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TMCNet:  NETWORK 1 TECHNOLOGIES INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

[March 21, 2014]

NETWORK 1 TECHNOLOGIES INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) OVERVIEW Our principal business is the development, licensing and protection of our intellectual property assets. We presently own twenty-two (22) patents that relate to various technologies including patents covering (i) the delivery of power over Ethernet cables for the purpose of remotely powering network devices, such as wireless access ports, IP phones and network based cameras; (ii) foundational technologies that enable unified search and indexing, displaying and archiving of documents in a computer system; (iii) enabling technology for identifying media content on the Internet and taking further action to be performed based on such identification including, among others, the insertion of advertising and the facilitation of the purchase of goods and services related to such content; and (iv) systems and methods for the transmission of audio, video and data in order to achieve high quality of service (QoS) over computer and telephony networks. In addition, we continually review opportunities to acquire or license additional intellectual property. Our strategy is to pursue licensing arrangements with companies in industries that manufacture and sell products that make use of the technologies underlying our intellectual property as well as with other users of the technologies who benefit directly from the technologies including corporate entities and educational institutions.


We have been actively engaged in the licensing of our patent (U.S. Patent No.

6,218,930) covering delivery of power over Ethernet cables (the "Remote Power Patent"). As of March 1, 2014, we had entered into sixteen (16) license agreements with respect to our Remote Power Patent which, among others, include license agreements with Cisco Systems, Inc. and Cisco Linksys, LLC, Extreme Networks, Inc., Netgear, Inc., Microsemi Corporation, Motorola Solutions, Inc.

and NEC Corporation and several other major data networking equipment manufacturers (see Notes I[2] and I[3] to our financial statements included in this Annual Report). We have a pending litigation against eleven (11) data networking equipment manufacturers for infringement of our Remote Power Patent (see Note I[2] to our financial statements included in this Annual Report). Our current strategy includes continuing our licensing efforts with respect to our Remote Power Patent and efforts to monetize the two patent portfolios (the Cox Patent Portfolio and the Mirror Worlds Patent Portfolio) we acquired in 2013 (see "Business-Patents Related to Identification of Media on the Internet" and "Business - Patents Covering Document Stream Operating Systems" on pages 6-8 of this Annual Report). In addition, we continue to seek to acquire additional intellectual property assets to develop, commercialize, license or otherwise monetize such intellectual property. Our strategy includes working with inventors and patent owners to assist in the development and monetization of their patented technologies. We may also enter into strategic relationships with third parties to develop, commercialize, license or otherwise monetize their intellectual property. The form of such relationships may differ depending upon the opportunity and may include, among other things, a strategic investment in such third party, the provision of financing to such third party or the formation of a joint venture with such third party or others for the purpose of monetizing their intellectual property assets.

30 --------------------------------------------------------------------------------Our acquisition strategy is to focus on acquiring high quality patents which management believes have the potential to generate significant licensing opportunities as we have achieved with respect to our Remote Power Patent. Our Remote Power Patent has generated licensing revenue of an aggregate of $58,467,000 from May 2007 through December 31, 2013. In 2013 we acquired an aggregate of thirteen (13) additional patents and six (6) pending patent applications.

On February 28, 2013, as part of our acquisition strategy, we acquired from Dr.

Ingemar Cox, a technology leader in digital watermarking content identification, digital rights management and related technologies, four (4) patents (as well as a pending patent application) for a purchase price of $1,000,000 in cash and 403,226 shares of our common stock. In addition, we are obligated to pay Dr. Cox 12.5% of the net proceeds generated by us from licensing, sale or enforcement of the patents (see Note D[2] to our financial statements included in this Annual Report). In January 2014 and February 214, we were issued two additional patents (U.S. Patent No. 8,640,179 and U.S. Patent No. 8,656,441) by the United States Patent and Trademark Office related to the Cox Patent Portfolio.

