News Column

ANDREA ELECTRONICS CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

August 14, 2014

Overview

Our mission is to provide the emerging "voice interface" markets with state-of-the-art communications products that facilitate natural language, human/machine interfaces.

Examples of the applications and interfaces for which Andrea DSP Microphone and Audio Software Products and Andrea Anti-Noise Products provide benefit include: Internet and other computer-based speech; telephony communications; multi-point conferencing; speech recognition; multimedia; multi-player Internet and CD ROM interactive games; and other applications and interfaces that incorporate natural language processing. We believe that end users of these applications and interfaces will require high quality microphone and earphone products that enhance voice transmission, particularly in noisy environments, for use with personal computers, mobile personal computing devices, cellular and other wireless communication devices and automotive communication systems. Our Andrea DSP Microphone and Audio Software Products use "far-field" digital signal processing technology to provide high quality transmission of voice where the user is at a distance from the microphone. High quality audio communication technologies will be required for emerging far-field voice applications, ranging from continuous speech dictation, to Internet telephony and multiparty video teleconferencing and collaboration, to natural language-driven interfaces for automobiles, home and office automation and other machines and devices into which voice-controlled microprocessors are expected to be introduced during

the next several years. We outsource to Asia high volume assembly for most of our products from purchased components. We assemble some low volume Andrea DSP Microphone and Audio Software Products from purchased components. As sales of any particular Andrea DSP Microphone and Audio Software Product increases, assembly operations are transferred to a subcontractor in Asia.



Our Critical Accounting Policies

Our unaudited condensed consolidated interim financial statements and the notes to our unaudited condensed consolidated interim

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financial statements contain information that is pertinent to management's discussion and analysis. The preparation of unaudited condensed consolidated interim financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. On a continual basis, management reviews its estimates utilizing currently available information, changes in facts and circumstances, historical experience and reasonable assumptions. After such reviews, and if deemed appropriate, those estimates are adjusted accordingly. Actual results may vary from these estimates and assumptions under different and/or future circumstances. Our significant accounting policies are described in Note 2 of the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2013. A discussion of our critical accounting policies and estimates are included in Management's Discussion and Analysis or Plan of Operation in our Annual Report on Form 10-K for the year ended December 31, 2013. Management has discussed the development and selection of these policies with the Audit Committee of the Company's Board of Directors, and the Audit Committee of the Board of Directors has reviewed the Company's disclosures of these policies. There have been no material changes to the critical accounting policies or estimates reported in the Management's Discussion and Analysis section of the Annual Report on Form 10-K for the year ended December 31, 2013.



Cautionary Statement Regarding Forward-Looking Statements

This report contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of the Company. These forward-looking statements are generally identified by use of the words "believe", "expect", "intend", "anticipate", "estimate", "project" or similar expressions. The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, changes in economic, competitive, governmental, technological and other factors that may affect our business and prospects. Additional factors are discussed below under Part II, "Item 1A - Risk Factors" and in Part I, "Item 1A - Risk Factors" in the Company's Annual Report on Form 10-K for the year ended December 31, 2013. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, the Company does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events. Results Of Operations Three and Six Months ended June 30, 2014 compared to Three and Six Months ended June 30, 2013 Net Revenues For the Three Months Ended June 30, % For the Six Months Ended June 30, % 2014 2013 Change 2014 2013 Change Andrea Anti-Noise Products net revenues Sales of products to OEM customers for use with educational software $ 96,522$ 7,082



1,263 $ 101,081 $ 28,375 256 (a) All other Andrea Anti-Noise net product revenues

249,050 304,768 (18 ) 650,955 766,241 (15 ) (b) Total Andrea Anti-Noise Products net revenues $ 345,572$ 311,850



11 $ 752,036$ 794,616 (5 )

Andrea DSP Microphone and Audio Software Products net revenues Sales of automotive array microphone products 22,622 3,996 466 31,621 3,996 691 (c) All other Andrea DSP Microphone and Audio product net revenues 13,400 29,362 (54 ) 22,098 72,757 (70 ) (d) License revenues 217,627 626,413 (65 ) 412,471 775,832 (47 ) (e) Total Andrea DSP Microphone and Audio Software Products net revenues 253,649 659,771

(62 ) 466,190 852,585 (45 ) Total Revenues $ 599,221$ 971,621 (38 ) $ 1,218,226$ 1,647,201 (26 ) 16



(a) The increases of approximately $89,000 and $73,000 for the three and six

months ended June 30, 2014, respectively, as compared to the three and six

months ended June 30, 2013, represent increased product sales to our

educational customers for use with their distance learning products. We

believe that these changes in product sales relate to the timing of the

customers' demand for our products.

(b) The decreases of approximately $56,000 and $115,000 for the three and six

months ended June 30, 2014, respectively, as compared to the three and six

months ended June 30, 2013, in all other Andrea Anti-noise net product

revenues is primarily related to decreased demand from our distance learning

customers as well as our distributor and reseller customers.

