Stanton Ross - Chairman and Chief Executive Officer Thomas Heckman - Chief Financial Officer, Treasurer and Secretary

Vincent Colicchio - Noble Financial

Good morning, and welcome to the Digital Ally Incorporated first quarter 2014 operating results conference call. (Operator Instructions) Earlier today, Digital Ally Incorporated issued a press release that included certain cautionary language with respect to forward-looking statements. The company would ask you to review the language in the press release, regarding forward-looking statements as they are equally applicable to any forward-looking statements made during this conference call. Please note this event is being recorded. I would now like to turn the conference over to Stan Ross, CEO. Mr. Ross?

Thank you very much. And thank you, everybody, for joining us today. I've got a little breaking news that I look forward to sharing with you all at the end of the call. Digital Ally, as you know, has spend a lot of time and energy and effort in regards to always trying to be a leader out there in regards to product development and the quality of products that we deliver to law enforcement. I will share a little more about some of our latest breakthroughs and announcements that we look to have presenting to us here in the coming days. But first, I'd like to introduce Tom Heckman, who is the company's CFO, and let him do a quick recap of the quarterly numbers. Tom?

Thank you, Stan, and welcome to everybody. I appreciate you joining us today to go over the first quarter results. I do, however, wan to let you know that we did file the Form 10-Q with the Commission yesterday evening, and it should be available for everybody to review. It will be a much more complete review of the quarter and what happened to us, our high points, low points what have you than what I'm going to go through today. I also want to direct your attention to the fact that we did file Form S-3 this morning. The Form S-3 was required by the convertible notes that we issued in March of 2014, and I'll go over some of the major terms of that a little later in the conference call, but we did file the Form S-3 this morning. I don't know, if everyone has had a chance to look at it or not, but it basically is registering the shares that would be required, if and when the holder of the convertible note converts his notes to equity or if we would choose to do a paid-in-kind on the principal or interest payments, if we paid-in-kind in the form of stock. So anyway, I'll talk more about the terms of the convertible note a little later in this call. Let's begin with the first quarter operating results. First of all, we had an operating loss of $546,000 for the first quarter. Obviously, management and the directors are disappointed from the overall results. Quite frankly, it's not what we expected and it's not acceptable to either the board or to Stan and I, for those type of operating results. It does show a deterioration from a year ago, where we reported $181,000 operating earnings. And what I want to do is recognize that we did show a deterioration from a year ago, however, much has happened in the past years that makes a comparison to the year-ago period, very difficult and somewhat meaningless, when you understand what's happened to us and what's happened to the market in the intervening period. During that period we've introduced several new products. We've done a full changeover to an employee base sales system versus a third-party contractor system. We've had patent challenges with a company called Utility Associates that raised its head in mid-2013. We've been granted several patents or sales during that period of time. We also endured a budget sequester and eventually a shutdown of the government late in 2013. So much has happened in the last year. And for that reason, what I'd like to do is compare our Q1 results to Q4 2013 in my call today. Basically, Q4 or the fourth quarter of 2013 really represent a low point for digital. That was really abnormal when compared to the previous periods, but it did happen and we did endure that quarter, which was the fourth quarter. When you compare Q1 2014 operating results to Q4 2013, it shows the following: revenues improved 11%; gross margins improved to 59.4% versus 49.9%, almost a full 10 percentage points improvement in the gross margin; our total SG&A expense decreased by 14%; our operating loss was reduced by 65%; overall net loss improved by 47%; and EBITDA, what we've returned as cash flow, improved by 47%, all that when comparing Q1 of 2014 to Q4 of 2013. Overall, the way we view it and the way I like to present it is that Q1 2014 is a step in the total process of restoring profitability for Digital Ally. We still have steps to go, but its important first step where we reverse the negative trends that we saw in Q4. The revenue improvement that we showed in Q1 is composed of basically the domestic law enforcement market improved by $800,000 quarter-over-quarter. I think that really shows that the budget sequester and the shutdown as well as the Utility patent threats are subsiding and not affecting our business the way they had. International sales, though, declined $340,000. We only had roughly $20,000 in international revenues in Q1 versus mid-$300,000 in Q4. And we talked about that before international revenues are very spotty and sporadic. We are still bullish medium-to-longer term on a number of very large prospects internationally. And I think I really do believe that the international decline in revenue was a result of timing issues only and not anything permanent or trend that we're expecting to continue at all. During the quarter, the DVM-800, now, remember the DVM-800 was not launched commercially until the last week of December 2013. So the first quarter of 2014 was its first full quarter of sales and it represented on a revenue basis 27% of total Q1 revenues. It was our second leading product in terms of revenue generation. It was number one in terms of units sold. So quite a showing for the DVM-800, I think that really shows us and hopefully our investors that the DVM-800 is every bit as dominant as we thought it was. And it is taking market share from our competitors and our competitors are having a hard time dealing with the disruption that this thing is causing from a warranty standpoint. We are offering a five-year warranty with it. To the pricing standpoint, where the pricing is less than $4,000, and the features it provides, I really believe, we've got a wear on that DVM-800 and its showing that in the first quarter. What's happen with that, though, we're having a little bit of difficulty honestly in delivering all the DVM-800s. We've got to build out our supply chain obviously to fulfill those orders and we're having a little bit of difficulty in that regard. We've got some backlog at this time that we think we'll work through before the end of Q2. But that's a good problem to have and we like to deal with that everyday, if we have to. The FirstVU is gaining traction, but it's still somewhat disappointing in terms of sale closings. There are a lot of opportunities out there some of them very, very large that we continue to track after and we believe we're the preferred vendor, but we have not yet been awarded those contracts. And hopefully we can take that thing to provision in the