UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
-----------------------
FORM 10-QSB
-----------------------
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM __________ TO __________
COMMISSION FILE NUMBER 0-30420
-----------------------
CONVERSION SERVICES INTERNATIONAL, INC.
(EXACT NAME OF SMALL BUSINESS USER AS SPECIFIED IN ITS CHARTER)
-----------------------
DELAWARE 20-1010495
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
100 EAGLE ROCK AVENUE, EAST HANOVER, NEW JERSEY 07936
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICE)
ISSUER'S TELEPHONE NUMBER: (973) 560-9400
-----------------------
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.
Yes |X| No |_|
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date: as of November 19, 2004,
772,082,096 of common stock, par value $0.001, were outstanding.
CONVERSION SERVICES INTERNATIONAL, INC. AND SUBSIDIARIES
FORM 10-QSB
INDEX
PART I. -- FINANCIAL INFORMATION PAGE
----
Item 1. Financial Statements
Consolidated Balance Sheet as of September 30, 2004 (unaudited).................................................3
Consolidated Statements of Operations for the three and nine months ended
September 30, 2004 and 2003 (unaudited)......................................................................4
Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2003 (unaudited).........5
Notes to Consolidated Financial Statements (unaudited)..........................................................7
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations....................18
Item 3. Controls and Procedures..................................................................................28
PART II. OTHER INFORMATION
Item 1. Legal Proceedings........................................................................................28
Item 6. Exhibits and Reports on Form 8-K.........................................................................28
Signatures
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONVERSION SERVICES INTERNATIONAL, INC.
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
SEPTEMBER 30, 2004
(Unaudited)
ASSETS
CURRENT ASSETS
Cash $ 882,986
Restricted cash 83,375
Accounts receivable, net of allowance for doubtful accounts of $150,755 4,216,357
Accounts receivable from related parties; See note 8 900,942
Prepaid expenses 188,513
Costs in excess of billings 139,565
Deferred tax asset 63,938
------------
Total Current Assets 6,475,676
------------
PROPERTY AND EQUIPMENT, at cost, net; See note 2 697,399
------------
OTHER ASSETS
Restricted cash 4,251,000
Due from stockholders, including accrued interest of $25,696 207,719
Goodwill 2,506,224
Intangible assets, net of accumulated amortization of $461,063; See note 3 6,079,679
Deferred financing costs, net of accumulated amortization of $30,881 850,539
Discount on debt issued, net of accumulated amortization of
$270,434; See note 4 7,305,741
Equity investments 113,876
Other assets 4,433
------------
21,319,211
------------
Total Assets $ 28,492,286
============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Line of credit; See note 5 $ 3,200,000
Current portion of long-term debt 110,622
Accounts payable and accrued expenses 3,947,987
Short term note payable, See note 7 454,545
Deferred revenue 1,057,533
------------
TOTAL CURRENT LIABILITIES 8,770,687
LONG-TERM DEBT, net of current portion, See note 6 4,714,026
DEFERRED TAXES 36,900
------------
Total Assets 13,521,613
------------
MINORITY INTEREST; See note 13 157,104
------------
COMMITMENTS AND CONTINGENCIES --
STOCKHOLDERS' EQUITY
Common stock, $0.001 par value, 1,000,000,000 shares authorized;
768,510,668 issued and outstanding 768,511
Additional paid in capital 18,501,875
Foreign currency translation 4,053
Accumulated deficit (4,460,870)
------------
Total Stockholders' Equity 14,813,569
------------
Total Liabilities and Stockholders' Equity $ 28,492,286
============
See Notes to Consolidated Financial Statements.
3
CONVERSION SERVICES INTERNATIONAL, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended September 30, Nine Months Ended September 30,
---------------------------------- ----------------------------------
2004 2003 2004 2003
------------- ------------- ------------- -------------
REVENUE $ 6,877,872 $ 3,509,696 $ 18,655,937 $ 10,607,502
COST OF SERVICES 4,585,407 2,459,636 12,804,331 7,545,080
------------- ------------- ------------- -------------
GROSS PROFIT 2,292,465 1,050,060 5,851,606 3,062,422
------------- ------------- ------------- -------------
OPERATING EXPENSES
Selling and marketing 1,441,938 439,345 2,745,801 1,064,951
General and administrative 1,698,088 645,570 4,860,995 1,826,501
Research and development 270,976 -- 270,976 --
Depreciation and amortization 417,648 51,899 516,119 147,127
------------- ------------- ------------- -------------
3,828,650 1,136,814 8,393,891 3,038,579
------------- ------------- ------------- -------------
LOSS FROM OPERATIONS (1,536,185) (86,754) (2,542,285) 23,843
------------- ------------- ------------- -------------
OTHER INCOME (EXPENSE)
Equity in losses from investments (8,812) -- (24,900) --
Other income 289 -- 7,295 --
Interest income 1,519 -- 3,392 --
Interest expense (498,378) (11,587) (636,494) (92,304)
------------- ------------- ------------- -------------
(505,382) (11,587) (650,707) (92,304)
------------- ------------- ------------- -------------
LOSS BEFORE INCOME TAXES (2,041,567) (98,341) (3,192,992) (68,461)
INCOME TAXES (BENEFIT) 323,608 -- (136,271) --
MINORITY INTEREST (42,296) -- (42,296) --
------------- ------------- ------------- -------------
NET LOSS (2,322,879) (98,341) (3,014,425) (68,461)
UNSECURED CONVERTIBLE LINE OF CREDIT
BENEFICIAL CONVERSION FEATURE 547,619 -- 1,214,286 --
------------- ------------- ------------- -------------
NET LOSS ATTRIBUTABLE TO COMMON STOCKHOLDERS $ (2,870,498) $ (98,341) $ (4,228,711) $ (68,461)
============= ============= ============= =============
UNAUDITED PRO FORMA DATA (Note 1):
Loss before income taxes (benefit) $ -- $ (98,341) $ -- $ (68,461)
Income taxes (benefit) -- (39,277) -- (27,325)
------------- ------------- ------------- -------------
Net loss $ -- $ (59,064) $ -- $ (41,136)
============= ============= ============= =============
Net loss per share $ (0.00) $ (0.00) $ (0.01) $ (0.00)
============= ============= ============= =============
Weighted average number of common shares used
in the actual and pro forma net loss
per share calculations 766,699,073 593,000,000 689,233,712 593,000,000
See Notes to Consolidated Financial Statements.
4
CONVERSION SERVICES INTERNATIONAL, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine months ended September 30,
------------------------------
2004 2003
----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(4,228,711) $ (68,461)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation 104,211 56,622
Amortizaton of intangible assets, deferred financing costs and discount on debt issued 803,580 83,595
Beneficial conversion feature associated with convertible debt instruments 1,214,286
Deferred tax asset (136,238) --
Compensation expense for stock options and stock issued 94,625 --
Allowance for doubtful accounts 75,748 54,000
Write-off deferred loan costs 45,215 --
Loss on disposal of equipment 35,496 --
Loss on equity investments 24,900 --
Minority interest in Evoke Software Corporation (42,296)
Changes in operating assets and liabilities:
Increase in accounts receivable (1,059,936) (381,137)
Increase in accounts receivable from related parties (507,984)
(Increase) decrease in prepaid expenses 3,824 (5,319)
(Increase) in costs in excess of billings (139,565) --
Increase in due from stockholders (4,096) --
Decrease in other assets 14,721 57,313
Increase (decrease) in accounts payable and accrued expenses 920,258 (91,906)
Increase in deferred revenue (196,509) --
Increase (decrease) in other current liabilities 8,987 (2,086)
----------- -----------
Net cash used in operating activities (2,969,484) (297,379)
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of property and equipment (42,111) (20,759)
Investment in DeLeeuw Associates, net of cash acquired (2,010,266) --
Investment in Evoke Software Corp., net of cash acquired 346,073 --
Equity investment in Leading Edge Communications Corp. (83,000) --
----------- -----------
Net cash used in investing activities (1,789,304) (20,759)
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Cash overdraft (51,900) --
Net advances under line of credit 1,410,890 89,862
Issuance of convertible line of credit notes 4,000,000 1,522,438
Issuance of short-term note payable 1,000,000
Issuance of long-term note payable 5,000,000
Deferred loan costs in connection with line of credit (911,954) (95,436)
Principal payments on long-term debt (729,028) (295,785)
Principal payments on capital lease obligations (92,987) --
Distributions to stockholders -- (767,468)
Restricted cash (4,334,375) --
Costs incurred in connection with LCS merger (95,678) --
----------- -----------
Net cash provided by financing activities 5,194,968 453,611
----------- -----------
Effect of exchange rate changes on cash and cash equivalents 4,312
NET INCREASE IN CASH 440,492 135,473
CASH, beginning of period 442,494 --
----------- -----------
CASH, end of period $ 882,986 $ 135,473
=========== ===========
See Notes to Consolidated Financial Statements.
5
CONVERSION SERVICES INTERNATIONAL, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine months ended September 30,
-------------------------------
2004 2003
----------- -----------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest $ 134,546 $ 84,860
Cash paid for income taxes -- --
SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIES:
During 2004 and 2003, the Company entered into various capital lease
arrangements for computer and trade show equipment in the amount of
$338,000 and $12,300, respectively
During June 2004, the Company acquired substantially all of the assets and
liabilities of Evoke Software Corporation. The following assets and
liabilities were obtained as a result of the acquisition
Acquired cash $ 497,492 $ --
Acquired accounts receivable 579,839 --
Acquired customer contracts 1,962,000 --
Acquired tradename 444,775 --
Acquired computer software 1,381,000 --
Acquired prepaid expenses 78,533
Acquired other assets 11,350 --
Acquired furniture and equipment 183,717 --
Acquired deferred revenue (1,254,043) --
Acquired deferred compensation (443,174)
Acquired liabilities (1,301,856) --
Minority interest (199,400)
On March 4, 2004, the Company acquired DeLeeuw Associates, Inc. The
following assets and liabilities were obtained as a result of the
acquisition
Acquired accounts receivable $ 975,513 $ --
Acquired approved vendor status 1,597,000 --
Acquired tradename 722,000 --
Acquired goodwill 1,403,875 --
Acquired investment in limited liability company 55,776 --
Acquired deferred tax liability (300,000) --
Acquired liabilities (285,651) --
On May 5, 2004, a $2,000,000 unsecured convertible line of credit note was
converted into 16,666,666 shares of Company common stock. The conversion
price was $0.12 per share, which represented 75% of the market price on
the date of conversion. The $666,667 effect of this beneficial conversion
feature is reflected in the Company's statement of operations for the June
2004 quarter. The conversion price on the October 2003 note was adjusted
to a fixed conversion price of $0.105 per share on September 1, 2004, and
2,380,953 additional shares of common stock were issued to the
participating investor. Since the conversion price was less than the
market value of the common stock, the Company recorded a $547,619 discount
on debt issued in September 2004 as a result of the realization of a
contingency that reduced earnings available to common stockholders. The
Company has reflected this beneficial conversion charge in the
accompanying consolidated statements of operations.