(c) The increases of approximately $19,000 and $28,000 for the three and six

months ended June 30, 2014, respectively, as compared to the three and six

months ended June 30, 2013, in sales of automotive array microphone products

is primarily the result of increased product sales to integrators of public

safety vehicle solutions.

(d) The decreases of approximately $16,000 and $51,000 for the three and six

months ended June 30, 2014, respectively, as compared to the three and six

months ended June 30, 2013, in all other Andrea DSP Microphone and Audio

Software net product revenues is related to decreased demand from our OEM

customers.

(e) The decreases of approximately $409,000 and $363,000 for the three and six

months ended June 30, 2014, respectively, as compared to the three and six

months ended June 30, 2013, is the result of an decrease in sales of PC

models which feature our technology coupled with approximately $295,000 and

$150,000 of certain royalties related to a customer's licensing agreement

that were not reported for 2012 and the quarter ended March 31, 2013,

respectively. These revenues were recorded in the six months ended June 30,

2013. Cost of Revenues Cost of revenues as a percentage of net revenues for the three months ended June 30, 2014 increased to 42% from 25% for the three months ended June 30, 2013. This increase is because of the decrease of licensing revenue for the three months ended June 30, 2014, as compared to 2013. The cost of revenues as a percentage of net revenues for the three months ended June 30, 2014 for Andrea Anti-Noise Products was 66% compared to 72% for the three months ended June 30, 2013. The cost of revenues as a percentage of net revenues for the three months ended June 30, 2014 for Andrea DSP Microphone and Audio Software Products was 9% compared to 4% for the three months ended June 30, 2013. Cost of revenues as a percentage of net revenues for the six months ended June 30, 2014 increased to 41% from 34% for the six months ended June 30, 2013. This increase is because of the decrease of licensing revenue for the three months ended June 30, 2014, as compared to 2013. The cost of revenues as a percentage of net revenues for the six months ended June 30, 2014 for Andrea Anti-Noise Products was 60% compared to 64% for the six months ended June 30, 2013. The cost of revenues as a percentage of net revenues for the six months ended June 30, 2014 for Andrea DSP Microphone and Audio Software Products was 10% compared to 6% for the six months ended June 30, 2013. The decreases for the Andrea Anti-Noise Products revenues for the three and six month periods was attributable to the mix of different product revenues within the segment which reflected sales of higher margin products combined with an increase in revenues in this segment for three months ended June 30, 2014 as compared to 2013. The increases in cost of sales as a percentage of sales for Andrea DSP Microphone and Audio Software products segment for the three and six month periods relate to decreased licensing revenues.



Research and Development Expenses

Research and development expenses for the three months ended June 30, 2014 increased 4% to $173,367 from $167,357 for the three months ended June 30, 2013. For the three months ended June 30, 2014, the increase in research and development expenses reflects a 6% increase in our Andrea DSP Microphone and Audio Software Technology efforts to $103,201, or 60% of total research and development expenses and a 1% increase in our Andrea Anti-Noise Headset Product efforts to $70,166, or 40% of total research and development expenses. Research and development expenses for the six months ended June 30, 2014 increased less than 1% to $347,891 from $346,224 for the six months ended June 30, 2013. For the six months ended June 30, 2014, the increase in research and development expenses reflects a 1% increase in our Andrea DSP Microphone and Audio Software Technology efforts to $208,792, or 60% of total research and development expenses while our Andrea Anti-Noise Headset Product efforts remained relatively flat at $139,099, or 40% of total research and development expenses.



General, Administrative and Selling Expenses

General, administrative and selling expenses increased 5% to $517,217 for the three months ended June 30, 2014 from $494,661 for the three months ended June 30, 2013. This increase of approximately $23,000 is primarily related to an increase in monetization expenses of approximately $189,000 offset in part by decreases in expenses related to amortization, compensation and promotion and marketing. For the three months ended June 30, 2014, the expenses reflect a 24% increase in our Andrea DSP Microphone and Audio Software Technology efforts to $235,200 or 45% of total general, administrative and selling expenses and a 7% decrease in our Andrea Anti-Noise Headset Product efforts to $282,017, or 55% of total general, administrative and selling expenses. General, administrative and selling expenses increased 52% to, $1,644,080 for the six months ended June 30, 2014 from $1,082,123 for the six months ended June 30, 2013. For the six months ended June 30, 2014, the expenses reflect a 139% increase in our Andrea DSP

