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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-QSB
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the quarterly period ended June 30, 2006
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
For the transition period from _____________ to _____________
Commission file number 333-87224
ELECTRONIC SENSOR TECHNOLOGY, INC.
(Exact name of Small Business Issuer as Specified in Its Charter)
NEVADA 98-0372780
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
1077 Business Center Drive
Newbury Park, California 91320
(Address of Principal Executive Offices)
(805) 480-1994
(Issuer's Telephone Number, Including Area Code)
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act during the past 12 months (or
for such shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days.
Yes [ ] No [X]*
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date.
54,173,745 shares of common stock as of July 31, 2006
Transitional Small Business Disclosure Format (Check one): Yes [ ] No [X]
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* We were not required to file reports pursuant to Section 13 or 15(d) of the
Securities Exchange Act during the past 12 months because (i) our registered
common stock was registered under the Securities Act during such period and was
not registered under the Exchange Act, (ii) we did not have any registration
statement that became effective during such period and (iii) we had less than
300 shareholders of record throughout such period. Although we were not required
to do so, we voluntarily filed such reports with the Securities and Exchange
Commission during such period. On March 24, 2006 we filed a registration
statement on Form 10-SB to register our common stock pursuant to the Exchange
Act, which we subsequently withdrew pursuant to the request of the Securities
and Exchange Commission until our registration statement on Form SB-2, for which
an amendment was last filed on May 1, 2006, is declared effective. Once our
registration statement on Form SB-2 is declared effective, we plan to file
another registration statement on Form 10-SB to register our common stock
pursuant to the Exchange Act. Once our registration statement on Form 10-SB is
effective, we will be subject to the filing requirements of the Securities
Exchange Act.
PART I.
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
INDEX TO FINANCIAL STATEMENTS
Consolidated Balance Sheet (Unaudited) as of June 30, 2006 F-1
Consolidated Statements of Operations (Unaudited) for the Three and Six
Months Ended June 30, 2006 and 2005 F-2
Consolidated Statements of Cash Flows (Unaudited) for the Six Months Ended
June 30, 2006 and 2005 F-3
Notes to Consolidated Financial Statements F-4
1
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEET
JUNE 30, 2006
(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 3,735,141
Certificate of deposit-restricted 250,000
Accounts receivable, net of allowance for doubtful accounts of $17,700 280,149
Prepaid expenses 36,721
Inventories 1,164,020
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TOTAL CURRENT ASSETS 5,466,031
--------------
DEFERRED FINANCING COSTS, net of amortization of $121,079 709,176
PROPERTY AND EQUIPMENT, net of accumulated depreciation of $935,874 162,950
SECURITY DEPOSITS 12,817
--------------
$ 6,350,974
==============
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES:
Accounts payable and accrued expenses $ 454,726
Credit line borrowings 370,000
Deferred revenues 116,667
Derivative liabilities 4,087,959
--------------
TOTAL CURRENT LIABILITIES 5,029,352
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CONVERTIBLE DEBENTURES, net of unamortized discount of $5,638,889 1,361,111
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TOTAL LIABILITIES 6,390,463
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STOCKHOLDERS' DEFICIT:
Preferred stock, $.001 par value 50,000,000 shares authorized,
none issued and outstanding -
Common stock, $.001 par value, 200,000,000 shares authorized,
54,173,745 issued and outstanding 54,174
Additional paid-in capital (1,949,780)
Accumulated deficit 1,856,117
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TOTAL STOCKHOLDERS' DEFICIT (39,489)
--------------
$ 6,350,974
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See notes to consolidated financial statements
F-1
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Six Months Ended Three Months Ended
June 30, June 30,
------------------------------ ------------------------------
2006 2005 2006 2005
-------------- -------------- -------------- --------------
(Restated) (Restated)
REVENUES $ 1,154,224 $ 651,652 $ 621,407 $ 432,141
COST OF SALES 592,714 375,086 291,122 224,800
-------------- -------------- -------------- --------------
GROSS PROFIT 561,510 276,566 330,285 207,341
OPERATING EXPENSES:
Research and development 416,144 331,285 204,345 191,113
Selling, general and administrative 1,436,961 1,103,030 656,651 535,163
-------------- -------------- -------------- --------------
TOTAL OPERATING EXPENSES 1,853,105 1,434,315 860,996 726,276
-------------- -------------- -------------- --------------
LOSS FROM OPERATIONS (1,291,595) (1,157,749) (530,711) (518,935)
-------------- -------------- -------------- --------------
OTHER INCOME AND EXPENSE:
Other income - derivative 1,683,119 4,263,950 462,922 4,144,400
Other expense - derivative - (2,298,501) - -
Gain (loss) on sale of property and equipment - 9,287 - (3,970)
Interest expense (1,416,279) (34,271) (685,887) (13,706)
-------------- -------------- -------------- --------------
TOTAL OTHER INCOME AND EXPENSE 266,840 1,940,465 (222,965) 4,126,724
-------------- -------------- -------------- --------------
NET INCOME (LOSS) $ (1,024,755) $ 782,716 $ (753,676) $ 3,607,789
============== ============== ============== ==============
Earnings (loss) per share, basic $ (0.02) $ 0.01 $ (0.01) $ 0.07
============== ============== ============== ==============
Weighted average number of shares, basic 54,159,945 53,304,475 54,173,745 53,968,643
============== ============== ============== ==============
Earnings (loss) per share, diluted $ (0.02) $ 0.01 $ (0.01) $ 0.07
============== ============== ============== ==============
Weighted average number of shares, diluted 54,159,945 53,304,475 54,173,745 53,968,643
============== ============== ============== ==============
See notes to consolidated financial statements
F-2
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended
June 30,
----------------------------------
2006 2005
--------------- ---------------
(Restated)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ (1,024,755) $ 782,716
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Depreciation and amortization 18,865 5,605
Issuance of shares for services 21,000 -
Amortization of debt discount 1,166,667 -
Amortization of deferred financing costs 103,782 -
Recognition of derivative liabilities - 2,298,501
Decrease in fair value of derivative liability (1,683,119) (4,263,950)
Changes in assets and liabilities:
Accounts receivable 185,625 (98,020)
Inventories (224,400) (12,502)
Prepaid expenses 33,214 (9,361)
Security deposits - 140
Accounts payable and accrued expenses (26,072) 46,842
Deferred revenues (25,000) (25,000)
Due to related party - (60,000)
Interest payable - (26,961)
Other current liabilities - (2,626)
--------------- ---------------
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES (1,454,193) (1,364,616)
--------------- ---------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Decrease (increase) in restricted security deposit 668,678 -
Proceeds from sale of property and equipment - 30,280
Purchase of property and equipment (69,265) (77,780)
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NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES 599,413 (47,500)
--------------- ---------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Increase (decrease) in line of credit 370,000 (200,000)
Repayment of partners' loans payable - (110,000)
Proceeds from issuance of common stock - 3,811,708
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NET CASH PROVIDED BY FINANCING ACTIVITIES 370,000 3,501,708
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NET INCREASE (DECREASE) IN CASH (484,780) 2,089,592
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 4,219,921 26,430
--------------- ---------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 3,735,141 $ 2,116,022
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SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest $ 282,236 $ 40,870
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NON-CASH FINANCING ACTIVITIES
Fair Value of derivative liabilities issued in connection with issuance of
shares of common stock $ - $ -
=============== ===============
See notes to consolidated financial statements.
F-3
ELECTRONIC SENSOR TECHNOLOGY, INC.
Notes to Financial Statements
(Unaudited)
June 30, 2006
1) BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for
interim financial statements and with the instructions to Form 10-QSB and
Article 10 of Regulation S-B. Accordingly, they do not include all the
information and disclosures required for annual financial statements. These
financial statements should be read in conjunction with the consolidated
financial statements and related footnotes for the year ended December 31,
2005, included in the Annual Report filed on Form 10-KSB for the year then
ended, which will be amended and such financial statements restated in
accordance with the Current Report filed on Form 8-K on August 14, 2006.
