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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the quarterly period ended SEPTEMBER 30, 2006
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
For the transition period from _______ to _______
Commission file number 333-87224
ELECTRONIC SENSOR TECHNOLOGY, INC.
(Exact name of Small Business Issuer as Specified in Its Charter)
NEVADA 98-0372780
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
1077 Business Center Drive
Newbury Park, California 91320
(Address of Principal Executive Offices)
(805) 480-1994
(Issuer's Telephone Number, Including Area Code)
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act during the past 12 months (or
for such shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days.
Yes [ ] No [X](*)
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date. 54,173,745 shares of common
stock as of September 30, 2006
Transitional Small Business Disclosure Format (Check one):
Yes [ ] No [X]
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(*) We were not required to file reports pursuant to Section 13 or 15(d) of the
Securities Exchange Act during the past 12 months because (i) our registered
common stock was registered under the Securities Act during such period and was
not registered under the Exchange Act, (ii) we did not have any registration
statement that became effective during such period and (iii) we had less than
300 shareholders of record throughout such period. Although we were not required
to do so, we voluntarily filed such reports with the Securities and Exchange
Commission during such period. We are in the process of amending our
registration statement on Form SB-2, for which an amendment was most recently
filed on October 20, 2006. Once that registration statement is declared
effective, we will be required to file annual, quarterly and periodic reports
with the Securities and Exchange Commission during the fiscal year in which such
registration statement is declared effective.
PART I.
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
INDEX TO FINANCIAL STATEMENTS
Consolidated Balance Sheet (Unaudited) as of September 30, 2006 F-1
Consolidated Statements of Operations (Unaudited) for the Three and
Nine Months Ended September 30, 2006 and 2005 F-2
Consolidated Statements of Cash Flows (Unaudited) for the Nine Months
Ended September 30, 2006 and 2005 F-3
Notes to Consolidated Financial Statements F-4
1
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEET
SEPTEMBER 30, 2006
(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 2,409,017
Certificate of deposit-restricted 250,000
Accounts receivable, net of allowance for doubtful accounts of $20,762 319,534
Prepaid expenses 70,558
Inventories 1,335,254
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TOTAL CURRENT ASSETS 4,384,362
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DEFERRED FINANCING COSTS, net of amortization of $153,458 574,902
PROPERTY AND EQUIPMENT, net of accumulated depreciation of $946,846 206,769
SECURITY DEPOSITS 12,817
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$ 5,178,850
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LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES:
Accounts payable and accrued expenses $ 439,983
Deferred revenues 104,167
Derivative liabilities 4,359,649
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TOTAL CURRENT LIABILITIES 4,903,798
------------
CONVERTIBLE DEBENTURES, net of unamortized discount of $5,055,556 1,944,444
------------
TOTAL LIABILITIES 6,848,243
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STOCKHOLDERS' DEFICIT:
Preferred stock, $.001 par value 50,000,000 shares authorized,
none issued and outstanding -
Common stock, $.001 par value, 200,000,000 shares authorized,
54,173,745 issued and outstanding 54,174
Additional paid-in capital 8,516,354
Accumulated deficit (10,239,920)
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TOTAL STOCKHOLDERS' DEFICIT (1,669,392)
------------
$ 5,178,850
============
See unaudited notes to consolidated financial statements
F-1
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Nine Months Ended Three Months Ended
September 30, September 30,
-------------------------------- --------------------------------
2006 2005 2006 2005
-------------- -------------- -------------- --------------
REVENUES $ 1,549,757 $ 1,417,737 $ 395,533 $ 766,085
COST OF SALES 731,466 592,748 138,752 217,986
-------------- -------------- -------------- --------------
GROSS PROFIT 818,292 824,989 256,782 548,099
OPERATING EXPENSES:
Research and development 616,597 618,461 200,453 287,177
Selling, general and administrative 2,060,898 1,824,956 623,937 721,520
-------------- -------------- -------------- --------------
TOTAL OPERATING EXPENSES 2,677,494 2,443,418 824,389 1,008,697
-------------- -------------- -------------- --------------
LOSS FROM OPERATIONS (1,859,204) (1,618,429) (567,607) (460,598)
-------------- -------------- -------------- --------------
OTHER INCOME AND EXPENSE:
Other income - derivative 1,411,429 5,778,250 (271,690) 1,514,300
Other (expense) - derivative - (2,205,642) - -
Other income 2,100 83 2,100 -
Gain (loss) on sale of property and equipment (1,614) 9,287 (1,614) -
Interest (expense) (2,105,475) (54,658) (689,196) (20,387)
-------------- -------------- -------------- --------------
TOTAL OTHER INCOME AND EXPENSE (693,559) 3,527,320 (960,400) 1,493,913
-------------- -------------- -------------- --------------
NET INCOME (LOSS) $ (2,552,763) $ 1,908,891 $ (1,528,007) $ 1,033,315
============== ============== ============== ==============
Earnings (loss) per share, basic $ (0.05) $ 0.04 $ (0.03) $ 0.02
============== ============== ============== ==============
Weighted average number of shares, basic 54,164,569 53,525,865 54,173,745 53,968,643
============== ============== ============== ==============
Earnings (loss) per share, diluted $ (0.07) $ (0.03) $ (0.03) $ (0.01)
============== ============== ============== ==============
Weighted average number of shares, diluted 54,164,569 53,525,865 54,173,745 53,968,643
============== ============== ============== ==============
See unaudited notes to consolidated financial statements
F-2
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine Months Ended
September 30,
--------------------------------
2006 2005
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CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ (2,552,763) $ 1,908,891
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Depreciation and amortization 29,836 11,430
Issuance of shares for services 21,000 -
Amortization of debt discount 1,750,000 -
Amortization of deferred financing costs 136,160 -
Recognition of derivative liabilities - 2,205,642
Decrease in fair value of derivative liability (1,411,430) (5,778,250)
Changes in assets and liabilities:
Accounts receivable 146,242 (444,077)
Inventories (395,632) (253,195)
Prepaid expenses (622) (28,946)
Security deposits - 140
Accounts payable and accrued expenses (40,816) 290,724
Deferred revenues (37,500) (37,500)
Due to related party - (60,000)
Interest payable - (26,961)
Other current liabilities - (35,665)
-------------- --------------
Net cash provided by (used in) operating activities (2,355,525) (2,247,767)
CASH FLOWS FROM INVESTING ACTIVITIES:
Decrease (increase) in restricted security deposit 668,678 (912,651)
Proceeds from sale of property and equipment - 30,280
Purchase of property and equipment (124,057) (108,954)
-------------- --------------
Net cash provided by (used in) investing activities 544,621 (991,325)
CASH FLOWS FROM FINANCING ACTIVITIES:
Increase (decrease) in line of credit - (269,000)
Repayment of partners' loans payable - (110,000)
Proceeds from issuance of common stock - 3,811,708
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Net cash provided by financing activities - 3,432,708
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NET INCREASE (DECREASE) IN CASH (1,810,904) 193,617
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 4,219,921 26,430
-------------- --------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 2,409,017 $ 220,047
============== ==============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest $ 434,477 $ 67,380
============== ==============
NON-CASH FINANCING ACTIVITIES
Fair value of derivative liabilities issued in connection
with issuance of shares of common stock $ - $ 239,100
============== ==============
See unaudited notes to consolidated financial statements.
F-3
ELECTRONIC SENSOR TECHNOLOGY, INC.
NOTES TO FINANCIAL STATEMENTS
(Unaudited)
September 30, 2006
1) BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for
interim financial statements and with the instructions to Form 10-QSB and
Article 10 of Regulation S-B. Accordingly, they do not include all the
information and disclosures required for annual financial statements. These
financial statements should be read in conjunction with the consolidated
financial statements and related footnotes for the year ended December 31,
2005, included in the Annual Report filed on Form 10-KSB for the year then
ended, for which an amendment including restated financial statements and
related footnotes was filed on Form 10-KSB/A on September 26, 2006.