second quarter and third quarter of 2014. But to date, the FirstVU HD sales have not lived up the expectations, but the opportunities have lived up the expectations and we hope to get our fair share of those opportunities. We're also just now in the midst of launching our VuLink product. The VuLink being the bidirectional trigger between our FirstVU and our in-car video systems, we think that product alone will spur sales of both FirstVU HD and our in-car video systems, now that there are linked. No one else in the market has that type of product. The gross margin improvement, like I said, we almost improved 10 full percentage points in our margin from Q4 to Q1. That's primarily the result of the sales mix changing to the higher margin DVM-800. We hope that continues. Remember the DVM-800 is a lower retail price point than our legacy systems, but the margins are much improved from our legacy system. So what that will tell you is that the revenues will not increase as much as our gross margins because of that. We also see continued supply chain improvement in all of our products that we've been working on for a number of years here, and it's coming to fruition. The SG&A expense improvement that was primarily in two areas. The first one was a $122,000 reduction in our R&D expense. As we spoke before, we've had a number of projects that have gone full cycle that including the FirstVU HD as well as the DVM-800, but we do have some ancillary improvements and additional features that we're continuing to work on there, but the main development portion of those two products, which was substantial by the way and are completed at this time. So that's a normal reduction in R&D. We're also expecting more improvement in Q2 to more normal levels that we experienced in previous years. We also had an improvement in legal expenditures and accrual during the quarter and that declined $200,000 as well. So both of those were good developments and contributed to our SG&A expense improvement. From a P&L perspective, our issue is with revenue. $3.9 million in quarterly revenue is just not acceptable. It's not going to get us to breakeven. Breakeven is more in the mid-$4 million range, $4.2 million to $4.5 million, as we see it on a go forward basis. So we've got to improve our revenues and that's what we're focusing on at this time. Good points is the DVM-800 should continue to improve and take market share and increase our revenue generation there. The FirstVU HD is a dominant product, but it is in a new market channel. This is new technology for the police and it's just taking a while I think to get through the requisition cycle and gain market acceptance. We are in the near-term, launching our cloud-based solution, which will directly compete with Taser's, EVIDENCE.com. So we think that will also help us in improving the sales of the FirstVU HD. Our new product launches will also improve revenue, that being the VuLink, which I talked about previously. We are also launching a new commercial web-based reporting and tracking solution that will help in our commercial group being able to close larger fleet opportunities and which there's a number of them out there. That solution should be released in Q2 or early Q3. It's already generating a lot of excitement out there with our commercial fleet, potential customers, and I think we'll see some pretty quick results from that. From a balance sheet perspective, the major thing that happened during the quarter was the issuance of the $2 million in senior convertible notes that we've completed in March 2014. Let's go over some of the key provisions of that. There is a 6% cash coupon interest payment provision in there and its payable at quarter end, so that 6% coupon rate, it has a two year or 24 month term. There is no principal payments required for the first six months and thereafter it amortizes ratably over the remaining 18 months. The good thing about the amortization the principal, the company can elect, pick interest and pick principal, paid-in-kind where whenever those monthly payments come due we can elect to pay either in cash or in stock or in a combination of the two. And that's one of the reasons we were required to file the Form S-3 this morning. If and when we do elect to pay and pick interest and principal, they obviously would like the opportunity to sell those shares, if necessarily they see the market accepting of that. The holder of the convertible notes has a conversion right to convert any portion of those notes at $8.55 per share, anytime through the life of the notes, and given that notes have a term of 24 months, so $8.55 is a conversion price on those notes. The company, if the market price of our common stock goes up to $17.10, I think for 20 consecutive trading days, the company has a right to require conversion at that price. So the company has that right basically to put the conversion provision back to the holder. Also included in the offering, we were required to issue 100,000 warrants, common stock purchase warrants with an exercise price of $10 per share in a five year term, so we issued 100,000 warrants at $10 exercise price with the five year term and that was provided to the holder of the instrument. The total cost we incurred, and this includes the cost of the S-3 filing, all legal fees, printing fees, all the cash costs to issue the convertible note was roughly $225,000 and we were required to charge that off in the first quarter of 2014, so you'll see all $225,000 written-off, charged-off through the P&L in the first quarter of 2014. And the reason we were required to do that is we elected to account for the convertible debt at fair value in the financial statements. We did that for a number of reasons. We believed that with the convertible, with the conversion feature as well as the paid-in-kind feature, there were two derivatives that would have to be fair value under any provision or any accounting each quarter and that could whipsaw the P&L one way or another, either favorable or unfavorable. And really, number one it's non-cash and number two it's non-predictable. So we elected the full fair value method, which will fair value quarterly the debt and the derivatives. And whatever change occurs, which we believe will be much more manageable, much more understandable and much less in total magnitude than the other method, whatever the change in the total fair value is will be either credited to or charged-off through the P&L each quarter. So expect a little bit of, I guess strangeness in our future P&Ls due to this convertible debt feature, but remember it's primarily cashless. I mean all of this is a use of accounting and really until the warrants are actually exercised or the notes are converted, there is no transaction. This is estimating future transactions that may or may not occur. So be aware of that. As a result of the issuance of the convertible notes, you will notice that we improved our liquidity on the balance sheet. We now have about $1.4 million in cash and cash equivalents, not including the restricted cash of $662,000. Our net positive working capital is $8.3 million. And as a result, we do believe with the convertible note issued and the liquidity provided by that, it will provide all of the working capital we need to execute our business plan. So with that I'll turn it back to Stan.

