U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY
PERIOD ENDING SEPTEMBER 30, 2001.
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: 333-84045
PREDICTIVE SYSTEMS, INC.
------------------------
(Exact Name of Registrant as Specified in its Charter)
DELAWARE 13-3808483
---------------------------------- ---------------------------------------
(State or other Jurisdiction of (I.R.S. Employer Identification Number)
Incorporation or Organization)
19 WEST 44TH STREET, NEW YORK, NEW YORK 10036
(Address of Principal Executive Offices) (Zip Code)
(212) 659-3400
(Registrant's Telephone Number, Including Area Code)
Check whether the registrant: (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 [ ]
As of November 12, 2001, there were 36,353,241 shares of the registrant's common
stock, $.001 par value per share, outstanding.
INDEX
PREDICTIVE SYSTEMS, INC. AND SUBSIDIARIES
Page
----
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Balance Sheets as of September 30, 2001
(unaudited) and December 31, 2000 ........................ 1
Consolidated Statements of Operations for the three and nine
months ended September, 2001 and 2000 (unaudited) ..... .. 2
Consolidated Statement of Cash Flows for the nine months
ended September 30, 2001 and 2000 (unaudited) ............... 3
Notes to Consolidated Financial Statements (unaudited) ... 4
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS ..................... 7
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK .................................................... 16
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS ........................................ 17
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS ................ 17
ITEM 3. DEFAULTS UPON SENIOR SECURITIES .......................... 17
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ...... 17
ITEM 5. OTHER INFORMATION ........................................ 17
ITEM 6. EXHIBITS AND REPORT ON FORM 8-K .......................... 17
ITEM 7. SIGNATURES ............................................... 18
PART 1. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
PREDICTIVE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
September 30, 2001 December 31, 2000
------------------ -----------------
(unaudited)
ASSETS
Current assets
Cash and cash equivalents $ 41,101,355 $ 80,058,791
Investment in marketable securities, at market value 3,864,979 3,794,100
Restricted cash 1,106,847 --
Accounts receivable - net of allowance for
doubtful accounts of $2,177,473 and $1,292,491, respectively 13,847,852 22,454,109
Unbilled work in process 3,072,530 5,055,471
Inventory held for resale 3,125,475 --
Related party receivables 2,205,977 4,115,043
Receivables from employees and stockholders 27,764 423,074
Prepaid expenses and other current assets 2,398,230 2,335,192
------------ ------------
Total current assets 70,751,009 118,235,780
Property and equipment - net of accumulated
depreciation and amortization of $4,032,997 and $3,363,265, respectively 9,238,172 10,403,523
Intangible assets - net of accumulated amortization of $22,337,851 and $3,238,59 40,000,816 115,441,166
Long-term investments in related parties -- 2,000,000
Restricted cash 779,752 --
Other assets 657,430 248,068
------------ ------------
Total assets $121,427,179 $246,328,537
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable $ 6,111,124 $ 3,062,164
Accrued compensation 2,483,735 3,096,492
Accrued expenses and other current liabilities 7,518,779 9,418,105
Current portion of capital lease obligations 95,719 137,734
Deferred income 1,750,326 2,890,130
------------ ------------
Total current liabilities 17,959,683 18,604,625
------------ ------------
Noncurrent liabilities
Capital lease obligations 59,035 151,965
Deferred rent 19,020 530,589
Deferred income tax liability 3,347,072 3,347,072
------------ ------------
Total noncurrent liabilities 3,425,127 4,029,626
------------ ------------
Total liabilities 21,384,810 22,634,251
------------ ------------
Commitments and contingencies
Stockholders' equity
Common stock, $.001 par value, 200,000,000 shares authorized,
36,258,414 and 34,903,696 shares issued and outstanding 36,258 34,904
Additional paid-in capital 229,555,564 227,753,713
Deferred compensation (423,841) (694,280)
Accumulated deficit (129,399,233) (3,517,572)
Accumulated other comprehensive (loss) income 273,621 117,521
------------ ------------
Total stockholders' equity 100,042,369 223,694,286
------------ ------------
Total liabilities and stockholders' equity $121,427,179 $246,328,537
============ ============
The accompanying notes to consolidated financial statements are an integral
part of these consolidated balance sheets.
1
PREDICTIVE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months Ended September 30 Nine Months Ended September 30
--------------------------------- ---------------------------------
2001 2000 2001 2000
------------ ------------ ------------- ------------
Revenues:
Professional services $ 14,350,936 $ 23,754,147 $ 52,550,151 $ 64,722,534
Hardware and software sales 677,389 912,702 1,570,300 2,364,435
------------ ------------ ------------- ------------
Total revenues 15,028,325 24,666,849 54,120,451 67,086,969
------------ ------------ ------------- ------------
Cost of revenues:
Professional services 11,676,764 12,137,154 39,755,989 33,011,745
Hardware and software purchases 617,682 669,337 1,796,541 1,777,293
------------ ------------ ------------- ------------
Total cost of revenues 12,294,446 12,806,491 41,552,530 34,789,038
------------ ------------ ------------- ------------
Gross profit 2,733,879 11,860,358 12,567,921 32,297,931
------------ ------------ ------------- ------------
Sales and marketing 3,632,208 3,168,536 12,920,849 8,945,321
General and administrative 10,435,199 6,954,218 34,374,099 18,819,571
Depreciation and amortization 582,951 452,814 2,302,730 1,166,074
Intangibles amortization 6,424,362 213,177 19,099,253 639,531
Loss on equipment 443,498 -- 443,498 --
Impairment of intangibles 60,485,448 -- 60,485,448 --
Restructuring and other charges 4,571,028 -- 8,875,793 --
Loss on long-term investment in related party 1,000,000 -- 2,000,000 --
Noncash compensation expense 82,687 19,039 300,923 57,117
------------ ------------ ------------- ------------
Operating expenses 87,657,381 10,807,784 140,802,593 29,627,614
------------ ------------ ------------- ------------
Operating (loss) profit (84,923,502) 1,052,574 (128,234,672) 2,670,317
Other income (expense):
Interest income, net 570,725 2,073,247 2,302,408 5,262,756
Other income (expense) 104,387 (4,666) 50,603 (15,783)
------------ ------------ ------------- ------------
(Loss) income before income tax provision (84,248,390) 3,121,155 (125,881,661) 7,917,290
Income tax provision -- 1,339,374 -- 3,443,024
------------ ------------ ------------- ------------
Net (loss) income $(84,248,390) $ 1,781,781 $(125,881,661) $ 4,474,266
============ ============ ============= ============
Net (loss) income per share: Basic $ (2.33) $ 0.07 $ (3.51) $ 0.18
============ ============ ============= ============
Net (loss) income per share: Diluted $ (2.33) $ 0.05 $ (3.51) $ 0.13
============ ============ ============= ============
Weighted average shares outstanding: Basic 36,206,110 26,591,508 35,857,087 25,195,475
============ ============ ============= ============
Weighted average shares outstanding: Diluted 36,206,110 33,102,323 35,857,087 33,844,093
============ ============ ============= ============
The accompanying notes to consolidated financial statements are an integral
part of these consolidated statements.
