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ACORN ENERGY, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion includes statements that are forward-looking in nature. Whether such statements ultimately prove to be accurate depends upon a variety of factors that may affect our business and operations. Certain of these factors are discussed in this report and in our Annual Report on Form 10-K for the year ended December 31, 2011. REVENUES BY COMPANY The following table shows, for the periods indicated, the dollar amount (in thousands) of the consolidated revenues attributable to each of our consolidated companies. The financial results of OmniMetrix are included in our consolidated financial statements effective February 15, 2012. Accordingly, there are no comparative results reported for these activities for the three and six month periods ended June 30, 2011. Six months ended June 30, Three months ended June 30, 2011 2012 2011 2012 DSIT Solutions $ 4,814 $ 6,763 $ 2,403 $ 3,722 GridSense 2,140 1,907 1,499 989 OmniMetrix - 382 - 227 USSI 248 1,083 205 962 Total $ 7,202 $ 10,135 $ 4,107 $ 5,900 BACKLOG As of June 30, 2012, our backlog of work to be completed was as follows (amounts in millions of U.S. dollars): DSIT Solutions $ 9.5 GridSense 0.5 OmniMetrix 0.3 USSI 0.9 Total $ 11.2 RECENT DEVELOPMENTS (1) Additional Investment in USSI On July 30, 2012, Acorn entered into another Stock Purchase Agreement (the "Summer USSI Purchase Agreement") with USSI pursuant to which we made a payment to USSI of $2.5 million to purchase additional shares of USSI Preferred Stock. The USSI Preferred Stock is the same class of shares that we acquired earlier this year and provides that upon any future liquidation of USSI, to the extent funds are available for distribution to USSI's stockholders after the satisfaction of any USSI liabilities at that time, USSI would first repay Acorn for the purchase price of its USSI Preferred Stock. Thereafter, the Company would receive a further payment for such shares ratably with all other USSI Common Stock holders as though the Company's shares of USSI Preferred Stock were the same number of shares of USSI Common Stock. In connection with this investment, the Company also entered into a Second Amended and Restated Stockholders Agreement with USSI and its other stockholders providing for certain rights and obligations to purchase or sell our USSI securities and with regard to the management of USSI. 24-------------------------------------------------------------------------------- Table of Contents Following the July 30, 2012 payment to USSI, the Company owned approximately 93.6% of USSI on a fully diluted basis. The Summer USSI Purchase Agreement contemplates that we may make an additional investment of $2.5 million later this year in exchange for more shares of USSI Preferred Stock. If we fully fund that investment, we will own approximately 94.4% of USSI on a fully diluted basis (which amount would be diluted to approximately 85.1% if all options which could be awarded under USSI's 2012 Stock Purchase Plan were awarded and exercised). (2) Dividends On July 10, 2012, the Company's Board of Directors approved a third quarter 2012 dividend of $0.035 per share to be paid on September 4, 2012 to common stockholders of record on August 17, 2012. (3) BIRD Development Grant In June 2012, two of the Acorn Energy's companies, DSIT Solutions Ltd. and US Seismic Systems, Inc., were awarded a joint grant of up to $900,000 from the U.S. Binational Industrial Research and Development ("BIRD") Foundation. The grant was awarded for the joint development of the next generation integrated passive/active threat detection system for underwater site protection. The BIRD Foundation provides funding money for projects involving joint innovation and development between American and Israeli companies. The grant calls for the signing of a Cooperation and Project Funding Agreement between the companies and the BIRD Foundation within three months to enable commencement of the funding. Grants received from the BIRD Foundation are subject to repayment upon the commercial success of the integrated passive/active threat detection system. 25-------------------------------------------------------------------------------- Table of Contents OVERVIEW AND TREND INFORMATION Acorn Energy, Inc. ("Acorn" or "the Company") is a holding company focused on technology driven solutions for energy infrastructure asset management. Through our majority or wholly-owned operating subsidiaries we provide the following services and products: · Energy & Security Sonar Solutions . We provide sonar and acoustic related solutions for energy, defense and commercial markets with a focus on underwater site security for strategic energy installations and other advanced acoustic systems and real-time embedded hardware and software development and production through our DSIT Solutions Ltd. ("DSIT") subsidiary. · Smart Grid Distribution Automation. These products and services are provided by our GridSense subsidiaries (GridSense Inc. in the United States and GridSense Pty Ltd. and CHK GridSense Pty Ltd. in Australia - collectively "GridSense") which develop, market and sell remote monitoring and control systems to electric utilities and industrial facilities worldwide. · Energy and Security Sensor Systems. These products and services are provided by our US Seismic Systems, Inc. subsidiary ("USSI") which develops and produces "state of the art" fiber optic sensing systems for the energy, commercial security and defense markets worldwide. · Power Generation (PG) Monitoring. These products and services are provided by our newly acquired OmniMetrix subsidiary. OmniMetrix's PG products and