Thanks a lot, Tom. It's real exciting time for us. We always knew that the DVM-800 was going to be very disruptive and really make a splash in the market, once we're able to get it after and introduce it. And it has done that. The body camera, we felt the same way, we still believe that, matter of fact, because of some of the very new features that we are starting to be able to present and have completed. That body camera is going to be one of the most unique body cameras that's out there. I mentioned early on in my call, that I had two pieces of somewhat breaking news that I wanted to share in regards to the technology front. And the one and first is with the body camera. Currently, we are hosting the Lenexa Motorcycle Challenge, here in Lenexa, Kansas. And we actually have several of the officers including some stationary body cameras set up out there and are streaming live video back here to corporate headquarters, or actually that the truth of matter is any one from any location could get online and watch this event occurring right now. Our competitors have talked about streaming video, but their idea of streaming is stream into a tablet, stream into an iPhone and stuff like that. This is true streaming video to where an officer actions or the environment heaves in that video could be streamed directly live back to corporate headquarters. So that is occurring right now. We're very excited about that. That is a feature that a lot of our competition will have tough time overcoming, so we're real pleased with that. We also have talked about the cloud solution, Tom briefly mentioned on it, not only we're doing the cloud solution for law enforcement, but we also have it setup for our commercial markets as well. I think I've stated early on, we still anticipate our commercial division doubling again this year. So that should increase another $1.5 million in new revenues for the company, just through the commercial market. They too will start being able to take advantage of the body camera. It has a lot of applications and the duties that the commercial markets look at as well. And in the second technology, sort of breakthrough, that I wanted to tell about is the VuLink. Many of us, you've heard as talk about that technology how that actually ties the body camera and the DVM-800 together. Well, I'm very pleased to announce that not only have we developed an outstanding product, but we have gotten the word from the patent office that it appears that that the majority of our patent claims that we filed for will be granted. And that should happen in the next 30 days. So when that does come final and patents get issued, we will make sure to do a press release. So we continue to put ourselves in a position to where we have very unique opportunities when we go in the police departments. Our biggest competitor, obviously in the body camera is Taser, but Taser doesn't have in-car video. We have situations where departments now say, if you can't provide me a body camera and an in-car video system, there is the door. We don't want to do business with you. We've got a situation now with our in-car video system, price, features, warranty it's very difficult to compete against the DVM-800. And when you tie all of those two products together with the VuLink, you basically have completed your circle. So we're very ecstatic about what 2014 has to hold for us. There is no way you're going to see any lack of enthusiasm from me in regards to what I believe we will accomplish this year, because everything that we're seeing, whether it'd would be local, international, very large departments, still has us in the game. As I mentioned maybe earlier, there's probably, six, seven different departments that are evaluating our body cameras and they're looking at individually each department in excess of 1,000 pieces. So we're very pleased with the progress we made, outstanding work by our engineering team and we look forward to introducing the couple of more new products yet this year. Anyways, I'd like to go ahead and open up the lines for any Q&A that there maybe at this time.

