corp.
Consolidated Statements of Operations
For the Years Ended December 31, 2010 and 2009
See accompanying notes to consolidated financial statements.
DPAC Technologies Corp.
Consolidated Statements of Stockholders’ Equity
For the Years Ended December 31, 2010 and 2009
See accompanying notes to consolidated financial statements.
DPAC Technologies Corp.
Consolidated Statements of Cash Flows
For the Years Ended December 31, 2010 and 2009
See accompanying notes to consolidated financial statements.
DPAC Technologies Corp.
Notes to Consolidated Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations
DPAC Technologies Corp., (“DPAC”) through its wholly owned subsidiary, Quatech Inc., (“Quatech”) designs, manufactures, and sells device connectivity and device networking solutions for a broad market. Quatech sells its products through a global network of distributors, system integrators, value added resellers, and original equipment manufacturers (“OEM”). Quatech designs and manufactures communication and data acquisition products for personal computer based systems. The Company sells to customers in both domestic and foreign markets.
The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. All intercompany transactions and balances have been eliminated in consolidation.
Going Concern
The Company’s financial statements have been prepared on a going concern basis. Certain conditions exist that raise substantial doubt about the Company’s ability to continue as a going concern. These conditions include continued operating losses, deficit working capital balances and the inherent risk in extending or refinancing our bank line of credit, which matures on May 31, 2011. Our ability to continue as a going concern is dependent upon our ability to maintain positive cash flows from operations and to raise additional financing. Management believes that it has taken the necessary steps to achieve positive cash flows from operations, including the acquisition of a product line and reduction and management of the Company’s operating costs. The Company’s continued ability to obtain financing may be unavailable when needed. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As such, they do not include adjustments relating to the recoverability of recorded asset amounts and classification of recorded assets and liabilities that might result from the outcome of this uncertainty.
Liquidity
At December 31, 2010, the Company had a cash balance of $48,000 and a deficit in working capital of $1,428,000. This compares to a cash balance of $18,000 and a deficit in working capital of $1,343,000 at December 31, 2009. Although the Company has reported net losses in recent periods, a significant portion of our operating expenses are non-cash. For 2010, the Company reported a net loss of $665,000, which included the following non-cash operating expenses: depreciation and amortization of $684,000, provision for excess inventory of $166,000, non-cash compensation for stock options of $68,000, and non-cash interest expense of $95,000. For the year ended December 31, 2009, the Company reported a net loss of $1,133,000, which included the following non-cash operating expenses: depreciation and amortization of $595,000, provision for excess inventory of $48,000, non-cash compensation expense for stock options of $119,000, and non-cash interest expense of $108,000.
The Company has taken the following actions to reduce expenses and increase capital: In the third quarter of 2008, the Company reduced its cash operating expenses to align its cost structure with then current economic conditions and a downturn in the Company’s revenue levels, resulting in annualized operating cost savings of approximately $600,000. During the first quarter of 2009, the Company entered into an agreement with one of its contract manufacturers to sell certain equipment and inventory, lease a portion of its facility to the manufacturer, and further engage the manufacturer to produce more of the Company’s products. This transaction provided $150,000 in cash and has improved the operating efficiency of the Company. In the third quarter of 2009, the Company implemented additional cost reduction measures by reducing headcount and implementing a salary reduction program for all employees resulting in annual operating costs reductions of approximately $400,000. On September 30, 2009, the Company acquired the SocketSerial product line in a non cash transaction for the Company. Margins generated from revenues of this product line have helped enable the Company to achieve a cash flow break even from operations. In March of 2011, the Company entered into a Fourth Amendment to Credit Agreement extending the maturity date of its Bank revolving credit facility to May 31, 2011.
Going forward, the Company is dependent on financing its operations from through the contribution generated from future revenues and the use of its bank line of credit. Management believes that the actions it has taken will help enable the Company to generate positive cash flows from operations. Additionally, the Company experienced an increase in the rate of new orders during 2010, resulting in a 15% increase in net sales for 2010 compared to 2009, and a 23% increase in the size of its backlog of firm orders from $540,000 at December 31, 2009 to $664,000 at December 31, 2010. However, a further downturn in our revenue levels can severely impact the availability under our line of credit and limit our ability to meet our obligations on a timely basis and finance our operations as needed. The Company is currently talking to a number of other potential lenders with the intent of replacing the bank line of credit, which matures on May 31, 2011, with a new facility; however, we have not at this time received a commitment from another source that could replace the Bank line in its entirety. The Company may find it necessary to raise additional capital to fund its operations; however, there can be no assurance that additional capital will be available on acceptable terms, if at all, if and when it may be needed.
Use of Estimates
The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect certain reported amounts and disclosures. Actual results could differ from those estimates.
The Company calculates its reserve for excess and obsolete inventory based on the best estimate available as to the value of the items, and capitalizes labor and overhead to inventory based on estimates of applicable expenses. The Company estimates an allowance for doubtful accounts of its accounts receivable based upon a review of delinquent accounts and an assessment of the Company’s historical evidence of collections. Additionally, the Company calculated its warranty reserve on the best available measure of claims. Because of the inherent uncertainties in estimating the above, it is at least reasonably possible that the estimates used could change within the near term.
