Bio Key International Inc: Form 10-Q for the period ended Jun 30, 2012

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 as a fingerprint biometric technology company. 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 and authenticate 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.

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, 2011. There have been no material changes to our critical accounting policies and estimates from those disclosed in our 10-K filed on April 16, 2012.

RECENT ACCOUNTING PRONOUNCEMENTS

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, 2012 AS COMPARED TO JUNE 30, 2011

Consolidated Results of Operations - Percent Trend

Revenues

For the three months ended June 30, 2012 and 2011, service revenues included approximately $167,000 and $151,000, respectively, of recurring maintenance and support revenue, and no non-recurring custom services revenue for either three month periods. Recurring service revenue increased 11% from 2011 to 2012 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, 2012, license and other revenue (comprised of third party hardware and royalty) decreased 56% from the same period ending June 30, 2011. The Company realized an approximately $271,000 decrease (68%) in its core software license revenue primarily as a result of a lag in implementation of biometrics deployments in the blood bank sector. Blood banks have contributed significant revenue in the past, and since their consolidations, have extended their pre-implementation testing phase. Third-party hardware sales decreased by approximately $192,000 (47%), as a result of decreased demand from an existing OEM partner and decrease in new Healthcare deployments. The Company’s royalty income was derived from an OEM agreement, and resulted in a 16% decrease in revenue to $22,989 from $27,334 for the three months ended June 30, 2012 and 2011, respectively.

Costs of goods sold

For the three months ended June 30, 2012, cost of service decreased approximately $8,000 as a result of decreases to personnel related costs. License and other costs for the three months ended June 30, 2012 decreased approximately $143,000 directly associated with the decrease in third party hardware revenue.

Selling, general and administrative

Selling, general and administrative costs for the three months ended June 30, 2012 increased 16% from the same period in 2011. Reductions included business taxes, referral fees, and commission expense related to decreased sales. The decreases were offset by an increase in bad debt expense related to a contract whose payments are behind schedule, As a result of the payment delays, the Company has reserved an additional $193,000 to the balance of $386,000 which now represents 75% of the remaining balance owed under the contract.

Research, development and engineering

For the three months ended June 30, 2012, research, development and engineering costs decreased 10% as the Company no longer required additional temporary outside services for a specific project from the same period in 2011.

Other income and expense

Interest income for the quarter ended June 30, 2011, was attributable to the Note Receivable, which was fully paid in May 2011.

Interest expense for the quarter ended June 30, 2012 was for the holder of the Secured Note. Interest expense during 2011 was comprised of approximately $258,000 of non-cash amortization of the discount attached to the Secured Notes and $33,000 owing to the holders of the Secured Notes. The Company expects to incur approximately $12,000 in interest expense from its Secured Note until the end of 2012, at which point the Note is expected to be paid in full.

For the quarter ended June 30, 2011, the net discounts of notes payable and receivable were non-cash items with respect to the value of the net early payment discount granted to the holder of the note receivable (see Note 5).

SIX MONTHS ENDED JUNE 30, 2012 AS COMPARED TO JUNE 30, 2011

Consolidated Results of Operations - Percent Trend

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Revenues

For the six months ended June 30, 2012 and 2011, service revenues included approximately $340,000 and $293,000, respectively, of recurring maintenance and support revenue, and approximately $223,000 and $16,000, respectively, of non-recurring custom services revenue. Recurring service revenue increased 16% from 2011 to 2012 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, 2012 and 2011, license and other revenue (comprised of third party hardware and royalty) decreased as a result of several contributing factors. The Company realized an approximately $451,000 decrease (30%) in its core software license revenue primarily as a result two large orders in 2012 equal to 30% less than one large order from a single new customer in 2011. For the six months ended June 30, 2012 and 2011 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 decreased by approximately $241,000 (46%), as a result of decreased demand from an existing OEM partner and smaller Healthcare deployments. The Company’s royalty income was derived from an OEM agreement, and resulted in a 14% increase in revenue to $48,097 from $55,894 for the six months ended June 30, 2012 and 2011, respectively.

