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FLEXPOINT SENSOR SYSTEMS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

August 14, 2014

EXECUTIVE OVERVIEW

Flexpoint Sensor Systems, Inc. is a development stage company principally engaged in designing, engineering and manufacturing bend sensor technology and devices that use its patented Bend Sensor® technology, (a flexible potentiometer technology). For the past four years we have been making improvements to our technology and proving the versatility and durability of the Bend Sensor® by manufacturing Bend Sensor® devices and related products and introducing these to a variety of industries. We currently own nine patents and through our research and development efforts are in the process of filing for more that include fully integrated products being sold and supplied to our limited customer base. We have also jointly developing additional commercially viable products, including a universal sensor that will be used in the automotive, medical and industrial industries.

On April 9, 2013, we settled all disputes with R&D Products and their related parties. The settlement agreement gives the Company exclusive rights to over four additional patents, patent applications and related products that we anticipate opening or expanding our customer base. With the settlement of the litigation with R&D Products and Mr. deGreef, see below, we have begun marketing efforts on projects that had been on hold since the litigation started. These products had already received market acceptance prior to the litigation and will greatly enhance our product offerings and improve our revenue opportunities.

Our patented technology continues to gain recognition in various markets and industries as evidenced by the recent receipt of an initial production order from CPS Color Equipment S.p.A Italy and orders from a Fortune 100 automotive maker for our horn system. In October 2013, our horn system was installed in a limited number of vehicles to complete their "in-vehicle-testing" process that is required prior to moving forward with incorporating our system into various platforms of automobiles and trucks. Over the next six to nine months we will concentrate our marketing efforts and limited financial resources on current projects that we believe can be brought to market in the shortest period of time. We anticipate having additional products featuring our patented Bend Sensor® technology on the market over the next 8 to 12 months including products in the medical, sport shoe, residential home care and industrial control industries.

Over the past year we have been enhancing our relationships with various automotive Tier 1 suppliers as they have continued testing and proving our patented horn and seat switch reliability. Previously we announced that our steering wheel horn pad received implementation ready status for a U.S. Fortune 100 automaker that has also identified up to four vehicle platforms being considered for the Company's longer lasting and more cost effective horn switch.

The horn system has recently successfully completed in-vehicle testing which requires that the system be installed in a vehicle and driven for 150,000 miles without failure.

We continue to develop new types of products for our Bend Sensor® technologies and continue to receive small repeat production orders from existing customers. We have made improvements on our initial prototype for a Home Monitoring Presence Detection System using our Bend Sensor® technologies and have received development and design orders from various industries. In addition to the horn switch, we have continued to work with market makers and Tier I automotive suppliers in the U.S and Europe on numerous other applications for our sensors and

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devises. Based upon our discussions within the automotive industry in the U.S. and Europe our unique sensor systems meet the requirements for manufacturers to have lighter weight, more fuel efficient cars. Our Bend Sensor®

Our Bend Sensor® is lighter in weight, has fewer moving parts than conventional sensing devices, is more versatile and, due to its unique design is more cost effective. Product and design changes in the automotive industry are slow, averaging two to three years before actually being incorporated into a commercially viable automotive platform. Because of our recent work with several Tier 1 suppliers, we have shown the Bend Sensor® to be viable as the next generation of sensing devises to the industry. Due to the advanced technology of the Bend Sensor® and its versatility of applications, we anticipate being a part of the changes taking place in the automotive, energy and technological industries.

During the past six months, we completed the electronics and software that will be used in a running shoe and other sports related products. The completion of these components opens the way for Bend Tech and Flexpoint to aggressively market to major shoe manufactures. It also is a critical piece of the golf training aid that Bend Tech will market. Beyond its sport and recreational value, golf is a major industry that generates jobs, commerce, economic development and tax revenues for communities throughout the country. The total size of the golf economy nationally was estimated at $68.8 billion in 2011, up from $62 billion in 2000 (from http://www.wearegolf.org).

As part of the golf training project the Company entered into a development agreement with Bend Tech, LLC to manufacture working prototypes of a golf shoe and golf shaft that will utilize a series of Bend Sensors® in a high tech training aid for golf. Flexpoint was paid upon completion of various milestones during the development process. The agreement provided an added source of income for the Company during the second quarter of the year. In July the Company and Bend Tech announced that all work under the development agreement has been successfully completed and that they were working on finalizing a Manufacturing Agreement.

