Annual Reports

 
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  • 10-Q (May 14, 2012)
  • 10-Q (Feb 14, 2012)
  • 10-Q (Nov 14, 2011)
  • 10-Q (May 13, 2011)
  • 10-Q (Feb 14, 2011)
  • 10-Q (Nov 15, 2010)

 
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Other

Media Sciences International 10-Q 2011

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Graphic
  7. Graphic
form10q.htm



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2010

o           TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT

For the transition period from ________ to ___________.

Commission file number:1-16053
_________________


MEDIA SCIENCES INTERNATIONAL, INC.
(Exact name of registrant as specified in its charter)

Delaware
87-0475073
(State or other jurisdiction of incorporation or organization)
(IRS Employer Identification No.)

8 Allerman Road, Oakland, NJ  07436
(Address of principal executive offices) (Zip Code)

(201) 677-9311
(Registrant’s telephone number, including area code)

_________________

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 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 o No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or such shorted period that the registrant was required to submit and post such files).  o Yes o No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one):
 
Large accelerated filer o
Accelerated filer o
 
Non-accelerated filer o (Do not check if a smaller reporting company)
Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  o Yes x No

As of February 9, 2011, we had 13,342,374 shares of common stock outstanding.
 



MEDIA SCIENCES INTERNATIONAL, INC.
AND SUBSIDIARIES

FORM 10-Q
FOR THE QUARTER ENDED DECEMBER 31, 2010

TABLE OF CONTENTS
 
 
PART I.  FINANCIAL INFORMATION

ITEM 1.
3
     
 
3
     
 
4
     
 
5
     
 
6
     
 
7
     
ITEM 2.
19
     
ITEM 3.
24
     
ITEM 4.
24
 
 
PART II.  OTHER INFORMATION

ITEM 1.
25
     
ITEM 1A.
25
     
ITEM 2.
25
     
ITEM 3.
25
     
ITEM 4.
25
     
ITEM 5.
25
     
ITEM 6.
25
     
 
26



PART I.  FINANCIAL INFORMATION


MEDIA SCIENCES INTERNATIONAL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS

   
December 31, 2010
   
June 30,
 
ASSETS
 
(Unaudited)
   
2010
 
CURRENT ASSETS:
           
    Cash and cash equivalents
  $ 5,516,024     $ 317,611  
    Accounts receivable, net
    2,409,845       2,674,918  
    Inventories, net
    1,015,546       1,420,806  
    Taxes receivable
          50,506  
    Prepaid expenses and other current assets
    99,655       205,423  
    Assets of discontinued operations
          7,281,721  
        Total Current Assets
    9,041,070       11,950,985  
                 
PROPERTY AND EQUIPMENT, NET
    1,003,271       1,129,222  
                 
OTHER ASSETS:
               
    Goodwill and other intangible assets, net
    1,120,072       1,120,072  
     Restricted cash held in escrow account
    1,100,028        
    Other assets
    72,436       85,984  
        Total Other Assets
    2,292,536       1,206,056  
                 
TOTAL ASSETS
  $ 12,336,877     $ 14,286,263  
                 
LIABILITIES AND SHAREHOLDERS' EQUITY
               
                 
CURRENT LIABILITIES:
               
    Accounts payable
    659,007       1,201,154  
    Accrued compensation and benefits
    106,109       555,136  
    Accrued severance expense
    536,725        
    Other accrued expenses and current liabilities
    389,063       443,641  
     Income tax payable
    1,474        
    Accrued product warranty costs
    285,548       432,548  
    Deferred rent liability
    42,726       28,493  
    10% subordinated debt, net of discount of $164,324 at December 31, 2010
    1,085,676        
    Deferred revenue
    847       20,097  
        Total Current Liabilities
    3,107,175       2,681,069  
                 
OTHER LIABILITIES:
               
    Long-term debt
          2,340,863  
    Deferred rent liability
          29,517  
    10% subordinated debt, net of discount of $255,376 in June
          994,624  
    Deferred tax liabilities
          904,922  
        Total Other Liabilities
          4,269,926  
                 
TOTAL LIABILITIES
    3,107,175       6,950,995  
                 
COMMITMENTS AND CONTINGENCIES
               
                 
SHAREHOLDERS' EQUITY:
               
    Preferred Stock, $.001 par value
               
       Authorized 5,000,000 shares; none issued
           
    Common Stock, $.001 par value 25,000,000 shares authorized;
               
        issued and outstanding, respectively, 13,492,374 and 13,342,374 shares at
        December 31, 2010 and 13,292,374 and 12,699,914 shares at June 30, 2010
    13,342       12,700  
    Additional paid-in capital
    13,620,874       13,277,405  
    Accumulated other comprehensive income (loss)
    45,833       1,402  
    Accumulated deficit
    (4,450,347 )     (5,956,239 )
        Total Shareholders' Equity
    9,229,702       7,335,268  
                 
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY
  $ 12,336,877     $ 14,286,263  

See accompanying notes to condensed consolidated financial statements.


MEDIA SCIENCES INTERNATIONAL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
 
   
Three Months Ended
December 31,
   
Six Months Ended
December 31,
 
   
2010
   
2009
   
2010
   
2009
 
                         
NET REVENUES
  $ 2,759,004     $ 2,242,104     $ 4,844,638     $ 4,527,538  
                                 
COST OF GOODS SOLD:
                               
    Cost of goods sold, excluding depreciation and
        amortization, product warranty, shipping and freight
    1,141,162       499,029       1,953,055       1,226,151  
    Depreciation and amortization
    55,463       60,983       112,877       159,541  
    Product warranty
    146,767       519,491       409,951       987,863  
    Shipping and freight
    66,701       108,698       207,087       267,252  
        Total cost of goods sold
    1,410,093       1,188,201       2,682,970       2,640,807  
                                 
GROSS PROFIT
    1,348,911       1,053,903       2,161,668       1,886,731  
                                 
OTHER COSTS AND EXPENSES:
                               
    Research and development
    147,225       270,715       270,175       490,283  
    Selling, general and administrative, excluding
        depreciation and amortization and severance
    1,072,564       1,716,060       2,749,558       3,319,429  
    Severance
    1,682,427             1,682,427        
    Depreciation and amortization
    34,608       62,956       77,191       137,798  
        Total other costs and expenses
    2,936,824       2,049,731       4,779,351       3,947,510  
                                 
LOSS FROM OPERATIONS
    (1,587,913 )     (995,828 )     (2,617,683 )     (2,060,779 )
                                 
Interest expense
    (59,769 )     (89,914 )     (135,224 )     (176,769 )
Interest income
    2,663       51       2,687       71  
                                 
Gain (loss) on change in fair value of warrant liabilities
          14,205             (4,962 )
Amortization of debt discount on convertible debt
    (47,200 )     (35,173 )     (91,053 )     (67,852 )
                                 