Costs of goods sold

For the six months ended June 30, 2011, cost of service increased approximately $82,000 as a result of costs associated with non-recurring custom services revenue. License and other costs for the three months ended June 30, 2011 decreased approximately $166,000 directly associated with the decrease in third party hardware revenue.

Selling, general and administrative

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Selling, general and administrative costs for the six months ended June 30, 2012 decreased less than 1% from the same period in 2011. Reductions included commissions for reduced revenue, administrative personnel, professional services and marketing expenses which were offset by an increase in channel marketing expense related to increased non-recurring custom services revenue and bank charges associated with factoring fees and bad debt expense related to a contract whose payments are behind schedule, As a result of the payment delays, the Company has reserved an additional $193,000 for 2012.

Research, development and engineering

For the six months ended June 30, 2012, research, development and engineering costs decreased 12% as the Company no longer required additional temporary outside services for a specific project from the same period in 2011.

Other income and expense

For the six months ended June 30, 2011, the interest income was attributable to the Note Receivable, which was fully paid in May 2011.

Interest expense for the six months ended June 30, 2012 was for the holder of the Secured Note. 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. Interest expense during 2011 was comprised of approximately $308,000 of non-cash amortization of the discount attached to the Secured Notes and $91,000 owing to the holders of the Secured Notes. The Company expects to incur approximately $12,000 in interest expense from its Secured Note until the end of 2012, at which point the Note is expected to be paid in full.

For the six months ended June 30, 2011, the net discounts of notes payable and receivable were non-cash items with respect to the value of the net early payment discount granted to the holder of the note receivable (see Note 5).

LIQUIDITY AND CAPITAL RESOURCES

Net cash provided by operations during the six months ended June 30, 2012 was approximately $11,000. The cash provided by operating activities was primarily due to the following items:

• Positive cash flows related to a decrease in accounts receivable of approximately $138,000, due to focused collections;
• Negative cash flows from a decrease in deferred maintenance revenues of approximately $86,000;
• The Company recorded approximately $38,000 of charges during the first half of 2012 for the expense of issuing options to employees for services.

There were no cash flows under investing or financing activities during the period.

The Company has a reserve for bad debts of $579,000 which represents 75% of the remaining balance owed under a contract for payments that are behind schedule.

Net working deficit at June 30, 2012 was approximately $1,730,000 as compared to approximately $1,539,000 at December 31, 2011.

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.

As of December 2011, the Company entered into a 24-month accounts receivable factoring arrangement with a financial institution (the “Factor”). Pursuant to the terms of this arrangement, BIO-key, from time to time shall sell to the Factor certain of its accounts receivable balances on a non-recourse basis for credit approved accounts. The Factor shall then remit 75% of the accounts receivable balance to BIO-key (the “Advance Amount”), with the remaining balance, less fees to be forwarded to the Company once the Factor collects the full accounts receivable balance from the customer. Factoring fees range from 2.75% to 15% of the face value of the invoice factored and are determined by the number of days required for collection of the invoice. BIO-key expects to use this factoring arrangement periodically to assist with its general working capital requirements.

Liquidity outlook

At June 30, 2012, our total cash and cash equivalents were approximately $54,000, as compared to approximately $43,000 at December 31, 2011.

As discussed above, the Company has financed itself in the past through access to the capital markets by issuing secured and convertible debt securities, convertible preferred stock, common stock, and recently through factoring receivables. We currently require approximately $385,000 per month to conduct our operations, a monthly amount that we have been unable to consistently achieve through revenue generation. During the first half of 2012, we generated approximately $1,943,000 of revenue, which is below our average monthly requirements

The balance of the Company’s Secured Notes of approximately $346,000 will be due and payable to the holder together with all accumulated and unpaid interest on December 31, 2012.

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 their opinion 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, 2012. 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, 2012, 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, 2012, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.