In the opinion of the management of Electronic Sensor Technology, Inc. (the
"Company"), all adjustments (consisting of normal recurring accruals)
necessary to present fairly the Company's financial position as of
September 30, 2006, and the results of operations and cash flows for the
nine-month period ending September 30, 2006 have been included. The results
of operations for the nine-month period ended September 30, 2006 are not
necessarily indicative of the results to be expected for the full year. For
further information, refer to the consolidated financial statements and
footnotes thereto included in the Company's Annual Report filed on Form
10-KSB as filed with the Securities and Exchange Commission for the year
ended December 31, 2005, included in the Annual Report filed on Form 10-KSB
for the year then ended, for which an amendment including restated
financial statements and related footnotes was filed on Form 10-KSB/A on
September 26, 2006.
2) BASIS OF CONSOLIDATION
The accompanying financial statements include the accounts of the Company
and its wholly owned subsidiaries. All intercompany balances and
transactions have been eliminated in consolidation. Bluestone Ventures,
Inc. ("Bluestone") executed an Agreement and Plan of Merger ("Merger
Agreement") by and among Bluestone, Amerasia Technology, Inc.,
("Amerasia"), holder of approximately 55% of the partnership interests of
Electronic Sensor Technology, L.P., ("EST"), L & G Sensor Technology, L.P.,
("L&G"), holder of approximately 45% of the partnership interests of EST,
Amerasia Acquisition Corp., ("AAC") a wholly-owned subsidiary of Bluestone,
and L & G Acquisition Corp., ("LAC") a wholly-owned subsidiary of Bluestone
on January 31, 2005. Under the Merger Agreement (i) AAC merged with and
into Amerasia such that Amerasia became of wholly-owned subsidiary of
Bluestone, (ii) LAC merged with and into L&G such that L&G became a
wholly-owned subsidiary of Bluestone, (iii) as a result of the merger of
(i) and (ii), Bluestone indirectly acquired all of the partnership
interests of EST and (iv) Bluestone issued 20,000,000 shares of its common
stock to the shareholders of Amerasia and L&G. This merger has been treated
as a purchase only of the partnership interests of Electronic Sensor
Technology L.P.
For accounting purposes, the transaction was treated as a recapitalization
of EST and accounted for as a reverse acquisition. Accordingly, the
accompanying financial statements include the accounts of EST for the
period from January 1, 2005 to September 30, 2006 and the accounts of
Bluestone from February 1, 2005 to September 30, 2006.
3) NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
a) NATURE OF BUSINESS
The Company develops and manufactures electronic devices used for
vapor analysis. It markets its products through distribution channels
in over 20 countries.
F-4
b) CASH AND CASH EQUIVALENTS
The Company considers highly liquid financial instruments with
maturities of three months or less at the time of purchase to be cash
equivalents.
c) ALLOWANCE FOR DOUBTFUL ACCOUNTS
The allowance for doubtful accounts is based on the Company's
assessment of the collectibilty of customer accounts and the aging of
the accounts receivable. If there is a deterioration of a major
customer's credit worthiness or actual defaults are higher than the
Company's historical experience, the Company's estimates of the
recoverability of amounts due it could be adversely affected. The
Company regularly reviews the adequacy of the Company's allowance for
doubtful accounts through identification of specific receivables where
it is expected that payments will not be received. The Company also
establishes an unallocated reserve that is applied to all amounts that
are not specifically identified. In determining specific receivables
where collections may not be received, the Company reviews past due
receivables and gives consideration to prior collection history and
changes in the customer's overall business condition. The allowance
for doubtful accounts reflects the Company's best estimate as of the
reporting dates. Changes may occur in the future, which may require
the Company to reassess the collectibility of amounts and at which
time the Company may need to provide additional allowances in excess
of that currently provided.
d) LINE OF CREDIT
The Company has a revolving line of credit agreement for borrowings up
to $500,000. The line of credit is secured and collateralized with a
certificate of deposit in the amount of $250,000. No amounts were due
under this line of credit at September 30, 2006. The line of credit
expires on March 31, 2007.
e) REVENUE RECOGNITION
The Company records revenue from direct sales of products to end-users
when the products are shipped, collection of the purchase price is
probable and the Company has no significant further obligations to the
customer. Costs of remaining insignificant Company obligations, if
any, are accrued as costs of revenue at the time of revenue
recognition. Cash payments received in advance of product shipment or
service revenue are recorded as deferred revenue.
f) SHIPPING AND HANDLING
The Company accounts for shipping and handling costs as a component of
"Cost of Sales".
g) INVENTORIES
Inventories are comprised of raw materials, work in process, and
finished goods. Inventories are stated at the lower of cost or market
and are determined using the first-in, first-out method.
h) DEFERRED FINANCING COSTS
Deferred financing costs consist of direct costs incurred by the
Company in connection with the issuance of its convertible debentures.
The direct costs include cash payments and fair value of warrants
issued to the placement agent, which secured the financing. Deferred
financing costs are amortized over 48 months using the effective
interest rate method.
F-5
i) PROPERTY AND EQUIPMENT
Property and equipment are stated at cost, net of accumulated
depreciation. Depreciation is computed using the straight-line method
over the estimated useful lives of five years.
j) RESEARCH AND DEVELOPMENT
Research and development costs are charged to operations as incurred
and consists primarily of salaries and related benefits, raw materials
and supplies.
k) USE OF ESTIMATES
The preparation of the financial statements in conformity with
generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets
and liabilities and disclosures of contingent assets and liabilities
at the date of the financial statements and the recorded amounts of
revenues and expenses during the reporting period. Actual results
could differ from those estimates.
l) FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair value of certain financial instruments, including accounts
receivable, accounts payable and accrued liabilities, approximate
their carrying values due to the short maturity of these instruments.
The fair value of the convertible debentures issued by the Company in
December 2005 amounts to $7,000,000, based on the Company's
incremental borrowing rate. The carrying value of the derivative
liabilities associated with the convertible debentures represents its
fair value.
m) LONG-LIVED ASSETS
The Company reviews long-lived assets, such as property and equipment,
to be held and used or disposed of, for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. If the sum of the expected cash flows,
undiscounted and without interest, is less than the carrying amount of
the asset, an impairment loss is recognized as the amount by which the
carrying amount of the asset exceeds its fair value. At September 30,
2006 no assets were impaired.
n) DERIVATIVE LIABILITIES
In June 2005, the Financial Accounting Standard Board issued EITF
05-04. EITF 05-04 addresses the question as to whether liquidated
damages pursuant to a registration rights agreement should be combined
as a unit with the underlying financial instruments and be evaluated
as a single instrument. EITF 05-04 does not reach a consensus on this
matter and allows for the treatment as a combined unit (Views A and B)
as well as separate freestanding financial instruments (View C). On
September 15, 2005, the FASB staff postponed further discussion of
EITF 05-04. As of September 30, 2006, the FASB still has not
rescheduled EITF 05-04 for further discussion.
In connection with the issuance of a convertible debentures and
related warrants, we granted liquidated damages pursuant to a separate
registration right agreement. The Company adopted View C of EITF
05-04. Accordingly, the liquidated damages pursuant to this
registration right agreement were evaluated as a stand alone financial
instrument. This treatment did not have a significant different effect
than if the Company would have adopted View A or B, because the
classification of the warrants and certain embedded features of the
convertible debentures were classified as derivative liabilities. The
Company believes that should the FASB staff reach a consensus on EITF
05-04 and select combined treatment (View A or B), the embedded
conversion features and the warrants will have to be evaluated as a
combined unit with the liquidated damages
F-6
pursuant to the registration rights agreement, and accordingly, be
evaluated as derivative liabilities. The Company does not believe that
its measurement of the derivative liabilities under View A or View B
would significantly differ from its measurement of the derivative
liabilities under View C in these circumstances.
