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BLUEPHOENIX SOLUTIONS LTD - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

May 8, 2014

The following discussion and analysis provides information that we believe is relevant to an assessment and understanding of our results of operation and financial condition. You should read this analysis in conjunction with the attached condensed consolidated financial statements and related notes thereto, and with our audited consolidated financial statements and the notes thereto, included in our Annual Report on Form 10-K for the year ended December 31, 2013, as filed with the Securities and Exchange Commission (the "SEC") on March 28, 2014. Forward-Looking Statements The following discussion of our financial condition and results of operations contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are based on our management's beliefs and assumptions and on information currently available to our management. All statements other than statements of historical facts are "forward-looking statements" for purposes of these provisions, including those relating to future events or our future financial performance and financial guidance. In some cases, you can identify forward-looking statements by terminology such as "may," "might," "will," "should," "expect," "plan," "anticipate," "project," "believe," "estimate," "predict," "potential," "intend" or "continue," the negative of terms like these or other comparable terminology, and other words or terms of similar meaning in connection with any discussion of future operating or financial performance. These statements are only predictions. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. Any or all of our forward-looking statements in this document may turn out to be wrong. Actual events or results may differ materially. Our forward-looking statements can be affected by inaccurate assumptions we might make or by known or unknown risks, uncertainties and other factors. In evaluating these statements, you should specifically consider various factors, including the risks outlined under the caption "Risk Factors" set forth in Item 1A of Part II of this Quarterly Report on Form 10-Q, as well as those contained from time to time in our other filings with the SEC. We caution investors that our business and financial performance are subject to substantial risks and uncertainties.



Overview

We develop and market enterprise legacy migration solutions and provide tools and professional services to international markets through several entities including wholly-owned and majority-owned subsidiaries located in: the United States, United Kingdom, Italy, Romania and Israel. These technologies and services allow businesses to migrate from their legacy mainframe and distributed IT infrastructures to modern environments and programming languages.



Through the use of BluePhoenix developed technology, we:

perform conversions of legacy mainframe applications written in COBOL, CA

GEN, Natural, PL/1 to Java and C# code; perform conversions of legacy databases such as IDMS, ADABAS, VSAM, IMS, ICL to SQL Server, Oracle and DB2 environments; and



sell "Data Mirroring" software that allows companies to integrate legacy

databases with modern relational databases on a routine/ongoing basis enabling data share across an organization without migration.



The technology conversion tools are proprietary to us and perform automated code conversion of programming languages and database replication.

In addition to the technology tools, we provide professional services for:

project management of migrations;

understanding and mapping of the applications;

testing; remediation; and



on-going monitoring and management of the environments.

During 2013 and the first quarter of 2014, we continued to assess our infrastructure costs and reduce workforce and labor costs as they constitute a substantial portion of our costs of revenue, selling, general and administrative expenses and research and development costs. The number of our full-time employees has decreased from approximately 96 full-time employees and four full-time consultants as of December 31, 2013 to 71 full-time employees and eight full-time consultants as of March 31, 2014. 10 --------------------------------------------------------------------------------



Challenges and Opportunities

In a market that continues to innovate and evolve, new technologies and practices, by definition, render existing technology deployments out-of-date or legacy. By the same measure, however, in order for us to capitalize on the constant source of legacy solutions, we must evolve our solutions portfolio to deal with the changing definition of what constitutes "leading edge" technologies and the growing set that is deemed to be "legacy." Over time, as one legacy set of technologies is gradually replaced, we must be capable of addressing the modernization needs of the next set of aging technologies. However, these cycles are slow and provide us with the time to update our technology and products and build the necessary knowledge in house. The fact that the modernization needs of the market are evolving on a constant basis, necessitates that we be capable of tracking and predicting changes in technologies. Anticipating the needs of the IT modernization market and delivering new solutions that satisfy the emerging needs is a critical success factor. However, even if we develop modernization solutions that address the evolving needs of the legacy IT modernization market, we cannot assure that there will be a predictable demand for our offerings. Variables ranging from the macro-economic climate, to the competitive landscape, and to the perceived need that the enterprise market has for a specific modernization solution, may have an impact of a longer sales cycle or increased pricing pressure. To keep up with the anticipated growing demand for our solution, we must retain our skilled personnel in the fields of project management, legacy systems, and leading modern technologies. Maintaining and growing the requisite skill base can be problematic. Personnel with an understanding of legacy technologies are a finite resource and the market for recruiting and retaining such workforce can be highly competitive. Critical Accounting Policies

