U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934.
For the transition period from __________ to __________.
For the period ended June 30, 2005
Commission file number 000-27305
TELKONET, INC.
(Exact name of Issuer as specified in its charter)
Utah 87-0627421
(State of Incorporation) (IRS Employer Identification No.)
20374 Seneca Meadows Parkway, Germantown, MD 20876
(Address of Principal Executive Offices)
(240) 912-1800
Issuer's Telephone Number
Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes [x] No [ ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]
State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: 44,808,636 shares of Common Stock
($.001 par value) as of August 1, 2005.
TELKONET, INC.
QUARTERLY REPORT ON FORM 10-Q FOR THE
QUARTERLY PERIOD ENDING JUNE 30, 2005
Table of Contents
Page
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets:
June 30, 2005 and December 31, 2004 3
Condensed Consolidated Statements of Losses:
Three and Six months Ended June 30, 2005 and 2004 4
Condensed Consolidated Statement of Stockholders' Equity
January 1, 2005 through June 30, 2005 5
Condensed Consolidated Statements of Cash Flows:
Six months Ended June 30, 2005 and 2004 6-7
Notes to Unaudited Condensed Consolidated Financial Information:
June 30, 2005 8-19
Item 2. Management's Discussion and Analysis 20-29
Item 3. Quantitative and Qualitative Disclosures About Market Risk. 29
Item 4. Controls and Procedures 29
PART II. OTHER INFORMATION 30
Item 1. Legal Proceedings 30
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 30
Item 3. Defaults Upon Senior Securities 30
Item 4. Submission of Matters to a Vote of Security Holders 30
Item 5. Other Information 30
Item 6. Exhibits 31
2
Item 1. Financial Statements (Unaudited)
TELKONET, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
June 30, 2005 December 31, 2004
---------------- -----------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 5,861,879 $ 11,838,702
Accounts Receivable: net of allowance for doubtful
accounts of $13,000 at June 30, 2005 and December 31, 2004 71,567 63,147
Inventory (Note G) 1,839,991 1,873,718
Prepaid expenses and deposits 144,462 124,852
---------------- -----------------
Total current assets 7,917,899 13,900,419
PROPERTY AND EQUIPMENT:
Furniture and equipment, at cost 985,973 704,689
Less: accumulated depreciation 219,750 137,739
---------------- -----------------
Total property and equipment, net 766,223 566,950
EQUIPMENT UNDER OPERATING LEASES:
Capitalized equipment, at cost 904,625 525,664
Less: accumulated depreciation 172,212 75,329
---------------- -----------------
Total equipment under operating leases, net 732,413 450,335
OTHER ASSETS:
Long-term investments (Note F) 550,000 500,000
Deposits 154,216 76,288
---------------- -----------------
Total other assets 704,216 576,288
TOTAL ASSETS $ 10,120,751 $ 15,493,992
================ =================
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued liabilities $ 1,612,127 $ 1,195,924
Convertible debentures, net of discounts - including related parties (Note B) 173,956 --
Senior notes payable (Note C) 450,000 --
Customer deposits 84,444 32,975
---------------- -----------------
Total current liabilities 2,320,527 1,228,899
LONG TERM LIABILITIES:
Senior notes payable (Note C) -- 450,000
Convertible debentures, net of discounts - including related parties (Note B) -- 137,910
Deferred lease liability 41,582 30,911
---------------- -----------------
Total long term liabilities 41,582 618,821
COMMITMENTS AND CONTINGENCIES -- --
STOCKHOLDERS' EQUITY :
Preferred stock, par value $.001 per share; 15,000,000 shares authorized; none
issued and outstanding at June 30, 2005 and December 31, 2004 (Note E) -- --
Common stock, par value $.001 per share; 100,000,000 shares authorized; 44,729,573
and 44,335,989 shares issued and outstanding at June 30, 2005 and December 31,
2004, respectively (Note E) 44,730 44,336
Additional paid-in-capital 41,787,709 40,811,208
Accumulated deficit (34,073,797) (27,209,272)
---------------- -----------------
Stockholders' equity 7,758,642 13,646,272
---------------- -----------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 10,120,751 $ 15,493,992
================ =================
See accompanying footnotes to the unaudited condensed consolidated financial information
3
TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF LOSSES
(UNAUDITED)
For The Three months Ended June 30, For The Six months Ended June 30,
2005 2004 2005 2004
------------ ------------ ------------ ------------
Revenues, net:
Product $ 310,250 $ 226,022 $ 439,523 $ 345,813
Rental 162,697 45,881 279,612 66,189
------------ ------------ ------------ ------------
Total Revenue 472,947 271,903 719,135 412,002
Cost of Sales:
Product 253,773 238,701 344,755 367,239
Rental 98,383 20,428 164,791 26,294
------------ ------------ ------------ ------------
Total Cost of Sales 352,156 259,129 509,546 393,533
Gross Profit 120,791 12,774 209,589 18,469
Costs and Expenses:
Research and Development 472,802 413,489 920,727 846,204
Selling, General and Administrative 3,146,754 1,808,796 5,546,713 3,162,987
Consulting Fees -- 2,500,000 -- 2,500,000
Non-Employee Stock Options and
Warrants (Note D) 233,612 251,549 526,537 465,090
Depreciation and Amortization 46,462 32,710 85,766 47,700
------------ ------------ ------------ ------------
Total Operating Expense 3,899,630 5,006,544 7,079,743 7,021,981
Loss from Operations (3,778,839) (4,993,770) (6,870,154) (7,003,512)
Other Income (Expenses):
Interest Income 30,021 33,182 67,959 52,062
Interest Expense (31,165) (21,615) (62,330) (67,715)
------------ ------------ ------------ ------------
Total Other Income (Expenses) (1,144) 11,567 5,629 (15,653)
Loss Before Provision for Income Taxes (3,779,983) (4,982,203) (6,864,525) (7,019,165)
Provision for Income Taxes -- -- -- --
------------ ------------ ------------ ------------
Net Loss $ (3,779,983) $ (4,982,203) $ (6,864,525) $ (7,019,165)
============ ============ ============ ============
Loss per common share (basic and
assuming dilution) $ (0.08) $ (0.11) $ (0.15) $ (0.18)
============ ============ ============ ============
Weighted average common shares
outstanding 44,670,946 43,465,142 44,570,404 39,042,528
See accompanying footnotes to the unaudited condensed consolidated financial information
4
TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (UNAUDITED)
FOR THE PERIOD FROM JANUARY 1, 2005 TO JUNE 30, 2005
Preferred Additional
Preferred Stock Common Common Paid in Accumulated
Shares Amount Shares Stock Amount Capital Deficit Total
---------- ----------- ------------ ------------ ------------ ------------ ------------
BALANCE AT JANUARY 1, 2005 -- -- 44,335,989 $ 44,336 $ 40,811,208 $(27,209,272) $ 13,646,272
Shares issued for employee
stock options exercised
at approximately $1.09
per share -- -- 221,400 222 241,270 -- 241,492
Shares issued in exchange
for non-employee options
exercised at $1.00 per
share -- -- 41,666 42 41,625 -- 41,667
Shares issued in exchange
for warrants exercised
at $1.00 per share -- -- 74,400 74 74,326 -- 74,400
Shares issued for cashless
warrants exercised -- -- 36,150 36 (36) -- --
Shares issued to
consultants in exchange
for services rendered
at approximately
$5.73 per share -- -- 1,968 2 8,998 -- 9,000
Shares issued to an
employee in exchange
for services at
approximately $5.32 per
share -- -- 18,000 18 83,781 -- 83,799
Stock options and warrants
granted to consultants
in exchange for services
rendered (Note D) -- -- -- -- 526,537 -- 526,537
Net Loss -- -- -- -- -- (6,864,525) (6,864,525)
---------- ----------- ------------ ------------ ------------ ------------ ------------
BALANCE AT JUNE 30, 2005 -- $ -- 44,729,573 $ 44,730 $ 41,787,709 $(34,073,797) $ 7,758,642
========== =========== ============ ============ ============ ============ ============
See accompanying footnotes to the unaudited condensed consolidated financial information
5
TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
For The Six months Ended June 30,
2005 2004
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss from operating activities $ (6,864,525) $ (7,019,165)
Adjustments to reconcile net loss from operations to cash used in
operating activities
Amortization of debt discount - beneficial conversion feature of
convertible debentures 24,622 10,944
Amortization of debt discount - value of warrants attached to
convertible debentures 11,424 5,076
Stock options and warrants issued in exchange for services rendered
(Note D) 526,537 465,090
Common stock issued in exchange for services rendered (Note E) 92,799 178,881
Common stock issued in exchange for conversion of interest (Note B) -- 23,276
Common stock issued in exchange for consulting fees -- 2,500,000
Depreciation, including depreciation of equipment under operating leases 179,499 47,699
Increase / decrease in:
Accounts receivable (8,420) (74,481)
Inventory 33,727 (370,498)
Prepaid expenses and deposits (46,068) 6,295
Accounts payable and accrued expenses 416,203 499,987
Deferred lease liability 10,671 10,303
------------ ------------
NET CASH (USED IN) OPERATING ACTIVITIES (5,623,531) (3,716,593)
CASH FLOWS FROM INVESTING ACTIVITIES:
Costs of equipment under operating leases (379,566) (192,915)
Investment in Amperion and BPL Global (Note F) (50,000) --
Purchase of property and equipment, net (281,284) (400,389)
------------ ------------
NET CASH (USED IN) INVESTING ACTIVITIES (710,850) (593,304)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from sale of common stock, net of costs -- 12,726,843
Proceeds from exercise of warrants attached to notes payable 74,400 4,073,700
Proceeds from exercise of employee and non-employee stock options and
warrants 283,158 620,249
Payment of capital leases -- (11,834)
------------ ------------
NET CASH PROVIDED BY FINANCING ACTIVITIES 357,558 17,408,958
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (5,976,823) 13,099,061
CASH AND CASH EQUIVALENTS AT THE BEGINNING OF THE PERIOD 11,838,702 5,177,918
------------ ------------
CASH AND CASH EQUIVALENTS AT THE END OF THE PERIOD $ 5,861,879 $ 18,276,979
============ ============
See accompanying footnotes to the unaudited condensed consolidated financial information
6
TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
For The Six months Ended June 30,
---------------------------------
2005 2004
---------- ----------
Supplemental Disclosures of Cash Flow Information
Cash paid during the period for interest $ 27,000 $ 91,534
Income taxes paid -- --
Non-cash transactions:
Issuance of stock options and warrants in exchange for services
rendered (Note D) 526,537 465,090
Common stock issued for services rendered 92,799 178,881
Common stock issued in exchange for interest (Note B) -- 23,276
Common stock issued in exchange for consulting services -- 2,500,000
Common stock issued in exchange for conversion of Senior Notes (Note C) -- 2,539,000
Common stock issued in exchange for convertible debentures (Note B) -- 172,000
Write-off of beneficial conversion feature of conversion of
debenture (Note B) -- 134,134
Write-off of value of warrants attached to debenture in connection
with conversion (Note B) -- 531
See accompanying footnotes to the unaudited condensed consolidated financial information
7
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION
JUNE 30, 2005
(UNAUDITED)
NOTE A - SUMMARY OF ACCOUNTING POLICIES
- ---------------------------------------
General
- -------
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States of America for interim financial information and the instructions
to Form 10-Q. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements.
