UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-QSB
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|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Quarterly Period Ended March 31, 2005
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
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CONVERSION SERVICES INTERNATIONAL, INC.
(Exact name of small business user as specified in its charter)
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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
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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 May 13, 2005,
788,474,038 shares 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
Condensed Consolidated Balance Sheet as of March 31, 2005 (unaudited)....3
Condensed Consolidated Statements of Operations for the three months
ended March 31, 2005 and 2004 (restated) (unaudited)..................4
Condensed Consolidated Statements of Cash Flows for the three months
ended March 31, 2005 and 2004 (restated) (unaudited)...................5
Notes to Condensed Consolidated Financial Statements (unaudited).........7
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations...........................................23
Item 3. Controls and Procedures...........................................34
Part II. Other Information
Item 6. Exhibits and Reports on Form 8-K..................................37
Signatures
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CONVERSION SERVICES INTERNATIONAL, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEET
MARCH 31, 2005
(Unaudited)
ASSETS
CURRENT ASSETS
Cash $ 1,205,172
Accounts receivable, net of allowance for doubtful accounts of $259,147 3,676,742
Accounts receivable from related parties; (Note 16) 782,830
Prepaid expenses 263,114
------------
TOTAL CURRENT ASSETS 5,927,858
------------
PROPERTY AND EQUIPMENT, at cost, net; (Note 3) 564,697
------------
OTHER ASSETS
Restricted cash 4,293,569
Goodwill 4,690,972
Intangible assets, net of accumulated amortization of $1,191,031; (Note 4) 3,347,207
Deferred financing costs, net of accumulated amortization of $222,653; (Note 5) 670,656
Discount on debt issued, net of accumulated amortization of $1,582,659; (Note 6) 5,993,516
Equity investments 188,184
Other assets 80,087
------------
19,264,191
------------
Total Assets $ 25,756,746
============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Line of credit; (Note 7) $ 3,784,623
Current portion of long-term debt 129,890
Accounts payable and accrued expenses 3,314,514
Short term note payable, (Note 8) 727,272
Related party short term note payable; (Note 16) 299,554
Deferred revenue 1,783,097
------------
TOTAL CURRENT LIABILITIES 10,038,950
LONG-TERM DEBT, net of current portion; (Note 9) 5,044,126
------------
Total Liabilities 15,083,076
------------
MINORITY INTEREST 100,885
------------
COMMITMENTS AND CONTINGENCIES; (Note 15) --
STOCKHOLDERS' EQUITY
Common stock, $0.001 par value, 1,000,000,000 shares authorized;
781,010,668 issued and outstanding 781,011
Additional paid in capital 46,013,159
Accumulated deficit (36,224,083)
Accumulated other comprehensive income 2,698
------------
Total Stockholders' Equity 10,572,785
------------
Total Liabilities and Stockholders' Equity $ 25,756,746
============
See Notes to Condensed Consolidated Financial Statements.
3
CONVERSION SERVICES INTERNATIONAL, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three months ended March 31,
------------------------------
2005 2004
------------- -------------
(Restated)
REVENUE:
Services $ 5,015,293 $ 4,234,471
Related party services 1,096,402 969,887
Software 293,368 --
Support and maintenance 432,005 --
Other 35,470 57,679
------------- -------------
6,872,538 5,262,037
COST OF REVENUE:
Services 3,528,596 3,073,240
Related party services 1,011,858 756,624
Software 44,450 --
Support and maintenance 13,068 --
Other -- 9,436
------------- -------------
4,597,972 3,839,300
------------- -------------
GROSS PROFIT 2,274,566 1,422,737
------------- -------------
OPERATING EXPENSES
Selling and marketing 1,527,223 581,425
General and administrative 1,940,135 1,412,952
Research and development 241,676 --
Depreciation and amortization 431,456 50,244
------------- -------------
4,140,490 2,044,621
------------- -------------
LOSS FROM OPERATIONS (1,865,924) (621,884)
------------- -------------
OTHER INCOME (EXPENSE)
Equity in income (losses) from investments 43,292 (1,602)
Other income (expense) (2,191) 6,551
Interest income 24,192 443
Interest expense (1,364,854) (32,553)
------------- -------------
(1,299,561) (27,161)
------------- -------------
LOSS BEFORE INCOME TAXES (BENEFIT) AND MINORITY INTEREST (3,165,485) (649,045)
INCOME TAXES (BENEFIT) -- (215,600)
------------- -------------
LOSS BEFORE MINORITY INTEREST (3,165,485) (433,445)
MINORITY INTEREST 30,702 --
------------- -------------
NET LOSS $ (3,134,783) $ (433,445)
============= =============
Basic $ (0.00) $ (0.00)
Diluted $ (0.00) $ (0.00)
Shares used to compute net loss per share:
Basic 772,974,953 572,700,000
Diluted 772,974,953 572,700,000
See Notes to Condensed Consolidated Financial Statements.
4
CONVERSION SERVICES INTERNATIONAL, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three months ended March 31,
--------------------------
2005 2004
----------- -----------
(Restated)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(3,134,783) $ (433,445)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization of leasehold improvements 55,680 16,623
Amortizaton of intangible assets 279,889 34,160
Amortization of discount on debt 661,054 --
Amortization of relative fair value of warrants issued 331,737 --
Amortization of deferred financing costs 95,886 --
Deferred taxes -- (215,600)
Compensation expense for stock options and stock issued 15,794 --
Allowance for doubtful accounts 35,412 18,874
Write-off deferred loan costs -- 24,862
Loss on disposal of equipment -- 35,496
(Income) loss from equity investments (43,724) 1,602
Minority interest in Evoke Software Corporation (30,702) --
Changes in operating assets and liabilities:
(Increase) decrease in accounts receivable 637,075 (1,291,315)
Increase in accounts receivable from related parties (1,730) --
Decrease in prepaid expenses 46,345 37,587
Increase in due from stockholders -- (1,365)
(Increase) decrease in other assets (66,667) 14,721
Increase (decrease) in accounts payable and accrued expenses (463,431) 584,920
Increase in deferred revenue 455,875 89,242
----------- -----------
Net cash used in operating activities (1,126,290) (1,083,638)
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of property and equipment (20,367) (33,594)
Investment in DeLeeuw Associates, net of cash acquired -- (1,059,266)
----------- -----------
Net cash used in investing activities (20,367) (1,092,860)
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Cash overdraft -- 84,150
Net advances under line of credit 51,220 2,548,201
Line of credit repayment -- (1,789,110)
Issuance of convertible line of credit notes -- 2,000,000
Deferred loan costs in connection with line of credit / long term debt -- (30,534)
Principal payments on long-term debt -- (673,818)
Proceeds from sale of Company common stock 1,250,000 --
Principal payments on capital lease obligations (31,165) (3,327)
Principal payments on stockholder loans (8,363) --
Restricted cash 59,183 (83,375)
----------- -----------
Net cash provided by financing activities 1,320,875 2,052,187
----------- -----------
Effect of exchange rate changes on cash and cash equivalents 2,808 --
NET INCREASE IN CASH 177,026 (124,311)
CASH, beginning of period 1,028,146 411,586
----------- -----------
CASH, end of period $ 1,205,172 $ 287,275
=========== ===========
See Notes to Condensed Consolidated Financial Statements.
5
CONVERSION SERVICES INTERNATIONAL, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three months ended March 31,
---------------------------
2005 2004
------------ ------------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest $ 11,388 $ 35,379
Cash paid for income taxes -- --
SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIES:
During the three months ended March 31, 2005 and 2004, the Company entered
into various capital lease arrangements for computer and trade show equipment in
the amount of $13,378 and $64,749, respectively
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 $ -- $ 975,000
Acquired approved vendor status -- 539,000
Acquired tradename -- 722,000
Acquired goodwill -- 14,893,000
Acquired investment in limited liability company -- 56,000
Acquired liabilities -- (286,000)
See Notes to Condensed Consolidated Financial Statements.
6
CONVERSION SERVICES INTERNATIONAL, INC.
AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1 - Accounting Policies
Organization and Business
Conversion Services International, Inc. ("CSI") was incorporated in the
State of Delaware and has been conducting business since 1990. CSI and its
subsidiaries (together the "Company") are principally engaged in the information
technology services industry in the following areas: strategic consulting,
business intelligence, data warehousing and data management, on credit, to its
customers principally located in the northeastern United States.
Basis of Presentation
The accompanying financial statements have been prepared by the Company
and are unaudited. The results of operations for the three months ended March
31, 2005 are not necessarily indicative of the results to be expected for any
future period or for the full fiscal year. In the opinion of management, all
adjustments (consisting of normal recurring adjustments unless otherwise
indicated) necessary to present fairly the financial position, results of
operations and cash flows at March 31, 2005, and for all periods presented, have
been made. Footnote disclosure has been condensed or omitted as permitted in
interim financial statements.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of
the Company and its subsidiaries, Doorways, Inc., DeLeeuw, Evoke Software
Corporation (formerly known as Evoke Asset Purchase Corp.), LEC Corporation of
NJ and CSI Sub Corp. (DE). 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.
