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TMCNet:  TELKONET INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

[August 14, 2014]

TELKONET INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of the Company's financial condition and results of operations should be read in conjunction with the accompanying condensed consolidated financial statements and related notes thereto for the three and six months ended June 30, 2014, as well as the Company's consolidated financial statements and related notes thereto and management's discussion and analysis of financial condition and results of operations in the Company's Form 10-K for the year ended December 31, 2013, filed March 31, 2014.

Business Telkonet, Inc., formed in 1999 and incorporated under the laws of the state of Utah, is made up of two synergistic business divisions, EcoSmart Energy Management Technology and EthoStream High Speed Internet Access (HSIA) Network.

Our EcoSmart Suite of products (which include Telkonet's legacy "SmartEnergy" products) provides comprehensive savings, management and reporting of a building's room-by-room energy consumption. Telkonet's energy management products are currently installed in over 200,000 rooms in properties within the hospitality, military, educational and healthcare markets. The EcoSmart technology platform is rapidly being recognized as a leading solution-provider for reducing energy consumption, carbon footprints and eliminating the need for new energy generation in these marketplaces - all while improving occupant comfort and convenience.

Controlling energy consumption can make a significant impact on a property owner's bottom line, as heating, ventilation and air conditioning ("HVAC") costs represent a substantial portion of a facility's overall utility bill.

Hospitality is a key market for Telkonet. According to the EPA EnergySTAR for Hospitality analysis, the median hotel uses approximately 70,000 Btu/ft2 from all energy sources. Since fewer than 20% of the hotels in North America have an energy management system, there is considerable opportunity to assist those lodging facilities that are more energy intensive than necessary. With approximately 47,000 hotels in the USA alone, the market size is substantial.

Telkonet's EthoStream is one of the largest public High-Speed Internet Access ("HSIA") providers in the world, providing services to more than 8.0 million users monthly across a network of greater than 2,200 locations. With a wide range of product and service offerings and one of the most comprehensive management platforms available for HSIA networks, EthoStream offers solutions for any public access location.

Our direct sales efforts target the hospitality, education, commercial, utility and government/military markets. Taking advantage of legislation, including the Energy Independence and Security Act of 2007, or EISA, the Energy Policy Act of 2005, and the American Recovery and Reinvestment Act we've focused our sales efforts in areas with available public funding and incentives, such as rebate programs offered by utilities for efficiency upgrades. Through our proprietary platform, technology and partnerships with energy efficiency providers, we intend to position our Company as a leading provider of energy management solutions.

Telkonet's Series 5 Smart Grid networking technology allows commercial, industrial and consumer users to connect intelligent devices to a communications network using the existing low voltage electrical grid. Series 5 technology uses power line communications, or PLC, technology to transform existing electrical infrastructure into a communications backbone. Operating at 200 Mbps, the PLC platform offers a secure alternative in grid communications, transforming a traditional electrical distribution system into a "smart grid" that delivers electricity in a manner that can save energy, reduce cost and increase reliability.

On March 4, 2011, the Company sold its Series 5 PLC product line and related business assets to Dynamic Ratings, Inc. ("Dynamic Ratings"). The sales price was $1,000,000 in cash. In connection with the sale, Dynamic Ratings lent $700,000 to the Company in the form of a 6% promissory note dated March 4, 2011. Concurrently with the sale, the Company entered into a Distributorship Agreement and a Consulting Agreement with Dynamic Ratings. Under the Distributorship Agreement, the Company was designated as a distributor of the Series 5 product to non-utility markets and will receive preferred pricing for purchases of Series 5 product. Under the Consulting Agreement, the Company agreed to provide Dynamic Ratings with ongoing transition assistance and consulting services for the Series 5 product. The Consulting Agreement expired on March 31, 2013. The Distributorship Agreement had an initial term that was to expire on March 31, 2014, but was automatically renewed for one year.