In the opinion of management, all adjustments (consisting of normal recurring
accruals) considered necessary for a fair presentation have been included.
Accordingly, the results from operations for the three and six-month period
ended June 30, 2005, are not necessarily indicative of the results that may be
expected for the year ended December 31, 2005. The unaudited condensed
consolidated financial statements should be read in conjunction with the
consolidated December 31, 2004 financial statements and footnotes thereto
included in the Company's Form 10-KSB for the year ended December 31, 2004.
Basis of Presentation
- ---------------------
Telkonet, Inc. (the "Company"), formerly Comstock Coal Company, Inc., was formed
on November 3, 1999 under the laws of the state of Utah. The Company is engaged
in the business of developing products for use in the powerline communications
(PLC) industry. PLC products use existing electrical wiring in commercial
buildings and residences to carry high speed data communications signals,
including the internet. Since the Company's formation, it has focused on
development and marketing of its PLC technology.
The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiary, Telkonet Communications, Inc. Significant
intercompany transactions have been eliminated in consolidation.
Reclassification
- ----------------
Certain reclassifications have been made to conform prior periods' data to the
current presentation. These reclassifications had no effect on reported losses.
Concentrations of Credit Risk
- -----------------------------
Financial instruments and related items, which potentially subject the Company
to concentrations of credit risk, consist primarily of cash and cash
equivalents. The Company places its cash and temporary cash investments with
credit quality institutions. At times, such investments may be in excess of the
FDIC insurance limit. The allowance for doubtful accounts was $13,000 at June
30, 2005 and December 31, 2004.
Stock Based Compensation
- ------------------------
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation-Transition and Disclosure-an amendment of SFAS 123." This statement
amends SFAS No. 123, "Accounting for Stock-Based Compensation," to provide
alternative methods of transition for a voluntary change to the fair value based
method of accounting for stock-based employee compensation. In addition, this
statement amends the disclosure requirements of SFAS No. 123 to require
prominent disclosures in both annual and interim financial statements about the
method of accounting for stock-based employee compensation and the effect of the
method used on reported results. The Company has chosen to continue to account
for stock-based compensation using the intrinsic value method prescribed in APB
Opinion No. 25 and related interpretations. Accordingly, compensation expense
for stock options is measured as the excess, if any, of the fair market value of
the Company's stock at the date of the grant over the exercise price of the
related option. The Company has adopted the annual disclosure provisions of SFAS
No. 148 in its financial reports for the year ended December 31, 2004 and has
adopted the interim disclosure provisions for its financial reports for the
subsequent periods.
8
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION
JUNE 30, 2005
(UNAUDITED)
NOTE A - SUMMARY OF ACCOUNTING POLICIES (CONTINUED)
- ---------------------------------------------------
Stock Based Compensation (Continued)
- ------------------------------------
Had compensation costs for the Company's stock options been determined based on
the fair value at the grant dates for the awards, the Company's net loss and
losses per share would have been as follows (transactions involving stock
options issued to employees and Black-Scholes model assumptions are presented in
Note D):
For the three For the six
months ended June 30, months ended June 30,
2005 2004 2005 2004
------------ ------------ ------------ ------------
Net loss - as reported $ (3,779,983) $ (4,982,203) $ (6,864,525) $ (7,019,165)
Add: Total stock based employee compensation expense
as reported under intrinsic value method (APB. No. 25) -- -- -- --
Deduct: Total stock based employee compensation
expense as reported under fair value based method
(SFAS No. 123) (2,102,383) (1,672,345) (4,209,928) (3,138,935)
------------ ------------ ------------ ------------
Net loss - Pro Forma $ (5,882,366) $ (6,654,548) $(11,074,453) $(10,158,100)
Net loss attributable to common stockholders - Pro
forma $ (5,882,366) $ (6,654,548) $(11,074,453) $(10,158,100)
Basic (and assuming dilution) loss per share - as
reported $ (0.08) $ (0.11) $ (0.15) $ (0.18)
Basic (and assuming dilution) loss per share - Pro
forma $ (0.13) $ (0.15) $ (0.25) $ (0.26)
On December 16, 2004, the Financial Accounting Standards Board (FASB) issued
FASB Statement No. 123R (revised 2004), "Share-Based Payment" which is a
revision of FASB Statement No. 123, "Accounting for Stock-Based Compensation".
Statement 123R supersedes APB opinion No. 25, "Accounting for Stock Issued to
Employees", and amends FASB Statement No. 95, "Statement of Cash Flows".
Generally, the approach in Statement 123R is similar to the approach described
in Statement 123. However, Statement 123R requires all share-based payments to
employees, including grants of employee stock options, to be recognized in the
income statement based on their fair values. Pro-forma disclosure is no longer
an alternative. On April 14, 2005, the SEC amended the effective date of the
provisions of this statement. The effect of this amendment by the SEC is that
the Company will have to comply with Statement 123R and use the Fair Value based
method of accounting no later than the first quarter of 2006. Management has not
determined the impact that this statement will have on Company's consolidated
financial statements.
Revenue Recognition
- -------------------
For revenue from product sales, the Company recognizes revenue in accordance
with Staff Accounting Bulletin No. 104, REVENUE RECOGNITION ("SAB104"), which
superceded Staff Accounting Bulletin No. 101, REVENUE RECOGNITION IN FINANCIAL
STATEMENTS ("SAB101"). SAB 101 requires that four basic criteria must be met
before revenue can be recognized: (1) persuasive evidence of an arrangement
exists; (2) delivery has occurred; (3) the selling price is fixed and
determinable; and (4) collectibility is reasonably assured. Determination of
criteria (3) and (4) are based on management's judgments regarding the fixed
nature of the selling prices of the products delivered and the collectibility of
those amounts. Provisions for discounts and rebates to customers, estimated
returns and allowances, and other adjustments are provided for in the same
period the related sales are recorded. The Company defers any revenue for which
the product has not been delivered or is subject to refund until such time that
the Company and the customer jointly determine that the product has been
delivered or no refund will be required. SAB 104 incorporates Emerging Issues
Task Force 00-21 ("EITF 00-21"), MULTIPLE-DELIVERABLE REVENUE ARRANGEMENTS. EITF
00-21 addresses accounting for arrangements that may involve the delivery or
performance of multiple products, services and/or rights to use assets.
9
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION
JUNE 30, 2005
(UNAUDITED)
NOTE A - SUMMARY OF ACCOUNTING POLICIES (CONTINUED)
- ---------------------------------------------------
Revenue Recognition (Continued)
- -------------------------------
Currently, there are no warranties provided with the purchase of the Company's
products. The cost of replacing defective products and product returns have been
immaterial and within management's expectations. In the future, when the Company
deems warranty reserves are appropriate, such costs will be accrued to reflect
anticipated warranty costs.
For equipment under lease, revenue is recognized over the lease term for
operating lease and rental contracts. All of the Company's leases are accounted
for as operating leases. At the inception of the lease, no lease revenue is
recognized and the leased equipment and installation costs are capitalized and
appear on the balance sheet as "Equipment Under Operating Leases." The
capitalized cost of this equipment is depreciated from two to three years, on a
straight-line basis down to the Company's original estimate of the projected
value of the equipment at the end of the scheduled lease term. Monthly lease
payments are recognized as rental income.
New Accounting Pronouncements
- -----------------------------
In March 2005, the FASB issued FASB Interpretation (FIN) No. 47, "Accounting for
Conditional Asset Retirement Obligations, an interpretation of FASB Statement
No. 143," which requires an entity to recognize a liability for the fair value
of a conditional asset retirement obligation when incurred if the liability's
fair value can be reasonably estimated. The Company is required to adopt the
provisions of FIN 47 no later than the first quarter of fiscal 2006. The Company
does not expect the adoption of this Interpretation to have a material impact on
its consolidated financial position, results of operations or cash flows.
In May 2005 the FASB issued Statement of Financial Accounting Standards (SFAS)
No. 154, "Accounting Changes and Error Corrections, a replacement of APB Opinion
No. 20 and FASB Statement No. 3." SFAS 154 requires retrospective application to
prior periods' financial statements for changes in accounting principle, unless
it is impracticable to determine either the period-specific effects or the
cumulative effect of the change. SFAS 154 also requires that retrospective
application of a change in accounting principle be limited to the direct effects
of the change. Indirect effects of a change in accounting principle, such as a
change in non-discretionary profit-sharing payments resulting from an accounting
change, should be recognized in the period of the accounting change. SFAS 154
also requires that a change in depreciation, amortization, or depletion method
for long-lived, non-financial assets be accounted for as a change in accounting
estimate effected by a change in accounting principle. SFAS 154 is effective for
accounting changes and corrections of errors made in fiscal years beginning
after December 15, 2005. Early adoption is permitted for accounting changes and
corrections of errors made in fiscal years beginning after the date this
Statement is issued. The Company does not expect the adoption of this SFAS to
have a material impact on its consolidated financial position, results of
operations or cash flows.