Revenue recognition
Services
Revenue from consulting and professional services is recognized at the
time the services are performed on a project by project basis. For projects
charged on a time and materials basis, revenue is recognized based on the number
of hours worked by consultants at an agreed-upon rate per hour. For large
services projects where costs to complete the contract could reasonably be
estimated, the Company undertakes projects on a fixed-fee basis and recognizes
revenues on the percentage of completion method of accounting based on the
evaluation of actual costs incurred to date compared to total estimated costs.
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. 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 and are immaterial.
Software
Revenue from software licensing and maintenance and support are 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. The Company recognizes net license revenues based upon the residual
method after all licensed software product has been delivered as prescribed by
Statement of Position 98-9, "Modification of SOP No. 97-2 with Respect to
Certain Transactions." The Company recognizes maintenance revenues over the term
of the maintenance contract. The maintenance rates for both license agreements
with and without stated renewal rates are based upon the price when sold
separately. Vendor-specific objective evidence of the fair value of maintenance
for license agreements that do not include stated renewal rates is determined by
reference to the price paid by the Company's customers when maintenance is sold
separately (i.e. the prices paid by customers in connection with renewals).
7
The percentage-of-completion method of accounting is not applicable for
the Company's software sales.
Business Combinations
Business combinations are accounted for in accordance with SFAS No. 141,
"Business Combinations" ("SFAS 141"), which requires the purchase method of
accounting for business combinations be followed and in accordance with EITF No.
99-12 "Determination of the Measurement Date for the Market Price of Acquirer
Securities Issued in a Purchase Business Combination" ("EITF 99-12"). In
accordance with SFAS 141, the Company determines the recognition of intangible
assets based on the following criteria: (i) the intangible asset arises from
contractual or other rights; or (ii) the intangible is separable or divisible
from the acquired entity and capable of being sold, transferred, licensed,
returned or exchanged. In accordance with SFAS 141, the Company allocates the
purchase price of its business combinations to the tangible assets, liabilities
and intangible assets acquired based on their estimated fair values. The excess
purchase price over those fair values is recorded as goodwill. Additionally, in
accordance with EITF 99-12, the Company values an acquisition based upon the
market price of its common stock for a reasonable period before and after the
date the terms of the acquisition are agreed to and announced.
Research and development costs
The Company incurs research and development costs related to software
upgrades and the development of new versions of its Evoke Axio software product.
Research and development costs are charged to expense as incurred. Such costs
amounted to $241,676 and $0 during the three months ended March 31, 2005 and
2004, respectively.
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. Leasehold improvements are amortized over the shorter of the asset
life or the remaining lease term on a straight-line basis. 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.
Goodwill and intangible assets
Goodwill and intangible assets are accounted for in accordance with SFAS
No. 142 "Goodwill and Other Intangible Assets" ("SFAS 142"). Under SFAS 142,
goodwill and indefinite lived intangible assets are not amortized but instead
are reviewed annually for impairment, or more frequently if impairment
indicators arise. Separable intangible assets that are not deemed to have an
indefinite life will continue to be amortized over their estimated useful lives.
The Company tests for impairment whenever events or changes in circumstances
indicate that the carrying amount of goodwill or other intangible assets may not
be recoverable, or at least annually at December 31 of each year. These tests
are performed at the reporting unit level using a two-step, fair-value based
approach. The first step compares the fair value of the reporting unit with its
carrying amount, including goodwill. If the fair value of the reporting unit is
less than its carrying amount, a second step is performed to measure the amount
of impairment loss. The second step allocates the fair value of the reporting
unit to the Company's tangible and intangible assets and liabilities. This
derives an implied fair value for the reporting unit's goodwill. If the carrying
amount of the reporting unit's goodwill exceeds the implied fair value of that
goodwill, an impairment loss is recognized equal to that excess. In the event
that the Company determines that the value of goodwill or other intangible
assets have become impaired, the Company will incur a charge for the amount of
the impairment during the fiscal quarter in which the determination is made.
8
Goodwill represents the amounts paid in connection with the acquisitions
of Scosys and DeLeeuw. Additionally, as part of the Scosys, DeLeeuw and Evoke
acquisitions, the Company acquired identifiable intangible assets.
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.
The approved vendor status intangible asset is being amortized over an estimated
life of forty months.
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.
Stock compensation
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 650,000 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. Compensation expense of $15,794 and zero was
included in the reported results for the three months ended March 31, 2005 and
2004, respectively.
Had the Company determined compensation cost based upon the fair value at
the grant date for its stock options under SFAS No. 123, the Company's net loss
would have changed to the pro forma amounts indicated below:
9
Three months Three months
ended March 31, ended March 31,
2005 2004
------------- -------------
Net loss:
As reported $ (3,134,783) $ (433,445)
Less: Compensation expense per SFAS 123 (382,646) (7,385)
------------- -------------
Pro forma $ (3,517,429) $ (440,830)
============= =============
Net loss per share:
As reported
Basic $ (0.00) $ (0.00)
Diluted (0.00) $ (0.00)
Pro forma
Basic $ (0.00) (0.00)
Diluted (0.00) (0.00)
============= =============
There were no options granted prior to 2004. The per share weighted
average fair value of stock options granted during 2004 was $0.16 per share on
the date of grant using the Black-Scholes option-pricing model with the
following weighted average assumptions:
Expected dividend yield 0.0%
Risk-free interest rate 2.5%
Expected volatility 148.0%
Expected option life (years) 3.0
Pro forma information regarding net loss and net loss per share is
required by SFAS 123, as amended by SFAS 148, and has been determined as if the
Company had accounted for its employee stock options under the fair-value
method. 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.
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 March 31, 2005, one customer, LEC, a related party, comprised
approximately 17.6% of the Company's accounts receivable balance.
The Company maintains its cash with a high credit quality financial
institution. Each account is secured by the Federal Deposit Insurance
Corporation up to $100,000.
Income taxes
The Company accounts for income taxes, in accordance with SFAS No. 109,
"Accounting for Income Taxes" ("SFAS 109") and related interpretations, 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.
The Company records a valuation allowance to reduce the deferred tax
assets to the amount that is more likely than not to be realized. The Company's
current valuation allowance primarily relates to benefits from the Company's
NOL's.
10
Derivatives
The Company accounts for derivatives in accordance with SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133") and
related interpretations. SFAS 133, as amended, requires companies to recognize
all derivative instruments as either assets or liabilities in the balance sheet
at fair value. At December 31, 2004, the Company had not entered into any
transactions which were considered hedges under SFAS 133. The accounting for
changes in the fair value of a derivative instrument depends on: (i) whether the
derivative has been designated and qualifies as part of a hedging relationship,
and (ii) the type of hedging relationship. For those derivative instruments that
are designated and qualify as hedging instruments, a company must designate the
hedging instrument based upon the exposure being hedged as either a fair value
hedge, cash flow hedge or hedge of a net investment in a foreign operation.
Foreign Currency Translation
Local currencies are the functional currencies for Evoke's foreign
subsidiaries. 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.
Reclassification
Certain amounts in prior periods have been reclassified to conform to the
2005 financial statement presentation.
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.
Note 2: Recent Pronouncements
In December 2004, the FASB issued SFAS No. 123 (revised 2004) "Share-Based
Payment" ("SFAS No. 123R") that addresses the accounting for share-based payment
transactions in which a company receives employee services in exchange for (a)
equity instruments of the company or (b) liabilities that are based on the fair
value of the company's equity instruments or that may be settled by the issuance
of such equity instruments. SFAS No. 123R addresses all forms of share-based
payment awards, including shares issued under employee stock purchase plans,
stock options, restricted stock and stock appreciation rights. SFAS No. 123R
eliminates the ability to account for share-based compensation transactions
using APB Opinion No. 25, "Accounting for Stock Issued to Employees", that was
provided in Statement 123 as originally issued. Under SFAS No. 123R, companies
are required to record compensation expense for all share based payment award
transactions measured at fair value. This statement is effective for quarters
ending after December 15, 2005. The Company has not yet determined the impact of
applying the various provisions of SFAS No. 123R.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets
-- An Amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions
(SFAS 153). SFAS 153 eliminates the exception from fair value measurement for
nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB
Opinion No. 29, Accounting for Nonmonetary Transactions, and replaces it with an
exception for exchanges that do not have commercial substance. SFAS 153
specifies that a nonmonetary exchange has commercial substance if the future
cash flows of the entity are expected to change significantly as a result of the
exchange. SFAS 153 is effective for the fiscal periods beginning after June 15,
2005 and is required to be adopted by the Company in the third quarter of 2005.
