UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
DC 20549
FORM
10-K
Annual
Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934
Commission
file number: 000-27305
TELKONET,
INC.
(Exact
name of registrant as specified in its charter)
Utah
|
|
87-0627421
|
(State
or other jurisdiction of
|
|
(IRS
Employee Identification No.)
|
incorporation
or organization)
|
|
|
20374
Seneca Meadows Parkway
Germantown,
MD 20876
(Address
of principal executive offices)
(240)
912-1800
(Issuer’s
telephone number)
Securities
Registered pursuant to section 12(g) of the Act: None
Indicate
by check mark if the registrant is a well-know seasoned issuer, as defined
in
Rule 405 of the Securities Act. __Yes
X
No
Indicate
by check mark if the registrant is not required to file reports pursuant
to
Section 13 or Section 15(b) of the Act. __
Yes
X
No
Indicate
by check mark whether the registrant (1) has filed all reports required
to be
filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934
during
the preceding 12 months (or for such shorter period that the registrant
was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. X
Yes
___No
Check
if
disclosure of delinquent filers pursuant to Item 405 of Regulation S-K
is not
contained in this form, and no disclosure will be contained, to the best
of
Registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment
to this
Form 10-K.
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See the definition of
“accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange
Act.
___
Large Accelerated Filer
|
X Accelerated
Filer
|
___
Non-Accelerated Filer
|
Indicate
by check mark whether the registrant is a shell company (as defined in
Rule
12b-2 of the Exchange Act) __
Yes
X
No
Aggregate
market value of the voting stock held by non-affiliates of the registrant
as of
March 1, 2007: $136,993,170.
Number
of
outstanding shares of the registrant’s par value $0.001 common stock
as
of March 1, 2007: 57,002,301.
TELKONET,
INC.
FORM
10-K
INDEX
|
|
Page
|
|
Part
I
|
|
|
|
|
|
|
|
Item
1.
|
Description
of Business
|
1
|
|
|
|
Item
1A.
|
Risk
Factors
|
10
|
|
|
|
Item
1B.
|
Unresolved
Staff Comments
|
15
|
|
|
|
Item
2.
|
Description
of Property
|
15
|
|
|
|
Item
3.
|
Legal
Proceedings
|
16
|
|
|
|
Item
4.
|
Submission
of Matters to a Vote of Security Holders
|
16
|
|
|
|
|
|
|
|
Part
II
|
|
|
|
|
Item
5.
|
Market
for Registrant’s Common Equity, Related Stockholder Matters and
Registrant’s Purchases of Securities
|
17
|
|
|
|
Item
6.
|
Selected
Financial Data
|
19
|
|
|
|
Item
7.
|
Management’s
Discussion and Analysis of Financial Condition and Results of
Operations
|
19
|
|
|
|
Item
7A.
|
Quantitative
and Qualitative Disclosures About Market Risk.
|
32
|
|
|
|
Item
8.
|
Financial
Statements
|
32
|
|
|
|
Item
9.
|
Changes
in and Disagreements with Accountants on Accounting and Financial
Disclosure
|
32
|
|
|
|
Item
9A.
|
Controls
and Procedures
|
32
|
|
|
|
Item
9B.
|
Other
Information
|
35
|
|
|
|
|
Part
III
|
|
|
|
|
Item
10.
|
Directors
and Executive Officers of the Registrant
|
35
|
|
|
|
Item
11.
|
Executive
Compensation
|
38
|
|
|
|
Item
12.
|
Security
Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters
|
46
|
|
|
|
Item
13.
|
Certain
Relationships and Related Transactions
|
48
|
|
|
|
Item
14.
|
Principal
Accounting Fees and Services
|
49
|
|
|
|
|
Part
IV
|
|
|
|
|
Item
15.
|
Exhibits
and Financial Statement Schedules
|
50
|
PART
I
ITEM
1. DESCRIPTION
OF BUSINESS.
GENERAL
Business
Telkonet,
Inc., formed in 1999, develops and markets technology for the transmission
of
high-speed voice, video and data communications over the existing electrical
wiring within a building. Telkonet has made definitive inroads into the
Powerline communication (PLC) market and established the “leading” position for
in-building commercial communication solutions.
Through
the Company’s majority-owned subsidiary Microwave Satellite Technologies (MST),
the Company is able to offer quadruple play (“Quad-Play”) services to
multi-tenant unit (“MTU”) and multi-dwelling unit (“MDU”) residential,
hospitality and commercial properties. These Quad- Play services include video,
voice, high-speed internet and wireless fidelity (“Wi-Fi”) access.
The
Company’s recent acquisition of Ethostream, LLC, a leading high speed wireless
internet and technology provider for the hospitality industry (as
described in greater detail below under “Segment Reporting”), will enable
Telkonet to provide installation and support for PLC products and third party
applications to customers across North America. The Company’s new operating
division represented by the assets acquired from Smart Systems
International, a leading provider of energy management products and
solutions (as described in greater detail below under “Segment Reporting”)
will permit the Company to offer new energy management products and solutions
to
its customers in the United States and Canada.
As
a
result of Telkonet's acquisition of Smart Systems International and
EthoStream, the Company can now provide hospitality owners with a
greater return on investment on technology investments. Hotel owners
can leverage the Telkonet iWire System™ platform to support wired and wireless
Internet access and, in the future, to support a networked energy management
system. With the synergy of Ethostream, LLC’s centralized remote monitoring and
management platform extending over HSIA, digital video surveillance and energy
management, hospitality owners will have a complete technology offering based
on
Telkonet’s core PLC system as the infrastructure backbone, demonstrating true
technology convergence.
The
Company’s offices are located at 20374 Seneca Meadows Parkway, Germantown,
Maryland 20876. The reports that the Company files pursuant to the Securities
Exchange Act of 1934 can be found at the Company’s web site at
www.telkonet.com.
Segment
Reporting
We
classify our operations in two reportable segments: the Telkonet Segment
and the
MST Segment
Telkonet
Segment (“Telkonet”)
Through
the revolutionary Telkonet iWire System™ , Telkonet
utilizes proven PLC technology to deliver commercial high-speed Broadband
access
from an IP “platform” that is easy to deploy, reliable and cost-effective by
leveraging a building’s existing electrical infrastructure. The building’s
existing electrical wiring becomes the backbone of the local area network,
which
converts virtually every electrical outlet into a high-speed data port without
the costly installation of additional wiring or major disruption of business
activity.
The
Telkonet iWire System™ offers
a viable
and cost-effective alternative to the challenges of hardwiring and wireless
local area networks (LANs). Telkonet’s products are designed for use in
commercial and residential applications, including multi-dwelling units and
the
hospitality and government markets. Applications supported by the Telkonet
“platform” include, but are not limited to, VoIP telephones, internet
connectivity, local area networking, video conferencing, closed circuit security
surveillance and a host of other information services.
Telkonet’s
Product has been installed in all present target market segments. Government
and
regulatory certifications have been obtained to sell the product
internationally. Telkonet has been shipping PLC products since 2003, initially
targeting the multi-hospitality unit (MHU) market followed by the multi-dwelling
unit (MDU) market as well as the Government and Public Sector markets. Telkonet
employs both direct and indirect sales model to distribute and support product
on a worldwide basis.
On
March
9, 2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada for cash and Company
common stock having an aggregate value of $7,000,000. The purchase price
was
comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
stock. The Company is obligated to register the stock portion of the purchase
price on or before May 15, 2007 and 1,090,000 shares are being held in an
escrow
account for a period of one year following the closing from which certain
potential indemnification obligations under the purchase agreement may be
satisfied. The aggregate number of shares held in escrow is subject to
adjustment upward or downward depending upon the trading price of the Company’s
common stock during the one year period following the closing date.
On
March
15, 2007, the Company acquired 100% of the outstanding membership units of
Ethostream, LLC, a network solutions integration company that offers
installation, sales and service to the hospitality industry. The Ethostream,
LLC
acquisition will enable Telkonet to provide installation and support for
PLC
products and third party applications to customers across North America.
The
purchase price of $11,756,097 was comprised of $2.0 million in cash and
3,459,609 shares of the Company’s common stock. The entire stock portion of the
purchase price is being held in escrow to satisfy certain potential
indemnification obligations of the sellers under the purchase agreement.
The
shares held in escrow are distributable over the three years following the
closing. The aggregate number of shares issuable to the sellers is subject
to
downward adjustment in the event the Company’s common stock trades at or above a
price of $4.50 per share for twenty consecutive trading days during the one
year
period following the closing.
Competition
Telkonet
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
HomePlug(TM)
Powerline Alliance has grown over the past year and now includes many well
recognized brands in the networking and communications industries. These
include
Linksys (a Cisco company), Intel, GE, Motorola, Netgear, Sony and Samsung.
With
the exception of Motorola, who recently introduced a commercial product,
these
companies do not presently represent a direct competitive threat to Telkonet
since they only market and sell their products in the residential
sector.
There
can
be no assurance that other companies will not develop PLC products that compete
with Telkonet’s products in the future. They all have longer operating
histories, greater name recognition and substantially greater financial,
technical, sales, marketing and other resources than Telkonet. 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 Telkonet can. As a result, Telkonet 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 Telkonet or that would render Telkonet’s products obsolete or
noncompetitive.
Management
has focused its sales and marketing efforts primarily on the commercial sector,
which includes office buildings, hotels, schools, shopping malls, commercial
buildings, multi-dwelling units, government facilities, and any other commercial
facilities that have a need for Internet access and network connectivity.
Telkonet has also focused on establishing relationships with value added
resellers. Telkonet continues to examine, select and approach entities with
existing distribution channels that will be enhanced by Telkonet’s offerings.
Telkonet also intends to focus future sales and marketing efforts in Europe,
South America, Asia and the Pacific Rim.
Raw
Materials
Telkonet
has not experienced any significant or unusual problems in the purchase of
raw
materials or commodities. While Telkonet is dependent, in certain situations,
on
a limited number of vendors to provide certain raw materials and components,
it
has not experienced significant problems or issues purchasing any essential
materials, parts or components. Telkonet obtains the majority of its raw
materials from the following suppliers: Avnet Electronics Marketing, Digi-Key
Corporation, Intellon Corporation, and Parkview Metal Products. In addition,
Superior Manufacturing Services, a U.S. based company, provides substantially
all the manufacturing and assembly requirements for Telkonet.
Customers
Telkonet
is neither limited to, nor reliant upon, a single or narrowly segmented
consumer
base from which it derives its revenues. Presently, Telkonet is not dependent
on
any particular customer under contract. However, Telkonet’s sale of certain
rental contract agreements to Hospitality Leasing Corporation represented
approximately 18.0% of total revenues in each of 2005 and 2006. Telkonet’s
primary focus is in the commercial, government and international
markets.
Intellectual
Property
Telkonet
has applied for patents that cover the unique technology integrated into
the
Telkonet iWire SystemTM
product
suite. Telkonet also continues to identify, design and develop enhancements
to
its core technologies that will provide additional functionality,
diversification of application and desirability for current and future
users of
the Telkonet iWire SystemTM
product
suite.
In
January 2003, Telkonet received Federal Communications Commission
(FCC) approval to market the Telkonet iWire SystemTM product suite. 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. An independent, FCC-certified testing lab
has
verified the Company’s Gateway complies with the FCC technical requirements for
Class A digital devices. No further testing of this device is required and
the device may be manufactured and marketed for commercial use.
In
December 2003, Telkonet received approval from the U.S. Patent and Trademark
Office for its “Method and Apparatus for Providing Telephonic Communication
Services” Patent No.: 6,668,058. This invention covers the utilization of an
electrical power grid, for a concentration of electrical power consumers,
and
use of existing consumer power lines to provide for a worldwide voice and
data
telephony exchange
In
March 2005, Telkonet received final certification of its Telkonet iWire
SystemTM
product
suite from European Union (EU) authorities, which certification was
required before Telkonet could sell and permanently install products in
EU
countries. As a result of the certification, Telkonet products that will
be sold
and installed in EU countries will bear the Conformite Europeene (CE) mark,
a
symbol that demonstrates that the product has met the EU’s regulatory standards
and is approved for sale within the EU. Telkonet now has satisfied the
governmental requirements for product safety and certification in the EU
and is
free to sell and install the Telkonet iWire SystemTM
product
suite in the EU.
In
June 2005, Telkonet received the National Institute of Standards and
Technology (NIST) Federal Information Processing Standard (FIPS) 140-2
validation for the Gateway. In July 2005, Telkonet received FIPS 140-2
validation for the eXtender and iBridge. The U.S. federal government requires,
as a condition to purchasing certain information processing applications,
that
such applications receive FIPS 140-2 validation. U.S. federal agencies
use FIPS
140-2 compliant products for the protection of sensitive information. As
a
result of the foregoing validations, as of July 2005, all of Telkonet’s
powerline carrier products have satisfied all governmental requirements
for
security certification and are eligible for purchase by the U.S. federal
government. In addition to the foregoing, Canadian provincial authorities
use
FIPS 140-2 compliant products for the protection of sensitive designate
information. The Communications-Electronics Security Group (CESG) also has
stated that FIPS 140-2 compliant products meet its security criteria for
use in
data traffic categorized as “Private.” CESG is part of the United Kingdom’s
National Technical Authority for Information Assurance, which is a government
agency responsible for validating the security of information processing
applications for the government of the United Kingdom, financial institutions,
healthcare organizations, and international governments, among others.
In
November 2005, Telkonet received the Norma Official Mexicana
(NOM) certification, enabling Telkonet to sell the iWire SystemTM
product
suite in Mexico. NOM certification is required for Telkonet’s products to be
sold in Mexico, and no further certifications are required to sell the
Telkonet
iWire SystemTM
product
suite in Mexico.
In
December 2005, the United States Patent and Trademark Office issued Patent
No: 6,975,212 titled “Method and Apparatus for Attaching Power Line
Communications to Customer Premises”. The patent covers the method and apparatus
for modifying a three-phase power distribution network in a building in
order to
provide data communications by using a PLC signal to an electrical central
location point of the power distribution system. Telkonet’s Coupler technology
enables the conversion of electrical outlets into high-speed data ports
without
costly installation, additional wiring, or significant disruption of business
activity. The Coupler is an integral component of the Telkonet iWire
SystemTM
product
suite.
In
August
2006, the United States Patent and Trademark Office issued Patent No: 7,091,831,
titled "Method and Apparatus for Attaching Power Line Communications to
Customer
Premises". The patented technology incorporates a safety disconnect circuit
breaker into the Telkonet Coupler, creating a single streamlined unit.
In doing
so, installation of the Telkonet iWire System(TM) is faster, more efficient,
and
more economical than with separate disconnect switches, delivering optimal
signal quality. The Telkonet Integrated Coupler Breaker patent covers the
unique
technique used for interfacing and coupling its communication devices onto
the
three-phase electrical systems that are predominant in commercial
buildings.
In
January 2007, the United States Patent and Trademark Office issued Patent
No:
7,170,395 titled “Methods and Apparatus for Attaching Power Line Communications
to Customer Premises” for Delta phase power distribution system applications,
which are prevalent in the maritime industry, shipboard systems, along
with that
of heavy industrial plants and facilities.
Assumed
through the acquisition of SSI, the United States Patent and Trademark
Office
issued Patent No: 5,395,042 in March 1995 titled “Apparatus and Method for
automatic climate control” calculates and records the amount of time needed for
the thermostat to return the room temperature to the occupant’s set point once a
person re-enters the room
In
addition Telkonet currently has multiple patent applications under examination,
and intends to file additional patent applications covering a wide range
of
technologies including that of improved network topologies and techniques
for
imposing LANs over existing wired infrastructures.
Telkonet
has also filed multiple Patent Cooperation Treaty (PCT) patent applications,
which have been used to file national patent applications in foreign countries
including the European Union, Japan, China, Russia, India and
others.
Notwithstanding
the issuance of these patents, there can be no assurance that any of Telkonet’s
current or future patent applications will be granted, or, if granted,
that such
patents will provide necessary protection for the Company’s technology or its
product offerings, or be of commercial benefit to the Company.
Government
Regulation
We
are
subject to regulation in the United States by the FCC. FCC rules permit
the
operation of unlicensed digital devices that radiate radio frequency (RF)
emissions if the manufacturer complies with certain equipment authorization
procedures, technical requirements, marketing restrictions and product
labeling
requirements. An independent, FCC-certified testing lab has verified that
the
Company’s our PLC product line complies with the FCC technical requirements for
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.
In
Europe
and other overseas markets, Telkonet’s products are subject to safety and RF
emissions regulations adopted by the European Union (EU) for Information
Technology Equipment. In March 2005, the Company received final Conformite
Europeene (CE) certification, which is required for the Company to freely
market
and sell its products within the EU. As a result of the certification,
Telkonet’s products sold and installed in EU countries will bear the CE marking,
a symbol that demonstrates that the product has met the EU’s regulatory
standards and is approved for sale in the EU. The Restriction of Hazardous
Substances Directive (RoHS) directive took effect in the EU on July 1,
2006.
This directive restricts the use of six hazardous materials in the manufacture
of various types of electronic and electrical equipment. It is closely
linked
with the Waste Electrical and Electronic Equipment Directive (WEEE) which
sets collection, recycling and recovery targets for electrical goods and
is part
of a legislative initiative to solve the problem of huge amounts of toxic
e-waste. Telkonet has taken the appropriate measures to be fully
compliant with both of these directives.
Future
products designed by the Company will require testing for compliance with
FCC
and CE regulations. Moreover, if in the future, the FCC or EU changes its
technical requirements, further testing and/or modifications may be
necessary.
Research
and Development
During
the years ended December 31, 2006, 2005 and 2004, Telkonet spent $1,925,746,
$2,096,104, and $1,852,309, respectively, on research and development
activities. In 2006, research and development activities were focused on
the
development of Telkonet’s next generation product. In 2005, research and
development activities included (a) QoS for VoIP service for both commercial
and
FIPS 140-2 product applications, (b) design of the next generation high-speed
development platform, (c) design, prototype & release of the Integrated
Coupler Breaker product line, (d) design & development of the second
generation automated test equipment for manufacturing, (e) automated SQA
regression testing. In 2004, research and development activities included
(a)
development of a further cost-reduced (“G3”) iBridge/eXtender, (b) router
software development, and (c) advanced encryption support.
Long
Term Investments
Amperion,
Inc.
On
November 30, 2004, Telkonet 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%. Telkonet 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 Telkonet to regularly review the assumptions underlying the operating
performance and cash flow forecasts in assessing the carrying values of the
investment. Telkonet 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. Telkonet determined that
its
investment in Amperion was impaired based upon forecasted discounted cash
flow.
Accordingly, Telkonet wrote-off $92,000 and $400,000 of the carrying value
of
its investment through a charge to operations during the year-ended December
31,
2006 and 2005, respectively. The remaining value of Telkonet’s investment in
Amperion is $8,000 and $100,000 at December 31, 2006 and 2005, respectively,
and
the amount at December 31, 2006, represents the current fair value.
BPL
Global, Ltd.