On May 21, 2013, Mirror Worlds Technologies, LLC, our wholly-owned subsidiary, acquired all of the patents previously owned by Mirror Worlds, LLC (which subsequently changed its name to Looking Glass LLC) including nine (9) issued United States patents and five (5) pending applications covering foundational technologies that enable unified search and indexing, displaying and archiving of documents in a computer system (the "Mirror Worlds Patent Portfolio"). The consideration we paid for the Mirror Worlds Patent Portfolio consisted of (i) $3,000,000 in cash, (ii) 5-year warrants to purchase 875,000 shares of our common stock at $1.40 per share, and (iii) 5-year warrants to purchase 875,000 shares of our common stock at $2.10 per share (see Note D[2] to our financial statements included in this Annual Report). As part of the acquisition of the Mirror Worlds Patent Portfolio, we also entered into an agreement with Recognition Interface, LLC ("Recognition"), an entity that financed the commercialization of the Mirror Worlds Patent Portfolio prior to its sale to Mirror Worlds, LLC and also retained an interest in the licensing proceeds of the patent portfolio held by Mirror Worlds, LLC. Pursuant to the terms of our agreement with Recognition, Recognition received (i) 5-year warrants to purchase 250,000 shares of our common stock at $1.40 per share, and (ii) 5-year warrants to purchase 250,000 shares of our common stock at $2.10 per share. Recognition also received from us an interest in the net proceeds realized from the monetization of the Mirror Worlds Patent Portfolio as follows: (i) 10% of the first $125 million of net proceeds, (ii) 15% of the next $125 million of net proceeds, and (iii) 20% of any portion of the net proceeds in excess of $250 million. In addition, Abacus and Associates, Inc., an entity affiliated with Recognition, received a 60-day warrant to purchase 500,000 shares of our common stock at $2.05 per share which it exercised in full on July 22, 2013 resulting in proceeds to us of $1,025,000. As a result of such warrant exercise and in accordance with our agreement with Recognition, we issued additional warrants to Recognition to purchase an aggregate of 250,000 shares of our common stock (125,000 shares at an exercise price of $2.10 per share and 125,000 shares at an exercise price of $1.40 per share) (see Note D[2] to our financial statements included in this Annual Report).

31--------------------------------------------------------------------------------On May 22, 2013, through our wholly-owned subsidiary, Mirror Worlds Technologies, LLC, we initiated patent litigation against Apple, Inc., Microsoft, Inc., Hewlett-Packard Company, Lenovo Group Ltd., Lenovo (United States), Inc., Dell, Inc., Best Buy Co., Inc., Samsung Electronics America, Inc.

and Samsung Telecommunications America L.L.C., in the United States District Court for the Eastern District of Texas, Tyler Division, for infringement of U.S. Patent No. 6,006,227 (part of the Mirror Worlds Patent Portfolio we acquired) (see "Legal Proceedings" at page 24 hereof).

In September 2011, we initiated patent litigation against sixteen (16) data networking equipment manufacturers in the United States District Court for the Eastern District of Texas, Tyler Division, for infringement of our Remote Power Patent (see "Legal Proceedings" at pages 25-26 hereof). During the year ended December 31, 2012 and 2013 we settled the litigation against five (5) of the defendants. On January 25, 2013, certain defendants in the aforementioned litigation filed a motion to stay the litigation pending completion or termination of the Inter Partes Review proceedings at the United States Patent and Trademark Office (see below and Notes I[2] and I[5] to the financial statements included in this Annual Report). On March 5, 2013, the Court granted certain defendants' motion and stayed the litigation pending the disposition of the Inter Partes Review proceedings.

As a result of a settlement in July 2010 of certain patent litigation we had initiated against Cisco Systems, Inc. and Cisco-Linksys, LLC (collectively "Cisco"), we entered into non-exclusive licenses for our Remote Power Patent with Cisco and the other defendants. For the years ended December 31, 2013 and December 31, 2012, our royalty revenue from Cisco constituted 77% of our revenue. Due to our annual royalty rate structure with Cisco which includes declining rates as the volume of PoE product sales increase during the year, royalties from Cisco are anticipated to be highest in the first quarter of the calendar year and decline for each of the remaining calendar quarters of the year.

On July 20, 2012, an unknown third party filed with the United States Patent and Trademark Office ("USPTO") a request for ex parte reexamination of certain claims of our Remote Power Patent. On September 5, 2012, the USPTO issued an order granting the reexamination. The request for reexamination was stayed by the USPTO on December 21, 2012 pending the termination or completion of the Inter Partes Review proceedings at the USPTO involving our Remote Power Patent. Avaya Inc., Dell Inc., Sony Corporation of America and Hewlett Packard Co. are petitioners in Inter Partes Review proceedings (which were joined together) (the "IPR Proceeding") pending at the USPTO before the Patent Trial and Appeal Board (see "Legal Proceedings" at page 26 of this Annual Report). A hearing on the merits of the IPR Proceeding was held on January 9, 2014 and a decision is pending. Petitioners in the IPR Proceeding seek to cancel certain claims of the Remote Power Patent as unpatentable. In the event that the USPTO reaches a final determination in the IPR Proceeding or the ex parte reexamination (referenced above) that our Remote Power Patent is invalid, such a determination (unless overturned by the United States Court of Appeals for the Federal Circuit) would have a material adverse effect on our business, financial condition and results of operations as our entire current revenue stream is dependent upon the continued validity of our Remote Power Patent.