The Company is currently evaluating the effect that the adoption of SFAS 153
will have on its consolidated results of operations and financial condition but
does not expect it to have a material impact.
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs: an amendment
of ARB No. 43, Chapter 4," to clarify the accounting for abnormal amounts of
idle facility expense, freight, handling costs and wasted material. SFAS No. 151
is effective for inventory costs incurred during fiscal years beginning after
June 15, 2005. We do not believe the provisions of SFAS No. 151, when applied,
will have an impact on our financial position or results of operations.
11
Note 3 - Property and equipment
Property and equipment consisted of the following:
March 31,
2005
-----------
Computer equipment $ 980,212
Furniture and fixtures 202,376
Leasehold improvements 221,219
-----------
1,403,807
Accumulated depreciation (839,110)
-----------
$ 564,697
===========
Depreciation and amortization expense related to property and equipment totaled
$56,000 and $16,600 for the three months ended March 31, 2005 and 2004,
respectively.
Note 4 - Intangible assets
Intangibles acquired have been assigned as follows:
March 31, Amortization
2005 period
------------------------
Customer contracts $ 1,876,424 5 - 6 years
Approved vendor status 538,814 40 months
Computer software 1,381,000 3 years
Tradename 722,000 Indefinite
Proprietary rights and rights to the name of Scosys, Inc. 20,000 Indefinite
-----------
4,538,238
Accumulated amortization (1,191,031)
-----------
$ 3,347,207
===========
The estimated amortization expense for the next five years related to other
finite-lived intangible assets is estimated to be as follows:
Amortization of
Intangible assets
------------------
2006 $ 1,092,457
2007 941,324
2008 379,960
2009 115,897
2010 69,831
Thereafter 5,738
-----------
$ 2,605,207
===========
12
Note 5 - Deferred financing costs
The Company has incurred and capitalized financing costs in connection
with two financing transactions consummated during 2004. These costs were
deferred and are being amortized over the life of the related financing
agreement. The following illustrates the components of the deferred financing
costs:
March 31, 2005
---------
Laurus Master Fund $ 766,270
Sands Brothers 127,039
---------
$ 893,309
Accumulated amortization (222,653)
---------
$ 670,656
=========
Note 6 - 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:
March 31, 2005 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 (1,582,659)
-----------------
$ 5,993,516
=================
Note 7 - Line of credit
The Company has 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, which was 5.75% as of March 31, 2005) plus 1%, and maturing in
three years. The Company has no obligation to meet financial covenants under the
$2.0 million convertible minimum borrowing note or the $4.0 million revolving
note. 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. The Company has no obligation to meet financial covenants under
the $5.0 million secured convertible term note (See Note 9 to the Condensed
Consolidated Financial Statements). 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.
13
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.
As of March 31, 2005, approximately $3.8 million was outstanding under the
revolving line of credit. The interest rate on the revolving line and the
acquisition note was 6.75% as of March 31, 2005.
Under the Laurus agreement, the Company was obligated to ensure that the
shares provided for issuance under the agreement were properly registered by
December 19, 2004. As a result of the Company's Registration statement not being
declared effective prior to this date, and not being effective as of March 31,
2005, the Company is incurring liquidated damages to Laurus. As a result, the
Company has accrued $0.25 million for payment of these penalties through March
31, 2005.
Note 8 - 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 $1.0 million (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 Company also
issued Sands three common stock purchase warrants (the "Warrants") providing
Sands with the right to purchase 6.0 million 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.
14
Note 9 - Long term debt
Long-term debt consisted of the following:
March 31,
2005
-----------
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.
As of March 31, 2005, the interest rate on this note was 6.75%. See note 7 -
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, ranging from 18% to 32% as
of March 31, 2005, and have maturity dates through 2008. 206,642
-----------
7,206,642
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. (2,032,626)
-----------
Subtotal 5,174,016
Less: Current portion of long-term debt, including obligations under capital
leases of $129,890. (129,890)
-----------
$ 5,044,126
===========
Future annual payments of long-term debt is as follows:
Years Ending March 31,
----------------------
2006 $ 129,890
2007 5,069,614
2008 7,138
2009 2,000,000
-----------
$ 7,206,642
===========
15
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 $368,000.
The following schedule lists future minimum lease payments under the
capital leases with their present value as of March 31, 2005:
Years Ending March 31,
----------------------
2006 $164,113
2007 77,663
2008 7,726
------------
249,502
Less: Amount representing interest (42,860)
------------
$206,642
============
During the three months ended March 31, 2005 and 2004, the Company
recorded depreciation expense related to equipment under capital leases of
approximately $25,100 and $4,700, respectively.
Note 10 - 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 $12.6 million and zero for the three months ended March 31, 2005
and 2004, respectively. This allowance was recorded because, based on the weight
of available evidence, it is more likely than not that some, or all, of the
deferred tax asset may not be realized.
During 2005 and 2004, the Company's effective tax rate is 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%.
Note 11 - Common Stock
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 12.5 million shares of common
stock for a purchase price of $1.75 million. Under the terms of the Agreement,
CMKX-treme, Inc. initially purchased 3,571,428 shares of common stock for $0.5
million, and it was required to purchase the remaining 8,928,572 shares of
common stock for $1.25 million by December 31, 2004. On March 17, 2005,
CMKX-treme, Inc. remitted final payment for the remaining 8,928,572 shares.
Note 12 - Stock Based Compensation
The 2003 Incentive Plan ("2003 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. The options granted
may be a combination of both incentive and nonstatutory options, generally vest
over a three year period from the date of grant, and expire ten years from the
date of grant.
To the extent that CSI derives a tax benefit from options exercised by
employees, such benefit will be credited to additional paid-in capital when
realized on the Company's income tax return. There were no tax benefits realized
by the Company during 2005 or 2004.
The following summarizes the stock option transactions under the 2003 Plan
during 2005:
Weighted
average
Share exercise price
----------- -----------
Options outstanding at December 31, 2004 41,265,981 $ 0.15
Options granted -- --
Options exercised -- --
Options canceled (775,000) 0.21
----------- -----------
Options outstanding at March 31, 2005 40,490,981 $ 0.15
=========== ===========
16
The following table summarizes information concerning outstanding and
exercisable Company common stock options at March 31, 2005:
Weighted Weighted Weighted
average average average
Range of exercise Options exercise remaining Options exercise
prices outstanding price contractual life exercisable price
---------------------------------------------------------------------------------------------
$0.055 8,900,981 $ 0.055 9.4 8,900,981 $ 0.055
$0.165 - $0.23 31,590,000 0.180 9.2 6,400,000 0.165
---------------- ----------
40,490,981 15,300,981
================ ==========
Note 13 - Loss Per Share
Basic loss per share is computed on the basis of the weighted average
number of common shares outstanding. Diluted loss 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.
Basic and diluted loss per share were determined as follows:
For the three months ended March 31,
------------------------------
2005 2004
------------- -------------
(Restated)
Net loss available for common stockholders (A) $ (3,134,783) $ (433,445)
Weighted average outstanding shares of common stock (B) 772,974,953 572,700,000
Common stock and common stock equivalents (C) 772,974,953 572,700,000
Loss per share:
Basic (A/B) $ (0.00) $ (0.00)
============= =============
Diluted (A/C) $ (0.00) $ (0.00)
============= =============
For the three months ended March 31, 2005, 40,490,981 shares attributable
to outstanding stock options were excluded from the calculation of diluted loss
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 loss per share for the three months
ended March 31, 2005 because the effect was antidilutive.
Note 14 - Major Customers
During the three months ended March 31, 2005, the Company had sales to one
major customer, LEC, a related party (16.0%), which totaled approximately
$1,096,000. Amounts due from this customer included in accounts receivable was
approximately $783,000 at March 31, 2005. As of March 31, 2005, LEC accounted
for approximately 17.6% of the Company's accounts receivable balance.
17
During the three months ended March 31, 2004, the Company had sales to one
major customer, LEC, a related party (18.4%), which totaled approximately
$970,000. Amounts due from this customer included in accounts receivable was
approximately $823,000 at March 31, 2004. As of March 31, 2004, LEC accounted
for approximately 19.1% of the Company's accounts receivable balance.
See Note 16 "Related Party Transactions" in the Notes to the Condensed
Consolidated Financial Statements for further discussion.
Note 15 - Commitments and Contingencies
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. 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. This suit was settled on April 28,
2005 for an immaterial amount.
Lease Commitments
The Company's corporate headquarters are located at 100 Eagle Rock Avenue,
East Hanover, New Jersey 07936, where it operates under an amended lease
agreement expiring December 31, 2010. Our monthly rent with respect to our East
Hanover, New Jersey facility is $26,290. In addition to minimum rentals, the
Company is liable for its proportionate share of real estate taxes and operating
expenses, as defined. DeLeeuw Associates, LLC has an office at Suite 1460,
Charlotte Plaza, 201 South College Street, Charlotte, North Carolina 28244.