On
February 4, 2005, the Company’s Board of Directors approved an investment in BPL
Global, Ltd. (“BPL Global”), a privately held company. Telkonet funded an
aggregate of $131,000 as of December 31, 2005 and additional $44 during the
year
of 2006. This investment represents an equity interest of approximately 4.67% at
December 31, 2006. 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. Telkonet 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.
Telkonet reviewed the assumptions underlying the operating performance and
cash
flow forecasts in assessing the carrying values of the investment. The fair
value of Telkonet's investment in BPL Global, Ltd. amounted $131,044 and
$131,000 as of December 31, 2006 and 2005, respectively.
Backlog
As
of
March 1, 2007 and 2006, revenues to be recognized under non-cancelable leases
and service contracts in the hospitality market of approximately $1,331,000
and
$2,411,000, respectively. Additionally, Telkonet has a commitment to deploy
the
Telkonet iWire SystemTM
at 50
properties for a major resort company which deployment represents revenue
of
approximately $1,100,000 over a 3 year term.
In
conjunction with the acquisition of Smart Systems International on March
9,
2007, Telkonet assumed certain purchase orders relating to a major utilities
energy management initiative provided through the two selected providers.
The
current order backlog amounts to approximately $500,000 and the estimated
remaining program value amounts to $3,000,000 for products and services to
be
provided through 2008.
In
conjunction with the acquisition of Ethostream, LLC on March 15, 2007, Telkonet
acquired support contracts and monthly services for more than 1500 hotels
which
is expected to generate approximately $2,000,000 annual recurring support
and
internet advertising revenue.
MST
Segment (“MST”)
MST
is a
communications service provider offering quadruple play (“Quad-Play”) services
to multi-tenant unit (“MTU”) and multi-dwelling unit (“MDU”) residential,
hospitality and commercial properties. These Quad-Play services include video,
voice, high-speed internet and wireless fidelity (“Wi-Fi”) access. In addition,
MST currently offers or plans to offer a variety of next-generation
telecommunications solutions and services including satellite installation,
video conferencing, surveillance/security and energy management, and other
complementary professional services.
NuVisions™
MST
currently offers digital television service through DISH Network, a national
satellite television provider, under its private label NuVisions™ brand of
services. The NuVisions TV offering currently includes over 500 channels
of
video and audio programming, with a large high definition (more than 40
channels) and ethnic offering (over 100 channels from 17 countries) available
in
the market today. MST also offers its NuVisions Broadband high speed internet
service and NuVisions Digital Voice telephone service to multi-family residences
and commercial properties. MST delivers its broadband based services using
terrestrial fiber optic links and in February 2005, began deployment in New
York
City of a proprietary wireless gigabit network that connects properties served
in a redundant gigabit ring - a virtual fiber optic network in the air.
Wi-Fi
Network
MST
has
constructed a large NuVisions Wi-Fi footprint in New York City intended to
create a ubiquitous citywide Wi-Fi network. NuVisions Wi-Fi offers Internet
access in the southern-half of Central Park, Riverside Park from 60th to
79th
Streets, Dag Hammarskjold Plaza, and the United Nations Plaza. In addition,
MST
provides NuVisions Wi-Fi service in and around Trump Tower on Fifth Avenue,
Trump World Tower on First Avenue, the Trump Place properties located on
Riverside Boulevard, Trump Palace, Trump Parc, Trump Parc East as well as
portions of Roosevelt Island surrounding the Octagon residential community.
MST
currently has plans to deploy additional Wi-Fi “Hot Zones” throughout New York
City and continue to enlarge its Wi-Fi footprint as new properties are served.
Internet
Protocol Television (“IPTV”)
In
fourth
quarter of 2006, MST invested in an IPTV platform to deploy in 2007. IPTV
is a
method of distributing television content over IP that enables a more
user-defined, on-demand and interactive experience than traditional cable
or
satellite television. The IPTV service delivers traditional cable TV programming
and enables subscribers to surf the Internet, receive on-demand content,
and
perform a host of Internet-based functions via their TV sets.
Competition
The
home
entertainment and video programming industry is competitive, and MST expects
competition to intensify in the future. MST faces its most significant
competition from the franchised cable operators. In addition, MST’s competition
includes other satellite providers, telecom providers and off-air
broadcasters.
Hardwired
Franchised Cable System
Cable
companies currently dominate the market in terms of subscriber penetration,
the
number of programming services available, audience ratings and expenditures
on
programming. However, satellite services are gaining market share which MST
believes will provide it with the opportunity to acquire and consolidate
a
subscriber base by providing a high quality signal at a comparable or reduced
price to many cable
operators' current service.
Other
Operators
MST’s
next largest competitors are other operators who build and operate
communications systems such as satellite master antenna television systems,
commonly known as SMATV, or private cable headend systems, which generally
serve
condominiums, apartment and office complexes and residential developments.
MST
also competes with other national DBS operators such as EchoStar.
Off-Air
Broadcasters
A
majority of U.S. households that are not serviced by cable operators are
serviced only by broadcast networks and local television stations (“off-air
broadcasters”). Off-air broadcasters send signals through the air, which are
received by traditional television antennas. Signals are accessible to anyone
with an antenna and programming is funded by advertisers. Audio and video
quality is limited and service can be adversely affected by weather or by
buildings blocking a signal.
Traditional
Telephone Companies
Traditional
telephone companies such as Verizon and AT&T have recently diversified their
service offerings to compete with traditional franchised cable companies
in a
triple-play market. Although their subscriber growth is currently smaller
than
franchise cable companies, these traditional phone companies are developing
video offerings such as Verizon's FIOS product. These phone companies have
in
the past also been resellers of DIRECTV and EchoStar video programming, however,
rarely in the multi-dwelling unit market. In the future, video offerings
from
traditional phone companies may become a significant competitor in the MDU
market.
Customers/Strategy
MST’s
customer base and strategy is to target and cultivate a subscriber base that
will demand high margin products including, video, IPTV, VoIP, high-speed
Internet and Wi-Fi services.
MST
currently maintains service agreements with approximately 20 MDU and MTU
properties. Generally, under the terms of a service agreement, MST provides
either (i) “bulk services,” which may include one or all of a bundle of products
and services, at a fixed price per month to the owner of the MDU or MTU
property, and contract with individual residents for enhanced services, such
as
premium cable channels, for a monthly fee or (ii) contract with individual
residents of the MDU property for one or more basic or enhanced services
for a
monthly fee. These agreements typically include a revenue sharing arrangement
with property owners, whereby the property owner is entitled to a share of
the
revenues derived from subscribers who reside at the MDU/MTU property.
These revenue
sharing arrangements are either based upon a fix amount per subscriber or
based
on a percentage, typically between 7-10%, of the monthly fees MST charges
residents for its services. MST believes that its complementary products
and
services allows for future growth and as such are designed and integrated
with
scalability in mind.
Governmental
Regulation
Federal
Regulation
MST’s
systems do not use or
traverse public rights-of-way and thus are exempt from the comprehensive
regulation of cable systems under the
Federal
Communications Act of 1934, as amended (the “Communications Act”). Because its
systems are subject to minimal federal regulation, MST has greater
pricing freedom and is not required to serve any customer whom it does not
choose to serve, and management believes that MST has significantly more
competitive flexibility than do the franchised cable systems. Management
believes that these regulatory advantages help to make
MSTs’
private
systems competitive with larger franchised cable systems.
On
October 5, 1992, Congress enacted the Cable Consumer Protection and Competition
Act of 1992 (the “1992 Cable Act”), which imposed additional regulation on
traditional franchised cable operators and permits regulation of rates in
markets in which there is no “effective competition”, as defined in the 1992
Cable Act, and directed the FCC to adopt comprehensive new federal standards
for
local regulation of certain rates charged by traditional franchised cable
operators. Conversely, the legislation also provides for deregulation of
traditional hardwire cable in a given market where effective competition
is
shown to exist. Rates charged by private cable operators, typically already
lower than traditional franchise cable rates, are not subject to regulation
under the 1992 Cable Act.
In
February 1996, Congress passed the Telecommunications Act of 1996 (the “1996
Act”), which substantially amended the Communications Act. The 1996 Act contains
provisions intended to increase competition in the telephone, radio, broadcast
television, and hardwire and wireless cable television businesses. This
legislation has altered, and management believes will continue to alter,
federal, state, and local laws and regulations affecting the communications
industry, including certain of the services MST provides.
Under
the
federal copyright laws, permission from the copyright holder generally must
be
secured before a video program may be retransmitted. Section 111 of the
Copyright Act establishes the cable compulsory license pursuant to which
certain
“cable systems” are entitled to engage in the secondary transmission of
broadcast programming without the prior permission of the holders of copyrights
in the programming. In order to do so, a cable system must secure a compulsory
copyright license. Such a license may be obtained upon the filing of certain
reports with and the payment of certain licensing fees to the U.S. Copyright
Office. Private cable operators, such as MST, may rely on the cable compulsory
license with respect to the secondary transmission of broadcast programming.
Management does not expect the licensing fees to have a material adverse
effect
on MST’s business.
Under
the
retransmission consent provisions of the 1992 Cable Act, multichannel video
programming distributors, including, but not limited to, franchised and private
cable operators, seeking to retransmit certain commercial television broadcast
signals, notwithstanding the cable compulsory license, must first obtain
the
permission of the broadcast station in order to retransmit the station’s signal.
However, private cable systems, unlike franchised cable systems, are not
required under the FCC’s “must carry” rules to retransmit local television
signals. Although there can be no assurances that MST will be able to obtain
requisite broadcaster consents, management believes, in most cases, MST will
be
able to do so for little or no additional cost.
On
November 29, 1999, Congress enacted the Satellite Home Viewer Improvement
Act of
1999 (“SHVIA”), which amended the Satellite Home Viewer Act. SHVIA permits DBS
operators to transmit local television signals into local markets. SHVIA
generally seeks to place satellite operators on an equal footing with cable
television operators in regards to the availability of television broadcast
programming. SHVIA amends the Copyright Act and other applicable laws and
regulations in order to clarify the terms and conditions under which a DBS
operator may retransmit local and distant broadcast television stations to
subscribers. The law was intended to promote the ability of satellite services
to compete with cable television systems and to resolve disputes that had
arisen
between broadcasters and satellite carriers regarding the delivery of broadcast
television station programming to satellite service subscribers. As a result
of
SHVIA, television stations are generally entitled to seek carriage on any
DBS
operator's system providing local service in their respective markets. SHVIA
creates a statutory copyright license applicable to the retransmission of
broadcast television stations to DBS subscribers located in their markets.
Although there is no royalty payment obligation associated with this license,
eligibility for the license is conditioned on the satellite carrier's compliance
with applicable laws, regulations and FCC rules governing the retransmission
of
such “local” broadcast television stations to satellite service subscribers.
Noncompliance with such laws, regulations and/or FCC requirements could subject
a satellite carrier to liability for copyright infringement. SHVIA was extended
and re-enacted by the Satellite Home Viewer Extension and Reauthorization
Act
(“SHVERA”) in December of 2004.
MST
is
not directly subject to rate regulation or certification requirements by
the FCC
or state public utility commissions because its equipment installation and
sales
agent activities do not constitute the provision of common carrier or cable
television services. As a private cable operator, MST is not subject to
regulation as a DBS provider, but primarily relies upon its third-party
programming aggregators to procure all necessary re-transmission consents
and
other programming rights under the Communications Act and the Copyright Act.
State
and Local Cable System Regulation
MST
does
not anticipate that its deployment of video programming services will be
subject
to state or local franchise laws primarily due to the fact that its facilities
do not use or traverse public rights-of-way. Although MST may be required
to
comply with state and local property tax, environmental laws and local zoning
laws, management does not anticipate that compliance with these laws will
have
any material adverse impact on MST’s business.
Preferential
Access Right
MST
generally negotiates exclusive rights to provide satellite services singularly
or in competition with competing cable providers, and also negotiates, where
possible, “rights-of-first-refusal” to match price and terms of third-party
offers to provide other communication services in buildings where it has
negotiated broadcast access rights. Management believes that these preferential
rights of entry are generally enforceable under applicable law. However,
current
trends at the state and federal level suggest that the future enforceability
of
these provisions may be uncertain. The FCC has recently issued an order
prohibiting telecommunications service providers from negotiating exclusive
contracts with owners of commercial MDU properties, although it deferred
determination in a pending rulemaking whether to render existing exclusive
access agreements unenforceable, or to extend this prohibition to residential
MDUs due to an inadequate administrative record. Although it is open to question
whether the FCC has statutory and constitutional authority to compel mandatory
access, there can be no assurance that it will not attempt to do so. Any
such
action may undermine the exclusivity provisions of MST’s rights of entry on the
one hand, but would also open up many other properties to which MST could
provide a competing service. There can be no assurance that future state
or
federal laws or regulations will not restrict MST’s ability to offer access
payments, limit MDU owners' ability to receive access payments or prohibit
MDU
owners from entering into exclusive agreements, any of which could have a
material adverse effect on MST’s business.
Regulation
of the High-Speed lnternet and Wi-Fi Business
ISPs,
including Internet access providers, are largely unregulated by the FCC or
state
public utility commissions at this time (apart from federal, state and local
laws and regulations applicable to business in general). However, there can
be
no assurance that this business will not become subject to regulatory
restraints. Also, although the FCC has rejected proposals to impose additional
costs and regulations on ISPs to the extent they use local exchange telephone
network facilities, such change may affect demand for Internet related services.
No assurance can be given that changes in current or future regulations adopted
by the FCC or state regulators or other legislative or judicial initiatives
relating to Internet services would not have a material adverse effect on
MST’s
business.
Regulation
of the VoIP Business
IP-based
voice services are currently exempt from the reporting and pricing restrictions
placed on common carriers by the FCC. However, there are several state and
federal regulatory proceedings further defining what specific service offerings
qualify for this exemption. Due to the growing acceptance and deployment
of VoIP
services, the FCC and a number of state public service commissions are
conducting regulatory proceedings that could affect the regulatory duties
and
rights of entities that provide IP-based voice applications. There is regulatory
uncertainty as to the imposition of traditional retail, common carrier
regulation on VoIP products and services.
Long
Term Investments
MST
maintains an investment in Interactivewifi.com, LLC a privately held company.
This investment represents an equity interest of approximately 50% at December
31, 2006. Interactivewifi.com is engaged in providing internet and related
services to customers throughout metropolitan New York, including the Nuvisions
internet services. MST accounted for this investment under the cost method,
as
MST does not have the ability to exercise significant influence over operating
and financial policies of the investee. Telkonet reviewed the assumptions
underlying the operating performance and cash flow forecasts in assessing
the
carrying values of the investment. The fair value of MST’s investment in
Interactivewifi.com amounted to approximately $55,000 as of December 31,
2006.
Backlog
The
MST
subscriber portfolio includes approximately 20 MDU properties with bulk service
agreements and/or access licenses to service the individual subscribers in
metropolitan New York. The remaining terms of the access agreements provide
MST
access rights from 7 to 15 years with the final agreement expiring in 2016
and
the revenues to be recognized under non-cancelable bulk agreements provide
a
minimum of $1,800,000 in revenue through 2013.
Other
information
Employees
As
of
March 1, 2007, the Company had 104 full time employees comprised of 69 full
time
employees of Telkonet and 27 employees of MST. The Company anticipates that
it
will hire additional key staff throughout 2007 in the areas of business
development, sales and marketing, and engineering.
Following
the acquisition of SSI and Ethostream, LLC on March 9, 2007 and March 15,
2007,
respectively, the Company had 177 full
time
employees.
Environmental
Matters
The
Company does not anticipate any material effect on its capital expenditures,
earnings or competitive position due to compliance with government regulations
involving environmental matters.
Financial
Information About Geographic Areas
To
date,
the majority of the Company’s revenue has been derived in the United States,
although the Company continues to expand a growing portion of our revenue
from
international sales. International sales as a percentage of total revenue
represented 19% and 25% in 2006 and 2005, respectively. Our international
sales
are concentrated in Canada, Latin America and Western Europe and we continue
to
expand into other markets worldwide. The table below sets forth our net revenue
by major geographic region.
|
|
Year
Ended December 31,
|
|
|
|
2006
|
|
Percentage
Change
|
|
2005
|
|
Percentage
Change
|
|
2004
|
|
United
States
|
|
$
|
4,508,478
|
|
|
141%
|
|
$
|
1,871,241
|
|
|
197%
|
|
$
|
630,957
|
|
Worldwide
|
|
|
672,850
|
|
|
9%
|
|
|
617,082
|
|
|
812%
|
|
|
67,695
|
|
Total
|
|
$
|
5,181,328
|
|
|
108%
|
|
$
|
2,488,323
|
|
|
256%
|
|
$
|
698,652
|
|
The
Company’s results of operations, financial condition and cash flows can be
adversely affected by various risks. These risks include, but are not limited
to, the principal factors listed below and the other matters set forth in
this
annual report on Form 10-K. You should carefully consider all of these
risks.
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 December 31, 2006, the Company has incurred cumulative
losses
of $70,424,669 and has never generated enough funds through operations to
support its business. Additional capital may be required in order to provide
working capital requirements for the next twelve months. The Company’s losses to
date have resulted principally from:
·
|
research
and development costs relating to the development of the Telkonet
iWire
SystemTM
product suite;
|
·
|
costs
and expenses associated with manufacturing, distribution and marketing
of
the Company’s products;
|
·
|
general
and administrative costs relating to the Company’s operations;
and
|
·
|
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 Telkonet iWire SystemTM product suite. If 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.
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:
·
|
the
level of use of the Internet;
|
·
|
the
demand for high-tech goods;
|
·
|
the
amount and timing of capital expenditures and other costs relating
to the
expansion of the Company’s
operations;
|
·
|
price
competition or pricing changes in the
industry;
|
·
|
technical
difficulties or system downtime;
|
·
|
economic
conditions specific to the internet and communications industry;
and
|
·
|
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
March 1, 2007, the Company’s officers and directors owned 17.8% 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 that were raised in the Company’s debenture offerings, the note
offerings and the 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
December 31, 2006, the Company had outstanding employee options to purchase
a
total of 8,520,929 shares of common stock at exercise prices ranging from $1.00
to $5.97 per share, with a weighted average exercise price of $2.06. As of
December 31, 2006, the Company had outstanding non-employee options to purchase
a total of 1,815,937 shares of common stock at an exercise price of $1.00 per
share. As of December 31, 2006, the Company had warrants outstanding to purchase
a total of 4,557,850 shares of common stock at exercise prices ranging from
$2.59 to $4.87 per share, with a weighted average exercise price of $4.20.
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:
·
|
loss
of or delay in revenue and loss of market
share;
|
·
|
negative
publicity and damage to the Company’s reputation and brand;
and
|
·
|
decline
in the average selling price of the Company’s
products.
|
The
communication industry is intensely competitive and rapidly evolving.
The
Company operates in a highly competitive, quickly changing environment, and
our
future success will depend on our ability to develop and introduce new services
and service enhancements that achieve broad market acceptance in MDU and
commercial sectors. The Company will also need to respond effectively to new
product announcements by our competitors by quickly introducing competitive
products.