Cash and Cash Equivalents
The Company considers all short-term debt securities purchased with an initial maturity of three months or less to be cash equivalents.
Accounts Receivable
The Company extends unsecured credit to customers under normal trade agreements, which generally require payment within 30 days. Accounts greater than 90 days past due are considered delinquent. The Company does not charge interest on delinquent trade accounts receivable. Unless specified by the customer, payments are applied to the oldest unpaid invoice. Accounts receivable are presented at the amounts billed.
Management estimates an allowance for doubtful accounts, which was $23,479, and $26,674 as of December 31, 2010 and 2009, respectively. The estimate is based upon management’s review of delinquent accounts and an assessment of the Company’s historical evidence of collections. The Company incurred $0 and $1,000 of bad debt expense for the years ended December 31, 2010 and 2009, respectively. Specific accounts are charged directly to the reserve when management obtains evidence of a customer’s insolvency or otherwise determines that the account is uncollectible. Charge-offs of specific accounts for the years ended December 31, 2010 and 2009 totaled $3,195 and $23,773, respectively.
Inventories
Inventories, consisting principally of raw materials, sub-assemblies and finished goods, are stated at the lower of average cost or market. The Company regularly monitors inventories for excess or obsolete items and records a provision to write-down excess or obsolete items as required. At the end of each reporting period, the Company compares its inventory on hand to its forecasted requirements for the next twelve month period and the Company writes-off the cost of any inventory that is surplus, less any amounts that the Company believes it can recover from the disposal of such inventory. The Company’s sales forecasts are based upon historical trends, customer communications, and data regarding market trends and dynamics. Changes in the amounts recorded for surplus or obsolete inventory are included in cost of goods sold.
Property
Property is stated at cost less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets, generally ranging from 3 to 11 years. Leasehold improvements are amortized on a straight-line basis over the shorter of the useful lives of the improvements or the term of the related lease.
Capitalized Developed Software
Certain software development costs are capitalized after a product becomes technologically feasible and before its general release to customers. Significant judgment is required in determining when a product becomes “technologically feasible.” Capitalized development costs are then amortized over the product’s estimated life beginning upon general release of the product. Periodically, we compare a product’s unamortized capitalized cost to the product’s net realizable value. To the extent unamortized capitalized cost exceeds net realizable value based on the product’s estimated future gross revenues (reduced by the estimated future costs of completing and selling the product) the excess is written off. This analysis requires us to estimate future gross revenues associated with certain products and the future costs of completing and selling certain products. Changes in these estimates could result in write-offs of capitalized software costs. The Company capitalized software development costs of $0 and $29,282 for the years ended December 31, 2010 and 2009, respectively.
Financing Costs
Financing costs incurred are amortized over the life of the associated financing arrangements using the effective interest method. Amortization expense totaled approximately $46,675 and $50,068 for the years ended December 31, 2010 and 2009, respectively.
Long-lived Assets
The Company assesses potential impairments to its long-lived assets when there is evidence that events or changes in circumstances indicate the carrying amount of an asset may not be recovered. An impairment loss is recognized when the undiscounted cash flows expected to be generated by an asset (or group of assets) is less than its carrying amount. Any required impairment loss is measured as the amount by which the assets’ carrying value exceeds its fair value, and is recorded as a reduction in the carrying value of the related asset and a charge to operations.
Goodwill and Intangible Assets
Goodwill and indefinite lived intangible assets are tested for impairment annually at December 31st or more frequently when events or circumstances indicate that the carrying value of the Company’s single reporting unit more likely than not exceeds its fair value. The Company utilizes the two step test as required to assess goodwill for impairment. The first step of the goodwill impairment test consists of comparing the carrying value of the reporting unit to its fair value. Management estimates the fair value of the Company using an average of two methods and compares the fair value to the carrying amount (net book value) to ascertain if potential goodwill impairment exists. The Company utilizes methods that focus on its ability to produce income (“Income Approach”) and the estimated consideration it would receive if there were a sale of the Company (“Market Approach”). Key assumptions utilized in the determination of fair value in step one of the test included the following: the Company’s market capitalization; market multiples of comparable companies within its industry; revenue and expense forecasts used in the evaluation are based on trends of historical performance and management’s estimate of future performance; cash flows utilized in the discounted cash flow analysis are estimated using a weighted average cost of capital determined to be appropriate for the Company. Based on the Company’s analysis for impairment at December 31, 2010, the estimated fair value of the Company significantly exceeded its carrying value; therefore there was no impairment of goodwill and other indefinite lived intangibles. Consequently, the second step of the impairment test was not necessary.
Amortizable Intangible Assets
At December 31, 2010, amortizable intangible assets consisted of the following:
At December 31, 2009 amortizable intangible assets consisted of the following:
The developed technology was acquired in the DPAC - Quatech merger on February 28, 2006. The fair value was determined to be $2,450,094 at the acquisition date and is being amortized over its estimated life of 5 years. The fair value for the customer list acquired with the SocketSerial product line acquisition on September 30, 2009 of $50,000 is being amortized over its expected life of 5 years.
