UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-QSB
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|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2005
or
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Transition Period From to
Commission File Number 0-30420 [GRAPHIC OMITTED]
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CONVERSION SERVICES INTERNATIONAL, INC.
(Exact name of small business user as specified in its charter)
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Delaware 20-1010495
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
100 Eagle Rock Avenue, East Hanover, New Jersey 07936
(Address of principal executive office)
Issuer's telephone number: (973) 560-9400
----------------------
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days. Yes |X| No
|_|
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date: as of August 15, 2005,
811,403,459 shares of common stock, par value $0.001, were outstanding.
Conversion Services International, Inc. and Subsidiaries
Form 10-QSB
Index
Part I. -- Financial Information Page
Item 1. Financial Statements
Condensed Consolidated Balance Sheet as of June 30, 2005 (unaudited)........3
Condensed Consolidated Statements of Operations for the three and
six months ended June 30, 2005 and 2004 (restated) (unaudited)...........4
Condensed Consolidated Statements of Cash Flows for the three and
six months ended June 30, 2005 and 2004 (restated) (unaudited)...........5
Notes to Condensed Consolidated Financial Statements (unaudited)............7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations..........................................24
Item 3. Controls and Procedures..............................................36
Part II. Other Information
Item 6. Exhibits and Reports on Form 8-K.....................................39
Signatures
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CONVERSION SERVICES INTERNATIONAL, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEET
JUNE 30, 2005
(Unaudited)
ASSETS
CURRENT ASSETS
Cash $ 646,006
Accounts receivable, net of allowance for doubtful accounts of $216,437 4,305,995
Accounts receivable from related parties; (Note 16) 1,060,053
Prepaid expenses 376,813
-------------
TOTAL CURRENT ASSETS 6,388,867
-------------
PROPERTY AND EQUIPMENT, at cost, net; (Note 3) 539,702
-------------
OTHER ASSETS
Restricted cash 4,327,295
Goodwill 4,690,972
Intangible assets, net of accumulated amortization of $1,542,122; (Note 4) 2,996,116
Deferred financing costs, net of accumulated amortization of $318,539; (Note 5) 574,770
Discount on debt issued, net of accumulated amortization of $2,109,155; (Note 6) 5,681,155
Equity investments 191,578
Other assets 115,295
-------------
18,577,181
-------------
Total Assets $ 25,505,750
=============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Line of credit; (Note 7) $ 3,413,830
Current portion of long-term debt 133,527
Accounts payable and accrued expenses 3,189,132
Note payable; (Note 8) 863,636
Related party note payable; (Note 16) 1,632,325
Deferred revenue 1,759,205
-------------
TOTAL CURRENT LIABILITIES 10,991,655
LONG-TERM DEBT, net of current portion; (Note 9) 5,225,279
-------------
Total Liabilities 16,216,934
-------------
MINORITY INTEREST 79,943
-------------
COMMITMENTS AND CONTINGENCIES; (Note 15) --
STOCKHOLDERS' EQUITY
Common stock, $0.001 par value, 1,000,000,000 shares authorized;
788,474,038 issued and outstanding 788,474
Additional paid in capital 47,910,746
Accumulated deficit (39,494,387)
Accumulated other comprehensive income 4,040
-------------
Total Stockholders' Equity 9,208,873
-------------
Total Liabilities and Stockholders' Equity $ 25,505,750
=============
See Notes to Condensed Consolidated Financial Statements.
3
CONVERSION SERVICES INTERNATIONAL, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three months ended June 30, Six months ended June 30,
------------------------------ ------------------------------
2005 2004 2005 2004
------------- ------------- ------------- -------------
(Restated) (Restated)
REVENUE:
Services $ 5,417,199 $ 5,516,838 $ 10,432,492 $ 9,751,309
Related party services 1,075,235 870,667 2,171,637 1,840,554
Software 387,560 128,523 680,928 128,523
Support and maintenance 496,003 -- 928,008 --
Other 30,250 -- 65,720 57,679
------------- ------------- ------------- -------------
7,406,247 6,516,028 14,278,785 11,778,065
COST OF REVENUE:
Services 3,860,470 3,658,907 7,389,066 6,732,147
Related party services 923,596 718,978 1,935,454 1,475,602
Software 51,512 1,740 95,962 1,740
Support and maintenance 13,068 -- 26,136 --
Other -- -- -- 9,436
------------- ------------- ------------- -------------
4,848,646 4,379,625 9,446,618 8,218,925
------------- ------------- ------------- -------------
GROSS PROFIT 2,557,601 2,136,403 4,832,167 3,559,140
------------- ------------- ------------- -------------
OPERATING EXPENSES
Selling and marketing 1,566,764 785,943 3,093,987 1,367,368
General and administrative 1,622,275 1,782,127 3,562,410 3,195,079
Research and development 234,445 -- 476,121 --
Depreciation and amortization 503,906 102,108 935,362 152,352
------------- ------------- ------------- -------------
3,927,390 2,670,178 8,067,880 4,714,799
------------- ------------- ------------- -------------
LOSS FROM OPERATIONS (1,369,789) (533,775) (3,235,713) (1,155,659)
------------- ------------- ------------- -------------
OTHER INCOME (EXPENSE)
Equity in income (losses) from investments 3,393 (14,486) 46,685 (16,088)
Other income (expense) (6,335) 455 (8,526) 7,006
Interest income 33,726 1,429 57,918 1,872
Interest expense (1,952,241) (772,228) (3,317,095) (804,781)
------------- ------------- ------------- -------------
(1,921,457) (784,830) (3,221,018) (811,991)
------------- ------------- ------------- -------------
LOSS BEFORE INCOME TAXES (BENEFIT) AND MINORITY INTEREST (3,291,246) (1,318,605) (6,456,731) (1,967,650)
INCOME TAXES (BENEFIT) -- (244,278) -- (459,878)
------------- ------------- ------------- -------------
LOSS BEFORE MINORITY INTEREST (3,291,246) (1,074,327) (6,456,731) (1,507,772)
MINORITY INTEREST 20,942 -- 51,644 --
------------- ------------- ------------- -------------
NET LOSS $ (3,270,304) $ (1,074,327) $ (6,405,087) $ (1,507,772)
============= ============= ============= =============
Basic $ (0.00) $ (0.00) $ (0.01) $ (0.00)
Diluted $ (0.00) $ (0.00) $ (0.01) $ (0.00)
Weighted average shares used to compute net loss per share:
Basic 785,160,730 680,777,170 779,060,270 627,289,684
Diluted 785,160,730 680,777,170 779,060,270 627,289,684
See Notes to Condensed Consolidated Financial Statements.
4
CONVERSION SERVICES INTERNATIONAL, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six months ended June 30,
----------------------------
2005 2004
------------ ------------
(Restated)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (6,405,087) $ (1,507,772)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization 112,611 43,652
Amortizaton of intangible assets 630,981 116,233
Amortization of discount on debt 1,873,265 --
Amortization of warrants issued 663,474 --
Amortization of deferred financing costs 191,772 --
Deferred taxes -- (459,879)
Compensation expense for stock options and stock issued 20,994 89,000
Non-cash beneficial conversion feature charge -- 666,667
Allowance for doubtful accounts 4,148 65,368
Write-off deferred loan costs -- 24,862
Loss on disposal of equipment -- 35,496
(Income) loss from equity investments (47,118) 16,088
Minority interest (51,644) --
Changes in operating assets and liabilities:
(Increase) decrease in accounts receivable 36,379 (1,133,077)
Increase in accounts receivable from related parties (278,953) --
Increase in prepaid expenses (67,354) (63,339)
Increase in cost in excess of billings -- (26,428)
Increase in due from stockholders -- (2,731)
(Increase) decrease in other assets (101,876) 14,721
Increase (decrease) in accounts payable and accrued expenses (588,811) 642,566
Increase in deferred revenue 431,983 49,244
------------ ------------
Net cash used in operating activities (3,575,236) (1,429,329)
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of property and equipment (33,791) (186,389)
Investment in DeLeeuw Associates, net of cash acquired -- (2,010,266)
Investment in Evoke Software Corp., net of cash acquired -- 466,583
Equity investment in Leading Edge Communications Corp. -- (83,000)
------------ ------------
Net cash used in investing activities (33,791) (1,813,072)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Cash overdraft -- (51,900)
Net advances under line of credit 680,427 2,041,125
Line of credit repayment -- (1,789,110)
Proceeds from stockholder loans to the Company 1,367,914 --
Proceeds from issuance of convertible line of credit notes -- 4,000,000
Deferred loan costs in connection with line of credit -- (30,534)
Principal payments on long-term debt -- (657,882)
Proceeds from sale of Company common stock 1,250,000 --
Principal payments on capital lease obligations (54,274) (44,171)
Principal payments on stockholder loans (53,342) --
Restricted cash 25,457 (83,375)
------------ ------------
Net cash provided by financing activities 3,216,182 3,384,153
------------ ------------
Effect of exchange rate changes on cash and cash equivalents 10,705 --
NET INCREASE (DECREASE) IN CASH (382,140) 141,752
CASH, beginning of period 1,028,146 411,586
------------ ------------
CASH, end of period $ 646,006 $ 553,338
============ ============
See Notes to Condensed Consolidated Financial Statements.
5
CONVERSION SERVICES INTERNATIONAL, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six months ended June 30,
---------------------------
2005 2004
------------ ------------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest $ 91,636 $ 60,046
Cash paid for income taxes -- --
SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIES:
During the six months ended June 30, 2005 and 2004, the
Company entered into various capital lease arrangements
for computer and trade show equipment in the amount
of $33,240 and $227,139, respectively.
On March 4, 2004, the Company acquired DeLeeuw
Associates, Inc. The components and allocations
of the purchase price were based on the fair value of
assets and liabilities acquired as of the acquisition
date. The following assets and liabilities were
obtained as a result of the acquisition.
Accounts receivable $ -- $ 975,000
Approved vendor status (40 month life) -- 539,000
Tradename (indefinite life) -- 722,000
Goodwill -- 15,844,000
Other assets -- 56,000
Current liabilities -- (286,000)
On June 28, 2004, the Company acquired substantially
all of the assets and liabilities of Evoke Software
Corporation. The components and allocations of the
purchase price were based on the fair value of assets
and liabilities acquired as of the acquisition date.
The following assets and liabilities were obtained
as a result of the acquisition.
Customer contracts (Six year life) $ -- $ 1,962,000
Computer software (Three year life) -- 1,381,000
Goodwill -- 10,269,000
Tradename (Indefinite life) -- 651,000
Accounts receivable -- 580,000
Furniture and equipment -- 184,000
Cash -- 497,000
Prepaid expenses -- 78,000
Other assets -- 11,000
Deferred revenue -- (1,254,000)
Deferred compensation -- (443,000)
Other liabilities -- (1,302,000)
Minority interest -- (199,000)
See Notes to Condensed Consolidated Financial Statements.
6
CONVERSION SERVICES INTERNATIONAL, INC.
AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1 - Accounting Policies
Organization and Business
Conversion Services International, Inc. ("CSI") was incorporated in the
State of Delaware and has been conducting business since 1990. CSI and its
subsidiaries (together the "Company") are principally engaged in the information
technology services industry in the following areas: strategic consulting,
business intelligence, data warehousing and data management, on credit, to its
customers principally located in the northeastern United States.
Conversion Services International, Inc., the registrant, was formerly
known as LCS Group, Inc. (LCS). In January 2004, CSI merged with and into a
wholly owned subsidiary of LCS. In connection with this transaction, among other
things, LCS changed its name to "Conversion Services International, Inc."
Basis of Presentation
The accompanying financial statements have been prepared by the Company
and are unaudited. The results of operations for the three and six months ended
June 30, 2005 are not necessarily indicative of the results to be expected for
any future period or for the full fiscal year. In the opinion of management, all
adjustments (consisting of normal recurring adjustments unless otherwise
indicated) necessary to present fairly the financial position, results of
operations and cash flows at June 30, 2005, and for all periods presented, have
been made. Footnote disclosure has been condensed or omitted as permitted in
interim financial statements.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of
the Company and its subsidiaries, Doorways, Inc., DeLeeuw, Evoke Software
Corporation (formerly known as Evoke Asset Purchase Corp. and now known as CSI
Sub Corp. II (DE)), LEC Corporation of NJ and CSI Sub Corp. (DE). All
intercompany transactions and balances have been eliminated in the
consolidation. Investments in business entities in which the Company does not
have control, but has the ability to exercise significant influence (generally
20-50% ownership), are accounted for by the equity method.
Revenue recognition
Services
Revenue from consulting and professional services is recognized at the
time the services are performed on a project by project basis. For projects
charged on a time and materials basis, revenue is recognized based on the number
of hours worked by consultants at an agreed-upon rate per hour. For large
services projects where costs to complete the contract could reasonably be
estimated, the Company undertakes projects on a fixed-fee basis and recognizes
revenues on the percentage of completion method of accounting based on the
evaluation of actual costs incurred to date compared to total estimated costs.
Revenues recognized in excess of billings are recorded as costs in excess of
billings. Billings in excess of revenues recognized are recorded as deferred
revenues until revenue recognition criteria are met. Reimbursements, including
those relating to travel and other out-of-pocket expenses, are included in
revenues, and an equivalent amount of reimbursable expenses are included in cost
of services and are immaterial.
Software
Revenue from software licensing and maintenance and support is recognized
when persuasive evidence of an arrangement exists, delivery has occurred, the
fee is fixed or determinable, and collectibility is reasonably assured. The
Evoke software is delivered by the Company either directly to the customer or to
a distributor on an order by order basis. The software is not sold with any
right of return privileges and, as a result, a returns reserve is not
applicable. The Company recognizes net license revenues based upon the residual
method after all licensed software product has been delivered as prescribed by
Statement of Position 98-9, "Modification of SOP No. 97-2 with Respect to
7
Certain Transactions." The Company recognizes maintenance revenues over the term
of the maintenance contract. The maintenance rates for both license agreements
with and without stated renewal rates are based upon the price when sold
separately. Vendor-specific objective evidence of the fair value of maintenance
for license agreements that do not include stated renewal rates is determined by
reference to the price paid by the Company's customers when maintenance is sold
separately (i.e. the prices paid by customers in connection with renewals).
See Note 19 to the Condensed Consolidated Financial Statements for further
discussion on the Evoke Software business.