10
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION
JUNE 30, 2005
(UNAUDITED)
NOTE B - CONVERTIBLE PROMISSORY NOTES PAYABLE
A summary of convertible promissory notes payable at June 30, 2005 and December
31, 2004 is as follows:
June 30, 2005 December 31, 2004
------------- -----------------
Convertible notes payable ("Series B Debenture"),
in quarterly installments of interest only at 8%
per annum, unsecured and due three years from the
date of the note with the latest maturity February
2006; Noteholder has the option to convert unpaid
note principal, together with accrued and unpaid
interest, to the Company's common stock at a rate
of $.55 per share six months after issuance. $ 210,000 $ 210,000
Debt Discount - beneficial conversion feature, net
of accumulated amortization of $73,871 and $49,249
at June 30, 2005 and December 31, 2004,
respectively. (24,621) (49,243)
Debt Discount - value attributable to warrants
attached to notes, net of accumulated amortization
of $34,265 and $22,841 at June 30, 2005 and
December 31, 2004, respectively. (11,423) (22,847)
------------- -----------------
Total 173,956 137,910
------------- -----------------
Less: current portion (173,956) --
------------- -----------------
$ -- $ 137,910
============= =================
11
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION
JUNE 30, 2005
(UNAUDITED)
NOTE B - CONVERTIBLE PROMISSORY NOTES PAYABLE (CONTINUED)
Series B Debentures
- -------------------
In 2002, the Company issued convertible promissory notes (the "Series B
Debentures") to Company officers, shareholders, and sophisticated investors in
exchange for $472,900, exclusive of placement costs and fees. The Series B
Debentures accrue interest at 8% per annum and are due and payable three years
from the date of the note with the latest maturity date of December 2005.
Noteholders have the option to convert any unpaid note principal, together with
accrued and unpaid interest, to the Company's common stock at a rate of $.55 per
share beginning six months after issuance.
In accordance with EITF 98-5, the Company recognized an imbedded beneficial
conversion feature present in the Series B Debenture note. The Company allocated
a portion of the proceeds equal to the intrinsic value of that feature to
additional paid-in capital. The Company recognized and measured an aggregate of
$147,859 of the proceeds, which is equal to the intrinsic value of the imbedded
beneficial conversion feature, to additional paid in capital and a discount
against the Series B Debentures. The debt discount attributed to the beneficial
conversion feature is amortized over the Series B Debentures maturity period
(three years) as interest expense.
In connection with the placement of the Series B Debentures in 2002, the Company
issued non-detachable warrants granting the holders the right to acquire, in the
aggregate, 472,900 shares of the Company's common stock at $1.00 per share. In
accordance with EITF 00-27 the Company recognized the value attributable to the
warrants in the amount of $68,595 to additional paid in capital and a discount
against the Series B Debentures. The Company valued the warrants in accordance
with EITF 00-27 using the Black-Scholes pricing model and the following
assumptions: contractual terms of 3 years, an average risk free interest rate of
1.67%, a dividend yield of 0%, and volatility of 26%. The debt discount
attributed to the value of the warrants issued is amortized over the Series B
Debentures maturity period (three years) as interest expense.
In 2003, the Company issued convertible Series B Debentures to Company officers,
shareholders, and sophisticated investors in exchange for $2,027,100, exclusive
of placement costs and fees. The Series B Debentures accrue interest at 8% per
annum and are payable and due three years from the date of the note with the
latest maturity date of February 2006. Noteholders have the option to convert
any unpaid note principal together with accrued and unpaid interest to the
Company's common stock at a rate of $.55 per share beginning six months after
issuance.
In accordance with EITF 98-5, the Company recognized an imbedded beneficial
conversion feature present in the Series B Debenture note. The Company allocated
a portion of the proceeds equal to the intrinsic value of that feature to
additional paid-in capital. The Company recognized and measured an aggregate of
$1,761,675 of the proceeds, which is equal to the intrinsic value of the
imbedded beneficial conversion feature, to additional paid in capital and a
discount against the Series B Debentures. The debt discount attributed to the
beneficial conversion feature is amortized over the Series B Debentures maturity
period (three years) as interest expense.
In connection with the placement of the Series B Debenture notes in 2003, the
Company issued non-detachable warrants granting the holders the right to
acquire, in the aggregate, 2,027,100 shares of the Company's common stock at
$1.00 per share. In accordance with EITF 00-27, the Company recognized the value
attributable to the warrants in the amount of $265,425 to additional paid in
capital and a discount against the Series B Debentures. The Company valued the
warrants in accordance with EITF 00-27 using the Black-Scholes pricing model and
the following assumptions: contractual terms of 3 years, an average risk free
interest rate of 1.25%, a dividend yield of 0%, and volatility of 26%. The debt
discount attributed to the value of the warrants issued is amortized over the
Series B Debentures maturity period (three years) as interest expense.
12
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION
JUNE 30, 2005
(UNAUDITED)
NOTE B - CONVERTIBLE PROMISSORY NOTES PAYABLE (CONTINUED)
Debenture-1
- -----------
During the year ended December 31, 2001, the Company issued convertible
promissory notes (the "Debenture-1") to Company officers, shareholders, and
sophisticated investors in exchange for $940,000, exclusive of placement costs
and fees. The Debenture-1 accrues interest at 8% per annum and is due and
payable three years from the date of the note with the latest maturity date of
November 2004. The noteholders have the option to convert any unpaid note
principal, together with accrued and unpaid interest, to the Company's common
stock at a rate of $.50 per share beginning six months after issuance. In
accordance with EMERGING ISSUES TASK FORCE ISSUE 98-5, ACCOUNTING FOR
CONVERTIBLE SECURITIES WITH A BENEFICIAL CONVERSION FEATURES OR CONTINGENTLY
ADJUSTABLE CONVERSION RATIOS ("EITF 98-5"), the Company recognized an imbedded
beneficial conversion feature present in the Debenture-1 note. The Company
allocated a portion of the proceeds equal to the intrinsic value of that feature
to additional paid in capital. The Company recognized and measured an aggregate
of $837,874 of the proceeds, which is equal to the intrinsic value of the
imbedded beneficial conversion feature, to additional paid in capital and a
discount against the Debenture-1. The debt discount attributed to the beneficial
conversion feature is amortized over the Debenture-1's maturity period (three
years) as interest expense.
In connection with the placement of the Debenture-1 notes, the Company issued
non-detachable warrants granting the holders the right to acquire, in the
aggregate, 940,000 shares of the Company's common stock at $1.00 per share. In
accordance with Emerging Issues Task Force Issue 00-27, Application of Issue No.
98-5 to Certain Convertible Instruments ("Eitf 00-27"), the Company recognized
the value attributable to the warrants in the amount of $77,254 to additional
paid-in capital and a discount against the Debenture-1.The Company valued the
warrants in accordance with EITF 00-27 using the Black-Scholes pricing model and
the following assumptions: contractual terms of 3 years, an average risk free
interest rate of 1.25%, a dividend yield of 0%, and volatility of 26%. The debt
discount attributed to the value of the warrants issued is amortized over the
Debenture-1's maturity period (three years) as interest expense.
During the year ended December 31, 2002, the Company issued the Debenture-1 to
Company officers, shareholders, and sophisticated investors in exchange for
$749,100, exclusive of placement costs and fees. The Debenture-1 accrues
interest at 8% per annum and is due and payable three years from the date of the
note with the latest maturity date of May 2005. Noteholders have the option to
convert any unpaid note principal together with accrued and unpaid interest to
the Company's common stock at a rate of $.50 per share beginning six months
after issuance.
In accordance with EITF 98-5, the Company recognized an imbedded beneficial
conversion feature present in the Debenture-1 note. The Company allocated a
portion of the proceeds equal to the intrinsic value of that feature to
additional paid in capital. The Company recognized and measured an aggregate of
$693,018 of the proceeds, which is equal to the intrinsic value of the imbedded
beneficial conversion feature, to additional paid-in capital and a discount
against the Debenture-1. The debt discount attributed to the beneficial
conversion feature is amortized over the Debenture-1's maturity period (three
years) as interest expense.
In connection with the placement of the Debenture-1 notes in 2002, the Company
issued non-detachable warrants granting the holders the right to acquire, in the
aggregate, 749,100 shares of the Company's common stock at $1.00 per share. In
accordance with EITF 00-27, the Company recognized the value attributable to the
warrants in the amount of $56,082 to additional paid in capital and a discount
against the Debenture-1. The Company valued the warrants in accordance with EITF
00-27 using the Black-Scholes pricing model and the following assumptions:
contractual terms of 3 years, an average risk free interest rate of 1.67%, a
dividend yield of 0%, and volatility of 26%. The debt discount attributed to the
value of the warrants issued is amortized over the Debenture-1's maturity period
(three years) as interest expense.
13
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION
JUNE 30, 2005
(UNAUDITED)
NOTE B - CONVERTIBLE PROMISSORY NOTES PAYABLE (CONTINUED)
The Company amortized the Debenture 1 and the Series B Debenture debt discount
attributed to the beneficial conversion feature and the value of the attached
warrants and recorded non-cash interest expense of $36,046 and $16,020 for the
six months ended June 30, 2005 and 2004, respectively.
During the year ended December 31, 2003, the Debenture-1 noteholders demanded
registration of that number of common shares of the Company sufficient to cover
the conversion of their debentures and exercise of the attached warrants.
Accordingly, the Company notified the Series B Debenture noteholders, Senior
noteholders (Note C) and warrant holders with piggy-back registration rights of
their right to participate in the registration. During the year ended December
31, 2003, the Company issued an aggregate of 7,217,836 shares of common stock in
connection with the conversion of $1,627,100 aggregate principal amount of the
Debenture-1 and $2,180,000 aggregate principal amount of the Series B
Debentures. The Company also issued an aggregate of 525,403 shares of common
stock in exchange for accrued interest of $195,148 and $85,586 for Debenture 1
and Series B Debentures, respectively. During the six months ended June 30,
2004, the Company issued an aggregate of 324,001 shares of common stock in
connection with the conversion of $62,000 aggregate principal amount of the
Debenture-1 and $110,000 aggregate principal amount of the Series B Debentures.
The Company also issued an aggregate of 42,999 shares of common stock in
exchange for accrued interest of $23,276 for Debenture 1 and Series B
Debentures. All Debentrure-1 had been converted to common stock as of June 30,
2004. There was no Debenture-1 outstanding at June 30, 2005 and December 31,
2004. The remaining outstanding Series B Debenture at June 30, 2005 and December
31, 2004 was $210,000. The Company has accounted for the outstanding Series B
Debenture as a current liability at June 30, 2005.
In connection with the conversion of Debenture-1 and Series B Debentures, the
Company wrote off the unamortized debt discount attributed to the beneficial
conversion feature and the value of the attached warrants in the amount of
$2,046,479 and $296,470, respectively, as of December 31, 2003, and an
additional $134,134 and $531, respectively, during the six-month period ended
June 30, 2004.