Total amortization expense related to the above assets was $500,020 and $490,020 for the years ended December 31, 2010 and 2009, respectively.
Revenue Recognition
Revenue on sales to customers is recognized upon shipment provided that persuasive evidence of a sales arrangement exists, the price is fixed or determinable, title has transferred, collection of resulting receivables is reasonably assured, and there are no remaining significant obligations. Revenue on sales to distributors where a right of return exists is recognized upon “sell-through,” when products are shipped from the distributor to the distributor’s customer. Revenue related to those products in our distribution channel at the end of each reporting period which has not sold-through is deferred. The amount of deferred revenue included in other accrued liabilities on the Company’s balance sheet was $68,587 and $9,991 at December 31, 2010 and 2009, respectively.
A reserve for defective products is recorded for customers based on historical experience or specific identification of an event necessitating a reserve. Development revenue is recognized when services are performed and was not significant for any of the periods presented.
The Company also offers marketing incentives to certain customers. These incentives are incurred based on the level of expenses the customers incur and are charged to operations as expenses in the same period.
Advertising Costs
The cost of advertising is charged to expense as incurred. Advertising expense for the years ended December 31, 2010 and 2009 totaled approximately $77,000 and $64,000, respectively.
Shipping and Handling Costs
The costs of shipping and handling billed to customers in sale transactions are recorded as revenue. Costs incurred for shipping and handling to customers are reported in cost of good sold. Total shipping and handling costs incurred to ship goods to customers were approximately $82,000 and $68,000 for the years ended December 31, 2010 and 2009, respectively.
Concentration of Credit Risk
Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of accounts receivable, which are derived primarily from distributors, original equipment manufacturers, and end customers.
The Company maintains its cash balances primarily in one financial institution which is insured under the Federal Deposit Insurance Corporation.
Stock-Based Compensation
The Company recognizes compensation expense, using a fair-value based method, for costs related to all share-based payments including stock options and stock issued under our employee stock plans. The Company estimates the fair value of share-based payment awards on the date of grant using a Black-Scholes option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense on a straight-line basis over the requisite service periods in our consolidated statements of operations.
Income Taxes
Deferred tax assets and liabilities are determined based on temporary differences between financial reporting and tax bases of assets and liabilities and are measured using enacted tax rates and laws that will be in effect when the differences are expected to reverse. The Company records a valuation allowance against deferred tax assets when it is more likely than not that such assets will not be realized. During the years ended December 31, 2010 and 2009, the Company recorded a full valuation allowance associated with its net deferred tax assets.
The Company adheres to the provisions of ASC 740, “Income Taxes”. ASC 740 prescribes a recognition threshold that a tax position is required to meet before being recognized in the financial statements, and provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure, and transition issues. It is the Company’s practice to recognize penalties and/or interest related to income tax matters in interest and penalties expense.
As of December 31, 2010, the Company’s prior three income tax years remain subject to examination by the Internal Revenue Service, as well as various state and local taxing authorities.
Net Income (Loss) per Share
Basic earnings per share are computed by dividing net income (loss) by the weighted-average number of common shares outstanding for the period. Diluted earnings (loss) per share reflect the potential dilution of securities by including other common stock equivalents, including stock options, in the weighted-average number of common shares outstanding for a period, if dilutive.
The table below sets forth the reconciliation of the denominator of the earnings per share calculation:
The number of shares of common stock, no par value, outstanding at both December 31, 2010 and 2009 was 109,414,896. Additionally, there were unissued accrued dividend shares of 32,580,930 and 3,571,429 issuable at December 31, 2010 and 2009, respectively. The Company issued the 32,580,930 shares on March 28, 2011.
Preferred Stock
At December 31, 2010 the Company had outstanding 30,000 shares of convertible, voting, cumulative, 15% Series A preferred stock. Dividends accrue and are payable quarterly in arrears at the annual rate of 9% of the Original Issue Price of $100 per share, either in cash or common stock, at the decision of the Company. Since the Company was not listed for trading on the American Stock Exchange, a NASDAQ Stock Market or the New York Stock Exchange as of December 31, 2009, effective beginning January 1, 2010, dividends accrue and are to be paid quarterly in arrears at the annual rate of 15%. For purposes of valuing the common stock payable to holders of Series A Preferred in lieu of cash with respect to such quarterly dividends, the value shall be deemed to be the average of the closing bid or sale prices (whichever is applicable) over the 10 day period ending the day prior to the dividend payment date. During the year ended December 31, 2009, the Company issued 11,408,553 common shares in payment of dividends of $191,252. At December 31, 2010, the Company had accrued dividends of $482,500, of which $465,000 is distributable in common stock, equating to 32,580,930 common shares issuable, and $17,500 of which is accrued to be paid in cash. The Company did not issue any common shares during the year ended December 31, 2010. At December 31, 2009, The Company had accrued dividends of $67,500, of which $50,000 was distributable in common stock, equating to 3,571,429 common shares issuable, and $17,500 of which was accrued to be paid in cash.