Forward-Looking Statements In accordance with the Private Securities Litigation Reform Act of 1995, we can obtain a "safe-harbor" for forward-looking statements by identifying those statements and by accompanying those statements with cautionary statements which identify factors that could cause actual results to differ materially from those in the forward-looking statements. Accordingly, the following "Management's Discussion and Analysis of Financial Condition and Results of Operations" may contain certain forward-looking statements regarding strategic growth initiatives, growth opportunities and management's expectations regarding orders and financial results for the remainder of 2014 and future periods. These forward-looking statements are based on current expectations and current assumptions which management believes are reasonable. However, these statements involve risks and uncertainties that could cause actual results to differ materially from any future results encompassed within the forward-looking statements. Factors that could cause or contribute to such differences include those risks affecting the Company's business as described in the Company's filings with the SEC, including the current reports on Form 8-K, which factors are incorporated herein by reference. The Company expressly disclaims a duty to provide updates to forward-looking statements, whether as a result of new information, future events or other occurrences.

20 Critical Accounting Policies and Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. On an ongoing basis, we evaluate significant estimates used in preparing our condensed consolidated financial statements including those related to revenue recognition, uncollectible accounts receivable, guarantees and product warranties, stock-based compensation, potential impairment of goodwill and other long-lived assets, contingent liabilities and business combinations. We base our estimates on historical experience, underlying run rates and various other assumptions that we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results could differ from these estimates. The following are critical judgments, assumptions, and estimates used in the preparation of the condensed consolidated financial statements.

Revenue Recognition For revenue from product sales, we recognize revenue in accordance with ASC 605-10, and ASC Topic 13 guidelines that require that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and (4) collectability is reasonably assured. Determination of criteria (3) and (4) are based on management's judgments regarding the fixed nature of the selling prices of the products delivered and the collectability of those amounts. Provisions for discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period the related sales are recorded. The guidelines also address the accounting for arrangements that may involve the delivery or performance of multiple products, services and/or rights to use assets.

Multiple-Element Arrangements ("MEAs"):The Company accounts for contracts that have both product and installation under the MEAs guidance in ASC 605. The Company believes the volume of these contracts will continue to increase.

Arrangements under such contracts may include multiple deliverables, a combination of equipment and services. The deliverables included in the MEAs are separated into more than one unit of accounting when (i) the delivered equipment has value to the customer on a stand-alone basis, and (ii) delivery of the undelivered service element(s) is probable and substantially in our control. Arrangement consideration is then allocated to each unit, delivered or undelivered, based on the relative selling price of each unit of accounting based first on vendor-specific objective evidence ("VSOE") if it exists, second on third-party evidence ("TPE") if it exists and on estimated selling price ("ESP") if neither VSOE or TPE exist.

· VSOE - In most instances, products are sold separately in stand-alone arrangements. Services are also sold separately through renewals of contracts with varying periods. We determine VSOE based on its pricing and discounting practices for the specific product or service when sold separately, considering geographical, customer, and other economic or marketing variables, as well as renewal rates or stand-alone prices for the service element(s).

· TPE - If we cannot establish VSOE of selling price for a specific product or service included in a multiple-element arrangement, we use third-party evidence of selling price. We determine TPE based on sales of comparable amount of similar product or service offered by multiple third parties considering the degree of customization and similarity of product or service sold.

· ESP - The estimated selling price represents the price at which we would sell a product or service if it were sold on a stand-alone basis. When neither VSOE nor TPE exists for all elements, we determine ESP for the arrangement element based on sales, cost and margin analysis, as well as other inputs based on our pricing practices. Adjustments for other market and Company-specific factors are made as deemed necessary in determining ESP.

When MEAs include an element of customer training, it is not essential to the functionality, efficiency or effectiveness of the MEA. Therefore the Company has concluded that this obligation is inconsequential and perfunctory. As such, for MEAs that include training, customer acceptance of said training is not deemed necessary in order to record the related revenue, but is recorded when the installation deliverable is fulfilled. Historically, training revenues have not been significant.

We provide call center support services to properties installed by us and also to properties installed by other providers. In addition, we provide the property with the portal to access the Internet. We receive monthly service fees from such properties for our services and Internet access. We recognize the service fee ratably over the term of the contract. The prices for these services are fixed and determinable prior to delivery of the service. The fair value of these services is known due to objective and reliable evidence from contracts and standalone sales. We report such revenues as recurring revenues.

