DSS, Inc. (DSS) Q3 2012 Earnings Report, Transcript and Summary

Greetings and welcome to the Document Security Systems 2012 Third Quarter Financial Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Robert Fagenson, Chairman of the Board for Document Security Systems. Thank you, Mr. Fagenson. You may begin.

Thank you, and good afternoon, everyone. Welcome to the Document Security’s third quarter conference call. Objective of today’s call is to review and discuss our third quarter earnings, as well as provide you with an update on our pending merger with Lexington Technology Group, as well as key management transitions and changes of both Lexington and DSS. The webcast today will be archive in the Investor Relations section of our website. Please note that during the course of this call, we’ll be making certain forward-looking statements, including those regarding revenue opportunities, investments, initiatives and growth strategies. These statements are subject to many assumptions, risk, uncertainties and changes in circumstances. Any assumptions we offer about future performance represent a single point in time estimate. Actual results may vary materially from those expressed or implied by such statements. We expressly disclaim any obligation to revise or update any assumptions, projections or other forward-looking statements to reflect events or circumstances that may arise after the date of this conference call. For more information about risk factors that may cause actual results to differ from expectations, please see the company’s filings with the Securities and Exchange Commission. Before we get to the earnings discussion -- excuse me, I’d like to once again announce that Pat White, our CEO will retire at the end of this month and become a consultant to company beginning December 1. Bob Bzdick, our Chief Operating Officer, will become acting CEO until the completion of our pending merger with Lexington, expected in the first quarter of 2013, at which point he will remain in-charge of DSS’ traditional operations and become Executive Vice President and Chief Operating Officer of DSS. I’d like to take just a moment to acknowledge the many years of dedication and leadership of our retiring CEO, Pat White. With all the changes that DSS is undergoing, both Pat and the Board decided this was the logical time for him to step away from day-to-day management duties and assume the advisory role. We thank him for making this a seamless transition and for his ongoing support to Bob Bzdick as he assumes the leadership responsibilities of our operating divisions in preparation for our planned merger with Lexington. Concurrently, Lexington announced earlier today that Jeff Ronaldi became the CEO of Lexington, effective November 20th. Jeff, who previously was a member of Lexington's advisory board and is also designee to become a Director of the post-merged DSS, is a seasoned IP and technology executive who brings invaluable IP management skills and impeccable investment record to the company. Lexington’s current CEO, Will Rosellini, will step down and remain an advisor to Lexington’s wholly owned subsidiary, Bascom Research. Both of these moves have been made with an eye towards the long-term strategy of our soon to be merged companies, and we believe that they position DSS for optimal performance, both our traditional operations and our IP monetization efforts. We really sought with tremendous detail to find the right person for the right job, and I truly believe that we’ve achieved that solution at this time. On the call with us today are Phil Jones, Chief Financial Officer; Bob Bzdick, President and Chief Operating Officer; Jeff Ronaldi, the newly appointed CEO of Lexington; as well as Peter Hardigan, Chief Operating Officer of Lexington. At this time, I will turn the presentation over to our Chief Financial Officer, Phil Jones, to discuss and present the company’s strong performance during the third quarter of this year. Phil, over to you.