Series A preferred stock can, at the option of the holder, be converted into fully paid shares of common stock. The number of shares of common stock into which shares of Series A preferred may be converted shall be obtained by multiplying the number of shares of Series A preferred to be converted by the Original Issue Price of $100 and dividing the result by the product of $0.034 (the “Reference Price”) times 1.25, which equates to approximately 71 million common shares should the total number of outstanding preferred shares be converted. After December 31, 2009, the Company can redeem the Series A preferred shares at a price per share equal to the Original Issue Price. The holders of preferred stock have preference in the event of liquidation or dissolution of the Company over the holders of common stock.
Fair Value of Financial Instruments
The carrying value of the Company’s cash and cash equivalents, accounts receivable, accounts payable, and debt approximate fair value due to the relatively short period of time to maturity.
Fair Value Measurements
In September 2006, the FASB issued ASC No. 820, Fair Value Measurements (“ASC 820,” and previously referred to as Statement No. 157). The accounting pronouncement establishes a three-level hierarchy which prioritizes the inputs used in measuring fair value. In general, fair value determined by Level 1 inputs utilize quoted prices in active markets for identical assets or liabilities. Fair values determined by Level 2 inputs utilize data points that are observable such as quoted prices, interest rates and yield curves. Fair values determined by Level 3 inputs are unobservable data points for the asset or liability, and includes situations in which there is little, if any, market activity for the asset or liability.
The following table represents our financial assets and liabilities measured at fair value on a recurring basis and the basis for that measurement:
The Company values the put warrant liability by calculating the difference between the Company’s closing stock price at the end of a reporting period and the exercise price per share multiplied by the number of warrants granted. The Company has classified the fair value of the warrants as a liability and changes in the fair value of the warrants are recognized in the earnings of the Company. The Company recognized a loss of $10,600 and a gain of $15,800 for the years ended December 31, 2010 and 2009, respectively, related to the change in value of the put warrant liability. In addition, the actual settlement amount of the put warrant liability could differ materially from the value determined based on the Company’s stock price. There was no change in the valuation technique used by the Company since the last reporting period.
The Subordinated Debt Agreement, which funded on January 31, 2008, provides for a formula driven success fee equal to 7.0 times the trailing twelve months EBITDA minus indebtedness plus cash, times 5.5%, to be paid at maturity or a triggering event. The success fee is being accounted for as a separate contingent component of the note and will be revalued at each reporting period. The success fee is calculated at the end of each reporting period based on the trailing twelve months EBITDA, with the resultant amount multiplied by the percentage of the loan period remaining at each measurement date. As such, the liability is trued up at each reporting period based on the time elapsed, with the remaining unamortized portion of the success fee accreted monthly as additional interest expense over the remaining term of the loan. Based on the results of the above calculation, the Company recorded a liability of $18,319 and $0 for the success fee as of December 31, 2010 and 2009, respectively. There was no change in the valuation technique used by the Company since the last reporting period.
Comprehensive Income
The Company had no items of other comprehensive income for 2010 and 2009.
Recently Issued Accounting Standards
In January 2009, the Securities and Exchange Commission (“SEC”) issued Release No. 33-9002, “Interactive Data to Improve Financial Reporting.” The final rule requires companies to provide their financial statements and financial statement schedules to the SEC and on their corporate websites in interactive data format using the eXtensible Business Reporting Language (“XBRL”). The rule was adopted by the SEC to improve the ability of financial statement users to access and analyze financial data. The SEC adopted a phase-in schedule indicating when registrants must furnish interactive data. Under this schedule, the Company will be required to submit filings with financial statement information using XBRL commencing with its June 30, 2011 quarterly report on Form 10-Q. The Company is currently evaluating the impact of XBRL reporting on its financial reporting process.
In October 2009, the FASB amended revenue recognition guidance for arrangements with multiple deliverables. The guidance eliminates the residual method of revenue recognition and allows the use of management’s best estimate of selling price for individual elements of an arrangement when vendor specific objective evidence (“VSOE”), vendor objective evidence (“VOE”) or third-party evidence (“TPE”) is unavailable. This guidance should be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. Full retrospective application of the guidance is optional. The Company is currently evaluating the impact of adopting this guidance on its financial statements.
In April 2010, the FASB issued Accounting Standards Update 2010-13 (ASU 2010-13), “Compensation-Stock Compensation (Topic 718).” ASU 2010-13 provides amendments to ASC Topic 718 to clarify that an employee share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity securities trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity. The amendments in ASU 2010-13 are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The provision of ASU 2010-13 are not expected to have a material effect on the financial position, results of operations or cash flows of the Company.
In December 2010, the FASB issued an Accounting Standards Update 2010-28(“ASU 2010-28”), “Intangibles-Goodwill and Other (Topic 350)”. ASU 2010-28 amends ASC Topic 350. ASU 2010-28 clarifies the requirement to test for impairment of goodwill. ASC Topic 350 requires that goodwill be tested for impairment if the carrying amount of a reporting unit exceeds its fair value. Under ASU 2010-28, when the carrying amount of a reporting unit is zero or negative an entity must assume that it is more likely than not that a goodwill impairment exists, perform an additional test to determine whether goodwill has been impaired and calculate the amount of that impairment. The modifications to ASC Topic 350 resulting from the issuance of ASU 2010-28 are effective for fiscal years beginning after December 15, 2010 and interim periods within those years. Early adoption is not permitted. The provisions of ASU 2010-28 are not expected to have a material effect on the financial position, results of operations or cash flows of the Company.