32--------------------------------------------------------------------------------At December 31, 2013, we had net operating loss carryforwards (NOLs) totaling approximately $25,239,000 expiring through 2029, with a future tax benefit of approximately $8,581,000. At December 31, 2013 and 2012, $5,659,000 and $6,194,000, respectively, was recorded as a deferred tax asset on our balance sheet. During the year ended December 31, 2013, as a result of income (before taxes) for the year of $1,561,000, $545,000 was recorded as income tax expense and the deferred tax asset was reduced by $535,000 to $5,659,000. To the extent that we earn income in the future, we will report income tax expense and such expense attributable to federal income taxes will reduce the recorded income tax asset reflected on the balance sheet. Management will continue to evaluate the recoverability of the NOL and adjust the deferred tax asset appropriately. Utilization of NOL credit carryforwards can be subject to a substantial annual limitation due to ownership change limitations that could occur in the future, as required by Section 382 of the Internal Revenue Code of 1986, as amended, as well as similar state provisions.

RESULTS OF OPERATIONS Year Ended December 31, 2013 Compared To Year Ended December 31, 2012 Revenue. We had revenue of $8,017,000 or a 7.8% decrease for the year ended December 31, 2013 ("2013") as compared to revenue of $8,698,000 for the year ended December 31, 2012 ("2012"), which was related to the receipt of royalties pursuant to license agreements for our Remote Power Patent. The decrease in revenue of $681,000 for 2013 was primarily due to decreased royalties from our licensees and greater license initiation fees achieved from patent litigation settlements of $645,000 for 2012 as compared with $258,000 of such license initiation fees for 2013.

Cost of Revenue. We had a cost of revenue of $2,359,000 and $2,602,000 for 2013 and 2012, respectively. Included in the cost of revenue for 2013 were contingent legal fees of $1,858,000 payable to our patent litigation counsel (see Note D[1] to our financial statements included in this Annual Report) and $397,000 of incentive (royalty bonus) compensation payable to our Chairman and Chief Executive Officer pursuant to his employment agreement (see Note H[1] to our financial statements included in this Annual Report). Included in the cost of revenue for 2012 were contingent legal fees of $2,070,000 payable to our patent litigation counsel and $435,000 of incentive (royalty bonus) compensation payable to our Chairman and Chief Executive Officer pursuant to his employment agreement.

Gross Profit. The gross profit for 2013 was $5,658,000 as compared to $6,096,000 for 2012. The decrease in gross profit of $438,000 or 7.2% for 2013 was primarily due to decreased royalties from our licensees.

Operating Expenses. Operating expenses for 2013 were $4,133,000 as compared to $2,763,000 for 2012. General and administrative expenses include overhead expenses, and finance, accounting, legal and other professional services incurred by us. General and administrative expenses increased by $288,000 from $2,438,000 for 2012 to $2,735,000 for 2013, due primarily to increased legal fees related to our patent litigations. Amortization of patents was $1,008,000 for 2013 compared to $9,000 in 2012. The increased cost of amortization of patents in 2013 was due to our acquisition of thirteen (13) additional patents in 2013. Non-cash compensation expense related to the issuance of stock options was $390,000 for 2013 as compared to $316,000 for 2012.

33 --------------------------------------------------------------------------------Interest Income. Interest income for 2013 was $36,000 as compared to interest income of $39,000 for 2012.

Operating Income. We had an operating income of $1,525,000 for 2013 compared with an operating income of $3,333,000 for 2012. The decrease in operating income of $1,808,000 was primarily due to increased patent amortization expense, decreased revenue and increased legal costs and non-cash compensation expense.