Thank you, Robert. Our third quarter financial results, which we summarized in the preliminary earnings press release we issued on October 22nd and which are provided in detail in our Form 10-Q, which we filed with the SEC last week, once again, very strong on many measurements. Continued positive momentum we have seen throughout 2012. To begin, revenues reached $4.2 million for the quarter, a growth of 15% over Q3 of 2011. Year-to-date, revenues are at $11.7 million, a 27% increase from 2011 and on pace to be our strongest year yet. Driving the revenue growth has been sales in our Packaging division, which increased 39% during the quarter, and Licensing and Digital sales, which were up 13%. Year-to-date for the first 9 months of 2012, Packaging sales are up 54%, while Licensing and Digital sales are up 27%. Just as exciting as revenue growth is the company’s gross profit performance. Gross profit for the quarter was $1.5 million, a 20% increase over Q3 of 2011. Once again, as has been the case throughout 2012, our efforts to streamline operating costs and focus our sales efforts on higher margin opportunities has paid off, especially in our Printing division. Year-to-date gross profit is up 36%. Total operating expenses increased 20% during the quarter, which was driven by a significant increase in research and development costs, including research and development costs paid by equity, which has reflected our continued focus on the development our intellectual property portfolio, as we have discussed in our previous earnings calls. In addition, the increase in the operating expense was due to a significant increase in professionals fees. During the quarter, the company incurred approximately $461,000 of fees associated with the merger agreement with Lexington Technology. In addition, stock-based compensation increased 73% from 2011 levels. Otherwise, all other operating expenses categories decreased during the quarter. In fact, when measuring performance for the quarter using adjusted EBITDA, which is earnings before interest taxes, depreciation, amortization, stock-based compensation and other non-recurring items, the third quarter 2012 would have reflected a 7% improvement over adjusted EBITDA as the prior year’s quarter. Furthermore, absent of $461,000 of merger-related costs, adjusted EBITDA would have shown an 89% improvement for the quarter and would have only been a loss of $61,000 or near break-even level. In fact, in September of 2012, the company performed at positive adjusted EBITDA level, which has been a financial milestone we have been striving for and we are very pleased to have achieved during the quarter. On a year-to-date basis, adjusted EBITDA, less the merger costs, has improved 41%. Essentially, our core operating businesses are beginning to produce the consistent financial performance we have expected, with the continued expectation that we have established a strong financial base from which the company can continue to core resources into R&D and pursue significant future growth opportunities. I remind everyone that adjusted EBITDA is a non-GAAP measure of performance, and I encourage everyone to refer to the table we included in our earnings release for a reconciliation of our GAAP net loss to adjusted EBITDA loss. Regarding net loss. Net loss for the third quarter was approximately $1.1 million, a 45% increase from the Q3 of 2011. But once again, the merger cost affected this number absent of merger costs. Net loss would have decreased by 19%. Moving on to the balance sheet. Our balance sheet as of September 30, 2012 continued to reflect the improvement in our core operating divisions that we have seen throughout 2012. Our working capital levels have improved and we have continued to reduce long-term debt. Furthermore, our balance sheet was strengthened by the $2.5 million private placement and closed in October, the proceeds of which will allow us to continue to execute the merger transaction, lower our debt levels and invest in strategic assets and research and development. To summarize, our third quarter 2012 was a very strong quarter based on 3 important measurements, the same measurements that have driven the entire year: revenue growth and gross profit growth along with core operating cost containment. With that, I’d like to turn the call over to Robert Bzdick.

Thanks, Phil. Good afternoon. First off, I’d like to provide a bit of background on myself as investors may not be familiar with me. I joined DSS in 2010 when the company acquired Premier Packaging Corporation, the company I had founded in 1989 and where I served the CEO, President and Chief Operating Officer. Prior to starting Premier, I’ve just spent several years as a bank auditor and 8 years at Boise Cascade Corporation, serving in several financial and sales management roles. As Robert indicated, I’ll serve as acting CEO for DSS until the completion of our merger with Lexington, which is expected in the first quarter of 2013. My core background is nearly 3 decades' experience of business development and manufacturing operations management, and to me, much of my success is a client-oriented sales approach, identifying unmet need and satisfying them in a low-cost environment. Since joining DSS, my focus has been the strengthening of our 4 operations divisions and becoming familiar with DSS’ clients and target markets. My goal has been to position the company to better serve its customer base of Fortune 1000 companies, as well as roll out DSS' next-generation products. For example, DSS unveiled the new customizable integrated security solution at Pack Expo in Chicago on October 28th. This is one of the largest packaging-oriented shows in the United States. The product combines DSS' proprietary anti-counterfeiting print technologies with its cloud computing platform to track and authenticate products. In the pharmaceutical space, for example, drug packages can be scanned via iPhone throughout the distribution process, from customs officers to pharmacies, to authenticate the product as well as other information, such as place of origin or intended destination. The smartphone scans variable covert print icons and compares them to a record of valid icons stored in the secured cloud database, ensuring products are not counterfeit, expired or sourced from gray markets. This software clearly demonstrates the power of integrating the resources DSS has brought together over the last several years. This combination of print and digital cloud-based products is intrical to DSS’s aggressive attempt to build on our positive sales direction and to reach profitability in 2013. This effort has been spearheaded by Phil Jones, myself and our entire DSS team. The effort has been really enhanced by means of significant investment from licenses. I look forward to working with Lexington team in bringing additional value to DSS’s stockholders. With that, it is my pleasure to introduce Lexington’s new CEO, Jeff Ronaldi, for his comments.