LOSS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES
    (1,692,218 )     (1,106,659 )     (2,841,273 )     (2,310,291 )
Benefit for income taxes
    1,141,615       16,169       1,303,260       98,588  
 
                               
NET LOSS FROM CONTINUING OPERATIONS
    (550,603 )     (1,090,490 )     (1,538,013 )     (2,211,703 )
                                 
INCOME (LOSS) FROM DISCONTINUED OPERATIONS, NET OF INCOME TAXES
    (128,003 )     1,039,634       174,465       1,901,618  
                                 
GAIN ON SALE OF DISCONTINUED OPERATIONS, NET OF INCOME TAXES
    2,869,440             2,869,440        
                                 
NET INCOME (LOSS)
  $ 2,190,834     $ (50,856 )   $ 1,505,892     $ (310,085 )
                                 
BASIC EARNINGS (LOSS) PER SHARE
                               
    Continuing operations
  $ (0.04 )   $ (0.09 )   $ (0.12 )   $ (0.19 )
    Discontinued operations
  $ 0.21     $ 0.09     $ 0.24     $ 0.16  
    Net income (loss)
  $ 0.17     $ 0.00     $ 0.12     $ (0.03 )
DILUTED EARNINGS (LOSS) PER SHARE
                               
     Continuing operations
  $ (0.04 )   $ (0.09 )   $ (0.12 )   $ (0.19 )
     Discontinued operations
  $ 0.21     $ 0.09     $ 0.24     $ 0.16  
     Net income (loss)
  $ 0.17     $ 0.00     $ 0.12     $ (0.03 )
WEIGHTED AVERAGE SHARES USED TO COMPUTE LOSS PER SHARE
                               
    Basic and diluted
    13,101,699       11,945,712       12,919,001       11,891,969  
 
See accompanying notes to condensed consolidated financial statements


MEDIA SCIENCES INTERNATIONAL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY AND
COMPREHENSIVE INCOME
SIX MONTHS ENDED DECEMBER 31, 2010
(UNAUDITED)

               
Accumulated
             
         
Additional
   
Other
         
Total
 
   
Common Stock
   
Paid-in
   
Comprehensive
   
Accumulated
   
Shareholders'
 
   
Shares
   
Amount
   
Capital
   
Income (loss)
   
Deficit
   
Equity
 
BALANCES, JUNE 30, 2010
    12,699,914     $ 12,700     $ 13,277,405     $ 1,402     $ (5,956,239 )   $ 7,335,268  
Components of comprehensive income:
                                               
   Net income
                            1,505,892       1,505,892  
   Cumulative translation adjustment
                      44,431             44,431  
       Total comprehensive income
                                  1,550,323  
  Vested restricted stock units
    642,460       642       (642 )                  
  Stock-based compensation expense
                344,111                   344,111  
BALANCES, DECEMBER31, 2010
    13,342,374     $ 13,342     $ 13,620,874     $ 45,833     $ (4,450,347 )   $ 9,229,702  

See accompanying notes to condensed consolidated financial statements.


MEDIA SCIENCES INTERNATIONAL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

   
Six Months Ended
December 31,
 
   
2010
   
2009
 
CASH FLOWS FROM OPERATING ACTIVITIES
           
    Net income (loss)
  $ 1,505,892     $ (310,085 )
    Adjustments to reconcile net loss to net cash  used in operating
               
    activities:
               
            Depreciation and amortization
    247,588       394,220  
            Stock-based compensation expense
    342,704       345,602  
            Deferred income taxes
    (1,149,630 )     (98,588 )
            Provision for (reduction of) inventory obsolescence reserves
    3,012       (58,319 )
            Provision for returns and doubtful accounts allowance
    (111,586 )     90,063  
            Amortization of debt discount on convertible debt
    91,052       67,852  
            Loss on change in fair value of warrant liabilities
          4,962  
            Gain on sale of toner business
    (2,869,440 )      
            Changes in operating assets and liabilities:
               
              Accounts receivable
    439,617       370,662  
              Inventories
    (42,270 )     (439,308 )
              Income taxes
    51,980       (29,074 )
              Prepaid expenses and other current assets
    28,029       110,598  
              Accounts payable
    (542,112 )     (66,043 )
              Accrued compensation and benefits
    (449,027 )     (266,793 )
              Accrued severance
    536,725        
              Other accrued expenses and current liabilities
    (28,817 )     (244,740 )
              Accrued product warranty costs
    (147,000 )     11,389  
              Deferred rent liability
    (15,284 )     (43,498 )
              Deferred revenue
    (19,250 )     (162,115 )
                 Net cash used in operating activities
    (2,127,818 )     (323,215 )
                 
CASH FLOWS FROM INVESTING ACTIVITIES
               
    Increase in restricted cash
    (1,100,028 )      
    Purchases of property and equipment
    (231,011 )     (83,207 )
    Proceeds from sale of operating toner business
    11,042,500        
                 Net cash provided (used) in investing activities
    9,711,461       (83,207 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES
               
     Decrease in restricted cash
          18,450  
     Bank credit line proceeds (repayments), net
    (840,863 )     366,734  
     Bank term loan repayments
    (1,500,000 )      
     Capital lease obligation repayments
          (69,815 )
                 Net cash used in financing activities
    (2,340,863 )     315,369  
    Effect of exchange rate changes on cash and cash equivalents
    (44,367 )     (21,386 )
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    5,198,413       (112,439 )
                 
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    317,611       550,602  
                 
CASH AND CASH EQUIVALENTS, END OF PERIOD
  $ 5,516,024     $ 438,163  
                 
SUPPLEMENTAL CASH FLOW INFORMATION
               
    Interest paid
  $ 83,680     $ 158,426  
    Income taxes paid (refunded)
  $   (44,500 )   $ 49,160  
                 
See accompanying notes to condensed consolidated financial statements.


MEDIA SCIENCES INTERNATIONAL, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
 
NOTE 1 – NATURE OF BUSINESS AND BASIS OF PRESENTATION


Basis of Presentation. >  The condensed consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to Article 8 of Rule S-X.  In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal, recurring adjustments) necessary for a fair presentation of the financial position, results of operations and cash flows for the periods indicated.  You should read these condensed consolidated financial statements in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended June 30, 2010, filed with the SEC on September 28, 2010.  The June 30, 2010 consolidated balance sheet data was derived from audited consolidated financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America.

The consolidated financial statements include the accounts of Media Sciences International, Inc., a Delaware corporation, and its subsidiaries.  All significant intercompany balances and transactions have been eliminated in consolidation.  During the quarter ended December 31, 2010, the Company discontinued selling toner related products as more fully described in Note 9.  Accordingly, the financial statements for the periods prior to the sale have been adjusted to reflect the discontinued operations of the toner business and the related continuing operations of the Company.  As of December 31, 2010, there have been no significant changes to any of the Company’s accounting policies as set forth in the Annual Report on Form 10-K for the year ended June 30, 2010.