DeLeeuw leases this space which has a stated expiration date of December 31,
2005. Our monthly rent with respect to our Charlotte, North Carolina facility is
$2,831. Evoke leases offices in the following locations: Riata Corporate Park
Building VII, 12357-III Riata Trace Parkway, Austin, Texas; 1900 13th Street,
Boulder, Colorado; and Am Soldnermoos 17, D-85399 Hallbergmoos, Germany. The
expiration dates for these leases are July 2006, July 2006 and May 2005. Monthly
rentals for these offices are $22,872, $5,284 and $2,000, respectively.
Rent expense, including automobile rentals, totaled approximately $205,539
and $78,784 for the three months ended March 31, 2005 and 2004, respectively.
The Company is committed under several operating leases for automobiles
that expire during 2007.
Note 16 - Related Party Transactions
For the three months ended March 31, 2005 and 2004, the Company invoiced
LEC $1,096,000 and $970,000, respectively, for the services of consultants
subcontracted to LEC by the Company. As of March 31, 2005 and 2004, the Company
had accounts receivable due from LEC of approximately $783,000 and $823,000,
respectively. There are no known collections problems with respect to LEC. We
feel confident in the collectibility of these accounts receivable as the
majority of its billing is derived from Fortune 100 clients. The collection
process is slow as these clients require separate approval on their own internal
systems, which extends the payment cycle.
On November 8, 2004, Mr. Newman entered into a stock purchase agreement
with a private investor, CMKX-treme, Inc. Pursuant to the agreement, CMKX-treme,
Inc. agreed to purchase 2,833,333 shares of common stock for a purchase price of
$250,000. As of March 31, 2005, the shares have not been issued to CMKX-treme,
Inc. because the investor has not yet remitted payment for the shares.
On November 8, 2004, Mr. Peipert entered into a stock purchase agreement
with a private investor, CMKX-treme, Inc. Pursuant to the agreement, CMKX-treme,
Inc. agreed to purchase 5,666,667 shares of common stock for a purchase price of
$500,000. As of March 31, 2005, the shares have not been issued to CMKX-treme,
Inc. because the investor has not yet remitted full payment for the shares.
18
On November 10, 2004, the Company and Dr. Michael Mitchell, the former
President, Chief Executive Officer and sole director of LCS, executed a one-year
consulting agreement whereby Dr. Mitchell would perform certain consulting
services on behalf of the Company. Dr. Mitchell will receive an aggregate amount
of $250,000 as compensation for services provided to the Company. As of March
31, 2005, an aggregate amount of $150,000 has been paid to Dr. Mitchell for
services provided under this consulting agreement.
As of December 14, 2004, Scott Newman, our President, Chief Executive
Officer and Chairman, had loaned the Company $200,000, and Glenn Peipert, our
Executive Vice President, Chief Operating Officer and Director, had loaned the
Company $125,000. The unsecured loans by Mr. Newman and Mr. Peipert each accrue
interest at a simple rate of 3% per annum, and each has a term expiring on
January 1, 2006. As of March 31, 2005, approximately $177,000 and $123,000
remained outstanding to Messrs. Newman and Peipert, respectively.
As of March 30, 2005, Messrs. Newman, Peipert and Robert C. DeLeeuw have
agreed to personally support our cash requirements to enable us to fulfill our
obligations through May 1, 2006, to the extent necessary, up to a maximum amount
of $2.5 million. Mr. Newman personally guaranties up to $1.4 million, Mr.
Peipert guaranties up to approximately $0.7 million and Mr. DeLeeuw personally
guaranties approximately $0.4 million. We believe that our reliance on such
commitment is reasonable and that Messrs. Newman, Peipert and DeLeeuw have
sufficient liquidity and net worth to honor such commitment. We believe that
this written commitment provides us with the legal right to request and receive
such advances. Any loan by Messrs. Newman, Peipert and DeLeeuw to the Company
would bear interest at 3% per annum.
Note 17 - Segment Information
The Company has two reportable segments: services and software, which
includes support and maintenance. The 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 the assets of Scosys, Inc., DeLeeuw Associates,
Inc. and the equity adjustment related to its equity investment in Leading Edge
Communications Corporation have all been included in the services business
segment. The Company maintains offices for its services business in East
Hanover, New Jersey and Charlotte, North Carolina.
The 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 three months ended March 31,
--------------------------------------------------------------------------------------------
2005 2004
-------------------------------------------- --------------------------------------------
Services Software Consolidated Services Software Consolidated
-------------------------------------------- --------------------------------------------
(Restated) (Restated)
Net revenues from external customers $ 6,245,117 $ 627,421 $ 6,872,538 $ 5,262,037 $ -- $ 5,262,037
Segment net loss (2,062,049) (1,072,734) (3,134,783) (433,445) -- (433,445)
Interest income 24,192 -- 24,192 443 -- 443
Interest expense 875,417 489,437 1,364,854 32,553 -- 32,553
Depreciation and amortization 192,830 238,626 431,456 50,244 -- 50,244
Total segment assets 24,072,826 1,683,920 25,756,746 23,357,111 -- 23,357,111
19
Geographic Information
For the three months ended March 31,
------------------------------------
2005 2004
------------------------------------
Revenues:
United States $ 6,717,990 $ 5,262,037
International 154,548 --
------------------------------------
$ 6,872,538 $ 5,262,037
====================================
As of March 31,
------------------------------------
2005 2004
------------------------------------
Long-lived assets:
United States $ 562,573
International 2,124 --
------------------------------------
$ 564,697 $ --
====================================
Note 18 - Pro Forma Results of Operations
The following unaudited statement of income reflects the pro-forma consolidated
results of Conversion Services International, Inc. and DeLeeuw Associates, LLC
for the three months ended March 31, 2004 as if the entities had been
consolidated for the entire three month period.
For the three months
ended March 31, 2004
-----------
Revenues $ 6,356,816
Net Loss $ (456,399)
Net Loss per share $ (0.00)
Note 19 - Subsequent Events
In April 2005, Glenn Peipert loaned $250,000 to the Company, which had
been received as partial payment from CMKX-treme related to his sale of stock
which was disclosed in Note 16 - related party transactions. Such loan bears
interest at 3% per annum and is due May 1, 2006.
On May 6, 2005, Joseph Santiso was elected to the Board of Directors of
the Company. Mr. Santiso founded and is President of The BCI Group. Mr. Santiso
and present director Lawrence K. Reisman will comprise the newly formed Audit
Committee, Compensation Committee and Nominating and Corporate Governance
Committee.
On May 9, 2005, Laurus Master Fund. Ltd. elected to convert $1,000,000 of
the principal amount outstanding under the minimum borrowing note dated August
16, 2004 into shares of common stock of the Company at a conversion price of
$0.14 per share. As a result of this conversion, the Company issued 7,142,857
shares of common stock to Laurus.
In May 2005, a compensation plan was approved for independent members of
the Company's Board of Directors. This plan provides for a $10,000 per year
payment to each independent director with 50% being paid in cash and 50% in
Company common stock, a $1,000 payment for each meeting attended in person, a
$500 payment for each meeting attended via telephone, a $500 payment for each
committee meeting attended, and an annual option grant to be determined by the
Board of Directors.
20
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Overview of our Business
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 "Risk Factors" 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 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 services based clients are
primarily in the financial services, pharmaceutical, healthcare 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 delivers value to its clients, utilizing a combination of
business acumen, technical proficiency, experience and a proven set of "best
practices" methodologies to deliver cost effective services. The Company is
committed to being a leader in data warehousing and business intelligence
consulting, enabling it to be a valuable asset and trusted advisor to its
customers.
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 strategic consulting, 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.
Revenues for the Company are categorized by strategic consulting, business
intelligence, data warehousing, data management, and software and support and
maintenance. They are reflected in the chart below as a percentage of overall
revenues:
Category of Services Percentage of Revenues for the
three months ended March 31,
2005 2004
---- ----
Strategic Consulting 38.6% 18.5%
Business Intelligence 20.6% 26.7%
Data Warehousing 16.1% 15.9%
Data Management 14.7% 38.9%
Software & Support 9.5% 0.0%
Other 0.5% 0.0%
Strategic consulting revenues were 38.6% of total revenues for the three
months ended March 31, 2005, increasing by 20.1% of total revenues as compared
to 18.5% for the comparable prior year period. The Company acquired DeLeeuw
Associates, whose revenue base is entirely in the strategic consulting category
of services, in March 2004. During the three months ended March 31, 2005,
DeLeeuw revenues were $2.2 million, or 84.2% of strategic consulting revenues as
compared to $0.4 million for the three months ended March 31, 2004, representing
an increase of $1.8 million.