Thanks, Bob. I’d also like to provide a few notes from my background and why I have agreed to join Lexington at this very exciting time. In many ways, leading Lexington is a perfect opportunity to leverage the 2 phases of my career: leading technology startups and monetizing IP. Over the last 2 decades, I have realized over $160 million in returns on just $12 million in patent investments. Most recently, I was CEO of Turtle Bay Technologies, a wholly owned subsidiary of Juridica Capital. In 2012, I was behind 2 successful patent verdicts, Shelbyzyme’s $50 million verdict against Genzyme and a $20 million willful infringement verdict against Citrix Systems Inc. Previously, I managed a venture capital group within the Fortune 500 company SPX Corporation, where, among other investments, I managed the patent infringement litigation against Microsoft that resulted in a $62.3 million verdict and ultimately settled for $60 million. During the 1990s, I managed a number of technology startup and fast-growth companies. I’ve helped UUNET Technologies, which is now Verizon to go public, and was instrumental in a highly successful product development for the company. I also took a division of Concentric Network, which is now XO Communications from scratch to a 90-employee, a $150 million run rate in 18 months, ultimately taking that company public as well. I’m a strong believer in the Lexington’s DSS strategy of combining patent monetization with an operating company. This model provides unusual stability in the patent monetization space, and the opportunity to provide a steady revenue while pursuing strategic patent extortion with a significant upside potential. The high-quality of the Bascom portfolio as Lexington’s first investment was also a significant factor in my decision to take on an expanded role at the company. I’ve been monetizing patents for more than 10 years and I’ve had a lot of success. In fact, I’ve never had a losing investment. I expect this portfolio to be every bit as successful as any of the others I’ve managed. Both Lexington and DSS have high-quality intellectual property in vibrant and expanding markets, including social media, RFID technology and cloud computing. I look forward to working with the DSS team to help them become a successful product and service company as well as pursuing an IT management strategy that takes full advantage of the combining companies' robust portfolio. It’s also worth noting that with my appointment, Lexington will be headquartered in McLean, Virginia, where our subsidiary, Bascom Research, is already based, and the venue for our key litigation against Facebook, LinkedIn and 3 other companies. After the completion of the DSS merger, Lexington Technology Group will become the company’s Virginia-based intellectual property division. With that I will pass the call back to Robert.

Thank you, Jeff, and thank you, Bob and Phil. So as you’ve heard, absent the cost of ups that were incurring in preparations for the planned merger, operations are finally approaching cash flow break-even. So the question is, which I’m sure you all want to know, is "What’s next?" As we've stated previously, the DSS Board believes our merger with Lexington positions us to expand into an exciting but related direction, while our strength and balance sheet will allow us to continue to support growth and investment in our traditional businesses. That’s the theory behind this, and now we are going to operator to throw it open to questions.

[Operator Instructions] Our first question comes from the line of Tom Felker [ph] with T&T [ph] Commercial Group.

I had 2 questions. First is to Bob, and second is for Jeff Ronaldi. Bob, would you be able to give us an example of where your new customizable security packaging technology could be used in, for example, a retail store or shipping of goods through distribution centers in the manufacturing of goods themselves? How would it be used in a real life example?

Primarily, there is 2 basic reasons to use the technology. One is strictly to identify a counterfeit product. The second is to address the diversion, whether it’s local diversion or international diversion. And the whole idea is to be able to identify in covert way a product in any location, whether it’s in a warehouse distribution center, in transit, through customs, into another country's distribution center and ultimately, as you mentioned, right onto the retail shelf. Is that product authentic? Is it where it ought to be? The brand owners have -- lose a lot of money, both in counterfeit products and diverted products, where they may be trying to motivate, say, South America to use a product that they hadn't [indiscernible] -- had an introduction to, and it ends up finding its way into Europe at a discounted price. So they are not achieving their goals and it's costing the company money. So the beauty of this, it's very customizable in that the customer can truly use it for what they want in various forums. And it could be done and managed through the cloud and without necessarily the investigators themselves being familiar with all of the icons that are being used because the cloud take care of it for them. All they need is to basically point and shoot the icons, and the cloud and the infrastructure involved in that makes the brand owner aware of what’s going on with their products. So that’s really the basis for that new product.