In June 2004, the Company signed an unsecured convertible line of credit
note in exchange for $2,000,000. The note bears interest at 7% per annum,
is convertible into shares of Company common stock, and expires on June 6,
2009. The conversion price is 75% of the average bid price for the ten
trading days prior to the date of conversion. However, on September 1,
2004, the conversion price was reset to a fixed conversion price of $0.105
per share. As a result of the discount on debt issued, the Company
recorded a charge of $1,500,000 in September 2004, which will be amortized
to interest expense over the five year life of the debt agreement.
On August 16, 2004, the Company executed a revolving line of credit
agreement and a secured convertible term note with Laurus Master Fund,
Ltd. ("Laurus"), whereby the Company will have access to a $6,000,000
revolving line of credit and an additional $5,000,000 cash to be used for
acquisitions. These notes provide beneficial conversion features to Laurus
and, as a result, the Company has recorded a $5,621,600 discount on debt
in the third quarter of 2004 which will be amortized to interest expense
over the three year life of the debt instrument. Additionally, warrants to
purchase up to 12,000,000 shares of Company common stock were issued as
part of the above transaction. A relative fair value of $2,041,200 was
also ascribed to the warrants. This relative fair value will also be
amortized to interest expense over the life of the debt instrument. See
footnote 5 - Line of Credit for further discussion surrounding this
transaction.
On September 22, 2004, the Company issued subordinated secured convertible
promissory notes in the amount of $1,000,000. These notes bear interest at
8% per annum and expire September 22, 2005. These notes are convertible
into shares of Company common stock and include beneficial conversion
priviliges. As a result, the Company has recorded a discount on debt
relating to this transaction in the amount of $454,500 in the third
quarter of 2004 which will be amortized to interest expense over the one
year life of the debt instrument. A relative fair value of $545,500 was
ascribed to the warrants to purchase up to 6,000,000 shares of Company
common stock which were issued as part of this transaction. The relative
fair value will be amortized to interest expense over the one year life of
the debt instrument.
See Notes to Consolidated Financial Statements.
6
CONVERSION SERVICES INTERNATIONAL, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1 - ACCOUNTING POLICIES
ORGANIZATION AND BUSINESS
Conversion Services International, Inc. (the "Company") was incorporated
in the State of Delaware and has been conducting business since 1990. The
Company is principally engaged in the information technology services industry
in the following areas: data warehousing, business intelligence, management
consulting and professional services, on credit, to its customers principally
located in the northeastern United States. On November 1, 2002, the Company
acquired the operations of Scosys, Inc. ("Scosys"). Scosys is engaged in the
information technology services industry. On January 30, 2004, the Company
became a public company through its merger with a wholly owned subsidiary of LCS
Group, Inc. Although LCS Group, Inc. (now known as Conversion Services
International, Inc.) was the legal survivor in the merger and remains the
Registrant with the Securities and Exchange Commission, the merger was accounted
for as a reverse acquisition, whereby the Company was considered the "acquirer"
of LCS Group, Inc. for financial reporting purposes, as the Company's
stockholders control more than 50% of the post transaction combined company.
Among other matters, reverse merger accounting requires LCS Group, Inc. to
present in all financial statements and other public filings, prior historical
and other information of the Company, and a retroactive restatement of the
Company's historical stockholders' equity. The retroactive restatement took
place subsequent to the merger on January 30, 2004. On March 4, 2004, the
Company acquired DeLeeuw Associates, Inc. ("DeLeeuw"). DeLeeuw is a management
consulting firm specializing in integration, reengineering and project
management. On May 1, 2004, the Company acquired a 49% interest in Leading Edge
Communications Corporation ("LEC"), a provider of enterprise software and
services solutions for technology infrastructure management. On June 28, 2004,
the Company acquired substantially all the assets of Evoke Software Corporation
("Evoke"), a provider of data discovery, profiling and quality management
software. Doorways, Inc. is a wholly owned subsidiary of the Company that is
currently dormant.
BASIS OF PRESENTATION
In the opinion of management, the accompanying consolidated balance sheet
and related interim consolidated statements of operations and cash flows include
all adjustments necessary for their fair presentation in conformity with
accounting principles generally accepted in the United States of America.
Preparing financial statements requires management to make estimates and
assumptions that affect the reported amounts of assets, liabilities, revenue and
expenses. Actual results and outcomes may differ from management's estimates and
assumptions.
Interim results are not necessarily indicative of results for a full year.
The information included in this Form 10-QSB should be read in conjunction with
Management's Discussion and Analysis and financial statements and notes thereto
included in the Conversion Services International, Inc. Registration Statement
on Form SB-2/A filed with the Securities and Exchange Commission (the "SEC") on
September 30, 2004.
PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements include the accounts of
the Company and its subsidiaries, Doorways, Inc., DeLeeuw, and Evoke Software
Corporation (formerly known as Evoke Asset Purchase Corp.). All intercompany
transactions and balances have been eliminated in the consolidation. Investments
in business entities in which the Company does not have control, but has the
ability to exercise significant influence (generally 20-50% ownership), are
accounted for by the equity method.
7
REVENUE RECOGNITION
PROFESSIONAL SERVICES
Revenue from consulting and professional services is recognized at the time the
services are performed, evidence of an arrangement exists, the fee is fixed or
determinable and collectibility is reasonably assured. Reimbursements, including
those relating to travel and other out-of-pocket expenses, are included in
revenues, and an equivalent amount of reimbursable expenses are included in cost
of services.
Revenues for large services projects are recognized using the percentage of
completion method for long-term construction type contracts where costs to
complete the contract could reasonably be estimated. Revenues recognized in
excess of billings are recorded as costs in excess of billings. Billings in
excess of revenues recognized are recorded as deferred revenues until revenue
recognition criteria are met. The relationship of costs incurred to date
compared to estimated total costs at completion is used to determine the
percentage of completion on the project. This percentage is applied to the total
revenue to be earned on the project and that portion of revenue is recognized in
the current period. Additionally, billings in excess of revenue recognized on
projects being accounted for using the percentage-of-completion method are
recorded as deferred revenues. The percentage-of-completion method is not
applicable for the Company's software sales.
SOFTWARE
Revenue from software licensing and maintenance and support are also recognized
when persuasive evidence of an arrangement exists, delivery has occurred, the
fee is fixed or determinable, and collectibility is reasonably assured. The
Evoke software is delivered by the Company either directly to the customer or to
a distributor on an order by order basis. The software is not sold with any
right of return privileges and, as a result, a returns reserve is not
applicable. License fee revenue is recognized by the Company in the period in
which delivery occurs. Maintenance and support revenue is recorded in revenue on
a pro rata basis over the term of the maintenance and support agreement.
Deferred revenue is recorded when customers are invoiced for software
maintenance and support. The revenue is recognized over the term of the
maintenance and support agreement.
The Company licenses software and provides a maintenance and support agreement
to customers. These items are invoiced as separate items and vendor-specific
objective evidence is determined for the maintenance and support, generally by
identifying in the contract the cost of the maintenance and support to the
customer in subsequent renewal periods.
ACCOUNTS RECEIVABLE
The Company carries its accounts receivable at cost less an allowance for
doubtful accounts. On a periodic basis, the Company evaluates its accounts
receivable and adjusts the allowance for doubtful accounts, when deemed
necessary, based upon its history of past write-offs and collections,
contractual terms and current credit conditions.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost and includes equipment held
under capital lease arrangements. Depreciation, which includes amortization of
leasehold improvements, is computed principally by an accelerated method and is
based on the estimated useful lives of the various assets ranging from three to
seven years. When assets are sold or retired, the cost and accumulated
depreciation are removed from the accounts and any gain or loss is included in
operations.
Expenditures for maintenance and repairs have been charged to operations.
Major renewals and betterments have been capitalized.
AMORTIZATION
The Company amortizes deferred financing costs utilizing the effective
interest method over the term of the related debt instrument. Acquired software
is amortized on a straight-line basis over an estimated useful life of three
years. Acquired contracts are amortized over a period that approximates the
estimated life of the contracts, based upon the estimated annual cash flows
obtained from those contracts, generally five to six years.
8
GOODWILL AND INTANGIBLE ASSETS
Goodwill represents the amounts paid in connection with a settlement
agreement with the Elligent Consulting Group to re-acquire the ownership rights
to the Company in 1998 and in connection with the acquisitions of Scosys,
DeLeeuw and Evoke. Additionally, as part of the Scosys, DeLeeuw and Evoke
acquisitions, the Company acquired identifiable intangible assets. FASB
Statement 142 was adopted as of January 1, 2002 for all goodwill recognized in
the Company's balance sheet as of December 31, 2001. This statement changed the
accounting for goodwill from an amortization method to an impairment-only
approach, and introduced a new model for determining impairment charges.
Goodwill and intangible assets are reviewed for impairment whenever events
or circumstances indicate impairment might exist, or at least annually. The
Company assesses the recoverability of its assets, in accordance with SFAS No.
142 "Goodwill and Other Intangible Assets," comparing projected undiscounted
cash flows associated with those assets against their respective carrying
amounts. Impairment, if any, is based on the excess of the carrying amount over
the fair value of those assets. The Company's goodwill and intangible assets
were evaluated and deemed not to be impaired at December 31, 2003. There have
been no events or circumstances that would indicate that there has been any
impairment during the nine months ended September 30, 2004.
DEFERRED FINANCING COSTS
The Company capitalizes costs associated with the issuance of debt
instruments. These costs are amortized on a straight-line basis over the term of
the related debt instruments, which currently range from one to three years.
DISCOUNT ON DEBT
The Company has allocated the proceeds received from convertible debt
instruments between the underlying debt instrument and the detachable warrants
and has recorded the discount on the debt instrument due to a beneficial
conversion feature as a deferred charge. This deferred charge is being amortized
to interest expense over the life of the related debt instruments, which
currently range from one to five years.
CONCENTRATIONS OF CREDIT RISK
Financial instruments which potentially subject the Company to
concentrations of credit risk are cash and accounts receivable arising from its
normal business activities. The Company routinely assesses the financial
strength of its customers, based upon factors surrounding their credit risk,
establishes an allowance for doubtful accounts, and as a consequence believes
that its accounts receivable credit risk exposure beyond such allowances is
limited. At September 30, 2004, one customer, LEC, a related party company,
comprised approximately 17.6% of the Company's accounts receivable balance.
ADVERTISING
The Company expenses advertising costs as incurred. Advertising costs
amounted to $44,600 and $132,300, and $400 and $2,700, for the three and nine
month periods ended September 30, 2004 and 2003, respectively.