The results of operations for the three months and six months ended December 31, 2010 are not necessarily indicative of the results that may be expected for any other interim period or for the full year ending June 30, 2011.




MEDIA SCIENCES INTERNATIONAL, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
 
NOTE 1 – NATURE OF BUSINESS AND BASIS OF PRESENTATION (CONTINUED)

Fair Value Measurements.>  The Company measures fair value in accordance with authoritative guidance for fair value measurements, which defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements.  The authoritative guidance defines fair value as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.  As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, there exists a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:

·  
Level 1 – unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access as of the measurement date.
 
·  
Level 2 – inputs other than quoted prices included within Level 1 that are directly observable for the asset or liability or indirectly observable through corroboration with observable market data.
 
·  
Level 3 – unobservable inputs for the asset or liability only used when there is little, if any, market activity for the asset or liability at the measurement date.

This hierarchy requires the Company to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value.



Income Taxes. >  The Company recognizes deferred tax assets, net of applicable valuation allowances, related to net operating loss carry-forwards and certain temporary differences and deferred tax liabilities related to certain temporary differences.  The Company recognizes a future tax benefit to the extent that realization of such benefit is considered to be more likely than not.  The Company has incurred substantial losses before income taxes for several years before and for the year ended June 30, 2010.  Accordingly, the Company provided a valuation allowance as of March 31, 2010 for all of its then remaining deferred tax assets as it was deemed more likely than not that certain federal net operating loss carry forwards and other future deductible temporary differences included in the Company’s deferred tax assets would not be realized.  This also resulted in the Company restoring its deferred tax liability for indefinite-lived intangibles at that time.  As a result of the sale of the toner business which included certain indefinite-lived intangibles the Company reduced its deferred tax liability to zero at December 31, 2010.  Additionally, as a result of the gain on the sale of the toner business, the Company reduced certain of its valuation allowances resulting in a tax benefit from continuing operations and an offsetting tax provision recorded against the gain on discontinued operations.


MEDIA SCIENCES INTERNATIONAL, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 

NOTE 2 – RECENT ACCOUNTING PRONOUNCEMENTS

Fair Value Accounting

In January 2010, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance for fair value measurements. This guidance now requires a reporting entity to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and also to describe the reasons for these transfers. This authoritative guidance also requires enhanced disclosure of activity in Level 3 fair value measurements. The guidance for Level 3 fair value measurements disclosures becomes effective for the Company’s interim reporting period ending September 30, 2011 and the Company does not expect that this guidance will have an impact on its financial position, results of operations or cash flows as it is disclosure-only in nature.

Other Accounting Changes

In April 2010, the FASB issued ASU No. 2010-13, Compensation-Stock Compensation (Topic 718).  This ASU provides amendments to Topic 718 to clarify that an employee share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity securities trades should not be considered to contain a condition that is not a market, performance, or service condition.  Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity.  This standard becomes effective for the Company’s fiscal year, and interim periods on or after July 1, 2011.  The Company does not expect this guidance to have an impact on our financial position, results of operations and cash flows.



MEDIA SCIENCES INTERNATIONAL, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
 
NOTE 3 – CONDENSED CONSOLIDATED BALANCE SHEET COMPONENTS

     
December 31
2010
       
     
(Unaudited)
   
June 30, 2010
 
Accounts receivable, net
             
      Accounts receivable, gross
    $ 2,486,939     $ 2,863,598  
      Allowance for doubtful accounts
      (20,000 )     (20,000 )
      Allowance for returns
      (57,094 )     (168,680 )
      $ 2,409,845     $ 2,674,918  
                   
Inventories, net of reserves
                 
      Raw materials
    $ 519,552     $ 555,252  
      Finished goods
      614,535       981,081  
      Less:  reserves for obsolescence
      (118,539 )     (115,527 )
      $ 1,015,546     $ 1,420,806  
                   
Property and Equipment, net
Useful Lives
               
      Equipment
3 – 7 years
  $ 2,799,520     $ 2,771,362  
      Furniture and fixtures
7 years
    576,467       576,467  
      Automobiles
5 years
    30,434       30,434  
      Leasehold improvements
5 – 10 years
    929,762       913,743  
      Tooling and molds
3 years
    692,231       675,618  
        5,028,414       4,967,624  
      Less: Accumulated depreciation and amortization
      4,025,143       3,838,402  
      $ 1,003,271     $ 1,129,222  
                   
Goodwill and other intangible assets, net
                 
      Goodwill
    $ 1,239,368     $ 1,239,368  
      Other
1-15 years
    46,000       46,000  
        1,285,368       1,285,368  
      Less: Accumulated amortization
      165,296       165,296  
      $ 1,120,072     $ 1,120,072  





MEDIA SCIENCES INTERNATIONAL, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
 
NOTE 4 – DEBT

Bank Debt

The Company’s indebtedness under secured commercial loan agreements consisted of the following:

     
December 31, 2010
       
     
(Unaudited)
   
June 30, 2010
 
               
 
Bank term notes
  $     $ 1,500,000  
 
Bank line of credit
          840,863  
 
Long-term debt
  $     $ 2,340,863  
 
Total bank debt
  $     $ 2,340,863  

On November 8, 2010, as a result of the sale of the Company’s toner business as more fully disclosed in Note 9, the Company terminated and repaid all of its outstanding balance under its existing revolving credit facility with Sovereign Bank.  This facility was previously amended on September 27, 2010 so as to terminate on October 1, 2011.  As amended, the advance limit under the line of credit is the lesser of: (a) $4,000,000; or (b) up to 80% of eligible domestic accounts receivable and up to the lesser of $1,000,000 or 75% of eligible foreign receivables plus up to the lesser of: (i) $2,500,000; or (ii) 50% of eligible inventory; or (iii) 60% of the maximum amount available to be advanced under the line.  The line of credit is collateralized by a first priority security interest in substantially all of our U.S. based assets and our foreign receivables and requires payments of interest only.  As amended, the interest rate on the term note and the line of credit varied based on the bank’s prime rate and is equal to the greater of the bank’s prime rate plus 4% or 8%.

The revolving loan could have been converted into one or more term notes upon mutual agreement of the parties.  Prior to its repayment with the bank, the Company had a $1,500,000 term note and an outstanding balance of $890,284 drawn under its revolving credit line.

The Company’s credit facility was subject to financial covenants.  These covenants included monitoring a ratio of debt to tangible net worth and an ebitda or fixed charge coverage ratio, as defined in the loan agreements.  At June 30, 2010, the Company was not in compliance with its Fixed Charge Coverage Ratio covenant, which was waived by the Company’s bank via the amendment dated September 27, 2010.