Business Combinations
Business combinations are accounted for in accordance with SFAS No. 141,
"Business Combinations" ("SFAS 141"), which requires the purchase method of
accounting for business combinations be followed and in accordance with EITF No.
99-12 "Determination of the Measurement Date for the Market Price of Acquirer
Securities Issued in a Purchase Business Combination" ("EITF 99-12"). In
accordance with SFAS 141, the Company determines the recognition of intangible
assets based on the following criteria: (i) the intangible asset arises from
contractual or other rights; or (ii) the intangible is separable or divisible
from the acquired entity and capable of being sold, transferred, licensed,
returned or exchanged. In accordance with SFAS 141, the Company allocates the
purchase price of its business combinations to the tangible assets, liabilities
and intangible assets acquired based on their estimated fair values. The excess
purchase price over those fair values is recorded as goodwill. Additionally, in
accordance with EITF 99-12, the Company values an acquisition based upon the
market price of its common stock for a reasonable period before and after the
date the terms of the acquisition are agreed to and announced.
Research and development costs
The Company incurs research and development costs related to software
upgrades and the development of new versions of its Evoke Axio software product.
Research and development costs are charged to expense as incurred. Such costs
amounted to $234,445 and $476,121 during the three and six months ended June 30,
2005, respectively.
Accounts receivable
The Company carries its accounts receivable at cost less an allowance for
doubtful accounts. On a periodic basis, the Company evaluates its accounts
receivable and adjusts the allowance for doubtful accounts, when deemed
necessary, based upon its history of past write-offs and collections,
contractual terms and current credit conditions.
Property and equipment
Property and equipment are stated at cost and includes equipment held
under capital lease arrangements. Depreciation, which includes amortization of
leasehold improvements, is computed principally by an accelerated method and is
based on the estimated useful lives of the various assets ranging from three to
seven years. Leasehold improvements are amortized over the shorter of the assets
estimated useful life or the remaining lease term on a straight-line basis. When
assets are sold or retired, the cost and accumulated depreciation are removed
from the accounts and any gain or loss is included in operations.
Expenditures for maintenance and repairs have been charged to operations.
Major renewals and betterments have been capitalized.
Goodwill and intangible assets
Goodwill and intangible assets are accounted for in accordance with SFAS
No. 142 "Goodwill and Other Intangible Assets" ("SFAS 142"). Under SFAS 142,
goodwill and indefinite lived intangible assets are not amortized but instead
are reviewed annually for impairment, or more frequently if impairment
indicators arise. Separable intangible assets that are not deemed to have an
indefinite life will continue to be amortized over their estimated useful lives.
The Company tests for impairment whenever events or changes in circumstances
indicate that the carrying amount of goodwill or other intangible assets may not
be recoverable, or at least annually at December 31 of each year. These tests
are performed at the reporting unit level using a two-step, fair-value based
approach. The first step compares the fair value of the reporting unit with its
8
carrying amount, including goodwill. If the fair value of the reporting unit is
less than its carrying amount, a second step is performed to measure the amount
of impairment loss. The second step allocates the fair value of the reporting
unit to the Company's tangible and intangible assets and liabilities. This
derives an implied fair value for the reporting unit's goodwill. If the carrying
amount of the reporting unit's goodwill exceeds the implied fair value of that
goodwill, an impairment loss is recognized equal to that excess. In the event
that the Company determines that the value of goodwill or other intangible
assets have become impaired, the Company will incur a charge for the amount of
the impairment during the fiscal quarter in which the determination is made.
Goodwill represents the amounts paid in connection with the acquisitions
of Scosys and DeLeeuw. Additionally, as part of the Scosys, DeLeeuw and Evoke
acquisitions, the Company acquired identifiable intangible assets.
Acquired software is amortized on a straight-line basis over an estimated
useful life of three years. Acquired contracts are amortized over a period that
approximates the estimated life of the contracts, based upon the estimated
annual cash flows obtained from those contracts, generally five to six years.
The approved vendor status intangible asset is being amortized over an estimated
life of forty months.
Deferred financing costs
The Company capitalizes costs associated with the issuance of debt
instruments. These costs are amortized on a straight-line basis over the term of
the related debt instruments, which currently range from one to three years.
Discount on debt
The Company has allocated the proceeds received from convertible debt
instruments between the underlying debt instrument and the detachable warrants
and has recorded the discount on the debt instrument due to a beneficial
conversion feature as a deferred charge. This deferred charge is being amortized
to interest expense over the life of the related debt instruments, which
currently range from one to five years.
Stock compensation
The Company follows Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25") in accounting for its
employee stock options. Under APB 25, because the exercise of the Company's
employee stock option equals the market price of the underlying stock on the
date of grant, no compensation expense is recognized in the Company's
consolidated statements of operations. The Company is required under Statement
of Financial Accounting Standards (SFAS) 123, "Accounting for Stock-Based
Compensation", which established a fair value based method of accounting for
stock compensation plans with employees and others to disclose pro forma
financial information regarding option grants made to its employees.
The Company follows EITF No. 96-18, "Accounting for Equity Instruments
That Are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services" ("EITF 96-18") in accounting for stock options
issued to non-employees. Under EITF 96-18, the equity instruments should be
measured at the fair value of the equity instrument issued. During the three
months ended June 30, 2004, the Company granted 650,000 stock options to
non-employee recipients. In compliance with EITF 96-18, the fair value of these
options was determined using the Black-Scholes option pricing model. The Company
is recording the fair value of these options as expense over the three year
vesting period of the options. Compensation expense of $5,200 and $21,000 and
$1,875 and $1,875 was included in the reported results for the three and six
months ended June 30, 2005 and 2004, respectively.
Had the Company determined compensation cost based upon the fair value at
the grant date for its stock options under SFAS No. 123, the Company's net loss
would have changed to the pro forma amounts indicated below:
9
Three months ended June 30, Six months ended June 30,
------------------------------ ------------------------------
2005 2004 2005 2004
------------- ------------- ------------- -------------
Net loss:
As reported $ (3,270,304) $ (1,074,327) $ (6,405,087) $ (1,507,772)
Less: Compensation expense per SFAS 123 (40,299) (6,231) (422,944) (6,231)
------------- ------------- ------------- -------------
Pro forma $ (3,310,603) $ (1,080,558) $ (6,828,031) $ (1,514,003)
============= ============= ============= =============
Net loss per share:
As reported
Basic $ (0.00) $ (0.00) $ (0.01) $ (0.01)
Diluted (0.00) $ (0.00) (0.01) $ (0.01)
Pro forma
Basic $ (0.00) (0.00) $ (0.01) (0.00)
Diluted (0.00) (0.00) (0.01) (0.00)
============= ============= ============= =============
There were no options granted prior to 2004 or during the six month period
ended June 30, 2005. The per share weighted average fair value of stock options
granted during 2004 was $0.16 per share on the date of grant using the
Black-Scholes option-pricing model with the following weighted average
assumptions:
Expected dividend yield 0.0%
Risk-free interest rate 2.5%
Expected volatility 148.0%
Expected option life (years) 3.0
Pro forma information regarding net loss and net loss per share is
required by SFAS 123, as amended by SFAS 148, and has been determined as if the
Company had accounted for its employee stock options under the fair-value
method. The Black-Scholes option pricing model used in this valuation was
developed for use in estimating the fair value of traded options, which have no
vesting restrictions and are fully transferable. Option valuation models require
the input of highly subjective assumptions. The Company's stock-based
compensation has characteristics significantly different from those of traded
options, and changes in the assumptions used can materially affect the fair
value estimate.
Concentrations of credit risk
Financial instruments which potentially subject the Company to
concentrations of credit risk are cash and accounts receivable arising from its
normal business activities. The Company routinely assesses the financial
strength of its customers, based upon factors surrounding their credit risk,
establishes an allowance for doubtful accounts, and as a consequence believes
that its accounts receivable credit risk exposure beyond such allowances is
limited. At June 30, 2005, two customers, LEC, a related party, and Bank of
America comprised approximately 31.9% of the Company's accounts receivable
balance.
The Company maintains its cash with a high credit quality financial
institution. Each account is secured by the Federal Deposit Insurance
Corporation up to $100,000.
Income taxes
The Company accounts for income taxes, in accordance with SFAS No. 109,
"Accounting for Income Taxes" ("SFAS 109") and related interpretations, under an
asset and liability approach that requires the recognition of deferred tax
assets and liabilities for the expected future tax consequences of events that
have been recognized in the Company's financial statements or tax returns. In
estimating future tax consequences, the Company generally considers all expected
future events other than enactments of changes in the tax laws or rates.
The Company records a valuation allowance to reduce the deferred tax
assets to the amount that is more likely than not to be realized. The Company's
current valuation allowance primarily relates to benefits from the Company's
NOL's.
10
Derivatives
The Company accounts for derivatives in accordance with SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133") and
related interpretations. SFAS 133, as amended, requires companies to recognize
all derivative instruments as either assets or liabilities in the balance sheet
at fair value. At June 30, 2005, the Company had not entered into any
transactions which were considered hedges under SFAS 133. The accounting for
changes in the fair value of a derivative instrument depends on: (i) whether the
derivative has been designated and qualifies as part of a hedging relationship,
and (ii) the type of hedging relationship. For those derivative instruments that
are designated and qualify as hedging instruments, a company must designate the
hedging instrument based upon the exposure being hedged as either a fair value
hedge, cash flow hedge or hedge of a net investment in a foreign operation.
Foreign Currency Translation
Local currencies are the functional currencies for Evoke's foreign
subsidiaries. Assets and liabilities are translated using the exchange rates in
effect at the balance sheet date. Income and expenses are translated at the
average exchange rates during the period. Translation gains and losses not
reflected in earnings are reported as a component of stockholders' equity.
Reclassification
Certain amounts in prior periods have been reclassified to conform to the
2005 financial statement presentation.
Use of estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Note 2: Recent Pronouncements
In June 2005, the FASB issued Emerging Issues Task Force ("EITF") No.
04-5, "Determining Whether a General Partner, or the General Partners as a
Group, Controls a Limited Partnership or Similar Entity When the Limited
Partners Have Certain Rights". EITF No. 04-5 replaces counterpart requirements
in SOP 78-9, which provides guidance on accounting for investments in
real-estate ventures and limited partnerships. Under EITF No. 04-5, the general
partner's control would be overcome if the limited partners have either
"kick-out rights"- the right to dissolve or liquidate the partnership or
otherwise remove the general partner "without cause" or participating rights -
the right to effectively participate in significant decisions made in the
ordinary course of the partnership's business. The kick-out rights and the
participating rights must be substantive in order to overcome the general
partner's control. EITF 04-5 is effective after June 29, 2005. The Company does
not believe that the adoption of EITF 04-5 will have a material effect on the
consolidated results of operations
The FASB issued Staff Position FIN46(R)-5, Implicit Variable Interests
Under FASB Interpretation No. 46 (revised December 2003), in March 2005. It
addresses whether a reporting enterprise should consider whether it holds an
implicit variable interest in a variable interest entity ("VIE") or potential
VIE when specific conditions exist. The Company does not expect any impact on
its financial position or results of operations as a result of its adoption of
FIN 46(R)-5 in the second quarter of 2005.
The FASB issued Staff Position FIN 47, Accounting for Conditional Asset
Retirement Obligations, an interpretation of FASB Statement No. 143, in March
2005. The Interpretation is effective no later than the end of fiscal years
ending after December 15, 2005. The statement clarifies the term "conditional
asset retirement obligation" as used in FASB 143. The Company believes that it
is already in compliance with the statement and does not expect any impact on
financial position or results of operations when adopted.
The FASB issued Statement of Financial Accounting Standard No. 123
(revised 2004), Share-Based Payment ("SFAS 123(R)"), in December 2004; it
replaces SFAS 123, and supersedes APB 25. Under SFAS 123(R), companies would
have been required to implement the standard as of the beginning of the first
interim reporting period that begins after June 15, 2005. However, in April
2005, the SEC announced the adoption of an Amendment to Rule 4-01(a) of
Regulation S-X regarding the compliance date for SFAS 123(R) that amends the
compliance dates and allows companies to implement SFAS 123(R) beginning with
the first annual reporting period beginning on or after June 15, 2005. The
Company intends to adopt SFAS 123(R) in its fiscal year beginning January 1,
2006.
11
The Company currently uses the intrinsic value method to value stock
options, and accordingly, no compensation expense has been recognized for stock
options since the Company grants stock options with exercise prices equal to the
Company's common stock market price on the date of the grant. SFAS 123(R)
requires the expensing of all stock-based compensation, including stock options
and restricted shares, using the fair value method. The Company intends to
expense stock options using the Modified Prospective Transition method as
described in SFAS 123(R). This method will require expense to be recognized for
stock options over their respective remaining vesting periods. No expense will
be recognized for stock options vested in periods prior to the adoption of SFAS
123(R). The Company is evaluating the impact of its adoption of SFAS 123(R) on
its results of operations and financial position. Adoption is not expected to
have a material effect on the Company's financial position or results of
operations.
The FASB issued Statement of Financial Accounting Standard No. 151,
Inventory Costs -- an amendment of ARB No. 43, Chapter 4 ("SFAS 151"). SFAS 151
is effective, and will be adopted, for inventory costs incurred during fiscal
years beginning after June 15, 2005 and is to be applied prospectively. SFAS 151
amends the guidance in ARB No. 43, Chapter 4, Inventory Pricing, to require
current period recognition of abnormal amounts of idle facility expense,
freight, handling costs and wasted material (spoilage). Adoption is not expected
to have a material effect on the Company's financial position or results of
operations.
The FASB issued Statement of Financial Accounting Standard No. 153,
Exchanges of Nonmonetary Assets -- an amendment of APB Opinion No. 29 ("SFAS
153"). SFAS 153 is effective, and will be adopted, for nonmonetary asset
exchanges occurring in fiscal periods beginning after June 15, 2005 and is to be
applied prospectively. SFAS 153 eliminates the exception for fair value
treatment of nonmonetary exchanges of similar productive assets and replaces it
with a general exception for exchanges of nonmonetary assets that do not have
commercial substance. A nonmonetary exchange has commercial substance if the
future cash flows of the entity are expected to change significantly as a result
of the exchange. Adoption is not expected to have a material effect on the
Company's financial position or results of operations.