In the opinion of the management of Electronic Sensor Technology, Inc. (the
"Company"), all adjustments (consisting of normal recurring accruals)
necessary to present fairly the Company's financial position as of June 30,
2006, and the results of operations and cash flows for the six-month period
ending June 30, 2006 have been included. The results of operations for the
six-month period ended June 30, 2006 are not necessarily indicative of the
results to be expected for the full year. For further information, refer to
the consolidated financial statements and footnotes thereto included in the
Company's Annual Report filed on Form 10-KSB as filed with the Securities
and Exchange Commission for the year ended December 31, 2005, which will be
amended and such financial statements restated in accordance with the
Current Report filed on Form 8-K on August 14, 2006.
2) RESTATEMENT OF JUNE 30, 2005 FINANCIAL STATEMENTS
On August 14, 2006 and March 17, 2006, we filed Current Reports on Form 8-K
stating that the financial statements contained in our Quarterly Report on
Form 10-QSB for the interim period ended June 30, 2005 (in addition to the
financial statements for the fiscal year ended December 31, 2005 and the
interim periods ended March 31, 2005, September 30, 2005 and March 31,
2006) should not longer be relied upon as we did not properly account for
certain liquidated damages associated with a $3.985 million private
placement of warrants and shares of our common stock that occurred in
February 2005. In determining the proper accounting for the liquidated
damages, we are considering the guidance contained in Emerging Issue Task
Force ("EITF") 05-04 View C, "The Effect of a Liquidated Damages Clause on
a Freestanding Financial Instrument", subject to EITF Issue No. 00-19,
"Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company's Own Stock". The restated amounts
presented in this Quarterly Report and contained on the Consolidated
Statement of Operations reflects the balances for "Other income-derivative"
and "Other expense-derivative" for the three- and six-month periods ended
June 30, 2005, in accordance with the foregoing. Correspondingly, the
restated amount on the Consolidated Statement of Cash Flows properly
reflects the amount related to the fair value of derivative liabilities for
the six-months period ended June 30, 2005. See Note 6 - Derivative
Liabilities, for further information on the accounting and measurement of
the derivative liabilities associated with the February 2005 private
placement of warrants and shares of our common stock, as well as those
associated with the December 2005 private placement of warrants and
convertible debentures, and related agreements.
3) BASIS OF CONSOLIDATION
The accompanying financial statements include the accounts of the Company
and its wholly owned subsidiaries. All intercompany balances and
transactions have been eliminated in consolidation. Bluestone Ventures,
Inc. ("Bluestone") executed an Agreement and Plan of Merger ("Merger
Agreement") by and among Bluestone, Amerasia Technology, Inc.,
("Amerasia"), holder of approximately 55% of the partnership interests of
Electronic Sensor Technology, L.P., ("EST"), L & G Sensor Technology, L.P.,
("L&G"), holder of approximately 45% of the partnership interests of EST,
Amerasia Acquisition Corp., ("AAC") a wholly-owned subsidiary of Bluestone,
and L & G Acquisition Corp., ("LAC") a wholly-owned
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subsidiary of Bluestone on January 31, 2005. Under the Merger Agreement (i)
AAC merged with and into Amerasia such that Amerasia became of wholly-owned
subsidiary of Bluestone, (ii) LAC merged with and into L&G such that L&G
became a wholly-owned subsidiary of Bluestone, (iii) as a result of the
merger of (i) and (ii), Bluestone indirectly acquired all of the
partnership interests of EST and (iv) Bluestone issued 20,000,000 shares of
its common stock to the shareholders of Amerasia and L&G. This merger has
been treated as a purchase only of the partnership interests of Electronic
Sensor Technology L.P.
For accounting purposes, the transaction was treated as a recapitalization
of EST and accounted for as a reverse acquisition. Accordingly, the
accompanying financial statements include the accounts of EST for the
period from January 1, 2005 to June 30, 2006 and the accounts of Bluestone
from February 1, 2005 to June 30, 2006.
4) NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
a) NATURE OF BUSINESS
The Company develops and manufactures electronic devices used for
vapor analysis. It markets its products through distribution channels
in over 20 countries.
b) CASH AND CASH EQUIVALENTS
The Company considers highly liquid financial instruments with
maturities of three months or less at the time of purchase to be cash
equivalents.
c) LINE OF CREDIT
The Company has a revolving line of credit agreement for borrowings up
to $500,000. The line of credit is secured and collateralized with a
certificate of deposit in the amount of $250,000. The line of credit
had borrowings of $370,000 against it at June 30, 2006. The line of
credit expires on March 31, 2007.
d) REVENUE RECOGNITION
The Company records revenue from direct sales of products to end-users
when the products are shipped, collection of the purchase price is
probable and the Company has no significant further obligations to the
customer. Costs of remaining insignificant Company obligations, if
any, are accrued as costs of revenue at the time of revenue
recognition. Cash payments received in advance of product shipment or
service revenue are recorded as deferred revenue.
e) SHIPPING AND HANDLING
The Company accounts for shipping and handling costs as a component of
"Cost of Sales".
f) INVENTORIES
Inventories are comprised of raw materials, work in process, and
finished goods. Inventories are stated at the lower of cost or market
and are determined using the first-in, first-out method.
g) DEFERRED FINANCING COSTS
Deferred financing costs consist of direct costs incurred by the
Company in connection with the issuance of its convertible debentures.
The direct costs include cash payments and fair value of warrants
issued to the placement agent, which secured the financing. Deferred
financing costs are amortized over 48 months using the effective
interest rate method.
F-5
h) PROPERTY AND EQUIPMENT
Property and equipment are stated at cost, net of accumulated
depreciation. Depreciation is computed using the straight-line method
over the estimated useful lives of five years.
i) RESEARCH AND DEVELOPMENT
Research and development costs are charged to operations as incurred
and consists primarily of salaries and related benefits, raw materials
and supplies.
j) USE OF ESTIMATES
The preparation of the financial statements in conformity with
generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets
and liabilities and disclosures of contingent assets and liabilities
at the date of the financial statements and the recorded amounts of
revenues and expenses during the reporting period. Actual results
could differ from those estimates.
k) FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair value of certain financial instruments, including accounts
receivable, accounts payable and accrued liabilities, approximate
their carrying values due to the short maturity of these instruments.
The fair value of the convertible debentures issued by the Company in
December 2005 amounts to $7,000,000, based on the Company's
incremental borrowing rate. The carrying value of the derivative
liabilities associated with the convertible debentures represents its
fair value.
l) LONG-LIVED ASSETS
The Company reviews long-lived assets, such as property and equipment,
to be held and used or disposed of, for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. If the sum of the expected cash flows,
undiscounted and without interest, is less than the carrying amount of
the asset, an impairment loss is recognized as the amount by which the
carrying amount of the asset exceeds its fair value. At June 30, 2006
no assets were impaired.
m) DERIVATIVE LIABILITIES
The Company accounts for its liquidated damages granted pursuant to a
separate registration rights agreement pursuant to Emerging Issue Task
Force ("EITF") 05-04, View C, "The Effect of a Liquidated Damages
Clause on a Freestanding Financial Instrument", subject to EITF Issue
No. 00-19, "Accounting for Derivative Financial Instruments Indexed
to, and Potentially Settled in, a Company's Own Stock". Pursuant to
EITF 05-04, View C, liquidated damages payable in cash or stock are
accounted for as a separate derivative, which requires a periodical
valuation of its fair value and a corresponding recognition of
liabilities associated with such derivative.
The Company accounts for liquidated damages granted pursuant to
registration rights which are not included in a separate registration
right agreement as a combined unit with the warrants which are
contemporaneously issued with the registration rights pursuant to SFAS
133 "Accounting for Derivative and Hedging Activities" and EITF 00-19.