The Company accounts for liquidated damages granted pursuant to
registration rights which are not included in a separate registration
right agreement as a combined unit with the warrants which are
contemporaneously issued with the registration rights pursuant to SFAS
133 "Accounting for Derivative and Hedging Activities" and EITF 00-19.
The Company accounts for its embedded conversion features and
freestanding warrants pursuant to SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities", which requires a
periodic valuation of their fair value and a corresponding recognition
of liabilities associated with such derivatives. The recognition of
derivative liabilities related to the issuance of shares of common
stock is applied first to the proceeds of such issuance, at the date
of issuance, and the excess of derivative liabilities over the
proceeds is recognized as other expense in the accompanying
consolidated financial statements. The recognition of derivative
liabilities related to the issuance of convertible debt is applied
first to the proceeds of such issuance as a debt discount, at the date
of issuance, and the excess of derivative liabilities over the
proceeds is recognized as other expense in the accompanying
consolidated financial statements. Any subsequent increase or decrease
in the fair value of the derivative liabilities, which are measured at
the balance sheet date, are recognized as other expense or other
income, respectively.
o) BASIC AND DILUTED EARNINGS PER SHARE
Basic earnings per share are calculated by dividing income available
to stockholders by the weighted-average number of common shares
outstanding during each period. Diluted earnings per share are
computed using the weighted average number of common and dilutive
common share equivalents outstanding during the period. Dilutive
common share equivalents consist of shares issuable upon the exercise
of stock options and warrants embedded conversion features (calculated
using the reverse treasury stock method). The outstanding options,
warrants and shares equivalent issuable pursuant to embedded
conversion features amounted to 45,278,509 and 5,576,871 at September
30, 2006 and 2005, respectively. The outstanding options, warrants and
shares equivalent issuable pursuant to embedded conversion features
and warrants at September 30, 2006 and 2005, respectively, are
excluded from the loss per share computation for that period due to
their antidilutive effect. The Company adjusted the numerator for any
changes in income or loss that would result if the contract had been
recorded as an equity instrument for accounting purposes during the
period. However, the Company did not adjust the numerator for interest
charges during the period on the convertible debentures because it
would have been anti-dilutive.
F-7
The following sets forth the computation of basic and diluted earnings
per share at September 30:
2006 2005
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Numerator:
Net income (loss) $ (2,552,763) $ 1,908,891
Net other income/expense associated with
derivative contracts 1,411,429 3,572,608
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Net (loss)for diluted earnings per share purposes $ (3,964,192) $ (1,663,717)
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Denominator:
Denominator for basic earnings per share-
Weighted average shares outstanding 54,164,569 53,525,865
Effect of dilutive warrants, embedded
conversion features and liquidated damages 0 0
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Denominator for diluted earnings per share-
Weighted average shares outstanding 54,164,569 53,525,865
============ ============
Basic earnings (loss) per share $ (0.05) $ 0.04
============ ============
Diluted earnings (loss) per share $ (0.07) $ (0.03)
============ ============
p) STOCK BASED COMPENSATION
In December 2004, the FASB issued SFAS No. 123(R), "Share-Based
Payment," which replaces SFAS No. 123 and supersedes APB Opinion
No. 25. Under SFAS No. 123(R), companies are required to measure the
compensation costs of share-based compensation arrangements based on
the grant-date fair value and recognize the costs in the financial
statements over the period during which employees are required to
provide services. Share-based compensation arrangements include stock
options, restricted share plans, performance-based awards, share
appreciation rights and employee share purchase plans. In March 2005
the SEC issued Staff Accounting Bulletin No. 107, or "SAB 107". SAB
107 expresses views of the staff regarding the interaction between
SFAS No. 123(R) and certain SEC rules and regulations and provides the
staff's views regarding the valuation of share-based payment
arrangements for public companies. SFAS No. 123(R) permits public
companies to adopt its requirements using one of two methods. On April
14, 2005, the SEC adopted a new rule amending the compliance dates for
SFAS No. 123(R). Companies may elect to apply this statement either
prospectively, or on a modified version of retrospective application
under which financial statements for prior periods are adjusted on a
basis consistent with the pro forma disclosures required for those
periods under SFAS 123. Effective January 1, 2006, the Company has
fully adopted the provisions of SFAS No. 123(R) and related
interpretations as provided by SAB 107. As such, compensation cost is
measured on the date of grant as the excess of the current market
price of the underlying stock over the exercise price. Such
compensation amounts, if any, are amortized over the respective
vesting periods of the option grant. The Company applies this
statement prospectively.
q) RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In July 2005, the FASB issued FASB Staff Position ("FSP") 150-5,
"Accounting Under SFAS 150 for Freestanding Warrants and Other Similar
Instruments on Redeemable Shares". FSP 150-5 clarifies that warrants
on shares that are redeemable or puttable immediately upon exercise
and warrants on shares that are redeemable or puttable in the future
qualify as liabilities under SFAS 150, regardless of the redemption
feature or redemption price. The FSP is effective for the first
reporting period beginning after September 30, 2005, with resulting
changes to prior period statements reported as the cumulative effect
of an accounting change in accordance with the transition provisions
of SFAS 150. We adopted the provisions of FSP 150-5 on July 1, 2005,
which did not have a material effect on our financial statements.
F-8
In July 2005, the FASB issued EITF 05-6, "Determining the Amortization
period for Leasehold Improvements Purchased After Lease Inception or
Acquired in a Business Combination", which addressed the amortization
period for leasehold improvements made on operating leases acquired
significantly after the beginning of the lease. The EITF is effective
for leasehold improvements made in periods beginning after June 29,
2005. We adopted the provisions of EITF 05-6 on July 1, 2005, which
did not have a material impact to the Company's financial position,
results of operations and cash flows.
In September 2005, the FASB issued FASB Statement No. 157. This
Statement defines fair value, establishes a framework for measuring
fair value in generally accepted accounting principles (GAAP), and
expands disclosures about fair value measurements. This Statement
applies under other accounting pronouncements that require or permit
fair value measurements, the Board having previously concluded in
those accounting pronouncements that fair value is a relevant
measurement attribute. Accordingly, this Statement does not require
any new fair value measurements. However, for some entities, the
application of this Statement will change current practices. This
Statement is effective for financial statements for fiscal years
beginning after November 15, 2007. Earlier application is permitted
provided that the reporting entity has not yet issued financial
statements for that fiscal year. Management believes this Statement
will have no impact on the financial statements of the Company once
adopted.
4) CONVERTIBLE DEBENTURES
During December 2005, we issued in a private offering, $7,000,000 aggregate
principal amount of convertible debentures due December 7, 2009. The
convertible debentures are convertible at any time on or prior to the
maturity date at the option of the debenture holder at a conversion price
of $0.4544, which was subsequently reduced to $0.4000 as per a Forbearance
and Amendment Agreement, dated September 7, 2006, with the holders of the
convertible debentures (see Note 7), and can be redeemed at the lesser of
$0.4000 or 90% of the average of the volume weighted average price for the
20 consecutive trading days immediately prior to the conversion date. The
Company received $7,000,000 in cash as consideration. The convertible
debentures bear interest at 8%, payable in cash or stock, at the Company's
option, and are required to be redeemed in 9 equal quarterly payments
commencing January 1, 2008, in cash or stock, at the Company's option. If
the Company chooses to pay interest on or redeem the debentures in shares
of the Company's common stock, rather than in cash, the conversion rate for
such stock payment is the lesser of $0.4544, which was subsequently reduced
to $0.4000 as per a Forbearance and Amendment Agreement, dated September 7,
2006, with the holders of the convertible debentures (see Note 7), or 90%
of the average of the volume weighted average price for the 20 consecutive
trading days immediately prior to the interest payment or redemption date,
as applicable.