We completed PhaseTwo of the disposable directional colonoscope for Haemoband Surgical, Ltd, a Northern Ireland based company that specializes in unique medical devices. We received approval to move to Phase Three in July 2014. The estimated volumes quoted for this device are between 500,000 to 1 million sensors annually. The application will use a sensor that is an adaptation of a sensor that we already have commercially available; therefore, the cost associated with the development of this medical application has been marginal. With the completion of Phase Two management believes the Company moves closer to an agreement for a long-term contract with Haemoband. It is estimated that the annual demand for colonoscopy procedures ranges from 2.21 to 7.96 million in the United States and as the overall population continues to age more procedures will be required. One of the difficulties with the procedure is providing an inexpensive means of locating the exact position of the colonoscopes. With the use of our sensor array and monitoring equipment, the initial testing has shown that with the Bend Sensor® technology it is possible to locate the positioning of the colonoscopes. It is anticipated that completion and commercialization of this product will open up significant other markets for additional products that uses similar equipment for other unrelated products in the medical industry.

The Company continues working with HTK Engineering, LLC and Vista Brake who are currently marketing their safety mechanisms specifically designed for garbage trucks and other large commercial and emergency vehicles. Most commercial vehicles have an "air braking system" which can lose pressure and disengage the brakes while the vehicle is still running. Our Bend Sensor® technology is the key component of the HTK and Vista's systems which provide a backup braking system preventing the vehicle from inadvertently rolling into people, buildings or other vehicles. Part of the marketing effort has been to involve insurance companies who have paid claims related to the initial brake failure. Because our jointly designed systems are easily installed and adaptable to most vehicles insurance companies have indicated they would provide a reduction in premiums should their customers install the one of these systems. There are over 179,000 garbage and recycling trucks in use in the United States. and HTK is also pursuing opportunities for the system throughout Europe and Asia.

We continue to receive development orders from Intertek Industrial Corp. for their ProTek System. The ProTek System is an automotive seat-monitoring device integrated into emergency response vehicles. This monitoring device places the Company's Bend Sensors® in each rear passenger seat with a monitor viewable to the vehicle's driver. The foolproof system informs the driver if the emergency medical technicians are seated and properly secured prior to departure and while the vehicle is in motion. The system is installed in the seats of the rear compartments of the emergency vehicle and provides the driver with constant feedback as to the "seated and secured" status of passengers and personnel in the rear of the vehicle. The system is currently installed in ambulances and is being tested for use in other types of emergency vehicles. Through its relationship with Intertek the Company has further validated its technology in the automotive and safety industries and is currently working

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with other companies on similar systems for buses, cabs and heavy equipment operators to ensure the safety of the their passengers and drivers. A national surge in ambulance accidents has called for increased safety standards for emergency vehicles. Due to the rise in injuries and fatalities that result from these accidents, the National Fire Protection Association (NFPA) has taken on the task of rewriting the ambulance standard. As a result there is currently national legislation proposed that could take effect by the end of 2014. The proposed legislation will require a safety system similar to Intertek's ProTek System, which will give Intertek a significant competitive advantage being first to market with an already proven system that will meet the legislative requirements.

Using our Bend Sensor® technology the Company has developed a patented medical bed and with the settlement with R&D Products and Mr. deGreef we are now able to openly market this unique bed. Because of the Bend Sensor's® predictability the accompanying electronics of the bed are able to determine the position of the person in the bed and how they are moved. The bed has the ability to roll a patient left or right to relieve pressure areas that can cause bed sores or other life threatening complications for patients that are bed ridden as well as facilitate dressing changes. Needed adjustments can be programmed into the bed to relieve pressure areas to meet the required standards for patient care and comfort. The entire integrated system will also record the movements providing a chronological record of patient care. Our Bend Sensor® technology has many other medical applications that the Company is pursuing.

The Company anticipates marketing a similar bed as part of an in-home specialty mattress. The specialty (non-innerspring) segment of the bedding market has been growing rapidly over the past six to seven years. With the increasing demand of specialty mattresses almost every commercial mattress company has a specialty bed they promote. The Company has had some discussions with mattress companies who have expressed interest in the concept. Mr. deGreef has been intimately involved with the medical mattress and other products that have been placed on hold during the lawsuit, and has successfully marketed these products in prior years. Mr. deGreef is currently in discussions with additional interested clients.

