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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the quarterly period ended MARCH 31, 2008
or
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
For the transition period from _______________ to _______________
Commission file number 000-51859
ELECTRONIC SENSOR TECHNOLOGY, INC.
(Exact name of registrant 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)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 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 [X] No [ ]
Indicate by check mark whether the registrant is a large accelerated filer,
an accelerated filer, a non-accelerated filer, or a smaller reporting company.
See the definitions of "large accelerated filer," "accelerated filer" and
"smaller reporting company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer [ ] Accelerated filer [ ]
Non-accelerated filer [ ] Smaller reporting company [X]
(Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
155,853,383 shares of common stock as of May 1, 2008
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Certain statements in this quarterly report on Form 10-Q, including those
relating to the company's plans regarding business and product development;
product sales and distribution; market demands and developments in the homeland
security, analytical instrumentation/quality control and environmental
monitoring markets; and the sufficiency of the company's resources to satisfy
operation cash requirements are forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. These forward-looking statements
may contain the words "believe," "anticipate," "expect," "predict," "estimate,"
"project," "will be," "will continue," "will likely result," or other similar
words and phrases. Risks and uncertainties exist that may cause results to
differ materially from those set forth in these forward-looking statements.
Factors that could cause the anticipated results to differ from those described
in the forward-looking statements include: risks related to changes in
technology, our dependence on key personnel, our ability to protect our
intellectual property rights, emergence of future competitors, changes in our
largest customer's business and government regulation of homeland security
companies. The forward-looking statements speak only as of the date they are
made. We do not undertake to update forward-looking statements to reflect
circumstances or events that occur after the date the forward-looking statements
are made.
PART I.
FINANCIAL INFORMATION
Item 1. Financial Statements.
INDEX TO FINANCIAL STATEMENTS
Consolidated Balance Sheet (Unaudited) as of March 31, 2008 F-1
Consolidated Statements of Operations (Unaudited) for the Three
Months Ended March 31, 2008 and 2007 F-2
Consolidated Statements of Cash Flows (Unaudited) for the Three
Months Ended March 31, 2008 and 2007 F-3
Notes to Consolidated Financial Statements (unaudited) F-4
1
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEET
(Unaudited)
ASSETS March 31, December 31,
2008 2007
-------------- --------------
CURRENT ASSETS:
Cash and cash equivalents $ 2,051,495 $ 248,587
Certificate of deposit-restricted 12,384 12,384
Accounts receivable, net 221,636 281,400
Prepaid expenses 92,170 80,761
Inventories 752,014 818,989
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TOTAL CURRENT ASSETS 3,129,699 1,442,121
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DEFERRED FINANCING COSTS, net - 347,967
PROPERTY AND EQUIPMENT, net 151,963 174,111
SECURITY DEPOSITS 12,817 12,817
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$ 3,294,479 $ 1,977,016
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LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Accounts payable and accrued expenses $ 514,938 $ 520,685
Deferred revenues 29,167 41,667
Derivative liabilities - 2,376,543
Convertible debentures - current portion - 2,333,333
Obligation under capital lease due within one year 18,390 17,875
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TOTAL CURRENT LIABILITIES 562,495 5,290,103
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CONVERTIBLE DEBENTURES - long-term portion, net of 1,942,482 2,527,777
unamortized discount
LONG-TERM OBLIGATION UNDER CAPITAL LEASE 31,812 36,607
-------------- --------------
TOTAL LIABILITIES 2,536,789 7,854,487
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STOCKHOLDERS' EQUITY
Preferred stock, $.001 par value 50,000,000
shares authorized, none issued and outstanding - -
Common stock, $.001 par value 200,000,000 shares
authorized, 145,453,385 issued and outstanding,
and 10,400,000 shares to be issued at March 31, 2008,
and 56,756,098 issued and outstanding at
December 31, 2007 155,854 56,756
Additional paid-in capital 15,124,511 8,939,562
Accumlated deficit (14,522,675) (14,873,789)
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TOTAL STOCKHOLDERS' EQUITY 757,690 (5,877,471)
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$ 3,294,479 $ 1,977,016
============== ==============
See unaudited notes to consolidated financial statements
F-1
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended
March 31,
--------------------------------
2008 2007
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REVENUES $ 393,533 $ 477,275
COST OF SALES 228,140 253,843
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GROSS PROFIT 165,393 223,432
OPERATING EXPENSES:
Research and development 177,323 218,787
Selling, general and administrative 487,762 777,458
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TOTAL OPERATING EXPENSES 665,085 996,245
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LOSS FROM OPERATIONS (499,692) (772,813)
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OTHER INCOME (EXPENSE)
Other income (expense) - derivative 323,210 127,030
Other income (expense) - 1,854
Gain on extinguishment of debt 1,261,864 -
Interest (expense) (734,269) (709,499)
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TOTAL OTHER INCOME (EXPENSE) 850,805 (580,615)
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NET INCOME (LOSS) $ 351,113 $ (1,353,428)
============== ==============
Earnings (loss) per share, basic $ 0.01 $ (0.02)
============== ==============
Weighted average number of shares, basic 61,579,041 54,173,745
============== ==============
Loss per share, diluted $ 0.00 $ (0.03)
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Weighted average number of shares, diluted 63,387,932 54,173,745
============== ==============
See unaudited notes to consolidated financial statements