NOTE C - SENIOR NOTES PAYABLE
In the second quarter of 2003, the Company issued Senior Notes to Company
officers, shareholders, and sophisticated investors in exchange for $5,000,000,
exclusive of placement costs and fees. The Senior Notes are denominated in units
of $100,000, accrue interest at 8% per annum and are due three years from the
date of issuance with the latest maturity date of June 2006. Attached to each
Senior Note are warrants to purchase 125,000 shares of common stock. The
warrants have a three-year contractual life and are exercisable immediately
after the issuance of the Senior Note at an exercise price of $1.00 per share.
The Senior Notes are secured by a first priority security interest in all
intellectual property assets of the Company.
In September 2003, certain Senior noteholders elected to surrender their Senior
Note as consideration for the exercise of warrants to purchase shares of common
stock of the Company. The Company issued an aggregate of 2,011,000 restricted
shares of common stock for warrants exercised at $1.00 per share, in exchange
for $2,011,000 of Senior Notes.
In January 2004, certain noteholders requested to convert their senior notes
into Company restricted shares of common stock. The Company's Board of Directors
approved this request by amending the terms of the Senior Note for a limited
time. The Company immediately notified all of the outstanding Senior Note
Holders of this temporary conversion option, and indicated that it would accept
the surrender of the Senior Notes as consideration for the purchase of the
registrant's common shares at a price of $2.10 per share. The conversion price
represented the current market price of the Company's common stock. The
remaining outstanding senior notes at June 30, 2005 and December 31, 2004 was
$450,000. The Company has accounted for the senior notes outstanding as current
liabilities at June 30, 2005.
14
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION
JUNE 30, 2005
(UNAUDITED)
NOTE D - STOCK OPTIONS AND WARRANTS
Employee Stock Options
- ----------------------
The following table summarizes the changes in options outstanding and the
related prices for the shares of the Company's common stock issued to employees
of the Company under a non-qualified employee stock option plan.
Options Outstanding Options Exercisable
------------------- -------------------
Weighted Average Weighted Weighted
Number Remaining Contractual Average Number Average
Exercise Prices Outstanding Life (Years) Exercise Price Exercisable Exercise Price
--------------- ----------- ------------ -------------- ----------- --------------
$1.00 - $1.99 5,976,267 7.46 $1.00 4,979,184 $1.00
$2.00 - $2.99 2,167,100 8.58 $2.29 771,650 $2.25
$3.00 - $3.99 1,845,000 9.44 $3.34 326,417 $3.46
$4.00 - $4.99 250,000 9.98 $4.57 1,000 $4.64
$5.00 - $5.99 315,000 9.79 $5.30 13,500 $5.08
----------- ------------ -------------- ----------- --------------
10,553,367 8.17 $1.89 6,091,751 $1.30
=========== ============ ============== =========== ==============
Transactions involving stock options issued to employees are summarized as
follows:
Weighted Average
Number of Shares Price Per Share
---------------- ---------------
Outstanding at January 1, 2003 1,950,000 $ 1.00
Granted 7,202,333 1.22
Exercised (109,333) 1.01
Cancelled or expired (750,000) 1.00
---------------- ---------------
Outstanding at December 31, 2003 8,293,000 $ 1.19
================ ===============
Granted 2,108,000 3.06
Exercised (540,399) 1.08
Cancelled or expired (245,834) 1.74
---------------- ---------------
Outstanding at December 31, 2004 9,614,767 $ 1.61
================ ===============
Granted 1,205,000 3.97
Exercised(Note E) (221,400) 1.09
Cancelled or expired (45,000) 2.37
---------------- ---------------
Outstanding at June 30, 2005 10,553,367 $ 1.89
================ ===============
The weighted-average fair value of stock options granted to employees during the
period ended June 30, 2005 and 2004 and the weighted-average significant
assumptions used to determine those fair values, using a Black-Scholes option
pricing model are as follows:
2005 2004
---- ----
Significant assumptions (weighted-average):
Risk-free interest rate at grant date 3.50 to 3.75% 1.00%
Expected stock price volatility 71% 32%
Expected dividend payout - -
Expected option life-years 5.0 10.0
If the Company recognized compensation cost for the non-qualified employee stock
option plan in accordance with SFAS No. 123, the Company's pro forma net loss
and net loss per share would have been $(11,074,453) and $(0.25) for the period
ended June 30, 2005 and $ (10,158,100) and $(0.26) for the period ended June 30,
2004, respectively.
15
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION
JUNE 30, 2005
(UNAUDITED)
NOTE D - STOCK OPTIONS AND WARRANTS (CONTINUED)
Non-Employee Stock Options
- --------------------------
The following table summarizes the changes in options outstanding and the
related prices for the shares of the Company's common stock issued to the
Company consultants. These options were granted in lieu of cash compensation for
services performed.
Options Outstanding Options Exercisable
------------------- -------------------
Weighted Average Weighed Weighted
Number Remaining Contractual Average Number Average
Exercise Price Outstanding Life (Years) Exercise Price Exercisable Exercise Price
-------------- ----------- ------------ -------------- ----------- --------------
$1.00 1,897,503 6.83 $1.00 1,647,500 $1.00
$3.45 75,000 9.01 $3.45 75,000 $3.45
----------- ------------ -------------- ----------- --------------
1,972,503 6.96 $1.09 1,722,500 $1.11
=========== ============ ============== =========== ==============
Transactions involving options issued to non-employees are summarized as
follows:
Weighted Average
Number of Shares Price Per Share
---------------- ---------------
Outstanding at January 1, 2003 1,555,000 $ 1.00
Granted 1,900,000 1.00
Exercised (187,500) 0.96
Canceled or expired -- --
---------------- ---------------
Outstanding at December 31, 2003 3,267,500 $ 1.00
================ ===============
Granted 60,000 3.45
Exercised (328,331) 1.00
Canceled or expired (1,000,000) 1.00
---------------- ---------------
Outstanding at December 31, 2004 1,999,169 $ 1.07
================ ===============
Granted 60,000 3.45
Exercised (Note E) (41,666) 1.00
Canceled or expired (45,000) 3.45
---------------- ---------------
Outstanding at June 30, 2005 1,972,503 $ 1.09
================ ===============
The estimated value of the non-employee stock options vested during the period
ended June 30, 2005 was determined using the Black-Scholes option pricing model
and the following assumptions: estimated option life of 1 to 3 years, a risk
free interest rate of 3.00 to 4.00%, a dividend yield of 0% and volatility of
71%. The amount of the expense charged to operations in connection with granting
the options was $517,381 and $452,707 during the period ended June 30, 2005 and
2004, respectively.
16
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION
JUNE 30, 2005
(UNAUDITED)
NOTE D - STOCK OPTIONS AND WARRANTS (CONTINUED)
Warrants
- --------
The following table summarizes the changes in warrants outstanding and the
related prices for the shares of the Company's common stock issued to
non-employees of the Company. These warrants were granted in lieu of cash
compensation for services performed or financing expenses in connection with
placement of convertible debentures.
Warrants Outstanding Warrants Exercisable
-------------------- --------------------
Weighted Average Weighed Weighted
Number Remaining Contractual Average Number Average
Exercise Prices Outstanding Life (Years) Exercise Price Exercisable Exercise Price
--------------- ----------- ------------ -------------- ----------- --------------
$1.00 416,500 0.70 $1.00 416,500 $1.00
$2.97 35,000 0.89 $2.97 35,000 $2.97
----------- ------------ -------------- ----------- --------------
451,500 0.71 $1.15 451,500 $1.15
=========== ============ ============== =========== ==============
Transactions involving warrants are summarized as follows:
Weighted Average
Number of Shares Price Per Share
---------------- ---------------
Outstanding at January 1, 2003 3,531,460 $ 0.84
Granted 8,591,800 1.01
Exercised (6,963,770) 0.92
Canceled or expired -- --
---------------- ---------------
Outstanding at December 31, 2003 5,159,490 $ 1.01
================ ===============
Granted -- --
Exercised (4,468,590) 0.99
Canceled or expired (115,000) 1.00
---------------- ---------------
Outstanding at December 31, 2004 575,900 $ 1.12
================ ===============
Granted -- --
Exercised (Note E) (124,400) 1.00
Canceled or expired -- --
---------------- ---------------
Outstanding at June 30, 2005 451,500 $ 1.15
================ ===============
The Company did not grant any compensatory warrants to non-employees during the
period ended June 30, 2005. The estimated value of previously granted warrants
vested during the period ended June 30, 2005 was determined using the
Black-Scholes option pricing model and the following assumptions: warrant
remaining life of 0.89 years, a risk free interest rate of 3.33%, a dividend
yield of 0% and volatility of 71%. Compensation expense of $9,156 and $12,383
was charged to operations for the period ended June 30, 2005 and 2004,
respectively.
17
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION
JUNE 30, 2005
(UNAUDITED)
NOTE E - CAPITAL STOCK
The Company has authorized 15,000,000 shares of preferred stock, par value $.001
per share. As of June 30, 2005 and December 31, 2004, the Company had no
preferred stock issued and outstanding. The Company has authorized 100,000,000
shares of common stock, par value $.001 per share. As of June 30, 2005 and
December 31, 2004, the Company had 44,729,573 and 44,335,989 shares of common
stock issued and outstanding, respectively.
During the period ended June 30, 2005, the Company issued an aggregate of
221,400 shares of common stock for an aggregate purchase price of $241,942 to
certain employees upon exercise of employee stock options at approximately $1.09
per share. Additionally, the Company issued an aggregate of 41,666 shares of
common stock for an aggregate purchase price of $41,667 to consultants upon
exercise of non-employee stock options at $1.00 per share.
During the period ended June 30, 2005, the Company issued an aggregate of 1,968
shares of common stock, having an aggregate fair market value of $9,000, to
consultants in exchange for services rendered, which approximated the fair value
of the shares issued during the period services were completed and rendered.
Compensation costs of $9,000 were charged to operations during the period ended
June 30, 2005.
The Company issued an aggregate of 74,400 shares of common stock to consultants
upon the exercise of warrants at $1.00 per share. The Company also issued 36,150
shares of common stock in exchange for 50,000 cashless warrants exercised.
The Company issued an aggregate of 18,000 shares of common stock to an employee
in exchange for $83,799 of services rendered, which approximated the fair value
of the shares issued during the period services were completed and rendered.
Compensation costs of $83,799 were charged to operations during the period ended
June 30, 2005.
NOTE F - LONG-TERM INVESTMENTS
Amperion, Inc.