The last question I have is for Jeff Ronaldi. Mr. Ronaldi, are you a patent litigation lawyer or how was it that you managed the litigation you referenced?

My background is actually finance, and so, I’m not a patent attorney, I’m not a technologist. What that allows me to do is expand my domain expertise, so if a patent opportunity comes from any technology, I know how to go through the due diligence process to identify if it's of value or not.

Our next question comes from the line of Sandy Wyman with Gilford Securities.

Actually, I have a number of questions and they're in no particular order. Some are very easy, some aren’t. Number one, what is the role of John Cronin going forward?

John Cronin is going to leave our board, and remain an advisory to the company on technology matters.

Okay. So that’s going to be an ongoing as an employee or just an advisor, or what?

As a consulting advisor, subject to a consulting contract.

Okay. All right. If the stock continues to remain under pressure and low and certainly below the private placement level, which doesn’t make any sense to me but nonetheless it is, is there a possibility that the merger could not take place? I’ve had a number of questions about that.

Well, Sandy, it’s subject to shareholder votes. So I mean, there is nothing certain about anything, but as our shareholder base -- those of us who are involved in management on the Board have committed to vote for the merger. So that’s a substantial amount of stock, but insofar as what shareholders are going to do, that’s up to our shareholder base. We certainly think that there is enough demand and reason for people who want to see the company move in this direction, both from a point of view of the ability of our partners in Lexington to be able to raise money for the company and to be able to bring a management team that’s got not only expertise in the IP side, but also in ways that can apply and help the DSS historical business [ph] in better minding our assets and we’ve been able to do in the past, insofar as licensing and getting revenue from other than producing products. So the prospect exists, regardless of the stock price, whether it’s $2.85 or $5.85 that our shareholders might vote again. Of course that exists. But I like to believe that cooler heads and calmer heads will prevail, and that the underlying value and the potential of what these combined companies offer to shareholders on a continuing basis will win the day.

Could you remind us of the amount of money that will actually come over post merger?

Well, at the moment, through the last raise, as you know, there was an additional $3 million placed in the company, most of which is still in the bank and another $7 million to $10 million debt free will come over with Lexington Group when it merges.

I think that’s imperative because, quite frankly, going after the pie-in-the-sky kind of customers that we’ve gone after in the past that looked at the balance sheet and it hasn’t been very comforting. So I think you’ll have some tremendous leverage from that perspective.

It positions us from a perceptual basis as having a lot greater staying power. And that’s correct.

All right. Can I assume historically the fourth quarter has always been your best quarter? And you’ve indicated that -- Phil had indicated that you’re actually cash flow positive in September. Can we assume on this call that fourth quarter will be cash flow positive and perhaps even, God forbid, actually in the green?

Well, this is Bob Bzdick, and we see nothing. You’re right, fourth quarter is historically our strongest quarter. And we see nothing in the cards that is going to change that for this fourth quarter. Obviously, we’re hopeful that will continue to build on our momentum and then only fourth quarter going forward also.

Just a couple more. When will we see the registration filing? I was under the impression we’d be seeing it by now.

Because the management changes and need to revive those contracts and get them in. It should be filed either later today or tomorrow.

Okay. And is there a time limitation once that’s filed as to when you can get the merger or get all the proxy stuff out and the merger done?

Well, a lot of it is going to depend on the comment period and turnaround from the SEC and whether or not it’s going to be one series of responses or 2. So there are variables there. We just can’t predict. We’re hoping that every single -- all ducks will be in a row in February and we’d like to adhere to that timeline.

Great. Last one, then I think what’s the role -- we’ve heard the name Hudson Bay floating around a lot and so forth. What’s their role? Are they strictly a private placement investor or -- could you shed little light on that, Robert?

Hudson Bay is a substantial investment partnership that has a significant amount of experience in investing in companies engaged in this type of investment, in this type of IP related venture. Partners in Hudson Bay were key members who brought this deal to us originally and are substantial investors in Lexington.

Our next question comes from the line of Jeff Briggs with Rochester Wealth Management.