NOTE 2 - PRODUCT LINE ACQUISITION
On September 30, 2009, in a non-cash transaction for the Company, the Company acquired from Socket Mobile, Inc. (“Socket”) the SocketSerial product line and all assets of Socket which pertain to Socket’s serial card business (the “Business”), including the tangible personal property and assets of Socket related to the Business; rights to any contract, purchase order, license or other agreement to the ownership, manufacture and distribution of the assets; certain rights to the intellectual property and proprietary rights related to or useful in connection with the Business and customer lists; the SocketSerial brand name and the SocketSerial website. The products in the SocketSerial product line consist of a CompactFlash serial card, a PC serial card, a PC dual serial card, and a PC quad serial card, all with fixed and removable cable models. Also included are a USB to Serial Adapter, USB to Ethernet Adapter and a license to sell the Cordless Serial Adapter. Quatech intends to continue to manufacture and distribute the SocketSerial product line and assumed existing customer support responsibilities. The transaction was completed with the assistance of Development Capital Ventures, LP (“DCV”), the Company’s majority shareholder. DCV initially purchased the Assets from Socket and immediately transferred the Assets to the Company in exchange for 8,750 shares of the Company’s Series A Preferred Stock.
The Assets were acquired for a purchase price of $500,000, of which $450,000 was payable at closing, and a contingent $50,000 payment would have become payable upon the attainment by Quatech of $250,000 in quarterly sales revenue from the sale of SocketSerial products in any quarter through the quarter ending December 31, 2010. No sales of the SocketSerial products attained the $250,000 threshold in any quarterly period through December 31, 2010; therefore the contingent $50,000 is not payable. The purchase price was allocated as follows:
The acquired Assets were not placed fully into service until December 31, 2009 and will begin being depreciated in January 2010 under their respective lives, estimated to be 5 years, on a straight line basis.
NOTE 3 - INVENTORIES
Inventory components at year-end are shown in the following table:
Purchases of finished assemblies from three major vendors represented 37%, 30% and 11% of the total inventory purchased in 2010 and purchases from two major vendors represented 43% and 23% of inventory purchased in 2009. The Company has arrangements with these vendors to purchase product based on purchase orders periodically issued by the Company.
NOTE 4 - PROPERTY
At December 31, 2010 and 2009, property consisted of the following:
Depreciation expense totaled approximately $184,000 and $86,000 for the years ended December 31, 2010 and 2009, respectively.
NOTE 5 - INCOME TAXES
The income tax benefit consists of the following for the years ended December 31, 2010 and 2009:
At December 31, 2010 and 2009, net deferred tax balances consisted of the following:
Included in the total deferred tax assets, the Company has an income tax carryforward for federal net operating losses. The cumulative federal net operating loss carryforward of approximately $12,308,000 expires through 2030; however, as a result of the merger between Quatech, Inc. and DPAC Technologies Corp, a substantial portion of DPAC’s federal net operating loss carryforward is subject to the provisions of Sec. 382 of the Internal Revenue Code (IRC), and therefore, is not available for immediate benefit to the company. Management has not yet determined the final impact of the IRC Sec. 382 limitation on the federal net operating loss carryforward. The realization of the Company’s deferred tax assets, including this federal net operating loss, and the related valuation allowance are significant estimates requiring assumptions regarding the sufficiency of future taxable income to realize the future tax deduction from the reversal of deferred tax assets and the net operating loss prior to their expiration. The valuation allowance has been provided based upon the Company’s assessment of future realizability of certain deferred tax assets, as it is more likely than not that sufficient taxable income will not be generated to realize these temporary differences. The net increase in the valuation allowance was $252,201 for 2010 and $419,790 for 2009. The amount of the corresponding valuation allowance could change significantly in the near term if estimates of future taxable income are changed.
The Company recognizes deferred tax assets and liabilities based on the differences between the financial statement carrying values and the tax bases of assets and liabilities. The 2010 and 2009 valuation allowances were calculated using an assessment of both negative and positive evidence when measuring the need for a valuation allowance. Evidence evaluated by management included operating results during the most recent three-year period and future projections, with more weight given to historical results than expectations of future profitability, which are inherently uncertain. The Company’s net losses in recent periods represented sufficient negative evidence to require a full valuation allowance against its net deferred tax assets. This valuation allowance will be evaluated periodically and could be reversed partially or totally if business results have sufficiently improved to support realization of deferred tax assets.