F-2
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three Months Ended
March 31,
--------------------------------
2008 2007
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CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 351,113 $ (1,353,428)
Adjustments to reconcile net loss to net
cash provided by (used in) operating activities:
Depreciation and amortization 13,112 13,385
Decrease in allowance for doubtful accounts - (7,996)
Issuance of shares for payment of interest 280,000 -
Stock based compensation 13,101 54,409
Amortization of debt discount 583,428 583,334
Amortization of deferred financing costs 45,387 45,386
Gain on extinguishment of debt (1,261,864) -
Decrease in fair value of derivative liability (323,210) (118,280)
Changes in assets and liabilities:
Accounts receivable 59,765 84,674
Inventories 66,975 7,847
Prepaid expenses (11,410) 4,483
Accounts payable and accrued expenses (5,745) 209,576
Deferred revenues (12,500) (12,500)
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Net cash provided by (used in) operating activities (201,848) (489,110)
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CASH FLOWS FROM INVESTING ACTIVITIES:
Increase in certificate of deposit - (10,385)
Proceeds from sale of property and equipment 9,036 -
Purchase of property and equipment - (2,967)
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Net cash provided by (used in) investing activities 9,036 (13,352)
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CASH FLOWS FROM FINANCING ACTIVITIES:
Decrease in capital lease obligation (4,280) -
Proceeds from issuance of 9% convertible debentures 2,000,000 -
Proceeds from issuance of equity 3,500,000 -
Repayment of 8% convertible debentures (3,500,000) -
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Net cash provided by financing activities 1,995,720 -
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NET INCREASE (DECREASE) IN CASH 1,802,908 (502,462)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 248,587 1,094,141
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CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 2,051,495 $ 591,679
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SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the period for interest $ 1,817 $ 140,000
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NONCASH FINANCING AND INVESTING ACTIVITY:
Reclassification of derivative liability to
paid-in-capital $ 2,053,333 $ -
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Conversion of 8% convertible debentures into equity $ 500,000 $ -
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Debt discount related to 9% convertible debentures $ 57,613 $ -
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See unaudited notes to consolidated financial statements.
F-3
ELECTRONIC SENSOR TECHNOLOGY, INC.
Notes to Financial Statements
(Unaudited)
March 31, 2008
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-Q and
Item 10 of Regulation S-K. 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,
2007, included in the Annual Report filed on Form 10-KSB for the year then
ended.
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 March
31, 2008, and the results of operations and cash flows for the three month
period ending March 31, 2008 have been included. The results of operations
for the three month period ended March 31, 2008 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, 2007.
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.
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.
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) Certificate of Deposit - Restricted
The Company's credit card liability is secured and collateralized with
a certificate of deposit in the amount of approximately $12,000.
d) Allowance for Doubtful Accounts
The allowance for doubtful accounts is based on the Company's
assessment of the collectibility 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
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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.
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 8% 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. On March 31, 2008, $3.5 million of the
$7.0 million 8% convertible debentures was retired and the remaining
$3.5 million was converted into equity. As such, the unamortized
deferred financing costs related to the 8% convertible debentures were
written off.
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
3
instruments. The fair value of the 9% convertible debentures issued by
the Company on March 28, 2008 amounts to $2,000,000, 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 March 31, 2008
no assets were impaired.
n) Capital Lease
On June 28, 2007, the Company entered into a capital lease under which
the present value of the minimum lease payments amounted to $59,200.
The present value of the minimum lease payments was calculated using a
discount rate of 11.41%. The principal balance of the capital lease
obligation amounted to approximately $50,200 at March 31, 2008,
including approximately $18,400 in the current portion of capital
lease obligations in the accompanying consolidated balance sheet.
o) Derivative Liabilities
The Company accounts for its 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". In
December 2006, FASB issued FASB Staff Position No. EITF 00-19-2
"Accounting for Registration Payment Arrangements" ("FSP 00-19-2"),
which superseded EITF 05-04. FSP 00-19-2 provides that the contingent
obligation to make future payments or otherwise transfer consideration
under a registration payment arrangement, should be separately
recognized and measured in accordance with FASB Statement No.5,
"Accounting for Contingencies". The registration statement payment
arrangement should be recognized and measured as a separate unit of
account from the financial instrument(s) subject to that arrangement.
If the transfer of consideration under a registration payment
arrangement is probable and can be reasonably estimated at inception,
such contingent liability is included in the allocation of proceeds
from the related financing instrument. Pursuant to EITF 05-04, View C,
the liquidated damages paid 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. FSP00-19-2 did not have an impact on the Company's
accounting of the liquidated damages.
The Company had registered, as of March 31, 2008, all shares
underlying the 8% convertible debentures as well as all shares
underlying the warrants related to the 8% convertible debentures.