Although, so far the volumes for our applications and devises have been relatively small we continue to receive follow up orders for the universal sensor that we jointly developed last year. We expect to receive additional orders from other customers for this sensor as it becomes more recognizable in the market. Currently our customers for this type of sensor include companies in the following industries: automobiles, trucking, emergency vehicles, public transportation, military and other governmental entities. As anticipated, the Company is beginning to see the potential for more significant volumes and revenues from the sale of this sensing devise over the next year and beyond.

Finalizing additional long-term revenue generating production contracts with other customers remains our greatest challenge because our on-going business is dependent on the types of revenues and cash flows generated by such contracts. Cash flow and cash requirement risks are closely tied to, and are dependent upon, our ability to attract significant long-term production contracts. In the short term we must continue to obtain funding to operate and expand our operations so that we can deliver our unique Bend Sensor® and Bend Sensor® related technologies and products to the market. Management believes that even though we have made positive strides forward with our business plan, it is likely that significant progress may not occur for the next three to six months, primarily due to the time it takes for negotiating such contracts. Accordingly, we cannot guarantee that we will realize significant revenues or that we will become profitable over the next six to nine months.

Management believes with the signing of the development agreement with Bend Tech and receiving the exclusive rights to a group of products that have proven in the past to generate revenue streams, and the recent orders received for its automotive and industrial control devises, the Company is on the threshold of growing its customer base that should help in producing long-term production contracts that will be sustainable in the near future.

LIQUIDITY AND CAPITAL RESOURCES

Our revenue is primarily from design, contract, testing and limited production services and is not to a level to support our operations. Management anticipates that we may not realize significant revenue within the next three to nine months.

Since emerging from bankruptcy and for the past six months, we have relied on the proceeds of convertible loans from various sources including existing shareholder and private placements. From 2008 through 2011 the Company secured $2,126,391 in convertible notes with annual interest rates ranging from 10% to 12%. The notes were

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secured by the Company's assets and had various maturity dates and conversion features ranging from $0.25 to $0.10 per share. During the same time period the Company issued 7,710,663 in restricted common stock to retire $1,798,866 in debt and accrued interest. From 2008 through 2011 the Company issued an additional 3,657,250 restricted common shares to cancel $847,732 in Company debt related to investor relations, marketing to the automotive industry and various insurance related expenses.

During 2012 the Company issued 4,045,700 in restricted common shares of stock in lieu of cash and cancelled $501,622 in Company debt. The shares were issued to satisfy the Company's obligations for investor relations, sales and marketing expense and insurance expense associated with directors and officers insurance. The Company also issued 5,500,000 in restricted common shares of stock to retire $848,248 of the outstanding convertible notes and accrued interest, including the Maestro line of credit entered into in November 2010. Due to the difference between the market value of the shares issued and the stated conversion rate of the notes on the date of conversion the Company recognized a net gain on debt conversion of $371,021.

Over the past six months the Company has issued $240,000 in convertible promissory notes with conversion features ranging from $.05 to $.025 with an annual interest rate of 10%. The loans are secured by the Company's business assets, with various maturity dates. The Company previously negotiated extensions for all of the notes to June 30, 2014. The proceeds of these notes were used to fund operations, including the various development projects currently underway.

Management believes that our current cash burn rate is approximately $50,000 per month and the proceeds from the convertible notes and our engineering and design fees will not totally fund our anticipated growth in operations. We will therefore need to raise additional financing. We believe that this additional financing will provide the needed capital to extend operations to the development and production of our growing product offerings and growing manufacturing opportunities. However, we may not be able to obtain financing, or the sources of financing, if any, may not continue to be available, and if available, they may be on terms unfavorable to us.

As we enter into production and development agreements we must ensure that those agreements provide adequate funding for any pre-production research and manufacturing costs. As we are successful in establishing agreements with adequate initial funding, management believes that our operations for the long term will be funded by revenues, licensing fees and/or royalties related to these agreements. However, other than the recent development agreement with Bend Tech that we believe will provide future revenues, we have not formalized any additional agreements during the past year and there can be no assurance that the agreements we currently have will come to fruition in the near future or that a desired technological application can be brought to market on a commercially viable basis.