The FASB issued Statement of Financial Accounting Standards No. 154,
Accounting Changes and Error Corrections -- a replacement of APB Opinion No. 20
and FASB Statement No. 3 ("SFAS 154"). SFAS 154 is effective, and will be
adopted, for accounting changes made in fiscal years beginning after December
15, 2005 and is to be applied retrospectively. SFAS 154 requires that
retroactive application of a change in accounting principle be limited to the
direct effects of the change. Adoption is not expected to have a material effect
on the Company's financial position or results of operations.
Note 3 - Property and equipment
Property and equipment consisted of the following:
June 30,
2005
-----------------
Computer equipment $ 993,240
Furniture and fixtures 221,282
Leasehold improvements 221,219
------------------
1,435,741
Accumulated depreciation (896,039)
-----------------
$ 539,702
=================
Depreciation and amortization expense related to property and equipment totaled
$57,000 and $112,600 and $27,000 and $43,700 for the three and six months ended
June 30, 2005 and 2004, respectively.
12
Note 4 - Intangible assets
Intangibles acquired have been assigned as follows:
June 30, Amortization
2005 period
------------------------------
Customer contracts $ 1,876,424 5 - 6 years
Approved vendor status 538,814 40 months
Computer software 1,381,000 3 years
Tradename 722,000 Indefinite
Proprietary rights and rights to the name of Scosys, Inc. 20,000 Indefinite
--------------
4,538,238
Accumulated amortization (1,542,122)
--------------
$ 2,996,116
==============
The estimated amortization expense for the next five years related to other
finite-lived intangible assets is estimated to be as follows:
Amortization of
Intangible assets
-------------------
2006 $ 812,293
2007 925,603
2008 362,776
2009 103,832
2010 49,612
Thereafter --
-------------------
$ 2,254,116
===================
Note 5 - Deferred financing costs
The Company has incurred and capitalized financing costs in connection
with two financing transactions consummated during 2004. These costs were
deferred and are being amortized over the life of the related financing
agreement. The following illustrates the components of the deferred financing
costs:
June 30, 2005
---------------
Laurus Master Fund $ 766,270
Sands Brothers 127,039
----------------
$ 893,309
Accumulated amortization (318,539)
---------------
$ 574,770
===============
Note 6 - Discount on debt
The Company has allocated the proceeds received from convertible debt
instruments between the underlying debt instrument and the detachable warrants
and has recorded the discount on the debt instrument due to a beneficial
conversion feature as a deferred charge. This deferred charge is being amortized
to interest expense over the life of the related debt instruments, which
currently range from one to five years. The following illustrates the components
of the discount on debt:
13
June 30, 2005 Amortization period
----------------------------------------
Laurus Master Fund $ 5,835,765 3 years
Sands Brothers 454,545 1 year
Taurus Advisory Group 1,500,000 5 years
-----------------
7,790,310
Accumulated amortization (2,109,155)
-----------------
$ 5,681,155
=================
In May 2005, Laurus Master Fund exercised an option to convert $1,000,000 of
debt into equity of the Company and the Company issued 7,142,857 shares of
Company common stock to Laurus. As a result of this transaction, $514,286 of the
discount on debt established in August 2004 was charged to interest expense and
a new discount on debt was established for $899,850 which will be amortized to
interest expense on a monthly basis from May 2005 to August 2007.
Note 7 - Line of credit
The Company has a revolving line of credit with Laurus Master Fund, Ltd.
("Laurus"), whereby the Company has access to borrow up to $6.0 million based
upon eligible accounts receivable. This revolving line, effectuated through a
$2.0 million convertible minimum borrowing note and a $4.0 million revolving
note, provides for advances at an advance rate of 90% against eligible accounts
receivable, with an annual interest rate of prime rate (as reported in the Wall
Street Journal, which was 6.0% as of June 30, 2005) plus 1%, and maturing in
three years. We have no obligation to meet financial covenants under the $2.0
million convertible minimum borrowing note or the $4.0 million revolving note.
These notes will be decreased by 1.0% for every 25% increase above the fixed
conversion price prior to an effective registration statement and 2.0%
thereafter up to a minimum of 0.0%. This line of credit is secured by
substantially all the corporate assets. Both the $2.0 million convertible
minimum borrowing note and the $4.0 million revolving note provide for
conversion at the option of the holder of the amounts outstanding into the
Company's common stock at a fixed conversion price of $0.14 per share. In the
event that the Company issues common stock or derivatives convertible into
Company common stock for a price less than the aforementioned fixed conversion
price, then the fixed conversion price is reset using a weighted average
dilution calculation.
Additionally, in exchange for a secured convertible term note bearing
interest at prime rate (as reported in the Wall Street Journal) plus 1%, Laurus
has made available to the Company an additional $5.0 million to be used for
acquisitions. We have no obligation to meet financial covenants under the $5.0
million secured convertible term note (See Note 9 to the Condensed Consolidated
Financial Statements). This note is convertible into Company common stock at a
fixed conversion price of $0.14 per share. In the event that the Company issues
Company common stock or derivatives convertible into Company common stock for a
price less than the fixed conversion price, then the fixed conversion price is
reset to the lower price on a full-ratchet basis. This note matures in three
years. This cash will be restricted for use until approved acquisition targets
identified by the Company are approved by Laurus.
The Company issued Laurus a common stock purchase warrant that provides
Laurus with the right to purchase 12.0 million shares of the Company's common
stock. The exercise price for the first 6.0 million shares acquired under the
warrant is $0.29 per share, the exercise price for the next 3.0 million shares
acquired under the warrant is $0.31 per share, and the exercise price for the
final 3.0 million shares acquired under the warrant is $0.35 per share. The
common stock purchase warrant expires on August 16, 2011.
As of June 30, 2005, approximately $3.4 million was outstanding under the
revolving line of credit. The interest rate on the revolving line and the
acquisition note was 7.0% as of June 30, 2005. During May 2005, Laurus exercised
their option to convert $1,000,000 of debt borrowed by the Company under the
minimum borrowing note into common stock of the Company at an exercise price of
$0.14 per share. As a result of this exercise, the Company issued 7,142,857
shares of common stock to Laurus. This conversion provided the Company with the
ability to borrow an additional $1,000,000 under the revolving line of credit.
Under the Laurus agreement, the Company was obligated to ensure that the
shares provided for issuance under the agreement were properly registered by
December 19, 2004. As a result of the Company's Registration statement not being
declared effective prior to this date, and not being effective as of March 31,
2005, the Company is incurring liquidated damages to Laurus. As a result, the
Company has accrued $0.44 million for payment of these penalties through June
30, 2005.
14
See Note 19 to the Condensed Consolidated Financial Statements for
further discussion of the Laurus transaction.
Note 8 - Notes Payable
In September 2004, the Company issued to Sands Brothers Venture Capital
LLC, Sands Brothers Venture Capital III LLC and Sands Brothers Venture Capital
IV LLC (collectively, "Sands") three subordinated secured convertible promissory
notes equaling $1.0 million (the "Notes"), each with an annual interest rate of
8% expiring September 22, 2005. The Notes are secured by substantially all
corporate assets, but subordinate to Laurus. The Notes are convertible into
shares of the Company's common stock at the election of Sands at any time
following the consummation of a convertible debt or equity financing with gross
proceeds of $5 million or greater (a "Qualified Financing"). The Company also
issued Sands three common stock purchase warrants (the "Warrants") providing
Sands with the right to purchase 6.0 million shares of the Company's common
stock. The exercise price of the shares of the Company's common stock issuable
upon exercise of the Warrants shall be equal to a price per share of common
stock equal to forty percent (40%) of the price of the securities issued
pursuant to a Qualified Financing. If no Qualified Offering has been consummated
by September 8, 2005, then Sands may elect to exercise the Warrants at a fixed
conversion price of $0.14 per share. The latest that the Warrants may expire is
September 8, 2008.
15
Note 9 - Long term debt
June 30,
2005
-------------------
Secured convertible term note with a maturity date of
August 16, 2007 unless converted into common stock at
the note holder's option. The initial conversion price
is $0.14 per share. Interest accrues at a rate of prime
plus one percent. As of June 30, 2005, the interest
rate on this note was 7.0%. See note 7 - Line of credit
and note 19 - subsequent events, for further
description of this transaction. $ 5,000,000
Convertible line of credit note with a maturity date of
June 6, 2009 unless converted into common stock at the
Company or the note holder's option. Interest accrues
at 7% per annum. The original conversion price to
shares of common stock is equal to 75% of the average
trading price for the prior ten trading days. In
September 2004, the price was reset to $0.105 per
share. A warrant to purchase 4,166,666 shares of
Company common stock was also issued. The exercise
price of the warrant is $0.14 per share and the warrant
expires on June 6, 2009. An allocation of the relative
fair value of the warrant and the debt instrument was
performed. The relative fair value of the warrant was
determined to be $500,000 and is being amortized to
interest expense over the life of the note. A discount
on debt issued of $1,500,000 was recorded in September
2004 based on the reset conversion terms. 2,000,000
Notes payable under capital lease obligations payable
to various finance companies for equipment at varying
rates of interest, ranging from 18% to 32% as of June
30, 2005, and have maturity dates through 2008. 196,332
-------------------
7,196,332
Relative fair values ascribed to warrants associated
with the above debt agreements. This amount is being
accreted to the debt instrument over the term of the
related debt agreements, which range from three to five
years. (1,837,526)
Subtotal -------------------
5,358,806
Less: Current portion of long-term debt, including
obligations under capital leases of $133,527. (133,527)
------------------
$ 5,225,279
==================
Future annual payments of long-term debt is as follows:
Years Ending June 30,
---------------------
2006 $ 133,527
2007 5,052,035
2008 10,770
2009 2,000,000
-------------------
$ 7,196,332
===================
16
Obligations under Capital Leases
The Company has entered into various capital leases that are
collateralized by computer equipment and a trade show booth with an original
cost of approximately $387,862.
The following schedule lists future minimum lease payments under the
capital leases with their present value as of June 30, 2005:
Years Ending June 30,
---------------------
2006 $ 161,997
2007 57,746
2008 11,243
-----------------
230,986
Less: Amount representing interest (34,654)
-----------------
$ 196,332
=================
During the three and six months ended June 30, 2005 and 2004, the Company
recorded depreciation expense related to equipment under capital leases of
approximately $26,000 and $51,100 and $4,700 and $9,400, respectively.
Note 10 - Income Taxes
The Company's provision for income taxes is based on estimated effective
annual income tax rates. The provision may differ from income taxes currently
payable because certain items of income and expense are recognized in different
periods for financial statement purposes than for tax return purposes.
The Company evaluates the amount of deferred tax assets that are recorded
against expected taxable income over its forecasting cycle which is currently
two years. As a result of this evaluation, the Company has recorded a valuation
allowance of $13.7 million for the six months ended June 30, 2005. This
allowance was recorded because, based on the weight of available evidence, it is
more likely than not that some, or all, of the deferred tax asset may not be
realized. As of June 30, 2004, the Company had recorded a deferred tax asset of
$687,576.
During 2005, the Company's effective tax rate is estimated to be
approximately 40%. This rate is based upon the statutory federal income tax rate
of 34% plus a blended rate for the various states in which the Company incurs
income tax liabilities, net of the federal income tax benefit for state taxes
paid, of 6%.
Note 12 - Stock Based Compensation
The 2003 Incentive Plan ("2003 Plan") authorizes the issuance of up to
100,000,000 shares of common stock for issuance upon exercise of options. It
also authorizes the issuance of stock appreciation rights. The options granted
may be a combination of both incentive and nonstatutory options, generally vest
over a three year period from the date of grant, and expire ten years from the
date of grant.
To the extent that CSI derives a tax benefit from options exercised by
employees, such benefit will be credited to additional paid-in capital when
realized on the Company's income tax return. There were no tax benefits realized
by the Company during 2005 or 2004.
17
The following summarizes the stock option transactions under the 2003 Plan
during 2005:
Shares Weighted average
------------------ ------------------
Options outstanding at December 31, 2004 41,265,981 $ 0.15
Options granted -- --
Options exercised -- --
Options canceled (4,765,000) 0.18
------------------ ------------------
Options outstanding at June 30, 2005 36,500,981 $ 0.15
================== ==================
The following table summarizes information concerning outstanding and
exercisable Company common stock options at June 30, 2005:
Range of exercise Options Weighted Weighted average Options exercisable Weighted
------------------------------------------------------------------------------------------------
$0.055 8,900,981 $ 0.055 9.3 8,900,981 $ 0.055
$0.165 - $0.23 27,600,000 0.180 8.9 9,758,325 0.176
---------- ----------
36,500,981 18,659,306
========== ==========
Note 13 - Loss Per Share
Basic loss per share is computed on the basis of the weighted average
number of common shares outstanding. Diluted loss per share is computed on the
basis of the weighted average number of common shares outstanding plus the
effect of outstanding stock options using the "treasury stock" method.
Basic and diluted loss per share were determined as follows:
For the three months ended For the six months ended
June 30, June 30,
------------------------------ ------------------------------
2005 2004 2005 2005
------------- ------------- ------------- -------------
(Restated) (Restated)
Net loss available for common stockholders (A) $ (3,270,304) $ (1,074,327) $ (6,405,087) $ (1,507,772)
Weighted average outstanding shares of common stock (B) 785,160,730 680,777,170 779,060,270 627,289,684
Common stock and common stock equivalents (C) 785,160,730 680,777,170 779,060,270 627,289,684
Loss per share:
Basic (A/B) $ (0.00) $ (0.00) $ (0.01) $ (0.00)
============= ============= ============= =============
Diluted (A/C) $ (0.00) $ (0.00) $ (0.01) $ (0.00)
============= ============= ============= =============
For the three and six months ended June 30, 2005, 36,500,981 shares
attributable to outstanding stock options were excluded from the calculation of
diluted loss per share because the effect was antidilutive. Additionally, the
effect of 22,166,666 warrants which were issued on June 7, 2004, August 16, 2004
and September 22, 2004 were excluded from the calculation of diluted loss per
share for the three and six months ended June 30, 2005 because the effect was
antidilutive.
Note 14 - Major Customers
During the three and six months ended June 30, 2005, the Company had sales
to two major customers, LEC, a related party (14.5% and 15.2%), which totaled
approximately $1,075,235 and $2,171,637 and Bank of America (22.6% and 23.5%),
which totaled approximately $1,674,341 and $3,351,779, respectively. Amounts due
from LEC were approximately $1,060,000 and from Bank of America were
approximately $651,000 at June 30, 2005. As of June 30, 2005, LEC and Bank of
America accounted for approximately 19.8% and 12.1% of the Company's accounts
receivable balance, respectively.
