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, 2002.
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 1, 2002, there were 37,611,107 shares of the registrant's common
stock, $.001 par value per share, outstanding.
INDEX
PREDICTIVE SYSTEMS, INC.
Page
----
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Balance Sheets as of September 30, 2002
(unaudited)and December 31, 2001 ......................... 1
Consolidated Statements of Operations for the three and
nine months ended September 30, 2002 (unaudited) and 2001
(unaudited)............................................... 2
Consolidated Statements of Cash Flows for the nine months
ended September 30, 2002 (unaudited) and 2001
(unaudited)............................................... 3
Notes to Consolidated Financial Statements (unaudited) ... 4
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS ..................... 13
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK .................................................... 27
ITEM 4. CONTROLS AND PROCEDURES................................... 27
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS ........................................ 28
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS ................ 28
ITEM 3. DEFAULTS UPON SENIOR SECURITIES .......................... 28
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ...... 28
ITEM 5. OTHER INFORMATION ........................................ 28
ITEM 6. EXHIBITS AND REPORT ON FORM 8-K .......................... 28
ITEM 7. SIGNATURES ............................................... 30
PREDICTIVE SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
September 30, 2002 December 31, 2001
------------------ -----------------
(unaudited)
ASSETS
Current assets
Cash and cash equivalents $ 17,501,736 $ 41,277,867
Restricted cash 1,036,869 --
Accounts receivable - net of allowance for
doubtful accounts of $2,084,218 and $2,606,361, respectively 8,076,534 10,124,399
Related party receivables 1,424,715 1,052,540
Unbilled revenues 2,523,457 1,319,044
Inventory held for resale -- 2,205,986
Work in process - hardware and software 321,484 --
Receivables from employees and stockholders 18,378 61,526
Refundable income taxes 403,024 375,982
Prepaid expenses and other current assets 1,389,909 2,180,531
------------- -------------
Total current assets 32,696,106 58,597,875
Property and equipment - net of accumulated
depreciation and amortization of $956,744 and $4,587,357, respectively 613,913 6,323,100
Intangible assets - net of accumulated amortization of $2,032,293 and $25,171,316, respectively 2,231,251 36,242,922
Restricted cash 1,346,459 782,292
Other assets 455,717 547,103
------------- -------------
Total assets $ 37,343,446 $ 102,493,292
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable $ 1,688,383 $ 5,451,745
Accrued expenses and other current liabilities 7,412,326 11,469,090
Current portion of capital lease obligations 60,326 81,714
Deferred revenue 660,571 333,527
------------- -------------
Total current liabilities 9,821,606 17,336,076
------------- -------------
Noncurrent liabilities
Capital lease obligations 5,428 52,134
Deferred rent 235,563 165,251
Other long-term liabilities 3,000 3,000
------------- -------------
Total noncurrent liabilities 243,991 220,385
------------- -------------
Total liabilities 10,065,597 17,556,461
------------- -------------
Commitments and contingencies
Stockholders' equity
Common stock, $.001 par value, 200,000,000 shares authorized,
37,606,356 and 36,360,491 shares issued and outstanding, respectively 37,606 36,361
Additional paid-in capital 230,350,194 229,408,586
Deferred compensation (35,362) (182,581)
Accumulated deficit (203,375,029) (144,390,718)
Accumulated other comprehensive income 300,440 65,183
------------- -------------
Total stockholders' equity 27,277,849 84,936,831
------------- -------------
Total liabilities and stockholders' equity $ 37,343,446 $ 102,493,292
============= =============
The accompanying notes are an integral part of these consolidated financial
statements.
1
PREDICTIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months Ended September 30, Nine Months Ended September 30,
-------------------------------- -------------------------------
2002 2001 2002 2001
-------------- -------------- -------------- -------------
Revenues:
Professional services $ 10,339,260 $ 14,350,936 $ 36,001,201 $ 52,550,151
Reimbursed expenses 290,117 405,108 1,013,844 1,535,790
Hardware and software sales 1,894,049 677,389 2,496,835 1,570,300
------------- ------------- ------------- -------------
Total revenues 12,523,426 15,433,433 39,511,880 55,656,241
------------- ------------- ------------- -------------
Costs of revenues (excluding noncash compensation
expense of $12,621, $33,942, $48,466
and $135,231, respectively):
Professional services 6,907,090 11,780,052 25,973,027 40,082,074
Reimbursed expenses 290,117 405,108 1,013,844 1,535,790
Hardware and software 1,746,304 617,682 2,303,191 1,796,541
------------- ------------- ------------- -------------
Total cost of revenues 8,943,511 12,802,842 29,290,062 43,414,405
------------- ------------- ------------- -------------
Gross profit 3,579,915 2,630,591 10,221,818 12,241,836
------------- ------------- ------------- -------------
Sales and marketing (excluding noncash compensation
expense of $9,571, $31,002, $21,029
and $100,625, respectively) 1,745,167 3,632,208 6,719,364 12,920,849
General and administrative (excluding noncash
compensation expense of $6,903, $17,743, $32,773
and $65,067, respectively) 4,590,112 10,331,911 17,529,880 34,048,014
Depreciation and amortization 103,537 582,951 1,610,322 2,302,730
Intangibles amortization -- 6,424,362 1,960,500 19,099,253
Loss on equipment -- 443,498 -- 443,498
Impairment of intangibles -- 60,485,448 8,743,545 60,485,448
Impairment of property and equipment -- -- 4,510,193 --
Restructuring and other charges 82,740 4,571,028 4,319,344 8,875,793
Loss on long-term investments in related parties -- 1,000,000 -- 2,000,000
Noncash compensation expense 29,095 82,687 102,268 300,923
------------- ------------- ------------- -------------
Total operating expenses 6,550,651 87,554,093 45,495,416 140,476,508
------------- ------------- ------------- -------------
Operating loss (2,970,736) (84,923,502) (35,273,598) (128,234,672)
Other income (expense):
Interest income, net 73,650 570,725 316,287 2,302,408
Other income (expense), net 820,690 104,387 (719,374) 50,603
------------- ------------- ------------- -------------
Loss before cumulative effect of change in
accounting principle (2,076,396) (84,248,390) (35,676,685) (125,881,661)
Cumulative effect of change in accounting principle -- -- (23,307,626) --
------------- ------------- ------------- -------------
Net loss $ (2,076,396) $ (84,248,390) $ (58,984,311) $(125,881,661)
============= ============= ============= =============
Basic and diluted loss per common share before
cumulative effect of change in accounting principle $ (0.06) $ (2.33) $ (0.96) $ (3.51)
Cumulative effect of change in accounting principle -- -- (0.63) --
------------- ------------- ------------- -------------
Basic and diluted net loss per common share $ (0.06) $ (2.33) $ (1.59) $ (3.51)
============= ============= ============= =============
Basic and diluted weighted average common
shares outstanding 37,368,262 36,206,110 37,231,815 35,857,087
============= ============= ============= =============
The accompanying notes are an integral part of these consolidated financial
statements.
2
PREDICTIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
------------------------------
Nine Months Ended September 30,
------------------------------
2002 2001
------------- -------------
Cash flows from operating activities:
Net loss $ (58,984,311) $(125,881,661)
Adjustments to reconcile net loss to
net cash used in operating activities:
Noncash compensation expense 102,268 300,923
Depreciation and amortization 3,570,822 21,401,983
Loss on equipment -- 443,498
Impairment of intangibles 8,743,545 60,485,448
Impairment of property and equipment 4,510,193 --
Cumulative effect of change in accounting principle 23,307,626 --
Bad debt expense 10,257 4,269,283
Loss on long-term investments in related parties -- 2,000,000
Write-off of inventory held for resale 1,740,236 500,000
Write-off of receivables from employees -- 27,237
Noncash component of restructuring and other charges 497,319 4,650,410
(Increase) decrease in-
Restricted cash (1,601,036) (1,886,599)
Accounts receivable 1,665,433 5,891,469
Unbilled revenues (1,204,414) 1,279,003
Inventory held for resale 465,750 (3,125,475)
Work in process - hardware and software (321,484) --
Refundable income taxes (27,042) (342,198)
Prepaid expenses and other current assets 790,623 (739,437)
Other assets 91,387 (426,736)
(Decrease) increase in-
Accounts payable (3,763,363) 3,051,931
Accrued expenses and other current liabilities (4,056,761) (2,610,113)
Deferred revenue 327,044 (723,234)
Deferred rent and other long-term liabilities 70,312 (511,569)
------------- -------------
Net cash used in operating activities (24,065,596) (31,945,837)
------------- -------------
Cash flows from investing activities:
Purchase of marketable securities, net (505) (52,106)
Repayments from employee loans, net 33,396 54,259
Adjustments to purchase price of fiscal 2000 acquisitions -- (1,910,164)
Purchase of property and equipment, net (908,647) (7,154,541)
------------- -------------
Net cash used in investing activities (875,756) (9,062,552)
------------- -------------
Cash flows from financing activities:
Proceeds from sale of common stock to officer 50,000 --
Principal payments on capital leases (68,095) (134,945)
Proceeds from issuance of common stock in connection with Employee Stock Purchase Plan 57,513 204,312
Proceeds from exercise of stock options 890,041 1,844,258
------------- -------------
Net cash provided by financing activities 929,459 1,913,625
------------- -------------
Effects of exchange rates 235,762 137,328
------------- -------------
Net decrease in cash (23,776,131) (38,957,436)
Cash and cash equivalents - beginning of period 41,277,867 80,058,791
------------- -------------
Cash and cash equivalents - end of period $ 17,501,736 $ 41,101,355
============= =============
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest $ 29,030 $ 44,830
============= =============
Taxes $ 152,282 $ 523,610
============= =============
Supplemental disclosures of noncash investing and financing activities:
Noncash adjustment to purchase price of fiscal 2000 acquisitions $ -- $ 2,196,521
============= =============
The accompanying notes are an integral part of these consolidated financial
statements.
3
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
(1) BASIS OF PRESENTATION
Interim Financial Statements
The consolidated financial statements and accompanying financial information as
of September 30, 2002 and for the three and nine months ended September 30, 2002
and 2001 are unaudited and, in the opinion of management, include all
adjustments (consisting only of normal recurring adjustments) which Predictive
Systems, Inc. (the "Company" or "Predictive") 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 financial statements
for the year ended December 31, 2001 contained in its Annual Report on Form
10-K. Results for interim periods are not necessarily indicative of results for
the entire year.
Recently Issued Accounting Pronouncements
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 of
accounting. 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 effective January 1, 2002. As
required by the transitional provisions of SFAS 142, the Company evaluated
goodwill and intangible assets with indefinite lives for impairment as of
January 1, 2002. This evaluation was completed during the second quarter of
2002. As a result of this transitional testing, the Company recorded a noncash
impairment charge of $23,307,626 to reduce the carrying value of its goodwill
and other indefinite lived intangible assets. Such charge is reflected as a
cumulative effect of change in accounting principle in the accompanying
consolidated statements of operations for the nine months ended September 30,
2002.
In July 2001, the FASB issued Statement of Financial Accounting Standard No.
