Bio Key International Inc: Form 10-Q for the period ended Jun 30, 2011

CAUTIONARY STATEMENT FOR FORWARD-LOOKING STATEMENTS

The information contained in this Report on Form 10-Q and in other public statements by the Company and Company officers include or may contain certain forward-looking statements. All statements other than statements of historical facts contained in this Report on Form 10-Q, including statements regarding our future financial position, business strategy and plans and objectives of management for future operations, are forward-looking statements. The words “anticipate,” “believe,” “estimate,” “will,” “may,” “future,” “plan,” “intend” and “expect” and similar expressions generally identify forward-looking statements. Although we believe that our plans, intentions and expectations reflected in the forward-looking statements are reasonable, we cannot be sure that they will be achieved. Actual results may differ materially from the forward-looking statements contained herein due to a number of factors.

Many of these factors are set forth in the Company’s most recent Annual Report on Form 10-K under the caption “Risk Factors” and other filings with the Securities and Exchange Commission. These factors are not intended to represent a complete list of the general or specific factors that may affect us. It should be recognized that other factors, including general economic factors and business strategies may be significant, presently or in the future. Except as required by law, we undertake no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise.

OVERVIEW

BIO-key International, Inc. (the “Company,” “BIO-key,” “we,” or “us) was founded in 1993 to develop and market advanced fingerprint biometric technology and software solutions. Biometric technology is the science of analyzing specific human characteristics which are unique to each individual in order to identify a specific person from a broader population. First incorporated as BBG Engineering, the company became SAC Technologies in 1994. The BIO-key name was introduced in 2002.

We develop and market advanced fingerprint identification biometric technology and software solutions. We were among the initial pioneers in developing automated finger identification technology that can be used without the aid of non-automated methods of identification such as a personal identification, password, token, smart card, ID card, credit card, passport, driver’s license or other form of possession or knowledge based identification. This advanced BIO-key™ identification technology improves both the accuracy and speed of finger-based biometrics.

In partnerships with OEMs, integrators, and solution providers, we provide biometric software solutions to private and public sector customers. BIO-key provides the ability to positively identify individuals before granting access to valuable corporate resources, web portals or applications in seconds. Powered by our patented Vector Segment Technology™ our VST™, WEB-key® and BSP development kits are fingerprint biometric solutions that provide true interoperability with all major reader manufacturers, enabling application developers and integrators to seamlessly integrate fingerprint biometrics into virtually any application.

On August 15, 2011, the Company announced that it has signed a letter of intent to acquire Montreal-based S.I.C. Biometrics Inc. If such a combination is completed, BIO-key expects that its overall market reach would be strengthened, expanding opportunities for new projects and partnerships that could be fully satisfied via complete solutions for mobility, access control and consumer security. S.I.C., founded in 1999, designs, manufactures and internationally commercializes biometrics security products, including biometric plug-in mobile fingerprint scanners, biometric proximity cards and access control solutions. S.I.C. is credited with developing the first fingerprint reader for Apple mobile devices. While the terms of the definitive acquisition agreements will be made public when fully negotiated and signed, BIO-key anticipates that such an acquisition would be accretive to the company in the fourth quarter of 2011. In addition to due diligence and definitive documentation, the transaction will be subject to customary closing conditions, including any necessary regulatory approvals.

CRITICAL ACCOUNTING POLICIES

For detailed information on our critical accounting policies and estimates, see our financial statements and notes thereto included in this Report and in our Annual Report on Form 10-K, for the year ended December 31, 2010. There have been no material changes to our critical accounting policies and estimates from those disclosed in our 10-K filed on March 23, 2011.