INCOME TAXES
The Company accounts for income taxes under an asset and liability
approach that requires the recognition of deferred tax assets and liabilities
for the expected future tax consequences of events that have been recognized in
the Company's financial statements or tax returns. In estimating future tax
consequences, the Company generally considers all expected future events other
than enactments of changes in the tax laws or rates.
On January 1, 2001, the Company elected to be an "S" Corporation, whereby
the stockholders account for their share of the Company's earnings, losses,
deductions and credits on their federal and various state income tax returns.
The Company is subject to New York City and various state income taxes. On
September 30, 2003, the Company's "S" Corporation status was revoked in
connection with the conversion of convertible subordinated debt into shares of
common stock.
The Company evaluates the amount of deferred tax assets that are recorded
against expected taxable income over its forecasting cycle which is currently
two years. As a result of this evaluation, the Company has recorded a valuation
allowance of $1,439,000 in the third quarter of 2004. This allowance was
recorded because, based on the weight of available evidence, it is more likely
than not that some portion of the deferred tax asset may not be realizable.
9
For informational purposes, the accompanying statements of operations
include an unaudited pro forma adjustment for income taxes which would have been
recorded if the Company had not been an "S" Corporation. During the first nine
months of 2004, the Company's effective tax rate was estimated to be
approximately 40%. This rate is based upon the statutory federal income tax rate
of 34% plus a blended rate for the various states in which the Company incurs
income tax liabilities, net of the federal income tax benefit for state taxes
paid, of 6%. Since the Company was an "S" corporation for the full year of 2003,
the pro forma rate is based on the Company's estimated income tax rate for 2004
and is not based upon the prior year's effective tax rate.
DERIVATIVES
In September 1998, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 133 "Accounting for Derivative Instruments and Hedging
Activities" ("SFAS No. 133), which requires the recognition of all derivatives
as either assets or liabilities measured at fair value, with changes in value
reflected as current period income (loss) unless specific hedge accounting
criteria are met. The effective date of SFAS No. 133, as amended by SFAS No.
138, is for fiscal years beginning after September 15, 2000. The Company adopted
SFAS No. 133 as of January 1, 2001, resulting in no material impact upon
adoption or on the subsequent reporting periods.
EQUITY INVESTMENTS
In August 2003, DeLeeuw acquired a non-controlling interest in DeLeeuw
International (a company formed under the laws of Turkey). The Company is
accounting for its share of the income (losses) of this investment under the
equity method.
The Company acquired 49% of all issued and outstanding shares of common
stock of LEC as of May 1, 2004. The acquisition was completed through a Stock
Purchase Agreement between the Company and Mary Ferrara, the sole stockholder of
LEC. In connection with the acquisition, the Company (i) repaid a bank loan on
behalf of the seller in the amount of $35,000; (ii) repaid an LEC bank loan in
the amount of $38,000; and (iii) satisfied an LEC obligation for $10,000 of
prior compensation to an employee. The Company accounts for its share of the
income (losses) of this investment under the equity method.
FOREIGN CURRENCY TRANSLATION
Local currencies are the functional currencies for Evoke's foreign
operations. Assets and liabilities are translated using the exchange rates in
effect at the balance sheet date. Income and expenses are translated at the
average exchange rates during the period. Translation gains and losses not
reflected in earnings are reported as a component of stockholders' equity.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
10
NOTE 2 - PROPERTY AND EQUIPMENT
Property and equipment consisted of the following:
September 30,
2004
-----------
Computer equipment $ 932,320
Furniture and fixtures 260,577
Automobiles 72,833
Leasehold improvements 216,307
-----------
1,482,037
Accumulated depreciation (784,638)
-----------
$ 697,399
===========
NOTE 3 - INTANGIBLE ASSETS
Intangibles acquired have been assigned as follows:
September 30,
2004
-----------
Customer contracts $ 2,376,000
Approved vendor status 1,597,000
Computer software 1,381,000
Tradename 1,166,742
Proprietary rights and rights to the name of Scosys Inc. 20,000
-----------
6,540,742
Accumulated amortization (461,063)
-----------
$ 6,079,679
===========
NOTE 4 - DISCOUNT ON DEBT
The Company has allocated the proceeds received from convertible debt
instruments between the underlying debt instrument and the detachable warrants
and has recorded the discount on the debt instrument due to a beneficial
conversion feature as a deferred charge. This deferred charge is being amortized
to interest expense over the life of the related debt instruments, which
currently range from one to five years. The following illustrates the components
of the discount on debt:
September 30, 2004 Amortization period
---------------------------------------------
Laurus Master Fund $ 5,621,630 3 years
Sands Brothers 454,545 1 year
Taurus Advisory Group 1,500,000 5 years
-------------
7,576,175
Accumulated amortization (270,434)
-------------
$ 7,305,741
=============
NOTE 5 - LINE OF CREDIT
On March 30, 2004, the Company executed a $3,000,000 revolving line of
credit with North Fork Bank (formerly known as TrustCompany Bank) secured by
substantially all of the corporate assets. The terms of this note provided for
interest accruing on advances at seven eighths of one percent (7/8%) over the
institution's prime rate.
11
On August 16, 2004, the Company replaced its $3,000,000 line of credit
with North Fork Bank with a revolving line of credit with Laurus Master Fund,
Ltd. ("Laurus"), whereby the Company has access to borrow up to $6,000,000 based
upon eligible accounts receivable. This revolving line, effectuated through a
$2,000,000 convertible minimum borrowing note and a $4,000,000 revolving note,
provides for advances at an advance rate of 90% against eligible accounts
receivable, with an annual interest rate of prime rate (as reported in the Wall
Street Journal) plus 1%, and maturing in three years. These notes will be
decreased by 1.0% for every 25% increase above the fixed conversion price prior
to an effective registration statement and 2.0% thereafter up to a minimum of
0.0%. This line of credit is secured by substantially all the corporate assets.
Both the $2,000,000 convertible minimum borrowing note and the $4,000,000
revolving note provide for conversion at the option of the holder of the amounts
outstanding into the Company's common stock at a fixed conversion price of $0.14
per share. In the event that the Company issues common stock or derivatives
convertible into Company common stock for a price less than the aforementioned
fixed conversion price, then the fixed conversion price is reset using a
weighted average dilution calculation. Additionally, in exchange for a secured
convertible term note bearing interest at prime rate (as reported in the Wall
Street Journal) plus 1%, Laurus has made available to the Company an additional
$5,000,000 to be used for acquisitions. This note is convertible into Company
common stock at a fixed conversion price of $0.14 per share. In the event that
the Company issues Company common stock or derivatives convertible into Company
common stock for a price less than the fixed conversion price, then the fixed
conversion price is reset to the lower price on a full-ratchet basis. This note
matures in three years. This cash will be restricted for use until approved
acquisition targets identified by the Company are approved by Laurus. A portion
of Laurus's revolving line of credit was used to pay off all outstanding
borrowings from North Fork Bank. The Company issued Laurus a common stock
purchase warrant that provides Laurus with the right to purchase 12,000,000
shares of the Company's common stock. The exercise price for the first 6,000,000
shares acquired under the warrant is $0.29 per share, the exercise price for the
next 3,000,000 shares acquired under the warrant is $0.31 per share, and the
exercise price for the final 3,000,000 shares acquired under the warrant is
$0.35 per share. The common stock purchase warrant expires on August 16, 2011.
The Company paid $749,000 in brokerage and transaction closing related costs.
These costs were deducted from the $5,000,000 restricted cash balance provided
to the Company by Laurus. As of September 30, 2004, $3,200,000 was outstanding
under the revolving line of credit. The interest rate on the revolving line and
the acquisition note was 5.75% during September 2004. As a result of the
beneficial conversion feature associated with the aforementioned notes payable,
a discount on debt issued was recorded by the Company in the amount of
$5,621,630 in the September 2004 quarter which will be amortized to interest
expense over the three year life of the debt agreement.
12
NOTE 6 - LONG TERM DEBT
Long term debt consisted of the following:
September 30,
2004
-------------
Secured convertible term note with a maturity date of August 16, 2007
unless converted into common stock at the note holder's option. The
initial conversion price is $0.14 per share. Interest accrues at a
rate of prime plus one percent. See note 5 - Line of credit for
further description of this transaction. $ 5,000,000
Convertible line of credit note with a maturity date of June 6, 2009
unless converted into common stock at the Company or the note holder's
option. Interest accrues at 7% per annum. The original conversion
price to shares of common stock is equal to 75% of the average trading
price for the prior ten trading days. In September 2004, the price was
reset to $0.105 per share. A warrant to purchase 4,166,666 shares of
Company common stock was also issued. The exercise price of the
warrant is $0.14 per share and the warrant expires on June 6, 2009. An
allocation of the relative fair value of the warrant and the debt
instrument was performed. The relative fair value of the warrant was
determined to be $500,000 and is being amortized to interest expense
over the life of the note. A discount on debt issued of $1,500,000 was
recorded in September 2004 based on the reset conversion terms. 2,000,000
Notes payable under capital lease obligations payable to various
finance companies for equipment at varying rates of interest and
maturity dates through 2007. 239,142
-------------
7,239,142
Relative fair values ascribed to warrants associated with the above
debt agreements. This amount is being accreted to the debt instrument
over the term of the related debt agreements, which range from three
to five years. (2,414,494)
-------------
Subtotal 4,824,648
Less: Current portion of long term debt, including obligations under
capital leases of $110,622. (110,622)
-------------
$ 4,714,026
=============
Future annual payments of long term debt is as follows:
YEARS ENDING SEPTEMBER 30,
--------------------------
2005 $ 110,622
2006 103,875
2007 5,024,645
2008 --
2009 2,000,000
-------------
$ 7,239,142
=============
13
In May 2004, the conversion option in the unsecured convertible line of
credit note dated October 29, 2003 was exercised by the holder. As a result of
the exercise, 16,666,666 shares of the Company's common stock were issued at an
exercise price per share of $0.12, which price represents 75% of the fair market
value of the stock on the date of conversion. Since the conversion price was
less than the market value of the common stock, the Company recorded a $666,667
beneficial conversion charge that reduced earnings available to common
stockholders in the March 2004 quarter. The conversion price on the October 2003
note was adjusted to a fixed conversion price of $0.105 per share on September
1, 2004, and 2,380,953 additional shares of common stock were issued to the
participating investor. Since the conversion price was less than the market
value of the common stock, the Company recorded a $547,619 beneficial conversion
charge in September 2004 that reduced earnings available to common stockholders.
The Company has reflected this beneficial conversion charge in the accompanying
consolidated statements of operations.