143, "Accounting for Asset Retirement Obligations" (SFAS 143), which is
effective for fiscal years beginning after June 15, 2002. SFAS 143 requires,
among other things, the accounting and reporting of legal obligations associated
with the retirement of long-lived assets that result from the acquisition,
construction, development or normal operation of a long-lived asset. The Company
believes the adoption of SFAS 143 will not have a material impact on its
financial position or results of operations.
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 Statement of Financial Accounting Standard No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of" (SFAS 121) 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 121 for recognition and measurement of impairment, but amends the
accounting and reporting standards for segments of a business to be disposed of.
The Company adopted the provisions of SFAS 144 effective January 1, 2002. Given
the decline in revenues and market capitalization of the Company and the overall
deterioration of market conditions in the enterprise sector, the Company
reviewed its long-lived assets for impairment during the second quarter of 2002.
Based on this review, the Company recognized an impairment charge to reduce the
carrying value of its finite lived intangible assets and property and equipment
of $8,743,545 and $4,510,193, respectively. Such charges are reflected in the
accompanying consolidated statements of operations for the nine months ended
September 30, 2002.
In November 2001, the Emerging Issues Task Force (EITF) of the FASB concluded
that reimbursements received for "out-of-pocket" expenses should be classified
as revenue, and correspondingly cost of services, in the income statement. This
accounting treatment should be applied in financial reporting periods (years)
beginning as early as the first quarter of 2002. Upon application of the
pronouncement, comparative financial statements for prior periods must also be
reclassified in order to ensure consistency among all periods presented. The
Company adopted this pronouncement effective January 1, 2002 and has separately
disclosed the impact of adoption in the consolidated statements of operations.
4
In April 2002, the FASB issued Statement of Financial Accounting Standard No.
145 "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections" (SFAS 145). This statement
eliminates the automatic classification of gain or loss on an extinguishment of
debt as an extraordinary item of income and requires that such gain or loss be
evaluated for extraordinary classification under the criteria of Accounting
Principles Board No. 30 "Reporting Results of Operations." This statement also
requires sales-leaseback accounting for certain lease modifications that have
economic effects that are similar to sales-leaseback transactions, and makes
various other technical corrections to existing pronouncements. This statement
will be effective for the Company for the year ending December 31, 2003. The
Company is currently assessing, but has not yet determined the effect, if any,
of SFAS 145 on its financial position or results of operations.
In July 2002, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 146, "Accounting for Costs Associated with
Exit or Disposal Activities" (SFAS 146). SFAS 146 will supersede EITF No. 94-3,
"Liability Recognition for Certain Employee Termination Benefits and Other Costs
to Exit an Activity (including Certain Costs Incurred in a Restructuring)." SFAS
146 requires that costs associated with an exit or disposal plan be recognized
when incurred rather than at the date of a commitment to an exit or disposal
plan. SFAS 146 is to be applied prospectively to exit or disposal activities
initiated after December 31, 2002. The Company is currently assessing, but has
not yet determined the effect, if any, of SFAS 146 on its financial position or
results of operations.
Reclassification
Certain prior year amounts have been reclassified to conform to their current
year presentation.
(2) NET INCOME (LOSS) PER SHARE
Basic net income (loss) per share is computed by dividing net income (loss)
available to common stockholders by the weighted average number of common shares
outstanding. Diluted net income (loss) 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 anti-dilutive.
The conversion of 11,809,524 and 14,145,705 outstanding options as of September
30, 2002 and 2001, respectively, were not considered in the calculation of
diluted net loss per common share for the respective three and nine month period
ended September 30, 2002 and 2001 as the effect would be anti-dilutive.
5
(3) COMPREHENSIVE INCOME (LOSS)
The components of comprehensive income (loss) for the three and nine months
ended September 30, 2002 and 2001 are as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------- ----------------------------
2002 2001 2002 2001
------------- ------------ ------------ -------------
(unaudited) (unaudited)
Net loss $ (2,076,396) $(84,248,390) $(58,984,311) $(125,881,661)
Unrealized gain (loss) on
investments 1,653 3,931 (505) 18,773
Foreign currency translation
adjustment 9,582 320,445 235,762 137,328
------------- ------------ ------------ -------------
Comprehensive loss $ (2,065,161) $(83,924,014) $(58,749,054) $(125,725,560)
============= ============ ============ =============
(4) RESTRICTED CASH
In August 2002, the Company was required under the terms of a customer contract
to provide a letter of credit for the value of services to be performed. The
credit facility agreement used to provide this financial guarantee places
restrictions on the Company's cash and cash equivalents until the services are
rendered to the customer. The services are expected to be fully rendered by the
end of the fourth quarter of 2002. Restricted cash of $1,036,869 as of September
30, 2002 was pledged as collateral under this agreement and has been reflected
on the balance sheet as a current asset.
(5) BUSINESS CONCENTRATIONS AND CREDIT RISK
For the three months ended September 30, 2002 and 2001, approximately 14% and
17%, respectively, of revenues before reimbursed expenses were from one customer
who is a related party (Note 8). Two other customers accounted for approximately
32% of revenues before reimbursed expenses for the three months ended September
30, 2002, whereas one customer accounted for approximately 13% of revenues
before reimbursed expenses for the three months ended September 30, 2001.
For the nine months ended September 30, 2002 and 2001, approximately 16% and
19%, respectively, of revenues before reimbursed expenses were from one customer
who is a related party (Note 8). One other customer accounted for approximately
14% of revenues before reimbursed expenses for the nine months ended September
30, 2002. There were no other customers that accounted for more than 10% of
revenues before reimbursed expenses for the nine months ended September 30,
2001.
(6) GOODWILL AND INTANGIBLE ASSETS
In July 2001, the FASB issued SFAS No. 141, "Business Combinations" and SFAS No.
142, "Goodwill and Other Intangible Assets." SFAS No. 141 requires that all
business combinations subsequent to June 30, 2001 be accounted for under the
purchase method of accounting. SFAS No. 141 also requires that the fair value of
an assembled workforce acquired be included in the amount initially recorded as
goodwill. The Company reclassified into goodwill $2,947,748 initially recorded
as other intangible assets related to the value of the assembled workforce of
Synet Service Corporation ("Synet") and Global Integrity Corporation ("Global
Integrity") as required by this statement. SFAS No. 142 requires that upon
adoption, amortization of goodwill and indefinite lived intangibles cease, and
instead, the carrying value of goodwill be evaluated for impairment on at least
an annual basis.
6
The Company adopted this standard effective January 1, 2002. The Company
evaluated goodwill and its tradename intangible asset for impairment during the
second quarter of 2002 and determined that an impairment of $23,307,626 existed
at January 1, 2002. Accordingly, the Company restated the results for the three
months ended March 31, 2002 to reflect the adoption of SFAS 142 as follows:
Three Months Ended
March 31,
------------------
2002
-------------
Originally reported net loss $ (8,252,271)
Cumulative effect of change in
accounting principle (23,307,626)
-------------
Net loss as restated $ (31,559,897)
=============
Originally reported basic and diluted net loss
per common share $ (0.22)
Cumulative effect of change in
accounting principle (0.63)
-------------
Basic and diluted net loss
per common share as restated $ (0.85)
=============
The Company's reporting units utilized for evaluating the recoverability of
goodwill are the same as its operating segments.
The following table reports the amounts that loss and loss per basic and diluted
common share before the cumulative effect of change in accounting principle
would have been in all periods presented, exclusive of the amortization of
goodwill and indefinite lived intangibles recognized in those periods.
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------- ---------------------------------
2002 2001 2002 2001
------------- ------------ -------------- ---------------
Reported loss before cumulative effect
of change in accounting principle $ (2,076,396) $(84,248,390) $ (35,676,685) $ (125,881,661)
Add: Goodwill amortization -- 5,055,276 -- 14,991,922
Add: Assembled workforce amortization -- 388,836 -- 1,166,646
Add: Tradename amortization -- 126,500 -- 379,500
------------- ------------ -------------- ---------------
Adjusted loss before cumulative effect
of change in accounting principle $ (2,076,396) $(78,677,778) $ (35,676,685) $ (109,343,593)
============= ============ ============== ===============
Reported basic and diluted loss per
common share before cumulative effect
of change in accounting principle $ (0.06) $ (2.33) $ (0.96) $ (3.51)
Add: Goodwill amortization -- 0.14 -- 0.42
Add: Assembled workforce amortization -- 0.01 -- 0.03
Add: Tradenames amortization -- -- -- 0.01
------------- ------------ -------------- ---------------
Adjusted basic and diluted loss per
common share before cumulative effect
of change in accounting principle $ (0.06) $ (2.18) $ (0.96) $ (3.05)
============= ============ ============== ===============
Changes in the carrying amount of goodwill for the nine months ended September
30, 2002, by operating segment, are as follows:
US Managed Security International
Consulting Services Consulting
------------ ------------ ------------
Balance as of January 1, 2002 $ 14,071,908 $ 7,485,804 $ 2,231,251
Cumulative effect of change in accounting principle (14,071,908) (7,485,804) --
------------ ------------ ------------
Balance as of September 30, 2002 $ -- $ -- $ 2,231,251
============ ============ ============
7
As of September 30, 2002 and December 31, 2001, the Company's intangible assets
and related accumulated amortization consisted of the following:
As of September 30, 2002 As of December 31, 2001
--------------------------------------- ---------------------------------------
Gross Gross
Carrying Accumulated Carrying Accumulated
Value Amortization Net Value Amortization Net
----------- ------------ ----------- ----------- ------------ -----------
Amortized intangible assets
Customer list $ -- $ -- $ -- $ 4,500,000 $ 1,629,168 $ 2,870,832
Developed technology -- -- -- 9,575,000 1,994,789 7,580,211
Assembled workforce -- -- -- 4,666,000 1,718,252 2,947,748
---------- ---------- ----------- ----------- ----------- -----------
Total -- -- -- 18,741,000 5,342,209 13,398,791
---------- ---------- ----------- ----------- ----------- -----------
Indefinite lived intangible assets
Tradenames -- -- -- 2,530,000 527,084 2,002,916
---------- ---------- ----------- ----------- ----------- -----------
Total -- -- -- 2,530,000 527,084 2,002,916
---------- ---------- ----------- ----------- ----------- -----------
Total $ -- $ -- $ -- $21,271,000 $ 5,869,293 $15,401,707
========== ========== =========== =========== =========== ===========
The aggregate amortization expense for other intangible assets was approximately
$1,369,086 during the three months ended September 30, 2001 and $1,960,500 and
$4,107,331 during the nine months ended September 30, 2002 and 2001,
respectively. As of September 30, 2002, the Company had no intangible assets
subject to amortization.