RECENT ACCOUNTING PRONOUNCEMENTS

On January 1, 2011, the Company adopted Accounting Standards Update (ASU) 2010-20, “Receivables (Topic310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.” ASU 2010-20 is intended to provide additional information to assist financial statement users in assessing an entity’s risk exposures and evaluating the adequacy of its allowance for credit losses. The disclosures as of the end of a reporting period and the disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The amendments in ASU 2010-20 encourage, but do not require, comparative disclosures for earlier reporting periods that ended before initial adoption. However, an entity should provide comparative disclosures for those reporting periods ending after initial adoption. The adoption of ASU 2010-20 did not have a significant impact on its consolidated financial statements.

On January 1, 2011, the Company adopted ASU 2010-17, “Revenue Recognition-Milestone Method (Topic 605): Milestone Method of Revenue Recognition.” The amendments in this Update are effective on a prospective basis for milestones achieved in fiscal years, and interim periods within those years, beginning on or after June 15, 2010. The adoption of ASU 2010-17 did not have a significant impact on its consolidated financial statements.

On January 1, 2011, the Company adopted ASU 2009-13, “Multiple Element Arrangements.” ASU 2009-13 addresses the determination of when the individual deliverables included in a multiple arrangement may be treated as separate units of accounting. ASU 2009-13 also modifies the manner in which the transaction consideration is allocated across separately identified deliverables and establishes definitions for determining fair value of elements in an arrangement. The adoption of ASU 2010-13 did not have a significant impact on its consolidated financial statements.

Management does not believe that any other recently issued, but not yet effective, accounting standard if currently adopted would have a material effect on the accompanying consolidated financial statements.

RESULTS OF OPERATIONS

THREE MONTHS ENDED JUNE 30, 2011 AS COMPARED TO JUNE 30, 2010

Consolidated Results of Operations - Percent Trend

Revenues

For the three months ended June 30, 2011 and 2010, service revenues included approximately $151,000 and $103,000, respectively, of recurring maintenance and support revenue, and approximately $9,500 for the three months ended June 30, 2010 of non-recurring custom services revenue. Recurring service revenue increased 46% from 2010 to 2011 as the Company continued to bundle maintenance agreements to its expanding customer license base, and renewed existing maintenance agreements from its legacy customers.

For the three months ended June 30, 2011, license and other revenue (comprised of third party hardware and royalty) decreased in its core software, offset by a lesser increase in other revenue. The Company realized an approximately $830,000 decrease (68%) in its core software license revenue primarily as a result of an order received in 2010 from a new healthcare customer, specifically in the blood bank sector. Blood banks have contributed significant revenue in the past, yet due to a spending freeze in the blood bank industry which is under consolidation., most of our prospects are being asked to curtail purchases until late 2011 or early 2012. Third-party hardware sales increased by approximately $339,000 (491%), as a result of increased demand from an existing OEM partner and expansion of several Healthcare deployments. The Company’s royalty income was derived from an OEM agreement, and resulted in a 12% increase in revenue to $27,334 from $24,519 for the three months ended June 30, 2011 and 2010, respectively.

Costs of goods sold

For the three months ended June 30, 2011, cost of service increased approximately $12,000 as a result of increases to personnel related costs. License and other costs for the three months ended June 30, 2011 increased $177,166 directly associated with the increase in third party hardware revenue.

Selling, general and administrative

Selling, general and administrative costs for the three months ended June 30, 2011 decreased 29% from the same period in 2010. Reductions included referral fees and commission expense related to decreased sales, reduction in legal and accounting fees associated with the change in the accounting firm in 2010, and a reduction in travel.

Research, development and engineering

For the three months ended June 30, 2011, research, development and engineering costs increased 4% from the same period in 2011 as the Company employed temporary outside services for a specific new project offset by a reduction of engineering supplies.