The Company accounts for its embedded conversion features and
freestanding warrants pursuant to SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities", which requires a
periodic valuation of their fair value, at issuance and at each
subsequent balance sheet date, and a corresponding recognition of
liabilities associated with such derivatives. The
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recognition of derivative liabilities related to the issuance of
shares of common stock is applied first to the proceeds of such
issuance, at the date of issuance, and the excess of derivative
liabilities over the proceeds is recognized as other expense in the
accompanying consolidated financial statements. The recognition of
derivative liabilities related to the issuance of convertible debt is
applied first to the proceeds of such issuance as a debt discount, at
the date of issuance, and the excess of derivative liabilities over
the proceeds is recognized as other expense in the accompanying
consolidated financial statements. Any subsequent increase or decrease
in the fair value of the derivative liabilities, which are measured at
the balance sheet date, are recognized as other expense or other
income, respectively.
Embedded conversion features represent embedded derivatives which are
separated from their host and accounted for as derivatives. An
embedded derivative instrument may consist of:
1) The underlying is an interest rate that alters net interest
payments such that they could at least double the investor's
initial rate of return on the host contract, such as an
interest bearing debenture, and that is at least twice what
would otherwise be the market return for a contract that has
the same terms as the host contract and that involves a
debtor with similar credit quality;
2) The underlying is a an debt instrument which provides for
non-standard anti-dilution provisions upon conversion of a
debt instrument into equity, such as anti-dilution
provisions which reset to a lower conversion price than
initially stated in the debt instrument in the event of a
subsequent financing with a lower effective price which
classify the debt instrument as non-conventional debt;
3) The underlying is a debt instrument which provides for
variable number of shares upon conversion of a debt
instrument into equity;
4) The underlying is an instrument which provides for
acceleration of the repayment of a principal on a debt
instrument that requires principal repayments if the debt
involves a substantial premium and the acceleration is only
contingently exercisable and is not indexed to interest
rates or credit risk.
Freestanding warrants may be recorded as derivative liabilities if
they allow for net-cash settlement or if they give the counterparty a
choice of net-cash or physical settlement or would not qualify for the
following conditions for equity classification, among others:
1) The Company does not have sufficient authorized and unissued
shares available to settle the contract after considering
all other commitments that may require the issuance of stock
during the maximum period the derivative contract could
remain outstanding;
2) The contract does not contain an explicit limit on the
number of shares to be delivered in a share settlement;
3) The contract provides for cash payments to the counterparty
in the event the Company fails to make timely filings with
the SEC.
In June 2005, the Financial Accounting Standard Board issued EITF
05-04. EITF 05-04 addresses the question as to whether liquidated
damages pursuant to a registration rights agreement should be combined
as a unit with the underlying financial instruments and be evaluated
as a single instrument. EITF 05-04 does not reach a consensus on this
matter and allows for the treatment as a combined unit (Views A and B)
as well as separate freestanding financial instruments (View C). On
September 15, 2005, the FASB staff postponed further discussion of
EITF 05-04. As of May 31, 2006, the FASB still has not rescheduled
EITF 05-04 for further discussion.
F-7
In connection with the issuance of a convertible debentures and
related warrants, we granted liquidated damages pursuant to a separate
registration right agreement. The Company adopted View C of EITF
05-04. Accordingly, the liquidated damages pursuant to this
registration right agreement were evaluated as a stand alone financial
instrument. This treatment did not have a significant different effect
than if the Company would have adopted View A or B, because the
classification of the warrants and certain embedded features of the
convertible debentures were classified as derivative liabilities. The
Company believes that should the FASB staff reach a consensus on EITF
05-04 and select combined treatment (View A or B), the embedded
conversion features and the warrants will have to be evaluated as a
combined unit with the liquidated damages pursuant to the registration
rights agreement, and accordingly, be evaluated as derivative
liabilities. The Company does not believe that its measurement of the
derivative liabilities under View A or View B would significantly
differ from its measurement of the derivative liabilities under View C
in these circumstances.
The classification of each contract (e.g., embedded conversion
feature, liquidated damage, freestanding warrant) is reassessed at
each balance sheet date. If the classification required under EITF
00-19 changes as a result of events during the period (if, for
example, as a result of issuing an instrument which is convertible
into an undeterminable amount of shares we cannot ascertain that we
have a sufficient amount of authorized but unissued shares to satisfy
the maximum number of shares that could be required to net-share
settle the contract), the contract is reclassified as of the date of
the event that caused the reclassification. If a contract is
reclassified from permanent or temporary equity to an asset or
liability, the change in fair value of the contract during the period
the contract was classified as equity is accounted for as an
adjustment to stockholders' equity. The contract is subsequently
marked to fair value through earnings. If a contract is reclassified
from an asset or a liability to equity, gains or losses recorded to
account for the contract at fair value during the period that the
contract was classified as asset or liability is not reversed.
Additionally, because there is no explicit number of shares that are
to be delivered upon satisfaction of the liquidated damages, the
Company is unable to assert that it had sufficient authorized and
unissued shares to settle the liquidated damages. Accordingly, all of
the Company's previously issued and outstanding instruments, such as
warrants and options as well as those issued in the future, would be
classified as liabilities as well, effective with the granting of the
registration rights
n) BASIC AND DILUTED EARNINGS PER SHARE
Basic earnings per share are calculated by dividing income available
to stockholders by the weighted-average number of common shares
outstanding during each period. Diluted earnings per share are
computed using the weighted average number of common and dilutive
common share equivalents outstanding during the period. Dilutive
common share equivalents consist of shares issuable upon the exercise
of stock options and warrants embedded conversion features (calculated
using the reverse treasury stock method). The outstanding options,
warrants and shares equivalent issuable pursuant to embedded
conversion features amounted to 66,982,944 and 5,576,871 at June 30,
2006 and 2005, respectively. The outstanding options, warrants and
shares equivalent issuable pursuant to embedded conversion features
and warrants at June 30, 2006 and 2005, respectively, are excluded
from the loss per share computation for that period due to their
antidilutive effect.
F-8
The following sets forth the computation of basic and diluted earnings
per share at June 30:
2006 2005
---------------- ----------------
Numerator:
Net income (loss) $ (1,024,755) $ 782,716
Net other income/expense associated with
derivative contracts 1,683,119 1,965,449
---------------- ----------------
Net income (loss) for diluted earnings per share
purposes $ (2,707,874) $ (1,182,773)
================ ================
Denominator:
Denominator for basic earnings per share-
Weighted average shares outstanding 54,159,945 53,304,475
Effect of dilutive warrants, embedded
conversion features and liquidated damages - -
---------------- ----------------
Denominator for diluted earnings per share-
Weighted average shares outstanding 54,159,945 53,304,475
================ ================
Basic earnings (loss) per share $ (0.02) $ (0.02)
================ ================
Diluted earnings (loss) per share $ (0.02) $ (0.02)
================ ================
o) STOCK BASED COMPENSATION
In December 2004, the FASB issued SFAS No. 123(R), "Share-Based
Payment," which replaces SFAS No. 123 and supersedes APB Opinion No.
25. Under SFAS No. 123(R), companies are required to measure the
compensation costs of share-based compensation arrangements based on
the grant-date fair value and recognize the costs in the financial
statements over the period during which employees are required to
provide services. Share-based compensation arrangements include stock
options, restricted share plans, performance-based awards, share
appreciation rights and employee share purchase plans. In March 2005
the SEC issued Staff Accounting Bulletin No. 107, or "SAB 107". SAB
107 expresses views of the staff regarding the interaction between
SFAS No. 123(R) and certain SEC rules and regulations and provides the
staff's views regarding the valuation of share-based payment
arrangements for public companies. SFAS No. 123(R) permits public
companies to adopt its requirements using one of two methods. On April
14, 2005, the SEC adopted a new rule amending the compliance dates for
SFAS 123R. Companies may elect to apply this statement either
prospectively, or on a modified version of retrospective application
under which financial statements for prior periods are adjusted on a
basis consistent with the pro forma disclosures required for those
periods under SFAS 123. Effective January 1, 2006, the Company has
fully adopted the provisions of SFAS No. 123R and related
interpretations as provided by SAB 107. As such, compensation cost is
measured on the date of grant as the excess of the current market
price of the underlying stock over the exercise price. Such
compensation amounts, if any, are amortized over the respective
vesting periods of the option grant. The Company applies this
statement prospectively.