In connection with the issuance of the convertible debentures, the Company
issued five-year warrants to purchase 12,130,314 shares of common stock at
an exercise price of $0.4761 per share, which was subsequently reduced to
$0.4300 per share as per a Forbearance and Amendment Agreement, dated
September 7, 2006, with the holders of the warrants (see Note 7).
Furthermore, the Company granted liquidated damages pursuant to a
registration rights agreement.
The convertible debentures and related agreements provide, among other
things, for:
1) Liquidated damages amounting to 2% per month of the outstanding
principal amount, payable in cash or stock, to the debenture
holders in the event that a registration statement covering the
shares underlying the convertible debentures is not declared
effective within 150 days of the date the debentures were issued
(which was subsequently extended to February 28, 2007 as per a
Forbearance and Amendment Agreement, dated September 7, 2006,
with the holders of the convertible debentures and warrants - see
Note 7). The liquidated damages are payable in cash monthly or in
unpaid, bear interest at 18% per annum. If unpaid by January 1,
2008, they may be converted in shares of common stock at the same
prevailing rate as the remaining principal amount of the
convertible debentures;
F-9
2) Default interest rate of 18% and a default premium of 30% of
the principal amount of the debentures, payable in cash or stock.
Events of default include, among other things, if a payment,
whether cash or stock is not paid on time and cured within three
days, if the Company's common stock is not quoted for trading for
at least five trading days, if a registration is not effective
within 180 days after December 7, 2005 (which was subsequently
extended to February 28, 2007 as per a Forbearance and Amendment
Agreement, dated September 7, 2006 with the holders of the
convertible debentures and warrants - see Note 7). The default
interest rate and the default premium may be converted in shares
of common stock at the same prevailing rate as the remaining
principal amount of the convertible debentures;
3) A reset feature of the conversion price in the event of a
subsequent equity or convertible financing with an effective
price lower than the debenture conversion price, whereby the
aforementioned variable conversion price of the convertible
debentures is adjusted to the new lower effective price of the
subsequent equity or convertible financing; and
4) The warrants require that the Company reimburse any holder of
a warrant in respect of any trading loss resulting from the
failure of the Company to timely deliver shares issued pursuant
to the exercise of warrants. This compensation may be paid in
shares of common stock or cash. The exercise price of the
warrants, which is $0.4761 per share at the date of the agreement
(and was subsequently reduced to $0.4300 per share as per a
Forbearance and Amendment Agreement, dated September 7, 2006,
with the holders of the warrants - see Note 7), may be reduced to
$0.001 per share, at a monthly rate $0.03 per share if the
registration statement we are required to file at the request of
the warrant holders with respect to the common stock underlying
the warrants is not declared effective within six months of the
date of issuance of the warrants (which was subsequently extended
to February 28, 2007 as per a Forbearance and Amendment
Agreement, dated September 7, 2006 with the holders of the
warrants - see Note 7).
In connection with the issuance of the convertible debentures, we issued
485,213 warrants to a company in partial consideration for financial
advisory services, as well as paid $490,000 to this company. The warrants
have the same terms as those granted to the debenture holders. The fair
value of the warrants at the date of issuance amounted to approximately
$136,000. We also incurred approximately $102,500 in additional
professional fees relating to the issuance of the convertible debentures
and warrants. The payments of professional fees and the fair value of the
warrants, aggregating approximately $729,000 have been recorded as deferred
financing costs. The deferred financing costs are amortized over the term
of the convertible debentures. The amortization of deferred financing costs
approximated $136,200 for the nine-month period ending September 30, 2006.
See Note 5- Derivative Liabilities for further information on the
accounting and measurement of the derivative liabilities associated with
the issuance of the convertible debentures and related agreements.
We recognized a debt discount of $7,000,000 at the date of issuance of the
convertible debentures and the excess amount has been recorded as liability
and a corresponding increase to other expense. The debt discount is
recognized over the term of the convertible debentures.
5) DERIVATIVE LIABILITIES
FEBRUARY 2005 TRANSACTION
During February 2005, we recognized derivative liabilities of approximately
$6.0 million pursuant to the issuance of 3,985,000 freestanding warrants
and granting certain registration rights which provided for liquidated
damages in the event of failure to timely register the shares in connection
with the issuance of shares of common stock and the related warrants.
F-10
There are no liquidated damages provided for untimely effectiveness of the
registration of shares pursuant to piggy-back registration rights. The
Company intends to register all shares and warrants pursuant to the
subscriber piggy-back registration rights.
The agreement pursuant to which the warrants were issued and the
registration rights were granted provided for liquidated damages pursuant
to demand registration rights in the event of a failure to timely register
the shares after demand is made by the holders of a majority of the
warrants and shares of common stock issued pursuant to such agreement. The
demand registration rights of these investors are such that if the Company
fails to register the investors shares, including the shares underlying the
warrants, the Company will pay a cash penalty amounting to 1% of the amount
invested per month, $39,850, if the registration statement is not filed
within 60 days of demand or is not declared effective within 150 days from
the date of initial filing. The maximum liability associated with the
liquidated damages amounts to 49% of the gross proceeds associated with the
issuance of shares of common stock, which amounts to $1,952,650. The
percentage of liquidated damages amounts to the difference between
60 months, which is the inherent time limitation under which the underlying
shares would be free-trading (three year term and two year holding period)
and 11 months, which is the grace period for registering the shares (no
demand permitted for four months, two-month period to file and five-month
period to become effective), times the penalty percentage, which is 1%. The
Company believes that the likelihood that it will incur any liabilities
resulting from the liquidated damages pursuant to the demand registration
rights is remote considering that it will register the shares and the
shares underlying the warrants pursuant to piggy-back registration rights,
which do not contain liquidated damages.
Because the registration rights were not granted under a separate
registration rights agreement, we considered those features in evaluating
whether the associated warrants should be classified as derivative
liabilities. Considering that the amount of the maximum penalty is 49%, the
Company cannot conclude that that this discount represents a reasonable
approximation of the difference between registered and unregistered shares
under paragraph 16 of EITF 00-19. Accordingly, the warrants issued in
connection with the February 2005 transaction are considered derivative
liabilities.
The fair value of the warrants issued in connection with the February 2005
transaction at the date of issuance of the warrants and the granting of
registration rights and at September 30, 2006 is as follows:
At issuance At September 30, 2006
------------- ---------------------
Freestanding warrants $ 6,017,350 $ 0
The Company used the following assumptions, using the Black Scholes Model
to measure the identified derivatives as follows:
Freestanding warrants
At issuance At September 30, 2006
------------- ---------------------
Market price: $ 2.40 $ 0.32
Exercise price: $ 1.00 $ 1.00
Term: 3 years 1.58 years
Volatility: 39% 39%
Risk-free interest rate: 2.78% 4.69%
Number of warrants: 3,985,000 3,985,000
DECEMBER 2005 TRANSACTION
During December 2005, in connection with the issuance of the convertible
debentures, the Company determined that the conversion feature of the
convertible debentures represents an embedded derivative since the
debentures are convertible into a variable number of shares upon
conversion. Because there is no
F-11
explicit number of shares that are to be delivered upon satisfaction of the
convertible debentures and that there is no cap on the number of shares to
be delivered upon expiration of the contract to a fixed number, the Company
is unable to assert that it had sufficient authorized and unissued shares
to settle its obligations under the convertible debentures and therefore,
net-share settlement is not within the control of the Company. Accordingly,
the convertible debentures are not considered to be conventional debt under
EITF 00-19 and the embedded conversion feature must be bifurcated from the
debt host and accounted for as a derivative liability.