services deliver critical, real-time machine information to customers and provide remote diagnostics that give users real control over their equipment. During 2012, each of the four abovementioned activities represented a reportable segment. In addition, our "Other" segment represents IT and consulting activities at our DSIT subsidiary as well as Cathodic Protection activities in our newly acquired OmniMetrix subsidiary. As OmniMetrix's activities were acquired in February 2012, there are no comparative results reported for these activities for the three and six month periods ended June 30, 2011. The following analysis should be read together with the segment information provided in Note 11 to the interim unaudited condensed consolidated financial statements included in this quarterly report. DSIT Solutions DSIT reported increased revenues in the first half of 2012 as compared to the first half of 2011 as well as increased gross profit and net income. DSIT's revenues of $6.8 million for the first half of 2012 quarter represents an increase of approximately $1.9 million or 40% as compared to the first half of 2011. Second quarter 2012 revenues of $3.7 million also reflected an increase ($0.7 million or 22%) compared to first quarter 2012 revenues of $3.0 million. The increase in revenues from the first half of 2011 was due to increased revenues in our Energy & Sonar Security Solutions segment which reported first half 2012 revenues of $6.2 million compared to $4.0 million in the first half of 2011. The increase in revenues was due to the receipt of a major AquaShieldTM Diver Detection Sonar ("DDS") project (valued at $12.3 million) in the end of 2011 and the subsequent work on that project. The increase in revenues as compared to the first quarter of 2012 was due to increased progress on the large project received in late 2011. DSIT's gross profit in the first half of 2012 increased by approximately $0.7 million or 37% compared to first half 2011 gross profit. The increase in gross profit was attributable to the abovementioned increase in revenues which was partially offset by slightly reduced gross margins. Gross margins decreased in the first half of 2012 to 37% as compared to 38% in the first half of 2011. The decrease in gross margin was attributable to lower margin projects being worked on in 2012 as compared to 2011. During the first half of 2012, DSIT recorded approximately $0.5 million of Research and Development expense, an increase of approximately $0.2 million compared to the first half of 2011. The increase is attributable in part to preliminary work on joint development (with USSI) of the next generation integrated passive/active threat detection system for underwater site protection. During the first half of 2012, DSIT recorded approximately $1.5 million of selling, general and administrative (SG&A) expense; slightly below the $1.6 million recorded in the first half of 2011. The decrease is due to decreased marketing costs in 2012 as the first half of 2011 had a relatively high number of product demonstrations as well as a weaker New Israeli Shekel (NIS) during the period which decreased our NIS expenses when reported in U.S. dollars. 26-------------------------------------------------------------------------------- Table of Contents At December 31, 2011, DSIT had a backlog of approximately $13.6 million. During the first half of 2012, we received new orders totaling approximately $1.9 million and at the end of June 2012 had a backlog of approximately $9.5 million. DSIT expects to continue to show revenue growth in 2012 compared to 2011 and expects 2012 to be profitable as well. The level of profitability, however, is expected to be dependent upon anticipated increased levels of marketing and development costs planned for the balance of 2012. As noted in Recent Developments, in June 2012, DSIT together with USSI were awarded a joint $900,000 grant from the BIRD Foundation for the joint development of the next generation integrated passive/active threat detection system for underwater site protection. The grant calls for the signing of a Cooperation and Project Funding Agreement between the companies and the BIRD Foundation within three months to enable commencement of the funding. DSIT anticipates receipt of a majority (approximately 60%) of the grant based on the expected allocation of project costs between DSIT and USSI. DSIT has also recently received Israeli government approval for a program which provides funds to facilitate marketing in Asia. DSIT expects to receive approximately $300,000 of government participation in certain marketing expenses over the next three years. The lease for DSIT's current operating facilities in the Tel Aviv, Israel metropolitan area expires in August 2012. DSIT is currently negotiating an extension of the lease and does not anticipate a material change in its annual rent. GridSense In the first half of 2012, GridSense reported revenues of $1.9 million, a decrease of $0.2 million (11%) compared to first half 2011 revenues and a slight increase ($0.1 million or 8%) compared to first quarter 2012 revenues. The decreased first half 2012 revenues compared to first half 2011 revenues was primarily attributable to revenues recorded in 2011 with respect to the beginning of the fulfillment of an order of over 2,000 transformers monitors to a southeastern US electric utility which began in the second quarter of 2011. While Gridsense sees a general improvement in the overall business environment in the utility industry and expects utility spending to continue to increase in future quarters, the timing of such spending on products such as those that GridSense provides cannot be predicted with certainty due to the