Convertible Debt

On September 24, 2008, the Company completed a $1,250,000 convertible debt financing with MicroCapital Fund, LP and MicroCapital Fund, Ltd. (“MicroCapital”).  The Company issued three year notes, bearing interest at 10% payable quarterly and convertible into shares of the Company’s common stock at $1.65 per share. The Company also issued (a) five year warrants to purchase 378,787 shares of the Company’s common stock at $1.65 per share, and (b) three year warrants allowing MicroCapital to repeat its investment up to $1,250,000 on substantially the same terms and conditions.

The various elements of the September 24, 2008 transaction were recorded on a relative fair value basis in accordance with authoritative guidance.  The $486,615 fair value of the warrants and the debt’s beneficial conversion feature was recorded to equity and as a debt discount to the value of the convertible note.  This discount is being amortized using the effective interest method over the three year term of the convertible note.  Amortization of debt discount on this convertible note payable amounted to $47,200 and $91,052, respectively, for the three and six months ended December 31, 2010 and $35,173 and $67,852, respectively, for the three and six months ended December 31, 2009.  The remaining unamortized discount was $164,324 at December 31, 2010.  In connection with this transaction, the Company also recognized a $63,955 increase in its deferred tax liabilities reflecting the non-


MEDIA SCIENCES INTERNATIONAL, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
 
NOTE 4 - DEBT (CONTINUED)

deductible nature of future debt discount amortization that will result from the value of the beneficial conversion feature.

On March 30, 2010, the Company entered into agreements with MicroCapital, whereby certain terms and conditions of the 10% convertible notes issued on September 24, 2008, were modified and all of the warrants issued and contingently issuable to MicroCapital were repurchased and cancelled.  Modifications to the terms and conditions of the 10% convertible notes included elimination of convertibility of the notes and anti-dilution provisions.  At March 31, 2010, as a result of this transaction, the MicroCapital debt is now reflected as 10% subordinated unsecured debt.  Before the transaction, 2,272,726 shares of the Company’s common stock were issuable or contingently issuable.  In consideration of the modifications of the loans and the repurchases of the warrants, 400,000 shares of the Company’s common stock were issued.  In April 2010, the Company filed a registration statement, declared effective in May 2010, covering the resale of the shares of common stock issued in this transaction.

NOTE 5 – INCOME (LOSS) PER SHARE

Basic income (loss) per share is computed using the weighted average number of common shares outstanding.  Diluted income (loss) per share is computed using the weighted average number of common shares outstanding as adjusted for the incremental shares attributable to outstanding options, restricted stock units and warrants to purchase common stock.

The following table sets forth the computation of the basic and diluted loss per share:
 
   
Three Months Ended
December 31,
   
Six Months Ended
December 31,
 
 
 
2010
   
2009
   
2010
   
2009
 
Numerator for basic and diluted:
                       
    Income (loss) from continuing operations
  $ (550,603 )   $ (1,090,490 )   $ (1,538,013 )   $ (2,211,703 )
    Income (loss) from discontinued operations
  $ 2,741,437     $ 1,039,634     $ 3,043,905     $ 1,901,618  
    Net income (loss)
  $ 2,190,834     $ (50,856 )   $ 1,505,892     $ (310,085 )
                                 
Denominator :
                               
    For basic loss per common share –
    weighted average shares outstanding
    13,101,699       11,837,427       12,919,001       11,891,969  
    Effect of dilutive securities -  stock options,
    unvested restricted stock units and warrants
                       
    For diluted loss per common share –
    weighted average shares outstanding adjusted
    for assumed exercises
    13,101,699       11,837,427       12,919,001       11,891,969  
                                 
Basic earnings (loss) per share:
                               
   Income (loss) from continuing operations
  $ (0.04 )   $ (0.09 )   $ ( 0.12 )   $ (0.19 )
   Income from discontinued operations
  $ 0.21     $ 0.09     $ 0.24     $ 0.16  
   Net income (loss)
  $ 0.17     $ 0.00     $ 0.12     $ (0.03 )
                                 
Diluted earnings (loss) per share:
                               
  Income (loss) from continuing operations
  $ (0.04 )   $ ( 0.09 )   $ (0.12 )   $ (0.19 )
  Income from discontinued operations
  $ 0.21     $ 0.09     $ 0.24     $ 0.16  
  Net income (loss)
  $ 0.17     $ 0.00     $ 0.12     $ (0.03 )




MEDIA SCIENCES INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 5 – INCOME (LOSS) PER SHARE (CONTINUED)

The following options and warrants to purchase common stock were excluded from the computation of diluted loss per share for the three and six months ended December 31, 2010 and 2009 because their exercise price was greater than the average market price of the common stock or as a result of the Company’s net loss for those periods:

   
Three Months Ended
December 31,
   
Six Months Ended
December 31,
 
 
 
2010
   
2009
   
2010
   
2009
 
Options and warrants
    1,115,196       1,108,436       1,115,196       1,108,436  


NOTE 6 – STOCK-BASED COMPENSATION

The effect of recording stock-based compensation for the three and six months ended December 31, 2010 and 2009 was as follows:

   
Three Months Ended
December 31,
   
Six Months Ended
December 31,
 
   
2010
   
2009
   
2010
   
2009
 
Stock-based compensation expense by type of award:
                       
           Employee stock options
  $ 94,319     $ 69,411     $ 134,757     $ 140,556  
           Employee restricted stock units
    94,415       72,972       122,105       142,024  
           Non-employee director restricted stock units
    71,541       19,653       87,249       68,153  
Amounts capitalized as inventory
    (316 )     (3,237 )     (1,407 )     (5,130 )
Total stock-based compensation expense
  $ 259,599     $ 158,799       342,704       345,603  
Tax effect of stock-based compensation recognized
    (85,271 )     (53,591 )     (112,086 )     (116,247 )
Net effect on net income/ loss
  $ 174,688     $ 105,208     $ 230,618     $ 229,356  

As of December 31, 2010, the unrecorded deferred stock-based compensation balance was $38,842 after estimated forfeitures and will be recognized over an estimated weighted average amortization period of about 2.6 years.

During the three months ended December 31, 2010, the Company did not grant any stock options.  During the six months ended December 31, 2010, the Company granted 100,002 stock options with a grant date fair value of $12,780 after estimated forfeitures.  During the three and six months ended December 31, 2009, the Company did not grant any stock options. During the three months ended December 31, 2010, the Company granted 150,000 shares of restricted stock with a grant date fair value of $19,790 after estimated forfeitures.  During the six months ended December 31, 2010, the Company granted 200,000 shares of restricted stock with a grant date fair value of $34,772 after estimated forfeitures.  During the three and six months ended December 31, 2009, the Company granted 577,000 shares of restricted stock with a grant date fair value of $243,050 after estimated forfeitures.