The embedded conversion features are as follows:
Default Interest Rate and Premium: The default interest rate is 18% while
the stated rate of the convertible debentures is 8%. Additionally, the
Company is liable to pay for a premium amounting to 30% of the principal
amount of the convertible debentures in the event of default. This embedded
derivative could at least double the investor's initial rate of return on
the host contract and could also result in a rate of return that is at
least twice what otherwise would be the market return for a contract that
has the same terms as the host contract and that involves a debtor with a
similar credit quality. Furthermore, the default interest rate may be
triggered by certain events of defaults which are not related to
credit-risk-related covenants or the Company's creditworthiness (e.g., if a
registration statement is not timely filed). The default provisions are
effective, at the holders' option, upon an event of default.
Reset Feature Following Subsequent Financing: The debenture provides for a
reset feature of the conversion price in the event of a subsequent equity
or convertible financing with an effective price lower than the debenture
conversion price, whereby the aforementioned variable conversion price of
the convertible debentures is adjusted to the new lower effective price of
the subsequent equity or convertible financing, which amounts to 10% of the
shares issuable pursuant to the convertible debentures, which is the
effective discount to market value we would offer in the event we provide
for a subsequent private placement financing. This reset does not
constitute a standard anti-dilution provision and is indexed to an
underlying other than an interest rate or credit risk.
Conversion Rate: The convertible debentures are convertible at a variable
conversion price, which is the lesser of $0.4544, which was subsequently
reduced to $0.4000 as per a Forbearance and Amendment Agreement, dated
September 7, 2006, with the holders of the convertible debentures (see Note
7), or 90% of the average of the volume weighted average price for the
20 consecutive trading days immediately prior to the conversion date. The
convertible debentures are convertible at any time on or prior to the
maturity date at the option of the debenture holder. The implied conversion
embedded feature amounts to a conversion discount of 10% to market.
The Company believes that the aforementioned embedded derivatives meet the
criteria of SFAS 133, including Implementation issue No. B16 and EITF
00-19, when appropriate, and should be accounted for as derivatives with a
corresponding value recorded as a liability.
In connection with the issuance of the convertible debentures, the Company
issued warrants to the debenture holders. The related warrants require that
the Company reimburse any holder of a warrant in respect of any trading
loss resulting from the failure of the Company to timely deliver shares
issued pursuant to the exercise of warrants. This compensation may be paid
in shares of common stock or cash. Accordingly, we have accounted for such
warrants as derivatives.
In connection with the issuance of the convertible debentures, the Company
granted liquidated damages pursuant to a registration rights agreement. The
liquidated damages amount to 2% per month of the outstanding principal
amount, payable in cash or stock, to the debenture holders in the event
that a registration statement covering the shares underlying the
convertible debentures is not declared effective within 150 days of the
date the debentures were issued (which was subsequently extended to
February 28, 2007 as per a Forbearance and Amendment Agreement, dated
September 7, 2006 with the holders of the convertible debentures - see Note
7). The liquidated damages are payable in cash monthly or if unpaid, bear
interest at 18% per annum. If unpaid by January 1, 2008 and thereafter,
they may be converted in shares of common stock at the same prevailing rate
as the remaining principal amount of the convertible
F-12
debentures. Pursuant to View C of EITF 05-04 the liquidated damages are
accounted for as a separate derivative. While the liquidated damages may be
settled in stock if unpaid by January 1, 2008, the Company determined that
it was more likely that they would be paid in cash shortly after their
occurrence and has used such assumption in measuring the fair value of the
derivative liability associated with the liquidated damages. The maximum
liability associated with the liquidated damages amounts to 38% of the
gross proceeds associated with the issuance of the convertible debentures,
which amounts to $2,660,000.
Additionally, because there is no explicit number of shares that are to be
delivered upon satisfaction of the convertible debentures, the Company is
unable to assert that it had sufficient amount of authorized and unissued
shares to settle its obligations under the convertible debentures.
Accordingly, all of the Company's previously issued and outstanding
instruments, such as warrants, as well as those issued in the future, would
be classified as liabilities as well, effective with the issuance of the
convertible debentures and until the Company is able to assert that it has
a sufficient amount of authorized and unissued shares to settle its
obligations under all outstanding instruments. At the date of the issuance
of the convertible debentures, the Company had 1,941,871 warrants
outstanding which were classified as derivatives.
The fair value of the derivative liabilities at the date of issuance of the
convertible debentures and at September 30, 2006 are as follows:
At issuance At September 30, 2006
------------- ---------------------
Freestanding warrants $ 3,532,348 $ 1,135,397
Embedded conversion features 3,463,542 3,208,333
Liquidated damages 192,500 0
Other outstanding warrants 143,268 15,919
The Company used the following methodology to value the embedded conversion
features and liquidated damages:
It estimated the discounted cash flows payable by the Company, using
probabilities and likely scenarios, for event of defaults triggering the
30% penalty premium and 18% interest accrual, subsequent financing reset,
and liquidated damages, such as the untimely effectiveness of a
registration statement. If the additional cash consideration was payable in
cash or stock, it determined the amount of additional shares that would be
issuable pursuant to its assumptions. The Company revisits the weight of
probabilities and the likelihood of scenarios at each measurement date of
the derivative liabilities, which are the balance sheet dates.
The Company used the following assumptions to measure the identified
derivatives, using the Lattice valuation model, as follows:
Embedded conversion features
At issuance At September 30, 2006
------------- ---------------------
Market price: $ 0.4880 $ 0.32
Conversion price: $ 0.4544 $ 0.29
Term: 4 years 3.17 years
Volatility: 39% 39%
Risk-free interest rate: 4.39% 4.69%
Freestanding warrants
The derivative liability amounts to the fair value of the warrants issuable
upon exercise, assuming that the underlying shares will not be timely
registered. We computed the fair value of this embedded derivative using
the Black Scholes valuation model with the following assumptions:
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At issuance At September 30, 2006
------------- ---------------------
Market price: $ 0.488 $ 0.32
Exercise price: $ 0.4761 $ 0.43
Term: 5 years 4.17 years
Volatility: 39% 39%
Risk-free interest rate: 4.39% 4.69%
We adjusted the effective exercise price to reflect the contractual
adjustment based on the Forbearance Agreement assuming that the warrants
will most likely be registered before February 28, 2007.
Liquidated damages
The liquidated damages, payable in cash, are valued using the weighting
probabilities and likely scenarios to estimate the amount of liquidated
damages and were valued at approximately $192,500 and $0 at the date of the
grant of the registration rights and at September 30, 2006, respectively.
The aggregate fair value of the derivative liabilities associated with the
warrants, embedded conversion features, and liquidated damages in
connection with the issuance of the convertible debentures and related
agreements amounted to approximately $7.05 million at the date of issuance
which exceeded the principal amount of the convertible debentures by
approximately $50,000. The Company recognized $7,000,000 as debt discount
and the excess amount was recorded as other expenses in December 2005.
Additionally, approximately $136,000 of the fair value of the warrants was
recorded as deferred financing costs.
The aggregate fair value of all derivative liabilities upon their issuance
in 2005 of the various debt and equity instruments amounted to
$13.3 million, of which $10.7 million was allocated to the net proceeds of
the issuance of common stock and convertible debentures, $2.4 million was
allocated and charged to other expenses (in 2005), and approximately
$136,000 was allocated to deferred financing costs (in 2005).
The decrease in fair value of the derivative liabilities between
measurement dates, which are the date of issuance of the various debt and
equity instruments and the balance sheet date, which is September 30,
amounted to approximately $5.8 million and $1.4 million, and have been
recorded as other income in 2005 and 2006, respectively.