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
4
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.
p) 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 by dividing income available to stockholders, adjusted for
interest savings on the convertible debenture and changes in income or
loss associated with the derivative contract that would result if the
contract had been recorded as an equity instrument for accounting
purposes during the period, by the weighted average number of common
shares outstanding during the period plus the net effect of stock
options and warrants, effect of the convertible debentures, and
embedded conversion features.
The outstanding options, warrants and shares equivalent issuable
pursuant to embedded conversion features and warrants at March 31,
2007 are excluded from the loss per share computation for that period
due to their antidilutive effect.
The following sets forth the computation of basic and diluted earnings
per share at March 31:
2008 2007
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Numerator:
Net income (loss) $ 351,113 $ (1,353,428)
Net other (income)/expense associated with
derivative contracts (323,210) (127,030)
Interest expense in convertible debentures 1,081 -
-------------- --------------
Net income (loss) for diluted earnings per share
purposes $ 28,984 $ (1,480,458)
============== ==============
Denominator:
Denominator for basic earnings per share-
Weighted average shares outstanding 61,579,041 54,173,745
Effect of dilutive stock options and warrants,
determined under the treasury stock method - -
Assume issued common shares for convertible
debentures, determined under the if-converted
method 1,808,891 -
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Denominator for diluted earnings per share-
Weighted average shares outstanding 63,387,932 54,173,745
============== ==============
Basic earnings (loss) per share $ 0.01 $ (0.02)
============== ==============
Diluted earnings (loss) per share $ 0.00 $ (0.03)
============== ==============
q) Stock Based Compensation
The Company adopted SFAS No. 123R, "Share Based Payments." SFAS No.
123R requires companies to expense the value of employee stock options
and similar awards and applies to all outstanding and vested
stock-based awards.
In computing the impact, the fair value of each option is estimated on
the date of grant based on the Black-Scholes options-pricing model
utilizing certain assumptions for a risk free interest rate;
volatility; and expected remaining lives of the awards. The
assumptions used in calculating the fair value of share-based payment
awards represent management's best estimates, but these estimates
involve inherent uncertainties and the application of management
judgment. As a result, if factors change and the Company uses
different assumptions, the Company's stock-based compensation
5
expense could be materially different in the future. In addition, the
Company is required to estimate the expected forfeiture rate and only
recognize expense for those shares expected to vest. In estimating the
Company's forfeiture rate, the Company analyzed its historical
forfeiture rate, the remaining lives of unvested options, and the
amount of vested options as a percentage of total options outstanding.
If the Company's actual forfeiture rate is materially different from
its estimate, or if the Company reevaluates the forfeiture rate in the
future, the stock-based compensation expense could be significantly
different from what we have recorded in the current period. The impact
of applying SFAS No. 123R approximated $13,100 in additional
compensation expense during the period ended March 31, 2008. Such
amount is included in general and administrative expenses on the
statement of operations.
r) Recently Issued Accounting Pronouncements
SFAS No. 159
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option
for Financial Assets and Financial Liabilities -- including an
amendment of FAS 115 ("SFAS No. 159"). SFAS No. 159 allows companies
to choose, at specified election dates, to measure eligible financial
assets and liabilities at fair value that are not otherwise required
to be measured at fair value. Unrealized gains and losses shall be
reported on items for which the fair value option has been elected in
earnings at each subsequent reporting date. SFAS No. 159 also
establishes presentation and disclosure requirements. SFAS No. 159 is
effective for fiscal years beginning after November 15, 2007 and will
be applied prospectively. The Company is currently evaluating the
impact of adopting SFAS No. 159 on our consolidated financial
position, results of operations and cash flows.
FASB Statement Number 141 (revised 2007)
In December 2007, the FASB issued FASB Statement No. 141 (revised
2007), Business Combinations. This Statement replaces FASB Statement
No. 141, Business Combinations. This Statement retains the fundamental
requirements in Statement 141 that the acquisition method of
accounting (which Statement 141 called the purchase method) be used
for all business combinations and for an acquirer to be identified for
each business combination. This Statement defines the acquirer as the
entity that obtains control of one or more businesses in the business
combination and establishes the acquisition date as the date that the
acquirer achieves control. This Statement's scope is broader than that
of Statement 141, which applied only to business combinations in which
control was obtained by transferring consideration. By applying the
same method of accounting--the acquisition method--to all transactions
and other events in which one entity obtains control over one or more
other businesses, this Statement improves the comparability of the
information about business combinations provided in financial reports.
This Statement requires an acquirer to recognize the assets acquired,
the liabilities assumed, and any noncontrolling interest in the
acquiree at the acquisition date, measured at their fair values as of
that date, with limited exceptions specified in the Statement. That
replaces Statement 141's cost-allocation process, which required the
cost of an acquisition to be allocated to the individual assets
acquired and liabilities assumed based on their estimated fair values.
