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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended October 31, 2003
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 0-24015
STEELCLOUD, INC.
(Exact name of registrant as specified in its charter)
COMMONWEALTH OF VIRGINIA 54-1890464
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1306 Squire Court
DULLES, VIRGINIA 20166
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(Address of principal executive offices) (Zip Code)
(703) 450-0400
--------------
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12 (b) of the Exchange Act
TITLE OF EACH CLASS NAME OF EXCHANGE ON WHICH REGISTERED None.
Securities registered pursuant to Section 12 (g) of the Act:
TITLE OF EACH CLASS NAME OF EXCHANGE ON WHICH REGISTERED
- ------------------- ------------------------------------
Common Stock, $.001 par value per share Nasdaq SmallCap Market
Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 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 |_|
Indicate by check mark if there is disclosure of delinquent filers in
response to Item 405 of Regulation S-K contained herein and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. | |
The aggregate market value of the voting stock held by non-affiliates
of the issuer as of January 23, 2004 was $45,147,886.
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act). Yes | | No |X|
The number of shares outstanding of the registrant's Common Stock,
$.001 par value per share, on January 23, 2004 was 13,343,690.
Documents incorporated by reference
Portions of the Definitive Proxy Statement to be filed pursuant to Regulation
14A for SteelCloud, Inc.'s annual meeting for 2003 are incorporated by reference
into Part III of this Form 10-K.
STEELCLOUD, INC
2003 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I PAGE NUMBER
Item 1. Business.......................................................... 4
Item 2. Properties........................................................ 9
Item 3. Legal Proceedings................................................. 9
Item 4. Submission of Matters to a Vote of Security Holders............... 9
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters .............................................. 10
Item 6. Selected Financial Data........................................... 12
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations......................................... 13
Item 7A. Quantitative and Qualitative Disclosures About Market Risk........ 22
Item 8. Financial Statements and Supplementary Data....................... 22
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosures.............................. 22
Item 9A. Controls and Procedures........................................... 23
PART III
Item 10. Directors and Executive Officers of the Registrant................ 24
Item 11. Executive Compensation............................................ 24
Item 12. Security Ownership of Certain Beneficial Owners and Management.... 24
Item 13. Certain Relationships and Related Transactions.................... 24
(Item 10 - Item 13 information is incorporated by reference
from portions of the Company's definitive Proxy Statement
to be filed pursuant to Regulation 14A)
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K... 24
Signatures........................................................ 26
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ITEM 1. BUSINESS
GENERAL
SteelCloud, Inc. (formerly Dunn Computer Corporation) or (the
"Company") was founded in 1987 as a company that manufactured and marketed
custom computers, primarily to the Federal government.
The Company is principally engaged in the design, development and
manufacturing of custom computer servers and network security appliances. The
Company's custom computer servers are designed to meet the precise needs of
volume customers to reduce the customer's investments in logistics, integration
capacity and support. SteelCloud's network security appliances are developed in
collaboration with some of the world's premiere software companies. In addition,
SteelCloud develops proprietary software to optimize the performance of its
security appliances. SteelCloud's branded and co-branded appliances are
specially designed and optimized to deliver a dedicated network service such as
antivirus gateway protection, intrusion detection and secure content management.
The Company is focusing its efforts on the network security marketplace
and on the creation of additional SteelCloud intellectual property. The Company
is working toward the creation of its own family of hardened (highly secured)
appliances to be delivered as co-branded appliances with its software partners.
SteelCloud's primary business is to develop and manufacture products for
strategic software, technology, and managed services partners that develop,
implement and support Internet security and infrastructure solutions. With its
strategic partners, the Company can create and uniquely brand ready-to-use
turnkey network server appliance solutions combining both hardware and software.
The Company integrates either its own, its partner's, or other third-party
software into a custom designed server platform and manufactures the product
under a co-branded name or its partner's brand name allowing the partner to
deliver a complete turnkey solution. In addition to delivering computer
products, the Company develops and manufactures specialized servers and
infrastructure products for large commercial and government integrators as well
as certain governmental agencies. The Company enhances its product development
and manufacturing capability by providing custom supply chain and logistics
support services to its partners.