Total revenues do not include sales tax as we consider ourselves a pass through conduit for collection and remitting sales tax.

21 New Accounting Pronouncements For information regarding recent accounting pronouncements and their effect on the Company, see "New Accounting Pronouncements" in Note B of the Notes to Unaudited Condensed Consolidated Financial Statements contained herein.

EBITDA The Company defines EBITDA as net income (loss), excluding income tax expense (benefit), interest expense, interest income, and depreciation and amortization expense. Management believes that certain non-GAAP financial measures may be useful in certain instances to provide additional meaningful comparisons between current results and results in prior operating periods. Adjusted earnings before interest, taxes, depreciation and amortization and other non-operating income and expenses ("Adjusted EBITDA") is a metric used by management and frequently used by the financial community. Management believes that adjusted EBITDA provides insight into the Company's operating trends and facilitates comparisons between peer companies, since interest, taxes, depreciation and amortization can differ greatly between organizations as a result of differing capital structures and tax strategies. Adjusted EBITDA excludes certain items that are unusual in nature or not comparable from period to period. While management believes that non-GAAP measurements are useful supplemental information, such adjusted results are not intended to replace our GAAP financial results.

RECONCILIATION OF NET INCOME (LOSS) TO ADJUSTED EBITDA (Unaudited) Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Net income (loss) $ 219,085 $ (621,510 ) $ (559,123 ) $ (1,033,356 ) Interest expense, net 7,610 (18,061 ) 18,724 (1,423 ) Provision for income taxes 51,312 - 102,624 280 Depreciation and amortization expense 69,525 64,729 136,186 128,847 EBITDA 347,532 (574,842 ) (301,589 ) (905,652 ) Adjustments: Gain on sale of product line - (41,902 ) - (41,902 ) Stock-based compensation expense 4,617 83,496 6,641 85,519 Adjusted EBITDA $ 352,149 $ (533,248 ) $ (294,948 ) $ (862,035 ) Revenues The table below outlines product versus recurring revenues for comparable periods: Three Months Ended June 30, 2014 June 30, 2013 Variance Product $ 3,419,956 79% $ 2,659,751 74% $ 760,205 29% Recurring 933,392 21% 935,745 26% (2,353 ) 0% Total $ 4,353,348 100% $ 3,595,496 100% $ 757,852 21% Six Months Ended June 30, 2014 June 30, 2013 Variance Product $ 5,129,600 73% $ 4,825,251 72% $ 304,349 6% Recurring 1,856,365 27% 1,897,879 28% (41,514 ) -2% Total $ 6,985,965 100% $ 6,723,130 100% $ 262,835 4% 22 Product Revenue Product revenue principally arises from the sale and installation of EcoSmart Suite of products, SmartGrid and High Speed Internet Access equipment. These include TSE, Telkonet Series 5, Telkonet iWire, and wireless networking products. We market and sell to the hospitality, education, healthcare and government/military markets. The Telkonet Series 5 and the Telkonet iWire products consist of the Telkonet Gateways, Telkonet Extenders, the patented Telkonet Coupler, and Telkonet iBridges. The EcoSmart Suite of products consists of thermostats, sensors, controllers, wireless networking products switches, outlets and a control platform. The HSIA product suite consists of gateway servers, switches and access points.

For the three and six months ended June 30, 2014, product revenue increased by 29% and 6% respectively, when compared to the prior year periods. Product revenue in 2014 includes approximately $2.7 million attributed to the sale and installation of energy management products, and approximately $2.4 million for the sale and installation of HSIA products. The variance in product revenue can be partially attributed to a $0.1 million decrease in HSIA installations. Two long term EcoSmart projects, requiring the company to defer revenue of $0.4 million in the three months ended March 31, 2014 were completed and the revenue recognized during the three months ended June 30, 2014. The Company also recognized approximately $0.4 million in product revenue attributed to several multiple deliverable arrangements that were not completed at the end of the three months ended June 30, 2014.