FINANCIAL OBLIGATIONS AND CONTINGENT LIABILITIES

Our principal commitments at June 30, 2014 consisted of our operating lease of $8,950 per month, and total liabilities of $1,385,955, which includes $757,556 of convertible notes payable, net of discounts. Under the terms of our operating lease the average monthly payments are $8,950, including common area maintenance through December 31, 2014. The total future minimum payments under this lease as of June 30, 2014 are $53,700.

During 2013 and for the six months ended June 30, 2014, the Company has issued promissory notes in the aggregate of $872,313, net of discounts, at 10% interest and are secured by the Company's equipment. With the negotiated extension, notes are due and payable on or before June 30, 2014 (See Note 6 to the financial statements). Management anticipates extending the maturity date of the notes with the same terms.

As of June 30, 2014, we had accounts payable of $200,407 related to normal operating expenses, including health insurance, utilities, production supplies, travel expense, and expenses for professional fees, and $8,878 related party accounts payable for other operating expenses.

Accrued liabilities at June 30, 2014, were $379,115 and were related to payroll, payroll tax liabilities, accrued professional expenses, accrued insurance expense, accrued interest expense on notes and accrued paid time off.

On July 9, 2014, the Company issued a promissory note for $40,000. The note has an annual interest rate of 10% and is secured by the Company's equipment. The principal amount of the note and all accrued interest is due and payable on or before September 30, 2014 (See Note 10 to the financial statements).

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OFF-BALANCE SHEET ARRANGEMENTS

Other than our current operating lease we have not entered into any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources and would be considered material to investors.

CRITICAL ACCOUNTING ESTIMATES

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Estimates of particular significance in our financial statements include goodwill and the annual tests for impairment of goodwill and long-lived assets and valuing stock option compensation.

The Company's goodwill represents the excess of its reorganization value over the fair value of the net assets upon emergence from bankruptcy. Goodwill is not amortized, therefore we test our goodwill for impairment annually or when a triggering event occur using a fair value approach. A fair value based test is applied at the overall Company level. The test compares the fair value of the Company to the carrying value of its nets assets. The test requires various judgments and estimates. During 2013 and for the six months ended June 30, 2014, the Company recorded no impairment charge to reduce the carrying value of the goodwill to its estimated fair value. As part of the impairment testing, the Company considered factors such as the global market volatility, variables in the economy, and the overall uncertainty in the markets which has resulted in a decline in the market price of the Company's stock price and market capitalization for a sustained period, as indicators for potential goodwill impairment. Based upon our analysis for the impairment test for the six months ended June 30, 2014 compared the carrying value of the Company's net assets to the estimated fair value of the overall Company, and the present values of projected net cash flows of the Company over the next three years, no additional impairment was recognized during the six months ended June 30, 2014.

We test long-lived assets for impairment quarterly or when a triggering event occurs. Impairment is indicated if undiscounted cash flows are less than the carrying value of the assets. The amount of impairment is measured using a discounted-cash-flows model considering future revenues, operating costs and risk-adjusted discount rate and other factors. The analysis compares the present value of projected net cash flows for the remaining current year and next two years against the carrying value of the long-lived assets. If the carrying values of the long lives assets exceed the present value of the discounted projected revenues an impairment expense would be recognized in the period and the carrying value of the assets would be adjusted accordingly. Under similar analysis no impairment charge was taken during the six month period ended June 30, 2014. Impairment tests will be conducted on a quarterly basis and, should they indicate a carrying value in excess of fair value, additional charges may be required.

Financial accounting standards require that recognition of the cost of employee services received in exchange for stock options and awards of equity instruments be based on the grant-date fair value of such options and awards and is recognized as an expense in operations over the period they vest. The fair value of the options we have granted is estimated at the date of grant using the Black-Scholes American option-pricing model. Option pricing models require the input of highly sensitive assumptions, including expected stock volatility. In addition, our stock options have characteristics significantly different from those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimate. Management believes the best input assumptions available were used to value the options and that the resulting option values are reasonable. For the six month periods ended June 30, 2014 and 2013, we recognized $0.00 and $0.00, respectively, of stock-based compensation expense for our stock options and there is no additional unrecognized compensation cost related to employee stock options at the current time.

RESULTS OF OPERATIONS

The following discussions are based on the consolidated operations of Flexpoint Sensor Systems, Inc. and its subsidiaries and should be read in conjunction with our unaudited financial statements for the three and six months ended June 30, 2014 and 2013, included in Part I, Item 1, above, and the audited financial statements included in the Company's annual report on Form 10-K for the years ended December 31, 2013 and 2012.