Delays
in
product development and introduction could result in:
·
|
loss
of or delay in revenue and loss of market
share;
|
·
|
negative
publicity and damage to our reputation and brand; and
|
·
|
decline
in the selling price of our products and
services.
|
Additionally,
new companies are constantly entering the market, thus increasing the
competition. This could also have a negative impact on our ability to obtain
additional capital from investors. Larger companies who have been engaged in
our
industry business for substantially longer periods of time may have access
to
greater resources. These companies may have greater success in the recruitment
and retention of qualified employees, as well as in conducting their operations,
which may give them a competitive advantage. In addition, actual or potential
competitors may be strengthened through the acquisition of additional assets
and
interests. If the Company is unable to compete effectively or adequately respond
to competitive pressures, this may materially adversely affect our results
of
operation and financial condition. Large companies including Direct TV,
EchoStar, Time Warner, Cablevision and Verizon are active in our markets in
the
provision and distribution of communications services and we will also have
to
compete with such companies.
The
Company is not large enough to negotiate cable television programming contracts
as favorable as some of our larger competitors.
Programming
costs are generally directly related to the number of subscribers to which
the
programming is provided, with discounts available to large traditional cable
operatores and direct broadcast satallite (DBS) providers based on their high
subscriber levels. As a result, larger cable and DBS systems generally pay
lower
per subscriber programming costs. The Company has attempted to obtain volume
discounts from our suppliers. Despite these efforts, we believe that our per
subscriber programming costs are significantly higher than large cable
operatores and DBS providers with which we compete in some of our markets.
This
may put us at a competitive disadvantage in terms of maintaining our operating
results while remaining competitive with prices offered by these providers.
In
addition, as programming agreements come up for renewal, the Company cannot
assure you that we will be able to renew these agreements on comparable or
favorable terms. To the extent that we are unable to reach agreement with a
programmer on terms that we believe are reasonable, we may be forced to remove
programming from our line-up, which could result in a loss of
customers.
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 B” devices intended for
residential use to which more stringent standards apply. An independent,
FCC-certified testing lab has verified that the Company’s Telkonet’s iWire
SystemTM
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
HomePlug(TM) Powerline Alliance has grown over the past year and now includes
many well recognized brands in the networking and communications industries.
These include Linksys (a Cisco company), Intel, GE, Motorola, Netgear, Sony
and
Samsung. With the exception of Motorola, who recently introduced a commercial
product, these companies do not presently represent a direct competitive threat
to the Company since they only market and sell their products in the residential
sector. There can be no assurance that other companies will not develop PLC
products that compete with the Company’s products in the future. Some of 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, its sales
could
decline, its 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 Telkonet iWire SystemTM
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
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.
Any
acquisitions we make could result in difficulties in successfully managing
our
business and consequently harm our financial condition.
We
may
seek to expand by acquiring competing businesses in our current or other
geographic markets, including as a means to acquire spectrum. We cannot
accurately predict the timing, size and success of our acquisition efforts
and
the associated capital commitments that might be required. We expect to face
competition for acquisition candidates, which may limit the number of
acquisition opportunities available to us and may lead to higher acquisition
prices. There can be no assurance that we will be able to identify, acquire
or
profitably manage additional businesses or successfully integrate acquired
businesses, if any, without substantial costs, delays or other operational
or
financial difficulties. In addition, acquisitions involve a number of other
risks, including:
|
·
|
failure
of the acquired businesses to achieve expected
results;
|
|
·
|
diversion
of management’s attention and resources to
acquisitions;
|
|
·
|
failure
to retain key customers or personnel of the acquired businesses;
|
|
·
|
disappointing
quality or functionality of acquired equipment and people:
and
|
|
·
|
risks
associated with unanticipated events, liabilities or
contingencies.
|
Client
dissatisfaction or performance problems at a single acquired business could
negatively affect our reputation. The inability to acquire businesses on
reasonable terms or successfully integrate and manage acquired companies, or
the
occurrence of performance problems at acquired companies, could result in
dilution, unfavorable accounting treatment or one-time charges and difficulties
in successfully managing our business.
Our
inability to obtain capital, use internally generated cash or debt, or use
shares of our common stock to finance future acquisitions could impair the
growth and expansion of our business.
Reliance
on internally generated cash or debt to finance our operations or complete
acquisitions could substantially limit our operational and financial
flexibility. The extent to which we will be able or willing to use shares of
our
common stock to consummate acquisitions will depend on our market value which
will vary, and liquidity. Using shares of our common stock for this purpose
also
may result in significant dilution to our then existing stockholders. To the
extent that we are unable to use our common stock to make future acquisitions,
our ability to grow through acquisitions may be limited by the extent to which
we are able to raise capital through debt or additional equity financings.
No
assurance can be given that we will be able to obtain the necessary capital
to
finance any acquisitions or our other cash needs. If we are unable to obtain
additional capital on acceptable terms, we may be required to reduce the scope
of any expansion or redirect resources committed to internal purposes. In
addition to requiring funding for acquisitions, we may need additional funds
to
implement our internal growth and operating strategies or to finance other
aspects of our operations. Our failure to: (i) obtain additional capital on
acceptable terms; (ii) use internally generated cash or debt to complete
acquisitions because it significantly limits our operational or financial
flexibility; or (iii) use shares of our common stock to make future
acquisitions, may hinder our ability to actively pursue our acquisition
program.
We
rely on a limited number of third party suppliers. If these companies fail
to
perform or experience delays, shortages, or increased demand for their products
or services, we may face shortages, increased costs, and may be required to
suspend deployment of our products and services.
We
depend on a limited number of third party suppliers to provide the components
and the equipment required to deliver our solutions. If these providers fail
to
perform their obligations under our agreements with them or we are unable to
renew these agreements, we may be forced to suspend the sale and deployment
of
our products and services and enrollment of new customers, which would have
an
adverse effect on our business, prospects, financial condition and operating
results.
Our
management and operational systems might be inadequate to handle our potential
growth.
We
may experience
growth
that could place a significant strain upon our management and operational
systems and resources. Failure to manage our growth effectively could have
a
material adverse effect upon our business, results of operations and financial
condition. Our ability to compete effectively as a provider of PLC technology
and a provider of digital satellite television and high-speed Internet
products and services and to manage future growth will require us to continue
to
improve our operational systems, organization and financial and management
controls, reporting systems and procedures. We may fail to make these
improvements effectively. Additionally, our efforts to make these improvements
may divert the focus of our personnel. We must integrate our key executives
into
a cohesive management team to expand our business. If new hires perform poorly,
or if we are unsuccessful in hiring, training and integrating these new
employees, or if we are not successful in retaining our existing employees,
our
business may be harmed. To manage the growth we will need to increase our
operational and financial systems, procedures and controls. Our current and
planned personnel, systems, procedures and controls may not be adequate to
support our future operations. We may not be able to effectively manage such
growth, and failure to do so could have a material adverse effect on our
business, financial condition and results of operations
We
may be affected if the United States participates in wars or military or other
action or by international terrorism.
Involvement
in a war or other military action or acts of terrorism may cause significant
disruption to commerce throughout the world. To the extent that such disruptions
result in (i) delays or cancellations of customer orders, (ii) a general
decrease in consumer spending on information technology, (iii) our inability
to
effectively market and distribute our services or products or (iv) our inability
to access capital markets, our business and results of operations could be
materially and adversely affected. We are unable to predict whether the
involvement in a war or other military action will result in any long-term
commercial disruptions or if such involvement or responses will have any
long-term material adverse effect on its business, results of operations, or
financial condition.
ITEM
1B. UNRESOLVED
STAFF COMMENTS.
None.
ITEM
2. PROPERTIES.
The
Company presently leases 11,600 square feet of commercial office space in
Germantown, Maryland for its corporate headquarters. The Germantown lease
expires in November 2010. The Company is currently planning to increase the
office space of its Germantown headquarters by approximately 6,000 square feet
in April 2007 in conjunction with a corporate initiative to consolidate office
space.
The
Company also leases 1,800 square feet of office space in White Marsh, Maryland,
where it operates a portion of its sales and marketing activities. The White
Marsh lease expires in May 2007.
In
March
2005, the Company entered into a lease agreement for 6,742 square feet of
commercial office space in Crystal City, Virginia. The Crystal City lease
expires in March 2008. In February 2007, the Company executed a sublease for
this space commencing in April 2007 through the expiration of the lease in
March
2008.
In
conjunction with the January 2006 acquisition of MST, the Company presently
leases 12,600 square feet of commercial office space in Hawthorne, New Jersey
for its office and warehouse spaces. This lease expires in April 2010 with
an
option to extend the lease an additional five years.
Following
the acquisitions of SSI and Ethostream the Company assumed leases on 9,000
square feet of office space in Las Vegas, NV for the SSI office and warehouse
space on a month to month basis and 4,100 square feet of office space in
Milwaukee, WI for Ethostream and this lease expires in May 2011.
ITEM
3. LEGAL
PROCEEDINGS.
None.
ITEM
4. SUBMISSION
OF MATTERS TO A VOTE OF SECURITY HOLDERS.
On
December 8, 2006, the Company held its annual meeting of stockholders at which
the Company’s stockholders elected seven (7) directors to serve on the Company’s
Board of Directors and ratified the appointment of the Company’s independent
accountants for 2006. The following directors were elected at the annual meeting
based on the number of votes indicated below. Each director was elected to
serve
until the next annual meeting of stockholders or until his successor is elected
and qualified.
Director
Name
|
For
|
Against
|
Abstain
|
Broker
Non-votes
|
Warren
V. Musser
|
45,352,150
|
0
|
1,520,291
|
0
|
Ronald
W. Pickett
|
45,343,879
|
0
|
1,526,562
|
0
|
Stephen
L. Sadle
|
45,399,903
|
0
|
1,472,538
|
0
|
Thomas
C. Lynch
|
46,385,473
|
0
|
486,968
|
0
|
James
L. Peeler
|
46,376,673
|
0
|
495,768
|
0
|
Thomas
M. Hall
|
46,423,873
|
0
|
448,568
|
0
|
Seth
D. Blumenfeld
|
45,392,739
|
0
|
1,479,702
|
0
|
The
other
matters presented at the meeting were approved by the Company’s stockholders as
follows:
Matter
Voted Upon
|
For
|
Against
|
Abstain
|
Broker
Non-votes
|
Ratification
of Telkonet’s Amended and Restated Stock Incentive Plan
|
12,119,456
|
2,641,084
|
222,197
|
31,889,704
|
Ratification
of Independent Accountants
|
46,555,175
|
142,308
|
174,958
|
0
|
PART
II
ITEM
5. MARKET
FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES
OF EQUITY SECURITIES.
On
January 24, 2004, the Company’s common stock was listed for trading on the
American Stock Exchange (AMEX) under the ticker symbol “TKO.” Prior to January
24, 2004, the Company’s common stock was quoted on the OTC Bulletin Board under
the symbol “TLKO.OB.” As of March 1, 2007, the Company had 216 stockholders of
record and 57,002,301 shares of its common stock issued and outstanding.
The
following table documents the high and low sales prices for the Company’s common
stock on the AMEX for the period beginning January 1, 2005 through December
31,
2006. The information provided for the periods listed below was obtained from
the Yahoo! Finance web site.
|
|
High
|
|
Low
|
|
Year
Ended December 31, 2006
|
|
|
|
|
|
First
Quarter
|
|
$
|
4.51
|
|
$
|
3.35
|
|
Second
Quarter
|
|
$
|
4.49
|
|
$
|
2.46
|
|
Third
Quarter
|
|
$
|
3.50
|
|
$
|
1.65
|
|
Fourth
Quarter
|
|
$
|
3.27
|
|
$
|
2.32
|
|
Year
Ended December 31, 2005
|
|
|
|
|
|
|
|
First
Quarter
|
|
$
|
6.85
|
|
$
|
3.66
|
|
Second
Quarter
|
|
$
|
5.34
|
|
$
|
2.61
|
|
Third
Quarter
|
|
$
|
5.60
|
|
$
|
3.11
|
|
Fourth
Quarter
|
|
$
|
5.23
|
|
$
|
3.51
|
|
The
Company has never paid dividends on its common stock and does not anticipate
paying dividends in the foreseeable future.
Performance
Graph
Set
forth
below is a line graph comparing the cumulative total return on Telkonet’s common
stock against the cumulative total return of the Market Index for the American
Stock Exchange (U.S.) (“AMEX”) and for the peer group “Communications Services,
within the Standard Industrial Classification Code category, (SIC) Code 4899”,
for the period beginning August 15, 2002 and each fiscal year ending December
31
thereafter through the fiscal year ended December 31, 2006. Because Telkonet’s
common stock was not widely traded prior to August 15, 2002, the graph does
not
show the total return on Telkonet’s common stock prior to August 15, 2002. The
total returns assume $100 invested on August 15, 2002 with reinvestment of
dividends.
ITEM
6. SELECTED
FINANCIAL DATA
The
following table sets forth selected financial data for the last 5 years.
This
selected financial data should be read in conjunction with the consolidated
financial statements and related notes included in Item 15 of this Form
10-K.
|
|
Year
Ended December 31,
|
|
(in
thousands, except per share amounts)
|
|
2006
|
|
2005
|
|
2004
|
|
2003
|
|
2002
|
|
Total
revenues
|
|
$
|
5,181
|
|
$
|
2,488
|
|
$
|
698
|
|
$
|
94
|
|
$
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating
loss
|
|
|
(17,563
|
)
|
|
(15,307
|
)
|
|
(13,112
|
)
|
|
(6,564
|
)
|
|
(3,155
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
loss
|
|
|
(27,437
|
)
|
|
(15,778
|
)
|
|
(13,093
|
)
|
|
(7,657
|
)
|
|
(3,778
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss
per share - basic
|
|
|
(0.54
|
)
|
|
(0.35
|
)
|
|
(0.32
|
)
|
|
(0.37
|
)
|
|
(.22
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss
per share - diluted
|
|
|
(0.54
|
)
|
|
(0.35
|
)
|
|
(0.32
|
)
|
|
(0.37
|
)
|
|
(.22
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
weighted average common shares outstanding
|
|
|
50,824
|
|
|
44,743
|
|
|
41,384
|
|
|
20,702
|
|
|
17,120
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted
weighted average common shares outstanding
|
|
|
50,824
|
|
|
44,743
|
|
|
41,384
|
|
|
20,702
|
|
|
17,120
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Working
capital
|
|
|
(531
|
)
|
|
12,061
|
|
|
12,672
|
|
|
5,296
|
|
|
(894
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
assets
|
|
|
12,517
|
|
|
23,291
|
|
|
15,493
|
|
|
6,176
|
|
|
295
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Short-term
borrowings and current portion of long-term debt
|
|
|
—
|
|
|
6,350
|
|
|
—
|
|
|
15
|
|
|
310
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Long-term
debt, net of current portion
|
|
|
—
|
|
|
9,617
|
|
|
588
|
|
|
3,132
|
|
|
863
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stockholders’
equity (deficiency)
|
|
|
8,135
|
|
|
5,315
|
|
|
13,646
|
|
|
2,388
|
|
|
(1,527
|
)
|
ITEM
7. MANAGEMENT’S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
The
following discussion and analysis of the Company’s financial condition and
results of operations should be read in conjunction with the accompanying
financial statements and related notes thereto.
The
Company reports financial results for the following operating business
segments:
Telkonet
Through
the revolutionary Telkonet iWire System™ , Telkonet utilizes proven PLC
technology to deliver commercial high-speed Broadband access from an IP
“platform” that is easy to deploy, reliable and cost-effective by leveraging a
building’s existing electrical infrastructure. The building’s existing
electrical wiring becomes the backbone of the local area network, which converts
virtually every electrical outlet into a high-speed data port, without the
costly installation of additional wiring or major disruption of business
activity. The segment’s net sales in 2006 were $3,425,525, representing 66% of
the Company’s consolidated net sales.
MST
MST
is a
communications service provider offering Quad-Play services to MTU and MDU
residential, hospitality and commercial properties. These Quad-Play services
include video, voice, high-speed internet and wireless fidelity (“Wi-Fi”)
access. In addition, MST currently offers or plans to offer a variety of
next-generation telecommunications solutions and services, including satellite
installation, video conferencing, surveillance/security and energy management,
and other complementary professional services. The segments’ net sales upon
acquisition for the period February 1 through December 31, 2006 were $1,755,803,
representing 34% of the Company’s consolidated net sales.
Critical
Accounting Policies and Estimates
The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires us to make estimates
and assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. On an ongoing basis, we evaluate significant
estimates used in preparing our financial statements, including those related
to
revenue recognition, guarantees and product warranties and stock based
compensation. We base our estimates on historical experience, underlying
run
rates and various other assumptions that we believe to be reasonable, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities. Actual results could differ from these estimates.
The
following are critical judgments, assumptions, and estimates used in the
preparation of the 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.
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.
MST
accounts for the revenue, costs and expense related to residential cable
services as the related services are performed in accordance with SFAS
No. 51, Financial Reporting by Cable Television Companies. Installation
revenue for residential cable services is recognized to the extent of direct
selling costs incurred. Direct selling costs have exceeded installation revenue
in all reported periods. Generally, credit risk is managed by disconnecting
services to customers who are delinquent.
Guarantees
and Product Warranties
FASB
Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”),
requires that upon issuance of a guarantee, the guarantor must disclose and
recognize a liability for the fair value of the obligation it assumes under
that
guarantee.
The
Company’s guarantees issued subject to the recognition and disclosure
requirements of FIN 45 as of December 31, 2006 and 2005 were not material.
The
Company records a liability for potential warranty claims. The amount of the
liability is based on the trend in the historical ratio of claims to sales,
the
historical length of time between the sale and resulting warranty claim, new
product introductions and other factors. The products sold are generally covered
by a warranty for a period of one year. In the event the Company determines
that
its current or future product repair and replacement costs exceed its estimates,
an adjustment to these reserves would be charged to earnings in the period
such
determination is made. During the year ended December 31, 2006, the Company
experienced approximately 3% percent of units returned. Using this experience
factor a reserve of $23,300 was accrued. Prior to the fiscal year of 2005,
the
Company had not established historical ratio of claims, and the cost of
replacing defective products and product returns were immaterial and within
management's expectations, accordingly there were no warranties provided with
the purchase of the Company's products during the year ended December 31,
2004.
Stock
Based Compensation
On
January 1, 2006, the Company adopted Statement of Financial Accounting Standards
No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which
requires the measurement and recognition of compensation expense for all
share-based payment awards made to employees and directors including employee
stock options based on estimated fair values. SFAS 123(R) supersedes the
Company’s previous accounting under Accounting Principles Board Opinion
No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods
beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission
issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS
123(R). The Company has applied the provisions of SAB 107 in its adoption of
SFAS 123(R).
The
Company adopted SFAS 123(R) using the modified prospective transition method,
which requires the application of the accounting standard as of January 1,
2006,
the first day of the Company’s fiscal year 2006. The Company’s Consolidated
Financial Statements as of and for the year ended December 31, 2006 reflect
the
impact of SFAS 123(R). In accordance with the modified prospective transition
method, the Company’s Consolidated Financial Statements for prior periods have
not been restated to reflect, and do not include, the impact of SFAS 123(R).
Stock-based compensation expense recognized under SFAS 123(R) for the year
ended
December 31, 2006 was $1,080,895, net of tax effect.