(7) IMPAIRMENT OF LONG-LIVED ASSETS
As a result of the Company's operating performance for the six months ended June
30, 2002, the corresponding decline in its market capitalization, the general
economic environment, and its forecasted operating results for the foreseeable
future, the Company evaluated the carrying value of the long lived assets of its
US Consulting and Managed Security Services reporting units for impairment in
accordance with the provisions of SFAS 144 as of June 30, 2002. An impairment
loss under SFAS 144 is recognized if the carrying amount of a long-lived asset
group is not recoverable and exceeds its fair value. The carrying amount of a
long-lived asset group is not recoverable if it exceeds the sum of the
undiscounted cash flows expected to result from the use and eventual disposition
of the asset group. An impairment is measured as the amount by which the
carrying amount of a long-lived asset group exceeds its fair value. Given the
projected operating performance over the remaining useful lives of the definite
lived intangible assets and other long-lived assets for the US Consulting and
Managed Security Services reporting units, it was determined that the carrying
value of these assets were not recoverable as of the end of the second quarter
of 2002. As a result of these determinations, the Company recorded a charge in
June 2002 for the impairment of intangibles and the impairment of property and
equipment of $8,743,545 and $4,510,193, respectively. The fair value of the
asset groups was determined based on the discounted cash flows expected to be
generated from such asset groups over the estimated remaining useful life of the
principle asset in each group. There were no events or changes in circumstances
that caused the Company to review for impairment its long-lived assets during
the three months ended September 30, 2002.
The following is a summary of the impairment charges for the nine months ended
September 30, 2002:
Managed
Security
US Consulting Services Total
------------------------------------
Impairment of intangibles:
Customer lists $1,254,585 $ 866,249 $2,120,834
Developed technology 2,185,495 4,437,216 6,622,711
------------------------------------
$3,440,080 $5,303,465 $8,743,545
====================================
Impairment of property and equipment:
Computer equipment $1,587,881 $ 285,779 $1,873,660
Office furniture 268,624 -- 268,624
Capitalized software 2,217,879 -- 2,217,879
Leasehold improvements 150,030 -- 150,030
------------------------------------
$4,224,414 $ 285,779 $4,510,193
====================================
There were no impairment charges recognized during the three months ended
September 30, 2002.
(8) RELATED PARTIES
In June 2002 the Company entered into a consulting agreement with Meyer Capital
Partners LLC to assist management of the Company in the analysis, valuation and
screening process of potential merger and/or acquisition opportunities. A
director of the Company is the managing member of Meyer Capital Partners LLC.
For the three and nine months ended September 30, 2002, the Company recognized
expense of $30,000 for such services. As of September 30, 2002, the amounts due
to Meyer Capital Partners LLC was $10,000. Such amount is included in accrued
expenses and other current liabilities.
8
The Company provides network consulting services to Cisco Systems, Inc.
("Cisco") pursuant to a consulting services agreement. This agreement provides
that if the Company gives more favorable rates to another client it will inform
Cisco and Cisco will have the right to terminate this agreement. One of the
Company's directors is also an officer of Cisco. For the three and nine months
ended September 30, 2002 and 2001, the Company recognized revenues of
approximately $0, $28,000, $87,000 and $691,000, respectively, from services
performed for Cisco. As of September 30, 2002, amounts due from Cisco were $447.
Such amount is included in related party receivables. There were no amounts due
from Cisco as of December 31, 2001.
The Company provides network consulting services to BellSouth Corporation
("BellSouth") pursuant to a consulting services agreement. One of the Company's
directors is also an officer of BellSouth. For the three and nine months ended
September 30, 2002 and 2001, the Company recognized revenues of approximately
$1,700,000, $6,100,000, $2,600,000 and $10,100,000, respectively, from services
performed for BellSouth. As of September 30, 2002 and December 31, 2001, amounts
due from BellSouth were $1,269,121 and $994,322, respectively. Such amounts are
included in related party receivables.
The Company provided network consulting services to Riversoft PLC pursuant to a
consulting services agreement. Additionally, the Company purchased approximately
$500,000 of software inventory from Riversoft in 2001. Two of the Company's
directors served on Riversoft PLC's Board of Directors, one of which served
until December 19, 2001. One of the directors is also a general partner for a
venture capital firm, which owned approximately 10% of Riversoft PLC. In 2002,
Riversoft PLC was sold in an all cash transaction. For the nine months ended
September 30, 2001, the Company recognized revenues of approximately $70,000
from services performed for Riversoft PLC. No revenues were recognized for the
three and nine months ended September 30, 2002 or the three months ended
September 30, 2001. As of December 31, 2001, amounts due from Riversoft PLC were
$50,343. Such amount is included in related party receivables.
The Company and Science Application International Corporation ("SAIC") provide
network and security consulting services to each other pursuant to existing
agreements. For the three and nine months ended September 30, 2002 and 2001,
revenues from SAIC were approximately $19,000, $151,000, $49,000 and $177,000,
respectively, and the Company purchased approximately $0, $4,000, $29,000 and
$105,000, respectively, in consulting services from SAIC. Additionally, SAIC
provided the Company with various services relating to alarm, telecommunications
and IT support functions and the Company rented certain of its office space from
SAIC. For the three and nine months ended September 30, 2002 and 2001, the
Company paid approximately $583,000, $1,124,000, $198,000 and $740,000,
respectively, for such services and the rental of office space including the
buyout of the real estate lease in August 2002. Of the amounts paid for the nine
months ended September 30, 2002, approximately $136,000 was expensed. There were
no amounts expensed for the three months ended September 30, 2002. The remaining
amounts paid were accrued in the prior year in connection with our acquisition
plan. In addition, the Company and SAIC license certain of their respective
intellectual property to the other. The Company believes that these transactions
are on terms that are no less favorable than those that could be obtained from
unaffiliated third parties. As of September 30, 2002, $155,147 was due from
SAIC. Such amount is included in related party receivables. There were no
amounts due from SAIC as of December 31, 2001.
On December 22, 2000, the Company purchased a $1,000,000 12% Convertible
Promissory Note (the "Note") issued by Paradigm4, Inc. ("Paradigm4") which the
Company recorded as a long-term investment in related party. The Note was
payable 90 days from the date of purchase. The Company received a stock purchase
warrant (the "Warrant") to purchase up to 0.7692% of the outstanding shares of
Paradigm4 on a fully diluted basis at a price equal to $.01 per share. The
Warrant was exercisable immediately and expires on December 22, 2005. On March
22, 2001, Paradigm4 filed for federal bankruptcy protection. This action created
significant uncertainty regarding the Company's investment in Paradigm4. As a
result, the Company recorded a loss of $1,000,000 on its investment for the nine
months ended September 30, 2001.
On October 6, 2000, the Company purchased 1,000,000 shares of Series A Preferred
Stock in Three Pillars, which the Company had recorded as a long-term investment
in related party. At the time of the investment, Three Pillars had 3,800,000
shares of Series A Preferred Stock and 8,100,000 shares of common stock
outstanding, giving the Company an 8.4% interest on an as converted basis.
The Series A Preferred Stock has certain antidilution rights, but converts
initially on a one for one basis into common stock. The Series A Preferred Stock
has a liquidation preference equal to $1.00 per share plus a 10% cumulative
dividend. The Company also received certain registration rights with respect to
the shares purchased. During the nine months ended September 30, 2001, the
Company recognized a loss on its $1,000,000 investment in Three Pillars due to
management's determination that the value of the investment was impaired. The
Company did not recognize any revenues from Three Pillars for the nine months
ended September 30, 2002 and 2001.
Receivables from employees and stockholders represent short term lending to such
parties entered into in the normal course of business.
(9) 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.
9
In December 2001, the Company formed a strategic alliance with an unaffiliated
third party to outsource the monitoring services provided by its Managed
Security Services division. As a result of this alliance, the Company
established a restructuring plan that included the following: (1) a reduction of
the Company's workforce; (2) the write-off of equipment and software development
costs associated with the Company's security operations center which was no
longer needed as a result of the outsourcing; and (3) the incurrence of
nonrecoverable costs to convert clients to the alliance partner.
In January 2002, the Company's management foresaw the need to continue to lower
the operating costs of the business given continuing difficult market conditions
in the enterprise sector. Therefore, the Company established a 2002
restructuring 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 additional domestic
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.
For the three months ended September 30, 2002, the Company recorded
restructuring charges of $82,740 in connection with its 2002 restructuring plan.
Such charges consisted of $647,404 in severance benefits and other related
expenses for a reduction in headcount of 41 employees and $18,159 for exit costs
related to the closing of domestic offices. These charges were offset by a
reduction to previously accrued exit costs in the amount of $582,823 resulting
from favorable and unfavorable settlements and changes to subtenant assumptions
for leased domestic offices. For the three months ended September 30, 2001, the
Company recorded restructuring charges of $4,571,028 in connection with its 2001
restructuring plan. Such charges consisted of $951,917 in severance benefits and
other related expenses for a reduction in headcount of 86 employees and
$3,619,111 in exit costs related to real estate and electronic equipment. These
charges have been reflected as operating expenses of the Company.
For the nine months ended September 30, 2002, the Company recorded restructuring
charges of $4,319,344 in connection with its 2002 restructuring plan. Such
charges consisted of $2,738,751 in severance benefits and other related expenses
for a reduction in headcount of 147 employees, $1,621,775 in exit costs related
to real estate and electronic equipment for the closing of domestic offices, and
an increase to previously accrued exit costs in the amount of $108,818 resulting
from favorable and unfavorable settlements and changes to subtenant assumptions
for leased domestic offices. These charges were offset by $150,000 received for
equipment written-off to restructuring charges in 2001 in connection with the
outsourcing of the Company's monitoring services provided as part of the Managed
Security Services division. For the nine months ended September 30, 2001, the
Company recorded restructuring charges of $7,846,061 in connection with its 2001
restructuring plan. Such charges consisted of $2,768,336 in severance benefits
and other related expenses for a reduction in headcount of 191 employees and
$5,077,725 in exit costs related to real estate and electronic equipment. These
charges have been reflected as operating expenses of the Company. As of
September 30, 2002, restructuring charges of $2,108,464 remained unpaid and are
included in accrued expenses and other current liabilities on the accompanying
consolidated balance sheet.
A summary of the restructuring charges for the nine months ended September 30,
2002 were as follows:
Balance as Utilization Balance as
of 12/31/01 Expense Non-Cash Cash of 6/30/02
---------- ---------- ---------- ---------- ----------
Severance $ 17,320 $2,738,751 -- $2,051,270 $ 704,801
Exit Costs 1,115,996 1,730,593 497,319 1,228,735 1,120,535
Outsourcing monitoring services 722,224 (150,000) -- 289,096 283,128
---------- ---------- ---------- ---------- ----------
$1,855,540 $4,319,344 $ 497,319 $3,569,101 $2,108,464
========== ========== ========== ========== ==========
In June 2001, the Company wrote off $1,029,732 related to the abandonment of
internal software management tools that no longer suited the business needs of
the Company.
(10) INDUSTRY SEGMENT INFORMATION
The Company's reportable segments are US Consulting, International Consulting,
and Managed Security Services. Revenues and cash flows in the US Consulting and
International Consulting segments are generated by providing the following
services: network design and engineering, network and systems management,
integrated customer service, performance management, information security, and
business integration services.
10
Revenues and cash flows in the Managed Security Services segment are generated
by providing the following services: response and threat advisory through
Information Sharing and Analysis Centers, remote monitoring and management of
firewalls, and the provision of Open Source Intelligence programs.