5) CONVERTIBLE DEBENTURES
During December 2005, we issued in a private offering, $7,000,000 aggregate
principal amount of convertible debentures due December 7, 2009. The
convertible debentures are convertible at any time on or prior to the
maturity date at the option of the debenture holder at a conversion price
of $0.4544 and can be redeemed at the lesser of $0.4544 or 90% of the
average of the volume weighted average price for the 20 consecutive trading
days immediately prior to the conversion date. The Company received
$7,000,000 in cash as consideration. The convertible debentures bear
interest at 8%, payable in cash or stock, at the Company's option, and are
required to be redeemed in 9 equal quarterly payments commencing January 1,
2008, in cash or stock, at the Company's option. If the Company chooses to
pay interest on or redeem the debentures in shares of the Company's common
stock, rather than in cash, the conversion rate for such
F-9
stock payment is the lesser of $0.4544 and 90% of the average of the volume
weighted average price for the 20 consecutive trading days immediately
prior to the interest payment or redemption date, as applicable.
In connection with the issuance of the convertible debentures, the Company
issued five-year warrants to purchase 12,130,314 shares of common stock at
an exercise price of $0.4761 per share. Furthermore, the Company granted
liquidated damages pursuant to a registration rights agreement.
The convertible debentures and related agreements provide, among other
things, for:
1) Liquidated damages amounting to 2% per month of the outstanding
principal amount, payable in cash or stock, to the debenture
holders in the event that a registration statement covering the
shares underlying the convertible debentures is not declared
effective within 150 days of the date the debentures were issued
(although a registration statement covering the shares underlying
the convertible debentures has not been declared effective as of
June 30, 2006, no claims for liquidated damages have been
received from the debenture holders). The liquidated damages are
payable in cash monthly or if unpaid, bear interest at 18% per
annum. If unpaid by January 1, 2008 and thereafter, they may be
converted in shares of common stock at the same prevailing rate
as the remaining principal amount of the convertible debentures;
2) Default interest rate of 18% and a default premium of 30% of the
principal amount of the debentures, payable in cash or stock.
Events of default include, among other things, if a payment,
whether cash or stock is not paid on time and cured within three
days, if the Company's common stock is not quoted for trading for
at least five trading days, if a registration is not effective
within 180 days after December 7, 2005 (although a registration
statement covering the shares underlying the convertible
debentures has not been declared effective as of June 30, 2006,
no claims for liquidated damages have been received from the
debenture holders). The default interest rate and the default
premium may be converted in shares of common stock at the same
prevailing rate as the remaining principal amount of the
convertible debentures;
3) A reset feature of the conversion price in the event of a
subsequent equity or convertible financing with an effective
price lower than the debenture conversion price, whereby the
aforementioned variable conversion price of the convertible
debentures is adjusted to the new lower effective price of the
subsequent equity or convertible financing;
4) The warrants require that the Company reimburse any holder of a
warrant in respect of any trading loss resulting from the failure
of the Company to timely deliver shares issued pursuant to the
exercise of warrants. This compensation may be paid in shares of
common stock or cash. The exercise price of the warrants, which
is $0.4761 per share at the date of the agreement, may be reduced
to $0.001 per share, at a monthly rate $0.03 per share if the
registration statement we are required to file at the request of
the warrant holders with respect to the common stock underlying
the warrants is not declared effective within six months of the
date of issuance of the warrants.
In connection with the issuance of the convertible debentures, we issued
485,213 warrants to a company in partial consideration for financial
advisory services, as well as paid $490,000 to this company. The warrants
have the same terms as those granted to the debenture holders. The fair
value of the warrants at the date of issuance amounted to approximately
$136,000. We also incurred approximately $102,500 in additional
professional fees relating to the issuance of the convertible debentures
and warrants. The payments of professional fees and the fair value of the
warrants, aggregating approximately $729,000 have been recorded as deferred
financing costs. The deferred financing costs are amortized over the term
of the convertible debentures. The amortization of deferred financing costs
approximated $121,000 at June 30, 2006.
See Note 6 - Derivative Liabilities for further information on the
accounting and measurement of the derivative liabilities associated with
the issuance of the convertible debentures and related agreements.
F-10
We recognized a debt discount of $7,000,000 at the date of issuance of the
convertible debentures and the excess amount has been recorded as liability
and a corresponding increase to other expense. The debt discount is
recognized over the term of the convertible debentures.
6) DERIVATIVE LIABILITIES
FEBRUARY 2005 TRANSACTION
During February 2005, we recognized derivative liabilities of approximately
$6.0 million pursuant to the issuance of 3,985,000 freestanding warrants
and granting certain registration rights which provided for liquidated
damages in the event of failure to timely register the shares in connection
with the issuance of shares of common stock and the related warrants.
There are no liquidated damages provided for untimely effectiveness of the
registration of shares pursuant to piggy-back registration rights. The
Company intends to register all shares and warrants pursuant to the
subscriber piggy-back registration rights.
The agreement pursuant to which the warrants were issued and the
registration rights were granted provided for liquidated damages pursuant
to demand registration rights in the event of a failure to timely register
the shares after demand is made by the holders of a majority of the
warrants and shares of common stock issued pursuant to such agreement. The
demand registration rights of these investors are such that if the Company
fails to register the investors shares, including the shares underlying the
warrants, the Company will pay a cash penalty amounting to 1% of the amount
invested per month, $39,850, if the registration statement is not filed
within 60 days of demand or is not declared effective within 150 days from
the date of initial filing. The maximum liability associated with the
liquidated damages amounts to 49% of the gross proceeds associated with the
issuance of shares of common stock, which amounts to $1,952,650. The
percentage of liquidated damages amounts to the difference between 60
months, which is the inherent time limitation under which the underlying
shares would be free-trading (three year term and two year holding period)
and 11 months, which is the grace period for registering the shares (no
demand permitted for four months, two-month period to file and five-month
period to become effective), times the penalty percentage, which is 1%. The
Company believes that the likelihood that it will incur any liabilities
resulting from the liquidated damages pursuant to the demand registration
rights is remote considering that it will register the shares and the
shares underlying the warrants pursuant to piggy-back registration rights,
which do not contain liquidated damages.
Because the registration rights were not granted under a separate
registration rights agreement, we considered those features in evaluating
whether the associated warrants should be classified as derivative
liabilities. Considering that the amount of the maximum penalty is 49%, the
Company cannot conclude that that this discount represents a reasonable
approximation of the difference between registered and unregistered shares
under paragraph 16 of EITF 00-19. Accordingly, the warrants issued in
connection with the February 2005 transaction are considered derivative
liabilities.
The fair value of the warrants issued in connection with the February 2005
transaction at the date of issuance of the warrants and the granting of
registration rights and at June 30, 2006 is as follows:
At issuance At June 30, 2006
------------------- -------------------
Freestanding warrants $ 6,017,350 $ 0
The Company used the following assumptions, using the Black Scholes Model
to measure the identified derivatives as follows:
F-11
Freestanding warrants
At issuance At June 30, 2006
--------------- ------------------
Market price: $ 2.40 $ 0.19
Exercise price: $ 1.00 $ 1.00
Term: 3 years 1.58 years
Volatility: 39% 39%
Risk-free interest rate: 2.78% 5.13%
Number of warrants: 3,985,000 3,985,000
DECEMBER 2005 TRANSACTION
During December 2005, in connection with the issuance of the convertible
debentures, the Company determined that the conversion feature of the
convertible debentures represents an embedded derivative since the
debentures are convertible into a variable number of shares upon
conversion. Because there is no explicit number of shares that are to be
delivered upon satisfaction of the convertible debentures and that there is
no cap on the number of shares to be delivered upon expiration of the
contract to a fixed number, the Company is unable to assert that it had
sufficient authorized and unissued shares to settle its obligations under
the convertible debentures and therefore, net-share settlement is not
within the control of the Company. Accordingly, the convertible debentures
are not considered to be conventional debt under EITF 00-19 and the
embedded conversion feature must be bifurcated from the debt host and
accounted for as a derivative liability.