This Statement applies to all transactions or other events in which an
entity (the acquirer) obtains control of one or more businesses (the
acquirer), including those sometimes referred to as "true mergers" or
"mergers of equals" and combinations achieved without the transfer of
consideration, for example, by contract alone or through the lapse of
minority veto rights. This Statement applies to all business entities,
including mutual entities that previously used the
pooling-of-interests method of accounting for some business
combinations. It does not apply to: (a) The formation of a joint
venture, (b) The acquisition of an asset or a group of assets that
does not constitute a business, (c) A combination between entities or
businesses under common control, (d) A
6
combination between not-for-profit organizations or the acquisition of
a for-profit business by a not-for-profit organization.
This Statement applies prospectively to business combinations for
which the acquisition date is on or after the beginning of the first
annual reporting period beginning on or after December 15, 2008. An
entity may not apply it before that date. Management believes this
Statement will have no impact on the financial statements of the
Company once adopted.
FASB Statement Number 160
In December 2007, the FASB issued FASB Statement No. 160 -
Noncontrolling Interests in Consolidated Financial Statements - an
amendment of ARB No. 51. This Statement applies to all entities that
prepare consolidated financial statements, except not-for-profit
organizations, but will affect only those entities that have an
outstanding noncontrolling interest in one or more subsidiaries or
that deconsolidate a subsidiary. Not-for-profit organizations should
continue to apply the guidance in Accounting Research Bulletin No. 51,
Consolidated Financial Statements, before the amendments made by this
Statement, and any other applicable standards, until the Board issues
interpretative guidance.
This Statement amends ARB 51 to establish accounting and reporting
standards for the noncontrolling interest in a subsidiary and for the
deconsolidation of a subsidiary. It clarifies that a noncontrolling
interest in a subsidiary is an ownership interest in the consolidated
entity that should be reported as equity in the consolidated financial
statements. Before this Statement was issued, limited guidance existed
for reporting noncontrolling interests. As a result, considerable
diversity in practice existed. So-called minority interests were
reported in the consolidated statement of financial position as
liabilities or in the mezzanine section between liabilities and
equity. This Statement improves comparability by eliminating that
diversity.
A noncontrolling interest, sometimes called a minority interest, is
the portion of equity in a subsidiary not attributable, directly or
indirectly, to a parent. The objective of this Statement is to improve
the relevance, comparability, and transparency of the financial
information that a reporting entity provides in its consolidated
financial statements by establishing accounting and reporting
standards that require: (a) The ownership interests in subsidiaries
held by parties other than the parent be clearly identified, labeled,
and presented in the consolidated statement of financial position
within equity, but separate from the parent's equity, (b) The amount
of consolidated net income attributable to the parent and to the
noncontrolling interest be clearly identified and presented on the
face of the consolidated statement of income, (c) Changes in a
parent's ownership interest while the parent retains its controlling
financial interest in its subsidiary be accounted for consistently. A
parent's ownership interest in a subsidiary changes if the parent
purchases additional ownership interests in its subsidiary or if the
parent sells some of its ownership interests in its subsidiary. It
also changes if the subsidiary reacquires some of its ownership
interests or the subsidiary issues additional ownership interests. All
of those transactions are economically similar, and this Statement
requires that they be accounted for similarly, as equity transactions,
(d) When a subsidiary is deconsolidated, any retained noncontrolling
equity investment in the former subsidiary be initially measured at
fair value. The gain or loss on the deconsolidation of the subsidiary
is measured using the fair value of any noncontrolling equity
investment rather than the carrying amount of that retained
investment, (e) Entities provide sufficient disclosures that clearly
identify and distinguish between the interests of the parent and the
interests of the noncontrolling owners.
This Statement is effective for fiscal years, and interim periods
within those fiscal years, beginning on or after December 15, 2008
(that is, January 1, 2009, for entities with calendar year-ends).
Earlier adoption is prohibited. This Statement shall be applied
prospectively as of the beginning of the fiscal year in which this
Statement is initially applied, except for the presentation and
disclosure requirements. The presentation and disclosure requirements
shall be applied
7
retrospectively for all periods presented. Management believes this
Statement will have no impact on the financial statements of the
Company once adopted.
FASB 161 - Disclosures about Derivative Instruments and Hedging
Activities
In March 2008, the FASB issued FASB Statement No. 161, which amends
and expands the disclosure requirements of FASB Statement No. 133 with
the intent to provide users of financial statements with an enhanced
understanding of; how and why an entity uses derivative instruments,
how the derivative instruments and the related hedged items are
accounted for and how the related hedged items affect an entity's
financial position, performance and cash flows. This Statement is
effective for financial statements for fiscal years and interim
periods beginning after November 15, 2008. Management believes this
Statement will have no impact on the financial statements of the
Company once adopted.
4) Convertible debentures
8% Convertible Debentures
During December 2005, we issued in a private offering, $7,000,000 aggregate
principal amount of 8% 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 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 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.
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.
We paid professional fees of approximately $592,000 and issued 485,213
warrants with a fair value of approximately $136,000 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.