Other income and expense

For the quarter ended June 30, 2010, the derivative and warrant fair value income was attributable to embedded derivatives and detachable warrants issued with convertible debt in 2005, 2006 and 2009. The fair value of the derivatives fluctuated based on: our stock price on the valuation date, the debt conversion price, the volatility of our stock price over a period of time, changes in the value of the risk free interest rate, and the time to maturity of the outstanding debt at different points in time. Our convertible debt was converted to the Notes Payable, one of which was discounted as a result of the detachable warrants associated with the conversion. For the quarters ended June 30, 2011 and 2010, the amortization of the discount was attributable to the Notes Payable, including the balance of the unamortized debt discount due to the accelerated payment, and the convertible note, respectively.

For the quarters ended June 30, 2011 and 2010, the interest income was attributable to the Note Receivable, which was fully paid in May 2011. For the quarter ended June 30, 2011, the interest expense was attributable to the Notes Payable, of which approximately $346,000 remains outstanding.

For the quarter ended June 30, 2011, the discount of the note receivable with respect to the value of the net early payment discount granted to the holder of the note receivable (see Note 6).

SIX MONTHS ENDED JUNE 30, 2011 AS COMPARED TO JUNE 30, 2010

Consolidated Results of Operations - Percent Trend

Revenues

For the six months ended June 30, 2011 and 2010, service revenues included approximately $293,000 and $189,000, respectively, of recurring maintenance and support revenue, and approximately $16,000 and $15,000, respectively, of non-recurring custom services revenue. Recurring service revenue increased 51% from 2010 to 2011 as the Company continued to bundle maintenance agreements to its expanding customer license base, and renewed existing maintenance agreements from its legacy customers.

For the six months ended June 30, 2011 and 2010, license and other revenue (comprised of third party hardware and royalty) decreased as a result of several contributing factors. The Company realized an approximately $491,000 decrease (25%) in its core software license revenue primarily as a result one large order from single new customer in 2011 opposed to two large orders from new customers in 2010. For the six months ended June 30, 2011 and 2010 we shipped orders from McKesson for their continued deployment of our identification technology in their AccuDose® product line, and for continued expansion of biometric ID deployments with commercial partners ChoicePoint /Nexis Lexis, Educational Biometric Technology, and Identimetrics. Third-party hardware sales increased by approximately $357,000 (206%), as a result of increased demand from an existing OEM partner and expansion of several Healthcare deployments which we do not expect at the same rate of increase going forward. The Company’s royalty income was derived from an OEM agreement, and resulted in a 19% increase in revenue to $55,894 from $46,786 for the six months ended June 30, 2011 and 2010, respectively.

Costs of goods sold

For the six months ended June 30, 2011, cost of service increased approximately $16,000 as a result of increases to personnel related costs. License and other costs for the three months ended June 30, 2011 increased $177,166 directly associated with the increase in third party hardware revenue.

Selling, general and administrative

Selling, general and administrative costs for the six months ended June 30, 2011 decreased 16% from the same period in 2010. Reductions included referral fees for specific customers in 2010 only, reduction in legal and accounting fees associated with the change in the accounting firm in 2010, and a reduction in travel.

Research, development and engineering

For the six months ended June 30, 2011, research, development and engineering costs increased 4% from the same period in 2010 as the Company employed temporary outside services for a specific new project and in non-cash compensation charges in accordance with the provisions of ASC 718-10, offset by a reduction in travel and engineering supplies.

Other income and expense

For the six months ended June 30, 2010, the derivative and warrant fair value income was attributable to embedded derivatives and detachable warrants issued with convertible debt in 2005, 2006 and 2009. The fair value of the derivatives fluctuated based on: our stock price on the valuation date, the debt conversion price, the volatility of our stock price over a period of time, changes in the value of the risk free interest rate, and the time to maturity of the outstanding debt at different points in time. Our convertible debt was converted to the Notes Payable, one of which was discounted as a result of the detachable warrants associated with the conversion. For the six months ended June 30, 2011 and 2010, the amortization of the discount was attributable to the Notes Payable and the convertible note, respectively.

For the six months ended June 30, 2011 and 2010, the interest income was attributable to the Note Receivable, which was fully paid in May 2011. For the six months ended June 30, 2011, the interest expense was attributable to the Note Payable, of which approximately 10% ($346,000) remains outstanding.