- --------------
On November 30, 2004, the Company entered into a Stock Purchase Agreement
("Agreement") with Amperion, Inc. ("Amperion"), a privately held company.
Amperion is engaged in the business of developing networking hardware and
software that enables the delivery of high-speed broadband data over
medium-voltage power lines. Pursuant to the Agreement, the Company invested
$500,000 in Amperion in exchange for 11,013,215 shares of Series A Preferred
Stock for an equity interest of approximately 4.7%. The Company has the right to
appoint one person to Amperion's seven-person board of directors. The Company
accounted for this investment under the cost method, as the Company does not
have the ability to exercise significant influence over operating and financial
policies of the investee.
BPL Global, Ltd.
- ----------------
On February 4, 2005, the Company approved an investment of $100,000 in BPL
Global, Ltd. ("BPL Global"), a privately held company. This investment when
fully funded will represent an equity interest of approximately 5.8%.BPL Global,
is engaged in the business of developing broadband services via power lines
through joint ventures in the United States, Asia, Eastern Europe and the Middle
East. As of June 30, 2005, the Company has funded $50,000 of this commitment and
the remaining balance was funded in July 2005. The Company accounted for this
investment under the cost method, as the Company does not have the ability to
exercise significant influence over operating and financial policies of the
investee.
It is the policy of the Company to regularly review the assumptions underlying
the operating performance and cash flow forecasts in assessing the carrying
values of the investment. The Company identifies and records impairment losses
on investments when events and circumstances indicate that such decline in fair
value is other than temporary. Such indicators include, but are not limited to,
limited capital resources, limited prospects of receiving additional financing,
and limited prospects for liquidity of the related securities. The fair value of
the Company's investment in Amperion and BPL Global, remained at $500,000 and
$50,000, respectively, as of June 30, 2005.
18
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION
JUNE 30, 2005
(UNAUDITED)
NOTE G - INVENTORIES
Inventories are stated at the lower of cost or market determined by the
first-in, first-out (FIFO) method. Inventories primarily consist of Gateways,
eXtenders, Couplers and iBridges, which are the significant components of the
Telkonet solution. Components of inventories as of June 30, 2005 and December
31, 2004 are as follows:
June 30, 2005 December 31, 2004
------------- -----------------
Raw Materials $ 674,710 $ 748,110
Finished Goods 1,165,281 1,125,608
------------- -----------------
$ 1,839,991 $ 1,873,718
============= =================
NOTE H - BUSINESS CONCENTRATION
Revenue from three (3) major customers approximated $147,581 or 21% of sales for
the period ended June 30, 2005, and $190,452 or 46% of sales for the period
ended June 30, 2004. Total accounts receivable of $43,280, or 51% of total
accounts receivable was due from these three customers as of June 30, 2005 and
$88,164, or 58% of total accounts receivable was due from these three customers
as of June 30, 2004.
19
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
The following should be read in conjunction with the Company's Consolidated
Financial Statements and Notes thereto, included elsewhere within this Report.
Description of the Company
Telkonet, Inc. ("Telkonet" or the "Company") was formed in 1999 to develop
products for use in the powerline communications (PLC) industry. PLC products
use existing electrical wiring in commercial buildings and residences to carry
high speed data communications signals, including the Internet. Since the
Company's formation, it has focused on development and marketing of its PLC
technology.
The Company's PLC technology, the "PlugPlus(TM)" product suite (also refered to
as the Telkonet iWire System in certain commercial applications), consists of
four primary components, the Gateway, the eXtender, the Coupler and the iBridge.
The Gateway, the hub of the PlugPlus(TM)product suite, is a modular,
self-contained unit that accepts data from an existing network on one port and
distributes it via a second port. The Gateway integrates a communications
processor that runs a series of proprietary applications under Linux. The signal
generated by the Gateway can be directly coupled into low voltage wiring via the
Coupler, which interfaces directly between the Gateway and the building's
electrical panel. Multi-panel buildings typically require multiple Couplers,
which are connected to the Gateway via inexpensive coaxial cable and
concentrated using standard radio frequency splitters. A suite of software
applications running on the Gateway can perform communications functions or
system management functions. The iBridge serves as the user's network access
device and connects to a user's personal computer through a standard Ethernet
cable. The iBridge's AC line cord serves as its power source as well as its
network interface. The eXtender is used to extend the reach of the Gateway in
larger buildings or campus environments.
The PlugPlus(TM) product suite delivers data to the user at speeds in excess of
7 Mega bits per second (Mbps), with burst speeds of 12.6 Mbps. The PlugPlus(TM)
product suite is installed by connecting an incoming broadband signal (DSL, T-1,
satellite or cable modem) into the Gateway and connecting the Gateway to a
building's electrical panel using one or more Couplers. Once installed, the
Gateway distributes the high-speed Internet signal throughout the entire
existing network of electrical wires within the building. The user may access a
high-speed Internet signal by plugging the iBridge into any electrical outlet
and connecting a personal computer to the iBridge using the computer's built-in
Ethernet port. Multiple personal computers connected to the iBridge can
communicate with one another and can share a single broadband resource via the
Gateway.
The Company is a member of the HomePlug(TM) Powerline Alliance, an industry
trade group that engages in marketing and educational initiatives, and sets
standards and specifications for products, in the powerline communications
industry.
The Company's principal executive offices are located at 20374 Seneca Meadows
Parkway, Germantown, MD 20876
Forward Looking Statements
This report may contain "forward-looking statements," which represent the
Company's expectations or beliefs, including, but not limited to, statements
concerning industry performance and the Company's results, operations,
performance, financial condition, plans, growth and strategies, which include,
without limitation, statements preceded or followed by or that include the words
"may," "will," "expect," "anticipate," "intend," "could," "estimate," or
"continue" or the negative or other variations thereof or comparable
terminology. Any statements contained in this report or the information
incorporated by reference that are not statements of historical fact may be
deemed to be forward-looking statements within the meaning of Section 27(A) of
the Securities Act of 1933 and Section 21(F) of the Securities Exchange Act of
1934. For such statements, the Company claims the protection of the safe harbor
for forward-looking statements contained in the Private Securities Litigation
Reform Act of 1995. These statements by their nature involve substantial risks
and uncertainties, some of which are beyond the Company's control, and actual
results may differ materially depending on a variety of important factors, many
of which are also beyond the Company's control. You should not place undue
reliance on these forward-looking statements, which speak only as of the date of
this report. The Company does not undertake any obligation to update or release
any revisions to these forward-looking statements to reflect events or
circumstances after the date of this report or to reflect the occurrence of
unanticipated events, except to the extent such updates and/or revisions are
required by applicable law. CRITICAL ACCOUNTING POLICIES
The preparation of our consolidated financial statements in conformity
with accounting principles generally accepted in the United States requires us
to make estimates and judgments that affect our reported assets, liabilities,
revenues, and expenses, and the disclosure of contingent assets and liabilities.
We base our estimates and judgments on historical experience and on various
other assumptions we believe to be reasonable under the circumstances. Future
20
events, however, may differ markedly from our current expectations and
assumptions. While there are a number of significant accounting policies
affecting our consolidated financial statements, we believe the following
critical accounting policies involve the most complex, difficult and subjective
estimates and judgments:
o stock-based compensation; and
o revenue recognition.
STOCK-BASED COMPENSATION
In December 2002, the FASB issued SFAS No. 148 - Accounting for Stock-Based
Compensation - Transition and Disclosure. This statement amends SFAS No. 123 -
Accounting for Stock-Based Compensation, providing alternative methods of
voluntarily transitioning to the fair market value based method of accounting
for stock based employee compensation. FAS 148 also requires disclosure of the
method used to account for stock-based employee compensation and the effect of
the method in both the annual and interim financial statements. The provisions
of this statement related to transition methods are effective for fiscal years
ending after December 15, 2002, while provisions related to disclosure
requirements are effective in financial reports for interim periods beginning
after December 31, 2002.
We elected to continue to account for stock-based compensation plans using the
intrinsic value-based method of accounting prescribed by APB No. 25, "Accounting
for Stock Issued to Employees," and related interpretations. Under the
provisions of APB No. 25, compensation expense is measured at the grant date for
the difference between the fair value of the stock and the exercise price.
On December 16, 2004, the Financial Accounting Standards Board (FASB) issued
FASB Statement No. 123R (revised 2004), "Share-Based Payment" which is a
revision of FASB Statement No. 123, "Accounting for Stock-Based Compensation".
Statement 123R supersedes APB opinion No. 25, "Accounting for Stock Issued to
Employees", and amends FASB Statement No. 95, "Statement of Cash Flows".
Generally, the approach in Statement 123R is similar to the approach described
in Statement 123. However, Statement 123R requires all share-based payments to
employees, including grants of employee stock options, to be recognized in the
income statement based on their fair values. Pro-forma disclosure is no longer
an alternative. On April 14, 2005, the SEC amended the effective date of the
provisions of this statement. The effect of this amendment by the SEC is that
the Company will have to comply with Statement 123R and use the Fair Value based
method of accounting no later than the first quarter of 2006.
Revenue Recognition
- -------------------
For revenue from product sales, we recognize revenue in accordance with Staff
Accounting Bulletin No. 104, REVENUE RECOGNITION ("SAB104"), which superceded
Staff Accounting Bulletin No. 101, REVENUE RECOGNITION IN FINANCIAL STATEMENTS
("SAB101"). SAB 101 requires that four basic criteria must be met before revenue
can be recognized: (1) persuasive evidence of an arrangement exists; (2)
delivery has occurred; (3) the selling price is fixed and determinable; and (4)
collectibility is reasonably assured. Determination of criteria (3) and (4) are
based on management's judgments regarding the fixed nature of the selling prices
of the products delivered and the collectibility of those amounts. Provisions
for discounts and rebates to customers, estimated returns and allowances, and
other adjustments are provided for in the same period the related sales are
recorded. We defers any revenue for which the product has not been delivered or
is subject to refund until such time that we and the customer jointly determine
that the product has been delivered or no refund will be required. SAB 104
incorporates Emerging Issues Task Force 00-21 ("EITF 00-21"),
MULTIPLE-DELIVERABLE REVENUE ARRANGEMENTS. EITF 00-21 addresses accounting for
arrangements that may involve the delivery or performance of multiple products,
services and/or rights to use assets.
Currently, there are no warranties provided with the purchase of our products.