A First Amendment Agreement was entered into with the holders of the
convertible debentures on December 27, 2007. Pursuant to the agreement, the
convertible debentures holders agreed to extend the initial principal
payment date on the convertible debentures from January 1, 2008 to April 1,
2008.
A Conversion and Termination Agreement was entered into with the debentures
holders on February 26, 2008. Pursuant to the agreement, the convertible
debentures holders agreed that in exchange for $3,500,000, the debenture
holders would convert $3,500,000 of the principal amount of their 8%
convertible debentures, together with accrued interest thereon, at a
conversion price of $0.35 per share of Common Stock. Upon receipt of the
foregoing sum and the conversion shares of Common Stock, the debenture
holders agreed to cancel the remainder of their 8% convertible debentures
and 50% of the shares of Common Stock underlying warrants. With respect to
the remaining 6,065,157 shares of Common Stock underlying the warrants,
they will otherwise continue in full force and effect in accordance with
their terms. On March 31, 2008, we remitted $3,500,000 in cash and
processed for transfer 10,400,000 shares of common stock to the debenture
holders to completely retire the 8% convertible debentures.
The extinguishment of the convertible debentures resulted in a gain of
approximately $1,261,900, which included the write off of related
unamortized deferred financing costs of approximately $302,600.
8
9% Convertible Debentures
On March 28, 2008, we received $5,500,000 from an investor, $3,500,000 of
which was for Common Stock of the Company, and $2,000,000 for a convertible
debenture bearing an interest rate of 9%, payable semi-annually in cash.
The common stock shares were issued at a price of $0.0405 per share. The 9%
convertible debenture has a five (5)-year term, and the conversion rate of
the debenture is $0.0486. The difference between the conversion rate of the
debenture and the closing price of the Company's common stock on the date
of issuance resulted in a note discount of approximately $58,000. The note
discount will be amortized over the term of the convertible debenture.
A condition of the new investment required the Company to use $3,500,000 to
extinguish the 8% convertible debentures and this event occurred on March
31, 2008.
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. Such
warrants expired in February 2008.
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 March 31, 2008 is as follows:
9
At issuance At March 30, 2008
------------------ ------------------
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 March 31, 2008
------------------ ------------------
Market price: $ 2.40 $ 0.05
Exercise price: $ 1.00 $ 1.00
Term: 3 years 0.01 years
Volatility: 39% 36%
Risk-free interest rate: 2.78% 1.79%
Number of warrants: 3,985,000 3,985,000
December 2005 Transaction
During December 2005, in connection with the issuance of the 8% 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 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.
10
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, 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 results 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). The registration statement covering the shares
underlying the convertible debentures was declared effective on November
21, 2006.
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 March 31, 2008 are as follows:
At Issuance At March 31, 2008
---------------- -----------------
Freestanding warrants $ 3,532,348 $ 0
Embedded conversion features 3,463,542 0
Liquidated damages 192,500 0
Other outstanding warrants 143,268 0
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.
11
The Company used the following assumptions to measure the identified
derivatives, using the Lattice valuation model, as follows:
Embedded conversion features
At issuance At March 31, 2008
------------------ ------------------
Market price: $ 0.4880 $ 0.05
Conversion price: $ 0.4544 $ 0.045
Term: 4 years 1.68 years
Volatility: 39% 36%
Risk-free interest rate: 4.39% 1.79%
Freestanding warrants
The derivative liability amounts to the fair value of the warrants issuable
upon exercise. We computed the fair value of this embedded derivative using
the Black Scholes valuation model with the following assumptions:
At issuance At March 31, 2008
------------------ ------------------
Market price: $ 0.488 $ 0.05
Exercise price: $ 0.4761 $ 0.43
Term: 5 years 2.68 years
Volatility: 39% 36%
Risk-free interest rate: 4.39% 1.79%
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 March 31, 2008, 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 March 31, amounted
to approximately $323,000 and $127,000, and have been recorded as other
income in 2008 and 2007, respectively.
Conversion and Termination Agreement
A Conversion and Termination Agreement was entered into with the 8%
convertible debenture holders on February 26, 2008. Pursuant to the
agreement, the convertible debenture holders agreed that in exchange for
$3,500,000, the debenture holders would convert $3,500,000 of the principal
amount of their 8% convertible debentures, together with accrued interest
thereon, at a conversion price of $0.35 per share of
12
Common Stock. Upon receipt of the foregoing sum and the conversion shares
of Common Stock, the debenture holders agreed to cancel the remainder of
their 8% convertible debentures and 50% of the shares of Common Stock
underlying warrants. With respect to the remaining 6,065,157 shares of
Common Stock underlying the warrants, they will otherwise continue in full
force and effect in accordance with their terms. On March 31, 2008, we
remitted $3,500,000 in cash and processed for transfer 10,400,000 shares of
Common Stock to the debenture holders. The extinguishment of the $7,000,000
8% convertible debentures resulted in a gain of approximately $1,261,900,
which included the write off of related unamortized deferred financing
costs of approximately $302,600.