The Company's consulting services organization provides clients with a
seamless extension of their Information Technology ("IT") organizations. Expert
technical services include network analysis, security, design, troubleshooting
and implementation. SteelCloud provides IT support services to the public sector
as well as commercial customers. In addition, the Company is also a value-added
reseller for the software products of our strategic partners and certain other
software providers.
The Company was incorporated as Dunn Computer Corporation in Virginia
on February 26, 1998 in connection with the reorganization of Dunn Computer
Corporation, a Delaware Corporation, which was incorporated on April 22, 1997.
The Company's operating subsidiary, Dunn Computer Operating Company, was
incorporated in Virginia in July 1987. The Company's other subsidiaries are
International Data Products (IDP), acquired May 1998, STMS, Inc (STMS), acquired
September 1997, and Puerto Rico Industrial Manufacturing Operations Acquisition
Corporation (PRIMOA), incorporated in Puerto Rico in May 1998. In October 2002,
the Company determined to discontinue the PRIMOA subsidiary and thereby executed
a plan to dispose that operation. In September 2003, the Company sold the assets
of PRIMOA and contracted with a local Puerto Rican firm to provide its warranty
and support obligations for the duration of its contracts. Accordingly, the
operation has been classified as "discontinued" in the financials statements for
all years presented.
On September 25, 2000, the Company began doing business as ("d/b/a")
SteelCloud Company. On October 19, 2000, the Company changed its NASDAQ ticker
symbol from DNCC and began trading as SCLD. On May 15, 2001, the shareholders of
the Company approved the name change of the Company to SteelCloud, Inc.
effective on that date. In June 2003, the listing of the Company's shares of
common stock was transferred from the Nasdaq National Market to the Nasdaq Small
Cap Market. Unless the context otherwise requires, the "Company" or "Dunn
Computer Corporation" refers to SteelCloud Inc., its predecessor and its
subsidiaries. The principal executive offices are located at 1306 Squire Court,
Dulles, Virginia 20166. The Company's main telephone number is (703) 450-0400.
Inquiries may also be sent to SteelCloud at [email protected] for sales and
general information or [email protected] for investor relations information.
-4-
PRODUCTS AND SERVICES
The Company offers network appliances, infrastructure server products,
and consulting services. The Company believes it operates in one segment,
information technology.
NETWORK SERVER APPLIANCES: SteelCloud partners with leading software
and technology companies to create uniquely branded, ready-to-use turnkey
network server appliance solutions combining both hardware and software.
SteelCloud integrates the partner's software onto a custom designed server
platform, running Linux, FreeBSD, or Microsoft NT/2000. This process results in
an optimized, tested, and certified appliance, unique to the partner, which is
ready to deploy and use when it arrives at the customer site. The company has
leveraged its years of experience developing and managing custom server
platforms for mission-critical Department of Defense ("DOD") and security
programs to create a unique model for its partners. The Company assembles a
package of design, support, and logistical services that are custom tailored for
each particular software company, thereby augmenting the partner's internal
capabilities. In essence, SteelCloud takes responsibility for those tasks
necessary to successfully bring an appliance to market, which are impractical
for its software partners to perform.
The Company believes that its unique approach to the server appliance
market (collaborating with leading software manufacturers and leveraging their
significant product marketing and sales efforts) enables it to realize economies
of scale in development, sales, and marketing far greater than its revenue would
indicate under a more traditional strategy. The Company also believes that risks
relating to R&D (research and development) and inventory are also greatly
reduced through this approach.
INFRASTRUCTURE PRODUCTS: The Company designs, develops and manufactures
specialized custom servers, which are configured with single, dual, or quad
Intel Pentium or Xeon processors. These servers are designed to give its
customers with unique requirements, the highest level of performance,
reliability, and manageability available in the market today. The company
combines its hardware offerings with specialized software integration and
logistics programs to give its custom server customers unique solutions
unavailable from the traditional hardware-only vendors.
