Research Frontiers Incorporated — Q3 2018 Form 10-Q Summary
Business context and reporting period
Research Frontiers develops and licenses suspended particle device technology that controls the flow of light. Applications include automotive, architectural, aerospace, marine and consumer products. The company operates as a single business segment and primarily earns licensing fee and royalty income.
This unaudited report covers the three and nine months ended September 30, 2018, compared with the corresponding 2017 periods. The company had 27,662,211 common shares outstanding as of November 8, 2018.
Financial performance and condition
| Metric | Three months ended September 30, 2018 | Three months ended September 30, 2017 | Nine months ended September 30, 2018 | Nine months ended September 30, 2017 |
|---|---|---|---|---|
| Fee income | $359,725 | $488,336 | $1,117,849 | $1,229,631 |
| Operating expenses | $572,968 | $607,291 | $2,228,757 | $2,380,328 |
| Research and development | $190,647 | $185,296 | $660,086 | $598,638 |
| Operating loss | $(403,890) | $(304,251) | $(1,770,994) | $(1,749,335) |
| Net loss | $(688,301) | $(303,138) | $(2,051,960) | $(1,745,505) |
| Basic and diluted loss per share | $(0.03) | $(0.01) | $(0.08) | $(0.07) |
Reported operating margins were negative because fee income was substantially below total operating and research costs. The filing does not present a separate gross margin because the company reports licensing fee income and operating expenses rather than product cost of revenue.
- Net cash used in operating activities was $1,636,821 for the first nine months of 2018, compared with $1,020,520 in the prior-year period.
- Investing cash usage was $11,295, compared with $1,516,971 of investing cash provided in 2017, which included $1,523,333 from the sale of an investment.
- Financing activities provided $3,311,111, including proceeds from common stock and warrant issuances and warrant exercises.
- Cash and cash equivalents increased to $3,400,842 at September 30, 2018 from $1,737,847 at December 31, 2017.
- Working capital was $3,848,455, and shareholders’ equity was $3,730,477 at September 30, 2018.
- The company had no conventional debt reported at September 30, 2018. A $510,001 warrant liability was recorded as a current liability.
Material changes versus the prior comparable period
- Third-quarter fee income decreased $128,611, or approximately 26%, year over year. Nine-month fee income decreased $111,782, or approximately 9%.
- Management stated that ASC 606 reduced reported third-quarter revenue by $74,352 and nine-month revenue by $69,900 compared with the prior revenue recognition guidance. On the prior basis, third-quarter fee income would have been $434,050 and nine-month fee income $1,187,749.
- Third-quarter operating expenses declined $34,323, while nine-month operating expenses declined $151,571. Research and development increased $5,351 in the quarter and $61,448 for the nine-month period.
- The nine-month operating loss widened modestly despite lower operating expenses because of lower fee income and higher research and development spending.
- The third quarter included a $286,631 non-cash warrant market adjustment, substantially increasing the quarterly net loss. Excluding the accounting effect of ASC 606 and using the prior revenue standard, management estimated third-quarter net loss at $613,977 versus the reported $688,301.
- The company adopted ASC 606 on January 1, 2018 using the modified retrospective method. The adoption reduced opening accumulated deficit and increased opening royalties receivable by $58,021.
Guidance, outlook, risks and unusual items
- Management expects existing working capital to fund at least 18–24 months of operations as of the filing date.
- Projected quarterly cash-flow shortfall for the next 12 months is approximately $350,000 to $550,000, depending partly on planned hiring. Management may reduce operating expenses if necessary.
- The company has not generated sufficient license revenue to fund operations and remains dependent on cash balances, financing and commercialization by licensees.
- Future royalty income depends heavily on automotive adoption, vehicle production volumes, take rates, product pricing, exchange rates and the inclusion of SPD technology as standard or optional equipment.
- Six license agreements were in their initial multiyear terms at September 30, 2018, with remaining performance-obligation revenue of $386,113. Management expects annual renewals but provided no assurance that the agreements will renew.
- Four licensees each accounted for at least 10% of nine-month fee income, representing approximately 33%, 14%, 13% and 10%, respectively, creating customer concentration risk.
- The company raised approximately $3.25 million through equity-related transactions during the first nine months, including a $1.25 million convertible loan that converted into 1,388,893 shares and warrants, and a $2 million offering led by Gauzy Ltd.
- Warrants issued in connection with the 2018 financing were accounted for as a Level 3 liability. Changes in estimated fair value affect earnings and may cause volatility.
- Management reported that internal control over financial reporting was not effective because of a material weakness in accounting for warrants issued in a registered common-stock offering.
- The company has incurred operating losses since inception and maintains a full valuation allowance against deferred tax assets.
Important facts for investors to verify
- Whether licensee commercialization, particularly in automotive applications, produces sustained royalty growth sufficient to reduce the operating cash deficit.
- The timing and likelihood of renewal of the six multiyear license agreements and the realization of the disclosed $386,113 of remaining performance-obligation revenue.
- The company’s ability to maintain at least 18–24 months of liquidity given the stated quarterly cash shortfall of $350,000 to $550,000.
- The potential dilution from outstanding warrants and the future earnings impact of revaluing the $510,001 warrant liability.
- Progress in remediating the material weakness in warrant accounting and whether additional control deficiencies are identified.
- The comparability of 2018 and 2017 revenue and earnings because 2018 uses ASC 606 while prior periods were not recast.