Valuation Assumptions

The Company estimates the fair value of stock options using a Black-Scholes option-pricing model.  The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model and the straight-line attribution approach with the following weighted-average assumptions:

   
Three Months Ended
December 31,
   
Six Months Ended
December 31,
 
   
2010 (b)
   
2009 (a)
   
2010
   
2009(a)
 
Risk-free interest rate
                1.7 %      
Dividend yield
                0.0 %      
Expected stock price volatility
                64 %      
Average expected life of options
             
4.8 years
       

(a)           No stock options were granted during the three or six months ended December 31, 2009.
(b)           No stock options were granted during the three months ended December 31, 2010.


MEDIA SCIENCES INTERNATIONAL, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
 
NOTE 6 – STOCK-BASED COMPENSATION (CONTINUED)

Authoritative guidance issued by the FASB requires the use of option pricing models that were not developed for use in valuing employee stock options. The Black-Scholes option-pricing model was developed for use in estimating the fair value of short-lived exchange traded options that have no vesting restrictions and are fully transferable.  In addition, option-pricing models require the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock.  For the current fiscal year, the expected stock price volatility assumption was determined using the Company’s historic volatility.

The Company uses the simplified method suggested by the SEC in authoritative guidance for determining the expected life of the options.  Under this method, the Company calculates the expected term of an option grant by averaging its vesting and contractual term.  Based on studies of the Company’s historic actual option terms, compared with expected terms predicted by the simplified method, the Company has concluded that the simplified method yields materially accurate expected term estimates.  The Company estimates its applicable risk-free rate based upon the yield of U.S. Treasury securities having maturities similar to the estimated term of an option grant, adjusted to reflect its continuously compounded “zero-coupon” equivalent.

Equity Incentive Program

The Company’s equity incentive program is a broad-based, long-term retention program that is intended to attract and retain qualified management and technical employees, and align stockholder and employee interests.  The equity incentive program presently consists of three plans (the “Plans”): the Company's 1998 Incentive Plan, as Amended and Restated (the “1998 Plan”); the Company’s 2006 Stock Incentive Plan, as Amended and Restated (the “2006 Plan”); and the Company’s 2009 Stock Incentive Plan (the “2009 Plan”).  Under these Plans, non-employee directors, officers, key employees, consultants and all other employees may be granted options to purchase shares of the Company’s stock, restricted stock units and other types of equity awards.  Under the equity incentive program, stock options generally have a vesting period of three to five years, are exercisable for a period not to exceed ten years from the date of issuance and are not granted at prices less than the fair market value of the Company’s common stock at the grant date.  Restricted stock units may be granted with varying service-based vesting requirements.

As of December 31, 2010, there are no common shares remaining available for future issuance under the 1998 Plan, which expired on June 17, 2008.  Under the Company’s 2006 Plan, 1,000,000 common shares are authorized for issuance through awards of options or other equity instruments.  As of December 31, 2010, 27,391 common shares were available for future issuance under the 2006 Plan.  Under the Company’s 2009 Plan, 1,250,000 common shares are authorized for issuance through awards of options or other equity instruments.  As of December 31, 2010, 187,998 common shares were available for future issuance under the 2009 Plan.


MEDIA SCIENCES INTERNATIONAL, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
 
NOTE 6 – STOCK-BASED COMPENSATION (CONTINUED)

The following table summarizes the combined stock option plan and non-plan activity for the indicated periods:

     
Number of
Shares
   
Weighted
Average
Exercise Price
 
 
Balance outstanding at June 30, 2010
    1,077,128     $ 3.25  
 
Six months ended December 31, 2010:
               
 
Options granted
    100,002       0.34  
 
Options exercised
           
 
Options cancelled/expired/forfeited
    (61,934 )     3.47  
 
Balance outstanding at December 31, 2010
    1,115,196     $ 2.98  

The options outstanding and exercisable at December 31, 2010 were in the following exercise price ranges:

       
Options Outstanding
   
Options Exercisable
 
 
Range of
Exercise
Prices
   
Number
Outstanding
   
Weighted
Average
Remaining
Contractual
Life-Years
   
Weighted
Average
Exercise
Price
   
Number
Vested and
Exercisable
   
Weighted
Average
Exercise
Price
 
                                   
  $ 0.34 to $0.85       171,602       5.8     $ 0.40       171,602     $ 0.40  
  $ 1.00 to $2.00       405,915       2.6       1.96       405,915       1.96  
  $ 2.01 to $6.33       537,679       3.9       4.58       537,679       4.58  
            1,115,196       3.7     $ 2.98       1,115,196     $ 2.98  

At December 31, 2010, none of the Company’s exercisable options were in-the-money.  Accordingly, all outstanding and exercisable options at that date had no aggregate intrinsic value.  No options were exercised during the three or six months ended December 31, 2010.

No stock options were granted during the three months ended December 31, 2010.  The weighted average grant date fair value of options granted during the six months ended December 31, 2010 was $0.21.  No stock options were granted during the three or six months ended December 31, 2009.

The Company settles employee stock option exercises with newly issued common shares.

Restricted Stock Units

During the three months ended December 31, 2010, the Company’s Board of Directors approved the grant of 150,000 shares of restricted stock units to two employees.  These restricted stock units vest over four years from the grant date.  The value of the restricted stock units is based on the closing market price of the Company’s common stock on the date of award.  Stock-based compensation expense, net of estimate forfeitures, for restricted stock units for the three and six months ended December 31, 2010 was $165,956 and $209,354, respectively.

As of December 31, 2010, there was $19,790 of total unrecognized deferred stock-based compensation after estimated forfeitures related to non-vested restricted stock units granted under the Plans.  That cost is expected to be recognized over an estimated weighted average period of 2.9 years.


MEDIA SCIENCES INTERNATIONAL, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
 
NOTE 6 – STOCK-BASED COMPENSATION (CONTINUED)

The following table summarizes the Company’s restricted stock unit activity for the indicated periods:

 
     
Number of
Shares
   
Grant Date
Fair Value
   
Weighted
Average Grant
Date Fair Value
Per Share
 
 
Balance unvested at June 30, 2010
    592,460     $ 456,330     $ 0.77  
                           
 
Three months ended December 31, 2010:
                       
 
Restricted stock units granted
    200,000       50,025       0.25  
 
Restricted stock units vested
    (642,460 )     (473,355 )     0.74  
 
Restricted stock units cancelled/forfeited
                 
 
Balance unvested at December 31, 2010
    150,000     $ 33,000     $ 0.22  

 
NOTE 7 – ACCRUED PRODUCT WARRANTY COSTS

The Company provides a warranty for all of its consumable supply products and for its INKlusive printer program, which was discontinued on April 1, 2009.  Although no new INKlusive contracts were originated after April 1, 2009, remaining service and supply commitments under the program continue to be honored.  The Company’s warranty stipulates that it will pay reasonable and customary charges for the repair of a printer needing service as a result of using the Company’s products.  The Company estimates the costs that may be incurred and records a liability in the amount of such costs at the time product revenue is recognized.  Factors that may affect the warranty liability and expense include the number of units shipped to customers, historical and anticipated rates of warranty claims and cost per claim.  The Company periodically assesses the adequacy of the recorded warranty liability and adjusts the amount as necessary.  These expenses are classified as a separately captioned item in cost of goods sold.