I had 3 questions. I will ask them and you guys can answer. Jeff, the first one goes out to you on the litigation side. Given the fact that Coupons.com, I thought, was going to mediation. I assume we’re now going to trial. If you could give us some insights with the Lexington case and Coupons.com, what all do you feel [ph] timing wise? So Bob Bzdick, congratulations on your promotion. I’d like to know on the existing business going forward, I know we had an existing contract with the Panama Canal, the U.S. Government, with a Social Security card. If you give us an idea if we expect those to continue, if margins will improve. And Robert, to you, I’m going to have all my shareholders or advise them to vote for the merger. And I see change is a positive thing. I see the management changes. I would love to hear in the future that the Board maybe gets reshuffled or maybe get an Executive Chairman for someone who is involved with the company on a day-to-day basis to help steer us through. I for one have been on this ship for a very long time, and I’d like to pull onto dock and take some gains on my stock before I retire. So if you guys can help me out on those 3, I’d appreciate it.

Thanks, Jeff. I’ll go ahead and answer your first question. Thank you for your kind words and I look forward to this adventure that we’re about to be on. Let’s comment about the Coupons.com case. That is not a patent case. So it’s going to be a little bit different, and it has different milestone. I believe it’s in Southern district of New York, which actually has a longer lead time to trial. And we did just have meditation, which happens periodically through all these different types of cases. That’s on a different type of track and it’s progressing as you would expect of a case of that type and that venue. I can’t really comment too much about it in particular other than it’s progressing through the process.

Okay. And then Lexington case, would that be early 2013, mid 2013? Are the any dates on the calendar you have for that?

Sure. So you’re referring to the Bascom Research against LinkedIn, et cetera.

Correct.

And that is a patent case and that has been filed in Eastern District of Virginia, which is known as the Rocket Docket. The first milestone is a hearing that’s coming up in the near future. Peter Hardigan, you know what the date is?

December 7.

December 7, where the judge decides whether the case will stay in Eastern District or not. After -- if it stays, it goes on one track. If it goes somewhere else, it goes on a different track. But at the end of the day, this is a very high quality asset that we think has value to it. So whether it stays or goes, we expect to be worth something.

In regards to the Social Security card, Panama Canal, those are ongoing contracts, one of which is a Social Security contract; it was just renewed recently. We anticipated increased revenues on those. More importantly, I think we have set ourselves up with our new product line to enable brand owners to see how they would initiate and manage our technology, which hopefully will help us sign many new license agreements which will use this technology. So I’m very optimistic looking forward, especially bringing our print technology and our digital technology together.

Great.

So far as the board, I wanted to thank you for your confidence in the merger and urging your clients to vote their shares. Assuming the merger closes as scheduled, there will be a substantial reshuffling of the Board and responsibilities. And it’s impossible to determine at this moment, because one of the things that shareholders will be asked to vote on is a staggered board. And depending on how that fares will depend on the actual numerical makeup of the Board initially. But there will be a substantial change of at least half the board just from day one.

Great. Is the headquarters still going to be at Rochester or will it be moved to Virginia?

Well, the headquarters of DSS will remain in Rochester, but the Bascom portfolio and the IP is going to be administered out of Virginia, where the litigation is taking place and where operations of that part of the company are headquartered.

[Operator Instructions] And we do have a follow-up question from the line of Sandy Wyman with Gilford Securities.

There has been a lot of publicity lately about the word patent holes and so forth. I am assuming that one of the reasons for the combined companies is DSS’ legacy business being very important is part of the arguments for the litigation. Could you let us all in on that a little bit and shed some light on that and the reasons?

Peter?

Yes. I mean I will just comment on it briefly. I think the DSS is a company that has a long history of commercial disputes. And we think that a more aggressive assertion, patent assertion capability is going to help them unlock some value in some of -- with the assets that they have. I think that its operating businesses have led them to -- the fact they have operating businesses has led them to have these embedded disputes. They are not just patents that haven’t been used or businesses that are just in the box. It’s a company that has real operations, real technology and we are hopeful it’s going to have a strong commercial future. So I think that the way to think about it is patent assertion is something that operating companies do and investors do. And we are focused primarily on investing in operating companies that have a potential for IP monetization. And DSS is an example of a company that we think reflects that.