sales cycle of electric utilities which is typically long and requires much technical and application support. To address these long sales cycles, GridSense has expanded its customer pilot programs from just a handful to over twenty around the globe. We expect that many of these paid pilot projects will result is substantial commercial rollouts, possibly as early as late in 2012. GridSense's gross profit in the first half of 2012 decreased by approximately $0.2 million or 18% compared to first half 2011 gross profit. The decrease in gross profit was attributable to the abovementioned decrease in revenues combined with a decrease in gross margins. Gross margins decreased in the first half of 2012 to 43% as compared to 47% in the first half of 2011. The decrease in gross margin was attributable to higher shipping costs and raw materials costs due to purchases in smaller lot sizes in 2012 as well certain fixed costs being spread over a larger revenue base in 2011. Gross margin, however, increased in the second quarter of 2012 to 48% from 37% in the first quarter of 2012. The increase is attributable to design stabilization, buying in better economic order quantities and placing blanket purchase orders with multiple release dates to obtain better pricing. During the first half of 2012, GridSense recorded approximately $2.2 million of SG&A expense representing an increase of approximately $0.5 million (29%) compared to the first half of 2011. The increased SG&A costs are primarily due to additional staff in sales, marketing, administrative and accounting. During 2012, GridSense's employee count has increased by eight full-time positions. In response to improving industry conditions, GridSense expects to continue to expand its sales and support capabilities. We expect further increases in SG&A costs as additional employee positions (primarily in sales) are expected to be filled during the remainder of 2012. GridSense is also adding to its engineering team in order to accelerate the development of some key projects that GridSense believe will lead to the generation of new revenues and anticipates increased research and developments expenses going forward (approximately $0.7 million in the first half of 2012). We expect that GridSense will continue to require working capital support while it focuses on increasing its sales. Acorn continues to provide funds for GridSense's working capital needs and expects to do so in the future. In the period from January 1 to June 30, 2012, Acorn provided GridSense $2.0 million for its working capital needs. On July 31, 2012, GridSense had cash on hand of approximately $150,000. On August 3, 2012, we committed to fund an additional $3.0 million to GridSense, payable in increments as we deem necessary during the balance of 2012 and during 2013. We have no assurance that GridSense will increase its sales or reduce its need for additional financing to support its working capital needs following this additional funding by us. Additional working capital support may be in the form of a bank line, new investment by others, additional investment or loans 27-------------------------------------------------------------------------------- Table of Contents by Acorn, or a combination of the above. GridSense is currently in discussions with a bank to provide working capital financing; however, there is no assurance that such financing from the bank or any other party will be available in sufficient amounts, in a timely manner or on acceptable terms. The availability and amount of any additional investment from us in GridSense may be limited by the working capital needs of our corporate activities and other operating companies. USSI In the first half of 2012, USSI reported revenues of $1.1 million, an increase of $0.8 million (337%) compared to first half 2011 revenues of $248,000 and an increase of $841,000 (695%) compared to first quarter 2012 revenues of $121,000. The increased first half 2012 revenues compared to first half 2011 revenues as well and the increase in the second quarter of 2012 compared to the first quarter of 2012 was attributable to the delivery in the second quarter of the following two large proof of concept projects: 1) The world's largest commercial high temperature down-hole fiber-optic seismic array (40 - level array) which is designed for monitoring wells that use the latest unconventional oil and gas extraction technique known as hydrofracking, and 2) an Ultra-High Sensitivity fiber-optic based marine seismic array for oil and gas exploration to an international service provider for use as a marine array to aid in the collection and interpretation of data in the hostile environment of deep sea oil and gas operations. These two contracts generated 2012 revenue of over $800,000. USSI is moving forward with similar "proof of concept" demonstrations with a number of its other customers, and we expect that USSI's products will be validated via customer field testing, resulting in anticipated follow-on orders. In the first half of 2012, gross profit continued to be negative ($605,000) as it was in the first half of 2011 ($297,000). The negative gross profit is primarily due to large amounts of up front engineering design costs (non-recurring engineering costs or "NRE") that accompanied the production of the first commercial high temperature down hole fiber optic seismic array (40 - level array). Similar NRE accompanied USSI's other proof of concept projects in the second quarter. USSI is continuing to work to develop cost cutting measures for the manufacturing of its commercial products, including investment in equipment that will make manufacturing more efficient and improving the production process that will ultimately