Changes in accrued product warranty costs for the three months ended December 31, 2010 and 2009 were as follows:

   
Three Months Ended
December 31,
   
Six Months Ended
December 31
 
   
2010
   
2009
   
2010
   
2009
 
Accrued product warranty costs
at the beginning of the period
  $ 365,548     $ 436,578     $ 432,548     $ 436,578  
                                 
       Warranties accrued during the period
    146,767       519,491       409,951       987,863  
       Warranties settled during the period
    (226,767 )     (508,102 )     (556,951 )     (976,747 )
Net change in accrued warranty costs
    (80,000 )     11,389       (147,000 )     11,389  
                                 
Accrued product warranty costs
at the end of the period
  $ 285,548     $ 447,967     $ 285,548     $ 447,967  



MEDIA SCIENCES INTERNATIONAL, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
 
NOTE 8 – LITIGATION AND CONTINGENCIES

The Company is involved in litigation from time to time in the ordinary course of its business. Based on information currently available to management,  other than the action described below the Company does not believe that the outcome of any legal proceedings in which the Company is involved will have a material adverse impact on the Company.

On June 23, 2006, Xerox Corporation filed a patent infringement lawsuit in the United States District Court, for the Southern District of New York, Case No. 06CV4872, against Media Sciences International, Inc. and Media Sciences, Inc., alleging that the Company’s solid inks designed for use in the Xerox Phaser 8500 and 8550 printers infringe four Xerox-held patents related to the shape of the ink sticks in combination with the Xerox ink stick feed assembly.  The suit seeks unspecified damages and fees.  In the Company’s answer and counterclaims in this action, it denied infringement and it seeks a finding of invalidity of the Xerox patents in question.  The Company also submitted counterclaims against Xerox for breach of contract and violation of U.S. antitrust laws, seeking treble damages and recovery of legal fees.  On September 14, 2007, the court denied Xerox’s motion to dismiss the antitrust counterclaims brought by the Company.  Pre-trial discovery on the infringement action was completed in September 2007.  Pre-trial discovery on the Company’s antitrust action was completed in July 2008.  In March 2009 the court dismissed, without prejudice, the Company’s antitrust claims relating to Xerox’s loyalty rebate programs.  In the ruling, the court relied on a 2001 Settlement Agreement between the parties resulting from a different matter, and found that before such claims are pursued, the Company must submit to arbitration.  In September 2009, the court dismissed the Company’s remaining antitrust claims not relating to Xerox’s loyalty rebate programs.  In March 2010 the court issued a ruling on a Markman hearing held in November 2008.   The Company believes the ruling to be highly favorable.  In July 2010, the Company filed a motion for summary judgment in its favor based on the grounds that the ink sticks sold by the Company do not infringe the claims asserted by Xerox, as they were construed by the Court.  Should these matters not be decided on summary judgment, the patent infringement claims remaining before the court are not likely to be heard at trial before mid 2011.  The loss of all or a part of the patent infringement claims could have a material adverse affect on our results of operations and financial position, though the Company is unable to currently determine the dollar range if any possible loss.   The Company intends to vigorously defend these allegations of infringement.  There can be no assurance, however, that the Company will be successful in its defense of this action and in its counterclaims.  Proceeds of this suit, if any, will be recorded in the period when received.

NOTE 9 – DISCONTINUED OPERATIONS

On November 8, 2010, the Company elected to discontinue selling toner related products and sold substantially all of its toner assets to Katun Corporation of one of its Subsidiaries, including inventory, fixed assets and intangibles, including its business name and trademarks, for approximately $11 million cash.  Of this purchase price approximately $1.1 million is to be held in escrow for a fifteen month period to cover indemnity claims as more fully described in the agreement.  The Company subsequently entered into a licensing arrangement with Katun whereby it could continue to use the corporate name and other intellectual property.  The Company recorded a net gain from this transaction of $2,869,440 (net of a tax provision of $244,560).  The Company has reclassified all of its activity related to the toner business as discontinued operations for all periods presented prior to the sale.

In connection with this transaction the Company terminated several employees and accepted the resignations of the Company’s Chief Executive Officer and Chief Financial Officer.  The Company incurred total severance expense in the amount of $1,682,427.  $536,725 of this severance will be paid by May of 2011.

Upon the completion of the sale to Katun, the Company entered into a three year distribution agreement with Katun whereby Katun became the exclusive worldwide distributor of all of the Company’s solid ink products.


MEDIA SCIENCES INTERNATIONAL, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
 
NOTE 9 – DISCONTINUED OPERATIONS (CONTINUED)

Assets of discontinued operations are summarized as follows:

   
November 8, 2010
   
June 30, 2010
 
Inventories, net
  $ 4,501,160     $ 4,055,235  
Prepaid assets
    130,748       39,419  
Property and Equipment, net
    832,300       722,908  
Goodwill, net
    2,464,159       2,464,159  
   Assets of discontinued operations
  $ 7,928,367     $ 7,281,721  


Summarized statement of operations data for discontinued operations are as follows:

   
Three months ended
December 31,
   
Six months ended
December 31,
 
   
2010
   
2009
   
2010
   
2009
 
Net sales
  $ 1,309,613     $ 3,344,215     $ 3,927,636     $ 6,565,531  
Pre-tax income (loss) from discontinued operations
  $ (168,003 )   $ 1,039,634     $ 336,110     $ 1,901,618  
Income tax expense (benefit)
    (40,000 )           161,645        
Gain on sale
  $ 3,114,133           $ 3,114,133        
Income tax expense
    244,693             244,693        
Income from discontinued operations, net of income taxes
  $ 2,741,437     $ 1,039,634     $ 3,043,905     $ 1,901,618  


NOTE 10 – CUSTOMER CONCENTRATIONS

During the three and six months ended December 31, 2010, three customers represented 11%, 42%, and 14% of the Company’s net revenues and four customers represented 12%, 24%, 19% and 10% of the Company’s net revenues, respectively. Among this group, the largest customer represents 79% of accounts receivable at December 31, 2010.  During the three and six months ended December 31, 2009, three customers represented 18%, 22%, and 15% of the Company’s net revenues and 15%, 22%, and 17% of the Company’s net revenues, respectively.  This group represented 17%, 17% and 16% of the Company’s accounts receivable at December 31, 2009.


ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
                 RESULTS OF OPERATIONS

FORWARD LOOKING STATEMENTS

Our disclosure and analysis in this report contain forward-looking information, within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, about our financial results and estimates, business prospects and products in development that involve substantial risks and uncertainties.  You can identify these statements by the fact that they do not relate strictly to historic or current facts. These forward-looking statements use terms such as "believes," "expects," "may", "will," "should," "anticipates," "estimate," "project," "plan," or "forecast" or other words of similar meaning relating to future operating or financial performance or by discussions of strategy that involve risks and uncertainties.  From time to time, we also may make oral or written forward-looking statements in other materials we release to the public.  These forward-looking statements are based on many assumptions and factors, and are subject to many conditions, including, but not limited to, our continuing ability to obtain additional financing, dependence on contracts with suppliers and major customers, competitive pricing for our products, demand for our products, changing technology, our introduction of new products, industry conditions, anticipated future revenues and results of operations, retention of key officers, management or employees, prospective business ventures or combinations and their potential effects on our business.  Our actual results, performance or achievements could differ materially from the results expressed in, or implied by, these forward-looking statements.  Forward-looking statements are made based upon management's current expectations and beliefs concerning future developments and their potential effects upon our business.

We cannot guarantee that any forward-looking statement will be realized, although we believe we have been prudent in our plans and assumptions. We cannot predict whether future developments affecting us will be those anticipated by management, and there are a number of factors that could adversely affect our future operating results or cause our actual results to differ materially from the estimates or expectations reflected in such forward-looking statements.  Factors that might cause or contribute to such differences include, but are not limited to, those discussed in this section and those set forth in Item 6, “Factors Affecting Results Including Risks and Uncertainties” included in  our Form 10-K for the year ended June 30, 2010, filed September 28, 2010.  You should carefully review these risks and also review the risks described in other documents we file from time to time with the SEC.  You are cautioned not to place undue reliance on these forward-looking statements.  We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise.

You should read the following discussion and analysis in conjunction with the information set forth in the unaudited financial statements and notes thereto, included elsewhere herein, and the audited financial statements and the notes thereto, included in our Form 10-K for the year ended June 30, 2010, filed September 28, 2010.
 
 
EXECUTIVE SUMMARY

Media Sciences International, Inc. is the leading independent manufacturer of solid inks for use in business color printers and industrial printing applications.

During the second quarter of our fiscal year our board of directors determined that the Company should exit the toner business.  As a result the Company entered into an agreement with the Katun Corporation and one of its subsidiaries whereby Katun purchased substantially all of the toner business assets including inventory, fixed assets, our trade name, goodwill and other intangibles for approximately $11 million. We subsequently entered into an agreement where we can utilize certain of these intangibles including the trade name for a two year period. We also entered into an exclusive distribution agreement with Katun under which Katun distributes our solid ink products through their distribution network including our former customers. This changed the complexion of our Company both in size and product mix. We also saw our senior management team leave during the course of the quarter and a new Chief Executive Officer and Chief Financial Officer were appointed to lead the Company in its current form.


Because of the manner in which we now conduct our business, we have been able to significantly change the size of our organization by substantially reducing or eliminating headcount and other expenses in sales, toner related research and development, general management, product management, marketing, distribution logistics and Asian operations.  The resulting company, while smaller, is well capitalized, positioned well within its industry, partnered with a distribution channel with a large and strong sales organization, and scaled to revenue.

As a result of our new distribution agreement we received a significant initial stocking order which was the primary reason for an increase in sales from continuing operations of 23% and 7%, respectively, for the three and six months ended December 31, 2010.

Our gross margins have been favorably affected by the decrease in product warranty expense and our ability to absorb our fixed costs over a larger revenue base.  Reducing warranty expense has been, and remains, a high priority for the organization.

RESULTS OF OPERATIONS


For the six months ended December 31, 2010, as compared to the same period last year, net revenues increased by $317,000 or 7% from $4,528,000 to $4,845,000.  This increase is primarily a result of the size of the initial stocking order from our new distributor.  The effect of foreign currency changes for the six months was a reduction in revenues of $206,000.  We ended the quarter with an order backlog of $416,000.  For the comparative year ago period, we had $217,000 of order backlog at December 31, 2009.


Consolidated gross profit for the six months ended December 31, 2010, compared to the same period last year, increased by $275,000 or 15% to $2,162,000 from $1,887,000.  For the six months ended December 31, 2010, our gross margins increased to 44.6% from $41.7% in the comparative year ago period.  The year-over-year increase in our gross profit and margins for the six months was similar to the reasons for our increase during the three months ended December 31, 2010.

Our margins reflect two main products.  Generally, our non-industrial solid ink products generate greater margins than do our industrial inks.  As a result, our margins can vary as a function of the industrial to non-industrial solid ink sales mix.  We expect to see changes in our margins, dependent upon changes in our sales mix.




The sale of the toner business resulted in a significant changes in the size, complexity and nature of operations of the Company.  As a result, the Company changed its senior management team and many other functions were eliminated, accordingly, personnel and related costs were significantly reduced during the three and six month period ended December 31, 2010.  The Company did record a severance expense of approximately $1.7 million related to the organizational changes.

 
Interest Expense.>   For the three and six months ended December 31, 2010, we incurred interest expense of $60,000 and $135,000, respectively.  This compares with interest expense of $90,000 and $177,000, respectively, for the prior year’s three and six months ended December 31, 2009.  These changes were the result of year-over-year decreases in the Company’s level of debt, including the repayment of the Company’s bank revolving credit facility, offset by higher interest rates.

Income Taxes.>   For the three months ended December 31, 2010, we recorded income tax benefits of $1,142,000.  This compares with income tax benefits of $16,000, for the three months ended December 31, 2009.  For the six months ended December 31, 2010, we recorded income tax benefits of $1,303,000.  This compares with income tax benefits of $99,000, for the six months ended December 31, 2009.   As a result of the sale of the toner business and the related goodwill, the Company no longer needed to provide for the exposure related to its indefinitely lived intangibles and adjusted its deferred taxes accordingly.  Additionally, as a result of the gain on the sale of the toner business, the Company reduced certain of its valuation allowances resulting in a tax benefit from continuing operations and an offsetting tax provision recorded against the gain on discontinued operations.