The Company believes that its infrastructure/custom server products are
best suited to address the high volume needs of the federal government. The
Company teams with large federal integrators as its primary channel for
delivering its specialized servers.
CONSULTING SERVICES: SteelCloud provides an array of consulting
services surrounding the technologies addressed by its server appliances. The
Company's consulting services include network and security analysis, design and
implementation, as well as help desk consulting. These services are primarily
delivered in the form of short-term (less than three months) projects. The
Company's consulting services are performed for a fixed-fee or on an hourly
labor basis at pre-negotiated rates and estimated levels of effort. SteelCloud
is a value-added reseller for certain software products that are delivered in
conjunction with its consulting services. In some cases, SteelCloud provides its
appliance customers with additional technical services that complement their
appliance implementation.
Specific project-based services SteelCloud performs include network
analysis, network design, systems implementation, virus protection, network
security, software migrations, messaging system migrations and complete help
desk implementation and support. SteelCloud maintains expertise in specific
areas and technologies rather than general knowledge in many IT areas.
SteelCloud provides highly skilled professionals and services that leverage our
experience for maximum benefit to the client. Project management is the key
component of SteelCloud's operational strategy and success in project-based
engagements to ensure each project is delivered in accordance with the
customer's expectation and the Company's profitability objectives.
SteelCloud also provides network support services in the form of
fixed-rate hourly engineering services. Client contracts range in duration from
one month to three years. Staffing services consist of placing one or more
network engineers, user support technicians, or programmers on-site with a
client. These professionals perform work as a "virtual" employee for the client
and typically work under the direction of the client's management. Hourly rates
for staffing engagements are normally lower than for project-based engagements;
however, the contracts usually have substantially longer periods of performance.
SteelCloud's success in this area is achieved largely due to contract renewals
and increasing staffing requirements from existing customers.
-5-
E>
GOVERNMENT CONTRACTS
In fiscal 2003, the Company derived approximately 22% of its revenues
from sales of hardware and services to the U.S. Federal Government pursuant to
contracts with the General Services Administration (GSA) or other
agency-specific contracts. Certain Government customers reserve the right to
examine the Company's records as they relate to their contracts.
GSA CONTRACT. The Company has a multiple award schedule contract with
GSA (the "GSA" Contract). The Company's GSA contract was originally awarded in
April 1996. It was renewed in fiscal 2002 and is valid through March 31, 2007.
The GSA contract enables Government IT purchasers to acquire all of their
requirements from a particular vendor and largely limits the competition to
selected vendors holding GSA contracts. For fiscal year 2003, the Company's GSA
contract had sales of $7.4 million, which accounted for approximately 22% of the
Company's revenues.
COMMERCIAL CONTRACTS
In fiscal year 2003, SteelCloud derived approximately 78% of its
revenues from sales of hardware and services to the commercial marketplace and
state and local government. The Company's commercial customer base consists of
several Fortune 500 companies as well as medium-size commercial customers. The
Company generated approximately $8.1 million or 25% of its total net revenues
from contracts and awards with Lockheed Martin during fiscal year 2003. The
Company intends to continue to increase its commercial customer base in the
upcoming fiscal year. The Company's Appliance Partner program and its own sales
and marketing activities are concentrated on expanding the Company's commercial
customer base. Strategic partnerships with industry leading companies such as
Microsoft, Intel and Seagate enable the Company to further diversify its product
mix and attract high quality customers.