21
The Deleeuw Associates acquisition increased the Company's revenue base
and, as a result, the percentage of revenues contributed by each of the other
services categories were impacted by the increase in the strategic consulting
category. Business intelligence service revenues were approximately $1.4 million
for both of the three month periods ended March 31, 2005 and 2004. Data
warehousing revenues were $1.1 million for the three months ended March 31,
2005, an increase of $0.2 million, or 22.2%, from $0.9 million for the three
months ended March 31, 2004. The Company intends to continue to focus on
increasing revenues in these two categories during 2005.
Data management revenues were $1.2 million for the three months ended
March 31, 2005, a decrease of $0.9 million, or 42.9%, from $2.1 million for the
three months ended March 31, 2004. This category of services is less profitable
to the Company than the other service categories and, as a result, is being
de-emphasized and the Company's resources are being focused on the more
profitable service categories.
Software and support and maintenance revenues increased from zero for the
three months ended March 31, 2004 to 9.5% of revenues for the three months ended
March 31, 2005. This is attributable to revenues from licensing and supporting
the Evoke Axio Software which was acquired by the Company in June 2004.
The Company derives a majority 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 engagements. 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 rate per hour it is able
to charge 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 vertical markets, particularly in financial services, which
is serviced by the Company's strategic consulting service category.
As the Company continues to see increases in client spending and
improvements in economic conditions, it 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, 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 offering services
complementary to the Company's lines of business 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 service 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
service 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 $4.3 million to fund acquisitions via its financing transaction
with Laurus Master Fund, Ltd., some of these acquisitions may hinge upon future
financings.
During the three month period ended March 31, 2005, one of the Company's
clients, LEC, a related party, accounted for approximately 16.0% of total
revenues. For the three months ended March 31, 2004, two of our clients, LEC
(18.4%) and Verizon Wireless (15.4%), accounted collectively for approximately
33% of our total revenues.
The Company's most significant costs are personnel expenses, which consist
of consultant fees, benefits and payroll-related expenses.
22
Results of Operations
The following table sets forth selected financial data for the periods
indicated:
Selected Statement of Operations Data for
the three months Ended March 31,
------------------------------------------
2005 2004
------------------------------------------
Net sales $ 6,872,538 $ 5,262,037
Gross profit 2,274,566 1,422,737
Net loss (3,134,783) (433,445)
Net loss per share:
Basic $ (0.00) $ (0.00)
Diluted $ (0.00) $ (0.00)
Selected Statement of Financial Position Data
for the three months ended March 31,
------------------------------------------
2005
-------------------
Working capital $(4,111,092)
Total assets 25,756,746
Long-term debt 5,044,126
Total stockholders' equity 10,572,785
Three Months Ended March 31, 2005 and 2004
Revenue
The Company's revenues are primarily comprised of billings to clients for
consulting hours worked on client projects. Revenues for the three months ended
March 31, 2005 were $6.9 million, an increase of $1.6 million, or 30.6%, over
revenues of $5.3 million for the three months ended March 31, 2004.
Services
Revenues from services for the three months ended March 31, 2005 were $5.0
million, an increase of $0.8 million, or 18.4%, over revenues of $4.2 million
for the three months ended March 31, 2004. DeLeeuw Associates, which was
acquired by the Company in March 2004, contributed $1.9 million of the 2005
services revenue increase as compared to the prior year. Partially offsetting
this increase is a reduction in revenues from services of $1.1 million relating
to a decrease in the number of consultants in the ongoing business. Exclusive of
DeLeeuw Associates, the number of consultants decreased by approximately 29.0%
for the three months ended March 31, 2005 compared to the same period for the
prior year. The decline in the number of consultants was attributable to both
the conversion of our consultants to full time employees of our clients and a
reduction in consultants due to resignations.
Related party services
Revenues from related parties for the three months ended March 31, 2005
were $1.1 million, an increase of $0.1 million over revenues of $1.0 million for
the three months ended March 31, 2004. The increase is primarily attributed to
the hiring of four consultants, during the summer of 2004, under the independent
contractor agreement executed by the Company and LEC in November 2003.
Additionally, five part-time employees were replaced with full-time employees
which also contributed to the revenue increase.
Software
Software revenues are derived from the sale of software licenses
pertaining to the licensing of our Evoke Axio data profiling software. The
assets of Evoke were acquired by the Company in June 2004 and, as a result, the
Company has only included revenues since July 2004. Revenues from software for
the three months ended March 31, 2005 were $0.3 million as compared to zero for
the three months ended March 31, 2004.
23
Support and maintenance
Revenues from support and maintenance for the three months ended March 31,
2005 were $0.4 million as compared to zero in the prior year. This increase in
revenues is attributable to support and maintenance revenues derived from the
Evoke Axio Software which was acquired by the Company in June 2004.
Cost of revenue
Cost of revenue primarily includes payroll and benefits costs for the
Company's consultants as well as the cost of software that is sold or licensed
by the company. Cost of revenue was $4.6 million, or 66.9% of revenue for the
three months ended March 31, 2005, compared to $3.8 million, or 73.0% of revenue
for the three months ended March 31, 2004, representing an increase of $0.8
million, or 19.8%, as compared to the prior year.
Services
Cost of revenue for services was $3.5 million, or 70.4% of services
revenue for the three months ended March 31, 2005, compared to $3.1 million, or
72.6% of services revenue for the three months ended March 31, 2004 representing
an increase of $0.4 million, or 14.8%. Cost of revenue for DeLeeuw Associates
generated a $1.1 million increase in cost of revenues for services as compared
to the prior year. Partially offsetting this increase was a reduction in cost of
services resulting from the reduction in consultants on billing.
Related party services
Cost of revenue for related party services was $1.0 million, or 92.3% of
related party services revenue for the three months ended March 31, 2005,
compared to $0.8 million, or 78.0% of related party services revenue for the
three months ended March 31, 2004. The increased cost in 2005 reflects the cost
of full-time higher level consultants hired for specialized work, but at lower
gross margins than normal.
Software
Cost of revenue for software includes production costs related to the
Evoke Axio software product. Evoke was acquired by the Company in June 2004.
Cost of revenue for software was $44,000, or 15.2% of software revenue for the
three months ended March 31, 2005, compared to zero for the three months ended
March 31, 2004. In 2005, cost of software revenue related to the cost of the
Evoke Software revenues.
Support and maintenance
Cost of revenue for support and maintenance includes costs associated with
resolving customer inquiries. Cost of revenue for support and maintenance was
$13,000, or 3.0% of support and maintenance revenue for the three months ended
March 31, 2005, as compared to zero for the prior year. The increase in cost of
support and maintenance is entirely attributable to Evoke Software which was
acquired by the Company in June 2004.
Gross Profit
Gross profit was $2.3 million, or 33.1% of revenue for the three months
ended March 31, 2005, compared to $1.4 million, or 27.0% of revenue for the
three months ended March 31, 2004.
As a percentage of total gross profit for the three months ended March 31,
2005 and 2004, services contributed 65.4% and 81.6%, respectively, related party
services contributed 3.7% and 15.0%, respectively, software contributed 10.9%
and zero, respectively, support and maintenance 18.4% and zero, respectively,
and other contributed 1.6% and 3.4%, respectively.
24
Services
Gross profit from services was $1.5 million for the three months ended
March 31, 2005, an increase of $0.3 million, or 28.0%, as compared to $1.2
million for the three months ended March 31, 2004. As a percent of services
revenues, gross profit of 29.6% for the three months ended March 31, 2005
represented an increase of 2.2% points as compared to 27.4% of services revenues
for the three months ended March 31, 2004. The increase in the gross margin
percentage is the result of recording a full quarter of the higher margin
DeLeeuw business during the three months ended March 31, 2005 versus only
several weeks in 2004. The DeLeeuw business provided approximately $0.8 million
of increased gross profit during the three months ended March 31, 2005.
Partially offsetting this increase is an offsetting reduction in gross profit
resulting from having fewer billable consultants combined with the cost of
having consultants on the payroll that were not billable to clients during the
current year period as compared to the comparable period in the prior year.
Related party services
Gross profit for related party services was $85,000 , or 7.7% of related
party services revenue for the three months ended March 31, 2005, compared to
$0.2 million, or 22.0% of related party services revenue for the three months
ended March 31, 2004. The decline in the related party services gross profit
percentage is due to the increased costs of the full-time employees hired by
Company as compared to the part-time employees and the reduced billing rates
being realized on these consultants during the three months ended March 31,
2005.
Software
Gross profit resulting from software was $0.2 million, or 84.8% of
software revenue for the three months ended March 31, 2005, compared to zero for
the three months ended March 31, 2004. During the three months ended March 31,
2005, the Company deferred approximately $0.6 million of license revenue that is
being recognized over the life of the related support and maintenance
agreements.