Absent other transactions which would warrant the same accounting
treatment, the Company will discontinue the recognition of derivative
liabilities once it can assert that it has a sufficient amount of
authorized and unissued shares to settle its obligations which can be
settled in shares. As a result of the satisfaction of the Company's
obligations under its 8% convertible debentures, the Company can assert
that it has a sufficient amount of authorized and unissued shares to settle
its obligations which can be settled in shares at March 31, 2008.
Accordingly, the Company has reclassified all contracts, warrants, and
other convertible instruments outstanding at March 31, 2008 from liability
to equity. The amount of derivative liabilities that was reclassified to
equity approximated $2,053,000.
6) Stockholders' Equity
Common Stock
During the quarter, the Company elected to pay the fourth quarter 2007
interest on the 8% convertible debentures in shares of the Company's common
stock, rather than in cash. The Company issued 2,277,534 shares of the
Company's Common Stock to the holders of the 8% convertible debentures.
Additionally, a Conversion and Termination Agreement (see Note 5) was
entered into with the holders of the 8% convertible debentures whereby in
conjunction with the retirement of the debentures on March 31, 2008, the
holders were issued 10,400,000 shares of the Company's Common Stock.
On March 28, 2008, we received $5,500,000 from an investor, $3,500,000 of
which was for Common Stock of the Company, and $2,000,000 for a 9%
convertible debenture (see Note 4). The common stock shares were issued at
a price of $0.0405 per share. A total of 86,419,753 common shares were
issued to the investor.
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 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
13
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.
Management used Black Scholes methodology to determine the fair value of
the options on the date of issue based on the following assumptions. The
expected volatility was based on the average historical volatility of
comparable publicly-traded companies.
Exercise price $ 0.19 - $ 0.24
Market value $ 0.19 - $ 0.24
Expected dividend yield 0%
Expected volatility 36% - 39%
Risk free interest rate 4.03% - 4.54%
Expected life of option 5 years
The fair value of the granted stock options shares was approximately
$237,000 or $0.09 per share. Approximately $114,000 and $13,100 were
charged to compensation expense in 2007 and in the current period,
respectively. The remaining amount will be amortized to compensation
expense over future periods based on the vesting schedule of the respective
stock option shares. The total compensation cost related to nonvested
awards not yet recognized amounted to approximately $99,000 at March 31,
2008. This compensation cost will be recognized over the weighted average
period of the remaining terms of the stock options, unless the options are
terminated sooner.
14
The following tables summarize all stock option grants to employees and
non-employees as of March 31, 2008:
Weighted
Number of Average
Stock Options Options Exercise Price
--------------------------------------------------- -------------- --------------
Balance at December 31, 2006 1,219,500 $ 0.93
Granted 2,657,950 $ 0.22
Exercised - $ -
Forfeited (439,500) $ 0.73
-------------- --------------
Balance at December 31, 2007 3,437,950 $ 0.41
Granted - $ -
Exercised - $ -
Forfeited (350,000) $ 0.45
-------------- --------------
Balance at March 31, 2008 3,087,950 $ 0.40
============== ==============
Options exercisable at March 31, 2008 1,849,925 $ 0.53
============== ==============
Weighted average fair value of options granted
during 2008 - $ -
============== ==============
A summary of the status of the Company's nonvested shares as of March 31,
2008, and changes during the fiscal year then ended as presented below.
Weighted
Average Grant
Date Fair
Nonvested Shares Shares Value
----------------------------------- -------------- --------------
Nonvested at December 31, 2006 - $ -
Granted 2,657,950 $ 0.22
Vested (898,250) $ 0.09
Cancelled (161,500) $ 0.09
-------------- --------------
Nonvested at December 31, 2007 1,598,200 $ 0.09
Granted - $ -
Vested 260,175 $ 0.24
Cancelled (100,000) $ 0.24
-------------- --------------
Nonvested at March 31, 2008 1,238,025 $ 0.21
============== ==============
Options Outstanding Options Exercisable
------------------------------------------------------------- -----------------------------
Weighted
Number Average Weighted Number Weighted
Outstanding Remaining Average Exercisable Average
Exercise as of March Contractual Exercise at March 31, Exercise
Price 31, 2008 Years Price 2008 Price
------------- ------------- ------------- ------------- ------------- -------------
$ 0.19 280,750 8.92 $ 0.19 280,750 $ 0.19
$ 0.20 1,000,000 9.25 $ 0.20 100,000 $ 0.20
$ 0.24 965,700 8.83 $ 0.24 627,675 $ 0.24
$ 0.64 250,000 7.58 $ 0.64 250,000 $ 0.64
$ 1.00 591,500 6.83 $ 1.00 591,500 $ 1.00
------------- ------------- ------------- ------------- -------------
3,087,950 8.49 $ 0.40 1,849,925 $ 0.53
============= ============= ============= ============= =============
15
Item 2. Management's Discussion and Analysis or Plan of Operation.
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, 2007 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
filed with the Securities and Exchange Commission.