Recurring Revenue Recurring revenue is primarily attributed to recurring services. The Company recognizes revenue ratably over the service month for monthly support revenues and defers revenue for annual support services over the term of the service period. The recurring revenue consists primarily of HSIA support services and advertising revenue. Advertising revenue is based on impression-based statistics for a given period from customer site visits to the Company's login portal page under the terms of advertising agreements entered into with third-parties. A component of our recurring revenue is derived from fees, less payback costs, associated with less than 1% of our hospitality customers who do not internally manage guest-related, internet transactions.

Recurring revenue includes approximately 2,200 hotels in our broadband network portfolio. We currently support approximately 238,000 HSIA rooms with approximately 8.0 million monthly users. For the three and six months ended June 30, 2014, recurring revenue remained unchanged and decreased by 2% when compared to the prior year periods. The variance for the six months ended June 30, 2014 was attributed to a decrease in advertising and fee revenue.

Cost of Sales Three Months Ended June 30, 2014 June 30, 2013 Variance Product $ 1,978,291 58% $ 1,848,081 69% $ 130,210 7% Recurring 263,083 28% 270,517 29% (7,434 ) -3% Total $ 2,241,374 51% $ 2,118,598 59% $ 122,776 0% Six Months Ended June 30, 2014 June 30, 2013 Variance Product $ 3,326,318 65% $ 3,277,627 68% $ 48,691 1% Recurring 517,385 28% 536,680 28% (19,295 ) -4% Total $ 3,843,703 55% $ 3,814,307 57% $ 29,396 1% Costs of Product Sales Costs of product sales include equipment and installation labor related to the sale of Ethostream broadband networking equipment, and EcoSmart energy management technology. For the three and six months ended June 30, 2014, product costs as a percentage of sales were 58% and 65% compared to 69% and 68% for the prior year periods. The variance was attributed to a $0.1 million rebate associated with Ethostream broadband networking equipment. The Company also recognized revenue in the current period that was deferred in prior periods.

Costs associated with these revenues were expensed when incurred in those prior periods.

Costs of Recurring Revenue Recurring costs are comprised of labor and telecommunication services for our Customer Service department. For the three and six months ended June 30, 2014, recurring costs decreased by 3% and 4% when compared to the prior year period.

The variance is attributed to the decrease in support payroll and benefit costs associated with recurring sales.

23 Gross Profit Three Months Ended June 30, 2014 June 30, 2013 Variance Product $ 1,441,665 42% $ 811,670 31% $ 629,995 79% Recurring 670,309 72% 665,228 71% 5,081 1% Total $ 2,111,974 49% $ 1,476,898 41% $ 635,076 43% Six Months Ended June 30, 2014 June 30, 2013 Variance Product $ 1,803,282 35% $ 1,547,624 32% $ 255,760 17% Recurring 1,338,980 72% 1,361,199 72% (22,219 ) -2% Total $ 3,142,262 45% $ 2,908,823 43% $ 233,439 8% Gross Profit on Product Revenue The gross profit on product revenue for the three and six months ended June 30, 2014 increased by 79% and 17% when compared to the prior year period. The variance was a result of a 28% increase in sales, the broadband equipment rebate and deferred revenue recognized in the current period. Costs associated with these deferred revenues were recognized when incurred in prior periods.

Gross Profit on Recurring Revenue Our gross profit associated with recurring revenue increased by 1% and decreased by 2% for the three and six months ended June 30, 2014 when compared to the prior year periods. The increase for the three month comparison was due to a decrease in support staff salaries and benefits. The decrease for the six month comparison was mainly due to a decrease in advertising revenue which yields higher gross profit margins.

Operating Expenses Three Months Ended March 31, 2014 2013 Variance Total $ 1,833,967 $ 2,158,371 $ (324,404) -15% Six Months Ended June 30, 2014 2013 Variance Total $ 3,580,037 $ 3,985,224 $ (405,187 ) -10% During the three and six months ended June 30, 2014, operating expenses decreased by 15% and 10% when compared to the prior year periods, as outlined below.