The embedded conversion features are as follows:
Default Interest Rate and Premium: The default interest rate is 18% while
the stated rate of the convertible debentures is 8%. Additionally, the
Company is liable to pay for a premium amounting to 30% of the principal
amount of the convertible debentures in the event of default. This embedded
derivative could at least double the investor's initial rate of return on
the host contract and could also result in a rate of return that is at
least twice what otherwise would be the market return for a contract that
has the same terms as the host contract and that involves a debtor with
similar credit quality. Furthermore, the default interest rate may be
triggered by certain events of defaults which are not related to
credit-risk-related covenants or the Company's creditworthiness (e.g., if a
registration statement is not effective within 180 days after December 7,
2005). The default provisions are effective, at the holders' option, upon
an event of default. Although a registration statement covering the shares
underlying the convertible debentures has not been declared effective as of
June 30, 2006, the debenture holders have not notified the Company of an
election to accelerate the debentures, nor have any claims for liquidated
damages been received.
Reset Feature Following Subsequent Financing: The debenture provides for a
reset feature of the conversion price in the event of a subsequent equity
or convertible financing with an effective price lower than the debenture
conversion price, whereby the aforementioned variable conversion price of
the convertible debentures is adjusted to the new lower effective price of
the subsequent equity or convertible financing , which amounts to 10% of
the shares issuable pursuant to the convertible debentures, which is the
effective discount to market value we would offer in the event we provide
for a subsequent private placement financing. This reset does not
constitute a standard anti-dilution provision and is indexed to an
underlying other than an interest rate or credit risk.
Conversion Rate: The convertible debentures are convertible at a variable
conversion price, which is the lesser of $0.4544 or 90% of the average of
the volume weighted average price for the 20 consecutive trading days
immediately prior to the conversion date. The convertible debentures are
convertible at any time on or prior to the maturity date at the option of
the debenture holder. The implied conversion embedded feature amounts to a
conversion discount of 10% to market.
F-12
The Company believes that the aforementioned embedded derivatives meet the
criteria of SFAS 133, including Implementation issue No. B16 and EITF
00-19, when appropriate, and should be accounted for as derivatives with a
corresponding value recorded as a liability.
In connection with the issuance of the convertible debentures, the Company
issued warrants to the debenture holders. The related warrants require that
the Company reimburse any holder of a warrant in respect of any trading
loss resulting from the failure of the Company to timely deliver shares
issued pursuant to the exercise of warrants. This compensation may be paid
in shares of common stock or cash. Accordingly, we have accounted for such
warrants as derivatives.
In connection with the issuance of the convertible debentures, the Company
granted liquidated damages pursuant to a registration rights agreement. The
liquidated damages amount to 2% per month of the outstanding principal
amount, payable in cash or stock, to the debenture holders in the event
that a registration statement covering the shares underlying the
convertible debentures is not declared effective within 150 days of the
date the debentures were issued (although a registration statement covering
the shares underlying the convertible debentures has not been declared
effective as of June 30, 2006, no claims for liquidated damages have been
received from the debenture holders). The liquidated damages are payable in
cash monthly or if unpaid, bear interest at 18% per annum. If unpaid by
January 1, 2008 and thereafter, they may be converted in shares of common
stock at the same prevailing rate as the remaining principal amount of the
convertible debentures. Pursuant to View C of EITF 05-04 the liquidated
damages are accounted for as a separate derivative. While the liquidated
damages may be settled in stock if unpaid by January 1, 2008, the Company
determined that it was more likely that they would be paid in cash shortly
after their occurrence and has used such assumption in measuring the fair
value of the derivative liability associated with the liquidated damages.
Additionally, because there is no explicit number of shares that are to be
delivered upon satisfaction of the convertible debentures, the Company is
unable to assert that it had sufficient amount of authorized and unissued
shares to settle its obligations under the convertible debentures.
Accordingly, all of the Company's previously issued and outstanding
instruments, such as warrants, as well as those issued in the future, would
be classified as liabilities as well, effective with the issuance of the
convertible debentures and until the Company is able to assert that it has
a sufficient amount of authorized and unissued shares to settle its
obligations under all outstanding instruments. At the date of the issuance
of the convertible debentures, the Company had 1,941,871 warrants
outstanding which were classified as derivatives.
The fair value of the derivative liabilities at the date of issuance of the
convertible debentures and at June 30, 2006 are as follows:
At Issuance At June 30, 2006
------------------ ------------------
Freestanding warrants $ 3,532,348 $ 756,932
Embedded conversion features 3,463,542 4,359,649
Liquidated damages 192,500 192,500
Other outstanding warrants 143,268 0
The Company used the following methodology to value the embedded conversion
features and liquidated damages:
It estimated the discounted cash flows payable by the Company, using
probabilities and likely scenarios, for event of defaults triggering the
30% penalty premium and 18% interest accrual, subsequent financing reset,
and liquidated damages, such as the untimely effectiveness of a
registration statement. If the additional cash consideration was payable in
cash or stock, it determined the amount of additional shares that would be
issuable pursuant to its assumptions. The Company will revisit the weight
of probabilities and the likelihood of scenarios at each of the measurement
dates of the derivative liabilities, which are the balance sheet dates.
F-13
The Company used the following assumptions to measure the identified
derivatives, using the Lattice valuation model, as follows:
Embedded conversion features
At issuance At June 30, 2006
--------------- ------------------
Market price: $ 0.4880 $ 0.19
Conversion price: $ 0.4544 $ 0.17
Term: 4 years 3.42 years
Volatility: 39% 39%
Risk-free interest rate: 4.39% 5.13%
Freestanding warrants
The derivative liability amounts to the fair value of the warrants issuable
upon exercise, assuming that the underlying shares will not be timely
registered. We computed the fair value of this embedded derivative using
the Black Scholes valuation model with the following assumptions:
At issuance At June 30, 2006
--------------- ------------------
Market price: $ 0.488 $ 0.19
Exercise price: $ 0.4761 $ 0.34
Term: 5 years 4.42 years
Volatility: 39% 39%
Risk-free interest rate: 4.39% 5.13%
We adjusted the effective exercise price to reflect the contractual
adjustment assuming that the warrants will most likely be registered during
the fourth quarter of 2006.
Liquidated damages
The liquidated damages, payable in cash, are valued using the weighting
probabilities and likely scenarios to estimate the amount of liquidated
damages and were valued at approximately $192,500 at the date of the grant
of the registration rights and at June 30, 2006.
The aggregate fair value of the derivative liabilities associated with the
warrants, embedded conversion features, and liquidated damages in
connection with the issuance of the convertible debentures and related
agreements amounted to approximately $7.05 million at the date of issuance
which exceeded the principal amount of the convertible debentures by
approximately $50,000. The Company recognized $7,000,000 as debt discount
and the excess amount has been recorded as other expenses. Additionally,
approximately $136,000 of the fair value of the warrants was recorded as
deferred financing costs.
The aggregate fair value of all derivative liabilities upon issuance of the
various debt and equity instruments amounted to $13.3 million, of which
$10.7 million was allocated to the net proceeds of the issuance of common
stock and convertible debentures, $2.4 million was allocated to other
expenses and approximately $136,000 was allocated to deferred financing
costs.
The decrease in fair value of the derivative liabilities between
measurement dates, which are the date of issuance of the various debt and
equity instruments and the balance sheet date, which is June 30, 2006
amounted to approximately $8.7 million and has been recorded as other
income.
F-14
7) STOCKHOLDERS' DEFICIT
COMMON STOCK
Shares issued pursuant to services
During January 2006, the Company issued 75,000 shares to its former chief
executive officer for services rendered. The fair value of such shares
amounted to approximately $21,000 based on the quoted price of the
Company's shares at the date of issuance.