6) STOCKHOLDERS' DEFICIT
COMMON STOCK
Shares issued pursuant to services
During January 2006, the Company issued 75,000 shares to its former chief
executive officer for services rendered. The fair value of such shares
amounted to approximately $21,000 based on the quoted price of the
Company's shares at the date of issuance.
Conversion of shares for pre-merger liabilities
In connection with the Mergers that took place on January 31, 2005, the
Company issued, in aggregate, 2,783,892 shares of common stock in
satisfaction of liabilities incurred pursuant to notes payable, loan
payable, and related accrued interest to related parties.
OPTIONS
In 2005, the Board of Directors adopted the Electronic Sensor Technology,
Inc. 2005 Stock Incentive Plan. The purpose of the Stock Incentive Plan is
to attract and retain the services of experienced and knowledgeable
individuals to serve as our employees, consultants and directors. On the
date the Stock Incentive Plan was adopted, the total number of shares of
common stock subject to it was 5,000,000. The
F-14
Stock Incentive Plan is currently administered by the Board of Directors,
and may be administered by any Committee authorized by the Board of
Directors, so long as any such Committee is made up of Non-Employee
Directors, as that term is defined in Rule 16(b)-3(b) of the Securities
Exchange Act of 1934.
The Stock Incentive Plan is divided into two separate equity programs: the
Discretionary Option Grant Program and the Stock Issuance Program. Under
the Discretionary Option Grant Program, eligible persons may, at the
discretion of the administrator, be granted options to purchase shares of
common stock and stock appreciation rights. Under the Stock Issuance
Program, eligible persons may, at the discretion of the administrator, be
issued shares of common stock directly, either through the immediate
purchase of such shares or as a bonus for services rendered for Electronic
Sensor Technology (or a parent or subsidiary of Electronic Sensor
Technology).
Pursuant to the terms of the Discretionary Option Grant Program, the
exercise price per share is fixed by the administrator, but may not be less
than 85% of the fair market value of the common stock on the date of grant,
unless the recipient of a grant owns 10% or more of Electronic Sensor
Technology's common stock, in which case the exercise price of the option
must not be less than 110% of the fair market value. An option grant may be
subject to vesting conditions. Options may be exercised in cash, with
shares of the common stock of Electronic Sensor Technology already owned by
the person or through a special sale and remittance procedure, provided
that all applicable laws relating to the regulation and sale of securities
have been complied with. This special sale and remittance procedure
involves the optionee concurrently providing irrevocable written
instructions to: (i) a designated brokerage firm to effect the immediate
sale of the purchased shares and remit to Electronic Sensor Technology, out
of the sale proceeds available on the settlement date, sufficient funds to
cover the aggregate exercise price payable for the purchased shares plus
all applicable federal, state and local income and employment taxes
required to be withheld by Electronic Sensor Technology by reason of such
exercise and (ii) Electronic Sensor Technology to deliver the certificates
for the purchased shares directly to such brokerage firm in order to
complete the sale. The term of an option granted pursuant to the
Discretionary Option Grant Program may not be more than 10 years.
The Discretionary Option Grant Program also allows for the granting of
Incentive Options to purchase common stock, which may only be granted to
employees, and are subject to certain dollar limitations. Any options
granted under the Discretionary Option Grant Program that are not Incentive
Options are considered Non-Statutory Options and are governed by the
aforementioned terms. The exercise price of an Incentive Option must be no
less than 100% of the fair market value of the common stock on the date of
grant, unless the recipient of an award owns 10% or more of Electronic
Sensor Technology's common stock, in which case the exercise price of an
incentive stock option must not be less than 110% of the fair market value.
The term of an Incentive Option granted may not be more than five years if
the option is granted to a recipient who owns 10% or more of Electronic
Sensor Technology's common stock, or 10 years for all other recipients of
Incentive Options. Incentive Options are otherwise governed by the general
terms of the Discretionary Option Grant Program.
Pursuant to the terms of the Stock Issuance Program, the purchase price per
share of common stock issued is fixed by the administrator, but may not be
less than 85% of the fair market value of the common stock on the issuance
date, unless the recipient of a such common stock owns 10% or more of
Electronic Sensor Technology's common stock, in which case the purchase
price must not be less than 100% of the fair market value. Common stock may
be issued in exchange for cash or past services rendered to Electronic
Sensor Technology (or any parent or subsidiary of Electronic Sensor
Technology). Common stock issued may be fully and immediately vested upon
issuance or may vest in one or more installments, at the discretion of the
administrator.
All options outstanding at September 30, 2006 were fully-vested at
January 1, 2006, with the exception of 500,000 options held by our former
Chief Executive Officer, Matthew Collier, and 250,000 options held by the
Chairman of our Board of Directors, James Frey. Upon the termination of our
Chief Executive Officer in January 2006, 200,000 of his options vested and
the remainder of his 500,000 options were cancelled. The 200,000 vested
options were subsequently cancelled, without being exercised, in
April 2006.
F-15
Accordingly, no expense associated with the outstanding options was
recorded during the nine-month period ending September 30, 2006.
7) FORBEARANCE AND AMENDMENT AGREEMENT
On September 7, 2006, the Company entered into a Forbearance and Amendment
Agreement with the holders of the convertible debentures and warrants that
we issued in a private placement on December 7, 2005. The terms of the
convertible debentures and warrants required that we register the shares of
our common stock underlying such debentures and warrants within 180 days of
the date of issuance of the debentures and warrants. The failure to do so
is an event of default under the debentures, giving the holders the right
to accelerate the debentures and receive a premium of approximately 30% of
the outstanding amounts due under the debentures upon acceleration. The
failure to do so also reduces the exercise price of the warrants by
$0.03 per month until such shares are registered. In addition, the failure
to register such shares within 150 days of the date of issuance of the
debentures and warrants gives the holders the right to receive liquidated
damages in the amount of 2% per month of the purchase price of the
debentures and warrants, pursuant to a registration rights agreement, and
the failure to pay such liquidated damages relating to the debentures is an
event of default under the debentures.
Pursuant to the Forbearance and Amendment Agreement, the holders have
agreed, among other things, to abstain from exercising the aforementioned
rights and remedies arising out of the existing defaults under the
debentures and warrants unless we are unable to register the shares
underlying the convertible debentures and the warrants by February 28,
2007. In exchange for such forbearance, the Company agreed to reduce the
conversion price of the debentures issued on December 7, 2005 from
$0.4544 per share to $0.4000 per share and to reduce the exercise price of
the warrants issued to the holders of the convertible debentures on such
date from $0.4761 per share to $0.4300 per share.
The Forbearance and Amendment Agreement constitutes a temporary
modification of terms of the convertible debentures and associated
agreements. The temporary modification of terms impacts the probabilities
and likely scenarios in our valuation of freestanding warrants, derivatives
and liquidated damages associated with the convertible debentures and
related financial instruments used at issuance and at each subsequent
balance sheet date. Based on the terms of the Forbearance and Amendment
Agreement and management's analysis of the status of its current
registration statement, notwithstanding any unforeseen circumstances, the
Company believes that it will be able to register all of the shares of its
common stock underlying such debentures and warrants by February 28, 2007.
Accordingly, the Forbearance and Amendment Agreement provides for revised
probabilities and likely outcomes that the Company will use in its
valuation of the embedded conversion features, the freestanding warrants
and the liquidated damages associated with the issuance of the convertible
debentures, as required by SFAS 133, paragraph 17. Such valuation is
performed at each balance sheet date.
F-16
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
You should read the following discussion and analysis of our financial condition
and results of operations together with our interim financial statements and the
related notes appearing at the beginning of this report. The interim financial
statements and this Management's Discussion and Analysis of Financial Condition
and Results of Operations should be read in conjunction with the financial
statements and notes thereto for the year ended December 31, 2005 and the
related Management's Discussion and Analysis of Financial Condition and Results
of Operations, both of which are contained in our Annual Report on Form 10-KSB/A
filed with the Securities and Exchange Commission.