The cost of replacing defective products and product returns have been
immaterial and within management's expectations. In the future, when we deem
warranty reserves are appropriate, such costs will be accrued to reflect
anticipated warranty costs.
For equipment under lease, revenue is recognized over the lease term for
operating lease and rental contracts. All of our leases are accounted for as
operating leases. At the inception of the lease, no lease revenue is recognized
and the leased equipment, together with the initial direct costs of installation
and support are capitalized, and appear on the balance sheet as "Equipment Under
Operating Leases." The capitalized cost of this equipment is depreciated from
two to three years, on a straight-line basis down to our original estimate of
the projected value of the equipment at the end of the scheduled lease term.
Monthly lease payments are recognized as rental income.
21
REVENUES
- --------
The Company's revenue consists of direct product sales and a recurring
(lease) model in the commercial, government and international markets. The table
below outlines product versus recurring (lease) revenues for comparable periods:
------------------------------------------------------------
Three months Ended
------------------------------------------------------------
Revenue: June 30, 2005 June 30, 2004 Variance
Recurring (lease) $ 162,697 34% $ 45,881 17% $ 116,816 255%
Product 310,250 64% 226,022 83% 84,228 37%
---------- ------------ -----------
Total $ 472,947 100% $ 271,903 100% $ 201,044 74%
========== ============ ===========
------------------------------------------------------------
Six months Ended
------------------------------------------------------------
Revenue: June 30, 2005 June 30, 2004 Variance
Recurring (lease) $ 279,612 39% $ 66,189 16% $ 213,423 322%
Product 439,523 61% 345,813 84% 93,710 27%
---------- ------------ -----------
Total $ 719,135 100% $ 412,002 100% $ 307,133 75%
========== ============ ===========
RECURRING REVENUE
The increase in recurring (lease) revenue was primarily due to the
increase in non-cancelable leases. Accordingly, revenues associated with these
leases are recognized ratably over a three to five year lease term. Revenues to
be recognized under these non-cancelable leases (backlog) was approximately
$1,779,000 and $463,000 as of June 30, 2005 and 2004, respectively. The weighted
average remaining lease term was approximately 30 and 31 months,
respectively.The associated unamortized capitalized costs in connection with
these leases was approximately $732,000 and $203,000 or 41% and 44% of revenue
backlog, respectively.
PRODUCT REVENUE
Product revenue principally arises from the sale of iBridges and other
PlugPlus(TM) components directly to customers. Revenues to date have been
principally derived from the Commercial (Hospitality and Multi-Dwelling) and
International business units. The Company has expanded its international sales
and marketing efforts upon receiving its European certification (CE) in March
2005 resulting in product revenue of approximately $150,000 during the quarter
ending June 30, 2005. The Company plans to expand its sales and marketing
efforts in the government sector based on the receipt of the FIPS 140-2
certification received in July 2005.
COST OF SALES
-------------
--------------------------------------------------------
Three months Ended
--------------------------------------------------------
Cost of Sales: June 30, 2005 June 30, 2004 Variance
Recurring (lease) $ 98,383 60% $ 20,428 45% $ 77,955 382%
Product 253,773 82% 238,701 106% 15,072 6%
--------- --------- ---------
Total $ 352,156 74% $ 259,129 95% $ 93,027 36%
========= ========= =========
--------------------------------------------------------
Six months Ended
--------------------------------------------------------
Cost of Sales: June 30, 2005 June 30, 2004 Variance
Recurring (lease) $ 164,791 59% $ 26,294 45% $ 138,497 527%
Product 344,755 78% 367,239 106% (22,484) (6%)
--------- --------- ---------
Total $ 509,546 71% $ 393,533 96% $ 116,013 29%
========= ========= =========
22
RECURRING (LEASE) COSTS
Lease Cost primarily represents the amortization of the capitalized
costs which are amortized over the lease term and include Telkonet equipment,
installation labor and customer support. This increase compared to the prior
year quarter is commensurate with the increase in leases.
PRODUCT COSTS
Product cost primarily includes Telkonet equipment cost and
installation labor. During the period ended June 30, 2004, certain complex
installations resulted in additional installation labor as the Company was
implementing its initial installations. The Company continues to refine its
installation processes enabling lower costs.
GROSS PROFIT
------------
-----------------------------------------------------------
Three months Ended
-----------------------------------------------------------
Gross Profit: June 30, 2005 June 30, 2004 Variance
Recurring (lease) $ 64,314 40% $ 25,453 55% $ 38,861 153%
Product 56,477 18% (12,679) (6%) 69,156 545%
-------- -------- --------
Total $120,791 26% $ 12,774 5% $108,017 846%
======== ======== ========
-----------------------------------------------------------
Six months Ended
-----------------------------------------------------------
Gross Profit: June 30, 2005 June 30, 2004 Variance
Recurring (lease) $114,821 41% $ 39,895 60% $ 74,926 188%
Product 94,768 22% (21,426) (6%) 116,194 542%
-------- -------- --------
Total $209,589 29% $ 18,469 4% $191,120 1035%
======== ======== ========
Gross profit associated with both the recurring lease and product revenues for
the three and six-months ended June 30, 2005 improved over the same periods last
year primarily as a result of reduction of equipment costs and of improved
installation processes, including upfront site surveys and standardized
training.
OPERATING EXPENSES
------------------
Overall expenses decreased for the three months ended June 30, 2005
over the comparable period in 2004 by $1,106,914 or 22%, and increased for the
six months ended June 30, 2005 over the comparable period in 2004 by $57,762 or
1%. The operating expenses, excluding a $2,500,000 consultant fee expensed in
the three months ended June 30, 2004, increased for the three and six months
ended June 30, 2005 over the comparable period in 2004 by $1,393,086 or 56% and
$2,557,762 or 57%, respectively. This increase was principally due to salary and
travel costs related to increased sales and marketing functions and office rent
related to the Germantown, MD and Crystal City, VA leases. The number of
employees increased from 41 at June 30, 2004 to 72 at June 30, 2005. Other
increased costs were incurred in non-employee compensation for services,
advertising and trade shows, and rent.
LIQUIDITY AND CAPITAL RESOURCES
-------------------------------
The Company's current assets exceeded current liabilities as of June
30, 2005 and December 31, 2004 by $5,597,372 and $12,671,520, respectively. Of
the total current assets as of June 30, 2005 of $7,917,899 and as of December
31, 2004 of $13,900,419, cash represented $5,861,879 and $11,838,702,
respectively.
In January 2004, the Board of Directors determined to permit the Senior
Noteholders, for a limited period of time, to convert their Senior Notes into
the Company's common stock at a conversion price of $2.10 per share. In
connection with this transaction, Senior Noteholders converted Senior Notes
having an aggregate principal value of $2,539,000.
23
In February 2004, Telkonet completed a private placement of its common
stock resulting in net proceeds to the Company of approximately $12.8 million.
The Company sold 6,387,600 shares of its common stock at a discount of 18% to
the average market price of the Company's common stock for the preceding 30
days.
In March 2004, the Company received $3.9 million upon the exercise of
4,235,007 warrants to purchase the Company's common stock. Additionally, $0.2
million of debentures were converted into 324,000 shares of the Company's common
stock.
While the Company believes it has sufficient capital to meet its
working capital requirements for the next twelve months, additional financing
may be required in order to meet growth opportunities in financing and/or
investing activities. If additional capital is required and the Company is not
successful in generating sufficient liquidity from operations or in raising
sufficient capital resources on terms acceptable to the Company, this could have
a material adverse effect on the Company's business, results of operations,
liquidity and financial condition.
PRODUCT RESEARCH AND DEVELOPMENT
--------------------------------
Company-sponsored research and development costs related to both
present and future products are expended in the period incurred. Total expenses
for the three and six months ended June 30, 2005 increased $59,313 or 14% and
$74,523 or 9%, respectively, over the comparable period in 2004. This increase
was primarily related to an increase in salaries and related costs associated
with the addition of employees and costs related to CE, FIPS 140-2 and other
required certifications of the Company's product.
24
SELLING, GENERAL AND ADMINISTRATIVE
-----------------------------------
Selling, general and administrative expenses increased for the three
and six months ended June 30, 2005 over the comparable period in 2004 by
$1,337,958 or 74% and $2,383,726 or 75%, respectively. This increase is related
to an increase in payroll and associated costs for sales and marketing
resources, advertising, trade shows, and office rent and related facility costs.
ACQUISITION OR DISPOSITION OF PROPERTY AND EQUIPMENT
----------------------------------------------------
During the six months ended June 30, 2005, fixed assets increased by
$281,284 or 40% which is primarily related to furniture and fixtures in the
Crystal City, Virginia office, sales support software and computer equipment
related to new employees. The Company does not anticipate the sale or purchase
of any significant property, plant or equipment during the next twelve months,
other than computer equipment and peripherals to be used in the Company's
day-to-day operations.
In April 2005, the Company entered into a three-year lease agreement
for 6,742 square feet of commercial office space in Crystal City, Virginia.
Pursuant to this lease, the Company agreed to assume a portion of the build-out
cost for this facility.
NUMBER OF EMPLOYEES
-------------------
As of August 1, 2005, the Company had seventy-three (73) full time
employees. In order for the Company to attract and retain quality personnel, the
Company anticipates it will continue to offer competitive salaries to current
and future employees. The Company anticipates that it will increase its
employment base to meet the needs outlined in its business plan.
As the Company continues to expand, the Company plans to incur
additional costs for personnel. This projected increase in personnel is
dependent upon the Company generating revenues and obtaining sources of
financing in excess of its existing capital resources. Although the Company
believes it has sufficient capital as of August 1, 2005 to support the
anticipated growth in operations, there can be no assurance that the Company
will be successful in raising the funds required or generating revenues
sufficient to fund the projected increase in the number of employees.