SFAS
123(R) requires companies to estimate the fair value of share-based payment
awards on the date of grant using an option-pricing model. The value of the
portion of the award that is ultimately expected to vest is recognized as
expense over the requisite service periods in the Company’s Consolidated
Statement of Operations. Prior to the adoption of SFAS 123(R), the Company
accounted for stock-based awards to employees and directors using the intrinsic
value method in accordance with APB 25 as allowed under Statement of Financial
Accounting Standards No. 123, “Accounting for Stock-Based Compensation”
(“SFAS 123”). Under the intrinsic value method, no stock-based compensation
expense had been recognized in the Company’s Consolidated Statement of
Operations because the exercise price of the Company’s stock options granted to
employees and directors approximated or exceeded the fair market value of the
underlying stock at the date of grant.
Stock-based
compensation expense recognized during the period is based on the value of
the
portion of share-based payment awards that is ultimately expected to vest during
the period. Stock-based compensation expense recognized in the Company’s
Consolidated Statement of Operations for the year ended December 31, 2006
included compensation expense for share-based payment awards granted prior
to,
but not yet vested as of December 31, 2005 based on the grant date fair value
estimated in accordance with the pro forma provisions of SFAS 123 and
compensation expense for the share-based payment awards granted subsequent
to
December 31, 2005 based on the grant date fair value estimated in accordance
with the provisions of SFAS 123(R). SFAS 123(R) requires forfeitures to be
estimated at the time of grant and revised, if necessary, in subsequent periods
if actual forfeitures differ from those estimates. In the Company’s pro forma
information required under SFAS 123 for the periods prior to fiscal 2006, the
Company accounted for forfeitures as they occurred.
Upon
adoption of SFAS 123(R), the Company is using the Black-Scholes option-pricing
model as its method of valuation for share-based awards granted beginning in
fiscal 2006, which was also previously used for the Company’s pro forma
information required under SFAS 123. The Company’s determination of fair value
of share-based payment awards on the date of grant using an option-pricing
model
is affected by the Company’s stock price as well as assumptions regarding a
number of highly complex and subjective variables. These variables include,
but
are not limited to the Company’s expected stock price volatility over the term
of the awards, and certain other market variables such as the risk free interest
rate.
Year
Ended December 31, 2006 Compared to Year Ended December 31,
2005
Revenues
The
Company’s revenue consists of direct product sales and a recurring (lease) model
in the commercial, government and international markets of the Telkonet Segment.
Additionally, the MST Segment consists of eleven months of revenue from date
of
acquisition through December 31, 2006 providing certain Quad-Play services.
The
table below outlines product versus recurring (lease) revenues for comparable
periods:
|
|
Year
ended December 31,
|
|
Revenue:
|
|
2006
|
|
2005
|
|
Variance
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Product
|
|
$
|
3,092,967
|
|
|
60%
|
|
$
|
1,769,727
|
|
|
71%
|
|
$
|
1,323,240
|
|
|
75%
|
|
Rental
(lease)
|
|
|
2,088,361
|
|
|
40%
|
|
|
718,596
|
|
|
29%
|
|
|
1,369,765
|
|
|
191%
|
|
Total
|
|
|
5,181,328
|
|
|
100%
|
|
$
|
2,488,323
|
|
|
100%
|
|
|
2,693,005
|
|
|
108%
|
|
Product
Revenue
Product
revenue in the Telkonet Segment increased approximately $800,000, excluding
the
sale of certain rental contract agreements to HLC, for the year ended December
31, 2006, and the MST Segment revenue amounted to approximately $280,000 in
installation and ancillary services provided to customers for the eleven months
ended December 31, 2006. The Telkonet Segment revenue principally arises from
the sale of iBridges and other Telkonet iWire SystemTM
components directly to customers. Revenues to date have been principally derived
from the Commercial (Hospitality and Multi-Dwelling) and International business
units. The Telkonet Segment anticipates continued growth in Commercial and
International product revenue in the Value Added Reseller (VAR) purchase
programs. The Telkonet Segment expanded its international sales and marketing
efforts upon receiving its European certification (CE). The Company has received
the FIPS 140-2 certification and continues to pursue opportunities within the
government sector. The Company has extended its iWire SystemTM
to
included energy information, management and control solutions for residential
and commercial buildings.
In
the
year ended December 31, 2006 and 2005, Telkonet consummated a non-recourse
sale
of certain rental contract agreements and the related capitalized equipment
which were accounted for as operating leases with Hospitality Leasing
Corporation. The remaining rental income payments of the contracts were valued
at approximately $1,209,000 and $732,000 including the customer support
component of approximately $370,000 and $205,000 which Telkonet will retain
and
continue to receive monthly customer support payments over the remaining average
unexpired lease term of 36 and 26 months, respectively. In the years ending
December 31, 2006 and 2005, the Company recognized revenue of approximately
$683,000 and $439,000, respectively, for the sale, calculated based on the
present value of total unpaid rental payments, and expensed the associated
capitalized equipment cost, net of depreciation, of approximately $340,000
and
$267,000, respectively, and expensed associated taxes of approximately $64,000
and $40,000, respectively.
Rental
(lease)Revenue
A
significant increase in the overall recurring revenue was attributable to the
addition of the MST segment subscriber base in February 2006 and amounted to
approximately $1,476,000 for the eleven months ended December 31, 2006. The
MST
Segment subscriber portfolio in includes approximately 20 MDU properties with
service bulk service agreements and/or access licenses to service the individual
subscribers in metropolitan New York. The Telkonet Segment rental (lease)
revenue decreased by $95,000 in the year ended December 31, 2006 compared to
the
prior year primarily due to the sale of rental contracts to Hospitality Leasing
Corporation (HLC) and the VAR purchase program sales effort.
Cost
of Sales
|
|
Year
ended December 31,
|
|
Cost
of Sales:
|
|
2006
|
|
2005
|
|
Variance
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Product
|
|
$
|
2,062,399
|
|
|
67%
|
|
$
|
1,183,574
|
|
|
67%
|
|
$
|
878,825
|
|
|
74%
|
|
Rental
(lease)
|
|
|
2,418,260
|
|
|
116%
|
|
|
533,605
|
|
|
74%
|
|
|
1,884,655
|
|
|
353%
|
|
Total
|
|
|
4,480,659
|
|
|
86%
|
|
$
|
1,717,179
|
|
|
69%
|
|
|
2,763,480
|
|
|
161%
|
|
Product
Costs
The
Telkonet Segment product cost for the Telkonet iWire SystemTM
product
suite primarily includes equipment costs and installation labor. The related
product cost in connection with the non-recourse sale of approximately
$1,209,000 of rental contract agreements amounted to approximately $347,000
of
previously capitalized equipment cost and other related cost.
The
MST
product costs primarily consist of equipment and installation labor for
installation and ancillary services provided to customers.
Rental
(lease) Costs
MST
segment recurring costs primarily represent customer support, programming and
amortization of the capitalized costs to support the subscriber revenue.
Although MST's programming fees are a significant portion of the cost, MST
continues to pursue competitve agreements and volume discounts in conjunction
with the growth of the subscriber base. The customer support costs for the
year
ended December 31, 2006 include build-out of the support services necessary
for
the anticipated increase in subscribers in metropolitan New York. The
capitalized costs are amortized over the lease term and include equipment and
installation labor. The Telkonet Segment recurring costs increased for the
year
ended December 31, 2006 compared to the prior year due to an increase in the
number of iBridges supported and through the utilization of an out-sourced
Tier
I call center which was initiated in July 2005.
Gross
Profit
|
|
Year
ended December 31,
|
|
Gross
Profit:
|
|
2006
|
|
2005
|
|
Variance
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Product
|
|
$
|
1,030,568
|
|
|
33%
|
|
$
|
586,153
|
|
|
33%
|
|
$
|
444,415
|
|
|
76%
|
|
Rental
(lease)
|
|
|
(329,899
|
)
|
|
-16%
|
|
|
184,991
|
|
|
26%
|
|
|
(514,890
|
)
|
|
-278%
|
|
Total
|
|
|
700,669
|
|
|
14%
|
|
|
771,144
|
|
|
31%
|
|
|
(70,475
|
)
|
|
-9%
|
|
Product
Gross Profit
The
increase of Telkonet gross profit for the year 2006 associated with product
revenues over the prior year offsets by ancillary services provided by
MST.
Rental
(lease) Gross Profit
Telkonet
gross profit associated with recurring (lease) revenue decreased as a result
of
the sale of rental contracts to Hospitality Leasing Corporation (HLC) resulting
in a decrease in recurring (lease) revenue which was more than offset by
increased customer support services related to the increased number of iBridges
supported. As MST develops the infrastructure and continues to build-out the
subscriber base, the gross margins were $417,664 or -28% for the 11 months
end
December 31, 2006, primarily due to programming costs and the support
infrastructure. MST anticipates increased margins in 2007 as the projected
new
subscriber base absorbs the current infrastructure.
Operating
Expenses
|
|
Year
ended December 31,
|
|
|
|
2006
|
|
2005
|
|
Variance
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
|
18,263,255
|
|
$
|
16,077,912
|
|
|
2,185,343
|
|
|
14%
|
|
Overall
expenses increased for the year ended December 31, 2006 over the comparable
period in 2005 by $2,185,343 or 14%. Of this increase, operating expenses
related to the acquisition of MST represented $2,632,449 and were principally
due to salary and other operating costs related to the build-out of the “Quad
Play” subscriber infrastructure, including managerial and back-office support
personnel, professional fees and the amortization of MST’s intangible
assets. Additionally, the Telkonet operating expenses decreased for the
year ended December 31, 2006 due to a reduction in research and development
costs as well as a cost incurred in 2005 for the impairment of Telkonet’s
investment in Amperion.
Product
Research and Development
|
|
Year
ended December 31,
|
|
|
|
2006
|
|
2005
|
|
Variance
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
1,925,746
|
|
$
|
2,096,104
|
|
$
|
(170,358
|
)
|
|
-8%
|
|
Telkonet’s
research and development costs related to both present and future products
are
expensed in the period incurred. Total expenses for the year ended December
31,
2006 decreased over the comparable prior year by $170,358 or -8%. This decrease
was primarily related to costs associated to CE, FIPS 140-2 and other required
certifications of the Company’s product that were incurred in 2005.
Selling,
General and Administrative
|
|
Year
ended December 31,
|
|
|
|
2006
|
|
2005
|
|
Variance
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
14,346,364
|
|
$
|
12,041,661
|
|
$
|
2,304,703
|
|
|
19%
|
|
Selling,
general and administrative expenses increased for the year ended December 31,
2006 over the comparable prior year by $2,304,703 or 19%. This increase is
attributed to the administrative expenses associated with the acquisition of
MST
such as payroll costs, advertising, trade shows, facility costs and professional
fees. Also, the selling, general and administrative expenses for Telkonet have
remained approximately the same as the prior year.
Year
Ended December 31, 2005 Compared to Year Ended December 31,
2004
Revenues
Telkonet’s
revenue consists of direct product sales and a rental (lease) model in the
commercial, government and international markets. The table below outlines
product versus rental (lease) revenues for comparable periods:
|
|
Year
ended December 31,
|
|
Revenue:
|
|
2005
|
|
2004
|
|
Variance
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Product
|
|
$
|
1,769,727
|
|
|
71%
|
|
$
|
477,555
|
|
|
68%
|
|
$
|
1,292,172
|
|
|
271%
|
|
Rental
(lease)
|
|
|
718,596
|
|
|
29%
|
|
|
221,097
|
|
|
32%
|
|
|
497,499
|
|
|
225%
|
|
Total
|
|
$
|
2,488,323
|
|
|
100%
|
|
$
|
698,652
|
|
|
100%
|
|
$
|
1,789,671
|
|
|
256%
|
|
Product
revenue
Product
revenue principally arises from the sale of iBridges and other Telkonet iWire
SystemTM
components directly to customers. Revenues to date have been principally
derived
from the Commercial (Hospitality and Multi-Dwelling) and International business
units. The Company anticipates continued growth in Commercial and International
product revenue in the Value Added Reseller purchase programs. The Company
expanded its international sales and marketing efforts upon receiving its
European certification (CE) in March 2005. The Company expanded its sales
and
marketing efforts in the government sector in connection with the receipt
of the
FIPS 140-2 certification received in July 2005.
In
December 2005, the Company consummated a non-recourse sale of certain rental
contract agreements and the related capitalized equipment which were accounted
for as operating leases with Hospitality Leasing Corporation. The remaining
rental income payments of the contracts were valued at approximately $732,000,
including the customer support component of approximately $205,000 which
the
Company will retain and continue to receive monthly customer support payments
over the remaining average unexpired lease term of 26 months. In December
2005,
the Company recognized revenue of approximately $439,000 for the sale,
calculated based on the present value of total unpaid rental payments, and
expensed the associated capitalized equipment cost, net of depreciation,
of
approximately $267,000 and expensed associated taxes of approximately $40,000.
Rental
(lease) revenue
The
increase in rental (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
$2,411,000 including a non-recourse sale of $918,000 certain rental
contract agreements
in January 2006. The weighted average remaining lease term was approximately
31
months as of December 31, 2005. The associated unamortized capitalized costs
in
connection with these leases was approximately $664,000 or 26% of revenue
backlog.
Cost
of Sales
|
|
Year
ended December 31,
|
|
Cost
of Sales:
|
|
2005
|
|
2004
|
|
Variance
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Product
|
|
$
|
1,183,574
|
|
|
67%
|
|
$
|
459,225
|
|
|
96%
|
|
$
|
724,349
|
|
|
158%
|
|
Rental
(lease)
|
|
|
533,605
|
|
|
74%
|
|
|
83,634
|
|
|
38%
|
|
|
449,971
|
|
|
538%
|
|
Total
|
|
$
|
1,717,179
|
|
|
695
|
|
$
|
542,859
|
|
|
78%
|
|
$
|
1,174,320
|
|
|
216%
|
|
Product
Costs
Product
cost primarily includes Telkonet iWire SystemTM
product
suite equipment cost and installation labor. The related product cost in
connection with the non-recourse sale of approximately $766,000 of rental
contract agreements amounted to approximately $267,000 of previously capitalized
equipment cost and other related cost.
Rental
(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.
Gross
Profit
|
|
Year
ended December 31,
|
|
Gross
Profit:
|
|
2005
|
|
2004
|
|
Variance
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Product
|
|
$
|
586,153
|
|
|
33%
|
|
$
|
18,330
|
|
|
4%
|
|
$
|
567,823
|
|
|
3,098%
|
|
Rental
(lease)
|
|
|
184,991
|
|
|
26%
|
|
|
137,463
|
|
|
62%
|
|
|
47,528
|
|
|
-35%
|
|
Total
|
|
$
|
771,144
|
|
|
31%
|
|
$
|
155,793
|
|
|
22%
|
|
$
|
615,351
|
|
|
395%
|
|
Product
Costs
Gross
profit associated with the product revenues for the year ended December 31,
2005
improved over the prior year primarily as a result of reduction of equipment
costs and of improved installation processes, including upfront site surveys
and
standardized training.
Rental
(lease) Costs
Gross
profit associated with the rental (lease) revenue decreased as a result of
the
build-out of the customer support services.
Operating
Expenses
|
|
Year
ended December 31,
|
|
|
|
2005
|
|
2004
|
|
Variance
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
16,077,912
|
|
$
|
13,268,067
|
|
$
|
2,809,845
|
|
|
21%
|
|
Overall
expenses increased for the year ended December 31, 2005 over the comparable
period in 2004 by $2,809,845 or 21%. Excluding the fee paid pursuant to certain
agreements with consultants of $2,500,000 expensed in the year end December
31,
2004, the increase for the year ended December 31, 2005 over the prior year
amounted to $5,309,845 or 49%. 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 48 at December 31, 2004 to 66 at December 31, 2005.
In
addition, the Company wrote-off $400,000 of the carrying value of its investment
in Amperion through a charge to operations during the year end December 31,
2005.
Product
Research and Development
|
|
Year
ended December 31,
|
|
|
|
2005
|
|
2004
|
|
Variance
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
2,096,104
|
|
$
|
1,852,309
|
|
$
|
243,795
|
|
|
13%
|
|
Research
and development costs related to both present and future products are expensed
in the period incurred. Total expenses for the year ended December 31, 2005
increased over the comparable prior year by $243,795 or 13%. 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.
Selling,
General and Administrative
|
|
Year
ended December 31,
|
|
|
|
2005
|
|
2004
|
|
Variance
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
12,041,661
|
|
$
|
7,663,369
|
|
$
|
4,378,292
|
|
|
57%
|
|
Selling,
general and administrative expenses increased for the year ended December 31,
2005 over the comparable prior year by $4,378,292 or 57%. 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.
Liquidity
and Capital Resources
Working
Capital
Our
working capital surplus decreased by $12,591,438 during the twelve months ended
December 31, 2006 from a working capital surplus of $12,060,807 at December
31, 2005 to a working capital deficit of $(530,631) at December 31, 2006.
The decrease in working capital for the twelve months ended December 31, 2006,
is due to a combination of factors, of which the significant factors are set
out
below:
|
·
|
Cash
had a net decrease from working capital by $6,778,042 for the period
ended
December 31, 2006. The most significant uses of cash are as
follows:
|
|
o
|
Approximately
$13,972,000 of cash consumed directly in operating activities, including
interest paid of $991,000
|
|
o
|
Principal
repayments, in cash, of Senior Convertible Debentures and Senior
notes
amounted to $7,750,000 and $100,000,
respectively
|
|
o
|
The
cash payments in the acquisition of MST amounted to approximately
$958,000, net of acquired cash, and as part of the acquisition the
MST
debt payoff amounted to approximately $410,000—see discussion of MST
acquisition below;
|
|
o
|
An
offsetting amount of approximately $2,740,000 related to the impact
of
proceeds from stock options and warrant
exercises
|
|
o
|
An
additional offsetting amount from the sale of 2,400,000 shares of
common
stock at $2.50 per share for an aggregate purchase price of $6,000,000
|
|
o
|
Approximately
$2,324,000 was expended on net purchases of capitalized cost and
fixed
assets.
|
|
·
|
The
acquisition of MST included a second installment of $900,000 payable
in
January 2007 and at acquisition $400,000 of potential income tax
exposure
was accrued in accounts payable and accrued
liabilities.
|
Of
the
total $3,766,079 in current assets as of December 31, 2006, cash represented
$1,644,037. Of the total $20,377,956 in current assets as of December 31, 2005,
cash represented $8,422,079, and Restricted Certificate of Deposit represented
$10,000,000.
Senior
Notes
In
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 remaining outstanding senior note of $100,000 matured and was
repaid in June 2006.