Income Taxes (Benefit). A provision (benefit) for federal, state and local income taxes of $545,000 were recorded for 2013 which included $535,000 reduction in our deferred tax asset to $5,659,000. A provision for federal, state and local income taxes were recorded for 2012 of $746,000 which included a $709,000 reduction in our deferred tax asset.

Deferred Tax Benefit/NOLs. At December 31, 2013, we had net operating loss carryforwards (NOLs) totaling approximately $25,239,000 expiring through 2029, with a future tax benefit of approximately $8,581,000. At December 31, 2013 and 2012, $5,659,000 and $6,194,000, respectively, was recorded as a deferred tax asset on our balance sheet. During the year ended December 31, 2013, as a result of income (before taxes) for the year of $1,561,000, $545,000 was recorded as income tax expense and the deferred tax asset was reduced by $535,000 to $5,659,000. To the extent that we earn income in the future, we will report income tax expense and such expense attributable to federal income taxes will reduce the recorded income tax asset reflected on the balance sheet. Management will continue to evaluate the recoverability of the NOL and adjust the deferred tax asset appropriately. Utilization of NOL credit carryforwards can be subject to a substantial annual limitation due to ownership change limitations that could occur in the future, as required by Section 382 of the Internal Revenue Code of 1986, as amended, as well as similar state provisions.

Net Income (Loss). As a result of the foregoing, we realized net income of $1,016,000 or $0.04 per share (basic) and $0.04 (diluted) for 2013 compared with net income of $2,626,000 or $0.10 per share (basic) and $0.09 per share (diluted) for 2012.

LIQUIDITY AND CAPITAL RESOURCES We have financed our operations primarily from royalty revenue from licensing our Remote Power Patent and cash on hand. In accordance with our patent litigation settlement achieved in July 2010, we received aggregate upfront payments of approximately $32 million (net proceeds of $22 million after payment of legal fees, expenses and bonus compensation) and Cisco Systems, Inc. agreed to pay us quarterly royalties (which began for the first quarter of 2011) (see Note I[3] to our financial statements included in this Annual Report). At December 31, 2013 our principal sources of liquidity consisted of cash and cash equivalents of approximately $18,938,000 and working capital of approximately $19,794,000. We believe based on our current cash position and projected licensing revenue from our existing license agreements that we will have sufficient cash to fund our operations for the foreseeable future, although this may not be the case.

34 --------------------------------------------------------------------------------Working capital decreased by $2,908,000 to $19,794,000 at December 31, 2013 as compared to working capital of $22,702,000 at December 31, 2012. The decrease in working capital was primarily due to the cost of patent acquisitions which included cash payments to the sellers of an aggregate of $4,000,000 offset by proceeds from the exercise of stock options and warrants of $1,097,000.

We maintain our cash primarily in money market accounts. We do not have any derivative financial instruments. Accordingly, we do not believe that our investments have significant exposure to interest rate risk.

OFF-BALANCE SHEET ARRANGEMENTS We do not have any off-balance sheet arrangements.

CONTRACTUAL OBLIGATIONS We do not have any long-term debt, capital lease obligations, operating lease obligations, purchase obligations or other long-term liabilities except for the lease obligations set forth in Note D[5] to our financial statements included in this Annual Report.

Critical Accounting Policies: Patents: We own patents that relate to various computing, telecommunications, data networking and Internet related technologies. We capitalize the costs associated with acquisition, registration and maintenance of the patents and amortize these assets over their remaining useful lives, ranging from three (3) years to fifteen (15) years on a straight-line basis. Any further payments made to maintain or develop the patents would be capitalized and amortized over the balance of the useful life for the patents.

Revenue Recognition: We recognize revenue received from the licensing of our intellectual property in accordance with Staff Accounting Bulletin No. 104, "Revenue Recognition" ("SAB No. 104") and related authoritative pronouncements. Under this guidance, revenue is recognized when (i) persuasive evidence of an arrangement exists, (ii) all obligations have been performed pursuant to the terms of the license agreement, (iii) amounts are fixed or determinable and (iv) collectability of amounts is reasonably assured.

Income Taxes: We utilize the liability method of accounting for income taxes. Under such method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect at the balance sheet date. The resulting asset or liability is adjusted to reflect enacted changes in tax law. Deferred tax assets are reduced, if necessary, by a valuation allowance when the likelihood of realization is not assured.

35 --------------------------------------------------------------------------------Effect of New Accounting Pronouncements.

See Note B[14] to our financial statements included in the Annual Report.

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