18
During the three months ended June 30, 2004, the Company had sales to
three major customers; LEC, a related party (10.5%), which totaled approximately
$870,667; Bank of America (18.9%), which totaled approximately $1,130,000; and
Pfizer (13.0%), which totaled approximately $775,300. Amounts due from LEC, and
included in accounts receivable, were approximately $703,000 (16.0% of the
accounts receivable balance) at June 30, 2004. Additionally, amounts due from
Bank of America, and included in accounts receivable, were approximately
$422,000 (9.6% of the accounts receivable balance) at June 30, 2004 and amounts
due from Pfizer, and included in accounts receivable, were approximately
$528,000 (12.0% of the accounts receivable balance) at June 30, 2004.
During the six months ended June 30, 2004, the Company had sales to two
major customers; LEC, a related party (15.6%), which totaled approximately
$1,840,554 and Bank of America (14.2%), which totaled approximately $1,676,000.
Note 15 - Commitments and Contingencies
Legal Proceedings
On June 29, 2004, Viant Capital LLC commenced legal action against the
Company in the United States District Court for the Southern District of New
York. Through an agreement with Viant, Viant had the exclusive right to obtain
private equity transactions on behalf of the Company from February 18 to May 17,
2004. Viant alleged that it is owed a fee of approximately $450,000 relating to
the Company's loan from a private investor in May 2004. Management believed that
this loan did not qualify as a private equity transaction. This suit was settled
on April 28, 2005 for an immaterial amount.
Lease Commitments
The Company's corporate headquarters are located at 100 Eagle Rock Avenue,
East Hanover, New Jersey 07936, where it operates under an amended lease
agreement expiring December 31, 2010. Our monthly rent with respect to our East
Hanover, New Jersey facility is $26,290. In addition to minimum rentals, the
Company is liable for its proportionate share of real estate taxes and operating
expenses, as defined. DeLeeuw Associates, LLC has an office at Suite 1460,
Charlotte Plaza, 201 South College Street, Charlotte, North Carolina 28244.
DeLeeuw leases this space which has a stated expiration date of December 31,
2005. Our monthly rent with respect to our Charlotte, North Carolina facility is
$2,831.
Evoke leases offices in the following locations: Riata Corporate Park
Building VII, 12357-III Riata Trace Parkway, Austin, Texas; 1900 13th Street,
Boulder, Colorado; and Am Soldnermoos 17, D-85399 Hallbergmoos, Germany. The
expiration dates for these leases are July 2006, July 2006 and May 2005. Monthly
rentals for these offices are $22,872, $5,284 and $2,000, respectively.
Rent expense, including automobile rentals, totaled approximately $196,000
and $401,000 and $94,000 and $200,000 for the three and six months ended June
30, 2005 and 2004, respectively.
The Company is committed under several operating leases for automobiles
that expire during 2007.
Future minimum lease payments due under all operating lease agreements as
of June 30, 2005 are as follows:
Years Ending June 30, Office Automobiles Total
--------------------- ---------- ---------- ----------
2006 658,578 53,589 712,167
2007 327,736 37,786 365,522
2008 299,580 2,120 301,700
2009 299,580 -- 299,580
2010 299,580 -- 299,580
Thereafter 149,790 -- 149,790
---------- ---------- ----------
$2,034,844 $ 93,495 $2,128,339
========== ========== ==========
19
Note 16 - Related Party Transactions
For the three and six months ended June 30, 2005 and 2004, the Company
invoiced LEC $1,075,235 and $2,171,637 and $870,667 and $1,840,554,
respectively, for the services of consultants subcontracted to LEC by the
Company. As of June 30, 2005 and 2004, the Company had accounts receivable due
from LEC of approximately $1,060,000 and $786,232, respectively. There are no
known collections problems with respect to LEC. The majority of their billing is
derived from Fortune 1000 clients. The collection process is slow as these
clients require separate approval on their own internal systems, which extends
the payment cycle. The Company feels confident in the collectibility of these
accounts receivable as the majority of the revenues from LEC derive from Fortune
1000 clients.
On November 10, 2004, the Company and Dr. Michael Mitchell, the former
President, Chief Executive Officer and sole director of LCS, executed a one-year
consulting agreement whereby Dr. Mitchell would perform certain consulting
services on behalf of the Company. Dr. Mitchell will receive an aggregate amount
of $250,000 as compensation for services provided to the Company. As of June 30,
2005, an aggregate amount of $225,000 has been paid to Dr. Mitchell for services
provided under this consulting agreement.
Between December 14, 2004 and June 30, 2005, Scott Newman, our President,
Chief Executive Officer and Chairman, and Glenn Peipert, our Executive Vice
President, Chief Operating Officer and Director, have loaned the Company funds
on an unsecured basis. These loans by Mr. Newman and Mr. Peipert each originally
accrued interest at a simple rate of 3% per annum, and each has a term expiring
on January 1, 2006. On June 16, 2005, the Company's board of directors approved
an increase in the interest rate payable to Messrs. Newman and Peipert for
outstanding loans made by them to the Company from the current 3% per annum to
8% per annum. All new loans to the Company will also bear interest at 8% per
annum. As of June 30, 2005, approximately $639,250 and $993,075 remained
outstanding to Messrs. Newman and Peipert, respectively.
As of March 30, 2005, Messrs. Newman, Peipert and Robert C. DeLeeuw have
agreed to personally support our cash requirements to enable us to fulfill our
obligations through May 1, 2006, to the extent necessary, up to a maximum amount
of $2.5 million. Mr. Newman personally guaranties up to $1.4 million, Mr.
Peipert guaranties up to $0.7 million and Mr. DeLeeuw personally guaranties $0.4
million. We believe that our reliance on such commitment is reasonable and that
Messrs. Newman, Peipert and DeLeeuw have sufficient liquidity and net worth to
honor such commitment. We believe that this written commitment provides us with
the legal right to request and receive such advances. Any loan by Messrs.
Newman, Peipert and DeLeeuw to the Company originally provided for interest at
3% per annum, however, on June 16, 2005, the Company's Board of Directors
approved an increase in the interest rate payable to the shareholder's to 8% per
annum.
As of June 13, 2005, Messrs. Newman and Peipert have agreed to personally
support our cash requirements to enable us to fulfill our obligations through
July 1, 2006, to the extent necessary, up to a maximum amount of $1.5 million.
We believe that our reliance on such commitment is reasonable and that Messrs.
Newman and Peipert have sufficient liquidity and net worth to honor such
commitment. We believe that this written commitment provides us with the legal
right to request and receive such advances from any of these officers. Any loan
by Messrs. Newman and Peipert to the Company would bear interest at 8% per
annum. This amount is in addition to the amounts pledged on the March 30, 2005
support agreement.
Note 17 - Segment Information
The Company has two reportable segments: services and software, which
includes support and maintenance. The services segment includes the Company's
information technology services offerings in the following areas: data
warehousing, business intelligence, management consulting and professional
services to its customers principally located in the northeastern United States.
The Company's acquisitions the assets of Scosys, Inc., DeLeeuw Associates, Inc.
and the equity adjustment related to its equity investment in Leading Edge
Communications Corporation have all been included in the services business
segment. The Company maintains offices for its services business in East
Hanover, New Jersey and Charlotte, North Carolina.
The software segment resulted from the Company's acquisition of
substantially all the assets of Evoke Software Corporation ("Evoke") on June 28,
2004. Evoke is a provider of data discovery, profiling and quality management
software. Evoke's headquarters are in East Hanover, New Jersey and it maintains
development offices in Austin, Texas and Denver, Colorado. Additionally, Evoke
has sales offices in England and Germany. See Note 19 to the Notes to the
Condensed Consolidated Financial Statements for further discussion regarding
this segment.
20
The Company considers all revenues and expenses to be of an operating
nature and, accordingly, allocates them to industry segments regardless of the
profit center in which recorded. Corporate office expenses are allocated to
certain segments based on resources allocated. The accounting policies of the
reportable segments are the same as those described in the summary of
significant accounting policies.
The Company considers reportable segments as business units that offer
different products and are managed separately.
As of and for the three months ended June 30,
----------------------------------------------------------------------------------------
2005 2004
-------------------------------------------- ----------------------------------------
Services Software Consolidated Services Software Consolidated
------------ ------------ ------------ ------------ --------- ------------
(Restated) (Restated)
Net revenues from external customers $ 6,583,837 $ 822,410 $ 7,406,247 $ 6,516,028 $ -- $ 6,516,028
Segment net loss (2,197,570) (1,072,734) (3,270,304) (1,074,327) -- (1,074,327)
Interest income 33,726 -- 33,726 1,429 -- 1,429
Interest expense 1,467,723 484,518 1,952,241 772,228 -- 772,228
Depreciation and amortization 193,657 310,249 503,906 102,108 -- 102,108
Total segment assets 24,266,448 1,239,302 25,505,750 40,569,279 -- 40,569,279
As of and for the six months ended June 30,
----------------------------------------------------------------------------------------
2005 2004
-------------------------------------------- ----------------------------------------
Services Software Consolidated Services Software Consolidated
------------ ------------ ------------ ------------ --------- ------------
(Restated) (Restated)
Net revenues from external customers $ 12,828,952 $ 1,449,833 $ 14,278,785 $ 11,778,065 $ -- $ 11,778,065
Segment net loss (5,456,301) (948,786) (6,405,087) (1,507,772) -- (1,507,772)
Interest income 57,918 -- 57,918 1,872 -- 1,872
Interest expense 1,493,480 823,255 3,317,095 804,781 -- 804,781
Depreciation and amortization 386,486 548,876 935,362 152,352 -- 152,352
Total segment assets 24,266,448 1,239,302 25,505,750 40,569,279 -- 40,569,279
Geographic Information
For the three months ended For the six months ended
June 30, June 30,
------------------------------- -------------------------------
2005 2004 2005 2004
-------------- -------------- -------------- --------------
Revenues:
United States $ 7,257,330 $ 6,516,028 $ 13,997,696 $ 11,778,065
International 148,917 -- 281,089 --
-------------- -------------- -------------- --------------
$ 7,406,247 $ 6,516,028 $ 14,278,785 $ 11,778,065
============== ============== ============== ==============
As of June 30,
-------------------------------
2005 2004
-------------- --------------
Long-lived assets:
United States $ 538,432 --
International 1,270 --
-------------- --------------
$ 539,702 $ --
============== ==============
21
Note 18 - Pro Forma Results of Operations
The following unaudited statement of income reflects the pro-forma consolidated
results of Conversion Services International, Inc., DeLeeuw Associates, LLC and
Evoke Software Corporation for the six months ended June 30, 2004 as if the
entities had been consolidated for the entire six month period.
For the six months ended
June 30, 2004
--------------------
Revenues $ 15,252,681
Net Loss $ (2,825,907)
Net Loss per share $ (0.00)
Note 19 - Subsequent Events
In July 2005, the Company obtained two $250,000 short-term loans from a
third-party investor. Both loans bear interest at 8% per annum. The first loan
is dated July 6, 2005 and matures on September 6, 2005. The second loan is dated
July 22, 2005 and matures on September 22, 2005.
On July 18, 2005, the Company completed the sale of substantially all of
the assets Evoke and received aggregate consideration of $645,000 cash, the
assumption by Similarity Systems and Similarity Vector Technologies, Ltd. of
certain liabilities, 821,053 shares which are issuable by Similarity subject to
the Company's satisfactory completion of certain post-closing obligations, and
an earnout in an amount equal to 13% of certain Similarity revenues. The maximum
earnout consideration to which the Company is entitled under this agreement is
$1,400,000 and would be received over a three year period. CSI changed the name
of its "Evoke Software Corporation" subsidiary to "CSI Sub Corp II (DE)" in
August 2005. Also in July 2005, the Company issued 4,293,058 shares of Company
common stock to former Evoke employees and stockholders in accordance with the
June 2004 Evoke acquisition agreement.
On July 22, 2005, the Company entered into (and simultaneously
consummated) a merger agreement with McKnight Associates. In consideration of
this merger agreement, the Company paid the following consideration: $672,000 in
cash, the commitment to pay an additional $250,000, in cash, in January 2006,
the issuance of 13,636,363 shares of the Company common stock which was valued
on the closing date at $1,500,000, plus the assumption of substantially all of
the liabilities of McKnight.
On July 29, 2005 the Company, entered into (and simultaneously
consummated) an agreement and plan of merger (the "Agreement") with ISI Merger
Corp., a Delaware corporation and wholly owned subsidiary of the Company
("Merger Sub"), Integrated Strategies, Inc., a Delaware corporation ("ISI"), ISI
Consulting, LLC, a Delaware limited liability company ("LLC"), and Adam and
Larry Hock, individual majority stockholders and members of ISI and LLC,
respectively (the "Majority Stockholders"). Pursuant to the Agreement, ISI and
LLC merged with and into Merger Sub and the Company and Merger Sub paid the
following consideration: $2,050,000 in cash (reduced by certain amounts), the
issuance by Merger Sub of a promissory note in the amount of $580,000 (which was
reduced). The issuance by the Company of a subordinated promissory note in the
amount of $165,000, and the assumption of substantially all the liabilities of
ISI and LLC. The Agreement also provides for the commitment, subject to certain
revenue and profit thresholds (as described in the Agreement), to pay additional
cash and issue shares of the Company common stock. On August 1, 2005, Merger Sub
changed its name to Integrated Strategies, Inc.
On July 28, 2005, the Company entered into an amendment to the Securities
Purchase Agreement dated August 16, 2004 between the Company and Laurus Master
Fund ("Laurus"). Pursuant to the amendment, the Company released $4,327,295.08
(the "Funds") to Laurus, which was being held in the Restricted Account (which
was available to the Company for acquisitions) and issued an amended and
restated convertible note in the principal amount of $749,000 (the amount that
was funded through this facility as described in Note 7 to the Condensed
Consolidated Financial Statements). In satisfaction of the balance of the
Accrued Interest ($184,403) and any liquidated damages to which it was entitled
pursuant the Registration Rights Agreement entered into in August 2004, the
Company issued an option to purchase 5,000,000 shares of the Company's common
stock at a purchase price of $.001 per share. Laurus exercised the option to
purchase Company stock on August 1, 2005. Laurus also agreed to extend the
required filing date and effective date of the Registration Statement.