For the six months ended June 30, 2011, the discount of the note receivable and payable was a non-cash item with respect to the value of the net early payment discount granted to the holder of the note receivable and the balance of the unamortized debt discount attached to the Notes Payable.

LIQUIDITY AND CAPITAL RESOURCES

Net cash used in operations during the six months ended June 30, 2011 was approximately $532,000. The cash used for operating activities was primarily due to the following items:

• Negative cash flows related to an increase in accounts receivable of approximately $1,384,000, due to a large order received late in the quarter; and
• Positive cash flows from an increase in accounts payable and accrued expenses of approximately $426,000, attributable to the accrued commission and an increase of approximately $317,000 in accounts payable of which approximately $180,000 is for third party hardware shipped late in the quarter, both due to the orders received late in the June 2011 quarter, and some increase in deferred revenue for maintenance renewals and new orders.
• The Company recorded approximately $36,000 of charges during the first half of 2011 for the expense of issuing options to employees for services.

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The cash used for investing activities was primarily due to a capital expenditure of approximately $53,000 to upgrade development equipment.

The cash used for financing activities included the early repayment on the Shaar note of approximately $3,612,000, and outstanding dividends of approximately $125,000, largely offset by the early receipt of proceeds from the note receivable of approximately $3,350,000.

Working capital at June 30, 2011 was approximately $313,000 as compared to approximately $88,000 at December 31, 2010. The improvement was driven by both the reduction in accrued liability by payment of the current Notes Payable with the receipt of the Note Receivable, and the increase in Accounts Receivable with a lesser amount of associated liability in accounts payable and accrued accounts.

Since January 7, 1993 (date of inception), our capital needs have been principally met through proceeds from the sale of equity and debt securities.

We do not expect any material capital expenditures during the next twelve months.

We do not currently maintain a line of credit or term loan with any commercial bank or other financial institution.

Liquidity outlook

At June 30, 2011, our total of cash and cash equivalents was $38,029, as compared to $1,010,096 at December 31, 2010.

As discussed above, the Company has financed itself in the past through access to the capital markets by issuing convertible debt securities, convertible preferred stock and common stock. We currently require approximately $400,000 per month to conduct our operations. During the first six months of the 2011, we generated approximately $2,389,000 of revenue. While the Company expects to increase revenue through the remainder of 2011, there can be no assurance that we will achieve that goal.

If we are unable to generate sufficient revenue to meet our goals, we will need to obtain additional third-party financing to (i) conduct the sales, marketing and technical support necessary to execute our plan to substantially grow operations, increase revenue and serve a significant customer base; and (ii) provide working capital. Therefore, we may need to obtain additional financing through the issuance of debt or equity securities, or to restructure our financial position through similar transactions to those consummated during the 2009 to 2010 period.

Due to several factors, including our history of losses and limited revenue, our independent auditors have included an explanatory paragraph in opinions they have previously issued related to our annual financial statements as to the substantial doubt about our ability to continue as a going concern. Our long-term viability and growth will depend upon the successful commercialization of our technologies and our ability to obtain adequate financing. To the extent that we require such additional financing, no assurance can be given that any form of additional financing will be available on terms acceptable to us, that adequate financing will be obtained to meet our needs, or that such financing would not be dilutive to existing stockholders. If available financing is insufficient or unavailable or we fail to continue to generate meaningful revenue, we may be required to further reduce operating expenses, delay the expansion of operations, be unable to pursue merger or acquisition candidates, or continue as a going concern.

Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), evaluated the effectiveness of our disclosure controls and procedures as of June 30, 2011. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Based on the evaluation of our disclosure controls and procedures as of June 30, 2011, our CEO and CFO concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control Over Financial Reporting

No change in our internal control over financial reporting occurred during the fiscal quarter ended June 30, 2011, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.