NOTE 7 - SHORT TERM NOTES PAYABLE
In September 2004, the Company issued to Sands Brothers Venture Capital
LLC, Sands Brothers Venture Capital III LLC and Sands Brothers Venture Capital
IV LLC (collectively, "Sands") three subordinated secured convertible promissory
notes equaling $1,000,000 (the "Notes"), each with an annual interest rate of 8%
expiring September 22, 2005. The Notes are secured by substantially all
corporate assets, but subordinate to Laurus. The Notes are convertible into
shares of the Company's common stock at the election of Sands at any time
following the consummation of a convertible debt or equity financing with gross
proceeds of $5 million or greater (a "Qualified Financing"). The conversion
price of the shares of the Company's common stock issuable upon conversion of
the Notes shall be equal to a price per share of common stock equal to forty
percent (40%) of the price of the securities issued pursuant to a Qualified
Financing. If no Qualified Offering has been consummated by September 8, 2005,
then Sands may elect to convert the Notes at a fixed conversion price of $0.14
per share. In the event that the Company issues stock or derivatives convertible
into the Company's common stock for a price less than the aforementioned fixed
conversion price, then the fixed conversion price is reset using a weighted
average dilution calculation. The Company also issued Sands three common stock
purchase warrants (the "Warrants") providing Sands with the right to purchase
6,000,000 shares of the Company's common stock. The exercise price of the shares
of the Company's common stock issuable upon exercise of the Warrants shall be
equal to a price per share of common stock equal to forty percent (40%) of the
price of the securities issued pursuant to a Qualified Financing. If no
Qualified Offering has been consummated by September 8, 2005, then Sands may
elect to exercise the Warrants at a fixed conversion price of $0.14 per share.
The latest that the Warrants may expire is September 8, 2008. Finally, the
Company engaged Sands Brothers International Limited as its non-exclusive
financial advisor at $6,000 per month for a period of one year.
The fair value of the 6,000,000 warrants was determined to be $545,000
using the Black-Scholes option pricing model. The assumptions used in the fair
market calculation were as follows: stock price of $0.22, exercise price of
$0.14, term of four years, volatility (annual) of 150.23%, annual rate of
quarterly dividends of 0%, and risk free rate of 1.33%.The Company will amortize
this relative fair value of the warrants to interest expense over the one-year
life of the debt agreement. The note also includes a beneficial conversion
feature and a discount on debt of $454,500 was recorded in September 2004 and
will also be amortized over the one-year life of the debt agreement.
NOTE 8 - RELATED PARTY TRANSACTIONS
In November 2003, the Company executed an Independent Contractor Agreement
with LEC, whereby the Company agreed to be a subcontractor for LEC, and to
provide consultants as required to LEC. In return for these services, the
Company receives a fee from LEC based on the hourly rates established for
consultants subcontracted to LEC.
The Company acquired 49% of all issued and outstanding shares of common
stock of LEC as of May 1, 2004. The acquisition was completed through a Stock
Purchase Agreement between the Company and Mary Ferrara, the sole stockholder of
LEC. In connection with the acquisition, the Company (i) repaid a bank loan on
behalf of the seller in the amount of $35,000; (ii) repaid an LEC bank loan in
the amount of $38,000; and (iii) satisfied an LEC obligation for $10,000 of
prior compensation to an employee.
For the three and nine months ended September 30, 2004, the Company
invoiced LEC $941,000 and $1,727,200, respectively, for the services of
consultants subcontracted to LEC by the Company. As of September 30, 2004, the
Company had accounts receivable due from LEC of approximately $901,000.
As of September 30, 2004, Scott Newman, Chief Executive Officer, and Glenn
Peipert, Chief Operating Officer, owed the Company an aggregate of approximately
$208,000, including accrued interest. These loans bear interest at 3% per annum
and are due and payable by December 31, 2005. These loans were repaid in full as
of November 16, 2004.
14
NOTE 9 - OBLIGATIONS UNDER CAPITAL LEASES
The Company has entered into various capital leases that are
collateralized by computer equipment and a trade show booth with an original
cost of approximately $338,000.
The following schedule lists future minimum lease payments under the
capital leases with their present value as of September 30, 2004:
YEARS ENDING SEPTEMBER 30,
--------------------------
2005 $ 154,878
2006 120,441
2007 26,394
-----------
301,713
Less: Amount representing interest (62,571)
-----------
$ 239,142
==========
NOTE 10 - STOCK OPTIONS
The 2003 Incentive Plan authorizes the issuance of up to 100,000,000
shares of common stock for issuance upon exercise of options. It also authorizes
the issuance of stock appreciation rights. On March 29, 2004 and April 12, 2004,
the Company granted a total of 19,950,000 options to purchase its common stock
at an exercise price of $0.165 per share. The options granted are a combination
of both incentive and nonqualified options, vest over a three year period from
the date of grant, and expire ten years from the date of grant. Between May and
June 2004, the Company granted 11,905,000 options to purchase its common stock
at an exercise price of $0.20 per share. The options granted are all incentive
options, vest over a three year period from the date of grant, and expire ten
years from the date of grant. Between July and September 2004, the Company
granted 1,755,000 options to purchase its common stock at an exercise price of
$0.23 per share. The options granted are all incentive options, vest over a
three year period from the date of grant, and expire ten years from the date of
grant.
The Company follows Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25") in accounting for its
employee stock options. Under APB 25, because the exercise of the Company's
employee stock option equals the market price of the underlying stock on the
date of grant, no compensation expense is recognized in the Company's
consolidated statements of operations. The Company is required under Statement
of Financial Accounting Standards (SFAS) 123, "Accounting for Stock-Based
Compensation", which established a fair value based method of accounting for
stock compensation plans with employees and others to disclose pro forma
financial information regarding option grants made to its employees.
The Company follows EITF No. 96-18, "Accounting for Equity Instruments
That Are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services" ("EITF 96-18") in accounting for stock options
issued to non-employees. Under EITF 96-18, the equity instruments should be
measured at the fair value of the equity instrument issued. During the three
months ended June 30, 2004, the Company granted 450,000 stock options to
non-employee recipients. In compliance with EITF 96-18, the fair value of these
options was determined using the Black-Scholes option pricing model. The Company
is recording the fair value of these options as expense over the three year
vesting period of the options.
The following pro forma net income and earnings per share (EPS) reflects
the difference between stock compensation costs charged to operations under the
APB 25 intrinsic value method and pro forma stock compensation cost that would
have been recorded if the SFAS 123 fair value method had been applied. The
Black-Scholes option pricing model used in this valuation was developed for use
in estimating the fair value of traded options, which have no vesting
restrictions and are fully transferable. Option valuation models require the
input of highly subjective assumptions. The Company's stock-based compensation
has characteristics significantly different from those of traded options, and
changes in the assumptions used can materially affect the fair value estimate.
15
Nine months ended
September 30, 2004
------------------
Reported net loss $ (4,228,711)
Pro forma stock compensation, net of tax (156,285)
-------------
Pro forma net loss $ (4,384,996)
=============
Basic EPS:
As reported $ (0.01)
Pro forma $ (0.01)
Diluted EPS:
As reported $ (0.01)
Pro forma $ (0.01)
Weighted average fair value per option share granted $ 0.13
Weighted average assumptions used to value options granted:
Risk free interest rate 1.33%
Expected volatility 138% - 151%
Expected life (years) 3.00
NOTE 11 - EARNINGS PER SHARE
Basic earnings per share is computed on the basis of the weighted average
number of common shares outstanding. Diluted earnings per share is computed on
the basis of the weighted average number of common shares outstanding plus the
effect of outstanding stock options using the "treasury stock" method.
The components of basic and diluted earnings per share are as follows:
Three Months Ended September 30, Nine Months Ended September 30,
-------------------------------- -------------------------------
2004 2003 2004 2003
------------ ----------- ------------ -------------
Net loss available for common stockholders (A) $ (2,870,498) $ (98,341) $ (4,228,711) $ (68,461)
Weighted average outstanding shares of common stock (B) 766,699,073 593,000,000 689,233,712 593,000,000
Common stock and common stock equivalents (C) 766,699,073 593,000,000 689,233,712 593,000,000
Loss per share:
Basic (A/B) $ (0.00) $ (0.00) $ (0.01) $ (0.00)
============ =========== ============ =============
Diluted (A/C) $ (0.00) $ (0.00) $ (0.01) $ (0.00)
============ =========== ============ =============
For the three and nine months ended September 30, 2004, 34,060,000 shares
attributable to outstanding stock options were excluded from the calculation of
diluted earnings per share because the effect was antidilutive. There were no
stock options outstanding during 2003. Additionally, the effect of 22,166,666
warrants which were issued on June 7, 2004, August 16, 2004 and September 22,
2004 were excluded from the calculation of diluted earnings per share for both
the three and nine months ended September 30, 2004 because the effect was
antidilutive.
NOTE 12 - INCOME TAXES
The Company's provision for income taxes is based on estimated effective
annual income tax rates. The provision may differ from income taxes currently
payable because certain items of income and expense are recognized in different
periods for financial statement purposes than for tax return purposes.
The Company evaluates the amount of deferred tax assets that are recorded
against expected taxable income over its forecasting cycle which is currently
two years. As a result of this evaluation, the Company has recorded a valuation
allowance of $1,439,000 in the third quarter of 2004. This allowance was
recorded because, based on the weight of available evidence, it is more likely
than not that some portion of the deferred tax asset may not be realized.
16
During the first nine months of 2004, the Company's effective tax rate was
estimated to be approximately 40%. This rate is based upon the statutory federal
income tax rate of 34% plus a blended rate for the various states in which the
Company incurs income tax liabilities, net of the federal income tax benefit for
state taxes paid, of 6%. Since the Company was an "S" corporation for the full
year of 2003, the pro forma rate is based on the Company's estimated income tax
rate for 2004 and is not based upon the prior year's effective tax rate.
NOTE 13 - COMMITMENTS AND CONTINGENCIES
On June 29, 2004, Viant Capital LLC commenced legal action against the
Company in the United States District Court for the Southern District of New
York. Through an agreement with Viant, Viant had the exclusive right to obtain
private equity transactions on behalf of the Company from February 18 to May 17,
2004. Viant alleges that it is owed a fee of approximately $450,000 relating to
the Company's loan from a private investor in May 2004. Management believes that
this loan does not qualify as a private equity transaction and it intends to
vigorously defend the Company. As of November 19, 2004, there have been no
material developments in the suit. The Company has estimated the probable loss
related to this suit to be the agreed upon contract signing fee of $75,000 and
has recorded a liability for this amount.
In July 2004, the Company's lease agreement for its corporate headquarters
facility in East Hanover, New Jersey was amended. The lease term was extended to
December 31, 2010 from December 31, 2005, and an additional 3,500 square feet of
space was obtained.
NOTE 14 - SEGMENT INFORMATION
The Company has two reportable segments: professional services and
computer software. The professional services segment includes the Company's
information technology services offerings in the following areas: data
warehousing, business intelligence, management consulting and professional
services to its customers principally located in the northeastern United States.
The Company's acquisitions of Scosys, Inc., DeLeeuw Associates, Inc. and the
results reported from its equity investment in Leading Edge Communications
Corporation have all been included in the professional services business
segment. The Company maintains offices for its professional services business in
East Hanover, New Jersey and Charlotte, North Carolina.