The accounting policies for the segments are the same as those described in the
"Summary of Significant Accounting Policies," included in the Company's Annual
Report on Form 10-K for the year ended December 31, 2001. The Company evaluates
the performance of its segments based on their operating income (loss), which
represents segment revenues less direct costs of operation, excluding the
allocation of corporate expenses. Identifiable assets of the operating segments
principally consist of net accounts receivable, unbilled revenues, inventory
held for resale and work in process - hardware and software. Accounts
receivable and unbilled revenues for US Consulting and Managed Security Services
are managed on a combined basis. All other identifiable assets not attributable
to industry segments are included in corporate assets. The Company does not
track expenditures for long-lived assets on a segment basis. The table below
presents information on the revenues and operating income (loss) for each
segment for the three and nine months ended September 30, 2002 and 2001, and
items which reconcile segment operating income (loss) to the Company's reported
loss before cumulative effect of change in accounting principle.
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------ ------------------------------
2002 2001 2002 2001
------------- ------------- ------------- -------------
Revenues:
US Consulting $ 9,423,681 $ 11,662,489 $ 29,255,178 $ 44,799,296
International Consulting 2,271,102 2,052,448 6,775,320 5,547,173
Managed Security Services 828,643 1,718,496 3,481,382 5,309,772
------------- ------------- ------------- -------------
Total revenues 12,523,426 15,433,433 39,511,880 55,656,241
------------- ------------- ------------- -------------
Operating income (loss):
US Consulting 994,596 (39,801,589) (7,087,037) (44,871,979)
International Consulting 62,994 (982,873) (181,185) (4,293,858)
Managed Security Services (67,574) (24,611,308) (6,200,858) (26,154,345)
------------- ------------- ------------- -------------
Total operating income (loss) 990,016 (65,395,770) (13,469,080) (75,320,182)
------------- ------------- ------------- -------------
Corporate expenses:
Sales and marketing (139,545) (901,312) (683,021) (2,082,560)
General and administrative (3,605,835) (5,521,894) (13,129,063) (17,809,733)
Depreciation and amortization (103,537) (582,951) (1,610,322) (2,302,730)
Intangibles amortization -- (6,424,362) (1,960,500) (19,099,253)
Loss on equipment -- (443,498) -- (443,498)
Restructuring and other charges (82,740) (4,571,028) (4,319,344) (8,875,793)
Loss on long-term investments
in related parties -- (1,000,000) -- (2,000,000)
Noncash compensation expense (29,095) (82,687) (102,268) (300,923)
Interest income, net 73,650 570,725 316,287 2,302,408
Other income (expense), net 820,690 104,387 (719,374) 50,603
------------- ------------- ------------- -------------
Total corporate expenses (3,066,412) (18,852,620) (22,207,605) (50,561,479)
------------- ------------- ------------- -------------
Loss before cumulative effect of
change in accounting principle $ (2,076,396) $ (84,248,390) $ (35,676,685) $(125,881,661)
============= ============= ============= =============
Identifiable assets:
US Consulting and Managed
Security Services $ 10,367,523 $ 19,869,289 $ 10,367,523 $ 19,869,289
International Consulting 1,978,667 2,382,545 1,978,667 2,382,545
Corporate 24,997,256 99,175,345 24,997,256 99,175,345
------------- ------------- ------------- -------------
Total identifiable assets $ 37,343,446 $ 121,427,179 $ 37,343,446 $ 121,427,179
============= ============= ============= =============
11
(11) CONTINGENCIES
Except as set forth below, we are not a party to any material legal proceedings.
On November 13, 2001, a securities class action complaint was filed in the
United States District Court for the Southern District of New York against
Predictive, four investment banks that underwrote the Company's initial public
offering, and three of the Company's former officers and directors. This action
has been coordinated with over three hundred virtually identical actions against
other companies and the investment banks that underwrote their initial public
offerings. The complaint filed against the Company generally alleged that the
underwriters obtained excessive and undisclosed commissions from customers who
received allocations of shares in the Company's initial and secondary public
offerings and that the underwriters maintained artificially inflated prices in
the after market through "tie-in" arrangements, which required customers to buy
additional shares of the Company's stock at pre-determined prices in excess of
the offering prices. The complaint further alleged that the Company and certain
of its officers and directors violated Sections 11, 12(a)(2) and 15 of the
Securities Act of 1933 because the Company's registration statement did not
disclose the underwriters' purported misconduct. On April 20, 2002, the
plaintiffs amended their complaint, abandoning the Section 12(a)(2) claim, but
alleging violations of Sections 10(b) and 20(a) of the Securities Exchange Act,
and of Rule 10b-5 promulgated thereunder. Plaintiffs seek an unspecified amount
of damages on behalf of persons who purchased the Company's stock pursuant to
the registration statements. On July 15, 2002, the Company and the three former
officers and directors joined a motion to dismiss filed on behalf of the issuer
defendants. The Company believes that the allegations against it are without
merit and intends to defend the case vigorously.
(12) OTHER INCOME (EXPENSE)
Other income (expense) for the three and nine months ended September 30, 2002
included a reduction in an acquisition related exit cost accrual of
approximately $921,000 as a result of the negotiation of a favorable buyout of
an existing lease which was assumed in connection with the Global Integrity
acquisition. The liability for such lease had been fully accrued for as part of
the acquired assets and assumed liabilities of Global Integrity in fiscal 2001.
This income was offset by approximately $213,000 and $1,700,000, respectively,
for the three and nine months ended September 30, 2002 of inventory held for
resale which was no longer deemed saleable. As the Company was acting as an
agent of the supplier in the arrangement for the resale of this inventory and
the revenues were recognized on a net basis, such write-off has been classified
as other expense. Other income for the three and nine months ended September 30,
2001 primarily consisted of interest income.
(13) SUBSEQUENT EVENTS
Stock Option Exchange Program
In October 2002, the Company implemented an employee voluntary stock option
exchange program whereby the Company would exchange certain outstanding options
to purchase shares of the Company's common stock held by eligible employees of
the Company, with exercise prices per share greater than or equal to $0.80, for
new options to purchase shares of the Company's common stock (the "Offer to
Exchange"). Under the terms of the Offer to Exchange, the 193 participating
employees had certain of their existing options to purchase 4,085,860 shares of
the Company's common stock cancelled as of October 18, 2002 and received options
to purchase 3,089,424 shares of our common stock with an exercise price equal to
the closing market price of $0.22 per share on October 18, 2002. All new options
were granted under the 1999 Stock Incentive Plan, as amended. Each new option
vests in equal monthly installments in accordance with a four year vesting
schedule beginning on the date of grant. However, the vesting period will be
accelerated based on years of service with the Company measured at the date of
grant. Employees holding over 500,000 options, the maximum number of options
that may be issued per year to a single employee pursuant to the Company's 1999
Stock Incentive Plan, were only permitted to tender up to 500,000 of their
currently outstanding options in exchange for 500,000 new options. Therefore,
the Company also re-priced 1,500,000 of its Chief Executive Officer's
outstanding options to give these options the same terms as if he had been able
to fully participate in the option exchange program.
Adoption Of SFAS 123
In October 2002, the Company adopted Statement of Financial Accounting Standards
No. 123, "Accounting for Stock-Based Compensation" (SFAS 123). SFAS 123
established a fair-value-based method of accounting for stock-based compensation
plans. Pursuant to the transition provisions of SFAS 123, the Company will be
required to apply the fair value method of accounting to all option grants
issued on or after January 1, 2002. The fair value method will not be applied to
stock option awards granted in fiscal years prior to 2002. Such awards will
continue to be accounted for under the intrinsic value method pursuant to APB
25, except to the extent that prior years' awards are modified subsequent to
January 1, 2002. The Company is currently assessing, but has not yet determined,
the effect of adoption of SFAS 123 on its financial position or results of
operations.
12
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.
OVERVIEW
The principal source of our revenues is fees from professional services. We
provide network and security 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 also provide managed security services to our clients. We derive
revenues from these services on a subscription basis. We use our BusinessFirst
approach 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 hours 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. Revenues for
subscription-based contracts are recognized on a straight-line basis over the
period of service. 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 revenues from the sale of hardware and software.
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 primarily include compensation and benefits for our
consultants and project-related travel expenses. Costs of hardware and software
consist of acquisition costs of third-party hardware and software resold.
Given 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.
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.
13
In December 2001, the Company formed a strategic alliance with an unaffiliated
third party, to outsource the monitoring services provided by its Managed
Security Services division. As a result of this alliance, the Company
established a restructuring plan that included the following: (1) a reduction of
the Company's workforce; (2) the write-off of equipment and software development
costs associated with the Company's security operations center which was no
longer needed as a result of the outsourcing; and (3) the incurrence of
nonrecoverable costs to convert clients to the alliance partner.
In January 2002, the Company's management foresaw the need to continue to lower
the operating costs of the business given continuing difficult market conditions
in the enterprise sector. Therefore, the Company established a 2002
restructuring 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 additional domestic
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.
For the three months ended September 30, 2002, the Company recorded
restructuring charges of $82,740 in connection with its 2002 restructuring plan.
Such charges consisted of $647,404 in severance benefits and other related
expenses for a reduction in headcount of 41 employees and $18,159 for exit costs
related to the closing of domestic offices. These charges were offset by a
reduction to previously accrued exit costs in the amount of $582,823 resulting
from favorable and unfavorable settlements and changes to subtenant assumptions
for leased domestic offices. For the three months ended September 30, 2001, the
Company recorded restructuring charges of $4,571,028 in connection with its 2001
restructuring plan. Such charges consisted of $951,917 in severance benefits and
other related expenses for a reduction in headcount of 86 employees and
$3,619,111 in exit costs related to real estate and electronic equipment. These
charges have been reflected as operating expenses of the Company.
For the nine months ended September 30, 2002, the Company recorded restructuring
charges of $4,319,344 in connection with its 2002 restructuring plan. Such
charges consisted of $2,738,751 in severance benefits and other related expenses
for a reduction in headcount of 147 employees, $1,621,775 in exit costs related
to real estate and electronic equipment for the closing of domestic offices, and
an increase to previously accrued exit costs in the amount of $108,818 resulting
from favorable and unfavorable settlements and changes to subtenant assumptions
for leased domestic offices. These charges were offset by $150,000 received for
equipment written-off to restructuring charges in 2001 in connection with the
outsourcing of the Company's monitoring services provided as part of the Managed
Security Services division. For the nine months ended September 30, 2001, the
Company recorded restructuring charges of $7,846,061 in connection with its 2001
restructuring plan. Such charges consisted of $2,768,336 in severance benefits
and other related expenses for a reduction in headcount of 191 employees and
$5,077,725 in exit costs related to real estate and electronic equipment. These
charges have been reflected as operating expenses of the Company. As of
September 30, 2002, restructuring charges of $2,108,464 remained unpaid and are
included in accrued expenses and other current liabilities on the accompanying
consolidated balance sheet.
Critical Accounting Policies and Estimates
This discussion and analysis of our financial condition and results of
operations are based on our consolidated financial statements that have been
prepared under generally accepted accounting principles. The preparation of
financial statements in conformity with accounting principles generally accepted
in the United States requires our management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and the disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenue and expenses during the reporting period. Actual
results could materially differ from those estimates. We have disclosed all
significant accounting policies in note 2 to the consolidated financial
statements included in the Company's Annual Report on Form 10-K for the year
ended December 31, 2001. The consolidated financial statements and the related
notes thereto should be read in conjunction with the following discussion of our
critical accounting policies. Our critical accounting policies and estimates
are:
o Revenue recognition
o Valuation of goodwill, intangible assets and other long-lived
assets
o Stock based compensation
o Income taxes
Revenue Recognition: We currently recognize revenue from professional services.