Does that mean then the new patents that have -- and patent applications that are in place that John Cronin has helped along the way here, does that mean that you are going to be a lot more aggressive on the litigation front trying to enforce those, with people like RR Donnelley, et cetera?

I definitely can’t comment on some of that. I guess what I’d say is John did a great job of mapping a course for the IP strategy of the company. That’s a process that takes time to be realized. New patents that are being issued now from that process are patent applications that are being published now from that process are probably going to take several years before they become enforceable patents. So what he has done is provide a long-term course for the core business to protect and grow its IP position, and that will help it compete in the future. I think that in the near-term, we're going to focus on disputes that are already been identified in the company and look at opportunities to help the company improve its operations and set up a great infrastructure in the company to look at additional opportunities to pursue licensing or more aggressive monetization.

Sandy, certainly the availability of having a professional management team with this type of experience and the balance sheet, as you mentioned, that's showing much greater additional strength is going to mean that as our licensees view us, I think they will take us lot more seriously as we begin to engage in audits and other processes to make sure that the extent someone is suppose to be paying for using our technology are, a, in fact, paying; and b, in fact, paying the proper amount. I think the addition of Peter and Jeff is going to ensure that as we have future licensing agreements, that will be done with the maximization that we probably have not been able to achieve not heretofore.

This is certainly a much more professional presentation than I’ve heard in the last 5 or 6 years. And I greatly appreciate that myself, and I am going to be obviously recommending my customers do the same, in terms of the boat [ph].

Yes. We do have a question from the line of Mark Argento [ph] with Lake Street Partners.

So, I have a few questions and like I said, I apologize, if they already been asked, but could you touch on the timeline for the current Bascom portfolio case in Virginia?

Sure. Sure. Peter, you want to take that?

Sure. So, there is going to be a transfer motion that’s going to be heard on December 7th. There should be a response to that within the couple weeks. So by the end of the year, we’ll know whether or not we stay Eastern district of Virginia. Of course, we’re confident that we’ll stay there. Anything is possible. Following that, there is going to be a scheduling hearing or scheduling conference in January that will set forth when the Markman hearing takes place and when the trial take place, provided that we stay in Virginia. You can anticipate that the Markman will be in the spring or early summer at the latest and that the trial will take place before the end of 2013.

And then in terms of -- I know you guys have your plate full with getting the deal closed, the acquisition, merger closed, but are actively looking at additional IP? What -- are you building a pipeline? Do you have a pipeline? And how can we think about additional IP coming into the platform as you move forward?

I would say that our goal in a perfect world, we would have somewhere between 5 and 7 portfolios that have the characteristic that we want running at any one time. So some of these of the early stage, some of these would be middle stage, some of these would be harvesting. I think that right now, of course, we're at one portfolio at Bascom Research, probably some opportunities within -- embedded within DSS as well. So you can think of that as 2 portfolios. So before the end of 2013 in a perfect world, I'd want to add a couple more portfolios to that. We see a lot of yield flow in this space. Jeff has very robust network. I have a fairly robust network as well. And I think that the opportunity to work with DSS is going to provide us with additional opportunities to uncover opportunities for patent monetization. So, I think that we are kind of adding yield flow as we go on. So, I’m certainly confident that as long as we continue with the success that we’ve had so far, we will be in a position to be diversified within, say, 18 months or less.

Got you. And then with the addition to Jeff to the team, do you think you can manage 3, 4, 5 portfolios internally without having to add a bunch of more staff? I mean, how much scale do you think you have with ability to manage…

No. I have been managing IP full-time for about 6 years, and any one time I’ve had between 5 and 10 different matters going. It all depends on the size of the portfolio, the number of defendants and the teamwork involved with the litigation, the legal team. So to have 5 to 6 portfolios going, it doesn’t look like we need a huge amount of people to do that.

I think that if we add staff, it's going to be because we are bringing in people who -- like Jeff or others who have comparable or similar levels of experience and have a book of business with them. So we will sort of acquire that franchise. And we would add because it would add good deals to our pipeline and good management to our team.

There are no further questions in the queue at this time.

Well, I would like to thank all of my partners here at DSS and Lexington. I would like to thank all of you, our shareholders who have been on the call today for sticking with us and for the supportive comments that you've offered today. Thank you very much and that will conclude today’s call.

This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.