We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States. Accordingly, we are required to make certain estimates, judgments, and assumptions that we believe are 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 revenue and expenses during the periods presented.



There have been no material changes to our critical accounting policies and estimates as compared to the critical accounting policies and estimates described in our Annual Report on Form 10-K, filed with the SEC on March 28, 2014.

Recently Issued Accounting Pronouncements

New accounting standards that are applicable to the period:

On January 1, 2014 we adopted FASB ASU 2013-05, Foreign Currency Matters (Topic 830): Parent's Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity ("ASU 2013-05"). Under ASU 2013-05 when: a parent sells an investment in a foreign entity and ceases to have a controlling interest in that foreign entity or a foreign subsidiary disposes of substantially all of its assets; or, control of a foreign entity is obtained in which it held an equity interest before the acquisition date, the cumulative translation adjustment should be released into net income. The adoption of ASU 2013-05 did not have a significant impact on our results of operations or financial position.



On January 1, 2014 we adopted FASB ASU 2013-11, Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists ("ASU 2013-11"). ASU 2013-11 eliminates a diversity in practice regarding the presentation of an unrecognized tax benefit when a net operating loss carryforward or a tax credit carryforward exists. The adoption of ASU 2013-11 did not have a significant impact on the presentation of our results of operations or financial position.

New accounting standards issued and still not applicable for the period:

In April 2014, the FASB issued ASU No. 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. This ASU changes the requirements for reporting discontinued operations in subtopic 205-20 as well as the related disclosures. This ASU is effective prospectively for fiscal years, and interim periods within those years, beginning after December 15, 2014. We do not expect material impacts on the consolidated financial statements upon adoption.



Our Reporting Currency

The currency of the primary economic environment in which we, and most of our subsidiaries operate, is the U.S. dollar. In addition, a substantial portion of our revenue and costs are incurred in dollars. Thus, the dollar is our functional and reporting currency. 11 -------------------------------------------------------------------------------- We follow FASB ASC Topic 830 "Foreign currency translation" and accordingly non-monetary transactions denominated in currencies other than the dollar are measured and recorded in dollar at the exchange rates prevailing at transaction date. Monetary assets and liabilities denominated in currencies other than the dollar are translated at the exchange rate on the balance sheet date. Exchange gain or losses on foreign currency translation are recorded as income. Following is a summary of the most relevant monetary indicators for the reported periods: Revaluation Revaluation (Devaluation) of (Devaluation) of Inflation rate NIS euro For the three months ended March 31, in Israel against the US$ against the US$ % % % 2014 (0.49 ) 0.46 - 2013 0.02 (2.28 ) 5.0 Operating Results The following table presents the percentage relationships of certain items from our consolidated statement of operations, as a percentage of total revenue for the periods indicated:



Statement of Operations Data (US$ and as a Percentage of Revenue):

Three months ended March 31, 2014 2013 (in Thousands) % (in Thousands) % Revenue $ 1,871 100.0 $ 2,198 100.0 Cost of revenue 982 52.5 1,090 49.6 Gross profit 889 47.5 1,108 50.4 Research and development costs 335 17.9 347 15.8 Selling, general, and administrative expenses 1,414 75.6 1,509 68.7 Gain on sales of subsidiaries and AppBuilder - - 845 38.4 Operating profit (loss) (860 ) (46.0 ) 97 4.4 Financial income (expense), net 30 1.6 (73 ) (3.3 ) Profit (loss) before taxes on income (830 ) (44.4 ) 24 1.1 Taxes on income 18 1.0 48 2.2 Net loss from continued operation (848 ) (45.3 ) (24 ) (1.1 ) Net loss from discontinued operation - - 399 18.2 Net loss (848 ) (45.3 ) (423 ) (19.2 ) Net results attributable to non-controlling interests 75 4.0 177 8.1 Loss attributable to BluePhoenix' shareholders (923 ) (49.3 ) (600 ) (27.3 )