result in less man-hours required for each product sold. USSI expects that its gross margin will improve over the balance of 2012 as it benefits from: 1) Less NRE required on future projects, 2) lower cost production personnel used as opposed to higher cost engineers, and 3) allocating its fixed costs over a larger revenue base. During the first half of 2012, USSI recorded approximately $1.8 million of research and development ("R&D") expense as compared to $0.3 million in the first half of 2011. The increased R&D expense is due to an increase in engineering headcount as well as an increase in R&D materials used in product development. We expect R&D expense to continue at levels seen in the first half of 2012 as USSI continues to internally develop more efficient production versions of its current products and adds additional engineering headcount to continue it development of multiple product offerings. During the first half of 2012, USSI recorded approximately $1.4 million of SG&A expense representing an increase of approximately $0.8 million (122%) compared to the first half of 2011. Second quarter 2012 SG&A expense ($0.8 million) also reflects an increase of $0.2 million over first quarter 2012 SG&A expense of $0.6 million. The increased SG&A costs are due to increased sales and marketing activities combined with the costs of additional administrative personnel. For the balance of the year, we expect SG&A costs to level off and remain consistent with levels seen for the second quarter of 2012. In April 2012, USSI signed a license agreement with Northrop Grumman for several fiber-optic patents from Northrop's Navigation Systems Division. The licensed patents represent extensive research and development by Northrop Grumman. The licensed patents will be used by USSI to refine the next generation of high sensitivity oilfield fiber-optic geophone systems As noted in Recent Developments, in June 2012, USSI together with DSIT were awarded a joint $900,000 grant from the BIRD Foundation for the joint development of the next generation integrated passive/active threat detection system for underwater site protection. The grant calls for the signing of a Cooperation and Project Funding Agreement between the companies and the BIRD Foundation within three months to enable commencement of the funding. USSI anticipates receipt of approximately 40% of the grant based on the expected allocation of project costs between DSIT and USSI. We continue to anticipate significant growth in orders in 2012, particularly from new customers related to our 4D reservoir and shale gas monitoring systems following the numerous demonstrations performed during the year as well as follow-on projects from our existing "proof-of-concept" projects, each of which has the potential for annual multi-million dollar follow-up orders. We also anticipate significantly increased costs as we have grown our employee base from 28 full-time employees (inclusive of consultants) at the end of 2011 to 51 full-time employees (inclusive of consultants) as of July 31, 2012. We expect that USSI will continue to require working capital support while it works on transitioning from development to production and as it works on refining its manufacturing capabilities. USSI currently has no other sources of financing other 28-------------------------------------------------------------------------------- Table of Contents than its internally generated sales and investments by Acorn. As noted in Recent Developments, On July 30, 2012, Acorn entered into the Summer USSI Purchase Agreement with USSI pursuant to which we made a payment to USSI of $2.5 million to purchase additional shares of USSI Preferred Stock. The Summer USSI Purchase Agreement contemplates that we may make an additional investment of $2.5 million later this year in exchange for more shares of USSI Preferred Stock. On July 31, 2012, USSI had cash on hand of approximately $2.3 million. We have no assurance that USSI will not need additional financing from time-to-time to finance its working capital needs beyond our current investment. Additional financing for USSI may be in the form of a bank line, new investment by others, a loan or investment by Acorn, or a combination of the above. USSI is currently engaged in discussions with a bank in order to obtain a line-of-credit. There is no assurance that USSI will be able to obtain the line-of-credit or other support in sufficient amounts, in a timely manner or on acceptable terms. The availability and amount of any additional investment from us in USSI may be limited by the working capital needs of our corporate activities and other operating companies. OmniMetrix In accordance with applicable accounting standards, we began consolidating the results of OmniMetrix beginning February 15, 2012, the date we acquired OmniMetrix. Accordingly, there are no comparative results reported for OmniMetrix for the three month period ended June 30, 2011. During the period following our acquisition, we reported revenues of approximately $382,000 ($227,000 in the second quarter) and a net loss of $830,000 ($660,000 in the second quarter) with respect to OmniMetrix activities. Since our acquisition, OmniMetrix has engaged in developing a major marketing and promotion program to increase the penetration rate of its Power Generator monitoring products into the market. We anticipate that this promotion program, which began in the second quarter, will negatively impact OmniMetrix's gross profit and gross margin in the near term, but expect the gross profit and gross margin to increase as the penetration rate of its Power Generator monitoring products into the market increases. Since our acquisition, OmniMetrix has hired