The computer software segment resulted from the Company's acquisition of
substantially all the assets of Evoke Software Corporation ("Evoke") on June 28,
2004. Evoke is a provider of data discovery, profiling and quality management
software. Evoke's headquarters are in East Hanover, New Jersey and it maintains
development offices in Austin, Texas and Denver, Colorado. Additionally, Evoke
has sales offices in England and Germany.
The Company considers all revenues and expenses to be of an operating
nature and, accordingly, allocates them to industry segments regardless of the
profit center in which recorded. Corporate office expenses are allocated to
certain segments based on resources allocated. The accounting policies of the
reportable segments are the same as those described in the summary of
significant accounting policies.
The Company considers reportable segments as business units that offer
different products and are managed separately.
As of and for the nine months ended September 30,
-------------------------------------------------------------------------------------------
2004 2003
-------------------------------------------- -------------------------------------------
Professional Professional
services Software Consolidated services Software Consolidated
------------ ------------ ------------ ------------ ------------ ------------
Net revenues from external customers $ 17,876,860 $ 779,077 $ 18,655,937 $ 10,607,502 $ -- $ 10,607,502
Segment net loss (3,014,372) (1,214,339) (4,228,711) (68,461) -- (68,461)
Interest income 3,360 32 3,392 -- -- --
Interest expense 168,795 467,699 636,494 92,304 -- 92,304
Depreciation and amortization 211,399 304,720 516,119 147,127 -- 147,127
Total segment assets 24,180,363 4,311,923 28,492,286 4,314,344 -- 4,314,344
17
NOTE 15 - SUBSEQUENT EVENTS
On November 8, 2004, the Company entered into a Stock Purchase Agreement
(the "Agreement") with a private investor, CMKX-treme, Inc. Pursuant to the
Agreement, CMKX-treme, Inc. agreed to purchase 12,500,000 shares of common stock
for a purchase price of $1,750,000. Under the terms of the Agreement,
CMKX-treme, Inc. initially purchased 3,571,428 shares of common stock for
$500,000, and it is required to purchase the remaining 8,928,572 shares of
Common Stock for $1,250,000 by December 31, 2004.
On November 16, 2004, Scott Newman, President and Chief Executive Officer
of the Company, paid to the Company $188,520, the outstanding balance of Mr.
Newman's stockholder loan, and Glenn Peipert, Executive Vice President and Chief
Executive Officer of the Company, paid to the Company $19,806, the outstanding
balance of Mr. Peipert's stockholder loan.
Additionally, as of November 17, 2004, Mr. Newman has agreed to personally
support the Company's cash requirements to enable it to fulfill its obligations
through March 31, 2005, to the extent necessary, up to a maximum amount of
$500,000. The Company believes that its reliance on such commitment is
reasonable and that Mr. Newman has sufficient liquidity and net worth to honor
such commitment. The Company believes that Mr. Newman's written commitment
provides the Company with the legal right to request and receive such advances.
Any loan by Mr. Newman to the Company would bear interest at 3% per annum.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Management's Discussion and Analysis contains statements that are
forward-looking. These statements are based on current expectations and
assumptions that are subject to risks and uncertainties. Actual results could
differ materially because of factors discussed in "Issues and Uncertainties" and
elsewhere in this report. The Company undertakes no duty to update any
forward-looking statement to conform the statement to actual results or changes
in the Company's expectations.
Conversion Services International, Inc. provides professional services to
the Global 2000 as well as mid-market clientele relating to strategic
consulting, data warehousing, business intelligence and data management
consulting, and, as a result of its acquisition of Evoke Software Corporation,
the sale of software which is used to survey and quantify the quality of data.
This software is a tool that is used to identify problems with company data
prior to being transferred into a data warehouse. The Company's clients are
primarily in the financial services, pharmaceutical and telecommunications
industries, although it has clients in other industries as well. The Company's
clients are primarily located in the northeastern United States. The Company
enables organizations to leverage their corporate information assets by
providing strategy, process and methodology, best practices data warehousing,
business intelligence, enterprise reporting and analytic solutions. The
Company's business and technology offerings help clients improve performance and
maximize returns on technology investments.
The Company began operations in 1990. Its services were originally focused
on e-business solutions and data warehousing. In the late 1990s, the Company
strategically repositioned itself to capitalize on its data warehousing
expertise in the fast growing business intelligence/data warehousing space. The
Company became a public company via its merger with a wholly owned subsidiary of
LCS Group, Inc., effective January 30, 2004.
The Company's core strategy includes capitalizing on the already
established in-house business intelligence/data warehousing ("BI/DW") technical
expertise and its seasoned sales force. This is expected to result in organic
growth through the addition of new customers. In addition, this foundation will
be leveraged as the Company pursues targeted strategic acquisitions.
The Company derives a substantial portion of its revenue from professional
services engagements. Its revenue depends on the Company's ability to generate
new business, in addition to preserving present client activities. The general
domestic economic conditions in the industries the Company serves, the pace of
technological change, and the business requirements and practices of its clients
and potential clients directly affect this. When economic conditions decline,
companies generally decrease their technology budgets and reduce the amount of
spending on the type of information technology (IT) consulting the Company
provides. The Company's revenue is also impacted by the prices it obtains for
its services and by the size and chargeability, or utilization rate, of its
professional workforce. During periods of economic decline and reduced client
spending, competition for new engagements increases, and it becomes more
difficult to maintain its billing rates and sustain appropriate utilization
rates. If the Company is unable to maintain its billing rates or sustain
appropriate utilization rates for its professionals, its overall profitability
may decline. The Company is beginning to see improvements in economic
conditions, which have recently led to increased spending on consulting services
in certain verticals, particularly in financial services.
18
Although the Company is beginning to experience the benefits of some
positive economic indicators, it continues to experience pricing pressures as
competition for new engagements remains strong and as movements toward the use
of lower-cost service delivery personnel continue to grow within its industry.
Despite strong pricing pressures, the Company has improved its consolidated
billing rates in 2004 when compared to the prior year. The Company's growing
national presence and experienced, highly skilled workforce have enabled it to
successfully differentiate its value and capabilities from those of its
competitors, in effect, lessening the impact of current market pricing
pressures. Billing rates for the Company's operations improved 8.3% for the
three months ended September 30, 2004 when compared to the three months ended
June 30, 2004.
As the Company continues to see increases in client spending and
improvements in economic conditions, the Company will continue to focus on a
variety of growth initiatives in order to improve its market share and increase
revenue. Moreover, as the Company achieves top line growth and gain market
share, the Company will concentrate its efforts on improving margins and driving
earnings to the bottom line. The Company intends to improve margins by limiting
its use of outside consultants, complementing its service offerings with higher
level management consulting opportunities, continuously evaluating the size of
its workforce in order to balance the Company's skill base with the market
demand for services.
In addition to the conditions described above for growing the Company's
current business, the Company will continue to grow through acquisition. One of
the Company's objectives is to make acquisitions of companies in the BI/DW
industry that will accelerate the Company's business plan at lower costs than it
would generate internally and also improve its competitive positioning and
expand the Company's offerings in a larger geographic area. The industry is very
fragmented, with a handful of large international firms having data warehousing
and/or business intelligence divisions, and hundreds of regional boutiques
throughout the United States. These smaller firms do not have the financial
wherewithal to scale their businesses or compete with the larger players, and
the Company believes that the BI/DW industry as a whole is ready for
consolidation. The Company will continue to aggressively pursue these firms,
adding new geographies, areas of expertise and verticals to its current
business. These acquisitions will likely be consummated with a combination of
cash and stock. Although the Company has approximately $4.2 million to fund
acquisitions via its financing transaction with Laurus Master Fund, Ltd., some
of these acquisitions may hinge upon future financings.
Revenue from consulting and professional services is recognized at the
time the services are performed, evidence of an arrangement exists, the fee is
fixed or determinable and collectibility is reasonably assured. Reimbursements,
including those relating to travel and other out-of-pocket expenses, are
included in revenues, and an equivalent amount of reimbursable expenses are
included in cost of services. Revenues for large services projects are
recognized using the percentage of completion method for long-term construction
type contracts where costs to complete the contract could reasonably be
estimated. Revenues recognized in excess of billings are recorded as costs in
excess of billings. Billings in excess of revenues recognized are recorded as
deferred revenues until revenue recognition criteria are met. The
percentage-of-completion method is not applicable for the Company's software
sales. The relationship of costs incurred to date compared to estimated total
costs at completion is used to determine the percentage of completion on the
project. This percentage is applied to the total revenue to be earned on the
project and that portion of revenue is recognized in the current period.
Revenue from software licensing and maintenance and support are also
recognized when persuasive evidence of an arrangement exists, delivery has
occurred, the fee is fixed or determinable, and collectibility is reasonably
assured. The Evoke software is delivered directly by the Company either directly
to the customer or to a distributor on an order by order basis. The software is
not sold with any right of return privileges and, as a result, a FAS 48 returns
reserve is not applicable. License fee revenue is recognized by the Company in
the period in which delivery occurs. Maintenance and support revenue is recorded
in revenue on a pro rata basis over the term of the maintenance and support
agreement. Deferred revenue is recorded when customers are invoiced for software
maintenance and support. The revenue is recognized over the term of the
maintenance and support agreement. Additionally, billings in excess of revenue
recognized on projects being accounted for using the percentage-of-completion
method are recorded as deferred revenues. The Company licenses software and
provides a maintenance and support agreement to customers. These items are
invoiced as separate items and vendor-specific objective evidence is determined
for the maintenance and support, generally by identifying in the contract the
cost of the maintenance and support to the customer in subsequent renewal
periods.
During the nine month period ended September 30, 2004, two of the
Company's clients, Leading Edge Communications Corporation (17.9%), Bank of
America (13.4%), accounted for approximately 31% of total revenues. During the
nine month period ended September 30, 2003, one client, Verizon Wireless,
accounted collectively for approximately 30% of total revenues.
19
The Company's most significant costs are personnel expenses, which consist
of consultant fees, benefits and payroll-related expenses, and outside
consultants.