Convertible
Senior Notes
In
October 2005, the Company completed an offering of convertible senior notes
(the
“Notes”) in the aggregate principal amount of $20 million. The capital raised in
the Note offering was used for general working capital purposes. The Notes
bore
interest at a rate of 7.25%, payable in cash, and called for monthly principal
installments beginning March 1, 2006. The maturity date was 3 years from the
date of issuance of the Notes. The Noteholders were entitled, at any time,
to
convert any portion of the outstanding and unpaid Conversion Amount into shares
of Company common stock. At the option of the Company, the principal payments
could be paid either in cash or in common stock. Upon conversion into common
stock, the value of the stock was determined by the lower of $5 or 92.5% of
the
average recent market price. The Company also issued one million warrants to
the
Noteholders exercisable for five years at $5 per share. At any time after six
months, should the stock trade at or above $8.75 for 20 of 30 consecutive
trading days, the Company could cause a mandatory redemption and conversion
to
shares at $5 per share. At any time, the Company was entitled to pre-pay the
notes with cash or common stock. If the Company elected to use common stock
to
pre-pay the Notes, the price of the common stock would be deemed to be the
lower
of $5 or 92.5% of the average recent market price. If the Company prepaid the
Notes other than by mandatory conversion, the Company was obligated to issue
additional warrants to the Noteholders covering 65% of the amount pre-paid
at a
strike price of $5 per share. In addition to standard financial covenants,
the
Company agreed to maintain a letter of credit in favor of the Noteholders equal
to $10 million. Once the principal amount outstanding on the notes declined
below $15 million, the balance on the letter of credit was reduced by $.50
for
every $1 amortized.
These
notes were repaid on August 14, 2006 as discussed in greater detail below under
“Early Extinguishment of Debt.”
Principal
Payments of Debt
For
the
period of January 1, 2006 through August 14, 2006, the Company paid down
principal of $1,250,000 in cash and issued an aggregate of 4,226,246 shares
of
common stock in connection with the conversion of $10,821,686 aggregate
principal amount of the Senior Convertible Notes. Pursuant to the note
agreement, the Company issued an additional 1,081,820 warrants to the
Noteholders covering 65% of the $8,321,686 accelerated principal at a strike
price of $5 per share.
For
the
period of January 1, 2006 through August 14, 2006, the Company amortized the
debt discount to the beneficial conversion feature and value of the attached
warrants, and recorded non-cash interest expense in the amount of $251,759
and
$500,353, respectively. The Company also wrote-off the unamortized debt discount
attributed to the beneficial conversion feature and the value of the attached
warrants in the amount of $708,338 and $1,397,857, respectively, in connection
with paydown and conversion of the note.
Early
Extinguishment of Debt
On
August
14, 2006, the Company executed separate settlement agreements with the lenders
of its Convertible Senior Notes. Pursuant to the settlement agreements the
Company paid to the lenders in the aggregate $9,910,392 plus accrued but unpaid
interest of $23,951 and certain premiums specified in the Notes in satisfaction
of the amounts then outstanding under the Notes. Of the amount to be paid to
the
lenders under the Notes, $6,500,000 was paid in cash through a drawdown on
a
letter of credit previously pledged as collateral for the Company’s obligations
under the Notes. The remaining note balance of $1,428,314 and a Redemption
Premium of $1,982,078, calculated as 25% of remaining principal, was paid to
the
lenders in shares of Company’s common stock valued at the lower of $5.00 per
share and 92.5% of the arithmetic average of the weighted average price of
the
Company’s common stock on the American Stock Exchange for the twenty trading
days beginning on August 16, 2006. The Company also issued 862,452 warrants
to
purchase shares of the Company’s common stock at the exercise price of the lower
of $2.58 per share and 92.5% of the average trading price as described above.
The Company has accounted for the Redemption Premium and the additional warrants
issued as non-cash early extinguishment of debt expense during the year ended
December 31, 2006.
As
a
result of the execution of the settlement agreements and the payments required
thereby, the Company fully repaid and believes it satisfied all of its
obligations under the Notes. The Company also agreed to pay the expenses of
the
lenders incurred in connection with the negotiation and execution of the
settlement agreements. The settlement agreements were negotiated following
the
allegation by one of the lenders that the Company’s failure to meet the minimum
revenue test for the period ending June 30, 2006 as specified on the Notes
may
have constituted an event of default under the Notes, which allegation the
Company disputed.
In
conjunction with the settlement agreement, the Company recorded $4,626,679
of
loss from early extinguishment of debt, which consists of $1,982,078 redemption
premium paid with the Company’s common stock, $1,014,934 of additional warrants
issued to the lenders, write-off of the remaining unamortized debt discount
attributed to the beneficial conversion feature and the value of the attached
warrants in the amount of $430,040 and $845,143, respectively, and write-off
the
remaining unamortized financing costs of $354,484.
The
settlement agreements provide that the number of shares issued to the
noteholders shall be adjusted based upon the arithmetic average of the weighted
average price of the Company’s common stock on the American Stock Exchange for
the twenty trading days immediately following the settlement date. The
Company has concluded that, based upon the weighted average of the Company's
common stock between August 16, 2006 and September 13, 2006, the Company is
entitled to a refund from the two noteholders. One of the noteholders has
informed the Company that it does not believe such a refund is required.
As a result, the Company has declined to deliver to the noteholders certain
stock purchase warrants issued to them pursuant to the settlement agreements
pending resolution of this disagreement. One of the noteholders has alleged
that
the Company has failed to satisfy its obligations under the settlement agreement
by failing to deliver the warrants. In addition, the noteholder maintains that
the Company has breached certain provisions of the registration rights agreement
and, as a result of such breach, such noteholder claims that it is entitled
to
receive liquidated damages from the Company. As of March 15, 2007, no legal
claim has been filed by the noteholder.
Acquisition
of Microwave Satellite Technologies, Inc.
On
January 31, 2006, the Company acquired a 90% interest in MST from Frank
Matarazzo, the sole stockholder of MST in exchange for $1.8 million in cash
and
1.6 million unregistered shares of the Company’s common stock for an aggregate
purchase price of $9,000,000. The cash portion of the purchase price was paid
in
two installments, $900,000 at closing and $900,000 in February 2007. The stock
portion is payable from shares which will be held in escrow, 400,000 shares
of
which were paid at closing and the remaining 1,200,000 shares of which shall
be
issued based on the achievement of 3,300 “Triple Play” subscribers over a three
year period. In the period ended December 31, 2006, the Company issued 200,000
shares of the purchase price contingency valued at $900,000 as an adjustment
to
goodwill. In the event the Company’s common stock price is below $4.50 per share
upon issuance of the shares from escrow, a pro rata adjustment in the number
of
shares will be required to support the aggregate consideration of $5.4 million.
As of December 31, 2006, the Company’s common stock price was below $4.50. To
the extent that the market price of Company’s common stock is below $4.50 per
share upon issuance of the shares from escrow, the number of shares issuable
on
conversion is ratably increased, which could result in further dilution of
the
Company’s stockholders.
Acquisition
of Smart Systems International (SSI)
On
March
9, 2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada for cash and Company
common stock having an aggregate value of $7,000,000. The purchase price was
comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
stock. The Company is obligated to register the stock portion of the purchase
price on or before May 15, 2007 and 1,090,000 shares are being held in an escrow
account for a period of one year following the closing from which certain
potential indemnification obligations under the purchase agreement may be
satisfied. The aggregate number of shares held in escrow is subject to
adjustment upward or downward depending upon the trading price of the Company’s
common stock during the one year period following the closing date.
Acquisition
of Ethostream, LLC
On
March
15, 2007, the Company acquired 100% of the outstanding membership units of
Ethostream, LLC, a network solutions integration company that offers
installation, sales and service to the hospitality industry. The Ethostream
acquisition will enable Telkonet to provide installation and support for PLC
products and third party applications to customers across North America. The
purchase price of $11,756,097 was comprised of $2.0 million in cash and
3,459,609 shares of the Company’s common stock. The entire stock portion of the
purchase price is being held in escrow to satisfy certain potential
indemnification obligations of the sellers under the purchase agreement. The
shares held in escrow are distributable over the three years following the
closing. The aggregate number of shares issuable to the sellers is subject
to
downward adjustment in the event the Company’s common stock trades at or above a
price of $4.50 per share for twenty consecutive trading days during the one
year
period following the closing.
Proceeds
from the issuance of common stock
During
the twelve months ended December 31, 2006, the Company received $2,684,663
from
the exercise of employee and non-employee stock options and $55,138 from the
exercise of warrants.
During
the twelve months ended December 31, 2006, the Company issued 2,400,000 shares
of common stock valued at $2.50 per share for an aggregate purchase price of
$6,000,000. The Company also issued to this investor warrants to purchase 1.56
million shares of its common stock at an exercise price of $4.17 per share.
In
February 2007, the Company issued 4,000,000 shares of common stock valued at
$2.50 per share for an aggregate purchase price of $10,000,000. The Company
also
issued to this investor warrants to purchase 2.6 million shares of its common
stock at an exercise price of $4.17 per share.
Cash
flow analysis
Cash
utilized in operating activities was $13,971,529 during the year ended December
31, 2006 compared to $12,086,032 and $9,583,560 during the years ended December
31, 2005 and 2004, respectively. The
primary use of cash during the twelve months ended December 31, 2006 was net
operating expenses of the Company of $12,980,683 and interest expense payments
of $990,846.
The
Company was provided and utilized cash for investing activities $6,717,442
and
$10,925,719 during the twelve months ended December 31, 2006 and 2005,
respectively. During the period ended December 31, 2006, the proceeds from
the
release of funds from the Restricted Certificate of Deposit provided
$10,000,000
in
conjunction with the conversion and settlement agreement with the lenders under
the Company’s Convertible Senior Notes.
The expenditures were primarily the result of the acquisition of MST in January
2006 of $958,438, net of acquired cash. Additionally, cost of equipment under
operating leases amounted to $1,589,188, net of proceeds from sale of certain
equipment under operating lease of $350,571, and $458,271 for the December
31,
2006 and 2005, respectively. Furthermore, purchases of property and equipment
amounted to $734,888 and $336,448 for the year ended December 31, 2006 and
2005,
respectively.
The
Company was provided cash in financing activities of $476,045 and $19,595,128
during the year ended December 31, 2006 and 2005, respectively. The financing
activities represent proceeds from the sale of 2,400,000 shares of common stock
at $2.50 per share for an aggregate purchase price of $6,000,000 during the
twelve months ended December 31, 2006. Additionally, the financing activities
represent proceeds from the exercise of stock options and warrants of $2,739,801
and $1,174,538 during the years ended December 31, 2006 and 2005, respectively.
The proceeds of the financing activities were offset by repayment of debt
principal of $8,263,756 in 2006, including $7,750,000 of principal payments
in
conjunction with the conversion and settlement agreement with the lenders under
the Company’s Convertible Senior Notes
and approximately $410,000 in conjunction with the acquisition of
MST.
The
Company believes it has sufficient access to capital to meet its working capital
requirements through the remainder of 2007 in available cash and in cash
generated from operations. 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.
Inflation
We
do not
believe that inflation has had a material effect on our business, financial
condition or results of operations. If our costs were to become subject to
significant inflationary pressures, we may not be able to fully offset such
higher costs through price increases. Our inability or failure to do so could
adversely affect our business, financial condition and results of
operations.
Acquisition
or Disposition of Plant and Equipment
During
the year ended December 31, 2006, fixed assets increased $1,169,899 or 112%
primarily from the addition of the MST Segment assets acquired on January 31,
2006 of approximately $435,000 and approximately $674,000 of equipment purchase
for the MST build-out. The remainder related to computer equipment and
peripherals used in day-to-day operations. The Company anticipates significant
expenditures in the MST Segment to continue the build-out the head-end
equipment, IPTV and other related projects. The Telkonet segment 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
MST
presently leases 12,600 square feet of commercial office space in Hawthorne,
New
Jersey for its office and warehouse spaces. This lease will expire in April
2010.
Following
the acquisitions of SSI and Ethostream, the Company assumed leases on 9,000
square feet of office space in Las Vegas, NV for the SSI office and warehouse
space on a month to month basis and 4,100 square feet of office space in
Milwaukee, WI for Ethostream and this lease expires in May 2011.
New
Accounting Pronouncements
On
February 16, 2006 the Financial Accounting Standards Board (FASB) issued
SFAS 155, “Accounting for Certain Hybrid Instruments,” which amends SFAS 133,
“Accounting for Derivative Instruments and Hedging Activities,” and SFAS 140,
“Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities.” SFAS 155 allows financial instruments that have embedded
derivatives to be accounted for as a whole (eliminating the need to bifurcate
the derivative from its host) if the holder elects to account for the whole
instrument on a fair value basis. SFAS 155 also clarifies and amends certain
other provisions of SFAS 133 and SFAS 140. This statement is effective for
all
financial instruments acquired or issued in fiscal years beginning after
September 15, 2006. The Company does not expect its adoption of this new
standard to have a material impact on its financial position, results of
operations or cash flows.
In
September 2006, the FASB issued SFAS 157, Fair Value Measurements, which
defines fair value, establishes a framework for measuring fair value in
generally accepted accounting principles (“GAAP”), and expands disclosures about
fair value measurements. The Company will be required to adopt SFAS 157
effective for the fiscal year beginning January 1, 2008. The requirements
of SFAS 157 will be applied prospectively except for certain derivative
instruments that would be adjusted through the opening balance of retained
earnings in the period of adoption. The Company is currently evaluating the
impact of the adoption of SFAS 157 on the Company’s consolidated financial
statements and management believes that the adoption of SFAS 157 will not have
a
significant impact on its consolidated results of operations or financial
position.
In
September 2006, the FASB issued Statement of Financial Accounting Standards
No.
158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement
Plans - an amendment of FASB Statements No. 87, 88, 106, and 132R (‘SFAS
158’). SFAS 158 changes current practice by requiring employers to
recognize the overfunded or underfunded positions of defined benefit
postretirement plans, including pension plans, on the balance sheet. The
funded status is defined as the difference between the projected benefit
obligation and the fair value of plan assets. SFAS 158 also requires
employers to recognize the change in funded status in other comprehensive income
(a component of shareholders’ equity). SFAS 158 does not change the
requirements for the measurement and recognition of pension expense in the
statement of income. SFAS 158 is effective for fiscal years ending after
December 15, 2006. The Company does not anticipate any material impact to
its financial condition or results of operations as a result of the adoption
of
SFAS 158.
In
September 2006, the SEC issued Staff Accounting Bulletin 108, Considering
the Effects of Prior Year Misstatements When Quantifying Misstatements in
Current Year Financial Statements
(‘SAB
108’). SAB 108 provides interpretive guidance on how the effects of the
carryover or reversal of prior year financial statement misstatements should
be
considered in quantifying a current year misstatement. SAB 108 is
effective for financial statements covering the first fiscal year ending after
November 15, 2006. The Company does not anticipate any material impact to
its financial condition or results of operations as a result of the adoption
of
SAB 108.
In
December 2006, the FASB issued FSP EITF 00-19-2, Accounting for Registration
Payment Arrangements ("FSP
00-19-2")
which addresses accounting for registration payment arrangements. FSP
00-19-2
specifies that the contingent obligation to make future payments or otherwise
transfer consideration under a registration payment arrangement, whether
issued
as a separate agreement or included as a provision of a financial instrument
or
other agreement, should be separately recognized and measured in accordance
with
FASB Statement No. 5, Accounting for Contingencies. FSP
00-19-2
further clarifies that a financial instrument subject to a registration payment
arrangement should be accounted for in accordance with other applicable
generally accepted accounting principles without regard to the contingent
obligation to transfer consideration pursuant to the registration payment
arrangement. For registration payment arrangements and financial instruments
subject to those arrangements that were entered into prior to the issuance
of
EITF 00-19-2, this guidance is effective for financial statements issued
for
fiscal years beginning after December 15, 2006 and interim periods within
those
fiscal years. The
Company has not yet determined the impact that the adoption of FSP
00-19-2
will have on its financial statements.
In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities.” SFAS 159 permits entities to choose
to measure many financial instruments, and certain other items, at fair value.
SFAS 159 applies to reporting periods beginning after November 15, 2007.
The
adoption of SFAS 159 is not expected to have a material impact on the Company’s
financial condition or results of operations.
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
|
|
$
|
900,000
|
|
$
|
900,000
|
|
|
-
|
|
|
-
|
|
|
-
|
|
Capital
Lease Obligations
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
Operating
Lease Obligations
|
|
$
|
1,117,663
|
|
$
|
421,804
|
|
$
|
518,909
|
|
$
|
176,950
|
|
|
-
|
|
Purchase
Obligations
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
Other
Long-Term Liabilities Reflected on the Registrant’s Balance Sheet Under
GAAP
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
Total
|
|
$
|
2,017,663
|
|
$
|
1,321,804
|
|
$
|
518,909
|
|
$
|
176,950
|
|
|
-
|
|
(1)
Operating lease obligations includes approximately $266,872 of future lease
obligations, primarily related to office and warehouse space, in conjunction
with the January 2006 acquisition of Microwave Satellite Technologies, Inc.
ITEM
7A. QUANTITATIVE
AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Short
Term Investments
We
held
no marketable securities as of December 31, 2006. 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 400 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 March 1, 2007 was $131,044 and
$8,000 in BPL Global and Amperion, respectively, and at December 31, 2006,
are
recorded in other assets in the Consolidated Balance Sheets. The Company
determined that its investment in Amperion was impaired based upon forecasted
discounted cash flow. Accordingly, the Company wrote-off 80%, or $400,000
and
92%, or $92,000, of the carrying value of its investment through a charge
to
operations during the years ended December 31, 2005 and 2006, respectively.
The
fair value of the Company’s investment in BPL Global, remained at $131,044 as of
December 31, 2006.
ITEM
8. FINANCIAL
STATEMENTS.
See
the
Financial Statements and Notes thereto commencing on Page F-1.
ITEM
9. CHANGES
IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE.
None.
ITEM
9A. CONTROLS
AND PROCEDURES.
Evaluation
of Disclosure Controls and Procedures.
Under
the supervision and with the participation of our management, including our
Chief Executive Officer and Vice President of Finance (principal accounting
officer), the Company evaluated the effectiveness of the design and operation
of
its disclosure controls and procedures (as such term is defined in Rule
13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)).
Disclosure controls and procedures are the controls and other procedures
that
the Company designed to ensure that it records, processes, summarizes and
reports in a timely manner the information it must disclose in reports that
it
files with or submits to the Securities and Exchange Commission under the
Exchange Act. Based on this evaluation, the Chief Executive Officer and the
Vice
President of Finance concluded that the Company’s disclosure controls and
procedures were effective as of the end of the period covered by this
report.
Changes
in Internal Control over Financial Reporting.
During
the fourth quarter of 2006, there was no change in the Company’s internal
control over financial reporting (as such term is defined in Rule 13a-15(f)
under the Exchange Act) that has materially affected, or is reasonably likely
to
materially affect, the Company’s internal control over financial
reporting.
Management
Report On Internal Control over Financial Reporting.