Three Months Ended March 31, 2014 and 2013

Revenue. Revenue was $1.9 million for the first three months of 2014 a 14.9% decrease when compared to $2.2 million in the first three months of 2013. The decrease is attributable to the completion of several major projects. We currently concentrate our resources on providing legacy modernization solutions and services. Our revenue is generated from fixed-price projects, consulting fees, and long-term maintenance contracts. Revenue generated from fixed price projects was $1.1 million for the first quarter of 2014 and $1.6 million for the first quarter of 2013. This decrease is attributable to the completion of several major projects. Revenue generated from our consulting services was $383,000 for the first three months of 2014 compared to $251,000 for the first quarter of 2013. This increase is due to additional consulting projects. Revenue generated from our long-term maintenance contract services was $279,000 for the first three months of 2014 compared to $311,000 for the first quarter of 2013. 12

-------------------------------------------------------------------------------- Cost of revenue. Cost of revenue consists of salaries, fees paid to independent subcontractors and other direct costs. Cost of revenue was $982,000 for the first three months of 2014 compared to $1.1 million for the first three months of 2013, a decrease of 9.9%. This decrease resulted primarily from the reduction in our overall workforce. Cost of revenue as a percentage of revenue was 52.5% in the first three months of 2014 compared to 49.6% in the first three months of 2013. This increase is attributable to the reduction in salary costs due to the reduction in our workforce, offset by lower revenue. Gross profit. Gross profit for the first three months of 2014 was $889,000, a 19.8% decrease from $1.1 million for the first three months of 2013. Gross profit as a percentage of revenue, was 47.5% in the first three months of 2014 compared to 50.4% in the first three months of 2013. The decrease is mainly attributable to the lower revenue offset by the reduction in cost of revenue due to the reduction in our overall workforce. Research and development costs. Research and development costs consist of salaries and consulting fees that we pay to professionals engaged in the development of new software and related methodologies. Our research and development costs are allocated among our modernization suite of solutions and are charged to operations as incurred. Research and development costs for the first three months of 2014 were $335,000 compared to $347,000 for the first three months of 2013, a decrease of 3.5%. The decrease was the result of the reduction in salary costs due to the reduction in our workforce. As a percentage of revenue, research and development costs were 17.9% in the first three months of 2014 and 15.8% in the first three months of 2013. Selling, general, and administrative expenses. Selling, general, and administrative expenses consist primarily of wages and related expenses, travel expenses, sales commissions, selling expenses, marketing and advertising expenses, rent, insurance, utilities, professional fees, depreciation and amortization. Selling, general, and administrative expenses for the first three months of 2014 were $1.4 million compared to $1.5 million for the first three months of 2013, a decrease of 6.3%. Most of the decrease was the result of the reduction in salary costs due to the reduction in our workforce. As a percentage of revenue, selling, general and administrative expenses were 75.6% in the first three months of 2014 compared to 68.7% in the first three months of 2013. Gain on sales of subsidiaries and AppBuilder. Gain on sale of AppBuilder, in the first three months of 2013, amounted to $845,000, and constitutes proceeds previously received as part of the AppBuilder transaction that were subject to fulfillment of certain conditions that have been met. We did not sell any subsidiaries in the first three months of 2014. Financial income (expense), net. Financial expenses include interest paid on a loan extended by a third party and an expense due to derivative financial instruments. Financial expenses also include accounting charges related to warrants previously issued by us, which we record as a derivative, and expenses from fluctuations in foreign currency exchange rate. The financial income is the result of the effect of the change in our stock price and its effect on the value of our warrants. Our financial income was $30,000 for the first three months of 2014 compared to financial expense of $73,000 for the first three months of 2013. Taxes on income. In the first three months of 2014, we had income tax expense of $18,000 compared to $48,000 in the first three months of 2013. The tax expense in the first three months of 2014 and 2013 is current tax expense.