RESULTS OF OPERATIONS
REVENUE
Percentage of Revenues for the Percentage of Revenues for the
Category of Services nine months ended September 30, three months ended September 30,
2004 2003 2004 2003
---- ---- ---- ----
Strategic Consulting 34.7% 11.1% 45.6% 10.0%
Business Intelligence 17.0% 25.2% 12.7% 36.3%
Data Warehousing 16.3% 11.1% 16.6% 9.4%
Data Management 32.0% 52.6% 25.2% 44.3%
The Company's revenues are primarily comprised of billings to clients for
consulting hours worked on client projects. Revenues for the three and nine
months ended September 30, 2004 were $6.9 million and $18.7 million,
respectively, an increase of 96.0% and 75.9% over the three and nine months
ended September 30, 2003, respectively. $0.8 million, or 11.3% of revenues, and
$1.7 million, or 25.2% of revenues, represents an increase for the third quarter
of 2004 related to revenues from the Evoke and DeLeeuw acquisitions,
respectively, which were completed during 2004. Additionally, $0.9 million of
the increase in the third quarter of 2004 relates to project design and
infrastructure projects obtained in the fourth quarter of 2003 that are still
ongoing or have developed into new projects, and the acquisition of several new
clients during 2004. For the nine months ended September 30, 2004, $0.8 million,
or 4.2% of revenues, and $3.4 million, or 18.0% of revenues, is attributable to
the Evoke and DeLeeuw acquisitions which were completed in 2004. $3.9 million of
the increase for the three months ended September 30, 2004 relates to project
design and infrastructure projects obtained in the fourth quarter of 2003 that
are still ongoing or have developed into new projects, and the acquisition of
several new clients during 2004. The project design and infrastructure projects
are based upon time and materials and are billed and recognized at the time that
the services are performed as these are not related to fixed price projects.
There has been an increase in hourly rates charged for services. The
average rate for the three months ended September 30, 2004 increased by 8.3%
over the three month ended June 30, 2004. This is substantially attributable to
the acquisition of DeLeeuw, whose billing rates are higher than the Company's
traditional billing rates. DeLeeuw's focus is more highly concentrated on
management consulting, which is generally associated with higher billing rates.
Revenues for the three months ended September 30, 2004 increased 5.6% over the
three months ended June 30, 2004. If the average rates had not increased,
revenues would have decreased by 2.4% for the same period.
COST OF SERVICES
Cost of services primarily includes payroll and benefits costs for the
Company's consultants. Cost of services was $4.6 million, or 66.7% of revenue,
and $12.8 million, or 68.6% of revenue, for the three and nine months ended
September 30, 2004, respectively, compared to $2.5 million, or 70.1% of revenue,
and $7.5 million, or 71.1% of revenue, for the three and nine months ended
September 30, 2003, respectively. $0.1 million and $1.1 million of the increase
in cost of services during the three months ended September 30, 2004 is
attributed to costs related to operating Evoke and DeLeeuw, which were both
acquired during 2004. $0.9 million of the increase in the cost for the three
months ended September 30, 2004 resulted from costs related to consultants on
project design and infrastructure projects. Cost of services increased for the
nine months ended September 30, 2004 due to $2.3 million of cost to operate the
DeLeeuw and Evoke companies which were both acquired in 2004, and $3.0 million
of cost associated with producing the increased revenues and a shift in the
consulting force to higher paid consultants. This is directly correlated to the
increase in billing rates discussed above in the analysis of revenue.
20
Cost of Services for DeLeeuw Associates for the period of March 1, 2004
through September 30, 2004 were $2.2 million. Cost of services for the Company
(excluding DeLeeuw and Evoke) for the nine months ended September 30, 2004 were
$10.4 million, an increase of 37.9% over the nine months ended September 30,
2003.
GROSS PROFIT
Gross profit was $2.3 million, or 33.3% of revenue, and $5.9 million, or
31.4% of revenue for the three and nine months ended September 30, 2004,
respectively, compared to $1.1 million, or 29.9% of revenue, and $3.1 million,
or 28.8% of revenue, for the three and nine months ended September 30, 2003,
respectively. The DeLeeuw acquisition contributed gross profit of $0.6 million,
or 9.4% of revenues and $1.2 million, or 6.2% of revenues for the three and nine
months ended September 30, 2004 and the Evoke acquisition contributed gross
profit of $0.7 million, or 9.9% of revenues, and $0.7 million, or 3.6% of
revenues, for the three and nine months ended September 30, 2004. Gross profit
attributed to ongoing CSI operations was $1.0 million, or 42.1% of total gross
profit, and $4.0 million, or 68.5% of total gross profit, for the three and nine
months ended September 30, 2004, respectively.
As a percentage of total gross profit for the three months ended September
30, 2004, DeLeeuw contributed 28.2%, Evoke contributed 29.7%, and the ongoing
CSI operations contributed 42.1%. For the nine months ended September 30, 2004,
DeLeeuw contributed 19.8% of total gross profit, Evoke contributed 11.7% of
total gross profit, and the ongoing operations of the Company contributed the
remaining 68.5% of total gross profit.
The gross profit percentage for the three months ended September 30, 2004,
was 37.3%, 87.3% and 25.1% for DeLeeuw, Evoke, and ongoing operations of the
Company. The gross profit percentage for the nine months ended September 30,
2004, was 34.5%, 87.3% and 27.6% for DeLeeuw, Evoke, and ongoing operations of
the Company.
SELLING AND MARKETING
Selling and marketing expenses include payroll, employee benefits and
other headcount-related costs associated with sales and marketing personnel and
advertising, promotions, tradeshows, seminars and other programs. Selling and
marketing expenses were $1.4 million, or 21.0% of revenue, and $2.7 million, or
14.7% of revenue, for the three and nine months ended September 30, 2004,
respectively, compared to $0.4 million, or 12.5% of revenue, and $1.1 million,
or 10.0% of revenue, for the three and nine months ended September 30, 2003,
respectively. $0.5 million and $0.2 million of the increase in selling and
marketing expenses during the three months ended September 30, 2004 is
attributed to the costs related to operating Evoke and DeLeeuw, respectively,
which were both acquired during 2004. $0.3 million of the increase resulted from
increased payroll and related costs associated with the increased headcount in
the Company's existing companies' sales force. The Company has added six
additional salespeople and a Director of Marketing and Corporate Communications
through new hires and retaining staffs of acquired companies as part of the
Company's strategy to gain new clients and increase revenue. Three of the
additional salespeople and the Director of Marketing and Corporate
Communications were added in three months ended September 30, 2004. For the nine
months ended September 30, 2004, $0.5 million and $0.2 million of the increase
is attributed to the operations of the Evoke and DeLeeuw acquisitions,
respectively. Payroll expense and commissions increased by $0.6 million for the
nine months ended September 30, 2004 as compared with the same period in the
prior year due to the additional headcount discussed above.
GENERAL AND ADMINISTRATIVE
General and administrative costs include payroll, employee benefits and
other headcount-related costs associated with the finance, legal, facilities,
certain human resources and other administrative headcount, and legal and other
professional and administrative fees. General and administrative costs were $1.7
million, or 24.7% of revenue, and $4.9 million, or 26.1% of revenue, for the
three and nine months ended September 30, 2004, respectively, compared to $0.6
million, or 18.4% of revenue, and $1.8 million, or 17.2% of revenue, for the
three and nine months ended September 30, 2003, respectively. $0.4 million and
$0.1 million of the increase in general and administrative expenses during the
three months ended September 30, 2004 is attributed to the costs of operating
the Evoke and DeLeeuw companies subsequent to the acquisitions during 2004,
respectively. Additionally, $0.2 million is attributed to an increase in
officer's salaries as the result of hiring a chief financial officer during the
fourth quarter of 2003 and increasing the salaries of other Company officers to
compensate them competitively with other public companies the size of the
Company. The Company also increased general and administrative and development
headcount by twelve employees during 2004, as compared to 2003, to support the
increased size of the business which resulted in an increase in salaries of $0.2
million in comparing the third quarter of 2004 versus third quarter 2003. For
the three months ended September 2004 an increase of $0.1 million was incurred
as the result of legal and accounting fees associated with becoming a public
company and higher insurance premiums due to the growth of the Company. For the
nine months ended September 30, 2004, general and administrative expense
increased, as compared to the same period in the prior year, due to the
increased headcount of 15 and 43 and payroll costs of $775,000 and $625,000 for
the acquisitions of Evoke and DeLeeuw, respectively, in 2004.
21
RESEARCH AND DEVELOPMENT
Research and development costs primarily include the payroll, employee
benefits and other headcount-related costs associated with the employees working
on the development of upgrades and new versions of the Evoke Axio software
product. Research and development costs were $0.3 million, or 3.9% of revenue,
and $0.3 million, or 1.5% of revenue, for the three and nine months ended
September 30, 2004, respectively, compared to zero for the comparative periods
in the prior year. The research and development department was obtained in
association with the Evoke acquisition which was completed during 2004.
DEPRECIATION AND AMORTIZATION
Depreciation expense is recorded on the Company's property and equipment
which is generally depreciated over a period between three to seven years. The
Company amortizes deferred financing costs utilizing the effective interest
method over the term of the related debt instrument. Acquired software is
amortized on a straight-line basis over an estimated useful life of three years.
Acquired contracts are amortized over a period of time that approximates the
estimated life of the contracts, based upon the estimated annual cash flows
obtained from those contracts, generally five to six years. Depreciation and
amortization expenses were $0.4 million and $0.5 million for the three and nine
months ended September 30, 2004, respectively, compared to $52,000 and $0.1
million for the three and nine months ended September 30, 2003, respectively.
$0.3 million of the increase in depreciation and amortization during the three
and nine months ended September 30, 2004 is attributed to amortization of the
acquired Evoke intangible assets.
OTHER INCOME (EXPENSE)
The Company incurs interest expense on loans from financial institutions,
from capital lease obligations related to the acquisition of equipment used in
its business, and on the outstanding convertible line of credit notes.
Amortization of the discount on debt of $270,434 issued is also recorded as
interest expense. Interest expense recorded was $0.5 million and $0.6 million
for the three and nine months ended September 30, 2004, respectively, compared
to $12,000 and $0.1 million for the three and nine months ended September 30,
2003, respectively. This is directly related to the August and September
financings described below in the liquidity and capital resources section. The
Company recorded equity income in its investment in DeLeeuw International
(Turkey) of $3,841 and $11,478 for the three and nine months ended September 30,
2004, respectively, and an equity loss in its investment in LEC of $12,653 and
$36,378 for the three and nine months ended September 30, 2004, respectively.
INCOME TAXES
The Company evaluates the amount of deferred tax assets that are recorded
against expected taxable income over its forecasting cycle which is currently
two years. As a result of this evaluation, the Company has recorded a valuation
allowance of $1,439,000 in the quarter ending September 2004. This allowance was
recorded because, based on the weight of available evidence, it is more likely
than not that some portion of the deferred tax asset may not be realized.
No income tax expense or benefit was recorded in the prior year as the
Company was an "S" Corporation through September 30, 2003. Pro forma income
taxes for the comparable three and nine month periods in the prior year would
have been an income tax benefit of $39,000 and $27,000, respectively, using the
Company's estimated effective tax rate of 40%.
22
LIQUIDITY AND CAPITAL RESOURCES
Cash totaled $0.9 million as of September 30, 2004 compared to $0.4
million as of December 31, 2003. The Company's cash balance is primarily derived
from customer remittances, bank borrowings and acquired cash and is used for
general working capital needs. The Company had $83,000 on deposit with a
financial institution as collateral for a letter of credit and has classified
this as restricted cash on the accompanying consolidated balance sheet.