Conversion of shares for pre-merger liabilities
In connection with the Mergers, the Company issued, in aggregate, 2,783,892
shares of common stock in satisfaction of liabilities incurred pursuant to
notes payable, loan payable, and related accrued interest to related
parties.
OPTIONS
In 2005, the Board of Directors adopted the Electronic Sensor Technology,
Inc. 2005 Stock Incentive Plan. The purpose of the Stock Incentive Plan is
to attract and retain the services of experienced and knowledgeable
individuals to serve as our employees, consultants and directors. On the
date the Stock Incentive Plan was adopted, the total number of shares of
common stock subject to it was 5,000,000. The Stock Incentive Plan is
currently administered by the Board of Directors, and may be administered
by any Committee authorized by the Board of Directors, so long as any such
Committee is made up of Non-Employee Directors, as that term is defined in
Rule 16(b)-3(b) of the Securities Exchange Act of 1934.
The Stock Incentive Plan is divided into two separate equity programs: the
Discretionary Option Grant Program and the Stock Issuance Program. Under
the Discretionary Option Grant Program, eligible persons may, at the
discretion of the administrator, be granted options to purchase shares of
common stock and stock appreciation rights. Under the Stock Issuance
Program, eligible persons may, at the discretion of the administrator, be
issued shares of common stock directly, either through the immediate
purchase of such shares or as a bonus for services rendered for Electronic
Sensor Technology (or a parent or subsidiary of Electronic Sensor
Technology).
Pursuant to the terms of the Discretionary Option Grant Program, the
exercise price per share is fixed by the administrator, but may not be less
than 85% of the fair market value of the common stock on the date of grant,
unless the recipient of a grant owns 10% or more of Electronic Sensor
Technology's common stock, in which case the exercise price of the option
must not be less than 110% of the fair market value. An option grant may be
subject to vesting conditions. Options may be exercised in cash, with
shares of the common stock of Electronic Sensor Technology already owned by
the person or through a special sale and remittance procedure, provided
that all applicable laws relating to the regulation and sale of securities
have been complied with. This special sale and remittance procedure
involves the optionee concurrently providing irrevocable written
instructions to: (i) a designated brokerage firm to effect the immediate
sale of the purchased shares and remit to Electronic Sensor Technology, out
of the sale proceeds available on the settlement date, sufficient funds to
cover the aggregate exercise price payable for the purchased shares plus
all applicable federal, state and local income and employment taxes
required to be withheld by Electronic Sensor Technology by reason of such
exercise and (ii) Electronic Sensor Technology to deliver the certificates
for the purchased shares directly to such brokerage firm in order to
complete the sale. The term of an option granted pursuant to the
Discretionary Option Grant Program may not be more than 10 years.
The Discretionary Option Grant Program also allows for the granting of
Incentive Options to purchase common stock, which may only be granted to
employees, and are subject to certain dollar limitations. Any options
granted under the Discretionary Option Grant Program that are not Incentive
Options are considered Non-Statutory Options and are governed by the
aforementioned terms. The exercise price of an
F-15
Incentive Option must be no less than 100% of the fair market value of the
common stock on the date of grant, unless the recipient of an award owns
10% or more of Electronic Sensor Technology's common stock, in which case
the exercise price of an incentive stock option must not be less than 110%
of the fair market value. The term of an Incentive Option granted may not
be more than five years if the option is granted to a recipient who owns
10% or more of Electronic Sensor Technology's common stock, or 10 years for
all other recipients of Incentive Options. Incentive Options are otherwise
governed by the general terms of the Discretionary Option Grant Program.
Pursuant to the terms of the Stock Issuance Program, the purchase price per
share of common stock issued is fixed by the administrator, but may not be
less than 85% of the fair market value of the common stock on the issuance
date, unless the recipient of a such common stock owns 10% or more of
Electronic Sensor Technology's common stock, in which case the purchase
price must not be less than 100% of the fair market value. Common stock may
be issued in exchange for cash or past services rendered to Electronic
Sensor Technology (or any parent or subsidiary of Electronic Sensor
Technology). Common stock issued may be fully and immediately vested upon
issuance or may vest in one or more installments, at the discretion of the
administrator.
All options outstanding at June 30, 2006 were fully-vested at January 1,
2006, with the exception of 500,000 options held by our former Chief
Executive Officer, Matthew Collier, and 250,000 options held by the
Chairman of our Board of Directors, James Frey. Upon the termination of our
Chief Executive Officer in January 2006, 200,000 of his options vested, but
were cancelled, without being exercised, in April 2006. However, such
options were cancelled, without being exercised, in April 2006.
Accordingly, no expense associated with the outstanding options was
recorded during the six-month period June 30, 2006.
F-16
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
You should read the following discussion and analysis of our financial condition
and results of operations together with our interim financial statements and the
related notes appearing at the beginning of this report. The interim financial
statements and this Management's Discussion and Analysis of Financial Condition
and Results of Operations should be read in conjunction with the financial
statements and notes thereto for the year ended December 31, 2005 and the
related Management's Discussion and Analysis of Financial Condition and Results
of Operations, both of which are contained in our Annual Report on Form 10-KSB
filed with the Securities and Exchange Commission on March 24, 2006, which will
be amended and such financial statements restated in accordance with the Current
Report filed on Form 8-K on August 14, 2006.
The following discussion and other parts of this Form 10-QSB contain
forward-looking statements that involve risks and uncertainties. Forward-looking
statements can be identified by words such as "anticipates," "expects,"
"believes," "plans," and similar terms. Our actual results could differ
materially from any future performance suggested in this report as a result of
factors, including the risk factors discussed in Exhibit 99.1 hereto, which is
incorporated herein by reference, and factors discussed elsewhere in this report
and in our Annual Report on Form 10-KSB for the fiscal year ended December 31,
2005, which will be amended and such financial statements restated in accordance
with the Current Report filed on Form 8-K on August 14, 2006. All
forward-looking statements are based on information currently available to the
Company and we assume no obligation to update such forward-looking statements,
except as required by law. Service marks, trademarks and trade names referred to
in this Form 10-QSB are the property of their respective owners.
--------------------------------------------------------------------------------
OVERVIEW
The Company is engaged in the development, manufacturing, and sales of a
patented product called zNose(R); a device designed to detect and analyze
chemical odors and vapors, or, in other words, an electronic "nose." We believe
the zNose(R) is superior to other electronic "noses" because of its speed,
specificity and sensitivity. The zNose(R) is capable of measuring and
quantifying the chemistry of any compound, fragrance, vapor or odor with parts
per trillion sensitivity in 10 seconds. We also believe the zNose(R) has the
unique ability to quantify and speciate the subject chemical vapor by creating
visual olfactory images. This enables the measured odor or vapor to be easily
identified by the user.
We believe that our products will have broad applications in the homeland
security, environmental and laboratory instrumentation markets. The Company is
involved in ongoing product research and development efforts in that regard. The
Company has also concentrated its efforts on further product development,
testing and proving and assembling a sales and support organization.
The Company was originally incorporated under the laws of the state of Nevada as
"Bluestone Ventures, Inc." on July 12, 2000. From inception until February 1,
2005, we engaged in the business of acquiring, exploring and developing certain
mining properties in Ontario, Canada. Upon acquisition of Electronic Sensor
Technology, L.P. ("ELP"), we abandoned our mining business and adopted ELP's
business of developing, manufacturing and selling the vapor analysis device.
Prior to the closing of the mergers, as discussed in the footnotes to the
financial statements, on January 26, 2005, we changed our name to "Electronic
Sensor Technology, Inc."
Our executive offices are located at 1077 Business Center Circle, Newbury Park,
California 91320 and our telephone number is (805) 480-1994.
CRITICAL ACCOUNTING POLICIES
The Company records revenue from direct sales of products to end-users when the
products are shipped, collection of the purchase price is probable and the
Company has no significant further obligations to the customer. Costs of
remaining insignificant Company obligations, if any, are accrued as costs of
revenue at the time of revenue
2
recognition. Cash payments received in advance of product shipment or service
revenue are recorded as deferred revenue.