Net loss from discontinued operation. Net loss from discontinued operation in the first three months of 2013 was attributable to BridgeQuest, Inc. and amounted to $399,000. We did not have any gain or loss from discontinued operation in the first three months of 2014.

Net result attributable to non-controlling interest. Net loss attributable to non-controlling interest in the first three months of 2014 was $75,000 compared to $177,000 in the first three months of 2013, and represented the non-controlling share in the net loss of our subsidiary, Zulu Software Inc.



Liquidity and Capital Resources

How We Have Financed Our Business

Public Offerings

In 1997, we consummated two public offerings, and received net proceeds of $33.9 million after deducting underwriting discounts and commissions and offering expenses.

13 -------------------------------------------------------------------------------- In February 2006, we completed an underwritten public offering in Israel of series A convertible notes in an aggregate principal amount of NIS 54.0 million that were equal at the time of the transaction to approximately $11.5 million (the dollar amount was calculated based on the exchange rate at the date of the transaction). All of the notes have been converted into ordinary shares.



Private Placements

In 2004, we completed a $5 million private placement of convertible debentures and warrants to institutional investors. Pursuant to our agreement with the institutional investors, in March 2006, the institutional investors exercised their right to purchase from us, for an aggregate purchase price of $3 million, additional convertible debentures due in 2009. In 2008, the institutional investors converted the entire principal amount of the debentures into 405,198 ordinary shares. As of the date of this Quarterly Report on Form 10-Q., all warrants were expired.



In November 2007, we completed a $35 million private placement of ordinary shares and warrants issued to institutional investors. The net proceeds from the offering were mainly used for repayment of debt. As of the date of this Quarterly Report on Form 10-Q, all warrants were expired.

In October 2009, we completed a $4.2 million private placement of ordinary shares and warrants issued to institutional investors. Under the Securities Purchase Agreement entered into with the institutional investors, we sold to the investors 341,144 ordinary shares and the investors were also granted Series A Warrants exercisable into 204,686 ordinary shares, until October 2014. Warrants to purchase 102,343 ordinary shares are still outstanding as of March 31, 2014. The adjusted exercise price of these warrants is $1.5634 per share. As agreed with the investors, we registered the shares purchased by the investors and those underlying the warrants for resale under an effective registration statement. In November 2013, we completed a $2.5 million private placement of 625,000 ordinary shares which were issued directly to Prescott Group Aggressive Small Cap Master Fund, G.P. The ordinary shares issued in connection with this offering are subject to anti-dilution provisions in certain circumstances, including upon the occurrence of any issuance of ordinary shares or securities convertible into ordinary shares at a price below $4.00. Accordingly, we reserved up to an additional 1,042,523 ordinary shares to cover our anti-dilution undertaking. Prescott Group Aggressive Small Cap Master Fund, G.P. is affiliated with Prescott Capital.



Credit Facility

In October 2013, our subsidiary, BluePhoenix Solutions USA, Inc., entered into a loan agreement with Comerica Bank. As of March 31, 2014, we have not borrowed any amount under this credit facility. The principal terms of the agreement are as follows:



non-formula revolving line in the amount up to $500,000 backed by a guarantee;

borrowing base (accounts receivable based) loan in the amount up to $500,000;

both the non-formula revolving line and borrowing base loan are at market

based interest rates based on Prime + a margin; and

one year commitment. There are no financial covenants. There are some restrictions on cash balances to be held within banks other than Comerica. As of March 31, 2014, we were in compliance with these restrictions.