2
PREDICTIVE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
-----------------------------------
Nine Months Ended September 30
-----------------------------------
2001 2000
-------------- -------------
Cash flows from operating activities:
Net (loss) income $(125,881,661) $ 4,474,266
Adjustments to reconcile net (loss) income to
net cash (used in) provided by operating activities:
Noncash compensation expense 300,923 57,117
Deferred income taxes -- 2,438,005
Depreciation and amortization 21,401,983 1,805,605
Loss on equipment 443,498 --
Impairment of intangibles 60,485,448 --
Bad debt expense 4,269,283 253,622
Loss on long-term investment in related party 2,000,000 --
Write-off of software inventory 500,000 --
Write-off of receivables from employees 27,237 --
Noncash component of restructuring and other charges 4,650,410 --
Decrease (increase) in-
Restricted cash (1,886,599) --
Accounts receivable 5,891,469 (6,001,537)
Unbilled work in process 1,279,003 (2,350,295)
Inventory held for resale (3,125,475) --
Income taxes (342,198) 969,697
Prepaid expenses and other assets (1,166,173) (209,843)
Increase (decrease) in-
Accounts payable 3,051,931 (34,316)
Accrued expenses (2,610,113) 2,374,359
Deferred income (723,234) (551,016)
Deferred rent and other long-term liabilities (511,569) 454,365
-------------- --------------
Net cash (used in) provided by operating activities (31,945,837) 3,680,029
-------------- --------------
Cash flows from investing activities:
Purchase of marketable securities, net (52,106) (6,949,224)
Repayments from (payments to) employees, net 54,259 (85,226)
Adjustments to purchase price for fiscal 2000 acquisitions (1,910,164) --
Purchase of property and equipment, net (7,154,541) (5,521,323)
-------------- --------------
Net cash used in investing activities (9,062,552) (12,555,773)
-------------- --------------
Cash flows from financing activities:
Principal payments on capital leases (134,945) --
Proceeds from sale of stock through ESPP 204,312 1,305,702
Proceeds from sale of common stock, net of expenses -- 39,824,079
Proceeds from exercise of stock options 1,844,258 3,196,334
-------------- --------------
Net cash provided by financing activities 1,913,625 44,326,115
-------------- --------------
Effects of exchange rates 137,328 (219,756)
-------------- --------------
Net (decrease) increase in cash (38,957,436) 35,230,615
Cash and cash equivalents - beginning of period 80,058,791 89,633,634
-------------- --------------
Cash and cash equivalents - end of period $ 41,101,355 $ 124,864,249
============= ==============
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest $ 44,830 $ 43,989
============== ==============
Taxes $ 523,610 $ 83,734
============== ==============
Supplemental disclosures of noncash investing and financing activities:
Noncash adjustment to purchase price for fiscal 2000 acquisitions $ 2,196,521 $ --
============== ==============
The accompanying notes to consolidated financial statements are an integral
part of these consolidated statements.
3
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
(1) BASIS OF PRESENTATION
The consolidated financial statements and accompanying financial information as
of September 30, 2001 and for the three and nine months ended September 30, 2001
and 2000 are unaudited and, in the opinion of management, include all
adjustments (consisting only of normal recurring adjustments) which the Company
considers necessary for a fair presentation of the financial position of the
Company at such dates and the operating results and cash flows for those
periods. The financial statements included herein have been prepared in
accordance with generally accepted accounting principles and the instructions of
Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted. These financial statements should be read in conjunction with the
Company's audited financial statements for the year ended December 31, 2000.
Results for interim periods are not necessarily indicative of results for the
entire year.
(2) ACQUISITIONS
On October 16, 2000, the Company acquired Synet Service Corporation (Synet) in a
transaction accounted for as a purchase. Synet is a network and systems
management consulting firm that works with organizations to improve the
availability and reliability of e-commerce applications and network
infrastructure. The consideration for the acquisition consisted of an aggregate
of 1,922,377 shares of common stock at a fair value of $11.00 per share, par
value $0.001 per share, $9,000,000 cash paid upon closing of the transaction and
transaction expenses of $1,085,417. Approximately 522,000 shares were accounted
for as stock options until a related note was repaid in December 2000, at which
time the shares were considered to be issued for accounting purposes. The
Company also issued options to purchase 242,459 shares of common stock to
employees of Synet in exchange for their Synet options. These options had a fair
value of $1,110,893 and were accounted for as additional purchase price. The
Company acquired net tangible assets of $169,482 and recorded intangible assets
of approximately $33.4 million, which represented customer lists, workforce and
excess of the purchase price over the fair value of the net tangible assets of
approximately $30.4 million. Additionally, the Company recognized a deferred
income tax liability of $1,184,620 related to the nondeductibility of certain
acquired identifiable intangibles. In 2001, the Company recorded an additional
$306,000 to the purchase price for the closing of certain offices and a
reduction in workforce in connection with the Company's acquisition plan. This
amount consisted of $254,000 for severance benefits for 21 employees laid-off
and $52,000 for exit costs related to real estate. Additionally, the Company
recorded an additional $30,000 to the purchase price as part of the final
purchase price allocation. As of September 30, 2001, $16,000 remained unpaid for
exit costs. Such amount is reflected in accrued expenses and other current
liabilities. In the third quarter of fiscal 2001, the Company reviewed goodwill
and the intangible assets for impairment due to revenue declines in this
business. As a result of this review, an impairment loss of $18.2 million was
recognized for the difference between the estimated value of Synet based on
future undiscounted cashflows and the carrying amount of its assets and
liabilities, including goodwill. Since the acquisition, goodwill and the
intangible assets are being amortized on a straight-line basis over periods of
three to five years. The results of operations of Synet have been included in
the results of operations of the Company since the date of acquisition.
On December 14, 2000, the Company acquired Global Integrity Corporation (Global
Integrity) in a transaction accounted for as a purchase. Global Integrity
provides information security services to Fortune 500 and Global 1000 companies.
The consideration for the acquisition consisted of an aggregate of 5,240,275
shares of common stock at a fair value of $8.15 per share, par value $0.001 per
share, $31,460,270 cash paid upon the closing of the transaction and transaction
expenses of $1,830,162, of which all have been paid as of September 30, 2001.
The Company also issued options to purchase 551,048 shares of common stock to
employees of Global Integrity in exchange for their Global Integrity options.
These options had a fair value of $2,271,434 and were accounted for as
additional purchase price. Additionally, the Global Integrity stockholders and
optionholders have the right to earn up to an additional $14,012,500 in value
(to be paid in cash to stockholders and additional options to optionholders)
upon the achievement of certain revenue milestones by the acquired business. The
Company acquired net tangible assets of $4,313,033 and recorded intangible
assets of approximately $81.3 million, which represented customer lists,
workforce, tradenames, developed technology and excess of the purchase price
over the fair value of the net tangible assets of approximately $63.0 million.
Additionally, the Company recognized a deferred income tax liability of
$7,308,222 related to the nondeductibility of certain acquired identifiable
intangibles. In 2001, the Company recorded an additional $2.4 million to the
purchase price for the closing of certain offices and a reduction in workforce
in connection with the Company's acquisition plan. This amount consisted of
$178,000 for severance benefits for 15 employees laid-off and $2.2 million for
exit costs related to real estate. Additionally, the Company recorded an
additional $1.2 million to the purchase price as part of the final purchase
price allocation. As of September 30, 2001, $1.3 million remained unpaid for
severance benefits and exit costs. Such amount is reflected in accrued expenses
and other current liabilities. In the third quarter of fiscal 2001, the Company
reviewed goodwill and the intangible assets for impairment due to revenue
declines in this business. As a result of this review, an impairment loss of
$42.3 million was recognized for the difference between the estimated value of
Global Integrity based on future undiscounted cashflows and the carrying amount
of its assets and liabilities, including goodwill. Since the acquisition,
goodwill and the intangible assets are being amortized on a straight-line basis
over periods of three to five years. The results of operations of Global
Integrity have been included in the results of operations of the Company since
the date of acquisition.
4
The following unaudited information presents the pro forma results of operations
for the Company for the three and nine months ended September 30, 2000 as if the
acquisitions of Synet and Global Integrity had occurred on the first day of
these periods.
Three Months Ended Nine Months Ended
September 30, 2000 September 30, 2000
-------------------- --------------------
(unaudited) (unaudited)
Revenues $ 34,790,013 $ 92,931,562
Net loss $ (8,541,244) $ (18,244,431)
Per Share Information:
Net loss per share - Basic and Diluted $ (0.26) $ (0.55)
Weighted average shares outstanding -
Basic and Diluted $ 33,404,329 $ 33,165,760
(3) NET (LOSS) INCOME PER SHARE
Basic net (loss) income per share is computed by dividing net (loss) income
available to common stockholders by the weighted average number of shares
outstanding. Diluted net (loss) income per share reflects the potential dilution
that would occur if securities or other contracts to issue common stock were
exercised or converted into common stock, unless they are antidilutive.