additional personnel growing from 11 employees (one of which was in sales) to 25 employees (inclusive of consultants) at July 31, 2012, seven of which are sales and marketing personnel. We expect that OmniMetrix will continue to expand its sales and marketing team in the coming months. OmniMetrix currently has no other sources of financing other than its internally generated sales and investments by Acorn. To support OmniMetrix's marketing and promotion program, Acorn has committed to invest $2.5 million into OmniMetrix of which $0.5 million has been invested through July 31, 2012 with the balance expected to be funded over the balance of 2012. As of July 31, 2012, OmniMetrix had cash on hand of approximately $0.6 million. We have no assurance that OmniMetrix will not need additional financing for working capital after we complete our $2.5 million additional investment. Additional financing for OmniMetrix may be in the form of a bank line, new investment by others, a loan or investment by Acorn, or a combination of the above. There is no assurance that such support will be available from such sources in sufficient amounts, in a timely manner or on acceptable terms. The availability and amount of any additional investment from us in OmniMetrix may be limited by the working capital needs of our corporate activities and other operating companies. Corporate Corporate general and administrative expense in the first half of 2012 reflected a $1.2 million increase to $2.7 million as compared to $1.5 million of expense in the first half of 2011. The increase is due primarily to professional fees and costs incurred associated with our acquisition of OmniMetrix (approximately $300,000) in February 2012 as well as increased investor relation activities and personnel costs and bonuses . Second quarter 2012 corporate general and administrative expense ($1.5 million) was approximately $0.2 million less than first quarter 2012's expense of $1.3 million primarily due to lower professional fees associated with our acquisition of OmniMetrix. We expect our corporate general and administrative costs to stay near its current level as we are maintaining a higher level of investor relation activities than we have historically. In 2012, Acorn recorded an income tax benefit of $1.1 million with respect to an expected net operating loss carryback of its expected consolidated tax loss in 2012. Results of Operations The following table sets forth certain information with respect to the consolidated results of operations of the Company for the three and six month periods ended June 30, 2011 and 2012, including the percentage of total revenues during each period attributable to selected components of the operations statement data and for the period to period percentage changes in such 29-------------------------------------------------------------------------------- Table of Contents components. For segment data see Note 11 to the Unaudited Condensed Consolidated Financial Statements included in this quarterly report. The financial results of OmniMetrix are included in our condensed consolidated financial statements effective February 15, 2012. Accordingly, there are no comparative results reported for these activities for the three and six month period ended June 30, 2011. In August 2011, we sold our interests in CoaLogix. Those results are reflected below as discontinued operations. Six months ended June 30, Three months ended June 30, Change 2011 2012 2011 2012 from Change from 2011 to ($,000) % of revenues ($,000) % of revenues 2011 to 2012 ($,000) % of revenues ($,000) % of revenues 2012 Revenues $ 7,202 100 % $ 10,135 100 % 41 % $ 4,107 100% $ 5,900 100% 44% Cost of sales 4,681 65 % 7,346 72 % 57 % 2,760 67% 4,322 73% 57% Gross profit 2,521 35 % 2,789 28 % 11 % 1,347 33% 1,578 27% 17% R&D expenses 874 12 % 3,017 30 % 245 % 384 9% 1,699 29% 342% SG&A expenses 5,467 76 % 8,619 85 % 58 % 2,724 66% 4,390 74% 61% Operating loss (3,820 ) (53 )% (8,847 ) (87 )% 132 % (1,761 ) (43)% (4,511 ) (76)% 156% Finance expense, net (217 ) (3 )% 107 1 % (149 )% (100 ) (2)% 130 2% (230)% Gain on sale of HangXing 492 7 % - - % (100 )% - -% - -% Loss before taxes on income (3,545 ) (49 )% (8,740 ) (86 )% 147 % (1,861 ) (45)% (4,381 ) (74)% 135% Taxes on income (39 ) (1 )% 989 10 % (2,636 )% 26 1% 1,064 18% 3,992% Loss from continuing operations (3,584 ) (50 )% (7,751 ) (76 )% 116 % (1,835 ) (45)% (3,317 ) (56)% 81% Loss from discontinued operations, net of income taxes (1,404 ) (19 )% - - % (100 )% (568 ) (14)% - -% (100)% Non-controlling interest share of loss from discontinued operations 389 5 % - - % (100 )% 157 4% - -% (100)% Net loss (4,599 ) (64 )% (7,751 ) (76 )% 69 % (2,246 ) (55)% (3,317 ) (56)% 48% Net loss attributable to non-controlling interests 303 4 % 461 5 % 52 % 167 4% 205 3% 23% Net loss attributable to Acorn EnergyInc. $ (4,296 ) (60 )% $ (7,290 ) (72 )% 70 % $ (2,079 ) (51)% $ (3,112 ) (53)% 50% Revenues. Revenues in the first half of 2012 increased by $2.9 million or 41% from $7.2 million in the first half of 2011 to $10.1 million in the first half of 2012. The increased revenues was driven primarily by increased revenues at DSIT whose revenues increased by $1.9 million (40%) to $6.8 million compared to first half 2011 revenues of $4.8 million and USSI revenues which increased by $0.8 million (337%) to $1.1 million compared to first half 2011 revenues of $0.2 million. In addition, we recorded approximately $0.4 million of revenues associated with our newly acquired OmniMetrix subsidiary. GridSense revenues decreased by $0.2 million (11%) to $1.9 million compared to first half 2011 revenues of $2.1 million. The increase in DSIT revenues was primarily due to progress on a major