(Operator Instructions) We have a question from Vincent Colicchio, Noble Financial. Vincent Colicchio - Noble Financial: Stan, on the DVM-800, do you have the opportunity pipeline and it sounds like you do and the capacity to roll that product sequentially throughout the rest of the year?

Yes, we do, absolutely. The supply channel was a little tough getting fired up and started. I think we've overcome those hurdles and matter of fact, feel very confident that we'll be able to meet the demand. Vincent Colicchio - Noble Financial: And my next question is on the patent litigation situation with Utility Associates. Could you give us a sense for the magnitude, did it hurt you with one client or was it several, any color that would be helpful?

The one thing I could tell you is I am aware of at least a half of dozen of our very large, including a couple of them, that we had state contracts with. I mean sole-sourced state contracts with. And they contacted us, because they had received this threatening letter. And so we were able -- those folks clearly came to us, because they had a long-term commitment still ahead of it with them. I honestly can't get my arms around that how many additional departments, where we may have lost sales, because they bought into that letter. And that's what made us get so aggravated and frustrated to where we became proactive instead of just blowing them off. And we will continue to be very active, as matter of fact, we were very disappointed to find out that an ex-employee who has a confidentiality -- sorry, a non-compete agreement with us they had hired them as well. So these individuals really, really seem to be comfortable in taking risks or maybe that's all they had left, the Hail Mary pass, and is why they're doing what they are doing. But I'm very confident that our legal team is getting our arms around those issues, those former employees and we will have this wrapped up fairly soon.

Having no further questions. This concludes our question-and-answer session. I would like to turn the conference back over to Stan Ross for any closing remarks.

Again, I just want to thank everyone for their time today. Let me thank all our employees for their hard efforts that they've put in. And again, I want to reiterate my confidence, 2014 being a very, very good year for us and greatly improving in regards to over '13. And I think I had sort of laid out how that going to happen with just starting new products time and time again. So anyways, thank you all very much for your time. If you would like to have any follow-up questions, Tom and I both are available. Just give us call any time. Thank you.

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