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Three month period ended Six month period ended June 30, June 30, 2014 2013 2014 2013 Engineering, contract and testing revenue $ 43,302$ 28,495$ 96,653$ 41,775 Total operating costs and expenses 271,390 260,001 544,546 509,894 Net other income (expense) (23,444) (22,688) (48,589) (31,731) Net loss (251,532) (254,194) (496,480) (499,850) Basic and diluted loss per common share $ (0.00)$ (0.01)$ (0.01)$ (0.01)



For the three and six months ending June 30, 2014 revenue increased by $14,807 and $54,878, respectively, when compared to the same interim periods in 2013. The increase in revenue was primarily due to the Company entering into a development agreement with Bend Tech, the recognition of $10,000 in deferred income for the shoe development, and the work with Haemoband Surgical, LTC. The Company continues to execute on its business plan by concentrating its marketing resources on a limited number of customers that have the greatest potential to generate the most short-run revenue while still building relationships with our larger customers. Management believes this approach has the highest potential to bring long-term commercially viable products to market during the remainder of 2014 and beyond, and will provide sustainable cash flow to fund the Company's operations in the future. Currently, overall revenues are not sufficient to sustain our operations, but have steadily increased over the past two years and management anticipates that revenues will continue to increase as we continue to execute our long-term business plan and cultivate larger customer base with our existing product offering. However until a long-term production contract is in place there is no guarantee that our current customer base will order in sufficient volumes to sustain our operations. Therefore, management continues to work with larger companies and industries and is hopeful that in the near future we will sign a long-term licensing or manufacturing contract.

Revenue for the three and six months ending June 30, 2014 and 2013 was from design contract, development engineering and limited production. Revenue from research and development engineering contracts is recognized as the services are provided and accepted by the customer. Revenue from contracts to license technology to others is deferred until all conditions under the contract are met and then the sale is recognized as licensing royalty revenue over the remaining term of the contract. Revenue from the sale of a product is recorded at the time of shipment to the customer.

Of the $271,390 and $260,001 total operating costs and expense for the three months ending June 30, 2014 and 2013, respectively, $74,422 and $55,604 were for direct research and development cost, respectively. For the three months ended June 30, 2014, total operating expenses increased by $11,389 when compared to the same period in 2013, the majority of the increase related to increased research and development expenses.

Total operating expense increased by $34,652 for the six months ended June 30, 2014 when compared to the same period in 2013. Of the $544,546 and $509,894 total operating costs and expenses for the six months ending June 30, 2014 and 2013, respectively, $138,690 and $105,188 were for direct research and development cost, respectively. The increase in operating expense for the 2014 interim periods was primarily due to increases in research and development costs required to move the projects under development agreements toward commercialization.

The chart below represents a summary of our condensed consolidated balance sheets at June 30, 2014 and December 31, 2013.

June 30, 2013 December 31, 2013 Cash and cash equivalents $ 27,956$ 35,221 Total current assets 80,542 85,060 17



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(continued) June 30, 2013 December 31, 2013 Total assets $ 5,326,815$ 5,421,394 Total liabilities 1,379,267 995,367 Deficit accumulated during the development stage (20,904,759) (20,408,027) Total stockholders' equity $ 5,326,815$ 4,426,027



Cash and cash equivalents decreased by $7,265 at June 30, 2014 compared to December 31, 2013. The decrease in cash is due to the timing of payment of expenses and collection of accounts receivable. Our non-current assets decreased at June 30, 2014 due to the depreciation and amortization of long-lived assets. These assets include property and equipment valued at $21,770, net of depreciation; patents and proprietary technology of $321,035, net of amortization; goodwill of $4,896,917 and long-term deposits of $6,550 associated with the facility operating lease.

Total liabilities increased by $383,900 at June 30, 2014; the increase was primarily due to the increase in convertible notes payable of $237,209. The Company used the proceeds from the notes to fund operations. During the six months ended June 30, 2014, the Company recognized $10,000 in deferred revenue on the completion of the enhancements to our software and electronics for the sports show sensing device. Accrued liabilities and accounts payable increased by $160,558 during the period for investor relations and insurance related expenses.

INFLATION



We do not expect the impact of inflation on our operations to be significant for the next twelve months.


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