AquaShieldTM DDS order (valued at $12.3 million) which was received in the end of 2011. The increase in USSI revenues was due to the delivery in the second quarter of two large proof of concept projects: 1) the world's largest commercial high temperature down-hole fiber-optic seismic array (40 - level array) which is designed for monitoring wells that use the latest unconventional oil and gas extraction technique known as hydrofracking, and 2) a fiber-optic based marine seismic array for oil & gas exploration to an international service provider. The decrease in GridSense revenues was primarily due to 2011 revenues including the beginning of the fulfillment a major order of transformer monitors to a southeastern US electric utility which began in the second quarter of 2011 and ended in the fourth quarter of 2011. . Gross profit. Gross profit in the first half of 2012 reflected an increase of $0.3 million (11%) as compared to the first half of 2011 as gross profit increased from $2.5 million to $2.8 million. DSIT's first half 2012 gross profit increased by $0.7 million 30-------------------------------------------------------------------------------- Table of Contents (37%) over first half 2011 gross profit. The increase in DSIT's gross profit was attributable to increased revenues. DSIT's gross margin deteriorated slightly from 38% in 2011 to 37% in 2012. DSIT's decreased gross margin in 2012 was due to lower margin projects being worked on in 2012 as compared to 2011. GridSense's first half 2012 gross profit decreased by $179,000 (18%) compared to first half 2011 gross profit. The decrease in GridSense's gross profit was attributable to decreased revenues as well as reduced gross margins which deteriorated to 43% in 2012 from 47% in 2011. GridSense's decreased gross margins in 2012 was attributable to higher shipping costs and raw materials costs due to purchases made in smaller lot sizes in 2012 as well as certain fixed costs being spread over a larger revenue base in 2011. USSI continued to show a negative gross profit ($605,000, an increase of $308,000 compared to the negative gross profit in the first half of 2011) as it continues to incur large amounts of up front engineering design costs (non-recurring engineering costs or "NRE") that accompanied the production of the first commercial high temperature down hole fiber optic seismic array (40 level array). Similar NRE accompanied USSI's other proof of concept projects in the second quarter. In addition, we recorded approximately $75,000 of gross profit associated with our newly acquired OmniMetrix subsidiary. Research and development ("R&D") expenses. R& D expenses increased $2.1 million from $0.9 million in the first half of 2011 to $3.0 million in the first half of 2012. R&D expenses increased at all companies with most of the increase ($1.5 million) being attributed to USSI from an increase in its engineering headcount as well as an increase in R&D materials used in product development. Increased R&D expense at GridSense ($0.4 million) and at DSIT ($0.2 million) were due to GridSense adding to its engineering team in order to accelerate development of projects and DSIT's preliminary work on joint development (with USSI) of the next generation integrated passive/active threat detection system for underwater site protection. Selling, general and administrative expenses ("SG&A"). SG&A costs in the first half of 2012 increased by $3.2 million as compared to the first half of 2011. DSIT's SG&A decreased slightly ($1.6 million in the first half of 2011 compared to $1.5 million in the first half of 2012), the decrease being attributable to decreased marketing costs and a weakening of the NIS. Both GridSense and USSI recorded increases in SG&A expenses. GridSense recorded an increase of $0.5 million (29%) while USSI recorded an increase of $0.8 million (121%). GridSense's increased SG&A expense was attributable to increased personnel costs as it increased its employee count by eight full-time employees. USSI's increased SG&A expense was attributable to increased sales and marketing activities combined with the costs of additional personnel. Corporate general and administrative costs increased by $1.2 million from $1.5 in the first half of 2011 to $2.7 million in the first half of 2012 primarily due to professional fees and costs incurred in the acquisition of OmniMetrix (approximately $300,000) as well as increased investor relations and personnel costs. Additionally, $0.8 million of the increase in SG&A costs is due to the inclusion of OmniMetrix SG&A costs in the first half of 2012. Gain on sales of HangXing. In March 2011, we sold our 25% interest in HangXing International Automation Engineering Co. Ltd. ("HangXing") back to the majority owner, China Aero-Polytechnology Establishment for $492,000. Taxes on income. In 2012, Acorn recorded an income tax benefit of $1.1 million with respect to an expected net operating loss carryback of its expected consolidated tax loss in 2012. Loss from discontinued operations. In August 2011, we sold our entire investment in CoaLogix. Accordingly, all of CoaLogix' activity for the first six months of 2011 (a loss of $1.4 million prior to attribution of $0.4 million to non-controlling interests) is presented as a loss from discontinued operations. Net loss. We had a net loss of $7.3 million in the first half of 2012 compared with net loss of $4.3 million in the first half of 2011. Our loss in 2012 was primarily due to GridSense, USSI and OmniMetrix (in the period since our acquisition) losses of $2.1 million, $3.8 million and $0.8 million, respectively with corporate expenses contributing an additional $2.7 million. These losses were offset by DSIT's profit of