The following table reconciles the numerator and denominator for the
calculation:
Three Months Ended Nine Months Ended
September 30 September 30
--------------------------- ---------------------------
2001 2000 2001 2000
------------ ------------ ------------ ------------
(unaudited) (unaudited)
Numerator -
Net (loss) income $(84,248,390) $ 1,781,781 $(125,881,661) $ 4,474,266
------------ ------------ ------------- ------------
Denominator -
Denominator for basic earnings
per share - weighted average
shares outstanding 36,206,110 26,591,508 35,857,087 25,195,475
============ ============ ============ ============
Effect of dilutive securities -
Incremental shares for assumed
conversion of options -- 6,510,815 -- 8,648,618
------------ ------------ ------------ ------------
Denominator for diluted earnings
per share - weighted average
shares outstanding 36,206,110 33,102,323 35,857,087 33,844,093
============ ============ ============ ============
Net (loss) income per share -
Basic $ (2.33) $ 0.07 $ (3.51) $ 0.18
Diluted $ (2.33) $ 0.05 $ (3.51) $ 0.13
============ ============ ============ ============
5
(4) COMPREHENSIVE (LOSS) INCOME
The Company adopted Statement of Financial Accounting Standards No. 130,
Reporting Comprehensive Income, which established standards for reporting and
displaying comprehensive income and its components. The components of
comprehensive (loss) income are as follows:
Three Months Ended Nine Months Ended
September 30 September 30
--------------------------- ---------------------------
2001 2000 2001 2000
------------ ------------ ------------ ------------
(unaudited) (unaudited)
Net (loss) income $(84,248,390) $ 1,781,781 $(125,881,661) $ 4,474,266
Unrealized gain (loss) on
investments 3,931 13,070 18,773 (19,363)
Foreign currency translation
adjustment 320,445 (109,445) 137,328 (219,756)
------------ ------------ ------------ -------------
Comprehensive (loss) income $(83,924,014) $ 1,685,406 $(125,725,560) $ 4,235,147
============ ============ ============ =============
(5) RESTRUCTURING AND OTHER CHARGES
In February 2001, the Company's management foresaw the need to lower the
operating costs of the business given its near-term revenue projections.
Therefore, the Company established a plan that included the following: (1) a
reduction in its workforce for both domestic and international operations
related to professional consultant employees that had been underutilized for
several months and also to employees that held various management, sales and
administrative positions deemed to be duplicative functions; (2) the closing of
several domestic and international regional offices located in geographic areas
that no longer cost justified remaining open; and (3) the discontinuance of
electronic equipment leases and other expenses related to the reduction in
workforce.
As of September 30, 2001, 191 employees were laid-off. The Company recorded
restructuring charges of $7,853,084, of which $1,427,651 remained unpaid as of
September 30, 2001. Such charges consisted of $2,732,995 in severance benefits
and other related expenses and $5,120,089 in exit costs related to real estate
and electronic equipment. These charges have been reflected as operating
expenses of the Company.
In June 2001, the Company wrote-off approximately $1,030,000 related to the
abandonment of internal software management tools that no longer suited the
business needs of the Company.
(6) EFFECTS OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS 133).
SFAS 133 establishes accounting and reporting standards requiring that every
derivative instrument be recorded in the balance sheet as either an asset or
liability measured at its fair value. SFAS 133 requires that changes in the
derivative's fair value be recognized currently in earnings unless specific
hedge accounting criteria are met. SFAS 133 is effective for fiscal years
beginning after June 15, 1999. In July 1999, the FASB approved SFAS No. 137,
Accounting for Derivative Instruments and Hedging Activities-Deferral of the
Effective Date of SFAS 133, which amends SFAS 133 to be effective for all fiscal
quarters of all fiscal years beginning after June 15, 2000. As the Company
currently does not engage in derivative instruments or hedging activities, the
adoption of this accounting principle on January 1, 2001 did not have a material
impact on the Company's financial position or results of operations.
In July 2001, the FASB issued Statement of Financial Accounting Standards No.
141, "Business Combinations" (SFAS 141) and No. 142, "Goodwill and Other
Intangible Assets" (SFAS 142). SFAS 141 requires all business combinations
initiated after June 30, 2001 to be accounted for using the purchase method.
Under SFAS 142, goodwill and intangible assets with indefinite lives are no
longer amortized but are reviewed annually (or more frequently if impairment
indicators arise) for impairment. Separable intangible assets that are not
deemed to have indefinite lives will continue to be amortized over their useful
lives (but with no maximum life). The amortization provisions of SFAS 142 apply
to goodwill and intangible assets acquired after June 30, 2001. The Company
adopted the provisions of SFAS 142 in September 2001.
In August 2001, the FASB issued Statement of Financial Accounting Standard No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets" (SFAS
144). This statement supersedes SFAS No. 121 "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" and Accounting
Principles Board Opinion No. 30 "Reporting Results of Operations - Reporting the
Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions". The Statement retains the
fundamental provisions of SFAS No. 121 for recognition and measurement of
impairment, but amends the accounting and reporting standards for segments of a
business to be disposed of. The provisions of this statement are required to be
adopted no later than fiscal years beginning after December 31, 2001, with early
adoption encouraged. The Company is currently evaluating the impact of the
adoption of SFAS No. 144, which the Company expects will not be material.
6
(7) SUBSEQUENT EVENTS
In October and November 2001, the Company laid-off approximately 17 employees in
connection with the restructuring plan. These employees consisted primarily of
professional consultants. The Company will record restructuring charges for
severance payments of approximately $155,000 in connection with this reduction
in workforce.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS RELATING TO FUTURE EVENTS AND
FUTURE PERFORMANCE OF THE COMPANY WITHIN THE MEANING OF SECTION 27A OF THE
SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934,
INCLUDING, WITHOUT LIMITATION, STATEMENTS REGARDING THE COMPANY'S EXPECTATIONS,
BELIEFS, INTENTIONS OR FUTURE STRATEGIES THAT ARE SIGNIFIED BY THE WORDS
EXPECTS, ANTICIPATES, INTENDS, BELIEVES OR SIMILAR LANGUAGE. ACTUAL RESULTS
COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN SUCH FORWARD-LOOKING
STATEMENTS. ALL FORWARD-LOOKING STATEMENTS INCLUDED IN THIS DOCUMENT ARE BASED
ON INFORMATION AVAILABLE TO THE COMPANY ON THE DATE HEREOF, AND THE COMPANY
ASSUMES NO OBLIGATION TO UPDATE ANY FORWARD LOOKING STATEMENTS. THE COMPANY
CAUTIONS INVESTORS THAT ITS BUSINESS AND FINANCIAL PERFORMANCE ARE SUBJECT TO
SUBSTANTIAL RISKS AND UNCERTAINTIES. IN EVALUATING THE COMPANY'S BUSINESS,
PROSPECTIVE INVESTORS SHOULD CAREFULLY CONSIDER THE INFORMATION SET FORTH BELOW
UNDER THE CAPTION RISK FACTORS IN ADDITION TO THE OTHER INFORMATION SET FORTH
HEREIN AND ELSEWHERE IN THE COMPANY'S OTHER PUBLIC FILINGS WITH THE SECURITIES
AND EXCHANGE COMMISSION.