Support and maintenance
Gross profit for support and maintenance was $0.4 million, or 97.0% of
support and maintenance revenue for the three months ended March 31, 2005, as
compared to zero in the prior year. The gross profit for support and maintenance
is attributable to the Company's acquisition of Evoke Software in June 2004.
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 $1.5 million, or 22.2% of revenue for the three months
ended March 31, 2005, representing an increase of $0.9 million as compared to
$0.6 million, or 11.0% of revenue for the three months ended March 31, 2004.
$0.7 million of this increase relates to increased payroll expense, $0.1 million
relates to increased marketing expenses, and the remaining $0.1 million relates
to other various increases. $0.2 million of the increase in payroll is the
result of the acquisition of DeLeeuw Associates in March 2004, $0.2 million of
the increase is the result of the acquisition of Evoke in June 2004, and the
remaining $0.3 million of increased payroll expense primarily relates to
salaries and commissions for the ongoing CSI business.
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 $1.9
million, or 28.2% of revenue for the three months ended March 31, 2005 compared
to $1.4 million, or 26.9% of revenue for the three months ended March 31, 2004.
$0.5 million of the increase in general and administrative expenses during the
three months ended March 31, 2005 is attributed to the costs of operating Evoke
subsequent to the June 2004 acquisition. Additionally, a $0.2 million increase
is attributed to professional fees related to legal, accounting and consulting
fees primarily due to work related to the Company's public filing and financing
efforts. These increases were partially offset by $0.1 million of recruiting
costs incurred during the three months ended March 31, 2004 that did not recur
in 2005.
25
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 $0.2 million, or 3.5% of revenue
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 in June 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.
Amortization of leasehold improvements is taken over the shorter of the
estimated useful life of the asset or the remaining term of the lease. 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 for the three months ended March 31,
2005 compared to $0.1 million for the three months ended March 31, 2004. The
$0.3 million increase in depreciation and amortization during the three months
ended March 31, 2005, as compared to the prior year period, is attributed to
$0.2 million of amortization of the acquired Evoke and DeLeeuw Associates
intangible assets during the quarter and $0.1 million of increased depreciation
for the assets acquired from Evoke in June 2004 and for new assets purchased
during the past year.
Interest 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 issued of $0.7 million for the three months
ended March 31, 2005 is also recorded as interest expense. Total interest
expense recorded was $1.4 million for the three months ended March 31, 2005
compared to $33,000 for the three months ended March 31, 2004. This increase
relates to the interest and penalties associated with the Laurus and Sands
financing transactions described below in the liquidity and capital resources
section.
Other income (expense)
The Company recorded interest income of $24,000 and other income of
approximately $41,000 for the three months ended March 31, 2005, compared to
interest income of $400 and other income of $5,000 for the three months ended
March 31, 2004. The Company recorded equity income from its investments in
DeLeeuw International (Turkey) and LEC of approximately $43,000 for the three
months ended March 31, 2005.
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 $12.6 million as of March 31, 2005. This allowance was recorded
because, based on the weight of available evidence, it is more likely than not
that some, or all, of the deferred tax asset may not be realized.
A $215,600 income tax benefit was recorded during the three months ended
March 31, 2004.
LIQUIDITY AND CAPITAL RESOURCES
Cash totaled $1.2 million as of March 31, 2005 compared to $1.0 million as
of December 31, 2004. The Company's cash balance is primarily derived from
customer remittances, bank and other borrowings, and acquired cash and is used
for general working capital needs.
26
Working capital deficit is ($4.1 million) as of March 31, 2005 compared to
($3.0 million) as of December 31, 2004. The Company's working capital position
has deteriorated during the current quarter primarily due to losses incurred by
the Company. The losses generated by the Company have resulted in the need for
the Company to raise $1.25 million through the sale of Company stock.
Cash used by operations during the three months ended March 31, 2005 was
$1.1 million, unchanged from the comparable period in 2004. While sequential
quarter revenues increased by $0.4 million to $6.9 million during the three
months ended March 31, 2005 from $6.5 million for the three months ended
December 31, 2004, accounts receivable declined by $0.6 million primarily due to
increased collection efforts by the Company. Days sales outstanding have
declined to 58 days for the current quarter from 72 days in the prior quarter.
Deferred revenue increased by $0.5 million primarily due to the deferral of the
revenue recognition for Evoke software licenses invoiced in the current quarter.
These sources of cash were offset by a reduction in accounts payable and accrued
expenses of $0.5 million due to payments which were accrued at December 31,
2004, but paid during the current quarter, relating to $0.4 million of payroll
and $0.1 million of other miscellaneous payments. The remaining use of cash
relates to the losses generated by the Company during the current period. Cash
based losses (net loss plus non cash expenses) were $1.7 million during the
three months ended March 31, 2005.
Cash used by investing activities was $20,000 during the three months
ended March 31, 2005 was for the purchases of computer equipment for the
Company.
Cash provided by financing activities was $1.3 million during the three
months ended March 31, 2005. $1.25 million was raised through the sale of
Company common stock and $0.1 million was provided by the release of restricted
cash, partially offset by principal payments on capital lease obligations.
There are currently no material commitments for capital expenditures.
The Company expects to incur costs, in 2005, of approximately $125,000 in
order to improve its internal controls surrounding financial reporting and
disclosure. No costs were incurred during the three months ended March 31, 2005.
As of March 31, 2005 and December 31, 2004, the Company had accounts
receivable due from LEC of approximately $0.8 million. There are no known
collections problems with respect to LEC.
For the three months ended March 31, 2005 and 2004, we invoiced LEC $1.1
million and $1.0 million, respectively, for the services of consultants
subcontracted to LEC by us. We feel confident in the collectibility of these
accounts receivable as the majority of its billing is derived from Fortune 100
clients. The collection process is slow as these clients require separate
approval on their own internal systems, which extends the payment cycle.
The Company has 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, which was 5.75% as of March 31, 2005) plus 1%, and maturing in
three years. We have no obligation to meet financial covenants under the $2.0
million convertible minimum borrowing note or the $4.0 million revolving note.
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. We have no obligation to meet financial covenants under the $5.0
million secured convertible term note (See Note 9 to the Condensed Consolidated
Financial Statements). 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.
27
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.
As of March 31, 2005, approximately $3.8 million was outstanding under the
revolving line of credit. The interest rate on the revolving line and the
acquisition note was 6.75% as of March 31, 2005.
On May 9, 2005, Laurus Master Fund, Ltd. elected to convert $1,000,000 of
the principal amount outstanding under the minimum borrowing note dated August
16, 2004 into shares of common stock of the Company at a conversion price of
$0.14 per share. As a result of this conversion, the Company issued 7,142,857
shares of common stock to Laurus. This conversion provided the Company with
additional borrowing capacity under its line of credit.
Under the Laurus agreement, the Company was obligated to ensure that the
shares provided for issuance under the agreement were properly registered by
December 19, 2004. As a result of the Company's Registration statement not being
declared effective prior to this date, the Company is incurring liquidated
damages to Laurus. As a result, the Company has accrued $254,000 for payment of
these penalties through March 31, 2005.
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 $1.0 million (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 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.
The following is a summary of the debt instruments outstanding as of March
31, 2005:
----------------------------------------------------------------------------------------------------------------------
Lender Type of facility Outstanding as of March Remaining Availability
31, 2005 (not including (if applicable)
interest) (all numbers
approximate)
----------------------------------------------------------------------------------------------------------------------
Laurus Master Fund, Ltd. Convertible Line of Credit $3,800,000 $0
----------------------------------------------------------------------------------------------------------------------
Laurus Master Fund, Ltd. Convertible Term note $4,251,000 $0
----------------------------------------------------------------------------------------------------------------------
Sands Brothers Venture Capital Convertible Promissory Note $50,000 $0
LLC
----------------------------------------------------------------------------------------------------------------------
Sands Brothers Venture Capital Convertible Promissory Note $850,000 $0
III LLC
----------------------------------------------------------------------------------------------------------------------
Sands Brothers Venture Capital Convertible Promissory Note $100,000 $0
IV LLC
----------------------------------------------------------------------------------------------------------------------
Taurus Advisory Group, LLC Convertible Promissory Note $2,000,000 $0
investors
----------------------------------------------------------------------------------------------------------------------
Scott Newman Promissory Note $177,000 $0
----------------------------------------------------------------------------------------------------------------------
Glenn Peipert Promissory Note $123,000 $0
----------------------------------------------------------------------------------------------------------------------
TOTAL $11,351,000 $0
----------------------------------------------------------------------------------------------------------------------
28
The Company had generated losses during 2004 and these losses have
continued during the three months ended March 31, 2005. To that extent, the
Company has experienced continued negative cash flow which created a liquidity
issue for the Company during 2004. To address this issue, the following
financings were effectuated:
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 12.5 million shares of common
stock for a purchase price of $1.75 million. Under the terms of the Agreement,
CMKX-treme, Inc. initially purchased 3,571,428 shares of common stock for $0.5
million, and it was required to purchase the remaining 8,928,572 shares of
common stock for $1.25 million by December 31, 2004. As of March 17, 2005,
CMKX-treme, Inc. remitted final payment for the remaining 8,928,572 shares.