approximately $0.4 million for the first half of 2012, Acorn's income tax benefit of $1.1 million with respect to its expected net operating loss carryback and the non-controlling interest's share of our operations of approximately $0.5 million. Liquidity and Capital Resources As of June 30, 2012, we had working capital of $45.6 million. Our working capital includes $14.8 million of cash and cash equivalents, $18.0 million of short-term deposits, $6.0 million of funds held in escrow which are expected to be released in August 2012 and restricted deposits of approximately $1.9 million. Net cash decreased during the six months ended June 30, 2012 by $19.5 million, of which approximately $9.9 million was used in operating activities. The primary use of cash in operating activities during the first six months of 2012 was the cash used in operations by our subsidiaries ($4.1 million, $2.0 million, $0.6 million and $0.3 million used by USSI, GridSense, DSIT and OmniMetrix, respectively) in their operations combined with the $2.9 million of cash used in our corporate operating activities. 31-------------------------------------------------------------------------------- Table of Contents Cash used in investment activities of $8.2 million was primarily due to the net cash used in the acquisition of OmniMetrix ($7.8 million), the acquisition of property and equipment and a license ($0.5 million) and amounts used to fund severance liabilities ($0.2 million). These uses of cash were partially offset by the release, net of approximately $0.3 million of restricted deposits during the first six months. Net cash of $1.4 million was used in financing activities, primarily from the payment of dividends during the first six months of 2012 ($2.1 million) and the repayment of short and long-term debt, net of new borrowings ($0.5 million) which was partially offset by the proceeds from the exercise of options ($1.3 million). At June 30, 2012, DSIT had approximately $0.1 million of unrestricted cash in banks and NIS 4 million (approximately$1.0 million) in Israeli credit lines available to it from two Israeli banks (approximately $510,000 from each bank), none of which was then being used. The lines-of-credit are subject to maintaining certain financial covenants. At June 30, 2012, DSIT was in compliance with its financial covenants. As at June 30, 2012, DSIT also had an outstanding term loan from an Israeli bank in the amount of approximately $202,000. The loan is denominated in NIS and bears interest at the rate of the Israeli prime rate per annum plus 0.9%. The loan is to be repaid in equal payments of approximately $12,000 per month (principal and interest) through December 2013. As collateral for the term-loan, DSIT has deposited with an Israeli bank approximately $81,000 as a non-current restricted deposit. In addition to this restricted deposit, DSIT has also deposited with two Israeli banks approximately $2.1 million as collateral for various performance and bank guarantees for various projects as well as for its credit facilities at the banks. DSIT expects that most of these deposits will be released during the next twelve months, but expects to redeposit a majority of these funds again as collateral for new guarantees for new projects and for renewing its credit facilities. On July 31, 2012, DSIT had approximately $2.3 million of cash of which $2.2 million was restricted ($1.9 million current and $0.3 million non-current) and was utilizing approximately $0.1 million of its lines-of-credit. We believe that DSIT will have sufficient liquidity to finance its current level of activities from cash flows from its own operations over the next 12 months. This is based on continued utilization of its line-of-credit and its operating results. However, from time to time, DSIT may encounter cash flow difficulties arising from the timing of its milestones which triggers a billing. In addition, DSIT may require additional financing for a planned expansion of its marketing and development programs for the balance of 2012 and into 2013. This financing may be in the form of an expansion of a bank line, new investment by others, additional investment or loan by Acorn, or a combination of the above. The availability and amount of any additional investment from us in DSIT may be limited by the working capital needs of our corporate activities and the financing requirements of our other operating companies. On July 30, 2012, Acorn transferred $0.5 million to DSIT for working capital support and to help finance the expansion of its marketing and development programs. This follows a $1.0 million transfer to DSIT in May 2012. As at July 31, 2012, GridSense had approximately $150,000 of cash on hand. We expect that GridSense will continue to require working capital support while it works on increasing its sales. Acorn continues to provide funds for GridSense's working capital needs and expects to do so in the future. During the period from January 1 to July 31, 2012, Acorn provided GridSense $2.0 million for its working capital needs. On July 31, 2012, GridSense had cash on hand of approximately $150,000. On August 3, 2012, we committed to fund an additional $3.0 million to GridSense, payable in increments as we deem necessary during the balance of 2012 and during 2013. We have no assurance that GridSense will increase its sales or reduce its need for additional financing to support its working capital needs following this additional funding by us. This support may be in the form of a bank line, new investment by others, additional investment or loan by Acorn, or a combination of the above. GridSense is currently in discussions with a bank to provide working capital financing; however, there is