Working capital is ($2.3 million) as of September 30, 2004 compared to
($1.6 million) as of December 31, 2003. The Company's working capital position
has deteriorated during the nine month period primarily due to losses incurred
by the Company and liabilities assumed as a result of the acquisition of Evoke.
The losses generated by the Company and the payments in settlement of Evoke's
obligations have resulted in the need for $1.4 million of additional borrowings
against the Company's line of credit and a $1.0 million loan on a short term
note payable.
Cash used by operations during the nine months ended September 30, 2004
was $3.0 million, an increase of $2.7 million from the nine months ended
September 30, 2003. This increase in cash used by operations is primarily due to
a $2.0 million loss from operations (adjusted for non-cash charges), a $1.1
million increase in accounts receivable, a $0.5 million increase in the related
party receivables, and a $0.2 million reduction in deferred revenue during the
nine month period, which was partially offset by an increase in accounts payable
and accrued expenses of $0.9 million. Trade accounts receivable increased
primarily due to $0.9 million of receivables for DeLeeuw which was acquired in
March 2004 and $0.5 million for Evoke, which was acquired in June 2004. The
increase in the related party receivables is due to billings to LEC for work
performed under a subcontractor agreement beginning in December 2003. The
Company acquired 49% of LEC in 2004. Deferred revenue declined as a result of
recognition of the revenue as it was earned during 2004. Accounts payable and
accrued expenses increased primarily due to $0.3 million related to DeLeeuw and
$1.3 million related to Evoke, both of which were acquired during 2004.
Cash used by investing activities was $1.8 million during the nine months
ended September 30, 2004. This was due to payments of $2.1 million made
primarily as acquisition payments for DeLeeuw and for the purchases of equipment
for the Company, partially offset by $0.3 million of cash received as part of
the Evoke acquisition.
Cash provided by financing activities was $5.2 million during the nine
months ended September 30, 2004. During the first nine months of 2004, $4.0
million was raised from the issuance of line of credit notes and $1.0 million
was raised from the issuance of a short-term note payable and additional line of
credit borrowings of $1.4 million. $0.8 million of principal payments on
long-term debt and on capital lease obligations were made by the Company during
this time period.
There are currently no material commitments for capital expenditures.
As of December 31, 2003 and September 30, 2004, the Company had accounts
receivable due from Leading Edge Communications Corporation of approximately
$393,000 and $901,000, respectively. There are no known collections problems
with respect to LEC.
In May 2004, pursuant to the complete conversion of an unsecured
convertible line of credit note issued in October 2003, the participating
investor received 16,666,666 shares of common stock, plus interest paid in cash.
Further in May 2004, the Company raised an additional $2.0 million pursuant to a
new five-year unsecured promissory note with the same investor. In June 2004,
the Company replaced the May 2004 note by issuing a five-year $2.0 million
unsecured convertible line of credit note with the same investor. The note
accrues interest at an annual rate of 7%, and the conversion price of the shares
of common stock issuable under the note is equal to $0.105 per share. The
conversion price on the October 2003 note was adjusted to a fixed conversion
price of $0.105 per share on September 1, 2004, and 2,380,953 additional shares
of common stock were issued to the participating investor. In addition, such
investor received a warrant to purchase 4,166,666 shares of common stock, which
has an exercise price of $0.105 per share. This warrant expires in June 2009. An
initial beneficial conversion charge was recorded in June 2004 of $0.7 million
and an additional charge of $0.5 million was recorded in September 2004 as a
result of the reset of the conversion price.
23
In August 2004, the Company replaced its $3.0 million line of credit with
North Fork Bank with a revolving line of credit with Laurus Master Fund, Ltd.
("Laurus"), whereby the Company has access to borrow up to $6.0 million based
upon eligible accounts receivable. This revolving line, effectuated through a
$2.0 million convertible minimum borrowing note and a $4.0 million revolving
note, provides for advances at an advance rate of 90% against eligible accounts
receivable, with an annual interest rate of prime rate (as reported in the Wall
Street Journal) plus 1%, and maturing in three years. These notes will be
decreased by 1.0% for every 25% increase above the fixed conversion price prior
to an effective registration statement and 2.0% thereafter up to a minimum of
0.0%. This line of credit is secured by substantially all the corporate assets.
Both the $2.0 million convertible minimum borrowing note and the $4.0 million
revolving note provide for conversion at the option of the holder of the amounts
outstanding into the Company's common stock at a fixed conversion price of $0.14
per share. In the event that the Company issues common stock or derivatives
convertible into Company common stock for a price less than the aforementioned
fixed conversion price, then the fixed conversion price is reset using a
weighted average dilution calculation. Additionally, in exchange for a secured
convertible term note bearing interest at prime rate (as reported in the Wall
Street Journal) plus 1%, Laurus has made available to the Company an additional
$5.0 million to be used for acquisitions. This note is convertible into Company
common stock at a fixed conversion price of $0.14 per share. In the event that
the Company issues Company common stock or derivatives convertible into Company
common stock for a price less than the fixed conversion price, then the fixed
conversion price is reset to the lower price on a full-ratchet basis. This note
matures in three years. This cash will be restricted for use until approved
acquisition targets identified by the Company are approved by Laurus. A portion
of Laurus's revolving line of credit was used to pay off all outstanding
borrowings from North Fork Bank. The Company issued Laurus a common stock
purchase warrant that provides Laurus with the right to purchase 12.0 million
shares of the Company's common stock. The exercise price for the first 6.0
million shares acquired under the warrant is $0.29 per share, the exercise price
for the next 3.0 million shares acquired under the warrant is $0.31 per share,
and the exercise price for the final 3.0 million shares acquired under the
warrant is $0.35 per share. The common stock purchase warrant expires on August
16, 2011. The Company paid $0.75 million in brokerage and transaction closing
related costs. These costs were deducted from the $5.0 million restricted cash
balance provided to the Company by Laurus. As of September 30, 2004, $3.2
million was outstanding under the revolving line of credit. The interest rate on
the revolving line and the acquisition note was 5.75% during September 2004. As
a result of the beneficial conversion feature, a discount on debt issued of $5.6
million was recorded and is being amortized to interest expense over the three
year life of the debt agreement.
In September 2004, the Company issued to Sands Brothers Venture Capital
LLC, Sands Brothers Venture Capital III LLC and Sands Brothers Venture Capital
IV LLC (collectively, "Sands") three subordinated secured convertible promissory
notes equaling $1,000,000 (the "Notes"), each with an annual interest rate of 8%
expiring September 22, 2005. The Notes are secured by substantially all
corporate assets, but subordinate to Laurus. The Notes are convertible into
shares of the Company's common stock at the election of Sands at any time
following the consummation of a convertible debt or equity financing with gross
proceeds of $5 million or greater (a "Qualified Financing"). The conversion
price of the shares of the Company's common stock issuable upon conversion of
the Notes shall be equal to a price per share of common stock equal to forty
percent (40%) of the price of the securities issued pursuant to a Qualified
Financing. If no Qualified Offering has been consummated by September 8, 2005,
then Sands may elect to convert the Notes at a fixed conversion price of $0.14
per share. In the event that the Company issues stock or derivatives convertible
into common stock for a price less the aforementioned fixed conversion price,
then the fixed conversion price is reset using a weighted average dilution
calculation. The Company also issued Sands three common stock purchase warrants
(the "Warrants") providing Sands with the right to purchase 6,000,000 shares of
common stock. The exercise price of the shares of common stock issuable upon
exercise of the Warrants shall be equal to a price per share of common stock
equal to forty percent (40%) of the price of the securities issued pursuant to a
Qualified Financing. If no Qualified Offering has been consummated by September
8, 2005, then Sands may elect to exercise the Warrants at a fixed conversion
price of $0.14 per share. The latest that the Warrants may expire is September
8, 2008. Finally, the Company engaged Sands Brothers International Limited as
its non-exclusive financial advisor at $6,000 per month for a period of one
year. As a result of the beneficial conversion feature, a discount on debt
issued of $0.5 million was recorded in September 2004 and is being amortized to
interest expense over the one year life of the debt agreement.
Cash generating revenues from Evoke have been approximately 40% below
expectations during the three months ended September 30, 2004. The Company
expects the Evoke revenue to increase over the next several quarters as its
sales force has been actively soliciting business in the marketplace.
Additionally, the Company has continued to generate losses that have exceeded
expectations. To that extent, the Company has experienced continued negative
cash flow which has created a liquidity issue for the Company that it currently
believes to be short-term. To address this issue, the following financings were
effectuated:
24
In November 2004, the Company entered into a Stock Purchase Agreement (the
"Agreement") with a private investor, CMKX-treme, Inc. Pursuant to the
Agreement, CMKX-treme, Inc. agreed to purchase 12,500,000 shares of common stock
for a purchase price of $1,750,000. Under the terms of the Agreement,
CMKX-treme, Inc. initially purchased 3,571,428 shares of common stock for
$500,000, and it is required to purchase the remaining 8,928,572 shares of
common stock for $1,250,000 by December 31, 2004.
As of November 16, 2004, Scott Newman, President and Chief Executive
Officer of the Company, paid to the Company $188,520, the outstanding balance of
Mr. Newman's stockholder loan. Glenn Peipert, Executive Vice President and Chief
Executive Officer of the Company, paid to the Company $19,806, the outstanding
balance of Mr. Peipert's stockholder loan.
Additionally, as of November 17, 2004, Mr. Newman has agreed to personally
support the Company's cash requirements to enable it to fulfill its obligations
through March 31, 2005, to the extent necessary, up to a maximum amount of
$500,000. The Company believes that its reliance on such commitment is
reasonable and that Mr. Newman has sufficient liquidity and net worth to honor
such commitment. The Company believes that Mr. Newman's written commitment
provides the Company with the legal right to request and receive such advances.
Any loan by Mr. Newman to the Company would bear interest at 3% per annum.
The Company expects the aforementioned transactions to occur within the
contracted time periods. In the event that they do not materialize, the Company
may be required to seek additional sources of financing in the near future. If
the Company is unsuccessful in obtaining additional sources of financing, it
could experience difficulty meeting its current obligations as they become due.
The Company believes existing cash, borrowing capacity under the line of
credit and the contracted financings discussed above, or alternative financing
sources, and funds generated from operations to be sufficient to meet operating
requirements over the upcoming twelve month period. The Company may raise
additional funds in order to fund expansion, to develop new or enhanced products
and services, to respond to competitive pressures, or to acquire complementary
businesses or technologies. There is no assurance, however, that additional
financing will be available, or if available, will be available on acceptable
terms. Any decision or ability to obtain additional financing through debt or
equity investment will depend on various factors, including, among others,
revenues, financial market conditions, strategic acquisition and investment
opportunities, and developments in the Company's markets. The sale of additional
equity securities or future conversion of convertible debt would result in
additional dilution to the Company's stockholders.