--------------------------------------------------------------------------------
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, analytical instrumentation/quality control, and environmental
monitoring and detection 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
continuing to expand our 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. 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.
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 March 31, 2008 no assets were impaired.
16
The Company accounts for its 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". In December 2006, FASB issued FASB Staff Position No. EITF
00-19-2 "Accounting for Registration Payment Arrangements" ("FSP 00-19-2"),
which superseded EITF 05-04. FSP 00-19-2 provides that the contingent obligation
to make future payments or otherwise transfer consideration under a registration
payment arrangement, should be separately recognized and measured in accordance
with FASB Statement No.5, "Accounting for Contingencies". The registration
statement payment arrangement should be recognized and measured as a separate
unit of account from the financial instrument(s) subject to that arrangement. If
the transfer of consideration under a registration payment arrangement is
probable and can be reasonably estimated at inception, such contingent liability
is included in the allocation of proceeds from the related financing instrument.
Pursuant to EITF 05-04, View C, the liquidated damages paid 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. FSP00-19-2 did not have an impact on the Company's accounting
of the liquidated damages.
The Company had registered, as of March 31, 2008, all shares underlying the 8%
convertible debentures as well as all shares underlying the warrants related to
the convertible debentures.
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.
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:
Three Months Ended March 31
-----------------------------
Statement of Operations Data: 2008 2007
-------------------------------- ------------ ------------
Revenues ....................... 100% 100%
Cost of Sales .................. 58% 53%
Gross Profit ................... 42% 47%
Operating Expenses ............. 169% 209%
17
(Loss) From Operations ......... (127%) (162%)
Other Income (Expense) ......... 216% (122%)
Net Income (Loss) .............. 89% (284%)
Three Months Ended March 31, 2008 Compared to Three Months Ended March 31, 2007
Revenues are derived from product sales and product support services. For the
three months ending March 31, 2008, revenues were $394,000 which was $83,000
less than first quarter 2007. A total of 11 instruments were shipped during the
quarter versus 17 for the same period in 2007. Performance was impacted by a
significant drop in business from our Chinese distributor and partially offset
by an increase in domestic business. Domestic revenues increased 151% over last
year and accounted for 77% of total revenues for the quarter. The increase in
domestic revenues provided a big boost to product support revenues which were up
100% better than 2007. Product support revenues are derived primarily from
training and after-sale support services to domestic customers. These same
services are provided to our international customers by their respective sales
representative or distributor servicing their accounts.
Cost of Sales consist of product costs and expenses associated with product
support services. For the three months ending March 31, 2008, cost of sales was
$228,000, compared to $253,800 for the same period 2007. For the period, cost of
sales, as a percentage of revenues, were 58% versus 53% in 2007. Cost of sales
for the period was negatively impacted by overhead spending and labor variances
of approximately $31,000 and $11,000, respectively, caused by a slow down in
production to reflect lower sales activities and to work-off on-hand inventory.
Excluding the impact of the variances, cost of sales for first quarter 2008
would be 47% of revenues for an improvement of 6% over last year.
Gross profit was $165,400 or 42% of sales for the three months ending March 31,
2008, compared to $223,400 or 47% of sales for the same period in 2007. The
decrease in gross margin over last year is attributed to the labor and overhead
variances written off to cost of sales as noted above. Excluding the impact of
the variances, gross margin would have been 53% for an improvement of 6% over
last year. The improvement is due to a better sales mix as our most profitable
instrument accounted for 55% of sales for the quarter. In 2007, our lowest
margin unit accounted for 60% of sales.
Research and Development costs for the three months ending March 31, 2008 were
$177,300 versus $218,800 for the same period in 2007. The $41,500 decrease in
R&D expenses is attributed a reduction of personnel expenses due to a reduction
of census ($40,500). All other 2007 expenditures were in line with 2006
expenses.
Selling, General and Administrative expenses for the three months ending March
31, 2008 were $487,800, compared to $777,500 for the same period in 2007. The
$289,700 decrease in S, G & A expenses resulted from a reduction of personnel
expenses due to reduction of census ($180,800), a reduction of outside services
expenses, primarily consulting and legal ($100,900), and operating expenses
($8,000).
Interest expense for the three months ending March 31, 2008 was $734,300, as
compared to $709,500 for the same period in 2007. Interest expense results
primarily from the amortization of debt discount and stated interest associated
with our 8% convertible debentures, which were issued in December 2005. The
increase in interest expense in 2008 over same period last year is due primarily
to a reduction of offsetting interest income earned from short-term investment
of the company's excess funds. On March 31, 2008 the 8% convertible debentures,
and related debt discount, were retired.
Other income-derivatives primarily consist of the decrease in the fair value of
derivative liabilities between the measurement dates. The increase in other
income-derivative for the three month period ending March 31, 2008, as compared
to the prior period, is primarily attributable to a decrease in the quoted price
of our common stock. On March 31, 2008, we satisfied our obligations under the
8% convertible debentures and as a result, the Company can assert that it has a
sufficient amount of authorized and unissued shares to settle its obligations
which can be settled in shares. Accordingly, the Company reclassified all
contracts, warrants, and other convertible instruments outstanding at March 31,
2008 from liability to equity (see Note 5).