The following discussion and other parts of this Form 10-QSB contain
forward-looking statements that involve risks and uncertainties. Forward-looking
statements can be identified by words such as "anticipates," "expects,"
"believes," "plans," and similar terms. Our actual results could differ
materially from any future performance suggested in this report as a result of
factors, including the risk factors discussed in Exhibit 99.1 hereto, which is
incorporated herein by reference, and factors discussed elsewhere in this report
and in our Annual Report on Form 10-KSB/A for the fiscal year ended December 31,
2005. All forward-looking statements are based on information currently
available to the Company and we assume no obligation to update such
forward-looking statements, except as required by law. Service marks, trademarks
and trade names referred to in this Form 10-QSB are the property of their
respective owners.
--------------------------------------------------------------------------------
OVERVIEW
The Company is engaged in the development, manufacturing, and sales of a
patented product called zNose(R); a device designed to detect and analyze
chemical odors and vapors, or, in other words, an electronic "nose." We believe
the zNose(R) is superior to other electronic "noses" because of its speed,
specificity and sensitivity. The zNose(R) is capable of measuring and
quantifying the chemistry of any compound, fragrance, vapor or odor with parts
per trillion sensitivity in 10 seconds. We also believe the zNose(R) has the
unique ability to quantify and speciate the subject chemical vapor by creating
visual olfactory images. This enables the measured odor or vapor to be easily
identified by the user.
We believe that our products will have broad applications in the homeland
security, environmental and laboratory instrumentation markets. The Company is
involved in ongoing product research and development efforts in that regard. The
Company has also concentrated its efforts on further product development,
testing and proving and assembling a sales and support organization.
The Company was originally incorporated under the laws of the state of Nevada as
"Bluestone Ventures, Inc." on July 12, 2000. From inception until February 1,
2005, we engaged in the business of acquiring, exploring and developing certain
mining properties in Ontario, Canada. Upon acquisition of Electronic Sensor
Technology, L.P. ("ELP"), we abandoned our mining business and adopted ELP's
business of developing, manufacturing and selling the vapor analysis device.
Prior to the closing of the mergers, as discussed in the footnotes to the
financial statements, on January 26, 2005, we changed our name to "Electronic
Sensor Technology, Inc."
Our executive offices are located at 1077 Business Center Circle, Newbury Park,
California 91320 and our telephone number is (805) 480-1994.
CRITICAL ACCOUNTING POLICIES
The Company records revenue from direct sales of products to end-users when the
products are shipped, collection of the purchase price is probable and the
Company has no significant further obligations to the customer. Costs of
remaining insignificant Company obligations, if any, are accrued as costs of
revenue at the time of revenue recognition. Cash payments received in advance of
product shipment or service revenue are recorded as deferred revenue.
2
The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the financial
statements and the recorded amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
The Company reviews long-lived assets, such as property and equipment, to be
held and used or disposed of, for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. If the sum of the expected cash flows, undiscounted and without
interest, is less than the carrying amount of the asset, an impairment loss is
recognized as the amount by which the carrying amount of the asset exceeds its
fair value. At September 30, 2006 no assets were impaired.
We account for liquidated damages pursuant to Emerging Issue Task Force ("EITF")
05-04, View C, "The Effect of a Liquidated Damages Clause on a Freestanding
Financial Instrument", subject to EITF Issue No. 00-19, "Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock". Pursuant to EITF 05-04, View C, liquidated damages payable
in cash or stock are accounted for as a separate derivative, which requires a
periodical valuation of its fair value and a corresponding recognition of
liabilities associated with such derivative. We also account for our embedded
conversion features and freestanding warrants pursuant to SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities", which requires a
periodic valuation of their fair value and a corresponding recognition of
liabilities associated with such derivatives. The recognition of derivative
liabilities related to the issuance of shares of common stock is applied first
to the proceeds of such issuance, at the date of issuance, and the excess of
derivative liabilities over the proceeds is recognized as other expense in the
accompanying consolidated financial statements. The recognition of derivative
liabilities related to the issuance of convertible debt is applied first to the
proceeds of such issuance as a debt discount, at the date of issuance, and the
excess of derivative liabilities over the proceeds is recognized as other
expense in the accompanying consolidated financial statements. Any subsequent
increase or decrease in the fair value of the derivative liabilities is
recognized as other expense or other income, respectively. The valuation of such
derivatives requires significant judgment. We exercise our judgment in
determining the maximum liabilities associated with such derivatives as well as
the expected volatility related to their fair value. We base our estimate of the
maximum liabilities on our interpretation of the agreements related the
derivatives.
PLAN OF OPERATIONS
Over the course of the next 12 months, we intend to execute our business plan
and focus our business development efforts in the following key areas:
o By diversifying our product offerings to enhance the usefulness of our
solutions for customers who will have already adopted one or more
products;
o By enhancing our product lines and developing new products to attract
new customers; and
o By developing partnering relationships with wide-ranging sales and
distribution channel leaders already serving our vertical market space
in a way that assists them in developing new revenue streams and
opportunities through improved technical and sales support and
customer services.
RESULTS OF OPERATIONS
The following tables sets forth, in $ and as a percentage of revenues, certain
items included in the Company's Income Statements (see Financial Statements and
Notes) for the periods indicated:
NINE MONTHS ENDED SEPTEMBER 30
-------------------------------
STATEMENT OF OPERATIONS DATA: 2006 2005
----------------------------------- ------------- ------------
Revenues......................... 100% 100%
Cost of Sales.................... 47% 42%
Gross Profit..................... 53% 58%
Operating Expenses............... 173% 172%
(Loss) From Operations........... (120)% (114)%
Other Income (Expense)........... (45)% 249%
Net Income (Loss)................ (165)% 135%
3
NINE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED TO NINE MONTHS ENDED
SEPTEMBER 30, 2005
Revenues are derived from product sales and product support services. For the
nine months ending September 30, 2006, revenues were $1,549,800, compared to
$1,417,700 for the same period in 2005. The 9% increase in revenues results from
an increase in the number of zNose(R) units shipped from 37 during the nine
month period ending September 30, 2005 to 42 units for the same period in 2006.
Product support revenues for the nine month ending September 30, 2006 were
approximately the same as that in 2005 over the same period.
Cost of Sales consist of product costs and expenses associated with product
support services. For the nine months ending September 30, 2006, cost of sales
was $731,500, compared to $592,700 for the same period 2005. Cost of sales
increased from 42% of revenues in 2005 to 47% of revenues in 2006 due to quality
issues with some materials that required additional labor to investigate,
identify, locate and correct. There were also additional labor costs incurred to
produce the Model 4300, which is in the initial stages of production. The Model
4300 was introduced to market in June 2006.
Gross profit was $818,300 for the nine months ending September 30, 2006,
compared to $825,000 for the same period in 2005. Gross profit as a percentage
of revenues decreased from 58% in 2005 to 53% for the reasons noted in the Cost
of Sales discussion above. Margins, however, are expected to recover as the
vendor based quality issues have been resolved and through manufacturing and
learning curve efficiencies which are expected to result as production of the
Model 4300 increases.
Research and Development costs for the nine months ending September 30, 2006
were $616,600 versus $618,500 for the same period in 2005. Increased engineering
staffing resulted in personnel related expenses being approximately $55,000
greater than in 2005. The increased in staffing reduced the need to out-source
certain engineering tasks which resulted in a reduction of approximately $73,000
for external engineering support services. Additionally, there was also a slight
decrease in engineering overhead expenses of approximately $18,000.