As of March 30, 2005, Messrs. Newman, Peipert and Robert C. DeLeeuw have
agreed to personally support our cash requirements to enable us to fulfill our
obligations through May 1, 2006, to the extent necessary, up to a maximum amount
of $2.5 million. Mr. Newman personally guaranties up to $1.4 million, Mr.
Peipert guaranties up to $0.7 million and Mr. DeLeeuw personally guaranties $0.4
million. We believe that our reliance on such commitment is reasonable and that
Messrs. Newman, Peipert and DeLeeuw have sufficient liquidity and net worth to
honor such commitment. We believe that this written commitment provides us with
the legal right to request and receive such advances. Any loan by Messrs.
Newman, Peipert and DeLeeuw to the Company would bear interest at 3% per annum.
The Company has completed various financing transactions through the
issuance of common stock, as well as the issuance of notes and warrants
convertible into our common stock, while a registration statement was on file
with the Securities and Exchange Commission but had not yet been declared
effective. Those transactions were with the following entities:
o Taurus Advisory Group, LLC $ 4.0 million
o Laurus Master Fund, Ltd. $11.0 million
o Sands Brothers International Ltd.
(3 affiliated entities) $ 1.0 million
Even though all stockholders, noteholders and warrantholders have been
advised of their rights to rescind those financing transactions and they each
have agreed to waive their rights to rescind those transactions, there is a
remote possibility that each of those transactions could be reversed. In such an
event, the Company could be adversely affected and may have an obligation to
fund such rescissions.
The Company believes existing cash, borrowing capacity under the line of
credit or alternative financing sources, the funding to be provided by the
principal stockholders', and funds generated from operations should be
sufficient to meet operating requirements over the upcoming twelve month period.
We may raise additional funds through debt or equity transactions 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.
Off-balance sheet arrangements
The Company does not have any transactions, agreements or other
contractual arrangements that constitute off-balance sheet arrangements.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Revenue recognition
Our revenue recognition policy is significant because revenues are a key
component of our results from operations. In addition, revenue recognition
determines the timing of certain expenses, such as incentive compensation. We
follow very specific and detailed guidelines in measuring revenue; however,
certain judgments and estimates affect the application of the revenue policy.
Revenue results are difficult to predict and any shortfall in revenues or delay
in recognizing revenues could cause operating results to vary significantly from
quarter to quarter and could result in future operating losses or reduced net
income.
29
Services
Revenue from consulting and professional services is recognized at the
time the services are performed on a project by project basis. For projects
charged on a time and materials basis, revenue is recognized based on the number
of hours worked by consultants at an agreed-upon rate per hour. For large
services projects where costs to complete the contract could reasonably be
estimated, the Company undertakes projects on a fixed-fee basis and recognizes
revenues on the percentage of completion method of accounting based on the
evaluation of actual costs incurred to date compared to total estimated costs.
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. 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.
Software
Revenue from software licensing and maintenance and support are 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.
The percentage-of-completion method of accounting is not applicable for
the Company's software sales.
Business Combinations
We are required to allocate the purchase price of acquired companies to
the tangible and intangible assets acquired and liabilities assumed based on
their estimated fair values. Such a valuation requires us to make significant
estimates and assumptions, especially with respect to intangible assets.
Critical estimates in valuing certain intangible assets include, but are not
limited to, future expected cash flows from customer contracts, customer lists,
distribution agreements and acquired developed technologies, and estimating cash
flows from projects when completed and discount rates. Our estimates of fair
value are based upon assumptions believed to be reasonable, but which are
inherently uncertain and unpredictable and, as a result, actual results may
differ from estimates. These estimates may change as additional information
becomes available regarding the assets acquired and liabilities assumed.
Additionally, in accordance with EITF 99-12, the Company values an acquisition
based upon the market price of its common stock for a reasonable period before
and after the date the terms of the acquisition are agreed to and announced.
Impairment of Goodwill, Intangible Assets and Other Long-Lived Assets
We evaluate our identifiable goodwill, intangible assets, and other
long-lived assets for impairment on an annual basis and whenever events or
changes in circumstances indicate that the carrying value of an asset may not be
recoverable based on expected undiscounted cash flows attributable to that
asset. Future impairment evaluations could result in impairment charges, which
would result in an expense in the period of impairment and a reduction in the
carrying value of these assets.
30
Allowances for Doubtful Accounts
We make judgments regarding our ability to collect outstanding receivables
and provide allowances for the portion of receivables when collection becomes
doubtful. Provisions are made based upon a specific review of all significant
outstanding invoices. For those invoices not specifically reviewed, provisions
are provided at differing rates, based upon the age of the receivable. In
determining these percentages, we analyze our historical collection experience
and current economic trends. If the historical data we use to calculate the
allowance provided for doubtful accounts does not reflect the future ability to
collect outstanding receivables, additional provisions for doubtful accounts may
be needed and our future results of operations could be materially affected.
Stock-based Compensation
We issue stock options to our employees and provide our employees the
right to purchase ordinary shares under employee stock purchase plans. We
account for our stock-based compensation plans under the intrinsic value method
of accounting as defined by Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25") and related
interpretations. For equity instruments under fixed plans, APB 25 does not
require that any amount of expense to be recorded in the statement of income;
however, SFAS No. 123, "Accounting for Stock-Based Compensation" does require
disclosure of these amounts in a pro forma table to the financial statements. In
determining this disclosure the value of an option is estimated using the Black
Scholes option valuation model. This model requires the input of highly
subjective assumptions and a change in our assumptions could materially affect
the fair value estimate, and thus the total calculated costs associated with the
grant of stock options or issuance of stock under employee stock purchase plans.
In addition, in disclosing the fair-value cost of stock-based compensation, we
estimate that we will be able to obtain a 40% tax benefit on these costs. There
is the potential that this tax benefit will not be obtained to this extent or at
all, which directly impacts the level of expenses associated with stock-based
compensation. We expect our accounting policies, regarding stock-based
compensation to be materially affected by our adoption of SFAS123R, which is
described under "Recent Pronouncements." We have not yet determined what the
impact of the adoption of SFAS123R will be on our compensation philosophy.
Deferred Income Taxes
Determining the consolidated provision for income tax expense, income tax
liabilities and deferred tax assets and liabilities involves judgment. We record
a valuation allowance to reduce our deferred tax assets to the amount of future
tax benefit that is more likely than not to be realized. We have considered
future taxable income and prudent and feasible tax planning strategies in
determining the need for a valuation allowance. A valuation allowance is
maintained by the Company due to the impact of the current years net operating
loss (NOL). In the event that we determine that we would not be able to realize
all or part of our net deferred tax assets, an adjustment to the deferred tax
assets would be charged to net income in the period such determination is made.
Likewise, if we later determine that it is more likely than not that the net
deferred tax assets would be realized, then the previously provided valuation
allowance would be reversed. Our current valuation allowance relates
predominately to benefits derived from the utilization of our NOL's.
Recent Pronouncements
In December 2004, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards ("SFAS") No. 123R, "Share-Based Payment, an
Amendment of SFAS No. 123 and 95". This final standard replaces the existing
requirements under SFAS 123 and APB 25 and requires that all forms of
share-based payments to employees, including employee stock options and employee
stock purchase plans, be treated the same as other forms of compensation by
recognizing the related cost in the statements of income. SFAS 123R eliminates
the ability to account for stock-based compensation transactions using APB 25
and requires instead that such transactions be accounted for using a fair-value
based method. SFAS 123R is effective for interim or annual periods beginning
after June 15, 2005 and allows companies to restate the full year of 2005 to
reflect the impact of expensing under SFAS 123R as reported in the footnotes to
the financial statements for the first half of 2005. . The transitional
provisions of SFAS 123R allow companies to select either a modified-prospective
or modified-retrospective transition method which effectively impacts in which
periods actual expense will be reported in the statements of income. We are in
the process of determining the transitional method we will apply. We have not
determined how SFAS123R will modify, if at all, our compensation philosophy in
general or for stock option grants in particular. We cannot currently estimate
the amount of stock-based compensation expense which will be related to stock
option grants or the issue of warrants in 2005 and thereafter.
31
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 Company's 2004 Annual Report filed
with the Securities and Exchange Commission on Form 10-KSB on April 13, 2005.
Item 3. Controls and Procedures
Evaluation of disclosure controls and procedures.