As described below, significant management judgments and estimates must be made
and used in determining the amount of revenue recognized in any given accounting
period. Material differences may result in the amount and timing of our revenue
for any given accounting period depending upon judgments made or estimates
utilized by management.
14
We recognize revenue for fixed price contracts in accordance with SOP 81-1,
"Accounting for Performance of Construction Type and Certain Production Type
Contracts" (SOP 81-1). When reliable estimates are available for the costs and
efforts necessary to complete the consulting services and those services do not
include contractual milestones or other acceptance criteria, we recognize
revenue under the percentage of completion method based upon input measures,
such as hours. When such estimates are not available, we defer all revenue
recognition until we have completed the contract and have no further obligations
to the customer. Under each arrangement, revenues are recognized when an
agreement has been signed and the customer acknowledges an unconditional
obligation to pay, the services have been delivered, there are no uncertainties
surrounding customer acceptance, the fees are fixed and determinable, and
collection is considered probable.
Goodwill and Indefinite Lived Intangibles: Goodwill consists of the excess
purchase price over the fair value of identifiable net assets of acquired
businesses. Indefinite lived intangibles consist of the Company's tradename
intangible. The carrying value of goodwill and indefinite lived intangibles are
evaluated for impairment on an annual basis. Management also reviews goodwill
and its indefinite lived intangibles for impairment whenever events or changes
in circumstances indicate that their carrying amount may be impaired. If it is
determined that an impairment in value has occurred, goodwill and indefinite
lived intangibles will be written down to the present value of the expected
future operating cash flows to be generated by the respective reporting unit.
Upon adoption of SFAS 142, the Company evaluated goodwill and its tradename
intangible for impairment as required by that statement and determined that an
impairment of $23,307,626 existed at January 1, 2002. The Company's reporting
units utilized for evaluating the recoverability of goodwill and the indefinite
lived intangibles are the same as its operating segments.
Other Intangible Assets: Other intangible assets are carried at cost less
accumulated amortization and are amortized on a straight-line basis over their
expected lives, which are estimated to be three to five years. Other intangible
assets of the Company are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of the asset may not be
recoverable. Management also reevaluates the periods of amortization of other
intangible assets to determine whether events and circumstances warrant revised
estimates of useful lives. The Company evaluates the carrying value of its
long-lived assets in relation to the operating performance and future
undiscounted cash flows of the asset when indications of impairment are present.
If it is determined that an impairment in value has occurred, the excess of the
value of the asset will be written down to the present value of the expected
future operating cash flows to be generated by the asset. The Company determined
that its customer list and developed technology intangibles were impaired as of
June 30, 2002 and recorded an impairment charge of $8,743,545.
Impairment of Long-Lived Assets: Long-lived assets of the Company are reviewed
for impairment whenever events or changes in circumstances indicate that the
carrying amount of the asset may not be recoverable. Management also reevaluates
the periods of amortization of long-lived assets to determine whether events and
circumstances warrant revised estimates of useful lives. The Company evaluates
the carrying value of its long-lived assets in relation to the future
undiscounted cash flows of an asset when indications of impairment are present.
If it is determined that an impairment in value has occurred, the excess of the
value of the asset will be written down to the present value of the expected
future operating cash flows to be generated by the asset. Based on the
continuing difficult market conditions in the enterprise sector and the
Company's decline in revenue from current periods, the Company determined that
indications of impairment were present and reviewed its long-lived assets for
impairment during the second quarter of 2002. The Company determined that
property and equipment of its US Consulting and Managed Security Services
segments were impaired and recorded a $4,510,193 asset impairment charge as of
June 30, 2002.
Stock-Based Compensation: The Company accounts for its stock-based compensation
arrangements with its employees using the intrinsic value method in accordance
with the provisions of Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees" and complies with the disclosure provisions of
SFAS 123, "Accounting for Stock-based Compensation." In October 2002, the
Company adopted SFAS 123. SFAS 123 established a fair-value-based method of
accounting for stock-based compensation plans. Pursuant to the transition
provisions of SFAS 123, the Company will be required to apply the fair value
method of accounting to all option grants issued on or after January 1, 2002.
The fair value method will not be applied to stock option awards granted in
fiscal years prior to 2002. Such awards will continue to be accounted for under
the intrinsic value method pursuant to APB 25, except to the extent that prior
years' awards are modified subsequent to January 1, 2002. The Company is
currently assessing, but has not yet determined, the effect of adoption of SFAS
123 on its financial position or results of operations.
Income Taxes: Operating losses in prior periods have generated significant state
and federal tax net operating losses, or NOL carryforwards. Generally accepted
accounting principles in the United States require that we record a valuation
allowance against the deferred tax asset associated with this NOL if it is "more
likely than not" that we will not be able to utilize it to offset future taxes.
Due to our history of unprofitable operations, we have recorded a valuation
allowance equal to 100% of these deferred tax assets. It is possible, however,
that we could be profitable in the future at levels which cause management to
conclude that it is more likely than not that we will realize all or a portion
of the NOL carryforward. Upon reaching such a conclusion, we would record the
estimated net realizable value of the deferred tax asset at that time and would
then provide for income taxes at a rate equal to our combined federal and state
effective rates. Subsequent revisions to the estimated net realizable value of
the deferred tax asset could cause our provision for income taxes to vary
significantly from period to period, although our cash tax payments would remain
unaffected until the benefit of the NOL is utilized.
15
RESULTS OF OPERATIONS
Three Months Ended September 30, 2002 and 2001
REVENUES. Our principal source of revenues is fees from professional services.
Revenues decreased 18.9% to $12.5 million in the three months ended September
30, 2002 from $15.4 million in the three months ended September 30, 2001.
Revenues from professional services decreased 28.0% to $10.3 million in the
three months ended September 30, 2002 from $14.4 million in the three months
ended September 30, 2001. This decrease was primarily due to difficult market
conditions in the enterprise sector. Reimbursed expenses decreased to $290,000
in the three months ended September 30, 2002 from $405,000 in the three months
ended September 30, 2001. This decrease was primarily attributable to the nature
of the customer contracts in addition to the overall decline in professional
services revenues. Revenues from hardware and software sales increased 179.6% to
$1.9 million in the three months ended September 30, 2002 from $677,000 in the
three months ended September 30, 2001. This increase was primarily due to a
client request for us to supply all hardware and software associated with a
professional services project that commenced in June 2002. For the three months
ended September 30, 2002 and 2001, approximately 14.3% and 17.4%, respectively,
of revenues before reimbursed expenses were from one customer who is a related
party. Two other customers accounted for approximately 31.8% of revenues before
reimbursed expenses for the three months ended September 30, 2002, whereas one
customer accounted for approximately 12.7% for the three months ended September
30, 2001. The number of our billable consultants decreased from approximately
370 at September 30, 2001 to approximately 212 at September 30, 2002.
GROSS PROFIT. Gross profit increased 36.1% to $3.6 million in the three months
ended September 30, 2002 from $2.6 million in the three months ended September
30, 2001. As a percentage of revenues, gross profit increased to 28.6% in the
three months ended September 30, 2002 from 17.0% in the three months ended
September 30, 2001. Gross profit on professional services for the three months
ended September 30, 2002 was $3.4 million or 33.2% compared to $2.6 million or
17.9% for the three months ended September 30, 2001. The increase in gross
profit as a percentage of professional services revenues is primarily a result
of reductions in billable headcount in connection with our restructuring plans.
Gross profit on hardware and software sales for the three months ended September
30, 2002 was $148,000 or 7.8% compared to $60,000 or 8.8% for the three months
ended September 30, 2001. The decrease in gross profit as a percentage of
hardware and software sales is a result of a professional services project that
commenced in June 2002 with a lower resale margin. Costs of revenues decreased
30.1% to $8.9 million in the three months ended September 30, 2002 from $12.8
million in the three months ended September 30, 2001. Costs of revenues
attributable to professional services decreased 41.4% to $6.9 million for the
three months ended September 30, 2002 from $11.8 million for the three months
ended September 30, 2001. This decrease was due primarily to a decrease in
compensation and benefits paid to consultants as a result of reductions in
billable headcount in connection with our restructuring plans and a salary
reduction for employees effective in July 2002. Costs of revenues attributable
to hardware and software sales increased 182.7% to $1.7 million for the three
months ended September 30, 2002 from $618,000 for the three months ended
September 30, 2001. This increase was primarily due to a client request for us
to supply all hardware and software associated with a professional services
project that commenced in June 2002.
SALES AND MARKETING EXPENSES. Sales and marketing expenses decreased 52.0% to
$1.7 million in the three months ended September 30, 2002 from $3.6 million in
the three months ended September 30, 2001. As a percentage of revenues, sales
and marketing expenses decreased to 13.9% in the three months ended September
30, 2002 from 23.5% in the three months ended September 30, 2001. The decrease
in absolute dollars was primarily due to a decrease of $1.2 million in
compensation and benefits paid due to reductions in headcount in connection with
our restructuring plans and a salary reduction for employees effective in July
2002. The remaining $700,000 decrease in sales and marketing expenses was a
result of decreased expenditures for marketing and selling efforts, such as
conferences and mailings, and an overall decline in travel costs as part of our
cost cutting measures taken in 2002.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
decreased 55.6% to $4.6 million in the three months ended September 30, 2002
from $10.3 million in the three months ended September 30, 2001. As a percentage
of revenues, general and administrative expenses decreased to 36.7% in the three
months ended September 30, 2002 from 66.9% in the three months ended September
30, 2001. The decrease in absolute dollars was primarily due to a decrease of
$1.5 million in compensation and benefits costs as a result of reductions in
headcount in connection with our restructuring plans and a salary reduction for
employees effective in July 2002, a decrease of $397,000 in travel and
entertainment and training costs also as a result of reductions in headcount, a
decrease of $2.5 million in bad debt expense, and a decrease of $670,000 in
facilities and equipment leases in connection with our restructuring plans. The
remaining decrease of $592,000 was attributable to a reduction in professional
services and other administrative costs primarily as a result of nonrecurring
search fees for management level positions and human resource consulting fees
recorded for the three months ended September 30, 2001.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization decreased 82.2% to
$104,000 in the three months ended September 30, 2002 from $583,000 in the three
months ended September 30, 2001. The decrease was attributable to a reduction in
the carrying value of property and equipment due to the write-off of property
and equipment in connection with our restructuring plans and our evaluation of
the carrying value of the long-lived assets of our US Consulting and Managed
Security Services reporting units as of June 30, 2002 in accordance with the
provisions of SFAS 144. Such evaluation resulted in an impairment charge of $4.5
million relating to property and equipment.
16
INTANGIBLES AMORTIZATION. As a result of the analysis of our finite lived
intangible assets in accordance with the provisions of SFAS 144 at June 30,
2002, we recognized an impairment charge for the entire carrying value of our
finite lived intangible assets. As such, no amortization expense for our finite
intangible assets was recorded for the three months ended September 30, 2002.