In June 2003, the Company entered into an OEM agreement with Computer
Associates International, Inc. to deliver a family of hardened, ready-to-deploy
enterprise-class security appliance based on Computer Associates' eTrust
technology which provides comprehensive threat management, identity management
and access management across the full range of platforms and applications. The
first set of appliances delivered under this agreement featured eTrust
Antivirus, a powerful and cost-effective solutions for protecting enterprise
environments from viruses and malicious code. The anti-virus gateway (AVG)
appliance models 3000 and 5000 were available as of October 31, 2003. The
anti-virus gateway (AVG) appliance model 1000, which is aimed at small to medium
sized businesses, is scheduled for availability in early fiscal 2004. In
addition, the Company is currently developing a family of intrusion detection
system (IDS) appliances using Computer Associates' eTrust Intrusion Detection,
which can identify attacks directed at customers' businesses and automatically
mount effective defenses. The IDS appliances are scheduled for general
availability in early 2004. The resulting products are different from previous
SteelCloud appliances in that they are branded solutions integrated with the
proprietary SteelCloud Secure Console (SC2) software.
In July 2003, the Company was selected by Lockheed Martin to supply
specialized servers to the Automated Package Processing System (APPS) program
that will upgrade the existing parcel processing capability of the U.S. Postal
Service. The servers will be installed in more than 74 postal service locations.
The contract has an initial estimated value of more than $2.8 million with
contract options for an additional $3.2 million. The Company has shipped initial
delivery orders for more than 100 systems and full production is expected to
begin in fiscal year 2004. In addition, two of Lockheed Martin's subcontractors
on the APPS program have placed initial orders with the Company in excess of
$250,000 with plans to order additional systems.
In July 2003, the Company signed an OEM agreement with Microsoft
Corporation under which the Company's new line of branded security appliances
developed around the Company's proprietary SC2 software which will utilize a
special embedded version of Microsoft's Windows server. SteelCloud's contract
with Microsoft protects its intellectual property interest in the SC2 software.
In September 2003, the Company entered into a distribution agreement to
sell its hardened security appliances to value added resellers as well as end
users in North America through Arrow Electronics, Inc. Arrow Electronics is one
of the world's largest electronic distributors with approximately $7.4 billion
in worldwide sales.
-6-
The Company anticipates that Arrow will provide its US Channel Partners with an
efficient and effective means to purchase SteelCloud security appliances.
Additionally, the Company anticipates that Arrow's supply-chain services will
provide its reseller organizations in North America with the tools needed to
market SteelCloud security appliances such as online ordering and reporting,
financial services and product launch support.
MANUFACTURING AND PRODUCTION
SteelCloud's production operations are capable of assembling 100,000
systems per year in its existing Dulles, Virginia facility on a three-shift
basis. The Company is currently operating on a single shift basis.
COMPETITION AND MARKETING
The markets for the Company's products and services are highly
competitive. Many of the Company's competitors offer broader product lines and
may have greater financial, technical, marketing and other resources. These
competitors may benefit from component volume purchasing and product and process
technology license arrangements that are more favorable in terms of pricing and
availability than the Company's arrangements.
The Company competes with a large number of computer systems
integrators, custom computer manufacturers, resellers, and IT services
companies. The Company believes it is likely that these competitive conditions
will continue in the future. There can be no assurance the Company will continue
to compete successfully against existing or new competitors that may enter
markets in which the Company operates.
The Company's principal competitors are general-purpose server
manufacturers including Nokia, Sun Microsystems and Dell. The Company also
competes with system integrators such as Avnet and Pioneer Standard Electronics
as well as smaller companies such as Network Engines that specialize in building
server products and providing some level of integration services.
FEDERAL GOVERNMENT MARKET - The emergence of the GSA Schedule, which is
a list of pre-approved vendors from which the Government and/or federal agencies
may purchase goods and services, as a significant procurement vehicle has
enabled traditional mass-market commercial computer companies to be more
responsive to government requirements and become more competitive with the
Company in the Federal Government Market. The Company believes that the
Government's selection criteria for vendor selection consist of price, quality,
familiarity with the vendor, and size and financial capability of the vendor.
The government has increased the amount of information technology products
acquired through the GSA Schedule. Because the Company primarily targets custom
computer procurements, it rarely competes with national commercial computer
manufacturers such as Dell Computer Corporation and Hewlett-Packard in the
federal market.