Research and Development Three Months Ended June 30, 2014 2013 Variance Total $ 318,815 $ 287,291 $ 31,524 11% Six Months Ended June 30, 2014 2013 Variance Total $ 615,505 $ 589,433 $ 26,072 4% Our research and development costs related to both present and future products are expensed in the period incurred. Current research and development costs are associated with product development and integration. During the three and six months ended June 30, 2014, research and development costs increased 11% and 4% when compared to the prior year periods. The increases were due to costs of $0.01 million associated with the development of our EcoConnect Plus next generation product as well as salaries and wages of $0.02 million.

24 Selling, General and Administrative Expenses Three Months Ended March 31, 2014 2013 Variance Total $ 1,445,627 $ 1,806,351 $ (360,724 ) -20% Six Months Ended June 30, 2013 2013 Variance Total $ 2,828,346 $ 3,266,944 $ (438,598 ) -13% During the three and six months ended June 30, 2014, selling, general and administrative expenses decreased over the comparable prior year periods by 20% and 13%. The decreases are primarily attributed to a $0.2 million decrease in bonus and stock option expenses, a $0.1 million write down of sales and use expense as well as decreased expenditures for legal, accounting, trade shows and bad debt expense.

Liquidity and Capital Resources We have financed our operations since inception primarily through private and public offerings of our equity securities, the issuance of various debt instruments and asset based lending, and cash generated from operations.

Working Capital Our working capital decreased by $554,894 during the six months ended June 30, 2014 from working capital deficit (current liabilities in excess of current assets) of $570,401 at December 31, 2013 to a working capital deficit of $1,125,295 at June 30, 2014.

Business Loan On September 11, 2009, the Company entered into a Loan Agreement in the aggregate principal amount of $300,000 with the Wisconsin Department of Commerce (the "Department"). The outstanding principal balance bears interest at the annual rate of 2%. Payment of interest and principal is to be made in the following manner: (a) payment of any and all interest that accrues from the date of disbursement commenced on January 1, 2010 and continued on the first day of each consecutive month thereafter through and including December 31, 2010; (b) commencing on January 1, 2011 and continuing on the first day of each consecutive month thereafter through and including November 1, 2016, the Company is required to pay equal monthly installments of $4,426; followed by a final installment on December 1, 2016 which shall include all remaining principal, accrued interest and other amounts owed by the Company to the Department under the Loan Agreement. The Company may prepay amounts outstanding under the Loan Agreement in whole or in part at any time without penalty. The Loan Agreement is secured by substantially all of the Company's assets and the proceeds from this loan were used for the working capital requirements of the Company. The Loan Agreement contains covenants which required, among other things, that the Company keep and maintain 75 existing full-time positions and create and fill 35 additional full-time positions in Milwaukee, Wisconsin by December 31, 2012. On June 18, 2012, the Department agreed to permanently waive all penalties associated with the Company's noncompliance with this covenant. The outstanding borrowings under the agreement as of June 30, 2014 and December 31, 2013 were $129,347 and $154,463, respectively.

Promissory Note On March 4, 2011, the Company sold all its Series 5 PLC product line assets to Wisconsin-based Dynamic Ratings, Inc. ("Purchaser") under an Asset Purchase Agreement ("APA"). Per the APA, the Company signed an unsecured Promissory Note (the "Note") due to Purchaser in the aggregate principal amount of $700,000. The outstanding principal balance bears interest at the annual rate of 6% and was originally due on March 31, 2014. The Note may be prepaid in whole or in part, without penalty at any time. The Note contains certain earn-out provisions that encompass both the Company's and Purchaser's revenue volumes. Amounts earned under the earn-out provisions were applied against the Note on June 30, 2012 and June 30, 2013. For the three and six months ended June 30, 2013, the non-cash reduction of principal calculated under these provisions and applied to the Note was $41,902. Payments not made when due, by maturity acceleration or otherwise, shall bear interest at the rate of 12% per annum from the date due until fully paid. Effective April 30, 2013, Purchaser approved an amendment to certain terms of the Note. Telkonet commenced a monthly payment of principal and interest of $20,000 to be applied against the outstanding balance starting May 1, 2013. The interest rate remains unchanged at 6% and the maturity date was extended to January 1, 2016. The outstanding principal balance of the Note as of June 30, 2014 and December 31, 2013 was $399,885 and $506,024, respectively.