Substantially all of our revenues are derived from professional services. We
provide information security and network consulting services to our clients on
either a project outsource or collaborative consulting basis. We derive revenues
from these services on both a fixed-price, fixed-time basis and on a
time-and-expense basis. We use our BusinessFirst methodology to estimate and
propose prices for our fixed-price projects. The estimation process accounts for
standard billing rates particular to each project, the client's technology
environment, the scope of the project and the project's timetable and overall
technical complexity. A member of our senior management team must approve all of
our fixed-price proposals in excess of $500,000. For these contracts, we
recognize revenue using a percentage-of-completion method primarily based on
costs incurred. We make provisions for estimated losses on uncompleted contracts
on a contract-by-contract basis and recognize such provisions in the period in
which the losses are determined. Professional services revenues for
time-and-expense based projects are recognized as services are performed. Any
payments received in advance of services performed are recorded as deferred
revenue. Our clients are generally able to reduce or cancel their use of our
professional services without penalty and with little or no notice. We also
derive limited revenues from the sale of hardware and software. We sell hardware
and software only when specifically requested by a client. We expect revenues
from the sale of hardware and software to continue to decline on a percentage
basis.
Since we recognize professional services revenues only when our consultants are
engaged on client projects, the utilization of our consultants is important in
determining our operating results. In addition, a substantial majority of our
operating expenses, particularly personnel and related costs, depreciation and
rent, are relatively fixed in advance of any particular quarter. As a result,
any underutilization of our consultants may cause significant variations in our
operating results in any particular quarter and could result in losses for such
quarter. Factors which could cause underutilization include:
- the reduction in size, delay in commencement, interruption or termination
of one or more significant projects;
- the completion during a quarter of one or more significant projects;
- the miscalculation of resources required to complete new or ongoing projects;
and
- the timing and extent of training, weather related shut-downs, vacations and
holidays.
Our cost of revenues consist of costs associated with our professional services
and hardware and software purchases. Costs of revenues associated with
professional services include compensation and benefits for our consultants and
project-related travel expenses. Costs of hardware and software purchases
consist of acquisition costs of third-party hardware and software resold.
In April 2000, we consummated a follow-on public offering for 3.8 million shares
of our common stock, of which 1.0 million shares were offered by the Company
resulting in net proceeds of approximately $39.8 million after deducting
underwriter discounts and commissions, and expenses as payable by us.
7
On October 16, 2000, we acquired Synet Service Corporation for an aggregate
purchase price of approximately $32.3 million. The purchase price was paid in
the form of 1,922,377 shares of our common stock, options to purchase 242,459
shares of our common stock and $9.0 million in cash in exchange for all of the
outstanding capital stock of Synet. The acquisition was accounted for as a
purchase and resulted in intangible assets of approximately $33.4 million
representing the customer lists, workforce and excess of the purchase price over
the fair value of the net tangible assets acquired. During 2001, the Company
adjusted the purchase price for $336,000 for the closing of certain offices and
a reduction in workforce in connection with the acquisition plan and to adjust
the final purchase price allocation. In the third quarter of fiscal 2001, the
Company reviewed goodwill and the intangible assets for impairment due to
revenue declines in this business. As a result of this review, an impairment
loss of $18.2 million was recognized for the difference between the estimated
value of Synet based on future undiscounted cashflows and the carrying amount of
its assets and liabilities, including goodwill. Since the acquisition, the
intangible assets are being amortized over a period of 3-5 years.
On December 14, 2000, we acquired Global Integrity Corporation for an aggregate
purchase price of approximately $78.3 million. The purchase price was paid in
the form of 5,240,275 shares of our common stock, options to purchase 551,048
shares of common stock and $31.5 million in cash in exchange for all of the
outstanding capital stock of Global Integrity. The acquisition was accounted for
as a purchase and resulted in intangible assets of approximately $81.3 million
representing the customer lists, workforce, tradenames, developed technology and
excess of the purchase price over the fair value of the net tangible assets
acquired. During 2001, the Company adjusted the purchase price for $3.6 million
for the closing of certain offices and a reduction in workforce in connection
with the acquisition plan and to adjust the final purchase price allocation. In
the third quarter of fiscal 2001, the Company reviewed goodwill and the
intangible assets for impairment due to revenue declines in this business. As a
result of this review, an impairment loss of $42.3 million was recognized for
the difference between the estimated value of Global Integrity based on future
undiscounted cashflows and the carrying amount of its assets and liabilities,
including goodwill. Since the acquisition, the intangible assets are being
amortized over a period of 3-5 years.
In February 2001, the Company's management foresaw the need to lower the
operating costs of the business given its near-term revenue projections.
Therefore, the Company established a plan that included the following: (1) a
reduction in its workforce for both domestic and international operations
related to professional consultant employees that had been underutilized for
several months and also to employees that held various management, sales and
administrative positions deemed to be duplicative functions; (2) the closing of
several domestic and international regional offices located in geographic areas
that no longer cost justified remaining open; and (3) the discontinuance of
electronic equipment leases and other expenses related to the reduction in
workforce.
Given the decline in revenue related to the service provider customer base,
coupled with the continuing uncertainty in the professional network consulting
services marketplace, we believe that our quarterly revenue and operating
results are likely to vary significantly in the future and that period-to-period
comparisons of our operating results are not necessarily meaningful and should
not be relied on as indications of future performance.
RESULTS OF OPERATIONS
Three Months Ended September 30, 2001 and 2000
REVENUES. Revenues decreased 39.1% to $15.0 million in the three months ended
September 30, 2001 from $24.7 million in the three months ended September 30,
2000. Revenues from professional services decreased 39.6% to $14.4 million in
the three months ended September 30, 2001 from $23.8 million in the three months
ended September 30, 2000. This decrease was primarily due to the severe
contraction in spending by telecom service providers in both domestic and
international operations and difficult market conditions in the enterprise
sector. Revenues from hardware and software sales decreased 25.8% to $677,000 in
the three months ended September 30, 2001 from $913,000 in the three months
ended September 30, 2000. This decrease was primarily due to a decline in client
requests for hardware and software in connection with professional services
projects. During the three months ended September 30, 2001, BellSouth
Corporation accounted for 17.4% of our revenues. The number of our billable
consultants decreased to 370 as of September 30, 2001 from 409 as of September
30, 2000.
GROSS PROFIT. Gross profit decreased 76.9% to $2.7 million in the three months
ended September 30, 2001 from $11.9 million in the three months ended September
30, 2000. As a percentage of revenues, gross profit decreased to 18.2% in the
three months ended September 30, 2001 from 48.1% in the three months ended
September 30, 2000. This decrease in gross profit is a result of a decrease in
utilization of the related consultants in addition to a lower margin recognized
in the sale of software inventory. Cost of revenues decreased 4.0% to $12.3
million in the three months ended September 30, 2001 from $12.8 million in the
three months ended September 30, 2000. This decrease in cost of revenues was due
primarily to a decrease in compensation and benefits paid to consultants as a
result of reductions in billable headcount.
SALES AND MARKETING EXPENSES. Sales and marketing expenses increased 14.6% to
$3.6 million in the three months ended September 30, 2001 from $3.2 million in
the three months ended September 30, 2000. As a percentage of revenues, sales
and marketing expenses increased to 24.2% in the three months ended September
30, 2001 from 12.8% in the three months ended September 30, 2000. The increase
in absolute dollars was primarily due to an increase of $392,000 in compensation
and benefits paid and an increase of $72,000 in sales and marketing efforts.
8
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
increased 50.1% to $10.4 million in the three months ended September 30, 2001
from $7.0 million in the three months ended September 30, 2000. As a percentage
of revenues, general and administrative expenses increased to 69.4% in the three
months ended September 30, 2001 from 28.2% in the three months ended September
30, 2000. The increase in absolute dollars was primarily due to an increase of
$472,000 in compensation and benefits costs, an increase of $405,000 in
facilities and equipment leases, an increase of $2.4 million in bad debt
expense, and an increase of $124,000 in professional services and other
administrative costs.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased 28.7% to
$583,000 in the three months ended September 30, 2001 from $453,000 in the three
months ended September 30, 2000. This increase was due to purchases of
additional computer equipment to support our growth, offset by write-offs of
leasehold improvements and furniture in connection with the restructuring plan.