A reconciliation of the Company’s effective tax rate compared to the federal statutory rate is as follows:
NOTE 6 - DEBT
At December 31, 2010 and 2009, outstanding debt consisted of the following:
Revolving Credit Facility
The Company has a revolving line of credit with a Bank providing for a maximum facility of $1,500,000 working capital line of credit through May 31, 2011. At December 31, 2010, the facility had a floating interest rate at the 30 day LIBOR (.26% at December 31, 2010) plus 8.5%. Per the terms of the Third Amendment to Credit Facility, the line expired on December 15, 2010. In March 2011, the Company entered into a Fourth Amendment (“Amendment”) to Credit Agreement, effective as of December 15, 2010, extending the maturity date to May 31, 2011, and maintaining the interest rate at the LIBOR Rate, plus 8.5%. Interest is payable monthly on the last day of each month, until maturity. The Company is obligated to pay to the Bank an extension fee of $17,500 per the terms of the Fourth Amendment, with $7,500 due with the signing of the agreement and $10,000 due at maturity. All other terms and conditions of the Credit Agreement remain unchanged by the Amendment. Availability under the line of credit is formula driven based on applicable balances of the Company’s accounts receivable and inventories. Based on the formula, at December 31, 2010 the Company had availability to draw up to the maximum line amount of $1,500,000. For 2010, the average debt balance on the line of credit was $1,500,000 and the weighted average interest rate was 8.75%. The Credit Facility is secured by substantially all of the assets of the Company and expires on May 31, 2011.
As of December 31, 2010, we were not in compliance with certain of our bank financial covenants, which included purchasing assets in excess of $100,000.00 from Socket Mobile, Inc. through the assistance of Development Capital Venture, L.P. without the express written consent of the bank. These defaults were waived by Fifth Third Bank by agreement (entered into in March, 2011), but any other events of default were not waived. Each of the loan agreements with Canal Mezzanine Partners and the State of Ohio provide for cross-default of such loans in the event the Company defaults on a material agreement (such as the Bank credit facility) under certain terms. Further, each of the loan agreements provide for restrictive covenants, including the incurrence of additional indebtedness and certain equity financings, which restrict the Company’s ability to access other sources of liquidity, absent refinancing all of the existing indebtedness. The Company is currently talking to a number of other potential lenders with the intent of replacing the bank line of credit with a new facility; however, we have not at this time received a commitment from another source that could replace the Bank line in its entirety. The Bank line currently is set to mature in May, 2011. Additionally, the Canal Mezzanine and State of Ohio loan agreements contain provisions that accelerate the maturity and repayment of outstanding borrowings upon the acceleration of the Bank debt.
Ohio Development Loan
On January 27, 2006 Quatech entered into a Loan Agreement with the Director of Development of the State of Ohio pursuant to which Quatech borrowed $2,267,000 for certain eligible project financing. The State of Ohio debt accrues interest at the rate of 9.0% per year. Payments of interest only were due and payable monthly from March 2006 through February 2007. Thereafter, Quatech was obligated to make 48 consecutive monthly principal payments of $10,417 plus interest with the then balance due on February 1, 2011. During the second quarter of 2010, the repayments terms of the note were modified by means of an Allonge to the original instrument and provided a new debt amortization table. The modification deferred all monthly principal payments for a period of 11 months from October 2009 through September 2010 and extended the maturity date of the note. Per the modified agreement, the Company was obligated to make only monthly interest payments from November 2009 through September 2010. Thereafter, Quatech is obligated to make monthly principal payments of $10,417 plus interest through January 2013, with the remaining balance due in January 2013. The Company is current on all payments through December 31, 2010. At maturity, Quatech is obligated to pay the State of Ohio a participation fee equal to the lesser of 10% of the maximum principal amount borrowed or $250,000. The State of Ohio debt is secured by all the assets of Quatech which security interest is subordinated to the interest of the Bank. The participation fee is being accrued as additional interest each month over the term of the loan.
Subordinated Debt
On January 31, 2008, the Company entered into a Senior Subordinated Note and Warrant Purchase Agreement (“Agreement”) with Canal Mezzanine Partners, L.P. (“Canal”), for $1,200,000. The subordinated note has a stated annual interest rate of 13% and a five year maturity date. Interest only payments are payable monthly during the first five years of the note with all principal due and payable on the fifth anniversary of the note. The Agreement also provides for a formula driven success fee based on a multiple of the trailing twelve months EBITDA, to be paid at maturity or a triggering event, and for issuance of warrants entitling Canal to purchase 3% of the Company’s fully diluted shares at time of exercise at a nominal purchase price. At December 31, 2010, the Company was not in compliance with the Funded Debt to EBITDA covenant. Subsequent to year end and effective December 31, 2010, the covenant was modified to read equal to or less than 5.0, with which the Company is in compliance, and expects to be able to remain in compliance with. In conjunction with the covenant modification and effective March 1, 2011, the interest rate was increased from 13% to 16% per annum.
In October 2008, the Company entered into an Amendment to the Agreement providing for a second tranche of Senior Subordinated Debt financing from Canal of $250,000, which was due and payable on February 15, 2009. In March 2010, the Company and Canal came to agreement, effective November 1, 2009, that established a modified payment schedule and increased the interest rate from 13% to 16% per annum. The Company repaid $55,000 of the principal balance. In April 2011, the Company and Canal came to agreement modifying the maturity date to July 31, 2011.