22
The Company also issued an amended and restated convertible secured
revolving note in the principal amount of $4,500,000 in favor of Laurus which
amended the $4 Million Revolving Note described in Note 7 to the Notes to the
Condensed Consolidated Financial Statements. In connection with this note, the
Company and Laurus entered into an Overadvance Letter Agreement, pursuant to
which Laurus made a loan to the Company in excess of the amount available using
the Company accounts receivable as collateral in the principal amount of
$2,700,000. The Company also entered into an agreement which reaffirms and
ratifies its obligations to Laurus in connection with a Master Security
Agreement, a Stock Pledge Agreement and Security Agreement, each of which were
entered into in August 2004. Pursuant to this agreement, the Company agreed to
cause ISI Merger Corp. within 5 days of the date of its acquisition by the
Company, and McKnight Associates (also recently acquired by the Company) to
execute a Joinder Agreement, pursuant to which ISI Merger Corp. and McKnight
Associates will agree to become a party to a Subsidiary Guaranty and the
Security Agreements. The Company utilized a portion of the $2,700,000 which was
advanced to it by Laurus to acquire Integrated Strategies, Inc. and ISI
Consulting, LLC. As a result of the restructuring of the Laurus debt, the
Company expects to record charges in the September 2005 quarter to write off the
unamortized discount on debt originally recorded in August 2004. Since the
revolving line of credit is still convertible into equity of the Company under
the new arrangement, the Company may need to record additional discount on debt
pertaining to the new transactions for the quarter ended September 2005.
On August 1, 2005, Sridhar Bhupatiraju and Scosys, Inc. commenced legal
action against the Company in the Superior Court of New Jersey. The complaint
alleges, among other things, the Company's failure to make certain payments
pursuant to an asset purchase agreement with Scosys, Inc. and the Company's
failure to make certain payments to Sridhar Bhupatiraju in accordance with his
employment agreement with the Company. The plaintiff's are seeking unspecified
compensatory damages, punitive damages, fees and other costs. Management
believes this suit to be without merit and intends to vigorously defend the
Company against this action.
On August 8, 2005, the stockholders of the Company approved an amendment
of the Company's Certificate of Incorporation to effect a reverse split of the
Company's issued and outstanding common stock, par value $0.001 per share, of
between a one-for-ten and a one-for-fifty reverse stock split in the discretion
of the Board of Directors and to reduce the amount of the Company's authorized
Common Stock from one billion to between twenty million and one hundred million,
in the discretion of the Board of Directors.
23
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Overview of our Business
Management's Discussion and Analysis contains statements that are
forward-looking. These statements are based on current expectations and
assumptions that are subject to risks and uncertainties. Actual results could
differ materially because of factors discussed in "Risk Factors" and elsewhere
in this report. The Company undertakes no duty to update any forward-looking
statement to conform the statement to actual results or changes in the Company's
expectations.
Conversion Services International, Inc. provides professional services to
the Global 2000 as well as mid-market clientele relating to strategic
consulting, data warehousing, business intelligence and data management. This
software is a tool that is used to identify problems with company data prior to
being transferred into a data warehouse. The Company's services based clients
are primarily in the financial services, pharmaceutical, healthcare and
telecommunications industries, although it has clients in other industries as
well. The Company's clients are primarily located in the northeastern United
States. The Company delivers value to its clients, utilizing a combination of
business acumen, technical proficiency, experience and a proven set of "best
practices" methodologies to deliver cost effective services. The Company is
committed to being a leader in data warehousing and business intelligence
consulting, enabling it to be a valuable asset and trusted advisor to its
customers.
The Company began operations in 1990. Its services were originally focused
on e-business solutions and data warehousing. In the late 1990s, the Company
strategically repositioned itself to capitalize on its data warehousing
expertise in the fast growing business intelligence/data warehousing space. The
Company became a public company via its merger with a wholly owned subsidiary of
LCS Group, Inc., effective January 30, 2004.
The Company's core strategy includes capitalizing on the already
established in-house strategic consulting, business intelligence/data
warehousing ("BI/DW") technical expertise and its seasoned sales force. This is
expected to result in organic growth through the addition of new customers. In
addition, this foundation will be leveraged as the Company pursues targeted
strategic acquisitions.
Revenues for the Company are categorized by strategic consulting, business
intelligence, data warehousing, data management, and software and support and
maintenance. They are reflected in the chart below as a percentage of overall
revenues:
Category of Services Percentage of Revenues for the three months Percentage of Revenues for the six months
ended June 30, ended June 30,
2005 2004 2005 2004
--------------------------------------------- --------------------------------------------
Strategic Consulting 31.0% 19.2% 31.7% 13.8%
Business Intelligence 18.8% 29.4% 21.0% 25.2%
Data Warehousing 22.1% 24.9% 20.5% 31.4%
Data Management 15.8% 26.5% 15.0% 29.6%
Software & Support 11.9% 0.0% 11.3% 0.0%
Other 0.4% 0.0% 0.5% 0.0%
Strategic consulting revenues were 31.0% and 31.7% of total revenues for
the three and six months ended June 30, 2005, increasing by 11.8% points and
17.9% points as compared to 19.2% and 13.8% of total revenues for the comparable
prior year periods. During March 2004, the Company acquired DeLeeuw Associates,
whose revenue base is entirely in the strategic consulting category of services
and comprises CSI's entire revenue base in this line of business. For the three
and six months ended June 30, 2005, DeLeeuw revenues were $2.3 million and $4.5
million, respectively, as compared to $1.3 million and $1.6 million for the
three and six months ended June 30, 2004, representing an increase of $1.0
million and $2.9 million, respectively. The increase is mostly attributable to
the doubling of revenues at DeLeeuw's largest client, which represented a $1.6
million increase in billings for the six months ended June 30, 2005 and the
addition of a new client that produced $0.7 million in revenues for that period.
24
The Deleeuw Associates acquisition increased the Company's revenue base
and, as a result, the percentage of revenues contributed by each of the other
services categories were impacted by the increased overall revenues in the
strategic consulting category. The Company intends to continue to focus on
increasing revenues in the strategic consulting, business intelligence and data
warehousing lines of business during 2005 and is de-emphasizing the data
management line of business since this category is less profitable to the
Company than the other service categories. The software line of business was
sold by the Company on July 18, 2005.
Business intelligence service revenues were 18.8% and 21.0% of total
revenues for the three and six months ended June 30, 2005, decreasing by 10.6%
points and 4.2% points as compared to 29.4% and 25.2% of total revenues for the
comparable prior year periods. On an absolute dollar basis, business
intelligence revenues decreased by $0.5 million for the three months ended June
30, 2005 and remained unchanged for the six months ended June 30, 2005 as
compared to the prior year. This decrease is primarily attributable to a 25.2%
decrease in billable hours in this line of business partially offset by an
increase in average billing rates of 11.3% for the three and six months ended
June 30, 2005 versus the prior period, respectively.
Data warehousing revenues were 22.1% and 20.5% of total revenues for the
three and six months ended June 30, 2005, decreasing by 2.8% points and 10.9%
points as compared to 24.9% and 31.4% of total revenues for the comparable prior
year periods. On an absolute dollar basis, data warehousing revenues were
unchanged for the three months ended June 30, 2005 and decreased by $0.7 million
for the six months ended June 30, 2005 as compared to the prior year. This
decrease for the six months ended June 30, 2005 is primarily attributable to an
23.3% decrease in average billing rates in this line of business partially
offset by a 15.2% increase in billable hours for the period versus the same
period in the prior year.
Data management revenues were 15.8% and 15.0% of total revenues for the
three and six months ended June 30, 2005, decreasing by 10.7% points and 14.6%
points as compared to 26.5% and 29.6% of total revenues for the comparable prior
year period. This category of services is less profitable to the Company than
the other service categories and, as a result, is being de-emphasized and the
Company's resources are being focused on the more profitable service categories.
Software and support and maintenance revenues increased from zero for the
three and six months ended June 30, 2004 to 11.9% and 11.3% of revenues for the
three and six months ended June 30, 2005, respectively. This is attributable to
revenues from licensing and support for the Evoke Axio Software which was
acquired by the Company in June 2004 (and subsequently sold on July 18, 2005).
The Company derives a majority of its revenue from professional services
engagements. Its revenue depends on the Company's ability to generate new
business, in addition to preserving present client engagements. The general
domestic economic conditions in the industries the Company serves, the pace of
technological change, and the business requirements and practices of its clients
and potential clients directly affect this. When economic conditions decline,
companies generally decrease their technology budgets and reduce the amount of
spending on the type of information technology (IT) consulting the Company
provides. The Company's revenue is also impacted by the rate per hour it is able
to charge for its services and by the size and chargeability, or utilization
rate, of its professional workforce. During periods of economic decline and
reduced client spending, competition for new engagements increases, and it
becomes more difficult to maintain its billing rates and sustain appropriate
utilization rates. If the Company is unable to maintain its billing rates or
sustain appropriate utilization rates for its professionals, its overall
profitability may decline. The Company is beginning to see improvements in
economic conditions, which have recently led to increased spending on consulting
services in certain vertical markets, particularly in financial services.
As the Company continues to see increases in client spending and
improvements in economic conditions, it will continue to focus on a variety of
growth initiatives in order to improve its market share and increase revenue.
Moreover, as the Company achieves top line growth, the Company will concentrate
its efforts on improving margins and driving earnings to the bottom line. The
Company intends to improve margins by limiting its use of outside consultants,
complementing its service offerings with higher level management consulting
opportunities, and continuously evaluating the size of its workforce in order to
balance the Company's skill base with the market demand for services.
25
In addition to the conditions described above for growing the Company's
current business, the Company will continue to grow through acquisition. One of
the Company's objectives is to make acquisitions of companies offering services
complementary to the Company's lines of business which will accelerate the
Company's business plan at lower costs than it would generate internally and
also improve its competitive positioning and expand the Company's offerings in a
larger geographic area. The service industry is very fragmented, with a handful
of large international firms having data warehousing and/or business
intelligence divisions, and hundreds of regional boutiques throughout the United
States. These smaller firms do not have the financial wherewithal to scale their
businesses or compete with the larger players, and the Company believes that the
service industry as a whole is ready for consolidation. The Company will
continue to aggressively pursue these firms, adding new geographies, areas of
expertise and verticals to its current business. These acquisitions will likely
be consummated with a combination of cash and stock. Some of these acquisitions
may hinge upon future financings.
During the three and six month periods ended June 30, 2005, two of the
Company's clients, LEC, a related party, accounted for approximately 14.5% and
15.2% and Bank of America accounted for approximately 22.6% and 23.5% of total
revenues, respectively. For the three months ended June 30, 2004, three of our
clients; LEC, a related party, (10.5%), Bank of America (18.9%), and Pfizer
(13.0%) accounted collectively for approximately 42.4% of our total revenues.
For the six months ended June 30, 2004, two of our clients; LEC, a related
party, accounted for approximately 15.6%, and Bank of America accounted for
approximately 14.2% of total revenues.
The Company's most significant costs are personnel expenses, which consist
of consultant fees, benefits and payroll-related expenses.
Results of Operations
The following table sets forth selected financial data for the periods
indicated:
Selected Statement of Selected Statement of
Operations Data for the three months Operations Data for the six months
Ended June 30, Ended June 30,
--------------------------------------- -------------------------------------
2005 2004 2005 2004
-------------------------------------- -------------------------------------
Net sales $ 7,406,247 $ 6,516,028 $ 14,278,785 $ 11,778,065
Gross profit 2,557,601 2,136,403 4,832,167 3,559,140
Net loss (3,270,304) (1,074,327) (6,405,087) (1,507,772)
Net loss per share:
Basic $ (0.00) $ (0.00) $ (0.01) $ (0.00)
Diluted $ (0.00) $ (0.00) $ (0.01) $ (0.00)
Selected Statement of
Financial Position Data for
the three months ended June 30,
--------------------------------
2005
--------------------------------
Working capital $ (4,602,787)
Total assets 25,505,750
Long-term debt 5,225,279
Total stockholders' equity 9,208,874
Three and Six Months Ended June 30, 2005 and 2004
Revenue
The Company's revenues are primarily comprised of billings to clients for
consulting hours worked on client projects. Revenues for the three and six
months ended June 30, 2005 were $7.4 million and $14.3 million, an increase of
$0.9 million, or 13.7% and $2.5 million, or 21.2%, as compared to revenues of
$6.5 million and $11.8 million for the three and six months ended June 30, 2004.
Services
Services revenues for the three and six months ended June 30, 2005 were
$5.4 million and $10.4 million, a decrease of $0.1 million, or 2.0% of services
revenues, and an increase of $0.6 million, or 7.0% of services revenues, as
compared to services revenues of $5.5 million and $9.8 million for the three and
six months ended June 30, 2004, respectively. DeLeeuw Associates, which was
acquired by the Company in March 2004, contributed an additional $2.9 million of
services revenue during the six months ended June 30, 2005 as compared to the
same period in the prior year. Partially offsetting this increase is a reduction
in revenues from services of $2.2 million relating to a decrease in the number
of consultants in the ongoing CSI business. Exclusive of DeLeeuw Associates,
billable hours declined by 38.9% due to an 11.9% reduction in the number of
consultants on billing for the six months ended June 30, 2005 compared to the
same period for the prior year. This decline in the number of consultants was
attributable to both the conversion of our consultants to full time employees of
our clients and a reduction in consultants in the Scosys division due to
resignations.
26
Related party services
Revenues from related parties for the three and six months ended June 30,
2005 were $1.1 million and $2.2 million, an increase of $0.2 million, or 23.5%
of related party revenues, and $0.3 million, or 18.0% of related party revenues,
as compared to related party revenues of $0.9 million and $1.8 million for the
three and six months ended June 30, 2004, respectively. The increase for the six
months ended June 30, 2005 compared to the same period in the prior year, is
primarily attributed to the average increase in billing rates of 18.2% and 14.9%
for the three and six months ended June 30, 2005 versus the same period for the
prior year.
Software
Software revenues are derived from the sale of software licenses
pertaining to the licensing of our Evoke Axio data profiling software. The
assets of Evoke were acquired by the Company in June 2004 (and subsequently sold
on July 18, 2005) and, as a result, the Company has only included revenues since
July 2004. Software revenues recognized in 2004 are the result of reselling
software from certain select vendors.. Revenues from software for the three and
six months ended June 30, 2005 were $0.4 million and $0.7 million as compared to
$0.1 million and $0.1 million in the prior year.