Additionally, there was no amortization recorded for goodwill and our indefinite
lived tradename intangible for the three months ended September 30, 2002 as
these assets are no longer amortized but are reviewed annually (or more
frequently if impairment indicators arise) for impairment under the provisions
of SFAS 142, which was adopted by the Company on January 1, 2002. Intangibles
amortization of $6.4 million for the three months ended September 30, 2001
consisted of amortization for all intangible assets, including goodwill,
assembled workforce and tradenames.
LOSS ON EQUIPMENT. For the three months ended September 30, 2001, we recognized
a loss of $443,000 for equipment that was not in service and deemed to have no
salvage value.
IMPAIRMENT OF INTANGIBLES. During 2001, we integrated the acquisitions of Synet
and Global Integrity, which were acquired in the fourth quarter of 2000. As we
approached the completion of the integration phase in the third quarter of 2001,
and in combination with revenue declines in the acquired companies in relation
to prior periods and forecasted earnings and the overall deterioration of market
conditions in the enterprise sector, we reviewed goodwill and the intangible
assets for impairment. For the three months ended September 30, 2001, we
recognized an impairment loss of $18.2 million and $42.3 million for the
difference between the estimated fair value of Synet and Global Integrity,
respectively, based on future discounted cashflows and the carrying amount of
each of their assets and liabilities, including goodwill.
RESTRUCTURING AND OTHER CHARGES. For the three months ended September 30, 2002,
we recorded restructuring charges of $83,000 in connection with our 2002
restructuring plan. Such charges consisted of $647,000 in severance benefits and
other related expenses for a reduction in headcount of 41 employees and $18,000
for exit costs related to the closing of domestic offices. These charges were
offset by a reduction to previously accrued exit costs in the amount of $583,000
resulting from favorable and unfavorable settlements and changes to subtenant
assumptions for leased domestic offices. For the three months ended September
30, 2001, we recorded restructuring charges of $4.6 million in connection with
our 2001 restructuring plan. Such charges consisted of $1.0 million in severance
benefits and other related expenses for a reduction in headcount of 86 employees
and $3.6 million in exit costs related to real estate and electronic equipment.
LOSS ON LONG-TERM INVESTMENTS IN RELATED PARTIES. For the three months ended
September 30, 2001, we recognized a loss on our $1.0 million investment in Three
Pillars due to management's determination that the value of the investment was
impaired.
NONCASH COMPENSATION EXPENSE. During 1999, we 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, in connection with our acquisitions of Synet and Global Integrity,
we issued options to Synet and Global Integrity optionholders in exchange for
their Synet and Global Integrity options. 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, 2002 and 2001, we
recorded approximately $29,000 and $83,000, respectively, of noncash
compensation expense related to these options. The decrease in noncash
compensation expense is a result of the cancellation of options as a result of
reductions in headcount in connection with our restructuring plans.
OTHER INCOME (EXPENSE). Other income for the three months ended September 30,
2002 primarily consisted of a reduction in an acquisition related exit cost
accrual of approximately $921,000 as a result of the negotiation of a favorable
buyout of an existing lease which was assumed in connection with the Global
Integrity acquisition. The liability for such lease had been fully accrued as
part of the acquired assets and assumed liabilities of Global Integrity in
fiscal 2001. This income was offset by approximately $213,000 of inventory held
for resale which was no longer deemed saleable. As the Company is acting as an
agent of the supplier in the arrangement for the resale of this inventory and
the revenues are recognized on a net basis, such write-off has been classified
as other expense. Other income for the three months ended September 30, 2001
primarily consisted of interest income.
Nine Months Ended September 30, 2002 and 2001
REVENUES. Our principal source of revenues is fees from professional services.
Revenues decreased 29.0% to $39.5 million in the nine months ended September 30,
2002 from $55.7 million in the nine months ended September 30, 2001. Revenues
from professional services decreased 31.5% to $36.0 million in the nine months
ended September 30, 2002 from $52.6 million in the nine months ended September
30, 2001. This decrease was primarily due to difficult market conditions in the
enterprise sector. Reimbursed expenses decreased to $1.0 million in the nine
months ended September 30, 2002 from $1.5 million in the nine months ended
September 30, 2001. This decrease was primarily attributable to the nature of
the customer contracts in addition to the overall decline in professional
services revenues. Revenues from hardware and software sales increased 59.0% to
$2.5 million in the nine months ended September 30, 2002 from $1.6 million in
the nine months ended September 30, 2001. This increase was primarily due to a
client request for us to supply all hardware and software associated with a
professional services project that commenced in 2002. For the nine months ended
September 30, 2002 and 2001, approximately 15.9% and 18.7%, respectively, of
revenues before reimbursed expenses were from one customer who is a related
party. One other customer accounted for approximately 13.7% of revenues before
reimbursed expenses for the nine months ended September 30, 2002. There were no
other customers that accounted for more than 10.0% of revenues before reimbursed
expenses for the nine months ended September 30, 2001. The number of our
billable consultants decreased from approximately 370 at September 30, 2001 to
approximately 212 at September 30, 2002.
17
GROSS PROFIT. Gross profit decreased 16.5% to $10.2 million in the nine months
ended September 30, 2002 from $12.2 million in the nine months ended September
30, 2001. As a percentage of revenues, gross profit increased to 25.9% in the
nine months ended September 30, 2002 from 22.0% in the nine months ended
September 30, 2001. Gross profit on professional services for the nine months
ended September 30, 2002 was $10.0 million or 27.9% compared to $12.5 million or
23.7% for the nine months ended September 30, 2001. The increase in gross profit
as a percentage of professional services revenues is primarily a result of
reductions in billable headcount in connection with our restructuring plans.
Gross profit on hardware and software sales for the nine months ended September
30, 2002 was $194,000 or 7.8% compared to $(226,000) or (14.4%) for the nine
months ended September 30, 2001. Included in gross profit for the nine months
ended September 30, 2001 is $500,000 for the write-off of software inventory,
which was no longer considered saleable. Excluding the impact of this write-off,
gross profit on hardware and software sales was $274,000 or 17.4% for the nine
months ended September 30, 2001. The decrease in gross profit as a percentage of
hardware and software sales, excluding the impact of the software inventory
write-off, is a result of a professional services project that commenced in June
2002 with a lower resale margin. Costs of revenues decreased 32.5% to $29.3
million in the nine months ended September 30, 2002 from $43.4 million in the
nine months ended September 30, 2001. Costs of revenues attributable to
professional services decreased 35.2% to $26.0 million for the nine months ended
September 30, 2002 from $40.1 million for the nine months ended September 30,
2001. 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 in connection with our restructuring plans and a salary
reduction for employees effective in July 2002. Costs of revenues attributable
to hardware and software sales increased 28.2% to $2.3 million for the nine
months ended September 30, 2002 from $1.8 million for the nine months ended
September 30, 2001. This increase was primarily due to a client request for us
to supply all hardware and software associated with a professional services
project that commenced in June 2002.
SALES AND MARKETING EXPENSES. Sales and marketing expenses decreased 48.0% to
$6.7 million in the nine months ended September 30, 2002 from $12.9 million in
the nine months ended September 30, 2001. As a percentage of revenues, sales and
marketing expenses decreased to 17.0% in the nine months ended September 30,
2002 from 23.2% in the nine months ended September 30, 2001. The decrease in
absolute dollars was primarily due to a decrease of $4.2 million in compensation
and benefits paid due to reductions in headcount in connection with our
restructuring plans and a salary reduction for employees effective in July 2002,
and a decrease of $571,000 in commissions paid as a result of declining revenues
for professional services and the merging of two separate sales forces for US
Consulting and Managed Security Services in 2002. The remaining $1.4 million
decrease in sales and marketing expenses was a result of decreased expenditures
for marketing and selling efforts, such as conferences and mailings, and an
overall decline in travel costs as part of our cost cutting measures taken in
2002.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
decreased 48.5% to $17.5 million in the nine months ended September 30, 2002
from $34.0 million in the nine months ended September 30, 2001. As a percentage
of revenues, general and administrative expenses decreased to 44.4% in the nine
months ended September 30, 2002 from 61.2% in the nine months ended September
30, 2001. The decrease in absolute dollars was primarily due to a decrease of
$6.6 million in compensation and benefits costs as a result of reductions in
headcount in connection with our restructuring plans and a salary reduction for
employees effective in July 2002, a decrease of $2.4 million in travel and
entertainment and training costs also as a result of reductions in headcount, a
decrease of $4.2 million in bad debt expense, and a decrease of $1.5 million in
facilities and equipment leases in connection with our restructuring plans. The
remaining decrease of $1.8 million was attributable to a reduction in
professional services and other administrative costs primarily as a result of
nonrecurring search fees for management level positions, human resource
consulting fees, and legal liabilities which were both probable and estimatable.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization decreased 30.0% to
$1.6 million in the nine months ended September 30, 2002 from $2.3 million in
the nine months ended September 30, 2001. The decrease was attributable to a
reduction in the carrying value of property and equipment due to the write-off
of property and equipment in connection with our restructuring plans and our
evaluation of the carrying value of the long-lived assets of our US Consulting
and Managed Security Services reporting units as of June 30, 2002 in accordance
with the provisions of SFAS 144. Such evaluation resulted in an impairment
charge of $4.5 million relating to property and equipment.
INTANGIBLES AMORTIZATION. Amortization of intangibles decreased to $2.0 million
for the nine months ended September 30, 2002 from $19.1 million for the nine
months ended September 30, 2001. For the nine months ended September 30, 2002,
the amount consisted of amortization for intangible assets deemed to have finite
lives pursuant to the provisions of SFAS 142 which was adopted effective January
1, 2002. Such intangible assets consisted of customer lists and developed
technology. As a result of the analysis of our finite lived intangible assets in
accordance with the provisions of SFAS 144 at June 30, 2002, we recognized an
impairment charge for the entire carrying value of our finite lived intangible
assets. As such, no amortization expense for intangible assets was recorded
since June 30, 2002. Intangibles amortization for the nine months ended
September 30, 2001 consisted of amortization for all intangible assets,
including goodwill, assembled workforce and tradenames.
18
LOSS ON EQUIPMENT. For the nine months ended September 30, 2001, we recognized a
loss of $443,000 for equipment that was not in service and deemed to have no
salvage value.
IMPAIRMENT OF INTANGIBLES. During 2001, we integrated the operations of Synet
and Global Integrity, which were acquired in the fourth quarter of 2000. As we
approached the completion of the integration phase in the third quarter of 2001,
and in combination with revenue declines in the acquired companies in relation
to prior periods and forecasted earnings and the overall deterioration of market
conditions in the enterprise sector, we reviewed goodwill and the intangible
assets for impairment. For the nine months ended September 30, 2001, we
recognized an impairment loss of $18.2 million and $42.3 million for the
difference between the estimated fair value of Synet and Global Integrity,
respectively, based on the future expected discounted cashflows and the carrying
amount of each of their assets and liabilities, including goodwill. We adopted
the provisions of SFAS 144 effective January 1, 2002. Given the continued
decline in revenues and our market capitalization, the overall deterioration of
market conditions in the enterprise sector, and our forecasted operating results
for the foreseeable future, we reviewed our long-lived assets for impairment as
of June 30, 2002. Based on this review, we recognized an impairment loss for the
nine months ended September 30, 2002 of $8.7 million to reduce the carrying
value of our finite lived intangible assets, consisting of customer lists and
developed technology.