INTANGIBLES AMORTIZATION. Amortization of intangibles increased to $6.4 million
for the three months ended September 30, 2001 from $213,000 for the three months
ended September 30, 2000. For the three months ended September 30, 2001, the
amount consisted of $213,000 amortization of intangibles related to the
acquisition of Network Resource Consultants and Company B.V. (NRCC) in August
1999, $1.8 million amortization of intangibles related to the acquisition of
Synet in October 2000 and $4.4 million amortization of intangibles related to
the acquisition of Global Integrity in December 2000. For the three months ended
September 30, 2000, amortization was solely related to intangibles as a result
of the NRCC acquisition.
LOSS ON EQUIPMENT. For the three months ended September 30, 2001, the Company
recognized a loss of $443,498 for equipment that was not in service and deemed
to have no salvage value.
IMPAIRMENT OF INTANGIBLES. For the three months ended September 30, 2001, the
Company recognized an impairment loss of $18.2 million and $42.3 million,
respectively, for the difference between the estimated value of Synet and Global
Integrity and the carrying amount of each of their assets and liabilities,
including goodwill.
RESTRUCTURING AND OTHER CHARGES. For the three months ended September 30, 2001,
the Company laid-off 86 employees in connection with its restructuring plan.
These employees consisted primarily of professional consultants and sales
personnel. The Company also closed additional domestic offices located in
geographic areas that no longer cost justified remaining open. Amounts
recognized as restructuring charges are $1.0 million in severance benefits and
$3.6 million in exit costs related to real estate and electronic equipment.
LOSS ON LONG-TERM INVESTMENT IN RELATED PARTY. For the three months ended
September 30, 2001, the Company recognized a loss on its $1.0 million investment
in Three Pillars, Inc. due to management's decision that the value of the
investment was impaired. Eric Meyer, one of the Company's directors, is a
general partner of Meyer Duffy Ventures LLP, a venture capital firm which is a
shareholder of Three Pillars.
NONCASH COMPENSATION EXPENSE. During 1999, the Company granted options to
purchase shares of common stock at exercises prices that were less than the fair
market value of the underlying shares of common stock, resulting in deferred
compensation. During 2000, related to the acquisition of Synet and Global
Integrity, the Company issued options to Synet and Global Integrity
optionholders in exchange for their Synet and Global Integrity options,
respectively. The unvested portion of the Synet and Global Integrity options
resulted in deferred compensation. These transactions result in noncash
compensation expense over the period that these specific options vest. During
the three months ended September 30, 2001 and 2000, the Company recorded
approximately $83,000 and $19,000, respectively, of noncash compensation
expenses related to these options.
OTHER INCOME (EXPENSE). Other income decreased to $675,000 in the three months
ended September 30, 2001 from $2.1 million in the three months ended September
30, 2000. This decrease was primarily due to a decrease in interest income as a
result of the utilization of cash and cash equivalents to fund current operating
needs, the Synet and Global Integrity acquisitions, and a general decline in
interest rates.
INCOME TAXES. For the three months ended September 30, 2001 the benefit for
income taxes was fully offset by valuation allowances. For the three months
ended September 30, 2000, the income tax provision was $1.3 million on pre-tax
income of approximately $3.1 million. The difference in the effective tax rates
relates to the provision for a valuation allowance against net operating losses
and an increase in expenses not deductible for tax purposes.
9
Nine Months Ended September 30, 2001 and 2000
REVENUES. Revenues decreased 19.3% to $54.1 million in the nine months ended
September 30, 2001 from $67.1 million in the nine months ended September 30,
2000. Revenues from professional services decreased 18.8% to $52.6 million in
the nine months ended September 30, 2001 from $64.7 million in the nine months
ended September 30, 2000. This decrease was primarily due to the severe
contraction in spending by telecom service providers in both domestic and
international operations and difficult market conditions in the enterprise
sector. Revenues from hardware and software sales decreased 33.6% to $1.6
million in the nine months ended September 30, 2001 from $2.4 million in the
nine months ended September 30, 2000. This decrease was primarily due to a
decline in client requests for hardware and software in connection with
professional services projects. During the nine months ended September 30, 2001,
BellSouth Corporation accounted for 18.7% of our revenues. The number of our
billable consultants decreased to 370 as of September 30, 2001 from 409 as of
September 30, 2000.
GROSS PROFIT. Gross profit decreased 61.1% to $12.6 million in the nine months
ended September 30, 2001 from $32.3 million in the nine months ended September
30, 2000. As a percentage of revenues, gross profit decreased to 23.2% in the
nine months ended September 30, 2001 from 48.1% in the nine months ended
September 30, 2000. This decrease in gross profit is a result of a decrease in
utilization of the related consultants in addition to a lower margin recognized
on the sale of software inventory and the write-off of $500,000 of software
inventory which was deemed to be no longer saleable. Excluding the impact of
this write-off, gross margin was 24.1% for the nine months ended September 30,
2001. Cost of revenues increased 19.4% to $41.6 million in the nine months ended
September 30, 2001 from $34.8 million in the nine months ended September 30,
2000. This increase in cost of revenues was due primarily to an increase in
compensation and benefits paid to consultants in the first six months of 2001 in
addition to the $500,000 write-off of software inventory.
SALES AND MARKETING EXPENSES. Sales and marketing expenses increased 44.4% to
$12.9 million in the nine months ended September 30, 2001 from $8.9 million in
the nine months ended September 30, 2000. As a percentage of revenues, sales and
marketing expenses increased to 23.9% in the nine months ended September 30,
2001 from 13.3% in the nine months ended September 30, 2000. The increase in
absolute dollars was primarily due to an increase of $659,000 in commissions
paid, an increase of $2.9 million in compensation and benefits paid, and an
increase of $438,000 in sales and marketing efforts.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
increased 82.7% to $34.4 million in the nine months ended September 30, 2001
from $18.8 million in the nine months ended September 30, 2000. As a percentage
of revenues, general and administrative expenses increased to 63.5% in the nine
months ended September 30, 2001 from 28.1% in the nine months ended September
30, 2000. The increase in absolute dollars was primarily due to an increase of
$4.8 million in compensation and benefits costs, an increase of $2.5 million in
facilities and equipment leases, an increase of $3.9 million in bad debt
expense, and an increase of $4.4 million in professional services and other
administrative costs.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased 97.5% to
$2.3 million in the nine months ended September 30, 2001 from $1.2 million in
the nine months ended September 30, 2000. This increase was due to purchases of
additional computer equipment to support our growth offset by write-offs of
leasehold improvements and furniture in connection with the restructuring plan.
INTANGIBLES AMORTIZATION. Amortization of intangibles increased to $19.1 million
for the nine months ended September 30, 2001 from $640,000 for the nine months
ended September 30, 2000. For the nine months ended September 30, 2001, the
amount consisted of $640,000 amortization of intangibles related to the
acquisition of NRCC in August 1999, $5.4 million amortization of intangibles
related to the acquisition of Synet in October 2000 and $13.1 million
amortization of intangibles related to the acquisition of Global Integrity in
December 2000. For the nine months ended September 30, 2000, amortization was
solely related to intangibles as a result of the NRCC acquisition.
LOSS ON EQUIPMENT. For the nine months ended September 30, 2001, the Company
recognized a loss of $443,498 for equipment that was not in service and deemed
to have no salvage value.
IMPAIRMENT OF INTANGIBLES. For the nine months ended September 30, 2001, the
Company recognized an impairment loss of $18.2 million and $42.3 million,
respectively, for the difference between the estimated fair value of Synet and
Global Integrity and the carrying amount of each of their assets and
liabilities, including goodwill.
RESTRUCTURING AND OTHER CHARGES. For the nine months ended September 30, 2001,
the Company laid-off 210 employees in connection with its restructuring plan.
These employees consisted of professional consultants and sales personnel, as
well as employees who held certain administrative and management positions
deemed to be duplicative functions. Amounts recognized as restructuring charges
included $2.7 million in severance benefits and other related expenses and $5.1
million in exit costs related to real estate and electronic equipment.