Support and maintenance
Revenues from support and maintenance for the three and six months ended
June 30, 2005 were $0.5 million and $0.9 million, respectively, as compared to
zero for each period, respectively, in the prior year. This increase in revenues
is attributable to support and maintenance revenues derived from the Evoke Axio
Software which was acquired by the Company in June 2004.
Cost of revenue
Cost of revenue primarily includes payroll and benefits costs for the
Company's consultants as well as the cost of software that is sold or licensed
by the company. Cost of revenue was $4.8 million, or 65.5% of revenue and $9.4
million, or 66.2% of revenue, for the three and six months ended June 30, 2005,
respectively, compared to $4.4 million, or 67.2% of total revenue, and $8.2
million, or 69.8% of total revenue, for the three and six months ended June 30,
2004, respectively, representing an increase of $0.4 million, or 10.7%, and $1.2
million, or 14.9%, as compared to the prior year.
Services
Cost of services was $3.9 million, or 71.3% of services revenue, and $7.4
million , or 70.8% of services revenue, for the three and six months ended June
30, 2005, respectively, compared to $3.7 million, or 66.3% of services revenue,
and $6.7 million, or 69.0% of services revenue, for the three and six months
ended June 30, 2004, respectively, representing an increase of $0.2 million, or
5.5%, and $0.7 million, or 9.8%, respectively. DeLeeuw Associates generated a
$1.8 million increase in cost of services, directly associated with its increase
in revenues in this category, for the six month period ended June 30, 2005 as
compared to the same period in the prior year. Additionally, the Company
incurred increased costs during the current quarter due to consultants which
were on payroll, however, were not billable to clients. Partially offsetting
this increase was a reduction in cost of services of $1.1 million resulting from
a 38.9% decrease in billable hours due to an 11.9% reduction in the number of
consultants on billing and a 14.2% increase in the average pay rates for
consultants.
Related party services
Cost of related party services was $0.9 million, or 85.9% of related party
services revenue, and $1.9 million, or 89.1% of related party services revenue,
for the three and six months ended June 30, 2005, respectively, compared to $0.7
million, or 82.6% of related party services revenue, and $1.5 million, or 80.2%
of related party services revenue, for the three and six months ended June 30,
2004, respectively. The increased cost in 2005 reflects the cost of nine
full-time higher level consultants hired for specialized work, but at lower
gross margins than normal.
27
Software
Cost of software includes production costs related to the Evoke Axio
software product. Evoke was acquired by the Company in June 2004. Cost of
software was $52,000, or 13.3% of software revenue and $0.1 million, or 14.1% of
software revenue for the three and six months ended June 30, 2005, respectively,
compared to $2,000 and $2,000 for the three and six months ended June 30, 2004,
respectively. In 2005, cost of software related to the cost of the Evoke
Software revenues. In 2004, cost of software is the result of reselling software
from certain select vendors.
Support and maintenance
Cost of support and maintenance includes costs associated with resolving
customer inquiries. Cost of support and maintenance was $13,000, or 2.6% of
support and maintenance revenue, and $26,000, or 2.8% of support and maintenance
revenues, for the three and six months ended June 30, 2005, respectively, as
compared to zero for the prior year. The current year cost of support and
maintenance is entirely attributable to Evoke Software which was acquired by the
Company in June 2004 (and subsequently sold on July 18, 2005).
Gross Profit
Gross profit was $2.6 million, or 34.5% of total revenue, and $4.8
million, or 33.8% of total revenue, for the three and six months ended June 30,
2005, compared to $2.1 million, or 32.8% of total revenue, and $3.6 million, or
30.2% of total revenue, for the three and six months ended June 30, 2004,
respectively.
As a percentage of total gross profit for the three and six months ended
June 30, 2005 and 2004, services contributed 60.9% and 87.0% and 63.0% and
84.8%, respectively, related party services contributed 5.9% and 7.1% and 4.9%
and 10.3%, respectively, software contributed 13.1% and 5.9% and 12.1% and 3.6%,
respectively, support and maintenance 18.9% and zero and 18.7% and zero,
respectively, and other contributed 1.2% and zero and 1.4% and 1.3%,
respectively.
Services
Gross profit from services was $1.6 million, or 28.7% of services revenue,
and $3.0 million, or 29.2% of services revenue, for the three and six months
ended June 30, 2005, a decrease of $0.3 million and zero, as compared to $1.9
million, or 33.7% of services revenue, and $3.0 million, or 31.0% of services
revenue, for the three and six months ended June 30, 2004, respectively. The
5.0% point decline in gross profit for the three month period is primarily due
to an 11.5% increase in the average pay rate to the consultants and 36.1% fewer
billable hours in the current period as compared to the prior year. The
reduction in billable hours is the result of an 11.9% reduction in the number of
consultants on billing. The 2.0% point decline in the gross profit for the six
month period is primarily due to a 14.2% increase in the average pay rate to
consultants and a 38.9% reduction in the billable hours in the current period as
compared to the prior year. The reduction in the billable hours is due to a
27.0% reduction in the number of consultants on billing.
Related party services
Gross profit for related party services was $0.2 million, or 14.1% of
related party services revenue, and $0.2 million, or 10.9% of related party
services revenue, for the three and six months ended June 30, 2005, compared to
$0.2 million, or 17.4% of related party services revenue, and $0.4 million, or
19.8% of related party services revenue, for the three and six months ended June
30, 2004, respectively. The decline in the related party services gross profit
percentage is due to the increased costs of the full-time employees hired by
Company as compared to the part-time employees and the reduced billing rates
being realized on these consultants during the three and six months ended June
30, 2005. The average pay rate to consultants increased by 23.5% and 24.9% for
the three and six months ended June 30, 2005 versus the same period in the prior
year.
Software
Gross profit resulting from software was $0.3 million, or 86.7% of
software revenue, and $0.6 million, or 85.9% of software revenue, for the three
and six months ended June 30, 2005, compared to $0.1 million, or 98.6% of
software revenue, and $0.1 million, or 98.6% of software revenue, for the three
and six months ended June 30, 2004, respectively.
28
Support and maintenance
Gross profit for support and maintenance was $0.5 million, or 97.4% of
support and maintenance revenue, and $0.9 million, or 97.2% of support and
maintenance revenue, for the three and six months ended June 30, 2005,
respectively, as compared to zero in the prior year's comparable periods. The
gross profit for support and maintenance is attributable to the Company's
acquisition of Evoke Software in June 2004.
Selling and marketing
Selling and marketing expenses include payroll, employee benefits and
other headcount-related costs associated with sales and marketing personnel and
advertising, promotions, tradeshows, seminars and other programs. Selling and
marketing expenses for the three and six months ended June 30, 2005 were $1.6
million, or 21.2% of revenue, and $3.1 million, or 21.7% of revenue,
respectively, representing an increase of $0.8 million and $1.7 million,
respectively, as compared to $0.8 million, or 12.1% or revenue, and $1.4
million, or 11.6% of revenue, for the three and six months ended June 30, 2004,
respectively.
The $0.8 million increase for the three months ended June 30, 2005, as
compared to the prior year, is primarily due to $0.4 million of Evoke operating
expenses that were not incurred in the prior year, $0.2 million of marketing
expenses related to increasing the Company's presence in the industry by hiring
the Company's new marketing department and attending trade shows and conferences
during the quarter, and $0.2 million of increased payroll, professional fees and
various other expenses.
The $1.7 million increase for the six months ended June 30, 2005, as
compared to the prior year, is primarily due to $0.9 million of operating
expenses for Evoke that were not incurred in the prior year, $0.3 million of
marketing expenses related to operating the Company's new marketing department
and attending trade shows and conferences, $0.6 million of increased payroll
costs, offset by $0.1 million of various cost reductions.
General and administrative
General and administrative costs include payroll, employee benefits and
other headcount-related costs associated with the finance, legal, facilities,
certain human resources and other administrative headcount, and legal and other
professional and administrative fees. General and administrative costs for the
three and six months ended June 30, 2005 were $1.6 million, or 21.9% of revenue,
and $3.6 million, or 24.9% of revenue, representing a decrease of $0.2 million
and an increase of $0.4 million as compared to $1.8 million, or 27.3% of
revenue, and $3.2 million, or 27.1% of revenue, for the three and six months
ended June 30, 2004, respectively.
The $0.2 million decrease for the three month period is primarily due to a
$0.1 million reduction in legal costs as a result of the Company's hiring of a
general counsel which resulted in bringing a large portion of the Company's
legal work in-house, a $0.1 million reduction in bad debt and travel expenses,
and a $0.2 million reduction in payroll and payroll related costs, primarily due
to headcount reductions in the development, administration and DeLeeuw
organizations, as compared to the prior year. These reductions were partially
offset by $0.2 million of increased Evoke operating expenses and various other
expense increases during the quarter.
The $0.4 million increase for the six months ended June 30, 2005 as
compared to the prior year is primarily due to a $0.4 million increase in
expenses related to the operation of Evoke, which was acquired in June 2004, a
$0.2 million increase in payroll and payroll related costs partially resulting
from the Company's funding the operating expenses for DeLeeuw for the entire six
months in the current year, whereas the Company only funded DeLeeuw for four
months in the prior year, and partially due to hiring several administrative
employees and providing annual increases for the Company's general and
administrative staff, and a $0.2 million increase in accounting and professional
fees resulting from the Company's financing and SEC filing transactions. These
increases were partially offset by a $0.1 million decrease in legal costs
resulting from hiring a general counsel, and a $0.2 million decrease in bad debt
and travel expenses during the current period and a $0.1 million reduction due
to recruiting costs incurred during the three months ended March 31, 2004 that
did not recur in 2005.
29
Research and Development
Research and development costs primarily include the payroll, employee
benefits and other headcount-related costs associated with the employees working
on the development of upgrades and new versions of the Evoke Axio software
product. Research and development costs for the three and six months ended June
30, 2005 were $0.2 million, or 3.2% of revenue, and $0.5 million, or 3.3% of
revenue, as compared to zero for the comparative periods in the prior year. The
research and development department was obtained in association with the Evoke
acquisition which was completed in June 2004.
Depreciation and amortization
Depreciation expense is recorded on the Company's property and equipment
which is generally depreciated over a period between three to seven years.
Amortization of leasehold improvements is taken over the shorter of the
estimated useful life of the asset or the remaining term of the lease. The
Company amortizes deferred financing costs utilizing the effective interest
method over the term of the related debt instrument. Acquired software is
amortized on a straight-line basis over an estimated useful life of three years.
Acquired contracts are amortized over a period of time that approximates the
estimated life of the contracts, based upon the estimated annual cash flows
obtained from those contracts, generally five to six years. Depreciation and
amortization expenses for the three and six months ended June 30, 2005 were $0.5
million and $0.9 million, representing an increase of $0.4 million and $0.7
million as compared to $0.1 million and $0.2 million for the three and six
months ended June 30, 2004.
The $0.4 million increase in depreciation and amortization expense for the
three months ended June 30, 2005 is primarily due to $0.3 million of increased
amortization of intangible assets associated with the acquisition of Evoke which
was completed in June 2004. The remaining $0.1 million increase primarily
relates to increased amortization of the Company's deferred financing costs.
The $0.7 million increase in depreciation and amortization expense for the
six months ended June 30, 2005 is primarily due to $0.6 million of increased
amortization of intangible assets associated with the acquisitions of both
DeLeeuw and Evoke in 2004 and $0.1 million of increased amortization of the
Company's deferred financing costs.
Interest Expense
The Company incurs interest expense on loans from financial institutions,
from capital lease obligations related to the acquisition of equipment used in
its business, and on the outstanding convertible line of credit notes.
Amortization of the discount on debt issued of $1.2 million and $1.9 million for
the three and six months ended June 30, 2005 is also recorded as interest
expense. Total interest expense recorded was $2.0 million and $3.3 million for
the three and six months ended June 30, 2005 compared to $0.8 million for each
of the three and six months ended June 30, 2004. This increase relates to the
interest, penalties and discount on debt amortization associated with the
Laurus, Taurus and Sands financing transactions described below in the liquidity
and capital resources section.
Other income (expense)
The Company recorded interest income of $34,000 and $58,000 and other
expense of approximately ($6,300) and ($8,500) for the three and six months
ended June 30, 2005, respectively, compared to interest income of $1,400 and
$1,900 and other income of $500 and $7,000 for the three and six months ended
June 30, 2004. The Company recorded equity income from its investments in
DeLeeuw International (Turkey) and LEC of approximately $3,400 and $47,000 for
the three and six months ended June 30, 2005 as compared to equity losses of
($14,000) and ($16,000) in the comparative prior year period.
Income Taxes
The Company evaluates the amount of deferred tax assets that are recorded
against expected taxable income over its forecasting cycle which is currently
two years. As a result of this evaluation, the Company has recorded a valuation
allowance of $13.7 million as of June 30, 2005. This allowance was recorded
because, based on the weight of available evidence, it is more likely than not
that some, or all, of the deferred tax asset may not be realized.
As of June 30, 2004, the Company had recorded a deferred tax asset of
$687,576.
30
LIQUIDITY AND CAPITAL RESOURCES
Cash totaled $0.6 million as of June 30, 2005 compared to $1.0 million as
of December 31, 2004. The Company's cash balance is primarily derived from
customer remittances, bank and other borrowings, and acquired cash and is used
for general working capital needs.
Working capital deficit is ($4.6 million) as of June 30, 2005 compared to
($3.0 million) as of December 31, 2004. The Company's working capital position
has deteriorated during the current quarter primarily due to losses incurred by
the Company. The losses generated by the Company have resulted in the need for
$1.25 million of Company stock sales and stockholder loans to the Company of
$1.4 million during the current six month period.
Cash used by operations during the six months ended June 30, 2005 was $3.6
million, increasing by $2.2 million from the comparable prior year period.