17 Microphone and Audio Software Technology efforts to $958,082, or 58% of total general, administrative and selling expenses and less than a 1% increase in our Andrea Anti-Noise Headset Product efforts to $685,998, or 42% of total general, administrative and selling expenses. This increase of approximately $562,000 is primarily related to costs associated with consummating the Revenue Sharing and Note Purchase Agreementand an increase in monetization expenses of approximately $526,000. Interest Income, net Interest income, net for the three months ended June 30, 2014 was $1,362 compared to $1,743 for the three months ended June 30, 2013. Interest income, net for the six months ended June 30, 2014 was $1,857 compared to $3,872 for the six months ended June 30, 2013. The decrease in interest income, net is due to the interest expense related to the Revenue Sharing and Note Purchase Agreement. Provision for Income Taxes

The provision for income taxes for the three and six months ended June 30, 2014 was $43,031 and $81,615, respectively. There was no benefit or provision for income taxes for the three and six months ended June 30, 2013. The provision for income taxes for the three and six months ended June 30, 2014 are a result of licensing revenues that are subject to withholding of income tax as mandated by the foreign jurisdiction in which the revenues are earned. Although the provisions could be offset by future tax benefits since it is unlikely that Company will be able to use these types of foreign tax credits as well as that the Company records a full valuation against deferred tax assets until such benefits will be utilized, the provisions will not be reduced by such tax benefits. Additionally, the Company expects to have taxable income as a result of the long-term deferred revenue created by the Revenue Sharing and Note Purchase Agreement. The Company will offset the taxable income by utilization of their net operating loss carry forwards and reduce its valuation allowance by approximately $300,000. This reduction will be offset by the same reduction of the deferred tax asset resulting in no benefit or provision for the three or six months ended June 30, 2014 relating to taxable income from the long-term deferred revenue. Net (Loss) Income

Net loss for the three months ended June 30, 2014 was $384,524 compared to net income of $63,787 for the three months ended June 30, 2013. Net loss for the six months ended June 30, 2014 was $1,354,409 compared to net loss of $333,641 for the six months ended June 30, 2013. The net loss for the three and six months ended June 30, 2014 and 2013 principally reflects the factors described above.



Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on its financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.



Liquidity And Capital Resources

At June 30, 2014, we had cash of $3,196,484 compared with $1,000,422 at December 31, 2013. The increase in our cash balance at June 30, 2014 was primarily a result of the $3,000,000 received in connection with the Revenue Sharing and Note Purchase Agreement offset in part by our cash used in operations. Our working capital balance at June 30, 2014 was $3,744,761 compared to working capital of $1,676,678 at December 31, 2013. The increase in working capital reflects an increase in total current assets of $2,111,677, partially offset by an increase in total current liabilities of $43,594. The increase in total current assets reflects an increase in cash of $2,196,062, a decrease in accounts receivable of $95,449, a decrease in inventories of $16,178 and an increase in prepaid expenses and other current assets of $27,242. The increase in total current liabilities of $43,594 reflects a decrease in trade accounts payable of $30,494, a decrease in short-term deferred revenue of $1,815 and an increase of $75,903 in other current liabilities. The increase in cash of $2,196,062 reflects $1,836,036 of net cash provided by operating activities, $41,811 of cash used in investing activities and $401,837 of cash provided by financing activities. The cash provided by operating activities of $1,836,036, excluding non-cash charges for the six months ended June 30, 2014, was attributable to a $13,834 decrease in accounts receivable, a $9,286 decrease in inventories, a $27,242 increase in prepaid expenses, other current assets and other assets, a $30,494 decrease in trade accounts payable, a $75,903 increase in other current liabilities, a $1,815 decrease in short-term deferred revenue, and a 3,000,000 increase in long-term deferred revenue. The changes in accounts receivable, inventories, prepaid expenses, other current assets and other assets, trade accounts payable, other current liabilities and short-term deferred revenue primarily reflect differences in the timing related to both the payments for and the acquisition of inventory as well as for other services in connection with ongoing efforts related to Andrea's various product lines. The increase in cash and long-term deferred revenue is primarily a result of the Revenue Sharing

and Note Purchase Agreement. 18 We plan to improve our cash flows in 2014 by aggressively pursuing monetization of our patents related to our Andrea DSP Microphone Audio Software, increasing the sales of our Andrea Anti-Noise Products through the introduction of new products as well as the increased efforts we are putting into our sales and marketing efforts. In February 2014, we entered into a Revenue Sharing and Note Purchase Agreement. Under this Agreement, we received $3,000,000 in exchange for a perpetual predetermined share in the rights of our specified future revenues from patents owned by Andrea. Additionally, we borrowed $400,000 of notes and have access to borrow up to an additional $3,800,000 during the next four years. The proceeds of the notes will be used to pay patent monetization expenses. As a result of the past few years of performance and the execution of this Agreement, we believe that we have sufficient liquidity to continue our operations at least through June 2015. As of August 8, 2014, Andrea had approximately $2,900,000 of cash deposits. We cannot assure that demand will continue for any of our products, including future products related to our Andrea DSP Microphone and Audio Software technologies, or, that if such demand does exist, that we will be able to obtain the necessary working capital to increase production and provide marketing resources to meet such demand on favorable terms, or at all.


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