The
Company’s management is responsible for establishing and maintaining adequate
internal control over financial reporting. Internal control over financial
reporting is defined in Rule 13a-15(f) under the Exchange Act as a process
designed by, or under the supervision of, the Company’s principal executive and
principal financial officers and effected by the Company’s board of directors,
management and other personnel, to provide reasonable assurance regarding
the
reliability of financial reporting and the preparation of financial statements
for external purposes in accordance with accounting principles generally
accepted in the United States of America and includes those policies and
procedures that:
|
· |
pertain
to the maintenance of records that, in reasonable detail, accurately
and
fairly reflect the transactions and dispositions of the Company’s
assets;
|
|
· |
provide
reasonable assurance that transactions are recorded as necessary
to permit
preparation of financial statements in accordance with accounting
principles generally accepted in the United States of America,
and that
the Company’s receipts and expenditures are being made only in accordance
with authorization of management and directors;
and
|
|
· |
provide
reasonable assurance regarding prevention or timely detection
of
unauthorized acquisition, use or disposition of the Company’s assets that
could have a material effect on the financial
statements.
|
Because
of its inherent limitations, internal control over financial reporting may
not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may
become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
Under
the
supervision and with the participation of the Company’s management, including
its principal executive and principal financial officers, the Company assessed,
as of December 31, 2006, the effectiveness of its internal control over
financial reporting. This assessment was based on criteria established in the
framework in
Internal Control-Integrated Framework
issued
by the Committee of Sponsoring Organizations of the Treadway Commission. Based
on the Company’s assessment, management concluded that the Company’s internal
control over financial reporting was effective as of December 31,
2006.
The
Company’s assessment of the effectiveness of its internal control over financial
reporting as of December 31, 2006 has been audited by Russell Bedford Stefanou
Mirchandani LLP, an independent registered public accounting firm, as stated
in
their report which is included in this Annual Report on Form
10-K.
RUSSELL
BEDFORD STEFANOU MIRCHANDANI LLP
CERTIFIED
PUBLIC ACCOUNTANTS
REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board
of Directors
Telkonet,
Inc.
Germantown,
MD
We
have audited management's assessment, included in the accompanying Management's
Report on Internal Control over Financial Reporting, that Telkonet, Inc. and
its subsidiaries (the Company) maintained effective internal control over
financial reporting as of December 31, 2006, based on criteria established
in
Internal Control-Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO). The Company's management is responsible for maintaining effective
internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility
is to express an opinion on management's assessment and an opinion on the
effectiveness of the Company's internal control over financial reporting based
on our audit.
We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control
over
financial reporting, evaluating management's assessment, testing and evaluating
the design and operating effectiveness of internal control, and performing
such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.
A
company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control
over
financial reporting includes those policies and procedures that (1) pertain
to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors
of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial
statements.
Because
of its inherent limitations, internal control over financial reporting may
not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
In
our opinion, management's assessment that Telkonet, Inc. and its wholly-owned
subsidiaries maintained effective internal control over financial reporting
as
of December 31, 2006, is fairly stated, in all material respects, based on
criteria established in Internal
Control Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO). Also, in our opinion, Telkonet, Inc. and its subsidiaries,
maintained, in all material respects, effective internal control over financial
reporting as of December 31, 2006, based on criteria
established in
Internal Control-Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO).
We
also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated financial
statements and financial statement schedules as of and for the year ended
December 31, 2006, of the Company and our report dated March 15, 2007 expressed
an unqualified opinion on those financial statements and financial statement
schedules and included an explanatory paragraph regarding the Company's adoption
of the provisions of Statement of Financial Accounting Standards No. 123(R),
"Share-Based Payment", effective January 1, 2006.
/s/
RUSSELL BEDFORD
STEFANOU MIRCHANDANI LLP
Russell
Bedford
Stefanou Mirchandani LLP
Certified
Public
Accountants
McLean,
Virginia
March
15, 2007
ITEM
9B. OTHER
INFORMATION.
None.
PART
III
ITEM
10. DIRECTORS
AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The
following table furnishes the information concerning the Company’s directors and
officers during the fiscal year ended December 31, 2006. The directors of the
Company are elected every year and serve until their successors are duly elected
and qualified.
Name
|
Age
|
Title
|
|
|
|
Ronald
W. Pickett
|
59
|
President,
Director & Chief Executive Officer
|
|
|
|
Frank
T. Matarazzo
|
45
|
President
& Chief Executive Officer, Microwave Satellite Technologies,
Inc.
|
|
|
|
Robert
P. Crabb
|
59
|
Chief
Marketing Officer
|
|
|
|
Stephen
Sadle
|
61
|
Senior
Vice President & Director
|
|
|
|
James
Landry
|
51
|
Chief
Technology Officer
|
|
|
|
Richard
J. Leimbach
|
38
|
Vice
President of Finance
|
|
|
|
Warren
V. Musser
|
80
|
Chairman
of the Board
|
|
|
|
Thomas
C. Lynch
|
64
|
Director
(1), (2)
|
|
|
|
Dr.
Thomas M. Hall
|
55
|
Director
(1), (2)
|
|
|
|
James
L. “Lou” Peeler
|
73
|
Director
(1), (2)
|
|
|
|
Seth
Blumenfeld
|
66
|
Director
|
_________________________
|
(1)
|
Member
of the Audit Committee
|
|
(2)
|
Member
of the Compensation Committee
|
Ronald
W. Pickett—President, Chief Executive Officer &
Director
Mr.
Pickett has served as the Company’s Chief Executive Officer since January 2003.
In addition, he has fostered the development of Telkonet since 1999 as the
Company’s principal investor and co-Founder. He was the Founder, and for twenty
years served as the Chairman of the Board and President of Medical Advisory
Systems, Inc. (a company providing international medical services and
pharmaceutical distribution) until its merger with Digital Angel Corporation
(AMEX: DOC) in March 2002. A graduate of Gordon College, Mr. Pickett has engaged
in various entrepreneurial activities for 35 years. Mr. Pickett has been a
director of the Company since January 2003.
Frank
T. Matarazzo—President & Chief Executive Officer, Microwave Satellite
Technologies, Inc. (MST)
Mr.
Matarazzo has been the President and Chief Executive Officer of Microwave
Satellite Technologies, Inc. since its inception in 1982. Mr. Matarazzo has
directed the growth and development of the Microwave Satellite Technologies,
Inc. (MST) and designed and constructed the first private cable television
systems operated by MST and continues to be involved in all technology deployed
at MST. Mr. Matarazzo’s experience includes employment for Conrac Avionics, as a
prototype design engineer, working on the development of the guidance/navigation
systems for military fighter planes as well as the development and construction
of the FM communication systems and engine interface units for the Space Shuttle
Columbia. He is known in the private cable television industry, having both
written articles for trade publications and served as a technical consultant
to
municipalities on the subject of satellite delivered information
systems.
Robert
P. Crabb—Chief Marketing Officer
Mr.
Crabb
has over 35 years of sales, marketing and corporate management experience,
including 15 years in the insurance industry in property and casualty brokerage
and sales and sales management with the Metropolitan Life Insurance Company.
His
entrepreneurial expertise also includes public company administration, financial
consulting, corporate management and commercial/residential real estate
development. Mr. Crabb is a former director of Telkonet and has been involved
with the Company since 1999.
Stephen
L. Sadle—Senior Vice President, Co-Founder & Director
From
1999
until he joined Telkonet in 2000, Mr. Sadle served as Senior Vice President
and
General Sales Manager of Internos (a provider of web-based vertical extranet
applications). From 1986 until 1999, Mr. Sadle was Vice President of Business
Development and Sales for the Driggs Corporation, a major heavy and
infrastructure contracting firm interfacing with government and the private
sectors. From 1970 until 1986, Mr. Sadle was President of a successful
infrastructure construction and development company in the Washington, D.C.
metropolitan area. Mr. Sadle has been a director of the Company since November
1999.
James
F. Landry—Chief Technology Officer
Mr.
Landry has served as the Company’s Chief Technology Officer since December 2004
and Vice President of Engineering from September 2001 to May 2004. Before
joining Telkonet, Mr. Landry was a Senior Member of 3Com Technical Staff since
1994. Mr. Landry has over 20 years experience in developing communications
hardware for the enterprise/carrier market with 3Com, US Robotics, Penril
Datacomm and Data General. While at 3Com/US Robotics, he was responsible for
the
development of the entire xDSL product line as well as a number of modems and
interface cards. At Penril, he served as the product development leader for
the
Series 1544 multiplexer/channel bank and at Data General he was technical leader
of system integration for ISDN, WAN. Mr. Landry brings a wealth of practical
design leadership and a solid history of delivering products to the marketplace.
Mr. Landry holds four US patents.
Richard
J. Leimbach—Vice President of Finance
Mr.
Leimbach has served as the Vice President of Finance since June 2006, also
served as Controller from January 2004 until June 2006. Mr. Leimbach is a
certified public accountant with over thirteen years of public accounting and
private industry experience. Prior to joining Telkonet, Mr. Leimbach was the
Controller with Ultrabridge, Inc., an applications solution provider. Mr.
Leimbach also served as Corporate Accounting Manager for Snyder Communications,
Inc., a global provider of integrated marketing solutions.
Warren
V. Musser—Chairman of the Board of Directors
Mr.
Musser, has taken over 50 companies public during his distinguished and
successful career as an entrepreneur, and is the founder and Chairman Emeritus
of Safeguard Scientifics, Inc. (a high-tech venture capital company, formerly
Safeguard Industries, Inc.). Mr. Musser is currently the Managing Director,
The
Musser Group (a business consulting firm) and Founder & President, Musser
and Company, Inc. (an investment banking firm). In addition, Mr. Musser is
a
Director of Internet Capital Group, Inc. (a business-to-business venture capital
company), and Mr. Musser is a Director and Vice Chairman of Nutri/System, Inc
(Nasdaq:NRTI). (a weight management company) and Co-Chairman of Eastern
Technology Council (a business advisory firm). Mr. Musser serves on a variety
of
civic, educational and charitable boards of directors, and serves as vice
president of development, Cradle of Liberty Council, Boy Scouts of America;
vice
chairman of The Eastern Technology Council; and chairman of the Pennsylvania
Partnership on Economic Education. Mr. Musser has been a director of the Company
since January 2003.
Thomas
C. Lynch—Director
Mr.
Lynch
is Senior Vice President and Director of The Staubach Company’s Federal Sector
(a real estate management and advisory services firm) in the Washington, D.C.
area. Mr. Lynch joined The Staubach Company in November 2002 after 6 years
as
Senior Vice President at Safeguard Scientifics, Inc. (NYSE: SFE) (a high-tech
venture capital company). While at Safeguard, he served nearly two years as
President and Chief Operating Officer at CompuCom Systems, a Safeguard
subsidiary. After a 31-year career of naval service, Mr. Lynch retired in the
rank of Rear Admiral. Mr. Lynch’s Naval service included chief, Navy Legislative
Affairs, command of the Eisenhower Battle Group during Operation Desert Shield,
Superintendent of the United States Naval Academy from 1991 to 1994 and Director
of the Navy Staff in the Pentagon from 1994 to 1995. Mr. Lynch presently serves
as a Director of Pennsylvania Eastern Technology Council, Armed Forces Benefit
Association, Catholic Leadership Institute, National Center for the American
Revolution at Valley Forge and Mikros Systems. Mr. Lynch has been a director
of
the Company since October 2003.
Dr.
Thomas M. Hall—Director
Dr.
Hall
is the Managing Member of Marrell Enterprises, LLC (a company that specializes
in international business development).Dr. Hall also serves on the board of
directors of Coris International SA (a Paris-based insurance services company
with subsidiaries in 36 countries). For 12 years (until 2002), Dr. Hall was
the
chief executive officer of Medical Advisory Systems, Inc. (a company providing
international medical services and pharmaceutical distribution). Dr. Hall holds
a bachelor of science and a medical degree from the George Washington University
and a master of international management degree from the University of Maryland.
Dr. Hall has been a director of the Company since April 2004.
James
L. “Lou” Peeler—Director
Mr.
Peeler was a founder and member of the board of Digital Communications
Corporation (DCC), which evolved into Hughes Network Systems (HNS), a provider
of global broadband, satellite, and wireless communications products for home
and business, such as DirecTV and DIRECWAY. Mr. Peeler retired as executive
vice
president of operations in 1999 after 27 years of service and is presently
a
member of the Advisory Council to Hughes Network Systems. Mr. Peeler also served
on the Board of Directors of Hughes Software Systems (HSS). Prior to the
founding of DCC, he was vice president of Engineering for Washington
Technological Associates (WTA) (a satellite communications development company),
where he was instrumental in the development of rocket and satellite
communications and instrumentation equipment. Mr. Peeler received a bachelor
of
science degree in electrical engineering from Auburn University. Mr. Peeler
has
been a director of the Company since April 2004.
Seth
D. Blumenfeld—Director
Mr.
Blumenfeld served as President of International Services for MCI International
(a provider of telecommunication services) from 1998 until his retirement in
January of 2005. Mr. Blumenfeld was President and Chief Operating Officer of
several of MCI's international subsidiaries from 1984 to 1998. Mr. Blumenfeld
earned his Doctorate Jurisprudence from Fordham University Law School in 1965.
He practiced law on Wall Street prior to serving as infantry captain for the
U.S. Army in Vietnam. From 1976 through 1978, Mr. Blumenfeld lived in Japan.
Mr.
Blumenfeld's involvement on professional boards and community associations
have
included Executive Committee member of the United States Council for
International Business, Member of the Board of Directors of the United States
Telecommunications Training Institute, Member of the State Department Advisory
Council on International Communications and Information Policy, Member of the
University of Colorado Institute for International Business Board of Advisors,
Member of the American Graduate School of International Management (Thunderbird)
Board of Advisors, Member of the Advisory Board of Visitors to Fordham
University School of Law, and honorary Chairman of the Connecticut Association
of Children with Learning Disabilities.
Audit
Committee
The
Company maintains an Audit Committee of the Board of Directors. For the year
ended December 31, 2006, Messrs. Hall, Lynch and Peeler served on the Audit
Committee. The Company’s Board of Directors has determined that each of Messrs.
Hall, Lynch and Peeler is a “financial expert” as defined by Item 401 of
Regulation S-K promulgated under the Securities Act of 1933 and the Securities
Exchange Act of 1934. The Company’s Board of Directors also has determined that
each of Messrs. Hall, Lynch and Peeler are “independent” as such term is defined
in Section 121(A) of the AMEX Rules and Rule 10A-3 promulgated under the
Securities Exchange Act of 1934. The Board of Directors has adopted an audit
committee charter, which was ratified by the Company’s stockholders at the 2004
Annual Meeting of Stockholders.
Compensation
Committee
The
Company maintains a Compensation Committee of the Board of Directors. For the
year ended December 31, 2006, Dr. Hall ad Messrs. Lynch and Peeler served on
the
Compensation Committee. The committee held 1 meeting during 2006.
Code
of Ethics
The
Board
has approved, and Telkonet has adopted, a Code of Ethics that applies to all
directors, officers and employees of Telkonet. A copy of the Company’s Code of
Ethics was filed as Exhibit 14 to the Company’s Annual Report on Form 10-KSB for
the year ended December 31, 2003 (filed with the Securities and Exchange
Commission on March 30, 2004). In addition, the Company will provide a copy
of
its Code of Ethics free of charge upon request to any person submitting a
written request to the Company’s Chief Executive Officer.
Beneficial
Ownership
SECTION
16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section
16(a) of the Securities Exchange Act of 1934 requires our directors and certain
of our officers to file reports of holdings and transactions in shares of
Telkonet common stock with the Securities and Exchange Commission. Based on
our
records and other information, we believe that in 2006 our directors and our
officers who are subject to Section 16 met all applicable filing
requirements.
ITEM
11. EXECUTIVE
COMPENSATION.
COMPENSATION
COMMITTEE REPORT
The
Compensation Committee of the Board of Directors has reviewed and
discussed the section of this Form 10-K entitled “Compensation Discussion and
Analysis” with management. Based on this review and discussion, the Committee
has recommended to the Board that the section entitled “Compensation Discussion
and Analysis,” be included in this Form 10-K for the fiscal year ended
December 31, 2006.
Thomas
M. Hall
Thomas
C. Lynch
James
L. Peeler
COMPENSATION
DISCUSSION AND ANALYSIS
Oversight
of Executive Compensation Program
The
Compensation Committee of the Board of Directors oversees the Company’s
compensation programs, which are designed specifically for the Company’s most
senior executives officers, including the Chief Executive Officer, Chief
Financial Officer and the other executive officers named in the Summary
Compensation Table (collectively, the “named executive officers”). Additionally,
the Compensation Committee is charged with the review and approval of all annual
compensation decisions relating to named executive officers.
The
Compensation Committee is composed of 3 independent, non-management members
of
the Board of Directors. Each year the Company reviews any and all relationships
that each director has with the Company and the Board of Directors subsequently
reviews these findings.
The
responsibilities of the Compensation Committee, as stated in its charter,
include the following:
|
·
|
annually
review and approve for the CEO and the executive officers of the
Company
the annual base salary, the annual incentive bonus, including the
specific
goals and amount, equity compensation, employment agreements, severance
arrangements, and change in control agreements/provisions, and
any other
benefits, compensation or
arrangements.
|
|
·
|
make
recommendations to the Board with respect to incentive compensation
plans,
including reservation of shares for issuance under employee benefit
plans.
|
|
·
|
annually
review and recommend to the Board of Directors for its approval
the
compensation, including cash, equity or other compensation, for
members of
the Board of Directors for their service as a member of the Board
of
Directors, a member of any committee of the Board of Directors,
a Chair of
any committee of the Board of Directors, and the Chairman of the
Board of
Directors.
|
|
·
|
annually
review the performance of the Company’s Chief Executive
Officer.
|
|
·
|
make
recommendations to the Board of Directors on the Company’s executive
compensation practices and policies, including the evaluation of
performance by the Company’s executive officers and issues of management
succession.
|
|
·
|
review
the Company’s compliance with employee benefit
plans.
|
|
·
|
make
regular reports to the Board.
|
|
·
|
annually
review and reassess the adequacy of the Compensation Committee
charter and
recommend any proposed changes to the Board for
approval.
|
The
Compensation Committee is also responsible for completing an annual report
on
executive compensation for inclusion in the Company's proxy statement. In
addition to such annual report, the Compensation Committee maintains written
minutes of its meetings, which minutes are filed with the minutes of the
meetings of the Board.
Overview
of Compensation Program
In
order
to recruit and retain the most qualified and competent individuals as senior
executives, the Company strives to maintain a compensation program that is
competitive in the global labor market. The purpose of the Company’s
compensation program is to reward exceptional organizational and individual
performance.
The
following compensation objectives are considered in setting the compensation
programs for our named executive officers:
|
·
|
drive
and reward performance which supports the Company’s core
values;
|
|
·
|
provide
a percentage of total compensation that is “at-risk,” or variable, based
on predetermined performance
criteria;
|
|
·
|
design
competitive total compensation and rewards programs to enhance
the
Company’s ability to attract and retain knowledgeable and experienced
senior executives; and
|
|
·
|
set
compensation and incentive levels that reflect competitive market
practices.
|
Compensation
Elements and Rationale
Compensation
for Named Executive Officers Other than the CEO
Compensation
for the named executive officers, other than the CEO, are made in the CEO’s sole
and exclusive discretion. While the Compensation Committee provides its
recommendations with respect to compensation for the named executive officers
(other than the CEO) as described in greater detail below, the CEO is only
required to consider the Compensation Committee’s recommendations, but is not
bound by its findings.