Deferred revenue increased by $0.4 million since December 31, 2004, primarily
due to the deferral of the revenue recognition for Evoke software licenses
invoiced in the current period. Accounts receivable increased by $0.3 million
since December 31, 2004, however, days sales outstanding have increased to 66
days for the six month period ended June 30, 2005 from 63 days for the year
ended December 31, 2004. This increase is primarily due to the timing of
collections from LEC. Additionally, the Company reduced accounts payable and
accrued expenses by $0.6 million due to a $0.4 million reduction in accrued
payroll costs, a $0.4 million reduction in accounts payable, and a $0.4 million
reduction in other accrued expenses. These reductions were partially offset by a
$0.4 million increase in accrued penalties relating to the Laurus transaction,
$0.1 million in accrued vacation, and $0.1 million increase in accrued interest
on outstanding debt. The Company also increased security deposits by $0.1
million. The remaining use of cash relates to the losses generated by the
Company during the current period. Cash based losses (net loss plus non cash
expenses) were $3.0 million during the six months ended June 30, 2005.
Cash used by investing activities was $34,000 during the six months ended
June 30, 2005. This was primarily for the purchases of computer equipment for
the Company.
Cash provided by financing activities was $3.2 million during the six
months ended June 30, 2005. $1.25 million was raised through the sale of Company
common stock, $1.4 million from stockholder loans to the Company, and $0.7
million was provided by additional borrowings under the Company's line of
credit, partially offset by $0.1 million of principal payments on capital lease
and stockholder loan obligations.
There are currently no material commitments for capital expenditures.
The Company expects to incur costs, in 2005, of approximately $125,000 in
order to improve its internal controls surrounding financial reporting and
disclosure. No costs were incurred during the three or six months ended June 30,
2005.
As of June 30, 2005 and December 31, 2004, the Company had accounts
receivable due from LEC of approximately $1.1 million and $0.8 million,
respectively. There are no known collections problems with respect to LEC.
For the three and six months ended June 30, 2005 and 2004, we invoiced LEC
$1.1 million and $2.2 million and $0.9 million and $1.8 million, respectively,
for the services of consultants subcontracted to LEC by us. The majority of its
billing is derived from Fortune 100 clients. The collection process is slow as
these clients require separate approval on their own internal systems, which
extends the payment cycle. We feel confident in the collectibility of these
accounts receivable as the majority of the revenues from LEC are derived from
Fortune 100 clients.
On July 18, 2005, the Company completed the sale of substantially all of
the assets Evoke and received aggregate consideration of $645,000 cash, the
assumption by Similarity Systems and Similarity Vector Technologies, Ltd. of
certain liabilities, 821,053 shares which are issuable by Similarity subject to
the Company's satisfactory completion of certain post-closing obligations, and
an earnout in an amount equal to 13% of certain Similarity revenues. The maximum
earnout consideration to which the Company is entitled under this agreement is
$1,400,000 and would be received over a three year period. Evoke had generated
losses since it was acquired by the Company in June 2004. As a result, this sale
is expected to reduce the negative cash flow that has been experienced by the
Company during 2004 and 2005.
31
As of June 30, 2005, the Company had a revolving line of credit with
Laurus Master Fund, Ltd. ("Laurus"), whereby the Company had access to borrow up
to $6.0 million based upon eligible accounts receivable. Additionally, in
exchange for a secured convertible term note, Laurus had made available to the
Company an additional $5.0 million to be used for acquisitions. As of June 30,
2005, approximately $3.4 million was outstanding under the revolving line of
credit. The interest rate on the revolving line and the acquisition note was
7.0% as of June 30, 2005.
On July 28, 2005, the Company entered into an amendment to the Securities
Purchase Agreement dated August 16, 2004 between the Company and Laurus Master
Fund ("Laurus"). Pursuant to the amendment, the Company released $4,327,295.08
(the "Funds") to Laurus, which was being held in the Restricted Account (which
was available to the Company for acquisitions) and issued an amended and
restated convertible note in the principal amount of $749,000. In satisfaction
of the balance of the Accrued Interest ($184,403) and any liquidated damages to
which it was entitled pursuant the Registration Rights Agreement entered into in
August 2004, the Company issued an option to purchase 5,000,000 shares of the
Company's common stock at a purchase price of $.001 per share.
The Company also issued an amended and restated convertible secured
revolving note in the principal amount of $4,500,000 in favor of Laurus which
amended the $4 Million Revolving Note. In connection with this note, the Company
and Laurus entered into an Overadvance Letter Agreement, pursuant to which
Laurus made a loan to the Company in excess of the amount available using the
Company accounts receivable as collateral in the principal amount of $2,700,000.
The Company also entered into an agreement which reaffirms and ratifies its
obligations to Laurus in connection with a Master Security Agreement, a Stock
Pledge Agreement and Security Agreement, each of which were entered into in
August 2004. Pursuant to this agreement, the Company agreed to cause ISI Merger
Corp. within 5 days of the date of its acquisition by the Company, and McKnight
Associates (also recently acquired by the Company) to execute a Joinder
Agreement, pursuant to which ISI Merger Corp. and McKnight Associates will agree
to become a party to a Subsidiary Guaranty and the Security Agreements. The
Company utilized a portion of the $2,700,000 which was advanced to it by Laurus
to acquire Integrated Strategies, Inc. and ISI Consulting, LLC. As a result of
the restructuring of the Laurus debt, the Company expects to record charges in
the September 2005 quarter to write off the unamortized discount on debt
originally recorded in August 2004. Since the revolving line of credit is still
convertible into equity of the Company under the new arrangement, the Company
may need to record additional discount on debt pertaining to the new
transactions for the quarter ended September 2005.
In September 2004, the Company issued to Sands Brothers Venture Capital
LLC, Sands Brothers Venture Capital III LLC and Sands Brothers Venture Capital
IV LLC (collectively, "Sands") three subordinated secured convertible promissory
notes equaling $1.0 million (the "Notes"), each with an annual interest rate of
8% expiring September 22, 2005. The Notes are secured by substantially all
corporate assets, but subordinate to Laurus. The Notes are convertible into
shares of the Company's common stock at the election of Sands at any time
following the consummation of a convertible debt or equity financing with gross
proceeds of $5 million or greater (a "Qualified Financing"). The Company also
issued Sands three common stock purchase warrants (the "Warrants") providing
Sands with the right to purchase 6,000,000 shares of the Company's common stock.
The exercise price of the shares of the Company's common stock issuable upon
exercise of the Warrants shall be equal to a price per share of common stock
equal to forty percent (40%) of the price of the securities issued pursuant to a
Qualified Financing. If no Qualified Offering has been consummated by September
8, 2005, then Sands may elect to exercise the Warrants at a fixed conversion
price of $0.14 per share. The latest that the Warrants may expire is September
8, 2008.
The following is a summary of the debt instruments outstanding as of June
30, 2005:
32
---------------------------------- ---------------------------- ---------------------------- -------------------------
Lender Type of facility Outstanding as of June 30, Remaining Availability
2005 (not including (if applicable)
interest) (all numbers
approximate)
---------------------------------- ---------------------------- ---------------------------- -------------------------
Laurus Master Fund, Ltd. Convertible Line of Credit $3,400,000 $0
---------------------------------- ---------------------------- ---------------------------- -------------------------
Laurus Master Fund, Ltd. Convertible Term note $4,251,000 $0
---------------------------------- ---------------------------- ---------------------------- -------------------------
Sands Brothers Venture Capital Convertible Promissory Note $50,000 $0
LLC
---------------------------------- ---------------------------- ---------------------------- -------------------------
Sands Brothers Venture Capital Convertible Promissory Note $850,000 $0
III LLC
---------------------------------- ---------------------------- ---------------------------- -------------------------
Sands Brothers Venture Capital Convertible Promissory Note $100,000 $0
IV LLC
---------------------------------- ---------------------------- ---------------------------- -------------------------
Taurus Advisory Group, LLC Convertible Promissory Note $2,000,000 $0
investors
---------------------------------- ---------------------------- ---------------------------- -------------------------
Scott Newman Promissory Note $639,250 $0
---------------------------------- ---------------------------- ---------------------------- -------------------------
Glenn Peipert Promissory Note $993,075 $0
---------------------------------- ---------------------------- ---------------------------- -------------------------
TOTAL $12,283,325 $0
---------------------------------- ---------------------------- ---------------------------- -------------------------
The Company had generated losses during 2004 and these losses have
continued during the six months ended June 30, 2005. To that extent, the Company
has experienced continued negative cash flow which created a liquidity issue for
the Company during 2004. To address this issue, the following financings were
effectuated:
As of March 30, 2005, Messrs. Newman, Peipert and Robert C. DeLeeuw have
agreed to personally support our cash requirements to enable us to fulfill our
obligations through May 1, 2006, to the extent necessary, up to a maximum amount
of $2.5 million. Mr. Newman personally guaranties up to $1.4 million, Mr.
Peipert guaranties up to $0.7 million and Mr. DeLeeuw personally guaranties $0.4
million. We believe that our reliance on such commitment is reasonable and that
Messrs. Newman, Peipert and DeLeeuw have sufficient liquidity and net worth to
honor such commitment. We believe that this written commitment provides us with
the legal right to request and receive such advances. Any loan by Messrs.
Newman, Peipert and DeLeeuw to the Company originally provided for interest at
3% per annum, however, on June 16, 2005, the Company's Board of Directors
approved an increase in the interest rate payable to the shareholder's to 8% per
annum.
As of June 13, 2005, Messrs. Newman and Peipert have agreed to personally
support our cash requirements to enable us to fulfill our obligations through
July 1, 2006, to the extent necessary, up to a maximum amount of $1.5 million.
We believe that our reliance on such commitment is reasonable and that Messrs.
Newman and Peipert have sufficient liquidity and net worth to honor such
commitment. We believe that this written commitment provides us with the legal
right to request and receive such advances from any of these officers. Any loan
by Messrs. Newman and Peipert to the Company would bear interest at 8% per
annum. This amount is in addition to the amounts pledged on the March 30, 2005
support agreement.
On June 16, 2005, the Company's board of directors approved an increase in
the interest rate payable to Messrs. Newman and Peipert for outstanding loans
made by them to the Company from the current 3% per annum to 8% per annum. All
new loans to the Company will also bear interest at 8% per annum.
In July 2005, the Company obtained two $250,000 short-term loans from a
third-party investor. Both loans bear interest at 8% per annum. The first loan
is dated July 6, 2005 and matures on September 6, 2005. The second loan is dated
July 22, 2005 and matures on September 22, 2005.
The Company has completed various financing transactions through the
issuance of common stock, as well as the issuance of notes and warrants
convertible into our common stock, while a registration statement was on file
with the Securities and Exchange Commission but had not yet been declared
effective. Those transactions were with the following entities:
o Taurus Advisory Group, LLC $4.0 million
o Laurus Master Fund, Ltd. $11.0 million
o Sands Brothers International Ltd. (3 affiliated entities) $1.0
million
33
Even though all stockholders, noteholders and warrantholders have been
advised of their rights to rescind those financing transactions and they each
have agreed to waive their rights to rescind those transactions, there is a
remote possibility that each of those transactions could be reversed. In such an
event, the Company could be adversely affected and may have an obligation to
fund such rescissions.
The Company believes existing cash, borrowing capacity under the line of
credit or alternative financing sources, the funding to be provided by the
principal stockholders', and funds generated from operations should be
sufficient to meet operating requirements over the upcoming twelve month period.
We may raise additional funds through debt or equity transactions in order to
fund expansion, to develop new or enhanced products and services, to respond to
competitive pressures, or to acquire complementary businesses or technologies.
There is no assurance, however, that additional financing will be available, or
if available, will be available on acceptable terms. Any decision or ability to
obtain additional financing through debt or equity investment will depend on
various factors, including, among others, revenues, financial market conditions,
strategic acquisition and investment opportunities, and developments in the
Company's markets. The sale of additional equity securities or future conversion
of convertible debt would result in additional dilution to the Company's
stockholders.
Off-balance sheet arrangements
The Company does not have any transactions, agreements or other contractual
arrangements that constitute off-balance sheet arrangements.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Revenue recognition
Our revenue recognition policy is significant because revenues are a key
component of our results from operations. In addition, revenue recognition
determines the timing of certain expenses, such as incentive compensation. We
follow very specific and detailed guidelines in measuring revenue; however,
certain judgments and estimates affect the application of the revenue policy.
Revenue results are difficult to predict and any shortfall in revenues or delay
in recognizing revenues could cause operating results to vary significantly from
quarter to quarter and could result in future operating losses or reduced net
income.
Services
Revenue from consulting and professional services is recognized at the
time the services are performed on a project by project basis. For projects
charged on a time and materials basis, revenue is recognized based on the number
of hours worked by consultants at an agreed-upon rate per hour. For large
services projects where costs to complete the contract could reasonably be
estimated, the Company undertakes projects on a fixed-fee basis and recognizes
revenues on the percentage of completion method of accounting based on the
evaluation of actual costs incurred to date compared to total estimated costs.
Revenues recognized in excess of billings are recorded as costs in excess of
billings. Billings in excess of revenues recognized are recorded as deferred
revenues until revenue recognition criteria are met. Reimbursements, including
those relating to travel and other out-of-pocket expenses, are included in
revenues, and an equivalent amount of reimbursable expenses are included in cost
of services.
Software
Revenue from software licensing and maintenance and support are recognized
when persuasive evidence of an arrangement exists, delivery has occurred, the
fee is fixed or determinable, and collectibility is reasonably assured. The
Evoke software is delivered by the Company either directly to the customer or to
a distributor on an order by order basis. The software is not sold with any
right of return privileges and, as a result, a returns reserve is not
applicable. License fee revenue is recognized by the Company in the period in
which delivery occurs. Maintenance and support revenue is recorded in revenue on
a pro rata basis over the term of the maintenance and support agreement.
Deferred revenue is recorded when customers are invoiced for software
maintenance and support. The revenue is recognized over the term of the
maintenance and support agreement.
The Company licenses software and provides a maintenance and support
agreement to customers. These items are invoiced as separate items and
vendor-specific objective evidence is determined for the maintenance and
support, generally by identifying in the contract the cost of the maintenance
and support to the customer in subsequent renewal periods.
34
Business Combinations
We are required to allocate the purchase price of acquired companies to
the tangible and intangible assets acquired and liabilities assumed based on
their estimated fair values. Such a valuation requires us to make significant
estimates and assumptions, especially with respect to intangible assets.
Critical estimates in valuing certain intangible assets include, but are not
limited to, future expected cash flows from customer contracts, customer lists,
distribution agreements and acquired developed technologies, and estimating cash
flows from projects when completed and discount rates. Our estimates of fair
value are based upon assumptions believed to be reasonable, but which are
inherently uncertain and unpredictable and, as a result, actual results may
differ from estimates. These estimates may change as additional information
becomes available regarding the assets acquired and liabilities assumed.