IMPAIRMENT OF PROPERTY AND EQUIPMENT. We adopted the provisions of SFAS 144
effective January 1, 2002. Given the decline in revenues and our market
capitalization, the overall deterioration of market conditions in the enterprise
sector, and our forecasted operating results for the foreseeable future, we
reviewed our long-lived assets for impairment at June 30, 2002. Based on this
review, we recognized an impairment loss for the nine months ended September 30,
2002 of $4.5 million to reduce the carrying value of our property and equipment,
consisting of computer equipment, furniture and fixtures, capitalized software
and leasehold improvements.
RESTRUCTURING AND OTHER CHARGES. For the nine months ended September 30, 2002,
we recorded restructuring charges of $4.3 million in connection with our 2002
restructuring plan. Such charges consisted of $2.7 million in severance benefits
and other related expenses for a reduction in headcount of 147 employees, $1.6
million in exit costs related to real estate and electronic equipment for the
closing of domestic offices, and an increase to previously accrued exit costs in
the amount of $109,000 resulting from favorable and unfavorable settlements and
changes to subtenant assumptions for leased domestic offices. These charges were
offset by $150,000 received for equipment written off to restructuring charges
in 2001 in connection with the outsourcing of our monitoring services provided
as part of the Managed Security Services division. For the nine months ended
September 30, 2001, we recorded restructuring charges of $7.8 million in
connection with our 2001 restructuring plan. Such charges consisted of $2.8
million in severance benefits and other related expenses for a reduction in
headcount of 191 employees 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 $1.0 million related to the write-off of internal
software management tools that no longer suit the business needs of the Company.
LOSS ON LONG-TERM INVESTMENTS IN RELATED PARTIES. On March 22, 2001, Paradigm4,
Inc. filed for federal bankruptcy protection. This action created significant
uncertainty regarding the carrying value of our investment in Paradigm4. As a
result, we recognized a loss on our $1.0 million investment in Paradigm4 for the
nine months ended September 30, 2001. For the nine months ended September 30,
2001, we also recognized a loss on our $1.0 million investment in Three Pillars
due to management's determination that the value of the investment was impaired.
NONCASH COMPENSATION EXPENSE. During 1999, we 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, in connection with our acquisitions of Synet and Global Integrity,
we 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 nine months ended September 30, 2002 and 2001,
we recorded approximately $102,000 and $301,000, respectively, of noncash
compensation expense related to these options. The decrease in noncash
compensation expense is a result of the cancellation of options as a result of
reductions in headcount in connection with our restructuring plans.
OTHER INCOME (EXPENSE). Other expense for the nine months ended September 30,
2002 primarily consisted of the write-off of approximately $1.7 million of
inventory held for resale which was no longer deemed saleable. As the Company is
acting as an agent of the supplier in the arrangement for the resale of this
inventory and the revenues are recognized on a net basis, such write-off has
been classified as other expense. This expense was offset by other income which
primarily consisted of a reduction in an acquisition related exit cost accrual
of approximately $921,000 as a result of the negotiation of a favorable buyout
of an existing lease which was assumed in connection with the Global Integrity
acquisition. The liability for such lease had been fully accrued as part of the
acquired assets and assumed liabilities of Global Integrity in fiscal 2001.
Other income for the nine months ended September 30, 2001 primarily consisted of
interest income.
19
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE. Upon adoption of SFAS 142,
we recorded a noncash charge of $23.3 million to reduce the carrying value of
our goodwill and other indefinite lived intangible assets, primarily consisting
of acquired tradenames.
LIQUIDITY AND CAPITAL RESOURCES. We have financed our operations through the
sale of equity securities and cash flows from operations. As of September 30,
2002, we had approximately $17.5 million in cash and cash equivalents and $2.4
million in restricted cash backing letters of credit issued pursuant to certain
operating real estate and equipment lease agreements and a customer contract.
Net cash used in operating activities decreased to $24.1 million for the nine
months ended September 30, 2002 from $31.9 million for the nine months ended
September 30, 2001. This decrease was primarily attributable to a reduction in
the operating loss for the nine months ended September 30, 2002 as compared to
the nine months ended September 30, 2001. We experienced a decrease in accounts
payable and accrued expenses and other current liabilities for the nine months
ended September 30, 2002 of approximately $7.8 million as compared to an
increase in accounts payable and accrued expenses and other current liabilities
for the nine months ended September 30, 2001 of approximately $442,000. Such
decrease included approximately $2.4 million paid for the purchase of software
inventory for resale, approximately $982,000 for the payment of retention
bonuses to employees of Global Integrity prior to the acquisition who achieved
their one year anniversary with the Company and therefore qualified for the
retention bonus, and approximately $574,000 in lease termination fees for office
space abandoned in 2001. We also experienced an increase in restricted cash of
$1.6 million in 2002 related to a new equipment operating lease and a
contractual obligation in connection with a customer contract entered into in
2002. These net outflows of cash were offset by net inflows of cash as a result
of decreases in accounts receivable and unbilled revenues of approximately
$461,000. The decrease in accounts receivable was primarily attributable to
increased collection efforts and declining revenues due to difficult market
conditions.
Net cash used in investing activities was $876,000 and $9.1 million,
respectively, for the nine months ended September 30, 2002 and 2001. Capital
expenditures were $909,000 for the nine months ended September 30, 2002 and
primarily consisted of computer equipment and leasehold improvements. Capital
expenditures were $7.2 million for the nine months ended September 30, 2001 and
consisted of computer equipment, office furniture, capitalized software and
leasehold improvements in connection with the investment in our infrastructure.
Net cash provided by financing activities was $929,000 and $1.9 million,
respectively, for the nine months ended September 30, 2002 and 2001. Cash
provided by financing activities primarily resulted from the receipt of proceeds
from the exercise of options and the sale of common stock in connection with our
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 $5.0 million or 80.0% of our accounts
receivable. At September 30, 2002 there were no amounts outstanding under this
facility. Amounts outstanding under the facility bear interest at the lender's
base rate which was 4.75% as of September 30, 2002.
For the three months ended September 30, 2002 the Company negotiated favorable
buyouts of two existing real estate operating leases for approximately $574,000.
As a result of such buyouts, the Company reduced its expected future minimum
lease payment obligation by approximately $2.7 million.
Based on our current revenue projections and continued cost-cutting efforts, we
believe that we will achieve positive cash flow in 2003. 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 additional credit facilities. 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.
In October 2002, the Company implemented an employee voluntary stock option
exchange program whereby the Company would exchange certain outstanding options
to purchase shares of the Company's common stock held by eligible employees of
the Company, with exercise prices per share greater than or equal to $0.80, for
new options to purchase shares of the Company's common stock (the "Offer to
Exchange"). Under the terms of the Offer to Exchange, the 193 participating
employees had certain of their existing options to purchase 4,085,860 shares of
the Company's common stock cancelled as of October 18, 2002 and received options
to purchase 3,089,424 shares of our common stock with an exercise price equal to
the closing market price of $0.22 per share on October 18, 2002. All new options
were granted under the 1999 Stock Incentive Plan, as amended. Each new option
vests in equal monthly installments in accordance with a four year vesting
schedule beginning on the date of grant. However, the vesting period will be
accelerated based on years of service with the Company measured at the date of
grant. Employees holding over 500,000 options, the maximum number of options
that may be issued per year to a single employee pursuant to the Company's 1999
Stock Incentive Plan, were only permitted to tender up to 500,000 of their
currently outstanding options in exchange for 500,000 new options. Therefore,
the Company also re-priced 1,500,000 of its Chief Executive Officer's
outstanding options to give these options the same terms as if he had been able
to fully participate in the option exchange program.
20
Recent Accounting Pronouncements
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 of
accounting. 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 effective January 1, 2002. As
required by the transitional provisions of SFAS 142, the Company evaluated
goodwill and intangible assets with indefinite lives for impairment as of
January 1, 2002. This evaluation was completed during the second quarter of
2002. As a result of this transitional testing, the Company recorded a noncash
impairment charge of $23,307,626 to reduce the carrying value of its goodwill
and other indefinite lived intangible assets. Such charge is reflected as a
cumulative effect of change in accounting principle in the accompanying
consolidated statements of operations for the nine months ended September 30,
2002.
In July 2001, the FASB issued Statement of Financial Accounting Standard No.
143, "Accounting for Asset Retirement Obligations" (SFAS 143), which is
effective for fiscal years beginning after June 15, 2002. SFAS 143 requires,
among other things, the accounting and reporting of legal obligations associated
with the retirement of long-lived assets that result from the acquisition,
construction, development or normal operation of a long-lived asset. The Company
believes the adoption of SFAS 143 will not have a material impact on its
financial position or results of operations.
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 Statement of Financial Accounting Standard No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of" (SFAS 121) 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 121 for recognition and measurement of impairment, but amends the
accounting and reporting standards for segments of a business to be disposed of.
The Company adopted the provisions of SFAS 144 effective January 1, 2002. Given
the decline in revenues and market capitalization of the Company and the overall
deterioration of market conditions in the enterprise sector, the Company
reviewed its long-lived assets for impairment during the second quarter of 2002.
Based on this review, the Company recognized an impairment charge to reduce the
carrying value of its finite lived intangible assets and property and equipment
of $8,743,545 and $4,510,193, respectively. Such charges are reflected in the
accompanying consolidated statements of operations for the nine months ended
September 30, 2002.
In November 2001, the Emerging Issues Task Force (EITF) of the FASB concluded
that reimbursements received for "out-of-pocket" expenses should be classified
as revenue, and correspondingly cost of services, in the income statement. This
accounting treatment should be applied in financial reporting periods (years)
beginning as early as the March 2002 quarter. Upon application of the
pronouncement, comparative financial statements for prior periods must also be
reclassified in order to ensure consistency among all periods presented. The
Company adopted this pronouncement effective January 1, 2002 and has separately
disclosed the impact of adoption in the consolidated statements of operations.
In April 2002, the FASB issued Statement of Financial Accounting Standard No.
145 "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections" (SFAS 145). This statement
eliminates the automatic classification of gain or loss on an extinguishment of
debt as an extraordinary item of income and requires that such gain or loss be
evaluated for extraordinary classification under the criteria of Accounting
Principles Board No. 30 "Reporting Results of Operations." This statement also
requires sales-leaseback accounting for certain lease modifications that have
economic effects that are similar to sales-leaseback transactions, and makes
various other technical corrections to existing pronouncements. This statement
will be effective for the Company for the year ending December 31, 2003. The
Company is currently assessing, but has not yet determined the effect, if any,
of SFAS 145 on its financial position or results of operations.
In July 2002, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 146, "Accounting for Costs Associated with
Exit or Disposal Activities" (SFAS 146). SFAS 146 will supersede EITF No. 94-3,
"Liability Recognition for Certain Employee Termination Benefits and Other Costs
to Exit an Activity (including Certain Costs Incurred in a Restructuring)." SFAS
146 requires that costs associated with an exit or disposal plan be recognized
when incurred rather than at the date of a commitment to an exit or disposal
plan. SFAS 146 is to be applied prospectively to exit or disposal activities
initiated after December 31, 2002. The Company is currently assessing, but has
not yet determined the effect, if any, of SFAS 146 on its financial position or
results of operations.