DISCLOSURE OF CONTRACTUAL OBLIGATIONS
-------------------------------------
-----------------------------------------------------------------------------------------------
PAYMENT DUE BY PERIOD
- ------------------------- -----------------------------------------------------------------------------------------------
CONTRACTUAL OBLIGATIONS TOTAL LESS THAN 1 YEAR 1-3 YEARS 3-5 YEARS MORE THAN 5 YEARS
- ------------------------- ----------------- ------------------- -------------------- ---------------- -------------------
Long-Term Debt - - - - -
Obligations
- ------------------------- ----------------- ------------------- -------------------- ---------------- -------------------
Capital Lease - - - - -
Obligations
- ------------------------- ----------------- ------------------- -------------------- ---------------- -------------------
Operating Lease $1,543,490 $411,128 $900,846 $231,516 -
Obligations
- ------------------------- ----------------- ------------------- -------------------- ---------------- -------------------
Purchase Obligations - - - - -
- ------------------------- ----------------- ------------------- -------------------- ---------------- -------------------
Other Long-Term - - - - -
Liabilities Reflected
on the Registrant's
Balance Sheet Under GAAP
- ------------------------- ----------------- ------------------- -------------------- ---------------- -------------------
Total $1,543,490 $411,128 $900,846 $231,516 -
- ------------------------- ----------------- ------------------- -------------------- ---------------- -------------------
TRENDS, RISKS AND UNCERTAINTIES
-------------------------------
The Company has sought to identify what it believes to be the most significant
risks to its business, but cannot predict whether or to what extent any of such
risks may be realized nor can there be any assurances that the Company has
identified all possible risks that might arise. Investors should carefully
consider all such risk factors in evaluating the Company's financial outlook.
25
TELKONET RECENTLY EMERGED FROM ITS DEVELOPMENT STAGE AND HAS NO OPERATING
HISTORY ON WHICH TO BASE AN EVALUATION OF ITS CURRENT BUSINESS AND FUTURE
PROSPECTS.
The Company emerged from its development stage as of December 31, 2003.
As a result, it has a limited operating history upon which to base an evaluation
of its current business and future prospects. The Company has not generated
substantial revenues since its inception. Because of the Company's brief
operating history, management has limited insight into trends that may emerge
and could materially adversely affect the Company's business. Prospective
investors should consider the risks and difficulties the Company may encounter
in its new and rapidly evolving market, especially given the Company's brief
operating history. These risks include the Company's ability to:
o market the PlugPlus(TM) product suite;
o build a customer base;
o generate revenues;
o compete favorably in a highly competitive market;
o access sufficient capital to support growth;
o recruit and retain qualified employees;
o introduce new products and services; and
o build technology and support systems.
THE COMPANY HAS A HISTORY OF OPERATING LOSSES AND AN ACCUMULATED DEFICIT AND
EXPECTS TO CONTINUE TO INCUR LOSSES FOR THE FORESEEABLE FUTURE.
Since inception through June 30, 2005, the Company has incurred
cumulative losses of $34,073,797 and has never generated enough funds through
operations to support its business. The Company expects to continue to incur
substantial operating losses through 2005. The Company's losses to date have
resulted principally from:
o research and development costs relating to the development of
the PlugPlus(TM) product suite;
o costs and expenses associated with manufacturing, distribution
and marketing of the Company's products;
o general and administrative costs relating to the Company's
operations; and
o interest expense related to the Company's indebtedness.
The Company is currently unprofitable and may never become profitable.
Since inception, the Company has funded its research and development activities
primarily from private placements of equity and debt securities, a bank loan and
short term loans from certain of its executive officers. As a result of its
substantial research and development expenditures and limited product revenues,
the Company has incurred substantial net losses. The Company's ability to
achieve profitability will depend primarily on its ability to successfully
commercialize the PlugPlus(TM) product suite.
POTENTIAL FLUCTUATIONS IN OPERATING RESULTS COULD HAVE A NEGATIVE EFFECT ON THE
PRICE OF THE COMPANY'S COMMON STOCK.
The Company's operating results may fluctuate significantly in the
future as a result of a variety of factors, most of which are outside the
Company's control, including:
o the level of use of the Internet;
o the demand for high-tech goods;
o the amount and timing of capital expenditures and other costs
relating to the expansion of the Company's operations;
o price competition or pricing changes in the industry;
o technical difficulties or system downtime;
26
o economic conditions specific to the internet and
communications industry; and
o general economic conditions.
The Company's quarterly results may also be significantly impacted by
certain accounting treatment of acquisitions, financing transactions or other
matters. Such accounting treatment could have a material impact on the Company's
results of operations and have a negative impact on the price of the Company's
common stock.
THE COMPANY'S DIRECTORS AND EXECUTIVE OFFICERS OWN A SUBSTANTIAL PERCENTAGE OF
THE COMPANY'S ISSUED AND OUTSTANDING COMMON STOCK. THEIR OWNERSHIP COULD ALLOW
THEM TO EXERCISE SIGNIFICANT CONTROL OVER CORPORATE DECISIONS.
As of August 1, 2005, the Company's officers and directors owned 24.0%
of the Company's issued and outstanding common stock. This means that the
Company's officers and directors, as a group, exercise significant control over
matters upon which the Company's stockholders may vote, including the selection
of the Board of Directors, mergers, acquisitions and other significant corporate
transactions.
FURTHER ISSUANCES OF EQUITY SECURITIES MAY BE DILUTIVE TO CURRENT STOCKHOLDERS.
Although the funds raised in the Company's debenture offerings, note
offering and private placement of common stock are being used for general
working capital purposes, it is likely that the Company will be required to seek
additional capital in the future. This capital funding could involve one or more
types of equity securities, including convertible debt, common or convertible
preferred stock and warrants to acquire common or preferred stock. Such equity
securities could be issued at or below the then-prevailing market price for the
Company's common stock. Any issuance of additional shares of the Company's
common stock will be dilutive to existing stockholders and could adversely
affect the market price of the Company's common stock.
THE EXERCISE OF OPTIONS AND WARRANTS OUTSTANDING AND AVAILABLE FOR ISSUANCE MAY
ADVERSELY AFFECT THE MARKET PRICE OF THE COMPANY'S COMMON STOCK.
As of June 30, 2005, the Company had outstanding employee options to
purchase a total of 10,553,367 shares of common stock at exercise prices ranging
from $1.00 to $5.97 per share, with a weighted average exercise price of $1.89.
As of June 30, 2005, the Company had outstanding non-employee options to
purchase a total of 1,972,503 shares of common stock at exercise prices ranging
from $1.00 to $3.45 per share, with a weighted average exercise price of $1.09
per share. As of June 30, 2005, the Company had warrants outstanding to purchase
a total of 451,500 shares of common stock at exercise prices ranging from $1.00
to $2.97 per share, with a weighted average exercise price of $1.15. In
addition, as of June 30, 2005, the Company had 33,974 additional shares
remaining of common stock which may be issued in the future under the Amended
and Restated Telkonet, Inc. Stock Incentive Plan. The Company anticipates that
the Board will authorize the issuance of additional shares under the plan. The
exercise of outstanding options and warrants and the sale in the public market
of the shares purchased upon such exercise will be dilutive to existing
stockholders and could adversely affect the market price of the Company's common
stock.
THE POWERLINE COMMUNICATIONS INDUSTRY IS INTENSELY COMPETITIVE AND RAPIDLY
EVOLVING.
The Company operates in a highly competitive, quickly changing
environment, and the Company's future success will depend on its ability to
develop and introduce new products and product enhancements that achieve broad
market acceptance in commercial and governmental sectors. The Company will also
need to respond effectively to new product announcements by its competitors by
quickly introducing competitive products.
Delays in product development and introduction could result in:
o loss of or delay in revenue and loss of market share;
o negative publicity and damage to the Company's reputation and
brand; and
o decline in the average selling price of the Company's
products.
GOVERNMENT REGULATION OF THE COMPANY'S PRODUCTS COULD IMPAIR THE COMPANY'S
ABILITY TO SELL SUCH PRODUCTS IN CERTAIN MARKETS.
FCC rules permit the operation of unlicensed digital devices that
radiate radio frequency emissions if the manufacturer complies with certain
equipment authorization procedures, technical requirements, marketing
restrictions and product labeling requirements. Differing technical requirements
apply to "Class A" devices intended for use in commercial settings, and "Class
27
B" devices intended for residential use to which more stringent standards apply.
An independent, FCC-certified testing lab has verified that the Company's
PlugPlus(TM) product suite complies with the FCC technical requirements for
Class A and Class B digital devices. No further testing of these devices is
required and the devices may be manufactured and marketed for commercial and
residential use. Additional devices designed by the Company for commercial and
residential use will be subject to the FCC rules for unlicensed digital
devices. Moreover, if in the future, the FCC changes its technical requirements
for unlicensed digital devices, further testing and/or modifications of devices
may be necessary. Failure to comply with any FCC technical requirements could
impair the Company's ability to sell its products in certain markets and could
have a negative impact on its business and results of operations.
PRODUCTS SOLD BY THE COMPANY'S COMPETITORS COULD BECOME MORE POPULAR THAN THE
COMPANY'S PRODUCTS OR RENDER THE COMPANY'S PRODUCTS OBSOLETE.
The market for powerline communications products is highly competitive.
The Company believes it has the only commercial integrated three phase solution
for "in-building" distribution of broadband utilizing the electrical wiring
infrastructure. The Linksys Division of Cisco Systems, Inc. (Linksys) and
Netgear, Inc. offer similar PLC solutions for the residential market. Although
Linksys and Netgear do not presently complete with the Company in the commercial
market, there can be no assurance that Linksys, Netgear or any other company
will not develop PLC products that compete with the Company's products in the
future. These potential competitors have longer operating histories, greater
name recognition and substantially greater financial, technical, sales,
marketing and other resources. These potential competitors may, among other
things, undertake more extensive marketing campaigns, adopt more aggressive
pricing policies, obtain more favorable pricing from suppliers and manufacturers
and exert more influence on the sales channel than the Company can. As a result,
the Company may not be able to compete successfully with these potential
competitors and these potential competitors may develop or market technologies
and products that are more widely accepted than those being developed by the
Company or that would render the Company's products obsolete or noncompetitive.
The Company anticipates that potential competitors will also intensify their
efforts to penetrate the Company's target markets. These potential competitors
may have more advanced technology, more extensive distribution channels,
stronger brand names, bigger promotional budgets and larger customer bases than
the Company does. These companies could devote more capital resources to
develop, manufacture and market competing products than the Company could. If
any of these companies are successful in competing against the Company, sales
could decline, margins could be negatively impacted, and the Company could lose
market share, any of which could seriously harm the Company's business and
results of operations.
THE FAILURE OF THE INTERNET TO CONTINUE AS AN ACCEPTED MEDIUM FOR BUSINESS
COMMERCE COULD HAVE A NEGATIVE IMPACT ON THE COMPANY'S RESULTS OF OPERATIONS.