Compensation
for the Company’s CEO
To
reward
both short and long-term performance in the compensation program and in
furtherance of the Company’s compensation objectives noted above, the Company’s
compensation program for the CEO is based on the following objectives:
The
Compensation Committee believes that a significant portion of the CEO’s
compensation should be tied not only to individual performance, but also to
the
Company’s performance as a whole measured against both financial and
non-financial goals and objectives. During periods when performance meets or
exceeds these established objectives, the CEO should be paid at or more than
expected levels. When the Company’s performance does not meet key objectives,
incentive award payments, if any, should be less than such levels.
|
(ii)
|
Incentive
Compensation
|
A
large
portion of compensation should be paid in the form of short-term and long-term
incentives, which are calculated and paid based primarily on financial measures
of profitability and stockholder value creation. The CEO has the incentive
of
increasing Company profitability and stockholder return in order to earn a
major
portion of his compensation package.
|
(iii)
|
Competitive
Compensation Program
|
The
Compensation Committee reviews the compensation of chief executive officers
at
peer companies to ensure that the compensation program for the CEO is
competitive. The Company believes that a competitive compensation program will
enhance its ability to retain a capable CEO.
Financial
Metrics Used in Compensation Programs
Several
financial metrics are commonly referenced in defining Company performance for
the CEO’s executive compensation. These metrics include quarterly metrics to
target cash flow break even and specific revenue goals to define Company
performance for purposes of setting the CEO’s compensation.
Compensation
Benchmarking Relative to Market
The
Company sets the CEO’s compensation by evaluating peer group companies. Peer
group companies are chosen based on size, industry, annual revenue and whether
they are publicly or privately held. Based on these criteria, the Compensation
Committee has identified 29 companies in the Company’s peer group. These peer
group companies include Catapult Communications Corp., Endwave Corp., Carrier
Access Corp., Crystal Technology, Echelon Corp. and FiberTower Corp. The
Compensation Committee has concluded that the CEO’s compensation falls within
the 50th
percentile of compensation for chief executive officers within the peer group
companies.
Review
of Senior Executive Performance
The
Compensation Committee reviews, on an annual basis, each compensation package
for the named executive officers. In each case, the Compensation Committee
takes
into account the scope of responsibilities and experience and balances these
against competitive salary levels. The Compensation Committee has the
opportunity to meet with the named executive officers at least once per year,
which allows the Compensation Committee to form its own assessment of each
individual’s performance. As indicated above, with the exception of the CEO,
recommendations with respect to compensation packages for the named executive
officers must be considered by the CEO in connection with establishing
compensation for those named executive officers. However, the recommendations
of
the Compensation Committee with respect to the compensation paid to the named
executive officers (other than the CEO) will not be binding on the
CEO.
Components
of the Executive Compensation Program
The
Compensation Committee believes the total compensation and benefits program
for
named executive officers should consist of the following:
|
·
|
retirement,
health and welfare benefits;
|
|
·
|
perquisites
and perquisite allowance payments;
and
|
Base
Salaries
With
the
exception of the CEO, whose compensation is set by the Compensation Committee
and approved by the Board of Directors, base salaries and merit increases for
the named executive officers are determined by the CEO in his discretion after
consideration of a competitive analysis recommendation provided by the
Compensation Committee. The Compensation Committee’s recommendation is
formulated through the evaluation of the compensation of similar executives
employed by companies in the Company’s peer group.
Stock
Incentive Plan
Under
the
Company’s Stock Incentive Plan (the “Plan”) incentive stock options and
non-qualified options to purchase shares of the Company’s common stock may be
granted to key employees. An important objective of the long-term incentive
program is to strengthen the relationship between the long-term value of the
Company’s stock price and the potential financial gain for employees as well as
the retention of senior management and key personnel. Stock options provide
named executive officers with the opportunity to purchase the Company’s common
stock at a price fixed on the grant date regardless of future market price.
Stock options generally ratably vest on a quarterly basis and become exercisable
over a five-year vesting period. A stock option becomes valuable only if the
Company’s common stock price increases above the option exercise price (at which
point the option will be deemed “in-the-money”) and the holder of the option
remains employed during the period required for the option to “vest” thus,
providing an incentive for an option holder to remain employed by the Company.
In addition, stock options link a portion of an employee’s compensation to
stockholders’ interests by providing an incentive to increase the market price
of the Company stock.
The
Company practice is that the exercise price for each stock option is equal
to
the fair market value on the date of grant. Under the terms of the Plan,
the
option price will not be less than the fair market value of the shares on
the
date of grant. Or in the case of a beneficial owner of more than 5.0% of
the
Company’s outstanding common stock on the date of grant, the option price will
not be less than 110% of the fair market value of the shares on the date
of
grant.
There
is
a limited term in which Plan participants can exercise stock options, known
as
the “option term.” The option term is generally ten years from the date of
grant. At the end of the option term, the right to purchase any unexercised
options expires. Option holders generally forfeit any unvested options if
their
employment with the Company terminates.
Certain
key executives may be a party to option agreements containing clauses that
cause
their options to become immediately and fully vested and exercisable upon
a
Change of Control, as defined in the Plan. Additionally, death or disability
of
the executive during his or her employment period may cause certain stock
options to immediately vest and become exercisable per the terms outlined
in the
stock option award agreement.
The
Compensation Committee awards options to named executive officers upon
commencement of their employment with the Company, and for successfully
acheiving or exceeding predetermined individual and Company performance goals.
In determining whether to award stock options and the number of stock options
granted to a named executive officer, the Compensation Committee reviews
the
compensation of executives at peer group companies to ensure that the
compensation program is competitive.
Retirement,
Health and Welfare Benefits
The
Company offers a variety of health and welfare and retirement programs to
all
eligible employees. The named executive officers generally are eligible for
the
same benefit programs on the same basis as the rest of the broad-based
employees. The Company’s health and welfare programs include medical, dental,
vision, life, accidental death and disability, and short and long-term
disability insurance. In addition to the foregoing, the named executive officers
are eligible to participate in the Company’s 401(k) Profit Sharing
Plan.
401(k) Profit
Sharing Plan
Telkonet
maintains a defined contribution profit sharing plan for employees (the
“Telkonet 401(k)”) that is administered by a committee of trustees appointed by
the Company. All Company employees are eligible to participate upon the
completion of six months of employment, subject to minimum age
requirements. Contributions by employees under the Telkonet 401(k) are
immediately vested and each employee is eligible for distributions upon
retirement, death or disability or termination of employment. Depending upon
the
circumstances, these payments may be made in installments or in a single
lump
sum.
MST
maintains a defined contribution profit sharing plan for employees (the “MST
401(k)”) that is administered by a committee of trustees appointed by the
Company. All Company employees are eligible to participate upon the completion
of three months of employment, subject to minimum age requirements. Each
year the Company makes a contribution to the MST 401(k) without regard to
current or accumulated net profits of the Company. These contributions are
allocated to participants in amounts of 100% of the participants’ contributions
up to 1% of each participant’s gross pay, then 10% of the next 5% of each
participant’s gross pay (a higher contribution percentage may be determined at
the Company’s discretion). In addition, the Company makes a one-time, annual
contribution of 3% of each participant’s gross pay to each participant’s
contribution account in the MST 401(k) plan. Participants become vested in
equal portions of their Company contribution account for each year of service
until full vesting occurs upon the completion of six years of service.
Distributions are made upon retirement, death or disability in a lump sum
or in
installments.
Perquisites
The
Company leases a vehicle for the use of Telkonet's CEO. The operating
lease will expire in September 2008. Additionally, in the first quarter of
2007
the Company began providing monthly car allowance stipends to certain executives
of MST and Ethostream.
EXECUTIVE
COMPENSATION
The
following table sets forth certain information with respect to compensation
for
services in all capacities for the years ended December 31, 2006, 2005 and
2004 paid to our Chief Executive Officer, Vice President of Finance (principal
financial officer) and the three other most highly compensated executive
officers who were serving as such as of December 31, 2006.
Summary
Compensation Table
Name
and Principal Position
|
Year
|
Salary
($)
|
Bonus
($)
|
Stock
Awards
($)
|
Option
Awards
($)
(3)(4)(5)
|
Non-Equity
Incentive Plan Compensation ($)
|
Change
in Pension Value and Nonqualified Deferred Compensation
Earnings
($)
|
All
Other
Compen-sation
($)
|
Total
($)
|
Ronald
W. Pickett
|
2006
|
$245,423
|
$0
|
$0
|
$0
|
$0
|
$0
|
$4,593
(3)
|
$250,016
|
President
and Chief
|
2005
|
$102,340
|
$200,000
|
$163,319
(1)
|
$0
|
$0
|
$0
|
$0
|
$465,659
|
Executive
Officer
|
2004
|
$100,089
|
$0
|
$107,779
(1)
|
$0
|
$0
|
$0
|
$0
|
$207,868
|
|
|
|
|
|
|
|
|
|
|
Frank
T. Matarazzo
|
2006
|
$244,539
|
$9,615
|
$0
|
$0
|
$0
|
$0
|
$0
|
$254,154
|
President
and Chief
|
2005
|
$0
(2)
|
$0
|
$0
|
$0
|
$0
|
$0
|
$0
|
$0
(2)
|
Executive
Officer, MST
|
2004
|
$0
(2)
|
$0
|
$0
|
$0
|
$0
|
$0
|
$0
|
$0
(2)
|
|
|
|
|
|
|
|
|
|
|
Stephen
L. Sadle
|
2006
|
$168,154
|
$6,610
|
$0
|
$0
|
$0
|
$0
|
$0
|
$174,764
|
Senior
Vice President
|
2005
|
$171,872
|
$10,000
|
$0
|
$124,770
|
$0
|
$0
|
$0
|
$306,642
|
|
2004
|
$171,983
|
$6,538
|
$0
|
$124,770
|
$0
|
$0
|
$0
|
$303,291
|
|
|
|
|
|
|
|
|
|
|
Richard
J. Leimbach
|
2006
|
$111,231
|
$5,000
|
$0
|
$36,312
|
$0
|
$0
|
$0
|
$152,543
|
Vice
President, Finance
|
2005
|
$102,340
|
$3,936
|
$0
|
$36,312
|
$0
|
$0
|
$0
|
$142,588
|
|
2004
|
$76,147
|
$3,269
|
$0
|
$5,825
|
$0
|
$0
|
$0
|
$85,241
|
|
|
|
|
|
|
|
|
|
|
James
F. Landry
|
2006
|
$174,886
|
$6,789
|
$0
|
$104,500
|
$0
|
$0
|
$0
|
$286,176
|
Chief
Technology
|
2005
|
$176,508
|
$15,000
|
$0
|
$38,124
|
$0
|
$0
|
$0
|
$229,632
|
Officer
|
2004
|
$172,514
|
$15,000
|
$0
|
$44,958
|
$0
|
$0
|
$0
|
$232,499
|
____________________
(1)
In
each year ending December 31, 2005 and 2004, Mr. Pickett earned 36,000 shares
issued under the Company’s Employee Stock Incentive Plan as additional
compensation pursuant to his employment agreement. The fair market value of
these shares upon issuance was $163,319, and $107,779,
respectively.
(2)
In
January 2006, the Company acquired a 90% interest in MST, a corporation wholly
owned by Frank T. Matarazzo, prior to the acquisition. No compensation was
paid
by Telkonet to Mr. Matarazzo for the years ended December 31, 2005, and
2004.
(3)
In 2004 the following assumptions were used to
determine the fair value of stock option awards granted: historical volatility
of 76% expected option life of 5.0 years and a risk-free interest rate of
1.35%.
(4)
In 2005 the following assumptions were used to
determine the fair value of stock option awards granted: historical volatility
of 71% expected option life of 5.0 years and a risk-free interest rate of
4.50%.
(5)
In 2006 the following assumptions were used to
determine the fair value of stock option awards granted: historical volatility
of 65% expected option life of 5.0 years and a risk-free interest rate
of
5.0%.
Employment
Agreements
Ronald
W.
Pickett, President and Chief Executive Officer, is employed pursuant to an
employment agreement for an unspecified term that commenced January 30, 2003
and
provides for an annual salary $100,000, 3,000 shares of the Company’s common
stock per month for each month of his employment and bonuses and benefits based
upon Telkonet’s internal policies. Mr. Pickett’s annual salary was increased to
$102,340 on August 1, 2004 and he received a bonus of $200,000 for the year
ended December 31, 2005. In January 2006, Mr. Pickett’s salary was increased to
$250,000 with an incentive bonus up to $150,000. The incentive portion of the
salary would be awarded based on the successful achievement of certain
performance metrics aligned with the Company’s 2006 operating plan.
Frank
T.
Matarazzo, President and Chief Executive Officer, MST, is employed pursuant
to
an employment agreement for a three-year term that commenced February 1, 2006
and provides for an annual salary of $250,000 and bonuses and benefits based
upon MST’s internal policies.
Robert
P.
Crabb, Chief Marketing Officer, is employed pursuant to an employment agreement
for a three year term that commenced January 18, 2003 and provides for an annual
salary of $120,000 and bonuses and benefits based upon Telkonet’s internal
policies. Mr. Crabb’s annual salary was increased to $172,340 in
2004.
Stephen
L. Sadle, Senior Vice President, is employed pursuant to an employment agreement
for a three-year term that commenced January 18, 2003 and renewed for a one-year
term through January 17, 2007 and provides for an annual salary of $130,000
and
bonuses and benefits based upon Telkonet’s internal policies. Mr. Sadle’s annual
salary was increased to $171,872 in 2004.
Richard
J. Leimbach, Vice President of Finance, has been employed since January 26,
2004
with an annual salary of $102,340 and bonuses and benefits based upon Telkonet’s
internal policies. Mr. Leimbach’s annual salary was increased to $130,000 in
2006.
James
F.
Landry, Chief Technology Officer, has been employed since September 24, 2001
with an annual salary of $160,000 with bonuses and benefits based upon
Telkonet’s internal policies. Mr. Landry’s annual salary was increased to
$176,508 in 2004.
Bill
Dukes, President and CEO of Smart Systems International (an operating division
of Telkonet), is employed pursuant to an employment agreement, dated March
9,
2007. Mr. Dukes’ employment agreement has a term of [one year] and provides for
a base salary of [$250,000] per year and bonuses and benefits based upon
Telkonet’s internal policies.
Robert
Zirpoli, [Senior Engineer] of Smart Systems International (an operating division
of Telkonet), is employed pursuant to an employment agreement, dated March
9,
2007. Mr. Zirpoli’s employment agreement has a term of [one year] and provides
for a base salary of [$100,000] per year and bonuses and benefits based upon
Telkonet’s internal policies.
Jason
Tienor, Chief Executive Officer of Ethostream, LLC, is employed pursuant to
an
employment agreement, dated March 15, 2007. Mr. Tienor’s employment agreement
has a term of three years, which may be extended by mutual agreement of the
parties thereto, and provides for a base salary of $148,000.00 per year and
bonuses and benefits based upon Telkonet’s internal policies.
Jeff
Sobieski, Chief Financial Officer of Ethostream, LLC, is employed pursuant
to an
employment agreement, dated March 15, 2007. Mr. Sobieski’s employment agreement
has a term of three years, which may be extended by mutual agreement of the
parties thereto, and provides for a base salary of $148,000.00 per year and
bonuses and benefits based upon Telkonet’s internal policies.
GRANT
OF PLAN BASED AWARDS
There
were no stock options or restricted stock awards granted in 2006.
OUTSTANDING
EQUITY AWARDS AT FISCAL YEAR-END TABLE
The
following table shows outstanding stock option awards classified as exercisable
and unexercisable as of December 29, 2006 for the named executive officers.
The table also shows unvested and unearned stock awards (both time-based awards
and performance-contingent) assuming a market value of $2.67 a share (the
closing market price of the Company’s stock on December 29,
2006).
OUTSTANDING
EQUITY AWARDS AT FISCAL YEAR-END
|
Option
Awards
|
Stock
Awards
|
Name
|
Number
of Securities Underlying Unexercised Options
(#)
Exerciseable
|
Number
of Securities Underlying Unexercised Options
(#)
Unexerciseable
|
Equity
Incentive Plan Awards: Number of Securities Underlying Unexercised
Unearned Options
(#)
|
Option
Exercise Price
($)
|
Option
Expiration Date
|
Number
of Shares or Units of Stock That Have Not Vested
(#)
|
Market
Value of Shares or Units of Stock That Have Not
Vested
($)
|
Equity
Incentive Plan Awards: Number of Unearned Shares, Units or Other
Rights
That Have Not Vested
(#)
|
Equity
Incentive Plan Awards: Market or Payout Value of Unearned Shares,
Units or
Other Rights That Have Not Vested
($)
|
Ronald
W. Pickett
|
-
|
-
|
-
|
N/A
|
N/A
|
-
|
-
|
-
|
-
|
Frank
T. Matarazzo
|
-
|
-
|
-
|
N/A
|
N/A
|
-
|
-
|
-
|
-
|
Stephen
L.
Sadle
|
900,000
|
-
|
-
|
$1.00
|
1/1/2003
|
-
|
-
|
-
|
-
|
Richard
J. Leimbach
|
32,500
|
55,000
|
-
|
(1)
|
(1)
|
-
|
-
|
-
|
-
|
James
F.
Landry
|
350,000
|
150,000
|
-
|
(2)
|
(2)
|
-
|
-
|
-
|
-
|
_________________
(1)
|
Includes
12,500 and 25,000 vested and unvested options, respectively, exerciseable
at $2.59 per share with an expiration of 1/26/2014 and 20,000 and
30,000
vested and unvested options, respectively, exerciseable at $5.08
per share
with an expiration of 1/1/2015.
|
(2) |
|
Includes
250,000 fully vested options, exerciseable at $1.00 per share with
expirations ranging from 12/3/2011 to 7/1/2013 and 100,000 and 150,000
vested and unvested options, respectively, exerciseable at $3.45
per share
with an expiration of 5/1/2014.
|
OPTION
EXERCISES AND STOCK VESTED
There
were no options exercised by, or stock awards vested for the account of, the
named executive officers during 2006.
POTENTIAL
PAYMENTS UPON TERMINATION OR CHANGE IN CONTROL
In
January 2003, the Company entered into an Employment Agreement with Mr. Sadle
pursuant to which, in the event of a change in control, Mr. Sadle will continue
to receive salary and benefits for a period of thirty-six months following
such change in control. All of Mr. Sadle’s options to purchase common stock will
also immediately vest upon a change of control.
For
purposes of Mr. Sadle’s Employment Agreement, the term "change in control" means
the first to occur of the following events (a) any person or group of commonly
controlled persons acquires, directly or indirectly, thirty percent (30%) or
more of the voting control or value of the equity interests in the Company;
or
(b) the shareholders of the Company approve an agreement to merge or consolidate
with another corporation or other entity resulting (whether separately or in
connection with a series of transactions) in a change in ownership of twenty
percent (20%) or more of the voting control or value of the equity interests
in
the Company, or an agreement to sell or otherwise dispose of all or
substantially all of the Company's assets (including, without limitation, a
plan
of liquidation or dissolution), or otherwise approve of a fundamental alteration
in the nature of the Company's business.