Additionally, included in the financial statement caption for the nine months
ended September 30, 2001 is $1,030,000 related to the write-off of internal
software management tools that no longer suit the business needs of the Company.
10
LOSS ON LONG-TERM INVESTMENT IN RELATED PARTY. On March 22, 2001, Paradigm4,
Inc. filed for federal bankruptcy protection. This action created significant
uncertainty regarding the Company's investment in Paradigm4. As a result, the
Company has recognized a loss on its $1.0 million investment in Paradigm4 for
the nine months ended September 30, 2001. For the nine months ended September
30, 2001, the Company has recognized a loss on its $1.0 million investment in
Three Pillars due to management's decision that the value of the investment was
impaired.
NONCASH COMPENSATION EXPENSE. During 1999, the Company granted options to
purchase shares of common stock at exercises prices that were less than the fair
market value of the underlying shares of common stock resulting in deferred
compensation. During 2000, related to the acquisition of Synet and Global
Integrity, the Company issued options to Synet and Global Integrity
optionholders in exchange for their Synet and Global Integrity options,
respectively. The unvested portion of their Synet and Global Integrity options
resulted in deferred compensation. These transactions result in noncash
compensation expense over the period that the specific options vest. During the
nine months ended September 30, 2001 and 2000, the Company recorded
approximately $301,000 and $57,000, respectively, of noncash compensation
expenses related to these options.
OTHER INCOME (EXPENSE). Other income decreased to $2.4 million in the nine
months ended September 30, 2001 from $5.2 million in the nine months ended
September 30, 2000. This decrease was primarily due to a decrease in interest
income as a result of the utilization of cash and cash equivalents to fund
current operating needs, the Synet and Global Integrity acquisitions, and a
general decline in interest rates.
INCOME TAXES. For the nine months ended September 30, 2001 the benefit for
income taxes was fully offset by valuation allowances. For the nine months ended
September 30, 2000, the income tax provision was $3.4 million on pre-tax income
of approximately $7.9 million. The difference in the effective tax rates relates
to the provision for a valuation allowance against net operating losses and an
increase in expenses not deductible for tax purposes.
LIQUIDITY AND CAPITAL RESOURCES. Since inception, we have financed our
operations through borrowings under short-term credit facilities, the sale of
equity securities and cash flows from operations. As of nine months ended
September 30, 2001, we had approximately $41.1 million in cash and cash
equivalents and $3.9 million in marketable securities.
Net cash used in operating activities was $31.9 million for the nine months
ended September 30, 2001 due to losses generated in operations and an increase
in accrued expenses.
Net cash used in investing activities was $9.1 million for the nine months ended
September 30, 2001. Cash used in investing activities resulted from capital
expenditures of approximately $7.2 million and adjustments to purchase price of
$1.9 million as a result of the acquisition plan. Capital expenditures consisted
of $2.2 million of costs incurred in connection with the development of software
to be used for internal purposes, $3.0 million related to purchases of computer
equipment to support such software, and $2.0 million related to purchases of
computer equipment, furniture, and leasehold improvements in connection with the
expansion of our operations in Germany and investment in our infrastructure.
Cash provided by financing activities was $1.9 million for the nine months ended
September 30, 2001. Cash provided by financing activities resulted from the
receipt of proceeds from the exercise of options and the sale of stock in
connection with the Company's Employee Stock Purchase Plan.
We have a demand loan facility, secured by a lien on all of our assets, under
which we may borrow up to the lesser of $10.0 million or 80.0% of our accounts
receivable. Amounts outstanding under the facility bear interest at the lender's
base rate which was 5.5% as of September 30, 2001. As of September 30, 2001,
there were no amounts outstanding under the facility.
We believe that our existing cash, cash equivalents and marketable securities
will be sufficient to meet our anticipated needs for working capital and capital
expenditures for at least the next twelve months. If cash generated from
operations is insufficient to satisfy our liquidity requirements, we may seek to
sell additional equity or debt securities or to obtain a credit facility. The
sale of additional equity or convertible debt securities could result in
dilution to our stockholders. The incurrence of indebtedness would result in
increased fixed obligations and could result in operating covenants that would
restrict our operations. We cannot assure you that financing will be available
in amounts or on terms acceptable to us, if at all.
11
RISK FACTORS
An investment in our company involves a high degree of risk. You should
carefully consider the risks described below before you decide to buy our common
stock. If any of the following risks actually occur, our business, results of
operations or financial condition would likely suffer. In this case, the trading
price of our common stock could decline.
Risks Related to Our Financial Condition and Business Model
Our limited operating history makes it difficult for you to evaluate our
business and to predict our future success. We commenced operations in February
1995 and therefore have only a limited operating history for you to evaluate our
business. Because of our limited operating history, large initial growth, the
fact that many of our competitors have longer operating histories, and a
volatile economy, we believe that the prediction of our future success is
difficult. You should evaluate our chances of financial and operational success
in light of the risks, uncertainties, expenses, delays and difficulties
associated with operating a new business, many of which are beyond our control.
You should not rely on our historical results of operations as indications of
future performance. The uncertainty of our future performance and the
uncertainties of our operating in a new and expanding market increase the risk
that the value of your investment will decline.
Adverse market conditions, particularly those affecting the professional
services industry, may impair our operating results
Our results depend to a large extent on market conditions affecting the
technology industry in general and the telecommunications and enterprise sectors
in particular. Adverse market conditions in the sectors in which we operate
could delay buying decisions or cause projects to be deferred, reduced in scope
or discontinued. These sectors have experienced a drastic downturn in the past
twelve months. If market conditions and corporate spending in these sectors does
not improve, our operating results will continue to suffer.
Because most of our revenues are generated from a small number of clients, our
revenues are difficult to predict and the loss of one client could significantly
reduce our revenues
During the nine months ended September 30, 2001, BellSouth Corporation accounted
for 18.7% of our revenues. Our five largest clients accounted for 42.0% of our
revenues for the nine months ended September 30, 2001. For the year ended
December 31, 2000, our five largest clients accounted for 37.8% of our revenues.
If one of our major clients discontinues or significantly reduces the use of our
services, we may not generate sufficient revenues to offset this loss of
revenues and our net loss will increase. In addition, the non-payment or late
payment of amounts due from a major client could adversely affect us. As of
September 30, 2001, the accounts receivable from BellSouth Corporation was
approximately $2.2 million, which related to work performed in June 2001 through
September 2001.
Our clients may terminate their contracts with us on short notice
Our services are often delivered pursuant to short-term arrangements and most
clients can reduce or cancel their contracts for our services without penalty
and with little or no notice. If a major client or a number of small clients
terminate our contracts or significantly reduce or modify their business
relationships with us, we may not be able to replace the shortfall in revenues.
Consequently, you should not predict or anticipate our future revenues based
upon the number of clients we have currently or the number and size of our
existing projects.
Our operating results may vary from quarter to quarter in future periods, and as
a result, we may fail to meet the expectations of our investors and analysts,
which may cause our stock price to fluctuate or decline
Our operating results have varied from quarter to quarter. Our operating results
may continue to vary as a result of a variety of factors. These factors include:
- the loss of key employees;
- the development and introduction of new service offerings;
- reductions in our billing rates;
- market conditions in the sectors in which we operate;
- the miscalculation of resources required to complete new or ongoing projects;
- the utilization of our workforce;
12
- the ability of our clients to meet their payments obligations to us; and
- the timing and extent of training.
Many of these factors are beyond our control. Accordingly, you should not rely
on quarter-to-quarter comparisons of our results of operations as an indication
of our future performance. In addition, our operating results may be below the
expectations of public market analysts or investors in some future quarter. If
this occurs, the price of our common stock is likely to decline.
We derive a substantial portion of our revenues from fixed-price projects, under
which we assume greater financial risk if we fail to accurately estimate the
costs of the projects
We derive a substantial portion of our revenues from fixed-price projects. For
the nine months ended September 30, 2001 and the year ended December 31, 2000,
fixed-price projects accounted for 48.0% and 43.2% of our revenue, respectively.