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.
21
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 and the fact that many of our competitors have longer
operating histories, 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 volatile 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 are experiencing a drastic downturn. We can not
predict how long this contraction will last, or the timing or strength of a
recovery, if any. If market conditions and corporate spending in these sectors
do 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, 2002, BellSouth Corporation accounted
for approximately 15.9% of revenues before reimbursed expenses. One other
customer accounted for approximately 13.7% of revenues before reimbursed
expenses for the nine months ended September 30, 2002. Our five largest clients
accounted for approximately 44.8% of our revenues before reimbursed expenses for
the nine months ended September 30, 2002. For the year ended December 31, 2001,
our five largest clients accounted for approximately 40.6% of our revenues
before reimbursed expenses. 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, 2002, the accounts receivable
from BellSouth and the 13.7% customer were approximately $1.3 million and $1.7
million, respectively, which related to work performed in June through September
2002.
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:
o the loss of key employees;
o the development and introduction of new service offerings;
o reductions in our billing rates;
o the miscalculation of resources required to complete new or ongoing
projects;
o the utilization of our workforce;
o the ability of our clients to meet their payments obligations to us;
and
o the timing and extent of training.
22
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, 2002 and the year ended
December 31, 2001, fixed-price projects accounted for 38.1% and 48.2% 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 an increase in net loss. We recognize revenues from fixed-price
projects based on our estimates 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. 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 the fluctuations in the demand for our services,
which could have adverse effects on our business
Our business has recently experienced lower revenues due to decreased
customer demand for our services. Since December 31, 2000, to scale back our
operations and to reduce our expenses in response to this reduced demand for our
services, we have decreased our headcount to 291 employees as of September 30,
2002 from approximately 691 employees as of December 31, 2000. While this action
has positively impacted our results of operations, there are several risks
inherent in our efforts to transition to a smaller workforce. Reducing the size
of our workforce could have adverse effects on our business by reducing our pool
of technical talent, making it more difficult for us to respond to customers,
limiting our ability to provide increased services quickly if and when the
demand for our services increases, and limiting our ability to hire and retain
key personnel. A key part of our strategy going forward is to grow our business.
In order to achieve this growth, demand for our services must increase. If the
opportunity to grow our business arises, we may need to modify our financial and
management controls, reporting systems and procedures and to train our work
force. We may not be able to do so successfully, causing our earnings to be
lower than they might otherwise be.
23
Our management team has experienced significant turnover which could interrupt
our business and adversely affect our growth
Our future success depends, in significant part, upon the continued
service and performance of our senior management and other key personnel. Neeraj
(Berry) Sethi was appointed our Chief Financial Officer in August 2002 and Shawn
Kreloff was appointed our Executive Vice President of Sales and Business
Development in September 2002. In addition, in connection with our recent
reductions 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 and security
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 and security 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 and security 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, security consulting 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 integrating the acquired company into our existing business;
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.
24
Competition for experienced personnel is intense and our inability to retain key
personnel could interrupt our business and adversely affect our growth
Our future success depends, in significant part, upon the continued
service and performance of our senior management and other key personnel. Losing
the services of any of these individuals may impair our ability to effectively
deliver our services and manage our company, and to carry out our business plan.
In addition, competition for qualified personnel in the network and security
consulting industry is intense and we may not be successful in attracting and
retaining these personnel. There may be only a limited number of persons with
the requisite skills to serve in these positions and it may become increasingly
difficult to hire these persons. Our business will suffer if we encounter delays
in hiring additional personnel.
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 and security
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
and security 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.
25
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 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 and 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 are currently involved in this type of litigation.
Litigation is often expensive and diverts management's attention and resources.
Our common stock could be delisted from Nasdaq
Our common stock currently trades on the Nasdaq National Market, which
specifies certain requirements for continued listing. One of the requirements is
that the minimum closing bid price per share of our common stock not be less
than $1.00 for a period of 30 consecutive trading days. On July 25, 2002, we
received notice from Nasdaq that for the prior 30 consecutive trading days the
minimum closing bid price per share of our common stock was less than $1.00 and,
in the event we did not regain compliance by October 23, 2002, Nasdaq would
delist our common stock from the Nasdaq National Market.
Due to the fact that our stock price has not met the $1.00 minimum
price requirement of the Nasdaq National Market, we have applied for listing on
the Nasdaq SmallCap Market, which deferred the institution of delisting
proceeding from the Nasdaq National Market. There can be no assurance that we
will be accepted for listing on the Nasdaq SmallCap Market. The Nasdaq SmallCap
Market also requires that the minimum closing bid price per share of our common
stock not be less than $1.00 for a period of 30 consecutive trading days.
However, in the event that our application for listing is accepted, we will have
until January 21, 2002 to regain compliance with the $1.00 minimum closing bid
price per share requirement to remain on the Nasdaq SmallCap Market. At that
time, we may be eligible for an additional 180-day period through July 21, 2003,
to regain compliance with the $1.00 minimum bid price requirement provided that
we meet the other initial listing requirements for the Nasdaq SmallCap Market.
Although we currently meet these initial listing requirements, there is no
assurance that we will continue to meet the requirements in the future.
There can be no assurance that we will be accepted for listing on the
Nasdaq SmallCap Market. If we are accepted and subsequently delisted, we may be
unable to have our common stock listed or quoted on any other organized market.
Even if our common stock is quoted or listed on another organized market, an
active trading market may not develop.
26
Delisting from Nasdaq would likely make it more difficult for us to
raise capital in the future. Delisting could also reduce the ability of holders
of our common stock to purchase or sell shares as quickly and as inexpensively
as they have done historically. It could have an adverse effect on the trading
price of our common stock, regardless of our actual operating performance.
Delisting might also adversely affect our relationships with vendors and
customers, and may subject our common stock to the "penny stock rules" contained
in Section 15(g) of the Securities Exchange Act of 1934.
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 28% 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.
ITEM 4. CONTROLS AND PROCEDURES
Based on their evaluation of our disclosure controls and procedures as of a date
within 90 days of the filing of this Report, the Chief Executive Officer and
Chief Financial Officer have concluded that such controls and procedures are
effective.
There were no significant changes in our internal controls or in other factors
that could significantly affect such controls subsequent to the date of their
evaluation.
27
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Except as set forth below, we are not a party to any material legal proceedings.
On November 13, 2001, a securities class action complaint was filed in
the United States District Court for the Southern District of New York against
Predictive, four investment banks that underwrote the Company's initial public
offering, and three of the Company's former officers and directors. This action
has been coordinated with over three hundred virtually identical actions against
other companies and the investment banks that underwrote their initial public
offerings. The complaint filed against Predictive generally alleged that the
underwriters obtained excessive and undisclosed commissions from customers who
received allocations of shares in the Company's initial and secondary public
offerings and that the underwriters maintained artificially inflated prices in
the after market through "tie-in" arrangements, which required customers to buy
additional shares of the Company's stock at pre-determined prices in excess of
the offering prices. The complaint further alleged that the Company and certain
of its officers and directors violated Sections 11, 12(a)(2) and 15 of the
Securities Act of 1933 because the Company's registration statement did not
disclose the underwriters' purported misconduct. On April 20, 2002, the
plaintiffs amended their complaint, abandoning the Section 12(a)(2) claim, but
alleging violations of Sections 10(b) and 20(a) of the Securities Exchange Act,
and of Rule 10b-5 promulgated thereunder. Plaintiffs seek an unspecified amount
of damages on behalf of persons who purchased the Company's stock pursuant to
the registration statements. On July 15, 2002, the Company and three former
officers and directors joined a motion to dismiss filed on behalf of the issuer
defendants. The Company believes that the allegations against it are without
merit and intends to defend the case vigorously.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
NONE.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
NONE.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
NONE.
ITEM 5. OTHER INFORMATION
The Audit Committee of the Board of Directors approved the categories of all
non-audit services performed by the Company's independent accountants during the
period covered by this report.
ITEM 6. EXHIBITS AND REPORT ON FORM 8-K
(a) The following exhibits are filed as part of this report:
10.1 Employment Agreement , dated August 26, 2002, by and between the Registrant
and Neeraj Sethi.
10.2 Employment Agreement , dated September 19, 2002, by and between the
Registrant and Shawn Kreloff.
10.3 Employment Agreement , dated November 11, 2002, by and between the
Registrant and Shirley Howell.
10.4 Employment Agreement , dated November 11, 2002, by and between the
Registrant and Gary Papilsky.
99.1 Certification under Section 906 of the Sarbanes-Oxley Act.
(b) The Company filed six reports on Form 8-K during the three months ended
September 30, 2002 and one report filed after September 30, 2002 through the
date hereof. Information regarding the items reported on is as follows:
July 30, 2002. The Company announced that Braden Kelly had resigned from its
Board of Directors.
August 27, 2002. The Company announced that Neeraj Sethi, the Company's acting
Chief Financial Officer was named the Company's Chief Financial Officer on a
permanent basis.
September 4, 2002. The Company announced that John Jacobs had resigned from its
Board of Directors.
28
September 16, 2002. The Company announced that Howard Morgan had joined its
Board of Directors and that Ronald Pettengill had resigned from its Board of
Directors.
September 19, 2002. The Company announced that it will expense the cost of stock
options by adopting the fair value method of accounting for stock options
contained in SFAS No. 123, Accounting for Stock-Based Compensation. The Company
also announced that it will offer its employees the opportunity to participate
in a voluntary stock option exchange program.
September 23, 2002. The Company announced that it had named Shawn Kreloff as
Executive Vice President of Sales and Business Development.
October 22, 2002. The Company announced the completion of its voluntary stock
option exchange program and the amendment of certain of its CEO's options to
give them the same terms as if they had been eligible for the voluntary option
exchange program.
29
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, 2002 /s/ ANDREW ZIMMERMAN
-----------------------------------------
Name: Andrew Zimmerman
Title: Chief Executive Officer
(principal executive officer)
Date: November 14, 2002 /s/ NEERAJ SETHI
-----------------------------------------
Name: Neeraj Sethi
Title: Chief Financial Officer
(principal accounting and financial officer)
30
CERTIFICATION PURSUANT TO RULE 13A-14 OR 15D-14 OF THE SECURITIES
EXCHANGE ACT OF 1934, AS ADOPTED PURSUANT TO SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002
I, Andrew Zimmerman, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Predictive Systems,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a. designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b. evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a. all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b. any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Dated: November 14, 2002
By: /s/ Andrew Zimmerman
------------------------
Name: Andrew Zimmerman
Title: Chief Executive Officer
31
CERTIFICATION PURSUANT TO RULE 13A-14 OR 15D-14 OF THE SECURITIES
EXCHANGE ACT OF 1934, AS ADOPTED PURSUANT TO SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002
I, Neeraj Sethi, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Predictive Systems,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a. designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b. evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a. all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b. any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Dated: November 14, 2002
By: /s/ Neeraj Sethi
------------------------
Name: Neeraj Sethi
Title: Chief Financial Officer
32