Selling, General and Administrative expenses for the nine months ending
September 30, 2006 were $2,060,900, compared to $1,825,000 for the same period
in 2005. The $235,900 increase was due to the hiring of new employees
necessitated by the growth of the business, expanded marketing activities,
offset by a reduction in legal and related expenses incurred in connection with
the company's reverse merger and IPO in 2005.
Interest expense for the nine months ending September 30, 2006 was $2,105,500,
as compared to $54,700 for the same period in 2005. The increase in interest
expense is primarily due to the amortization of debt discount and stated
interest associated with our convertible debentures, which were issued in
December 2005.
Other income-derivatives primarily consist of the decrease in the fair value of
derivative liabilities between the measurement dates. The increase in other
income for the nine month period ending September 30, 2006, as compared to the
prior period, is primarily attributable to a decrease in the quoted price of our
common stock. Please refer to Note 5 of our accompanying financial statements
for further explanation of the origin and nature of such income. We are unable
to determine whether we will record further decreases in the fair value of
derivative liabilities in the foreseeable future, which would be recorded as
other income-derivatives. Such decreases would be generally triggered by a
decrease in the fair value of our stock price, upon satisfaction of liquidated
damages pursuant to registration rights, or, possibly, upon satisfaction of our
convertible debentures.
Other expense-derivatives primarily consist of the recognition of derivative
liabilities we issued during the three-month period ended March 31, 2005. No
derivatives have been issued in 2006. Please refer to Note 5 of our accompanying
financial statements for further explanation of the origin and nature of such
expenses. We believe that we will incur additional expenses associated with the
fair value at issuance of financial instruments which will be recorded pursuant
to derivative accounting. However, we are unable to determine the expected
amount we would
4
recognize pursuant to such issuances since their fair value is computed based on
a number of assumptions, including, among others, the fair value of our stock
price, expected term and exercise price of the financial instrument and expected
volatility of our stock price, which will only be known at the date of issuance.
LIQUIDITY AND CAPITAL RESOURCES
For the nine months ending September 30, 2006, net cash used by the Company for
operating activities were $2,355,525 and $2,247,767 for 2006 and 2005
respectively. Cash used for the nine months ending September 30, 2006 was
comprised of the net loss for the period of $2,552,763, plus net non-cash items
(including depreciation and amortization expenses of $29,836, issuance of common
shares for services of $21,000, amortization of debt discount of $1,750,000,
amortization of deferred financing costs of $136,160, less decrease in fair
value of derivative liability of $1,411,430) of $525,566 minus the net change in
operating assets and liabilities of $328,328. Cash used in operations during the
same nine months of 2005 was comprised of the net income for the period of
$1,908,891, less net non-cash expenses (including depreciation and amortization
expenses of $11,430, recognition of derivative liabilities of $2,205,642, less
decrease in fair value of derivative liability of $5,778,250) of $3,561,178, and
less the net change in operating assets and liabilities of $595,480.
Investing activities provided cash of $544,621 in the first nine months of 2006
and used $991,325 during the same period in 2005. Cash of $124,057 in 2006, and
$108,954 in 2005 were used to purchase capital equipment. In 2005, $30,280 was
received from the sales of property and equipment, and $912,651 was used for
collateral on the company's credit line. Whereas in 2006, $668,678 was provided
through a reduction in the amount of collateral required for the company's
reduced line of credit.
There were no financing activities for the first nine months of 2006. In 2005,
financing activities provided $3,432,708 from the issuance of common stock for
$3,811,708, less decrease in the line of credit for $269,000 and repayment of
partners' loans for $110,000.
On September 30, 2006 the Company's cash (including cash equivalents) was
$2,409,017, compared to $220,047 on September 30, 2005. The Company had a
working deficit on September 30, 2006 of $519,436. The working deficit includes
$4,359,649 for derivative liabilities - excluding this amount from current
liabilities; the Company's working capital would be $3,840,213. The Company's
working deficit at September 30, 2005 was $212,423 - excluding derivative
liabilities; working capital would be $26,677.
The Company has a credit facility in place with East West Bank for $500,000. No
amounts were due under this line of credit at September 30, 2006. The line of
credit expires on March 31, 2007.
Although the Company possesses a bank operating line of credit, there can be no
assurance that these proceeds will be adequate for our long-term future capital
needs. There can be no assurance that any required or desired financing will be
available through any other bank borrowings, debt, or equity offerings, or
otherwise, on acceptable terms. If future financing requirements are satisfied
through the issuance of equity securities, investors may experience significant
dilution in the net book value per share of common stock and there is no
guarantee that a market will exist for the sale of the Company's shares.
The Company's primary capital needs are to fund its growth strategy, which
includes creating a sales and marketing staff for the marketing, advertising and
selling of the zNose(R) family of chemical detection products, increasing
distribution channels both in U.S. and foreign countries, introducing new
products, improving existing product lines and development of a strong corporate
infrastructure.
SEASONALITY AND QUARTERLY RESULTS
We do not foresee any seasonality to our revenues or our results of operations.
5
INFLATION
Although we currently use a limited number of sources for most of the supplies
and services that we use in the manufacturing of our vapor detection and
analysis technology, our raw materials and finished products are sourced from
cost-competitive industries. While prices for our raw materials may vary
significantly based on market trends, we do not foresee any material
inflationary trends for our product sources.
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any off-balance sheet arrangements.
ITEM 3. CONTROLS AND PROCEDURES
We have carried out an evaluation, under the supervision and with the
participation of our management, including our President and Chief Executive
Officer and our Treasurer and Chief Financial Officer, on the effectiveness of
the design and operation of our disclosure controls and procedures as of
September 30, 2006 pursuant to Exchange Act Rule 13a-15(b). Based upon that
evaluation, our President and Chief Executive Officer and our Treasurer and
Chief Financial Officer concluded that our disclosure controls and procedures
are effective to ensure that information required to be disclosed by us in the
reports that we file or submit under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in the Securities and
Exchange Commission's rules and forms.
6
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are not a party to any pending material legal proceedings and are not aware
of any threatened or contemplated proceeding by any governmental authority
against us.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
We did not sell any unregistered equity securities or repurchase any of our
equity securities during the three months ended September 30, 2006.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
During the three months ended September 30, 2006, there were no material
defaults upon senior securities, other than those related to the convertible
debentures and warrants that we issued on December 7, 2005 that were disclosed
under this Item in our quarterly report on Form 10-QSB for the period ended
June 30, 2006. On September 7, 2006, we entered into a Forbearance and Amendment
Agreement relating to such defaults, as more fully described in the current
report on Form 8-K that we filed with the Securities and Exchange Commission on
September 8, 2006.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to the vote of security holders during the three
months ended September 30, 2006.
ITEM 5. OTHER INFORMATION
There is no other information to report.
ITEM 6. EXHIBITS
Exhibit No. Description
----------- -------------------------------------------------------------------
31.1 Certification of Chief Executive Officer Pursuant to Section 302
of the Sarbanes-Oxley Act.
31.2 Certification of Principal Financial and Accounting Officer
Pursuant to Section 302 of the Sarbanes-Oxley Act.
32.1 Certification of Chief Executive Officer Pursuant to Section 906
of the Sarbanes-Oxley Act.
32.2 Certification of Principal Financial and Accounting Officer
Pursuant to Section 906 of the Sarbanes-Oxley Act.
99.1 Risk Factors.
7
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
ELECTRONIC SENSOR TECHNOLOGY, INC.
Dated: November 3, 2006 By: /s/ Teong C. Lim
--------------------------------
Name: Teong C. Lim
Title: Chief Executive Officer
(Principal Executive Officer)
Dated: November 3, 2006 By: /s/ Philip Yee
--------------------------------
Name: Philip Yee
Title: Secretary, Treasurer and
Chief Financial Officer
(Principal Financial and
Accounting Officer)