Under the supervision and with the participation of our management,
including our chief executive officer and our 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-15(e) as of the end of the period covered by this report. Based on that
evaluation, and as a result of comments received in February 2005 from the Staff
of the SEC pertaining to our Registration Statement on Form SB-2/A, File No.
333-115243 (the "Registration Statement"), our chief executive officer and our
chief financial officer have concluded that a material weakness exists with
regard to the valuation and purchase accounting of our recent acquisitions,
including the inability to prepare financial statements and footnotes in
accordance with SEC rules and regulations.
In connection with our acquisitions of DeLeeuw Associates, Inc. and Evoke
Software Corporation, we misapplied generally accepted accounting principles
whereby we did not value the acquisitions and record the resulting purchase
accounting in accordance with SFAS 141 and EITF 99-12. As a result, we were
required in March 2005 to restate our financial statements for the quarters
ended March 31, 2004, June 30, 2004 and September 30, 2004. Management now
believes and has determined that the disclosure controls and procedures for
these three quarters were not effective.
In light of the need for these restatements and the material weakness in
our valuation and purchase accounting for recent acquisitions, commencing in the
first quarter of our 2005 fiscal year, we are beginning to undertake a review of
our disclosure, financial information and internal controls and procedures
regarding these areas for future acquisitions. This review will include efforts
by our management and directors, as well as the use of additional outside
resources, as follows:
o Senior accounting personnel and our chief financial officer will
continue to review any future acquisition or divestiture in order to evaluate,
document and approve its accounting treatment in accordance with SFAS 141 and
EITF 99-12;
o We will augment, as necessary, such procedures by obtaining
concurrence with independent outside accounting experts prior to finalizing
financial reporting for such transactions; and
o We will incorporate the applicable parts of the action plan
described in the next paragraph.
In conjunction with the measures outlined below, we believe these actions
will strengthen our internal control over our valuation and purchase accounting
of future acquisitions, and this material weakness should be resolved.
Management does not anticipate any extra cost from this change in its valuation
and purchase accounting of future acquisitions.
In addition, we previously identified two internal control matters.
Neither relates to the subject matter of the material weakness described above,
yet combined with the above-referenced material weakness, constitute in the
aggregate a material weakness in our internal control over financial reporting.
These internal control matters, identified in October 2004 by Friedman LLP, our
independent registered public accounting firm, are summarized as follows:
o Lack of certain internal controls over period-end financial
reporting related to the identification of transactions, primarily contractual,
and accounting for them in the proper periods; and
32
o Accounting and reporting for our complex financing transactions
related to the beneficial conversion features and the determination of the fair
value of warrants in such transactions.
Management is establishing an action plan that it believes will correct
the aggregated material weaknesses described above. Our estimated costs related
to the correction of these material weaknesses is approximately $0.125 million,
most notably related to our conversion to the Great Plains accounting system
during the third quarter of 2004. The conversion to the Great Plains accounting
system required inconsequential modifications to our transaction processing
systems. The effect of the migration to this system has been to provide a better
audit trail than our previous system. The batch processing of transactions
provides the ability for review of transactions prior to being posted in the
accounting system. Further, the ability to close and lock periods to prevent
changes to prior periods provides greater reliability of the data and the
financial statements (resulting from the financial statements being prepared
directly by the accounting system as opposed to using spreadsheets, which have
greater potential for error). Finally, this system has the ability to provide
comparative financial statements to expectations, which drives variance
reporting. As a result of this system change, there were changes in our internal
control over financial reporting starting in the third quarter of 2004, as we
have redesigned the organization structure to drive more focus on our internal
control environment. Other measures included in our action plan are as follows:
o We have formed a Disclosure Committee consisting of our chief
executive officer, chief operating officer, senior vice president of sales,
general counsel and controller, chaired by our chief financial officer. The
Disclosure Committee is comprised of these key members of senior management who
have knowledge of significant portions of our internal control system, as well
as the business and competitive environment in which we operate. One of the key
responsibilities of each Disclosure Committee member is to review quarterly
reports, annual reports and registration statements to be filed with the SEC as
each progress through the preparation process. Open lines of communication to
financial reporting management exist for Disclosure Committee members to convey
comments and suggestions;
o A process to be established whereby material agreements are
reviewed by the legal, accounting and sales departments and an executive
management member that includes determination of appropriate accounting and
disclosure;
o Our accounting and legal departments are now working more closely
and in conjunction to accurately account for period-end financial reporting and
complex financing transactions;
o We are constantly assessing our existing environment and continue
to make further changes, as appropriate, in our finance and accounting
organization to create clearer segregation of responsibilities and supervision,
and to increase the level of technical accounting expertise including the use of
outside accounting experts;
o There will be closer monitoring of the preparation of our monthly
and quarterly financial information. We are in the process of instituting
regular quarterly meetings to review each department's significant activities
and respective disclosure controls and procedures and to have such in place by
the end of the second quarter of 2005;
o Department managers have been tasked with tracking relevant
non-financial operating metrics and other pertinent operating information and
communicating their findings to a member of the Disclosure Committee; and
o We will conduct quarterly reviews of the effectiveness of our
disclosure controls and procedures, and we have enhanced our quarterly close
process to include detailed analysis in support of the financial accounts, and
improved supervision over the process.
We believe that we will satisfactorily address the control deficiencies and
material weakness relating to these matters by the end of the second quarter of
2005, although there can be no assurance that we will do so.
At the same time as we continue our efforts to improve our internal
control environment, management of the Company is still in the process of
implementing the above procedures and controls, including review and evaluation,
to mitigate recognized weaknesses specifically for the preparation of the
financial statements for the periods covered by this Quarterly Report on Form
10-QSB. Management believes that these procedures and controls are not yet
effective in ensuring the proper collection, evaluation and disclosure of the
financial information for the periods covered by this. Based on the foregoing,
our chief executive officer and our chief financial officer concluded that our
disclosure controls and procedures were not yet effective at a reasonable
assurance level as of the date of this Quarterly Report.
33
Management, including our chief executive officer and our chief financial
officer, does not expect that our disclosure controls and internal controls will
prevent all error or all fraud, even as the same are improved to address any
deficiencies and/or weaknesses. 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. Over time, controls may become
inadequate because of changes in conditions or deterioration in the degree of
compliance with policies or procedures. 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.
Changes in internal control over financial reporting.
Our company also maintains a system of internal controls. The term
"internal controls," as defined by the American Institute of Certified Public
Accountants' Codification of Statement on Auditing Standards, AU Section 319,
means controls and other procedures designed to provide reasonable assurance
regarding the achievement of objectives in the reliability of our financial
reporting, the effectiveness and efficiency of our operations and our compliance
with applicable laws and regulations. In connection with the preparation of the
Registration Statement, our management identified certain weaknesses in our
internal control procedures and in our valuation and purchase accounting of our
acquisitions in 2004. Our management and Board have adopted corrective measures
as described in the third and fourth paragraphs of this Controls and Procedures
section above. The following measures have materially affected our internal
control over financial reporting since our last Quarterly Report:
o Senior accounting personnel and our chief financial officer will
continue to review any future acquisition or divestiture in order to evaluate,
document and approve its accounting treatment in accordance with SFAS 141 and
EITF 99-12;
o We will augment, as necessary, such procedures by obtaining
concurrence with independent outside accounting experts prior to finalizing
financial reporting for such transactions;
o We have formed a Disclosure Committee consisting of our chief
executive officer, chief operating officer, senior vice president of sales,
general counsel and controller, chaired by our chief financial officer. The
Disclosure Committee is comprised of these key members of senior management who
have knowledge of significant portions of our internal control system, as well
as the business and competitive environment in which we operate. One of the key
responsibilities of each Disclosure Committee member is to review quarterly
reports, annual reports and registration statements to be filed with the SEC as
each progress through the preparation process. Open lines of communication to
financial reporting management exist for Disclosure Committee members to convey
comments and suggestions;
o Our accounting and legal departments are now working more closely
and in conjunction to accurately account for period-end financial reporting and
complex financing transactions;
o There will be closer monitoring of the preparation of our monthly
and quarterly financial information. We are in the process of instituting
regular quarterly meetings to review each department's significant activities
and respective disclosure controls and procedures and to have such in place by
the end of the second quarter of 2005; and
o Department managers have been tasked with tracking relevant
non-financial operating metrics and other pertinent operating information and
communicating their findings to a member of the Disclosure Committee.
34
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits:
31.1 Certification of Chief Executive Officer pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934
31.2 Certification of Chief Financial Officer pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934
32.1 Certification of Chief Executive Officer pursuant to Rule
13a-14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section
1350
32.2 Certification of Chief Financial Officer pursuant to Rule
13a-14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section
1350
(b) Reports on Form 8-K:
None.
35
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)
May 19, 2005
36