Additionally, in accordance with EITF 99-12, the Company values an acquisition
based upon the market price of its common stock for a reasonable period before
and after the date the terms of the acquisition are agreed to and announced.
Impairment of Goodwill, Intangible Assets and Other Long-Lived Assets
We evaluate our identifiable goodwill, intangible assets, and other
long-lived assets for impairment on an annual basis and whenever events or
changes in circumstances indicate that the carrying value of an asset may not be
recoverable based on expected undiscounted cash flows attributable to that
asset. Future impairment evaluations could result in impairment charges, which
would result in an expense in the period of impairment and a reduction in the
carrying value of these assets.
Allowances for Doubtful Accounts
We make judgments regarding our ability to collect outstanding receivables
and provide allowances for the portion of receivables when collection becomes
doubtful. Provisions are made based upon a specific review of all significant
outstanding invoices. For those invoices not specifically reviewed, provisions
are provided at differing rates, based upon the age of the receivable. In
determining these percentages, we analyze our historical collection experience
and current economic trends. If the historical data we use to calculate the
allowance provided for doubtful accounts does not reflect the future ability to
collect outstanding receivables, additional provisions for doubtful accounts may
be needed and our future results of operations could be materially affected.
Stock-based Compensation
We issue stock options to our employees and provide our employees the
right to purchase ordinary shares under employee stock purchase plans. We
account for our stock-based compensation plans under the intrinsic value method
of accounting as defined by Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25") and related
interpretations. For equity instruments under fixed plans, APB 25 does not
require that any amount of expense to be recorded in the statement of income;
however, SFAS No. 123, "Accounting for Stock-Based Compensation" does require
disclosure of these amounts in a pro forma table to the financial statements. In
determining this disclosure the value of an option is estimated using the Black
Scholes option valuation model. This model requires the input of highly
subjective assumptions and a change in our assumptions could materially affect
the fair value estimate, and thus the total calculated costs associated with the
grant of stock options or issuance of stock under employee stock purchase plans.
In addition, in disclosing the fair-value cost of stock-based compensation, we
estimate that we will be able to obtain a 40% tax benefit on these costs. There
is the potential that this tax benefit will not be obtained to this extent or at
all, which directly impacts the level of expenses associated with stock-based
compensation. We expect our accounting policies, regarding stock-based
compensation to be materially affected by our adoption of SFAS123R, which is
described under "Recent Pronouncements." We have not yet determined what the
impact of the adoption of SFAS123R will be on our compensation philosophy.
Deferred Income Taxes
Determining the consolidated provision for income tax expense, income tax
liabilities and deferred tax assets and liabilities involves judgment. We record
a valuation allowance to reduce our deferred tax assets to the amount of future
tax benefit that is more likely than not to be realized. We have considered
future taxable income and prudent and feasible tax planning strategies in
determining the need for a valuation allowance. A valuation allowance is
maintained by the Company due to the impact of the current years net operating
loss (NOL). In the event that we determine that we would not be able to realize
all or part of our net deferred tax assets, an adjustment to the deferred tax
assets would be charged to net income in the period such determination is made.
Likewise, if we later determine that it is more likely than not that the net
deferred tax assets would be realized, then the previously provided valuation
allowance would be reversed. Our current valuation allowance relates
predominately to benefits derived from the utilization of our NOL's.
35
Recent Pronouncements
In December 2004, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards ("SFAS") No. 123R, "Share-Based
Payment, an Amendment of SFAS No. 123 and 95". This final standard replaces the
existing requirements under SFAS 123 and APB 25 and requires that all forms of
share-based payments to employees, including employee stock options and employee
stock purchase plans, be treated the same as other forms of compensation by
recognizing the related cost in the statements of income. SFAS 123R eliminates
the ability to account for stock-based compensation transactions using APB 25
and requires instead that such transactions be accounted for using a fair-value
based method. SFAS 123R is effective for interim or annual periods beginning
after June 15, 2005 and allows companies to restate the full year of 2005 to
reflect the impact of expensing under SFAS 123R as reported in the footnotes to
the financial statements for the first half of 2005. . The transitional
provisions of SFAS 123R allow companies to select either a modified-prospective
or modified-retrospective transition method which effectively impacts in which
periods actual expense will be reported in the statements of income. We are in
the process of determining the transitional method we will apply. We have not
determined how SFAS123R will modify, if at all, our compensation philosophy in
general or for stock option grants in particular. We cannot currently estimate
the amount of stock-based compensation expense which will be related to stock
option grants or the issue of warrants in 2005 and thereafter.
ISSUES AND UNCERTAINTIES
This Quarterly Report on Form 10-QSB contains statements that are
forward-looking. These statements are based on current expectations and
assumptions that are subject to risks and uncertainties. Actual results could
differ materially because of issues and uncertainties such as those referenced
below and elsewhere in this report, which, among others, should be considered in
evaluating the Company's financial outlook.
For further information, refer to the Company's 2004 Annual Report filed
with the Securities and Exchange Commission on Form 10-KSB/A on July 26, 2005.
Item 3. Controls and Procedures
Evaluation of disclosure controls and procedures.
Under the supervision and with the participation of our management,
including our chief executive officer and our chief financial officer, we have
evaluated the effectiveness of the design and operation of our disclosure
controls and procedures pursuant to Securities Exchange Act of 1934 Rule
13a-15(e) as of the end of the period covered by this report. Based on that
evaluation, and as a result of comments received in February 2005 from the Staff
of the SEC pertaining to our Registration Statement on Form SB-2/A, File No.
333-115243 (the "Registration Statement"), our chief executive officer and our
chief financial officer have concluded that a material weakness exists with
regard to the valuation and purchase accounting of our recent acquisitions,
including the inability to prepare financial statements and footnotes in
accordance with SEC rules and regulations.
In connection with our acquisitions of DeLeeuw Associates, Inc. and Evoke
Software Corporation, we misapplied generally accepted accounting principles
whereby we did not value the acquisitions and record the resulting purchase
accounting in accordance with SFAS 141 and EITF 99-12. As a result, we were
required in March 2005 to restate our financial statements for the quarters
ended March 31, 2004, June 30, 2004 and September 30, 2004. Management now
believes and has determined that the disclosure controls and procedures for
these three quarters were not effective.
36
In light of the need for these restatements and the material weakness in
our valuation and purchase accounting for recent acquisitions, commencing in the
first quarter of our 2005 fiscal year and continuing through the period covered
by this report, we are beginning to undertake a review of our disclosure,
financial information and internal controls and procedures regarding these areas
for future acquisitions. This review has included efforts by our management and
directors, as well as the use of additional outside resources, as follows:
o Senior accounting personnel and our chief financial officer will
continue to review any future acquisition or divestiture in order to evaluate,
document and approve its accounting treatment in accordance with SFAS 141 and
EITF 99-12;
o We will augment, as necessary, such procedures by obtaining
concurrence with independent outside accounting experts prior to finalizing
financial reporting for such transactions; and
o We will incorporate the applicable parts of the action plan
described in the next paragraph.
In conjunction with the measures outlined below, we believe these actions
will strengthen our internal control over our valuation and purchase accounting
of future acquisitions, and this material weakness should be resolved.
Management does not anticipate any extra cost from this change in its valuation
and purchase accounting of future acquisitions.
In addition, we previously identified two internal control matters.
Neither relates to the subject matter of the material weakness described above,
yet combined with the above-referenced material weakness, constitute in the
aggregate a material weakness in our internal control over financial reporting.
These internal control matters, identified in October 2004 by Friedman LLP, our
independent registered public accounting firm, are summarized as follows:
o Lack of certain internal controls over period-end financial
reporting related to the identification of transactions, primarily contractual,
and accounting for them in the proper periods; and
o Accounting and reporting for our complex financing transactions
related to the beneficial conversion features and the determination of the fair
value of warrants in such transactions.
Management has established an action plan that it believes will correct
the aggregated material weaknesses described above. Our estimated costs related
to the correction of these material weaknesses is approximately $0.125 million,
most notably related to our conversion to the Great Plains accounting system
during the third quarter of 2004. The conversion to the Great Plains accounting
system required inconsequential modifications to our transaction processing
systems. The effect of the migration to this system has been to provide a better
audit trail than our previous system. The batch processing of transactions
provides the ability for review of transactions prior to being posted in the
accounting system. Further, the ability to close and lock periods to prevent
changes to prior periods provides greater reliability of the data and the
financial statements (resulting from the financial statements being prepared
directly by the accounting system as opposed to using spreadsheets, which have
greater potential for error). Finally, this system has the ability to provide
comparative financial statements to expectations, which drives variance
reporting. As a result of this system change, there were changes in our internal
control over financial reporting starting in the third quarter of 2004, as we
have redesigned the organization structure to drive more focus on our internal
control environment. Other measures included in our action plan are as follows:
o We have formed a Disclosure Committee consisting of our chief
executive officer, chief operating officer, senior vice president of sales,
general counsel and controller, chaired by our chief financial officer. The
Disclosure Committee is comprised of these key members of senior management who
have knowledge of significant portions of our internal control system, as well
as the business and competitive environment in which we operate. One of the key
responsibilities of each Disclosure Committee member is to review quarterly
reports, annual reports and registration statements to be filed with the SEC as
each progress through the preparation process. Open lines of communication to
financial reporting management exist for Disclosure Committee members to convey
comments and suggestions;
o A process to be established whereby material agreements are
reviewed by the legal, accounting and sales departments and an executive
management member that includes determination of appropriate accounting and
disclosure;
o Our accounting and legal departments are now working more closely
and in conjunction to accurately account for period-end financial reporting and
complex financing transactions;
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o We are constantly assessing our existing environment and continue
to make further changes, as appropriate, in our finance and accounting
organization to create clearer segregation of responsibilities and supervision,
and to increase the level of technical accounting expertise including the use of
outside accounting experts;
o There will be closer monitoring of the preparation of our monthly
and quarterly financial information. We are in the process of instituting
regular quarterly meetings to review each department's significant activities
and respective disclosure controls and procedures and to have such in place by
the end of the second quarter of 2005;
o Department managers have been tasked with tracking relevant
non-financial operating metrics and other pertinent operating information and
communicating their findings to a member of the Disclosure Committee; and
o We will conduct quarterly reviews of the effectiveness of our
disclosure controls and procedures, and we have enhanced our quarterly close
process to include detailed analysis in support of the financial accounts, and
improved supervision over the process.
We believe that we will satisfactorily address the control deficiencies and
material weakness relating to these matters by the end of the third quarter of
2005, although there can be no assurance that we will do so.
At the same time as we continue our efforts to improve our internal
control environment, management of the Company is still in the process of
implementing the above procedures and controls, including review and evaluation,
to mitigate recognized weaknesses specifically for the preparation of the
financial statements for the periods covered by this Quarterly Report on Form
10-QSB. Management believes that these procedures and controls are not yet
effective in ensuring the proper collection, evaluation and disclosure of the
financial information for the periods covered by this. Based on the foregoing,
our chief executive officer and our chief financial officer concluded that our
disclosure controls and procedures were not yet effective at a reasonable
assurance level as of the date of this Quarterly Report.
Management, including our chief executive officer and our chief financial
officer, does not expect that our disclosure controls and internal controls will
prevent all error or all fraud, even as the same are improved to address any
deficiencies and/or weaknesses. A control system, no matter how well conceived
and operated, can provide only reasonable, not absolute, assurance that the
objectives of the control system are met. Over time, controls may become
inadequate because of changes in conditions or deterioration in the degree of
compliance with policies or procedures. Further, the design of a control system
must reflect the fact that there are resource constraints, and the benefits of
controls must be considered relative to their costs. Because of the inherent
limitations in all control systems, no evaluation of controls can provide
absolute assurance that all control issues and instances of fraud, if any,
within the Company have been detected. These inherent limitations include the
realities that judgments in decision-making can be faulty, and that breakdowns
can occur because of simple error or mistake. Additionally, controls can be
circumvented by the individual acts of some persons, by collusion of two or more
people, or by management override of the control.
Changes in internal control over financial reporting.
Our company also maintains a system of internal controls. The term
"internal controls," as defined by the American Institute of Certified Public
Accountants' Codification of Statement on Auditing Standards, AU Section 319,
means controls and other procedures designed to provide reasonable assurance
regarding the achievement of objectives in the reliability of our financial
reporting, the effectiveness and efficiency of our operations and our compliance
with applicable laws and regulations. In connection with the preparation of this
quarterly report, our management identified certain weaknesses in our internal
control procedures and in our valuation and purchase accounting of our
acquisitions in 2004. Our management and Board have adopted corrective measures
as described in the third and fourth paragraphs of this Controls and Procedures
section above. The following measures have materially affected our internal
control over financial reporting since our last Quarterly Report:
o Senior accounting personnel and our chief financial officer
continue to review any future acquisition or divestiture in order to evaluate,
document and approve its accounting treatment in accordance with SFAS 141 and
EITF 99-12;
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o We have augmented, as necessary, such procedures by obtaining
concurrence with independent outside accounting experts prior to finalizing
financial reporting for such transactions;
o Our Disclosure Committee meets at the end of every quarter;
o Our accounting and legal departments continue to work more closely
and in conjunction to accurately account for period-end financial reporting and
complex financing transactions;
o There will be closer monitoring of the preparation of our monthly
and quarterly financial information. We have instituted regular quarterly
meetings to review each department's significant activities and respective
disclosure controls and procedures; and
o Department managers have been tasked with tracking relevant
non-financial operating metrics and other pertinent operating information and
communicating their findings to a member of the Disclosure Committee.
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits:
31.1 Certification of Chief Executive Officer pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934
31.2 Certification of Chief Financial Officer pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934
32.1 Certification of Chief Executive Officer pursuant to Rule
13a-14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C.
Section 1350
32.2 Certification of Chief Financial Officer pursuant to Rule
13a-14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C.
Section 1350
(b) Reports on Form 8-K: Form 8-K, filed on April 13, 2005, pertaining to Item
4.02 regarding the non-reliance on previously issued financial statements
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CONVERSION SERVICES INTERNATIONAL, INC.
By: /s/ Scott Newman
----------------------------------
Name: Scott Newman
Title: President and Chief Executive Officer
(Principal Executive Officer and
Duly Authorized Officer)
August 19, 2005
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