The warrants associated with the Canal debt have a 10 year life and are exercisable at any time. The subordinated note has been discounted by the fair value of the detachable warrants, with a corresponding contribution to capital. The discount, calculated to be $63,800 at time of issuance, is being amortized as additional interest expense and accretes the note to face value at maturity. The Company determined the fair value of the warrant by using the Black-Scholes pricing model and calculating 3% of fully diluted shares at time of issuance, including a potential 50 million common shares for the conversion of the outstanding Series A preferred stock, which equated to approximately 4.9 million shares and using the closing stock price on the date of the transaction of $0.014 per share.
The success fee is defined as equal to 7.0 times the trailing twelve months EBITDA minus indebtedness plus cash, times 6.0%, to be paid at maturity or a triggering event. The success fee is being accounted for as a separate contingent component of the note and will be revalued at each reporting period. The success fee is calculated at the end of each reporting period based on the trailing twelve months EBITDA, with the resultant amount multiplied times the percentage of the loan period remaining at each measurement date. As such, the liability is trued up at each reporting period based on the time elapsed, with the remaining unamortized portion of the success fee accreted monthly as additional interest expense over the remaining term of the loan. $18,319 was accrued for the success fee was accrued at December 31, 2010 based on the formula calculation and no success fees were accrued as of December 31, 2009.
Put Warrant Liability
In connection with the Subordinated Loan Agreement between the Company and the Hillstreet Fund, entered into on February 28, 2006 and which was paid in full on January 31, 2008, the Company issued a 10-year warrant (“Put Warrant”) for 5,443,457 common shares at an exercise price of $0.00001 per share. The warrant expires on February 28, 2016. The Put Warrant continues to remain outstanding and can be “put” to the Company at any time based on criteria set forth in the warrant agreement at a price equal to the greatest of (i) the fair market value as established by a capital transaction or public offering; (ii) six times the Company’s EBITDA for the trailing 12 month period; and (iii) an appraised value. The Company values the put warrant liability by calculating the difference between the Company’s closing stock price at the end of a reporting period and the exercise price per share multiplied by the number of warrants granted. The Company has classified the fair value of the warrant as a liability and changes in the fair value of the warrant are recognized in the earnings of the Company. The Company recognized a loss of $10,600 and a gain of $15,800 for the years ended December 31, 2010 and 2009, respectively, related to the change in value of the put warrant liability. In addition, the actual settlement amount of the put warrant liability could differ materially from the value determined based on the Company’s stock price.
The aggregate amounts of combined long term debt, excluding the put warrant liability, maturing as of December 31st in future years is $320,000 in 2011, $125,000 in 2012, and $3,039,000 in 2013.
Interest expense incurred of $641,000 for the year ended December 31, 2010 included the following non-cash charges: accretion of participation and success fees of $35,000, amortization of deferred financing costs of $47,000, and amortization of the discount for warrants of $13,000.
Interest expense incurred of $580,000 for the year ended December 31, 2009 included the following non-cash charges: accretion of participation fees of $46,000, amortization of deferred financing costs of $50,000, and amortization of the discount for warrants of $13,000.
NOTE 7 - COMMITMENTS AND CONTINGENCIES
Lease Commitments
The Company leases office and operation facilities in Hudson, Ohio under an operating lease arrangement that expires on March 31, 2014. The minimum annual rentals under this lease are being charged to expense on a straight line basis over the lease term. Deferred rents were $8,775 as of December 31, 2010 and $13,500 as of December 31, 2009. The facility lease requires additional payments for property taxes, insurance and maintenance costs. Additionally, the Company leases certain equipment under operating leases. The Company had no capital leases as of December 31, 2010. The following table summarizes the future minimum payments under the Company’s operating leases at December 31, 2010:
Rent expense under operating leases was approximately $109,000 and $122,000 for the years ended December 31, 2010 and 2009, respectively. The amounts for both 2010 and 2009 are net of rental receipts of $59,000 as the Company has sublet a portion of its facility in Hudson, OH to one of its contract manufacturers.
Legal Proceedings
We are subject to various legal proceedings and threatened legal proceedings from time to time as part of our business. We are not currently party to any legal proceedings nor are we aware of any threatened legal proceedings, the adverse outcome of which, individually or in the aggregate, we believe would have a material adverse effect on our business, financial condition and results of operations. However, any potential litigation, regardless of its merits, could result in substantial costs to us and divert management’s attention from our operations. Such diversions could have an adverse impact on our business, results of operations and financial condition.
Other Contingent Contractual Obligations
Over time, the Company has made and continues to make certain indemnities, commitments and guarantees under which it may be required to make payments in relation to certain transactions. These include: indemnities to past, present and future directors, officers, employees and other agents pursuant to the Company’s Articles, Bylaws, resolutions, agreements or otherwise; indemnities to various lessors in connection with facility leases for certain claims arising from such facility or lease; indemnities to vendors and service providers pertaining to claims based on the negligence or willful misconduct of the Company; and indemnities pursuant to contracts involving protection of selling security holders against claims by third parties arising from any alleged inaccuracy of information in registration statements filed by the Company with the SEC or involving indemnification of the other parties to contracts from any damages arising from misrepresentations made by the Company. The Company may also issue a guarantee in the form of a standby letter of credit as security for contingent liabilities under certain customer contracts. The duration of these indemnities, commitments and guarantees varies and, in certain cases, may be indefinite. The majority of these indemnities, commitments and guarantees may not provide for any limitation of the future payments that the Company could potentially be obligated to make. The Company has not recorded any liability for these indemnities, commitments and guarantees in the accompanying balance sheets.