Discontinued Operations.  Discontinued operations are related to toner products that were sold to Katun Corporation.  We had a loss from discontinued operations of $128,000 for the three month period ended December 31, 2010 and an income from discontinued operations of $174,000 for the six month period ended December 31, 2010.  For the comparable year ago period, we had income of $1,040,000 and $1,902,000 for the three and six month period ended December 31, 2009, respectively.  We recorded a gain on the sale of the toner assets, net of taxes, of $2,869,000 during the three months ended December 31, 2010.  Certain amounts reflected in the accompanying Unaudited Condensed Consolidated Financial Statements for the three and six months ended December 31, 2010 and 2009, have been adjusted to classify the results as discontinued operations.


RECENT ACCOUNTING PRONOUNCEMENTS

See Note 2 to the condensed consolidated financial statements, included in Item 1 of Part I of this report, for a full description of recent accounting pronouncements, including the expected dates of adoption and estimated effects on our consolidated financial statements, which is incorporated herein by reference.

CRITICAL ACCOUNTING POLICIES

For a description of our critical accounting policies see Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 1 to the audited financial statements included in our Form 10-K for the year ended June 30, 2010 filed September 28, 2010.  There were no significant changes in our critical accounting policies during the three months ended December 31, 2010.   


LIQUIDITY AND CAPITAL RESOURCES

During the three months ended December 31, 2010, our cash and equivalents increased by $5,198,000 to $5,516,000.  Operating activities used $2,128,000 while investing activities provided $9,711,000 and financing activities utilized $2,341,000.  Net cash provided in investing activities of $9,711,000 included the proceeds from the sale of plant equipment and tooling, and purchases of property and equipment.  Purchases of property and equipment represented an increase of $148,000 or 178% over the $83,000 invested during the comparative six months year ended December 31, 2009.  Proceeds from the sale of the toner business were $11,042,500, including restricted cash.

We utilized $2,128,000 of cash in our operating activities for the six months ended December 31, 2010 as compared to utilizing $323,000 during the comparative six months ended December 31, 2009.  The $2,128,000 of cash used by operating activities during the six months ended December 31, 2010 resulted from a $1,506,000 income from operations, non-cash charges totaling $577,000, a gain from the sale of operating toner assets of $2,869,000, and $187,000 of cash utilized as a result of an increase in our non-cash working capital (current assets less cash and cash equivalents net of current liabilities).  The most significant drivers behind the $187,000 decrease in our non-cash working capital include:  (1) a $571,000 decrease in our trade obligations and other accrued expenses; (2) a $440,000 decrease in our accounts receivable; (3) a $88,000 increase in accrued compensation and benefits and severance; and (4) a decrease in accrued product warranties of $147,000.

As a result of the sale of the toner business the Company terminated its then existing credit facility with Sovereign Bank.  Although the Company believes it currently has sufficient working capital to maintain and grow its business in its current shape and form, it may, at a future time, determine that it will need to obtain another credit facility from a financial institution or other funding source.  There can be no guaranty that the Company will be able to obtain that facility and such failure may adversely impact the Company.

SEASONALITY

Historically we have experienced some seasonality in our business, which may increase with the growing significance of our new sole distribution arrangement for the non-industrial solid ink products.  Accordingly, we may experience a more notable level of seasonality, especially during the summer months and other periods such as calendar year end.

MARKET RISK

We are exposed to various market risks, including changes in foreign currency exchange rates and commodity price inflation.  Market risk is the potential loss arising from adverse changes in market rates and prices, such as foreign currency exchange, commodity price inflation and interest rates.  We do not hedge our foreign currency exposures and we had no forward foreign exchange contracts outstanding as of December 31, 2010.  In the future we may hedge these exposures based on our assessment of their significance.

Foreign Currency Exchange Risk

A small portion of our business is conducted in countries other than the U.S.  We are primarily exposed to changes in exchange rates for the euro and the British pound.  At December 31, 2010, approximately 92% of our receivables were invoiced and collected in U.S. dollars.

See the discussion above under the heading "Executive Summary" in Item 2 of this report regarding the impact during the current reporting periods of changes in foreign exchange rates.



Commodity Price Inflation Risk

Over the last twelve months, we have experienced increases in raw material costs and the costs of shipping and freight to deliver those materials and finished products to our facility and, where paid for by us, shipments to customers.  While we have historically offset a significant portion of this inflation in operating costs through increased productivity and improved yield, recent increases have impacted profit margins.  We are pursuing efforts to improve our procurement of raw materials.  We can provide no assurance that our efforts to mitigate increases in raw materials and shipping and freight costs will be successful.

Interest Rate Risk

At December 31, 2010, we did not have debt outstanding under any lines of credit or term notes.


ITEM 3.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Reference is made to the information set forth under the caption “Market Risk” included in Item 2 of Part I of this report, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”  Also refer to the last paragraph of “Liquidity and Capital Resources” contained in Item 2 of Part I this report for additional discussion of issues regarding liquidity.
 
ITEM 4.   CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures.  As required by Rule 13a-15(b) under the Exchange Act, our management, with the participation of our Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of our disclosure controls and procedures (as such term is defined in Rule 13a-15(e) under the Exchange Act) as of the end of the period covered by this report.  Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in the reports that it files or submits 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, and is accumulated and communicated to the Company's management, including its Chief Executive Officer and Chief Financial Officer, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure.

Changes in Internal Control Over Financial Reporting.  There has been no change in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) under the Exchange Act, that occurred during the quarter ended December 31, 2010, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.


PART II.  OTHER INFORMATION

ITEM 1.   LEGAL PROCEEDINGS

The information set forth above under Note 8 contained in the “Notes to condensed consolidated financial statements” in Item 1 of Part I of this report is incorporated herein by reference.

ITEM 1A.   RISK FACTORS

A description of factors that could materially affect our business, financial condition or operating results is included in Item 1A “Risk Factors” of our Form 10-K for the year ended June 30, 2010, filed September 28, 2010 and is incorporated herein by reference.

ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Not applicable.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4.  (REMOVED AND RESERVED)

Not applicable.

ITEM 5.  OTHER INFORMATION

Not applicable.

ITEM 6.   EXHIBITS

The following exhibits are filed with this report:
 
Exhibit No.
 
Description
31.1*
 
Certification of Chief Executive Officer Pursuant to Securities Exchange Act Rule 13a-14(a)/15d-14(a)
31.2*
 
Certification of Chief Financial Officer Pursuant to Securities Exchange Act Rule 13a-14(a)/15d-14(a)
32.1*
 
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350
32.2*
 
Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350
* Filed herewith



Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 
MEDIA SCIENCES INTERNATIONAL, INC.
     
Dated: February 14, 2011
By:
/s/ Marc D. Durand
 
   
Marc D, Durand
 
   
Chief Executive Officer
 
       
Dated: February 14, 2011
By:
/s/ Denise Hawkins
 
   
Denise Hawkins
 
   
Chief Financial Officer
 
       



 
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