We assume greater financial risks on a fixed-price project than on a
time-and-expense based project. If we miscalculate the resources or time we need
for these fixed-price projects, the costs of completing these projects may
exceed the price, which could result in a loss on the project and a decrease in
net income. Further, the average size of our contracts has increased in recent
quarters, resulting in a corresponding increase in our exposure to the financial
risks of fixed-price engagements. We recognize revenues from fixed-price
projects based on our estimate of the percentage of each project completed in a
reporting period. To the extent our estimates are inaccurate, the revenues and
operating profits, if any, that we report for periods during which we are
working on a fixed-price project may not accurately reflect the final results of
the project and we would be required to record an expense for these periods
equal to the amount by which our revenues were previously overstated.
Our operating results may fluctuate due to seasonal factors which could result
in greater than expected losses
Our results of operations may experience seasonal fluctuations as businesses
typically spend less on network management services during the summer and
year-end vacation and holiday periods. Additionally, as a large number of our
employees take vacation during these periods, our utilization rates during these
periods tend to be lower, which reduces our margins and operating income.
Accordingly, we may report greater than expected losses for these periods.
Our long sales cycle makes our revenues difficult to predict and could cause our
quarterly operating results to be below the expectations of public market
analysts and investors
The timing of our revenues is difficult to predict because of the length and
variance of the time required to complete a sale. This unpredictability is often
compounded by uncertain market conditions. Before hiring us for a project, our
clients often undertake an extensive review process and may require approval at
various levels within their organization. Any delay due to a long sales cycle
could reduce our revenues for a quarter and cause our quarterly operating
results to be below the expectations of public market analysts or investors. If
this occurs, the price of our common stock is likely to decline.
We may need to raise additional capital to grow our business, which we may not
be able to do
Our future liquidity and capital requirements are difficult to predict because
they depend on numerous factors, including the success of our existing and new
service offerings and competing technological and market developments. As a
result, we may not be able to generate sufficient cash from our operations to
meet additional working capital requirements, support additional capital
expenditures or take advantage of acquisition opportunities. Accordingly, we may
need to raise additional capital in the future. Our ability to obtain additional
financing will be subject to a number of factors, including market conditions,
our operating performance and investor sentiment. These factors may make the
timing, amount, terms and conditions of additional financing unattractive for
us. If we are unable to raise additional funds when needed, our ability to
operate and grow our business could be impeded.
Risks Related to Our Strategy and Market
We may have difficulty managing our operations, which may harm our business
A key part of our strategy is to grow our business; however, our rapid growth
has placed a significant strain on our managerial and operational resources.
From January 1, 1997 to September 30, 2001, our staff increased from
approximately 123 to approximately 508 employees. Since such time, as a result
of market conditions and other factors, we have decreased our staff to 489
employees as of October 31, 2001. As a result of this reduction, the remaining
employees have been charged with additional responsibilities. To manage our
growth, we must continue to improve our financial and management controls,
reporting systems and procedures, and expand and train our work force. We may
not be able to do so successfully.
Our management team has experienced significant turnover which could interrupt
our business and adversely affect our growth
13
Our future success depends, in significant part, upon the continued service and
performance of our senior management and other key personnel. Andrew Zimmerman
has recently been appointed our Chief Executive Officer. In addition, in
connection with our recent reduction in staff, many members of our senior
management team have either departed, or been redeployed and given new
responsibilities. If the restructuring of our senior management team does not
lead to the results we expect, our ability to effectively deliver our services,
manage our company, and carry out our business plan may be impaired.
We may not be able to hire and retain qualified network systems consultants
which could affect our ability to compete effectively
Our continued success depends on our ability to identify, hire, train and retain
highly qualified network management consultants. These individuals are in high
demand and we may not be able to attract and retain the number of highly
qualified consultants that we need. If we cannot retain, attract and hire the
necessary consultants, our ability to grow, complete existing projects and bid
for new projects will be adversely affected.
Competition in the network consulting industry is intense, and therefore we may
lose projects to our competitors
Our market is intensely competitive, highly fragmented and subject to rapid
technological change. We expect competition to intensify and increase over time.
We may lose projects to our competitors, which could adversely affect our
business, results of operations and financial condition. In addition,
competition could result in lower billing rates and gross margins and could
require us to increase our spending on sales and marketing.
We face competition from systems integrators, value added resellers, network
services firms, telecommunications providers, and network equipment and computer
systems vendors. These competitors may be able to respond more quickly to new or
emerging technologies and changes in client requirements or devote greater
resources to the expansion of their market share.
Additionally, our competitors have in the past and may in the future form
alliances with various network equipment vendors that may give them an advantage
in implementing networks using that vendor's equipment.
We also compete with internal information technology departments of current and
potential clients. To the extent that current or potential clients decide to
satisfy their needs internally, our business will suffer.
If we are unable to find suitable acquisition candidates, our growth could be
impeded
A component of our growth strategy is the acquisition of, or investment in,
complementary businesses, technologies, services or products. Our ability to
identify and invest in suitable acquisition and investment candidates on
acceptable terms is crucial to this strategy. We may not be able to identify,
acquire or make investments in promising acquisition candidates on acceptable
terms. Moreover, in pursuing acquisition and investment opportunities, we may be
in competition with other companies having similar growth and investment
strategies. Competition for these acquisitions or investment targets could also
result in increased acquisition or investment prices and a diminished pool of
businesses, technologies, services or products available for acquisition or
investment.
Our acquisition strategy could have an adverse effect on client satisfaction and
our operating results
Acquisitions, including those already consummated, involve a number of risks,
including:
o adverse effects on our reported operating results due to accounting charges
associated with acquisitions;
o increased expenses, including compensation expense resulting from newly hired
employees; and
o potential disputes with the sellers of acquired businesses, technologies,
services or products.
Client dissatisfaction or performance problems with an acquired business,
technology, service or product could also have a material adverse impact on our
reputation as a whole. In addition, any acquired business, technology, service
or product could significantly underperform relative to our expectations.
Our international expansion efforts, which are a key part of our growth
strategy, may not be successful
We expect to expand our international operations and international sales and
marketing efforts. In January 1999, we commenced operations in England. In
August 1999, we acquired Network Resource Consultants and Company, a network
consulting company based in The Netherlands. Additionally, Synet Service
Corporation, acquired in October 2000, has a German subsidiary, whose operations
we have significantly increased, and Global Integrity Corporation, acquired in
December 2000, has existing operations in England and Japan. We have had limited
experience in marketing, selling and distributing our services internationally.
We may not be able to maintain and expand our international operations or
successfully market our services internationally. Failure to do so may
negatively affect our business, as well as our ability to grow.
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Our business may suffer if we fail to adapt appropriately to the challenges
associated with operating internationally
Operating internationally may require us to modify the way we conduct our
business and deliver our services in these markets. We anticipate that we will
face the following challenges internationally:
o the burden and expense of complying with a wide variety of foreign laws and
regulatory requirements;
o potentially adverse tax consequences;
o longer payment cycles and problems in collecting accounts receivable;
o technology export and import restrictions or prohibitions;
o tariffs and other trade barriers;
o difficulties in staffing and managing foreign operations;
o cultural and language differences;
o fluctuations in currency exchange rates; and
o seasonal reductions in business activity during the summer months in Europe.
If we do not appropriately anticipate changes and adapt our practices to meet
these challenges, our growth could be impeded and our results of operations
could suffer.
If we do not keep pace with technological changes, our services may become less
competitive and our business will suffer
Our market is characterized by rapidly changing technologies, frequent new
product and service introductions and evolving industry standards. As a result
of the complexities inherent in today's computing environments, we face
significant challenges in remaining abreast of such changes and product
introductions. If we cannot keep pace with these changes, we will not be able to
meet our clients' increasingly sophisticated network management needs and our
services will become less competitive.
Our future success will depend on our ability to:
o keep pace with continuing changes in industry standards, information
technology and client preferences;
o respond effectively to these changes; and
o develop new services or enhance our existing services.