Rights
under the Mr. Sadle’s Employment Agreement will be triggered in the event that,
following a change in control, the executive’s employment with the Company is
terminated for any reason or no reason.
If
a
change of control had occurred on January 1, 2007, Mr. Sadle would be entitled
to the following as of such date:
$515,616
in salary as well as benefits paid on the
employees behalf based upon Telkonet's internal policies for a period of 36
months.
Each
of
Mr. Tienor and Mr. Sobieski’s Employment Agreement obligate the Company to
continue to pay each executive’s base salary and provide continued participation
in employee benefit plans for the duration of the term of their employment
agreements in the event such executive is terminated without “cause” by the
Company or if the executive terminates his employment for “good reason.” “Cause”
is defined as the occurrence of any of the following: (i) theft, fraud,
embezzlement, or any other act of dishonesty by the executive; (ii) any material
breach by the executive of any provision of the employment agreement which
breach is not cured within a reasonable time (but not to exceed thirty (30)
days
after written notification thereof to the executive by Telkonet; (iii) any
habitual neglect of duty or misconduct of the executive in discharging any
of
his duties and responsibilities under the employment agreement after a written
demand for performance was delivered to the executive that specifically
identified the manner in which the board believed the executive had failed
to
discharge his duties and responsibilities, and the executive failed to resume
substantial performance of such duties and responsibilities on a continuous
basis immediately following such demand; (iv) commission by the executive of
a
felony or any offense involving moral turpitude; or (v) any default of the
executive’s obligations under the employment agreement, or any failure or
refusal of the executive to comply with the policies, rules and regulations
of
Telkonet generally applicable to Telkonet employees, which default, failure
or
refusal is not cured within a reasonable time (but not to exceed thirty (30)
days) after written notification thereof to the executive by Telkonet. If cause
exists for termination, the executive shall be entitled to no further
compensation, except for accrued leave and vacation and except as may be
required by applicable law. “Good reason” is defined as the occurrence of any of
the following: (i) any material adverse reduction in the scope of the
executive’s authority or responsibilities; (ii) any reduction in the amount of
the executive’s compensation or participation in any employee benefits; or (ii)
the executive’s principal place of employment is actually or constructively
moved to any office or other location 50 miles or more outside of Milwaukee,
Wisconsin.
In
the
event Telkonet fails to renew the employment agreements upon expiration of
the
term, then Telkonet shall continue to pay the executive's base salary and
provide the executive with continued participation in each employee benefit
plan
in which the executive participated immediately prior to expiration of the
term
for a period of three months following expiration of the term. Each of Messrs.
Tienor and Sobieski have agreed to not to compete with the Company or solicit
any Company employees for a period of one year following expiration or earlier
termination of the employment agreements.
Each
of
Mr. Dukes’ and Mr. Zirpoli’s employment agreements obligate the Company to
continue to pay the executive’s base salary and provide continued participation
in each Company benefit plan for a period of three months following the
termination of the executive’s employment without cause. In the event the
executive is terminated “for cause,” or for engaging in any unethical, immoral
or unprofessional conduct or violation of a Company policy, he shall not
be
entitled to any payment beyond such termination date, except for accrued
leave
and vacation and except as may be required by applicable law. For purposes
of
the employment agreements, “cause” includes, but is not be limited to, the
following: (i) theft, fraud, embezzlement, dishonesty or other similar behavior
by the executive; (ii) any material breach by the executive of any provision
of
the employment agreement; (iii) any habitual neglect of duty or misconduct
of
the executive in discharging any of his duties and responsibilities under
the
employment agreement; (iv) any conduct of the executive which is detrimental
to
or embarrassing to the Company, including, but not limited to, the executive
being indicated or convicted of a felony or any offense involving moral
turpitude; or (v) any default of the executive’s obligations under the
employment agreement, which default, failure or refusal is not cured within
a
reasonable time (but not to exceed thirty (30) days) after written notification
thereof to the executive by the Company.
Director
Compensation
In
2004,
each non-employee Director elected or appointed to the Board of Directors
was
granted an option to purchase forty thousand (40,000) shares of the Company’s
common stock and each Non-Employee Director will be granted an option to
purchase forty thousand (40,000) shares upon his or her re-election at an
annual meeting of the Company’s stockholders. These options vest on a quarterly
basis over a period of one-year.
Compensation
for 2006 to the non-employee directors was earned at the rate of $4,000 per
month plus $1,000 per meeting attended. The Chairman of the Audit Committee
earns compensation at the rate of $4,000 per month, and each non-employee
director earns $1,000 for each meeting of the Audit Committee
attended.
The
following table summarizes all compensation paid to the Company’s directors in
the year ended December 31, 2006.
Name
|
Fees
Earned or Paid in Cash
($)
|
Stock
Awards
($)
|
Option
Awards
($)
|
Non-Equity
Incentive Plan Compensation
($)
|
Change
in Pension Value and Nonqualified Deferred Compensation
Earnings
|
All
Other Compensation
($)
|
Total
($)
|
Warren
V. Musser
|
$
48,000
|
$
-
|
$
-
|
$
-
|
$
-
|
$
52,000 (1)
|
$
100,000
|
Thomas
M. Hall
|
52,000
|
-
|
34,500
(2)
|
-
|
-
|
-
|
86,500
|
Thomas
C. Lynch
|
52,000
|
-
|
34,500
(2)
|
-
|
-
|
-
|
86,500
|
James
L. Peeler
|
52,000
|
-
|
34,500
(2)
|
-
|
-
|
-
|
86,500
|
Seth
D. Blumenfeld
|
-
|
77,595(3)
|
-
|
-
|
-
|
-
|
77,595
|
Ronald
W. Pickett
|
-
|
-
|
-
|
-
|
-
|
-
|
-
|
Stephen
L. Sadle
|
-
|
-
|
-
|
-
|
-
|
-
|
-
|
(1)
fees
from annual consulting agreement dated September 2003 for non-director services.
(2)
stock
options granted in January 2006 pursuant to the non-employee director
compensation
(3)
20,000 shares issued for services performed through June 2006 pursuant to the
professional services agreement dated July 1, 2005.
COMPENSATION
COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
During
the year ended December 31, 2006, Messrs, Hall, Lynch and Peeler served as
members of the Company’s Compensation Committee. None of the members of the
Compensation Committee was an employee of the Company during the year ended
December 31, 2006 nor has any of them been an officer of the Company. No
executive officer of the Company served during the year ended December 31,
2006
as a member of a compensation committee or as a director of any entity of which
any of the Company’s directors served as an executive officer.
ITEM
12. SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
STOCKHOLDER MATTERS.
The
following table provides information concerning securities authorized for
issuance pursuant to equity compensation plans approved by the Company’s
stockholders and equity compensation plans not approved by the Company’s
stockholders as of December 31, 2006.
|
Number
of securities to be issued upon exercise of outstanding options,
warrants
and rights
|
Weighted
-average exercise price of outstanding options, warrants and
rights
|
Number
of securities remaining available for future issuance under equity
compensation plans (excluding securities reflected in column
(a))
|
|
(a)
|
(b)
|
(c)
|
Equity
compensation plans approved by security holders
|
10,336,866
|
$1.87
|
1,645,423
|
Equity
compensation plans not approved by security
holders
|
-
|
-
|
-
|
Total
|
10,336,866
|
$1.87
|
1,645,423
|
The
following table sets forth, as of March 1, 2007, the number of shares of
the
Company’s common stock beneficially owned by each director and executive officer
of the Company, by all directors and executive officers as a group, and by
each
person known by the Company to own beneficially more than 5.0% of the Company’s
outstanding common stock. As of March 1, 2007, there were no issued and
outstanding shares of any other class of the Company’s equity securities.
Name
and Address of Beneficial Owner
|
Amount
and Nature of Beneficial Ownership
|
Percentage
of Class
|
Officers
and Directors
|
|
|
Ronald
W. Pickett, President and CEO
20374
Seneca Meadows Parkway
Germantown,
MD 20876
|
2,574,699
|
4.5%
|
Frank
T. Matarazzo, President and CEO, MST
259-263
Goffle Road
Hawthorne,
NJ 07506
|
520,000(1)
|
0.9%
|
Stephen
L. Sadle, Senior Vice President
20374
Seneca Meadows Parkway
Germantown,
MD 20876
|
4,284,514(2)
|
7.4%
|
James
Landry, Chief Technology Officer
20374
Seneca Meadows Parkway
Germantown,
MD 20876
|
484,200(3)
|
0.8%
|
Richard
Leimbach, Vice President of Finance
20374
Seneca Meadows Parkway
Germantown,
MD 20876
|
41,000(4)
|
0.1%
|
Warren
V. Musser, Chairman
20374
Seneca Meadows Parkway
Germantown,
MD 20876
|
2,000,000(5)
|
3.4%
|
Thomas
C. Lynch, Director
20374
Seneca Meadows Parkway
Germantown,
MD 20876
|
100,000(6)
|
0.2%
|
Dr.
Thomas M. Hall, Director
20374
Seneca Meadows Parkway
Germantown,
MD 20876
|
647,790(7)
|
1.1%
|
James
“Lou” L. Peeler, Director
20374
Seneca Meadows Parkway
Germantown,
MD 20876
|
84,400(8)
|
0.1%
|
Seth
D. Blumenfeld, Director
20374
Seneca Meadows Parkway
Germantown,
MD 20876
|
65,000(9)
|
0.1%
|
All
Directors and Executive Officers as a Group
|
10,801,603
|
17.8%
|
_____________________
(1)
|
Includes
600,000 shares of the Company’s common stock issued to Mr. Matarazzo in
conjunction with the Company’s January 2006 acquisition of a 90% interest
in Microwave Satellite Technologies, Inc. As part of the purchase
price,
an additional 1,000,000 shares of the Company’s common stock are held in
escrow, issuable upon the achievement of certain performance targets
and
excluded from this table.
|
(2)
|
Includes
options exercisable within 60 days to purchase 900,000 shares of
the
Company’s common stock at $1.00 per share.
|
(3)
|
Includes
options exercisable within 60 days to purchase 250,000 and 150,000
shares
of the Company’s common stock at $1.00 and $3.45 per share,
respectively.
|
(4)
|
Includes
options exercisable within 60 days to purchase 17,500 and 22,500
shares of
the Company’s common stock at $2.59 and $5.08 per share,
respectively.
|
(5)
|
Includes
options exercisable within 60 days to purchase 2,000,000 shares
of the
Company’s common stock at $1.00 per share.
|
(6)
|
Includes
options exercisable within 60 days to purchase 20,000 and 80,000
shares of
the Company’s common stock at $2.00 and $3.45 per share,
respectively.
|
(7)
|
Includes
options exercisable within 60 days to purchase 80,000 shares of
the
Company’s common stock at $3.45 per share.
|
(8)
|
Includes
options exercisable within 60 days to purchase 80,000 shares of
the
Company’s common stock at $3.45 per share.
|
(9)
|
Includes
15,000 shares of the Company’s common stock to be issued within 60 days
pursuant to a Professional Services
Agreement.
|
ITEM
13. CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
INDEPENDENCE
Description
of Related Party Transactions
In
September 2003, the Company entered into a consulting agreement (renewable
annually) with The Musser Group to compensate Mr. Musser in the amount of
$100,000 per year for his services to the Company as a director. Mr. Musser,
Chairman of the Board of Directors, is the sole principal and owner of The
Musser Group. For the years ended December 31, 2006, 2005 and 2004, the
Company paid and expensed $100,000, $100,000 and $100,000, respectively.
On
July
1, 2005, Mr. Blumenfeld was retained as a consultant to Telkonet pursuant
to a
Professional Services Agreement between the Company and Mr. Blumenfeld. Pursuant
to the terms of the agreement, Mr. Blumenfeld received 10,000 shares of Company
stock upon execution of the agreement, 10,000 shares of Company stock per
quarter for the first year (for a total 50,000 shares in the first year)
and
5,000 shares of Company stock per quarter thereafter plus a five percent
(5%)
commission (payable in cash or Company stock) on international sales generated
by him with gross margins of 50% or greater. The stock awarded to Mr. Blumenfeld
pursuant to the agreement is restricted stock. The agreement has a one year
term, which is renewable annually upon both parties' agreement. This agreement
expired in June 2006.
In
December 2005, the Company issued an aggregate of 363,636 shares of common
stock
to Ronald W. Pickett, President and Chief Executive Officer of the Company,
in
exchange for $200,000 of Series B Debentures held by him. The Company also
issued an aggregate of 48,858 shares of common stock in exchange for accrued
interest of $26,872 for Series B Debentures held by Mr. Pickett. In addition,
the Company issued an aggregate of 200,000 shares of common stock upon the
exercise by Mr. Pickett of warrants to purchase shares of the Company’s common
stock at $1.00 per share.
In
February 2007, the Company entered into a one-year professional services
agreement with Global Transport Logistics, Inc. (“GTI”), for the provision of
consulting services for which GTI is paid a fee of $10,000 per month. GTI
is 50%
owned by Anthony Matarazzo, the brother of MST’s Chief Executive
Officer.
The
Chief
Administrative Officer at MST, Laura Matarazzo, is the sister of the President
of MST and receives an annual base salary of approximately $134,000 with
bonuses
and benefits based upon the Company’s internal policies.
The
Company’s Vice President of Government Sales, John Vasilj, is the son-in-law of
the President and CEO of the Company and receives an annual base salary of
approximately $150,000 with bonuses and benefits based upon the Company’s
internal policies.
Company’s
Policies on Related Party Transactions
Under
the
Company’s policies and procedures, related-party transactions that must be
publicly disclosed under the federal securities laws require prior approval
of the Company’s independent directors without the participation of
any director who may have a direct or indirect interest in the transaction
in
question. Related parties include directors, nominees for director, principal
shareholders, executive officers and members of their immediate families.
For
these purposes, a “transaction” includes all financial transactions,
arrangements or relationships, ranging from extending credit to the provision
of
goods and services for value and includes any transaction with a company
in
which a director, executive officer immediate family member of a director
or
executive officer, or principal shareholder (that is, any person who
beneficially owns five percent or more of any class of the Company’s voting
securities) has an interest by virtue of a 10-percent-or-greater equity
interest. The Company’s policies and procedures regarding related-party
transactions are not a part of a formal written policy, but rather, represent
the Company’s historical course of practice with respect to approval of
related-party transactions.
Director
Independence
The
Board
of Directors has determined that the following Directors are “independent” under
the listing standards of the American Stock Exchange (AMEX): Dr. Hall,
Mr. Lynch and Mr. Peeler. Each of Dr. Hall, Mr. Peeler and Mr. Lynch serve
on, and are the only members of, the Company’s Audit and Compensation
Committees. Although Telkonet does not maintain a standing Nominating Committee,
nominees for election as directors are considered and nominated by a majority
of
Telkonet’s independent directors in accordance with the AMEX listing standards.
“Independence” for these purposes is determined in accordance with
Section 121(A) of the AMEX Rules and Rule 10A-3 under the Securities
Exchange Act of 1934.
ITEM
14. PRINCIPAL
ACCOUNTANT FEES AND SERVICES.
The
following table sets forth fees billed to the Company by our auditors during
the
fiscal years ended December 31, 2006 and 2005. Additionally, the Company
incurred approximately $320,289, of consulting and internal
resources associated with its Sarbanes-Oxley compliance review.
|
|
December
31, 2006
|
|
December
31, 2005
|
|
1.
Audit Fees
|
|
$
|
229,552
|
|
$
|
119,090
|
|
2.
Audit Related Fees
|
|
|
52,600
|
|
|
62,825
|
|
3.
Tax Fees
|
|
|
--
|
|
|
1,175
|
|
4.
All Other Fees
|
|
|
--
|
|
|
--
|
|
Total
Fees
|
|
$
|
282,152
|
|
$
|
183,090
|
|
Audit
fees consist of fees billed for professional services rendered for the audit
of
the Company’s consolidated financial statements and review of the interim
consolidated financial statements included in quarterly reports and services
that are normally provided by Russell Bedford Stefanou Mirchandani LLP in
connection with statutory and regulatory filings or engagements.
Audit-related
fees consists of fees billed for assurance and related services that are
reasonably related to the performance of the audit or review of the Company’s
consolidated financial statements, which are not reported under “Audit Fees.”
Tax
fees
consists of fees billed for professional services for tax compliance, tax
advice
and tax planning. The tax fees relate to federal and state income tax reporting
requirements.
All
other
fees consist of fees for products and services other than the services reported
above.
Prior
to
the Company’s engagement of its independent auditor, such engagement is approved
by the Company’s audit committee. The services provided under this engagement
may include audit services, audit-related services, tax services and other
services. Pre-approval is generally provided for up to one year and any
pre-approval is detailed as to the particular service or category of services
and is generally subject to a specific budget. Pursuant to the Company’s Audit
Committee Charter, the independent auditors and management are required to
report to the Company’s audit committee at least quarterly regarding the extent
of services provided by the independent auditors in accordance with this
pre-approval, and the fees for the services performed to date. The audit
committee may also pre-approve particular services on a case-by-case basis.
All
audit fees, audit-related fees, tax fees and other fees incurred by the Company
for the year ended December 31, 2006, were approved by the Company’s audit
committee.
PART
IV
ITEM
15. EXHIBITS
AND FINANCIAL STATEMENT SCHEDULES.
The
following table sets forth selected unaudited quarterly information for
the
Company’s year-ended December 31, 2006 and 2005.
QUARTERLY
FINANCIAL DATA
(unaudited)
|
|
March
31,
2006
|
|
June
30,
2006
|
|
September
30,
2006
|
|
December
31,
2006
|
|
Net
Revenue
|
|
$
|
1,943,912
|
|
$
|
1,152,470
|
|
$
|
1,143,097
|
|
$
|
941,848
|
|
Gross
Profit
|
|
$
|
648,342
|
|
$
|
139,628
|
|
$
|
83,049
|
|
$
|
(170,433
|
)
|
Provision
for income taxes
|
|
$
|
-
|
|
$
|
-
|
|
$
|
-
|
|
$
|
-
|
|
Net
loss per share -- basic
|
|
$
|
(0.09
|
)
|
$
|
(0.16
|
)
|
$
|
(0.20
|
)
|
$
|
(0.08
|
)
|
Net
loss per share -- diluted
|
|
$
|
(0.09
|
)
|
$
|
(0.16
|
)
|
$
|
(0.20
|
)
|
$
|
(0.08
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
March
31,
2005
|
|
|
June
30,
2005
|
|
|
September
30, 2005
|
|
|
December
31,
2005
|
|
Net
Revenue
|
|
$
|
246,188
|
|
$
|
472,947
|
|
$
|
621,923
|
|
$
|
1,147,265
|
|
Gross
Profit
|
|
$
|
88,798
|
|
$
|
120,791
|
|
$
|
212,749
|
|
$
|
348,806
|
|
Provision
for income taxes
|
|
$
|
-
|
|
$
|
-
|
|
$
|
-
|
|
$
|
-
|
|
Net
loss per share -- basic
|
|
$
|
(0.07
|
)
|
$
|
(0.08
|
)
|
$
|
(0.08
|
)
|
$
|
(0.12
|
)
|
Net
loss per share -- diluted
|
|
|