no assurance that such financing from the bank or any other party will be available in sufficient amounts, in a timely manner or on acceptable terms. The availability and amount of any additional investment from us in GridSense may be limited by the working capital needs of our corporate activities and the financing requirements of our other operating companies. We expect that USSI will continue to require working capital support while it works on transitioning from development to production and as it works on refining its manufacturing capabilities. USSI currently has no other sources of financing other than its internally generated sales and investments by Acorn. In July 2012, we purchased additional USSI Preferred Stock in accordance with the Summer USSI Purchase Agreement and invested an additional $2.5 million in USSI (see Recent Developments). This followed an earlier investments in USSI during 2012 of $5.25 million. As of July 31, 2012, USSI had cash on hand of approximately $2.3 million. We have no assurance that USSI will not need additional financing from time-to-time to finance its working capital needs. Additional financing for USSI may be in the form of a bank line, new investment by others, a loan or investment by Acorn, or a combination of the above. USSI has begun discussions with a bank to provide working capital financing; however, there is no assurance that such financing from the bank or any other party will be available in sufficient amounts, in a timely manner or on acceptable terms. The availability and amount of any additional investment from us in USSI may be limited by the working capital needs of our corporate activities and the financing requirements of our other operating companies. 32-------------------------------------------------------------------------------- Table of Contents OmniMetrix currently has no other sources of financing other than its internally generated sales and investments by Acorn. To support OmniMetrix's marketing and promotion program, Acorn has committed to invest $2.5 million into OmniMetrix of which $0.5 million has been invested through July 31, 2012 with the balance expected to be funded over the balance of 2012. As of July 31, 2012, OmniMetrix had cash on hand of approximately $0.6 million. We have no assurance that OmniMetrix will not need additional financing for working capital after we complete our $2.5 million additional investment. Additional financing for OmniMetrix may be in the form of a bank line, new investment by others, a loan or investment by Acorn, or a combination of the above. There is no assurance that such support will be available from such sources in sufficient amounts, in a timely manner or on acceptable terms. The availability and amount of any additional investment from us in OmniMetrix may be limited by the working capital needs of our corporate activities and other operating companies. As at July 31, 2012, the Company's corporate operations (not including cash at any of our subsidiaries) had a total of approximately $13.1 million in cash and cash equivalents, virtually unchanged from our balance as of June 30, 2012. During the month of July, we received $4.0 million proceeds from a maturing CDAR. During the month, we also made an additional investment in USSI of $2.5 million (see Recent Developments), $0.5 million investment in OmniMetrix, advanced $0.5 million to DSIT and incurred approximately $0.5 million of corporate expenses. We believe that our current cash plus the cash generated from operations and borrowing from available lines of credit, if necessary, will provide more than sufficient liquidity to finance the operating activities of Acorn and the operations of its operating subsidiaries at their current level of operations for the foreseeable future and for the next 12 months in particular. Contractual Obligations and Commitments The table below provides information concerning obligations under certain categories of our contractual obligations as of June 30, 2012. CASH PAYMENTS DUE TO CONTRACTUAL OBLIGATIONS Years Ending June 30, (in thousands) 2018 and Total 2013 2014 - 2015 2016 - 2017 thereafterBank and other debt, utilized lines-of-credit and capital leases $ 224 $ 149 $ 75 $ - $ - Operating leases 1,992 849 900 239 4 Potential severance obligations (1) 3,949 - 951 321 2,677 Minimum royalty payments (2) 500 50 100 100 250 Total contractual cash obligations $ 6,665 $ 1,048 $ 2,026 $ 660 $ 2,931 We expect to finance these contractual commitments from cash currently on hand and cash generated from operations. (1) Under Israeli law and labor agreements, DSIT is required to make severance payments to dismissed employees and to employees leaving employment under certain other circumstances. The obligation for severance pay benefits, as determined by the Israeli Severance Pay Law, is based upon length of service and last salary. These obligations are substantially covered by regular deposits with recognized severance pay and pension funds and by the purchase of insurance policies. As of June 30, 2012, we accrued a total of $3.9 million for potential severance obligations to our Israeli employees of which approximately $2.7 million was funded. (2) In April 2012, USSI and Northrop Grumman signed a license agreement involving several of Northrop Grumman's fiber-optic technology patents. The license agreement is subject to an annual minimum royalty payment of 10% of the net selling price of each unit of licensed products used or sold during the term of the agreement. The agreement also calls for a minimum annual payment of $50,000 for the first ten years of the agreement beginning in 2012. The table above includes as a royalty payment only the minimum payment due. |