We may be unable to develop and introduce new services or enhancements to
existing services in a timely manner or in response to changing market
conditions or client requirements.
If the use of large-scale, complex networks does not continue to grow, we may
not be able to successfully increase or maintain our client base and revenues
To date, a majority of our revenues have been from network management services
related to large-scale, complex networks. We believe that we will continue to
derive a majority of our revenues from providing network design, performance,
management and security services. As a result, our future success is highly
dependent on the continued growth and acceptance of large-scale, complex
computer networks and the continued trend among our clients to use third-party
service providers. If the growth of the use of enterprise networks does not
continue or declines, our business may not grow and our revenues may decline.
We may not successfully penetrate the managed security services market
In December 2000, we entered into the managed security services market. This is
a new market for us and one in which we have not had significant experience.
Entering into this market requires a material financial commitment by us. To
date we have made a substantial infrastructure investment in order to serve this
market. We cannot assure you that our efforts in this new market will be
successful. Accordingly, we may lose some or all of the resources we invest in
this new market.
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Risks Related to Intellectual Property Matters and Potential Legal Liability
Unauthorized use of our intellectual property by third parties may damage our
brand
We regard our copyrights, trade secrets and other intellectual property as
critical to our success. Unauthorized use of our intellectual property by third
parties may damage our brand and our reputation. We rely on trademark and
copyright law, trade secret protection and confidentiality and/or license and
other agreements with our employees, customers, partners and others to protect
our intellectual property rights. However, we do not have any patents or patent
applications pending and existing trade secret, trademark and copyright laws
afford us only limited protection. Despite our precautions, it may be possible
for third parties to obtain and use our intellectual property without our
authorization. The laws of some foreign countries are also uncertain or do not
protect intellectual property rights to the same extent as do the laws of the
United States.
We may have to defend against intellectual property infringement claims, which
could be expensive and, if we are not successful, could disrupt our business
We cannot be certain that our services, the finished products that we deliver or
materials provided to us by our clients for use in our finished products do not
or will not infringe valid patents, copyrights, trademarks or other intellectual
property rights held by third parties. As a result, we may be subject to legal
proceedings and claims from time to time relating to the intellectual property
of others in the ordinary course of our business. We may incur substantial
expenses in defending against these third-party infringement claims, regardless
of their merit. Successful infringement claims against us may result in
substantial monetary liability or may materially disrupt the conduct of our
business.
Because our services are often critical to our clients' operations, we may be
subject to significant claims if our services do not meet our clients'
expectations
Many of our projects are critical to the operations of our clients' businesses.
If we cannot complete these projects to our clients' expectations, we could
materially harm our clients' operations. This could damage our reputation,
subject us to increased risk of litigation or result in our having to provide
additional services to a client at no charge. Although we carry general
liability insurance coverage, our insurance may not cover all potential claims
to which we are exposed or may not be adequate to indemnify us for all liability
that may be imposed.
Our stock price is likely to be highly volatile and could drop unexpectedly
The market price of our common stock is highly volatile, has fluctuated
substantially and may continue to do so. As a result, investors in our common
stock may experience a decrease in the value of their common stock regardless of
our operating performance or prospects. In addition, the stock market has, from
time to time, experienced significant price and volume fluctuations that have
affected the market prices for the securities of technology companies. In the
past, following periods of volatility in the market price of a particular
company's securities, securities class action litigation was often brought
against that company. Many technology-related companies have been subject to
this type of litigation. We may also become involved in this type of litigation.
Litigation is often expensive and diverts management's attention and resources.
We are controlled by a small group of our existing stockholders, whose interests
may differ from other stockholders
Our directors, executive officers and affiliates currently beneficially own
approximately 45% of the outstanding shares of our common stock. Accordingly,
these stockholders will have significant influence in determining the outcome of
any corporate transaction or other matter submitted to the stockholders for
approval, including mergers, acquisitions, consolidations and the sale of all or
substantially all of our assets, and also the power to prevent or cause a change
in control. The interests of these stockholders may differ from the interests of
the other stockholders.
Our charter documents and Delaware law may inhibit a takeover that stockholders
may consider favorable
Provisions in our charter and bylaws may have the effect of delaying or
preventing a change of control or changes in our management that stockholders
consider favorable or beneficial. If a change of control or change in management
is delayed or prevented, the market price of our common stock could decline.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Currency Rate Fluctuations.
Our results of operations, financial position and cash flows are not materially
affected by changes in the relative values of non-U.S. currencies to the U.S.
dollar. We do not use derivative financial instruments to limit our foreign
currency risk exposure.
Market Risk.
Our accounts receivable are subject, in the normal course of business, to
collection risks. We regularly assess these risks and have established policies
and business practices to protect against the adverse effects of collection
risks. As a result, we do not anticipate any material losses in this area.
Interest Rate Risks.
We do not currently have any outstanding indebtedness. In addition, our
investments are classified as cash and cash equivalents with original maturities
of three months or less. Therefore, we are not exposed to material market risk
arising from interest rate changes, nor do such changes affect the value of
investments as recorded by us.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Except as set forth below, we are not a party to any material legal proceedings.
On October 29, 1999, Art Eckert (Plaintiff) filed an action against the Company
in which he alleged that the Company was in breach of an employment agreement
between Plaintiff and the Company. Plaintiff also alleged that the Company
fraudulently induced Plaintiff to enter into this purported employment
agreement. Plaintiff seeks to recover damages in excess of $3.2 million with
respect to the claim for breach of contract, and damages in excess of $6.0
million with respect to the claim for fraudulent inducement. The Company filed a
motion to dismiss the claim for fraudulent inducement on December 13, 1999.
Plaintiff amended the complaint, essentially adding allegations with respect to
the claim for fraudulent inducement, and opposing the Company's motion.
By Decision and Order filed on July 11, 2000, Judge S. Barrett Hickman, in New
York Supreme Court, Putnam County, denied the Company's motion to dismiss the
claim for fraudulent inducement. The case is in the discovery phase and the
Company intends to defend it vigorously.
By Decision and Order dated July 16, 2001, Judge Hickman denied Plaintiff's
motion to amend his complaint to add a new cause of action for breach of an
implied covenant of good faith and fair dealing.
This matter is set for trial on May 6, 2002.
The Company has reason to believe it may be named as a defendant in a purported
securities class-action lawsuit which would allege claims against the Company
under Sections 11 and 15 of the Securities Act of 1933, as amended. We intend to
vigorously defend any such claims if and when they are made.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
On October 27, 1999, the SEC declared effective the Registration Statement on
Form S-1, SEC Registration Number 333-84045 for our public offering of common
stock in the United States (the Offering). We realized net proceeds of
approximately $67.0 million from the Offering. Since that time we have used the
proceeds for the following: $11.1 million for the acquisition of Synet; $33.3
million for the acquisition of Global Integrity; and $22.6 million to fund
current operating needs.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
NONE
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
NONE
ITEM 5. OTHER INFORMATION
NONE
ITEM 6. EXHIBITS AND REPORT ON FORM 8-K
(a) The following exhibit is filed as part of this report:
10.1. Agreement of Lease, Dated September 25, 2001, by and between the
Registrant and EBS Forty-Fourth Property Associates LLC.
(b) The Company did not file any reports on Form 8-K during the three months
ended September 30, 2001.
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ITEM 7. SIGNATURES
Pursuant to the requirements of the Securities Exchange Act, the Registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
PREDICTIVE SYSTEMS, INC.
(Registrant)
Date: November 14, 2001 /s/ ANDREW ZIMMERMAN
--------------------------------------------------------------------------------
Name: Andrew Zimmerman
Title: Chief Executive Officer
(principal executive officer)
Date: November 14, 2001 /s/ GERARD E. DORSEY
--------------------------------------------------------------------------------
Name: Gerard E. Dorsey
Title: Chief Financial Officer
(principal accounting and financial officer)
18