The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the financial
statements and the recorded amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
The Company reviews long-lived assets, such as property and equipment, to be
held and used or disposed of, for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. If the sum of the expected cash flows, undiscounted and without
interest, is less than the carrying amount of the asset, an impairment loss is
recognized as the amount by which the carrying amount of the asset exceeds its
fair value. At June 30, 2006 no assets were impaired.
The Company accounts for liquidated damages granted pursuant to a separate
registration rights agreement pursuant to Emerging Issue Task Force ("EITF")
05-04, View C, "The Effect of a Liquidated Damages Clause on a Freestanding
Financial Instrument", subject to EITF Issue No. 00-19, "Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock". Pursuant to EITF 05-04, View C, liquidated damages payable
in cash or stock are accounted for as a separate derivative, which requires a
periodical valuation of its fair value and a corresponding recognition of
liabilities associated with such derivative. The Company accounts for liquidated
damages granted pursuant to registration rights which are not included in a
separate registration right agreement as a combined unit with the warrants which
are contemporaneously issued with the registration rights pursuant to SFAS 133,
"Accounting for Derivative and Hedging Activities" and EITF 00-19. The Company
also accounts for its embedded conversion features and freestanding warrants
pursuant to SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities", which requires a periodic valuation of their fair value and a
corresponding recognition of liabilities associated with such derivatives. The
recognition of derivative liabilities related to the issuance of shares of
common stock is applied first to the proceeds of such issuance, at the date of
issuance, and the excess of derivative liabilities over the proceeds is
recognized as other expense in the accompanying consolidated financial
statements. The recognition of derivative liabilities related to the issuance of
convertible debt is applied first to the proceeds of such issuance as a debt
discount, at the date of issuance, and the excess of derivative liabilities over
the proceeds is recognized as other expense in the accompanying consolidated
financial statements. Any subsequent increase or decrease in the fair value of
the derivative liabilities, which are measured at the balance sheet date, are
recognized as other expense or other income, respectively. The valuation of such
derivatives requires significant judgment. We exercise our judgment in
determining the maximum liabilities associated with such derivatives as well as
the expected volatility related to their fair value. We base our estimate of the
maximum liabilities on our interpretation of the agreements related to the
derivatives.
PLAN OF OPERATIONS
Over the course of the next 12 months, we intend to execute our business plan
and focus our business development efforts in the following key areas:
o By diversifying our product offerings to enhance the usefulness of our
solutions for customers who will have already adopted one or more
products;
o By enhancing our product lines and developing new products to attract
new customers; and
o By developing partnering relationships with wide-ranging sales and
distribution channel leaders already serving our vertical market space
in a way that assists them in developing new revenue streams and
opportunities through improved technical and sales support and
customer services.
The terms of the convertible debentures and warrants that we issued in a private
placement on December 7, 2005 required that we register the shares of our common
stock underlying such debentures and warrants within 180 days of the date of
issuance of the debentures and warrants, as described more fully in the notes to
the consolidated
3
financial statements contained in this Quarterly Report. The failure to do so is
an event of default under the debentures, giving the debenture holders the right
to accelerate the debentures and receive a premium of approximately 30% of the
outstanding amounts due under the debentures upon acceleration. The failure to
do so also reduces the exercise price of the warrants by $0.03 per month until
such registration statement is declared effective. In addition, the failure to
register such shares within 150 days of the date of issuance of the debentures
and warrants gives the holders the right to receive liquidated damages in the
amount of 2% per month of the purchase price of the debentures and warrants,
pursuant to a registration rights agreement, and the failure to pay such
liquidated damages relating to the debentures is an event of default under the
debentures. Although we have been working diligently to obtain effectiveness of
our registration statement and continue to do so, we have thus far been unable
to have such registration statement declared effective by the Securities and
Exchange Commission. As such, the aforementioned penalties have been triggered.
At this time, the holders of the debentures and the warrants have the right to
declare an acceleration of debentures and to receive a premium thereon. If the
holders do so, we will owe them approximately $9.1 million, due and payable
immediately upon such declaration by the holders. Under the terms of the
warrants, the exercise prices of the warrants would have fallen from $0.4761 per
share to approximately $0.4061 per share. Pursuant to the registration rights
agreement, we would also owe the holders of the debentures and warrants
approximately $466,000, plus interest thereon at a rate of 18% per annum. As of
the present date, the holders of the debentures and warrants have not declared
an event of default under the debentures, nor have they made any demand for
payment of liquidated damages (although such demand is not required for the
latter). We are currently in settlement negotiations for the forbearance of the
exercise of the foregoing rights by the holders.
RESULTS OF OPERATIONS
The following tables sets forth, in $ and as a percentage of revenues, certain
items included in the Company's Income Statements (see Financial Statements and
Notes) for the periods indicated:
SIX MONTHS ENDED JUNE 30
----------------------------
STATEMENT OF OPERATIONS DATA: 2006 2005
------------------------------- ------------ ------------
Revenues..................... 100% 100%
Cost of Sales................ 51% 58%
Gross Profit................. 49% 42%
Operating Expenses........... 161% 220%
(Loss) From Operations....... (112)% (178)%
Other Income ................ 23% 298%
Net Income (loss)............ (89)% 120%
SIX MONTHS ENDED JUNE 30, 2006 COMPARED TO SIX MONTHS ENDED JUNE 30, 2005
Revenues are derived from product sales and product support services. For the
six months ended June 30, 2006 revenues were $1,154,224, compared to $651,652 in
2005. The 77% increase in revenues results mainly from an increase in the number
of zNose(R) units shipped from 19 units in 2005 to 32 units in 2006 for the
six-month period. Also contributing to the increase in revenues was a slight
increase in sales from product support services.
Cost of Sales consist of product costs and expenses associated with product
support services. For the six-month period, cost of sales was $592,714 for 2006
as compared to $375,086 in 2005. The increase in cost of sales was due to a
greater volume of products shipped in the current year as compared to last year.
The improvement in cost of sales as a percent of revenues, from 58% of 2005
revenues to 51% of 2006 revenues, is attributed to production efficiencies and
production economies of scales resulting in overhead being spread over a greater
volume of production - all of which contributed to a lower manufacture cost per
unit.
4
Gross profit was $561,510 for the six months ending June 30, 2006, compared to
$276,566 for the same period in 2005. The increase in gross profit was due to
greater sales volume, and an increase in high-margin support services revenues
over 2005. The improvement in 2006 gross profit from 42% in 2005 to 49% of
revenues is attributed to greater labor utilization, which improved labor
productivity and lowered the direct labor cost per manufactured unit.
Research and Development costs for the first six months of 2006 were $416,144
versus $331,285 for 2005. The increase of $84,859 in current year expenditures
over 2005 were mainly for greater personnel related expenses incurred for
enhancement of existing products and development of the Model 4300, the
company's newest zNose(R) product that was introduced to market in June 2006.
Selling, General and Administrative expenses for the six months ending June 30,
2006 were $1,436,961, compared to $1,103,030 for 2005. The $333,931 increase was
due to increased staffing required to support the growth of the company,
incurrence of necessary expenses associated with being a public company,
expansion of marketing activities including increased personnel staffing and
participation in a greater number of industry trade shows and conferences.
Interest expense for the first six months of 2006 was $1,416,279, as compared to
$34,271 in 2005. The increase in interest expense is primarily due to the
amortization of debt discount and stated interest associated with our $7,000,000
convertible debentures, which were issued in December 2005.
Other income-derivatives primarily consist of the decrease in the fair value of
derivative liabilities between the measurement dates. The increase in other
income during the six-month period ending June 30, 2006 when compared to prior
period is primarily attributable to a decrease in the quoted price of our common
stock. Please refer to Note 5 of our accompanying financial statements for
further explanation of the origin and nature of such income. We are unable to
determine whether we will record further decreases in the fair value of
derivative liabilities in the foreseeable future, which would be recorded as
other income-derivatives. Such decreases would be generally triggered by a
decrease in the fair value of our stock price, upon satisfaction of liquidated
damages pursuant to registration rights, or, possibly, upon satisfaction of our
convertible debentures.