18
Gain on extinguishment of debt is the gain realized from the early retirement of
the 8% convertible debentures on March 31, 2008 (see Note 4).
Liquidity and Capital Resources
For the three months ending March 31, net cash used by the Company for operating
activities were $201,848 and $489,110 for 2008 and 2007 respectively. Cash used
for the three months ending March 31, 2008 was comprised of the net income for
the period of $351,113, plus net non-cash items (including depreciation and
amortization expenses of $13,112, issuance of common shares for payment of
interest of $280,000, amortization of debt discount of $583,428, amortization of
deferred financing costs of $45,387, stock based compensation of $13,101, less
decrease in fair value of derivative liability of $323,210, gain on early
retirement of debt of $1,261,864) of $298,933 plus the net change in operating
assets and liabilities of $97,085. Cash used in operations during the same three
months of 2007 was comprised of the net loss for the period of $1,353,428, plus
net non-cash expenses (including depreciation and amortization expenses of
$13,385, stock based compensation of $54,409, amortization of debt discount of
$583,334, amortization of deferred financing costs of $45,386, less decrease in
fair value of derivative liability of $118,280, decrease in allowance for
doubtful accounts of $7,996) of $783,190, and plus the net change in operating
assets and liabilities of $294,080.
Investing activities provided cash of $9,036 in the first three months of 2008
and used cash of $13,352 during the same period in 2007. For the quarter, cash
of $9,036 was provided from the sale of machinery and equipment. In 2007, there
was an increase in our certificate of deposit of $10,385 and $2,967 was used to
purchase capital equipment.
Financing activities for the first three months of 2008 provided cash of
$1,995,720 which included $2,000,000 received from the issuance of 9%
convertible debentures to an investor, $3,500,000 from the issuance of equity to
the same investor, less $3,500,000 used to retire the 8% convertible debentures
and a decrease in capital lease obligation of $4,280. There were no financing
activities for the first three months of 2007.
On March 31, 2008 the Company's cash (including cash equivalents) was
$2,051,500, compared to $591,700 on March 31, 2007. The Company had a working
capital on March 31, 2008 of $2,567,200. The Company's working deficit at March
31, 2007 was $1,578,600 - excluding derivative liabilities; working capital
would be $1,659,600.
Seasonality and Quarterly Results
We have not experienced and do not foresee any seasonality to our revenues or
our results of operations.
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 have not experienced and 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. Quantitative and Qualitative Disclosures About Market Risk.
This Item is not applicable to smaller reporting companies.
Item 4T. Controls and Procedures.
The company's Chief Executive Officer and Chief Financial Officer, after
evaluating the effectiveness of the company's disclosure controls and procedures
(as defined in Rules 13a-15(e) under the Securities Exchange Act of
19
1934, as amended) as of the end of the period covered by this quarterly report
on Form 10-Q, have concluded that, based on such evaluation, the company's
disclosure controls and procedures were effective to ensure that material
information relating to the company is recorded, processed, summarized, and
reported in a timely matter. In designing and evaluating the disclosure controls
and procedures, the company's management recognized that any controls and
procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives, and the
company's management necessarily was required to apply its judgment in
evaluating the cost-benefit relationship of possible controls and procedures.
There were no changes in the company's internal control over financial reporting
that occurred during the period covered by this quarterly report that have
materially affected, or are reasonably likely to materially affect, the
company's internal control over financial reporting.
20
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 1A. Risk Factors.
This Item is not applicable to smaller reporting companies.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
We issued 1,464,129 shares of our common stock to Midsummer Investment, Ltd. on
January 11, 2008 and 813,405 shares of common stock to Islandia, L.P. on January
15, 2008, which issuances are more fully described in our current report on Form
8-K filed with the Securities and Exchange Commission on January 16, 2008.
On March 28, 2008, we issued 86,419,753 shares of our common stock, and a 9%
convertible debenture to Halfmoon Bay Capital Ltd. On March 31, 2008, we issued
6,685,714 shares of common stock to Midsummer and 3,714,286 shares of common
stock to Islandia. Such issuances are more fully described in our current
reports on Form 8-K filed with the Securities and Exchange Commission on
February 27, 2008 and April 3, 2008.
We did not repurchase any of our equity securities during the three months ended
March 31, 2008.
Item 3. Defaults Upon Senior Securities.
During the three months ended March 31, 2008, there were no material defaults
upon senior securities.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
Item 5. Other Information.
None.
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.
21
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.
By: /s/ Barry S. Howe
------------------------------------------------
Dated: May 15, 2008 Name: Barry S. Howe
Title: President and Chief Executive Officer
(Principal Executive Officer)
Dated: May 15, 2008 By: /s/ Philip Yee
------------------------------------------------
Name: Philip Yee
Title: Secretary, Treasurer and Chief Financial Officer
(Principal Financial and Accounting Officer)