The Company has written severance agreements with the current CEO and CFO that provide for compensation equivalent to one year of compensation and six months of compensation, respectively, should either individual be terminated for any reason other than cause.
NOTE 8 - STOCK OPTION PLANS
The Company recognizes compensation expense, using a fair-value based method, for costs related to all share-based payments including stock options and stock issued under our employee stock plans. The Company estimates the fair value of share-based payment awards on the date of grant using a Black-Scholes option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense on a straight-line basis over the requisite service periods in our consolidated statements of operations.
Under the terms of the Company’s 1996 Stock Option Plan, (the “Plan”), qualified and nonqualified options to purchase shares of the Company’s common stock are available for issuance to employees, officers, directors, and consultants. As amended on February 23, 2006, the Plan initially called for options to purchase 15,000,000 shares with an increase to the total number of options available in the plan of 4% of the number of outstanding shares of common stock each year until the end of the option plan. On February 23, 2006, the termination date for the plan was extended to January 11, 2011. At December 31, 2010, 22,655,000 shares were available for future grants under the Plan. Subsequent to year end and prior to the termination date of the plan, the Company issued 9,100,000 options shares.
Options issued under this Plan are granted with exercise prices at fair market value and generally vest immediately for options granted to directors and at a rate of 25% per year for options granted to employees, and expire within 10 years from the date of grant or 90 days after termination of employment.
During the years ended December 31, 2010 and 2009, the Company recognized compensation expense for stock options of $68,496 and $119,371. The expense is included in the consolidated statement of operations as general and administrative expense. Total unamortized compensation expense related to non-vested stock option awards at December 31, 2010 was $46,000, which is expected to be recognized over a weighted-average period of 0.7 years. The Company’s calculations were made using the Black-Scholes option-pricing model, with the following weighted average assumptions:
Expected volatilities are based on historical volatility of the Company’s stock. The Company used historical experience with exercise and post employment termination behavior to determine the options’ expected lives. The expected life represents the period of time that options granted are expected to be outstanding. The risk-free rate is based on the U.S. Treasury rate with a maturity date corresponding to the options’ expected life. The dividend yield is based upon the historical dividend yield.
The following table summarizes stock option activity under DPAC’s 1996 Stock Option Plans for the years ended December 31, 2010 and 2009:
No options were exercised in 2010 or 2009.
The outstanding and exercisable options at December 31, 2010 presented by price range are as follows:
NOTE 9 - CONCENTRATION OF CUSTOMERS
No single customer accounted for more than 10% of net sales for 2010 and one customer accounted for 11% of net sales in 2009. No single customer accounted for more than 10% and one customer accounted for 13% of accounts receivable at December 31, 2010 and 2009, respectively.
NOTE 10 - SEGMENT INFORMATION
Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the Company’s chief operating decision-maker, or decision-making group, in deciding how to allocate resources and in assessing performance. The Company’s chief executive officer reviews financial information and makes operational decisions based upon the Company taken as a whole. Therefore, the Company reports as a single segment.
The Company had export sales that accounted for 26% and 23% of total net sales in 2010 and 2009, respectively. Export sales were primarily to Western European countries, Canada, Brazil, and Singapore. Foreign sales are made in U.S dollars. All long-lived assets are located in the United States.
NOTE 11 - EMPLOYEE BENEFIT PLAN
The Company has a defined contribution plan covering substantially all employees. The Company matches 25% of employee deferral contributions up to 6% of eligible wages, as defined. The Company contributed matching contributions of approximately $11,000 and $15,000 in the years ended December 31, 2010 and 2009, respectively.
NOTE 12 - SALE OF MANUFACTURING CAPABILITY
The Company entered into an Equipment Purchase Agreement (the “Agreement”) that was consummated in January 2009 with one of its contract manufacturers (“Manufacturer”) and sold certain of its manufacturing equipment (consisting of manufacturing equipment, fixtures, tools, shelving and tables) for a sale price of $74,000. The Manufacturer also assumed the obligations of Quatech under a certain capital lease with a remaining balance of approximately $21,000 at December 31, 2008. Also pursuant to the Agreement, Quatech sold certain inventory valued at a sum of $150,000. Quatech and Manufacturer have agreed that Manufacturer will purchase additional active inventory thereafter from Quatech under terms and conditions to be determined. Also pursuant to the Agreement, the Company sublet to Manufacturer 4,911 square feet of space at the Company’s manufacturing facility located in Hudson, OH. Additionally, the Company has agreed to utilize Manufacturer as its manufacturer of all products and parts for existing products of the Company (other than under the Company’s Airborne wireless product line) for a period of 24 months under terms and conditions to be determined by the parties. A negligible loss was recorded with regard to the transaction as the assets were sold at the Company’s approximate net carrying value of the assets.