Although the Company believes that it has credible arguments that it is in
compliance with the rules on integration, there is a risk that certain of the
transactions/financings may not be determined to be by the SEC and therefore
subject to review.
OFF-BALANCE SHEET ARRANGEMENTS
The Company does not have any transactions, agreements or other
contractual arrangements that constitute off-balance sheet arrangements.
25
APPLICATION OF CRITICAL ACCOUNTING POLICIES
REVENUE RECOGNITION
PROFESSIONAL SERVICES
Revenue from consulting and professional services is recognized at the
time the services are performed, evidence of an arrangement exists, the fee is
fixed or determinable and collectibility is reasonably assured. Reimbursements,
including those relating to travel and other out-of-pocket expenses, are
included in revenues, and an equivalent amount of reimbursable expenses are
included in cost of services.
Revenues for large services projects are recognized using the percentage
of completion method for long-term construction type contracts where costs to
complete the contract could reasonably be estimated. Revenues recognized in
excess of billings are recorded as costs in excess of billings. Billings in
excess of revenues recognized are recorded as deferred revenues until revenue
recognition criteria are met. The relationship of costs incurred to date
compared to estimated total costs at completion is used to determine the
percentage of completion on the project. This percentage is applied to the total
revenue to be earned on the project and that portion of revenue is recognized in
the current period. Additionally, billings in excess of revenue recognized on
projects being accounted for using the percentage-of-completion method are
recorded as deferred revenues. The percentage-of-completion method is not
applicable for the Company's software sales.
SOFTWARE
Revenue from software licensing and maintenance and support are also
recognized when persuasive evidence of an arrangement exists, delivery has
occurred, the fee is fixed or determinable, and collectibility is reasonably
assured. The Evoke software is delivered by the Company either directly to the
customer or to a distributor on an order by order basis. The software is not
sold with any right of return privileges and, as a result, a returns reserve is
not applicable. License fee revenue is recognized by the Company in the period
in which delivery occurs. Maintenance and support revenue is recorded in revenue
on a pro rata basis over the term of the maintenance and support agreement.
Deferred revenue is recorded when customers are invoiced for software
maintenance and support. The revenue is recognized over the term of the
maintenance and support agreement.
The Company licenses software and provides a maintenance and support
agreement to customers. These items are invoiced as separate items and
vendor-specific objective evidence is determined for the maintenance and
support, generally by identifying in the contract the cost of the maintenance
and support to the customer in subsequent renewal periods.
ACCOUNTS RECEIVABLE
The Company carries its accounts receivable at cost less an allowance for
doubtful accounts. On a periodic basis, the Company evaluates its accounts
receivable and adjusts the allowance for doubtful accounts, when deemed
necessary, based upon its history of past write-offs and collections,
contractual terms and current credit conditions.
AMORTIZATION
The Company amortizes deferred financing costs utilizing the effective
interest method over the term of the related debt instrument. Acquired software
is amortized on a straight-line basis over an estimated useful life of three
years. Acquired contracts are amortized over a period that approximates the
estimated life of the contracts, based upon the estimated annual cash flows
obtained from those contracts, generally five to six years.
GOODWILL AND INTANGIBLE ASSETS
Goodwill represents the amounts paid in connection with a settlement
agreement with the Elligent Consulting Group to re-acquire the ownership rights
to the Company in 1998 and in connection with the acquisitions of Scosys,
DeLeeuw and Evoke. Additionally, as part of the Scosys, DeLeeuw and Evoke
acquisitions, the Company acquired intangible assets. FASB Statement 142 was
adopted as of January 1, 2002 for all goodwill recognized in the Company's
balance sheet as of December 31, 2001. This statement changed the accounting for
goodwill from an amortization method to an impairment-only approach, and
introduced a new model for determining impairment charges.
Goodwill and intangible assets are reviewed for impairment whenever events
or circumstances indicate impairment might exist, or at least annually. The
Company assesses the recoverability of its assets, in accordance with SFAS No.
142 "Goodwill and Other Intangible Assets," comparing projected undiscounted
cash flows associated with those assets against their respective carrying
amounts. Impairment, if any, is based on the excess of the carrying amount over
the fair value of those assets. The Company's goodwill and intangible assets
were evaluated and deemed not to be impaired at December 31, 2003. There have
been no events or circumstances that would indicate that there has been any
impairment during the nine months ended September 30, 2004.
26
CONCENTRATIONS OF CREDIT RISK
Financial instruments which potentially subject the Company to
concentrations of credit risk are cash and accounts receivable arising from its
normal business activities. The Company routinely assesses the financial
strength of its customers, based upon factors surrounding their credit risk,
establishes an allowance for doubtful accounts, and as a consequence believes
that its accounts receivable credit risk exposure beyond such allowances is
limited. At September 30, 2004, one customer, LEC, a related party company,
comprised approximately 17.6% of the Company's accounts receivable balance.
INCOME TAXES
The Company accounts for income taxes under an asset and liability
approach that requires the recognition of deferred tax assets and liabilities
for the expected future tax consequences of events that have been recognized in
the Company's financial statements or tax returns. In estimating future tax
consequences, the Company generally considers all expected future events other
than enactments of changes in the tax laws or rates.
On January 1, 2001, the Company elected to be an "S" Corporation, whereby
the stockholders account for their share of the Company 's earnings, losses,
deductions and credits on their federal and various state income tax returns.
The Company is subject to New York City and various state income taxes. On
September 30, 2003, the Company's "S" Corporation status was revoked in
connection with the conversion of convertible subordinated debt into shares of
common stock.
The Company evaluates the amount of deferred tax assets that are recorded
against expected taxable income over its forecasting cycle which is currently
two years. As a result of this evaluation, the Company has recorded a valuation
allowance of $1,439,000 in the third quarter of 2004. This allowance was
recorded because, based on the weight of available evidence, it is more likely
than not that some portion of the deferred tax asset may not be realized.
For informational purposes, the accompanying statements of operations
include an unaudited pro forma adjustment for income taxes which would have been
recorded if the Company had not been an "S" Corporation. During the first nine
months of 2004, the Company's effective tax rate was estimated to be
approximately 40%. This rate is based upon the statutory federal income tax rate
of 34% plus a blended rate for the various states in which the Company incurs
income tax liabilities, net of the federal income tax benefit for state taxes
paid, of 6%. Since the Company was an "S" corporation for the full year of 2003,
the pro forma rate is based on the Company's estimated income tax rate for 2004
and is not based upon the prior year's effective tax rate.
ISSUES AND UNCERTAINTIES
This Quarterly Report on Form 10-QSB contains statements that are
forward-looking. These statements are based on current expectations and
assumptions that are subject to risks and uncertainties. Actual results could
differ materially because of issues and uncertainties such as those referenced
below and elsewhere in this report, which, among others, should be considered in
evaluating the Company's financial outlook.
For further information, refer to the business description and risk
factors sections included in the Company's Registration Statement on Form SB-2/A
filed with the SEC on September 30, 2004.
27
ITEM 3. CONTROLS AND PROCEDURES
Under the supervision and with the participation of our management,
including the Chief Executive Officer and the Chief Financial Officer, we have
evaluated the effectiveness of the design and operation of our disclosure
controls and procedures pursuant to Securities Exchange Act of 1934 Rule
13a-14(c) as of the end of the period covered by this report. Based on that
evaluation, the Chief Executive Officer and the Chief Financial Officer have
concluded that subject to the limitations noted below, our disclosure controls
and procedures are effective in timely alerting them to material information
required to be included in our periodic SEC filings. In updating the evaluation
of disclosure controls and internal controls over financial reporting as of
September 30, 2004, the Company identified certain significant deficiencies in
the following areas:
o Lack of certain internal controls over period-end financial
reporting; and
o Accounting and reporting for the Company's complex financing
transactions.
Management has established a plan that it believes will correct the
deficiencies as described above and is currently executing the plan. The Company
converted to the Great Plains accounting system during the third quarter of
2004. As a result of this system change, there were changes in the Company's
internal control over financial reporting during the third quarter of 2004.
The Company's management, including the Chief Executive Officer and the
Chief Financial Officer, does not expect that the Company's disclosure controls
and internal controls will prevent all error or all fraud. A control system, no
matter how well conceived and operated, can provide only reasonable, not
absolute, assurance that the objectives of the control system are met. Further,
the design of a control system must reflect the fact that there are resource
constraints, and the benefits of controls must be considered relative to their
costs. Because of the inherent limitations in all control systems, no evaluation
of controls can provide absolute assurance that all control issues and instances
of fraud, if any, within the Company have been detected. These inherent
limitations include the realities that judgments in decision-making can be
faulty, and that breakdowns can occur because of simple error or mistake.
Additionally, controls can be circumvented by the individual acts of some
persons, by collusion of two or more people, or by management override of the
control.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On June 29, 2004, Viant Capital LLC commenced legal action against the
Company in the United States District Court for the Southern District of New
York. Through an agreement with Viant, Viant had the exclusive right to obtain
private equity transactions on behalf of the Company from February 18 to May 17,
2004. Viant alleges that it is owed a fee of approximately $450,000 relating to
the Company's loan from a private investor in May 2004. Management believes that
this loan does not qualify as a private equity transaction and it intends to
vigorously defend the Company. As of November 19, 2004, there have been no
material developments in the suit. The Company has estimated the probable loss
related to this suit to be the agreed upon contract signing fee of $75,000 and
has recorded a liability for this amount.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
31.1 Rule 13a-14(a)/15d-14(a) Certification by Chief Executive Officer.
31.2 Rule 13a-14(a)/15d-14(a) Certification by Chief Financial Officer.
32 Certifications by the Chief Executive Officer and Chief Financial Officer
Relating to a Periodic Report Containing Financial Statements.*
(b) Reports on Form 8-K:
Three reports on Form 8-K were filed during the reporting period, as follows:
Form 8-K filed by the Company on July 14, 2004, pertaining to Items 2 and 7
regarding an acquisition of assets and financial statements.
Form 8-K/A filed by the Company on September 14, 2004, pertaining to Item 9.01
regarding financial statements of a business acquired.
Form 8-K filed by the Company on September 27, 2004, pertaining to Items 1.01
and 9.01 regarding entry into material definitive agreements.
The Exhibit attached to this Form 10-QSB shall not be deemed "filed" for
purposes of Section 18 of the Securities Exchange Act of 1934 (the "Exchange
Act") or otherwise subject to liability under that section, nor shall it be
deemed incorporated by reference in any filing under the Securities Act of 1933,
as amended, or the Exchange Act, except as expressly set forth by specific
reference in such filing.
28
SIGNATURE
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.
CONVERSION SERVICES INTERNATIONAL, INC.
By: /S/ SCOTT NEWMAN
--------------------
Name: Scott Newman
Title: President and Chief Executive Officer
(Principal Executive Officer and Duly
Authorized Officer)
November 22, 2004