Other expense-derivatives primarily consist of the recognition of derivative
liabilities we issued during the three-month period ended March 31, 2005. No
derivatives were issued during the three-month period ended June 30, 2005 nor
were any derivatives issued in 2006. Please refer to Notes 5 and 6 of our
accompanying financial statements for further explanation of the origin and
nature of such expenses.
LIQUIDITY AND CAPITAL RESOURCES
For the six-month period, net cash used by the Company for operating activities
were $1,454,193 and $1,364,616 for 2006 and 2005 respectively. Cash used in the
first six months of 2006 was comprised of the net loss for the period of
$1,024,755, less net non-cash items (including depreciation and amortization
expenses of $18,865, issuance of common shares for services of $21,000,
amortization of debt discount of $1,166,667, amortization of deferred financing
costs of $103,782, less decrease in fair value of derivative liability of
$1,683,119) of $372,805 minus the net change in operating assets and liabilities
of $56,633. Cash used in operations during the same six months of 2005 was
comprised of the net income for the period of $782,716, less net non-cash
expenses of $1,959,844 (including depreciation and amortization expenses of
$5,605, recognition of derivative liabilities of $2,298,501, less decrease in
fair value of derivative liability of $4,263,950), less the net change in
operating assets and liabilities of $187,488.
Investing activities provided cash of $599,413 in the first six months of 2006
and used $47,500 during the same period in 2005. Cash of $69,265 in 2006 and
$77,780 in 2005 were used to purchase of capital equipment. In 2005, $30,280 was
received from the sales of property and equipment. Whereas in 2006, $668,678 was
provided due to a reduction in the amount of collateral required for the
company's line of credit.
Financing activities for the first six months of 2006 consisted of $370,000 from
the line of credit the company has in place with its bank. The funds from the
credit line were used for operating expenses. In 2005, financing activities
provided cash of $3,501,708 primarily from the issuance of common stock in
February.
5
On June 30, 2006 the Company's cash (including cash equivalents) was $3,735,141,
compared to $2,116,022 on June 30, 2005. The Company had a working capital on
June 30, 2006 of $436,679. The working capital includes $4,087,959 for
derivative liabilities - excluding this amount from current liabilities, the
Company's working capital would be $4,524,638. The Company's working deficit at
June 30, 2005 was $1,053,722 - excluding derivative liabilities of $1,753,400,
working capital would be $699,678.
The Company has a credit facility in place with East West Bank for $500,000. The
line of credit had borrowings of $370,000 against it at June 30, 2006. The funds
from the line of credit was used for operating expenses. The line of credit
expires on March 31, 2007.
Although the Company possesses a bank operating line of credit, there can be no
assurance that these proceeds will be adequate for our future capital needs.
There can be no assurance that any required or desired financing will be
available through any other bank borrowings, debt, or equity offerings, or
otherwise, on acceptable terms. If future financing requirements are satisfied
through the issuance of equity securities, investors may experience significant
dilution in the net book value per share of common stock and there is no
guarantee that a market will exist for the sale of the Company's shares.
The Company's primary capital needs are to fund its growth strategy, which
includes a sales and marketing staff to support the marketing, advertising and
selling of the zNose(R) family of chemical detection products, increasing
distribution channels both in the domestic and foreign markets, introducing new
products, improving existing product lines and development of a strong corporate
infrastructure.
SEASONALITY AND QUARTERLY RESULTS
We do not foresee any seasonality to our revenues or our results of operations.
INFLATION
Although we currently use a limited number of sources for most of the supplies
and services that we use in the manufacturing of our vapor detection and
analysis technology, our raw materials and finished products are sourced from
cost-competitive industries. While prices for our raw materials may vary
significantly based on market trends, we do not foresee any material
inflationary trends for our product sources.
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any off-balance sheet arrangements.
ITEM 3. CONTROLS AND PROCEDURES
We have carried out an evaluation, under the supervision and with the
participation of our management, including our Chief Executive Officer and our
Vice President of Finance and Administration, on the effectiveness of the design
and operation of our disclosure controls and procedures as of June 30, 2006
pursuant to Exchange Act Rule 13a-15(b). Based upon that evaluation, our Chief
Executive Officer and Vice President of Finance and Administration concluded
that our disclosure controls and procedures are effective to ensure that
information required to be disclosed by us in the reports that we file or submit
under the Exchange Act is recorded, processed, summarized and reported within
the time periods specified in the Securities and Exchange Commission's rules and
forms.
6
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are not a party to any pending material legal proceedings and are not aware
of any threatened or contemplated proceeding by any governmental authority
against us.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
We did not sell any unregistered equity securities or repurchase any of our
equity securities during the three months ended June 30, 2006.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
The terms of the convertible debentures and warrants that we issued in a private
placement on December 7, 2005 required that we register the shares of our common
stock underlying such debentures and warrants within 180 days of the date of
issuance of the debentures and warrants, as described more fully in the notes to
the consolidated financial statements contained in this Quarterly Report. The
failure to do so is an event of default under the debentures, giving the
debenture holders the right to accelerate the debentures and receive a premium
of approximately 30% of the outstanding amounts due under the debentures upon
acceleration. The failure to do so also reduces the exercise price of the
warrants by $0.03 per month until such registration statement is declared
effective. In addition, the failure to register such shares within 150 days of
the date of issuance of the debentures and warrants gives the holders the right
to receive liquidated damages in the amount of 2% per month of the purchase
price of the debentures and warrants, pursuant to a registration rights
agreement, and the failure to pay such liquidated damages relating to the
debentures is an event of default under the debentures. Although we have been
working diligently to obtain effectiveness of our registration statement and
continue to do so, we have thus far been unable to have such registration
statement declared effective by the Securities and Exchange Commission. As such,
the aforementioned penalties have been triggered.
At this time, the holders of the debentures and the warrants have the right to
declare an acceleration of debentures and to receive a premium thereon. If the
holders do so, we will owe them approximately $9.1 million, due and payable
immediately upon such declaration by the holders. Under the terms of the
warrants, the exercise prices of the warrants would have fallen from $0.4761 per
share to approximately $0.4061 per share. Pursuant to the registration rights
agreement, we would also owe the holders of the debentures and warrants
approximately $466,000, plus interest thereon at a rate of 18% per annum. As of
the present date, the holders of the debentures and warrants have not declared
an event of default under the debentures, nor have they made any demand for
payment of liquidated damages (although such demand is not required for the
latter). We are currently in settlement negotiations for the forbearance of the
exercise of the foregoing rights by the holders.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to the vote of security holders during the three
months ended June 30, 2006.
ITEM 5. OTHER INFORMATION
There is no other information to report.
7
ITEM 6. EXHIBITS
Exhibit No. Description
----------- -----------------------------------------------------------------
3.1 Amended and Restated Bylaws of Electronic Sensor Technology,
Inc., adopted on June 30, 2006.
31.1 Certification of Chief Executive Officer Pursuant to Rule
13a-14(a)/15d-14(a) of the Exchange Act.
31.2 Certification of Principal Financial and Accounting Officer
Pursuant to Rule 13a-14(a)/15d-14(a) of the Exchange Act.
32.1 Certification of Chief Executive Officer Pursuant to Rule
13a-14(b) or 15d-14(b) of the Exchange Act and 18 U.S.C. 1350.
32.2 Certification of Principal Financial and Accounting Officer
Pursuant to Rule 13a-14(b) or 15d-14(b) of the Exchange Act and
18 U.S.C. 1350.
99.1 Risk Factors.
8
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
ELECTRONIC SENSOR TECHNOLOGY, INC.
Dated: August 16, 2006 By: /s/ Teong C.Lim
----------------------------------------
Name: Teong C. Lim
Title: President and Chief Executive Officer
(Principal Executive Officer)
Dated: August 16, 2006 By: /s/ Francis Chang
---------------------------------------------
Name: Francis Chang
Title: Secretary, Treasurer and Vice President of
Finance and Administration
(Principal Accounting Officer)