DSS

Business Context and Reporting Period

Company: Document Security Systems, Inc. (DSS)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2010
Business Overview: DSS develops and sells anti-counterfeiting technologies for paper, plastic, and packaging. In February 2010, the Company acquired Premier Packaging Corporation to expand into the packaging market. The Company sold its Legalstore.com division in late 2009, exchanging assets for an equity investment in Internet Media Services, Inc. (IMS).

Key Financial Metrics

Note: Working Capital calculated as Current Assets ($3,366,174) minus Current Liabilities ($3,695,030). Total Debt includes Revolving line of credit ($285,705), Current portion of long-term debt ($300,000), Revolving notes from related party ($583,000), and Long-term debt ($2,101,812).

Material Changes vs. Prior Period

• Revenue Growth: Total revenue increased 23% in Q3 2010 and 22% for the nine-month period compared to 2009. This growth was driven primarily by the acquisition of Premier Packaging, which contributed $1.38 million in Q3 revenue.
• Segment Performance: While Packaging revenue grew, the legacy "Security and Commercial Printing" segment saw a 28% decline in Q3 revenue due to regional market weakness and the loss of a major commercial printing customer. "Legal Products" revenue dropped to zero as the division was sold in late 2009.
• Profitability: Gross profit decreased 9% in Q3 and 8% for the nine-month period. Gross margins compressed from 38% to 28% in Q3, attributed to the lower-margin packaging business mix and declining commercial printing sales.
• Operating Expenses: Total operating expenses decreased 13% in Q3 and 1% for the nine-month period. This was largely due to a one-time reversal of previously accrued expenses ($139,000) and reduced professional fees, offset by increased stock-based compensation ($130,000 in Q3 vs. $38,000 in 2009).
• Debt Structure: The Company incurred significant new debt to fund the Premier Packaging acquisition, including a $1.5 million term loan and a $1 million revolving credit line. As of September 30, 2010, the Company was in default on a related-party credit facility due to missed interest payments, though a waiver was obtained.

Guidance, Outlook, Risks, and Unusual Items

• Liquidity and Capital Needs: The Company reported negative working capital of approximately $329,000 and cash of $408,000. Management stated that while they have approximately $1.13 million available in credit facilities, they may need to raise additional equity or debt financing to fund operations and growth strategies.
• Unusual Items:
  • Dividend in Kind: The Board declared a dividend of 7.5 million shares of Internet Media Services (IMS) stock to be distributed to shareholders, recorded as a $229,000 dividend payable.
  • Tax Credits: The Company received $143,000 in New York State Qualified Emerging Technology Company (QETC) refundable tax credits in April 2010.
  • Equity Investment Loss: A loss of $121,393 was recognized on the equity method investment in IMS for the nine-month period.
• Legal Proceedings (ECB Litigation): The Company is engaged in ongoing patent validity and infringement litigation with the European Central Bank (ECB). The patent was deemed invalid in the UK, France, Germany, Belgium, and Austria. It remains valid in the Netherlands and Spain. A third party, Trebuchet Capital Partners, funds the litigation in exchange for a 49% interest in the patent and proceeds. The Company faces potential liability for legal fees if Trebuchet fails to meet obligations.
• Internal Controls: Management identified material weaknesses in internal controls over financial reporting, specifically regarding insufficient qualified accounting personnel and segregation of duties. Remediation costs are estimated between $200,000 and $400,000.
• Customer Concentration: Two customers accounted for 32% of consolidated revenue in the first nine months of 2010. One of these customers, representing 25% of sales, has a contract expiring in July 2011.

Investor Verification Checklist

• Debt Covenants: Verify the status of the default waiver on the related-party credit facility and compliance with covenants on the new Premier Packaging term loan.
• Customer Retention: Confirm the renewal status of the contract with the customer representing 25% of sales, which expires in July 2011.
• Legal Exposure: Monitor the outcome of the Dutch appeal regarding the ECB patent validity and the financial stability of Trebuchet Capital Partners regarding litigation funding.
• Capital Raising: Assess the Company's ability to secure additional equity financing given the negative working capital and ongoing operating losses.
• Internal Controls: Review progress on remediation of material weaknesses in financial reporting to avoid potential restatements.