Cash and Cash Equivalents

As of March 31, 2014, we had cash and cash equivalents of $871,000 and working capital of $1.6 million. As of December 31, 2013, we had cash and cash equivalents of $2.6 million and working capital of $2.3 million. The working capital decreased primarily due in large part to the decrease in cash and cash equivalents offset with an increase in trade receivables and a decrease in deferred revenue and a decrease in other current liabilities. Net cash used in operating activities during first three months of 2014, was $1.7 million compared to $1.1 million during first three months of 2013. The change is primarily attributable to the increase in our operating loss and an increase in our trade receivables offset by decrease in trade payables and 2014 not having a gain on sale of subsidiaries and Appbuilder . Net cash used in investment activities during the first three months of 2014 was $39,000 compared to net cash provided by investment activities during the first three months of 2013 of $800,000. Net cash provided by investment activities during the first three months of 2013 includes proceeds from sales of subsidiaries and AppBuilder of $800,000. 14 --------------------------------------------------------------------------------



Net cash used in financing activities was $121,000 during the first three months of 2013 for the repayment of loans to banks and a third party.

Our working capital is sufficient for our present requirements. Management acknowledges that uncertainty exists regarding funding of operations but believes working capital and borrowing capacity is sufficient to continue in operational existence for the foreseeable future. Additionally, the Company will continue to closely monitor its cash needs and fixed infrastructure costs.



Contractual Commitments and Guarantees

2009 Warrants

In October 2009, as part of a $4.2 million private placement, we issued to institutional investors Series A Warrants exercisable into 204,686 ordinary shares until October 2014, of which warrants to purchase 102,343 ordinary shares are still outstanding as of March 31, 2014. The adjusted exercise price of these warrants is $1.5634 per share. As agreed with the investors, we registered the shares purchased by the investors and those underlying the warrants for resale under an effective registration statement.



Chief Scientist

One of our subsidiaries has entered into an agreement with Israel'sOffice of the Chief Scientist, or OCS. This subsidiary is obliged to pay royalties to the OCS at a rate of 3% on sales of the funded products, up to 100% of the dollar-linked grant received in respect of these products from the OCS. As of March 31, 2014, the contingent liability amounted to $262,614.



Ministry of Production in Italy

During 2007, our subsidiary, I-Ter, received an amount of $585,000 from the Ministry of Production in Italy under a plan called Easy4Plan. Approximately $371,000 of that amount is in the form of a 10-year loan payable in equal annual installments until September 2018. The loan bears an annual interest of 0.87% and is linked to the euro. As of March 31, 2014, the remaining loan balance was approximately $202,000. Our subsidiary's operations have been reduced significantly, and if this trend continues, the Ministry of Production in Italy may require the immediate repayment of the full outstanding loan amount. We do not currently anticipate this occurrence.



Operating Leases

We are committed under operating leases for rental of office facilities, vehicles, and other equipment for the years 2014 until 2016. Operating lease payments for the first quarter of 2014 were approximately $102,000.

Indemnification of Office Holders

We entered into an undertaking to indemnify our office holders in specified limited categories of events and in specified amounts, subject to certain limitations.

Off Balance Sheet Arrangements

We did not have any off balance sheet arrangements in the three months ended March 31, 2014.

Effective Corporate Tax Rates Under Israeli law, Israeli corporations are generally subject to 26.5% corporate tax as of January 1, 2014. An Israeli company is subject to tax on its worldwide income. An Israeli company that is subject to Israeli taxes on the income of its non-Israeli subsidiaries will receive a credit for income taxes paid by the subsidiary in its country of residence, subject to certain conditions. Israeli tax payers are also subject to tax on income from a controlled foreign corporation, according to which an Israeli company may become subject to Israeli taxes on certain income of a non-Israeli subsidiary, if such subsidiary's primary source of income is a passive income (such as interest, dividends, royalties, rental income, or capital gains). Our international operations are taxed at the local effective corporate tax rate in the countries where our activities are conducted. We have significant amounts of carry forward losses, including at BluePhoenix Solutions USA Inc. from which our headquarters operates. Therefore, we do not estimate that changing our headquarters from Herzliya, Israel to Seattle, Washington in June 2013 will have a material impact on the amount of future tax payments until these carry forward losses are utilized or until we have taxable income on an ongoing basis. 15



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