The Company's long-term viability is substantially dependent upon the
continued widespread acceptance and use of the Internet as a medium for business
commerce. The Internet has experienced, and is expected to continue to
experience, significant growth in the number of users. There can be no assurance
that the Internet infrastructure will continue to be able to support the demands
placed on it by this continued growth. In addition, delays in the development or
adoption of new standards and protocols to handle increased levels of Internet
activity or increased governmental regulation could slow or stop the growth of
the Internet as a viable medium for business commerce. Moreover, critical issues
concerning the commercial use of the Internet (including security, reliability,
accessibility and quality of service) remain unresolved and may adversely affect
the growth of Internet use or the attractiveness of its use for business
commerce. The failure of the necessary infrastructure to further develop in a
timely manner or the failure of the Internet to continue to develop rapidly as a
valid medium for business would have a negative impact on the Company's results
of operations.
THE COMPANY MAY NOT BE ABLE TO OBTAIN PATENTS, WHICH COULD HAVE A MATERIAL
ADVERSE EFFECT ON ITS BUSINESS.
The Company's ability to compete effectively in the powerline
technology industry will depend on its success in acquiring suitable patent
protection. The Company currently has several patents pending. The Company also
intends to file additional patent applications that it deems to be economically
beneficial. If the Company is not successful in obtaining patents, it will have
limited protection against those who might copy its technology. As a result, the
failure to obtain patents could negatively impact the Company's business and
results of operations.
INFRINGEMENT BY THIRD PARTIES ON THE COMPANY'S PROPRIETARY TECHNOLOGY AND
DEVELOPMENT OF SUBSTANTIALLY EQUIVALENT PROPRIETARY TECHNOLOGY BY THE COMPANY'S
COMPETITORS COULD NEGATIVELY IMPACT THE COMPANY'S BUSINESS.
The Company's success depends partly on its ability to maintain patent
and trade secret protection, to obtain future patents and licenses, and to
operate without infringing on the proprietary rights of third parties. There can
be no assurance that the measures the Company has taken to protect its
intellectual property, including those integrated to its PlugPlus(TM) product
suite, will prevent misappropriation or circumvention. In addition, there can be
no assurance that any patent application, when filed, will result in an issued
patent, or that the Company's existing patents, or any patents that may be
28
issued in the future, will provide the Company with significant protection
against competitors. Moreover, there can be no assurance that any patents issued
to, or licensed by, the Company will not be infringed upon or circumvented by
others. Infringement by third parties on the Company's proprietary technology
could negatively impact its business. Moreover, litigation to establish the
validity of patents, to assert infringement claims against others, and to defend
against patent infringement claims can be expensive and time-consuming, even if
the outcome is in the Company's favor. The Company also relies to a lesser
extent on unpatented proprietary technology, and no assurance can be given that
others will not independently develop substantially equivalent proprietary
information, techniques or processes or that the Company can meaningfully
protect its rights to such unpatented proprietary technology. Development of
substantially equivalent technology by the Company's competitors could
negatively impact its business.
THE COMPANY DEPENDS ON A SMALL TEAM OF SENIOR MANAGEMENT, AND IT MAY HAVE
DIFFICULTY ATTRACTING AND RETAINING ADDITIONAL PERSONNEL.
The Company's future success will depend in large part upon the
continued services and performance of senior management and other key personnel.
If the Company loses the services of any member of its senior management team,
its overall operations could be materially and adversely affected. In addition,
the Company's future success will depend on its ability to identify, attract,
hire, train, retain and motivate other highly skilled technical, managerial,
marketing, purchasing and customer service personnel when they are needed.
Competition for these individuals is intense. The Company cannot ensure that it
will be able to successfully attract, integrate or retain sufficiently qualified
personnel when the need arises. Any failure to attract and retain the necessary
technical, managerial, marketing, purchasing and customer service personnel
could have a negative effect on the Company's financial condition and results of
operations.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Short Term Investments
We held no marketable securities as of June 30, 2005. Our excess cash is held in
money market accounts in a bank and brokerage firms both of which are nationally
ranked top tier firms with an average return of approximately 200 basis points.
Due to the conservative nature of our investment portfolio, an increase or
decrease of 100 basis points in interest rates would not have a material effect
on our results of operations or the fair value of our portfolio.
Investments in Privately Held Companies
We have invested in privately held companies, which are in the startup or
development stages. These investments are inherently risky because the markets
for the technologies or products these companies are developing are typically in
the early stages and may never materialize. As a result, we could lose our
entire initial investment in these companies. In addition, we could also be
required to hold our investment indefinitely, since there is presently no public
market in the securities of these companies and none is expected to develop.
These investments are carried at cost, which as of August 1, 2005 was $600,000
including $50,000 invested in BPL Global in July 2005, compared with $500,000 at
December 31, 2004, and are recorded in other assets in the Consolidated Balance
Sheets. To date, there have been no impairment charges based on management's
assessment of these investments. Both investments are transactions which have
occurred within the last six months.
Item 4. Controls and Procedures.
As of June 30, 2005, the Company performed an evaluation, under the supervision
and with the participation of management, including the Chief Executive and
Chief Financial Officers, of the effectiveness of the design and operation of
its disclosure controls and procedures as defined in Rules 13a - 15(e) and 15d -
15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based
upon that evaluation, the Chief Executive and Chief Financial Officers concluded
that the Company's disclosure controls and procedures are effective in timely
alerting them to material information required to be included in the Company's
periodic filings with the U.S. Securities and Exchange Commission. There were no
significant changes in the Company's internal controls or in other factors that
have materially affected, or are reasonable likely to materially affect, the
Company's internal controls subsequent to the date of the most recent
evaluation.
29
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
NONE
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
During the three months ended June 30, 2005, the Company agreed to issue 9,000
shares of common stock to Ronald W. Pickett, the Company's Chief Executive
Officer, pursuant to his employment agreement, dated January 30, 2004.
The foregoing issuance of stock was effected in reliance on the exemption from
registration provided by Section 4(2) of the Securities Act of 1933 and/or Rule
506 of Regulation D promulgated thereunder.
During the three months ended June 30, 2005, the Company granted options to
purchase 745,000 shares of common stock to certain employees of the Company.
These options are exercisable for a period of ten years following the date of
grant at an average exercise price of $3.40 per share. The options were issued
pursuant to the Amended and Restated Telkonet, Inc. Stock Incentive Plan. The
shares of common stock underlying the options have been registered with the
Securities and Exchange Commission on a Form S-8 Registration Statement.
ISSUER PURCHASES OF EQUITY SECURITIES
- ------------------------- ----------------------- ----------------------- ----------------------- ---------------------
(d) MAXIMUM NUMBER
(c) TOTAL NUMBER OF (OR APPROXIMATE
SHARES PURCHASED AS DOLLAR VALUE) OF
PART OF PUBLICLY SHARES THAT MAY YET
(a) TOTAL NUMBER OF (b) AVERAGE PRICE ANNOUNCED PLANS OR BE PURCHASED UNDER
PERIOD SHARES PURCHASED PAID PER SHARE PROGRAMS THE PLANS OR PROGRAMS
- ------------------------- ----------------------- ----------------------- ----------------------- ---------------------
January 1-January 30, 0 n/a 0 0
2005
- ------------------------- ----------------------- ----------------------- ----------------------- ---------------------
February 1-February 28, 0 n/a 0 0
2005
- ------------------------- ----------------------- ----------------------- ----------------------- ---------------------
March 1-June 30, 2005 0 n/a 0 0
- ------------------------- ----------------------- ----------------------- ----------------------- ---------------------
Total 0 n/a 0 0
- ------------------------- ----------------------- ----------------------- ----------------------- ---------------------
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
Item 5. Other Information.
None.
30
Item 6. Exhibits
Exhibits
No. Description
- --- -----------
3.1 Articles of Incorporation of the Registrant (incorporated by reference
to our Form 8-K (No. 000-27305), filed on August 30, 2000, and our Form
S-8 (No. 333-47986), filed on October 16, 2000)
3.2 Bylaws of the Registrant (incorporated by reference to our Registration
Statement on Form S-1 (No. 333 108307), filed on August 28, 2003)
4.1 Form of Series A Convertible Debenture (incorporated by reference to
our Form 10-KSB (No. 000-27305), filed on March 31, 2003)
4.2 Form of Series A Non-Detachable Warrant (incorporated by reference to
our Form 10- KSB (No. 000-27305), filed on March 31, 2003)
4.3 Form of Series B Convertible Debenture (incorporated by reference to
our Form 10-KSB (No. 000-27305), filed on March 31, 2003)
4.4 Form of Series B Non-Detachable Warrant (incorporated by reference to
our Form 10- KSB (No. 000-27305), filed on March 31, 2003)
4.5 Form of Senior Note (incorporated by reference to our Registration
Statement on Form S-1 (No. 333-108307), filed on August 28, 2003)
4.6 Form of Non-Detachable Senior Note Warrant (incorporated by reference
to our Registration Statement on Form S-1 (No. 333-108307), filed on
August 28, 2003)
10.1 Amended and Restated Telkonet, Inc. Incentive Stock Option Plan
(incorporated by reference to our Registration Statement on Form S-8
(No. 333-412), filed on April 17, 2002)
10.2 Employment Agreement by and between Telkonet, Inc. and Stephen L.
Sadle, dated as of January 18, 2003 (incorporated by reference to our
Registration Statement on Form S-1 (No. 333-108307), filed on August
28, 2003
10.3 Employment Agreement by and between Telkonet, Inc. and Robert P. Crabb,
dated as of January 18, 2003 (incorporated by reference to our
Registration Statement on Form S-1 (No. 333-108307), filed on August
28, 2003)
10.4 Employment Agreement by and between Telkonet, Inc. and Ronald W.
Pickett, dated as of January 30, 2003 (incorporated by reference to our
Registration Statement on Form S-1 (No. 333-108307), filed on August
28, 2003)
10.5 Employment Agreement by and between Telkonet, Inc. and E. Barry Smith,
dated as of February 17, 2003 (incorporated by reference to our
Registration Statement on Form S-1 (No. 333-108307), filed on August
28, 2003)
24 Power of Attorney (incorporated by reference to our Registration
Statement on Form S-1 (No. 333-108307), filed on August 28, 2003)
31.1 Certification of Ronald W. Pickett pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification of E. Barry Smith pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification of Ronald W. Pickett pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of E. Barry Smith pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
SIGNATURES
Pursuant to the requirements of the Exchange Act, the registrant has duly caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
Telkonet, Inc.
Registrant
Date: August 9, 2005 By: /s/ Ronald W. Pickett
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Ronald W. Pickett
Chief Executive Officer
31