25 Revolving Credit Facility On May 31, 2013, the Company entered into a Revolving Credit Facility (the "Agreement") with Bridge Bank, NA, (the "Bank") in a principal amount not to exceed $2,000,000. The Agreement was subject to a borrowing base that was equal to the sum of 80% of the Company's eligible accounts receivable and 25% of the eligible inventory. On August 1, 2013 the Agreement was modified to include the eligible receivables and the eligible inventory of Ethostream. The Agreement was available for working capital and other lawful general corporate purposes. As of December 31, 2013 and March 31, 2014, the Company was in violation of a financial performance covenant. Although the Company's violation of the financial performance covenant constituted a default under the Agreement, the Bank did not pursue any remedies under the default provisions of the Agreement. On May 31, 2014, the Company and the Bank mutually agreed to terminate the Agreement and the Company paid the remaining outstanding principal balance of $50,000.

Cash Flow Analysis Cash provided by continuing operations was $458,109 and $10,267 during the six months ended June 30, 2014 and 2013, respectively. As of June 30, 2014, our primary capital needs included business strategy execution, inventory procurement and managing current liabilities.

Cash provided by investing activities was $198,333 during the six months ended June 30, 2014 and cash used in investing activities was $400,633 during the six months ended June 30, 2013, respectively. During the year ended December 31, 2012, the Company was awarded a contract with a bonding requirement. During the six months ended June 30, 2013, the Company satisfied this requirement with cash collateral supported by an irrevocable standby letter of credit in the amount of $382,000. In 2014, the Company satisfied all obligations related to the bonding requirement and the cash was released. During the six months ended June 30, 2014, the Company purchased approximately $120,667 of furniture and fixtures to furnish its new corporate office located in Waukesha, Wisconsin. These assets will be depreciated over their respective estimated useful lives.

Cash used in financing activities was $131,255 and $58,276 during the six months ended June 30, 2014 and 2013, respectively.

Our independent registered public accountants report on our consolidated financial statements for the year ended December 31, 2013 includes an explanatory paragraph relating to our ability to continue as a going concern. We have incurred operating losses in past years and are dependent upon our ability to develop profitable operations and/or obtain necessary funding from outside sources, including by the sale of our securities, or obtaining loans from financial institutions, where possible. These factors, among others, raise doubt about our ability to continue as a going concern and may also affect our ability to obtain financing in the future.

Management expects that global economic conditions will continue to present a challenging operating environment through 2014; therefore working capital management will continue to be a high priority for 2014.

The Company continues to manage its sales tax liability of approximately $750,000 by establishing voluntary disclosure agreements ("VDAs") with the applicable states, which establishes a maximum look-back period and payment arrangements. However, if the aforementioned methods prove unsuccessful and the Company is examined or challenged by taxing authorities, there exists possible exposure of an additional $320,000 in sales tax liability, not including any applicable interest and penalties.

Prior to 2014, the Company successfully executed and paid in full VDAs in nineteen states totaling approximately $286,000 and is current with the subsequent filing requirements.

During the six months ended June 30, 2014, the Company successfully executed and paid in full VDAs in eight states totaling approximately $103,000 and is current with the subsequent filing requirements. In addition, the Company executed VDAs with three other states and has established payment plans with these states.

Off-Balance Sheet Arrangements The Company has no material off-balance sheet arrangements.

26 Acquisition or Disposition of Property and Equipment During the six months ended June 30, 2014, the Company had $120,667 of expenditures for furniture and fixtures. The Company does not anticipate any significant purchases of property or equipment during the next twelve months, other than computer equipment and peripherals to be used in the Company's day-to-day operations.

We presently lease two commercial office spaces in Germantown, Maryland totaling, in the aggregate, 16,400 square feet. Both leases expire in December 2015. On July 15, 2011, Telkonet executed a sublease agreement for 11,626 square feet of its space located in Germantown, Maryland. On June 27, 2012 the subtenant exercised its option to extend the expiration of the term of the sublease from January 31, 2013 to December 31, 2015.

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