COMMERCIAL MARKET - The information technology industry is highly
competitive. Pricing is very aggressive in the industry and the Company expects
pricing pressures to continue. The industry is also characterized by rapid
changes in technology and customer preferences, short product life cycles and
evolving industry standards.
The commercial market for the Company's IT products and services is a
highly fragmented market served by thousands of small value-added resellers and
specialized manufacturers. These companies typically service a small geographic
area and resell national brand computer and/or network hardware. The Company
believes its consulting services group can compete effectively in the
Washington, DC metropolitan market because it provides engineering services in
conjunction with its turnkey server appliances and products from its strategic
partners; e.g., Cisco, Microsoft, and Intel. The Company believes that its
ability to integrate its server systems with networking products also gives its
consulting services group a competitive advantage.
In the OEM server appliance market, the principal elements of
competition are product reliability, quality, customization, price, customer
service, technical support, value-added services, and product availability.
There can be no assurance that the Company will, in the future, be able to
compete effectively against existing and future competitors.
MARKETING - The Company markets its products and services to software
manufacturers, their channel partners, select commercial accounts, and the
federal government. The Company uses an in-house sales force and program
managers to market its products and services. SteelCloud markets its products
and services worldwide, either directly through its own sales personnel, or
through the marketing organizations of its appliance partners. The Company
believes that marketing is important for all of its target markets, although
less so in its appliance business because its success relies on the partner's
sales and marketing capabilities.
-7-
The Company strives to build a strong relationship with its customers.
The Company believes that a key to building customer loyalty is a team of
knowledgeable and responsive account executives and a knowledgeable technical
and support staff. The Company assigns each customer a trained account
executive, to which subsequent calls to the Company will be directed. The
account executive is augmented with a program manager for SteelCloud's larger
customers. The Company believes that these strong one-on-one relationships
improve the likelihood that the customer may consider the Company for future
purchases. The Company intends to continue to provide its customers with
products and technical services that offer the customer the best value.
The Company uses electronic commerce technologies in its marketing
efforts and believes that its customers will continue to expand and utilize
these technologies. The Internet is being used by customers to advertise
opportunities and to reference vendor information. The Company maintains a web
site on the Internet referencing its GSA catalogue and product offerings. The
Company is capable of accepting sales and processing payments over the Internet.
SUPPLIERS
The Company devotes significant resources to establishing and
maintaining relationships with its key suppliers. The Company, where possible,
purchases directly from component manufacturers such as Intel, Microsoft and
Cisco among others. The Company also purchases multiple products directly from
large national and regional distributors such as Arrow Electronics, TechData
Corporation and Ingram Micro.
Certain suppliers provide the Company with incentives in the form of
discounts, rebates, credits, and cooperative advertising, and market development
funds. The Company must continue to obtain products at competitive prices from
leading suppliers in order to provide competitively priced products for its
customers. In the event the Company is unable to purchase components from
existing suppliers, the Company has alternative suppliers it can rely upon. The
Company believes its relationships with its key suppliers to be good and
believes that generally, there are multiple sources of supply available should
the need arise.
PATENTS, TRADEMARKS AND LICENSES
The Company works closely with computer product suppliers and other
technology developers to stay abreast of the latest developments in computer
technology. While the Company does not believe its continued success depends
upon the rights to a patent portfolio, there can be no assurance that the
Company will continue to have access to existing or new technology for use in
its products.
The Company conducts its business under the trademarks and service
marks of "SteelCloud", "SteelCloud Company" and "Dunn Computer Corporation,".
The Company believes its trademarks and service marks have significant value and
are an important factor in the marketing of its products.
Because most software used on the Company's computers is not owned by
the Company, the Company has entered into software licensing arrangements with
several software manufacturers.
EMPLOYEES
As of October 31, 2003, the Company had 88 employees. Of this total, 4
were employed in an executive capacity, 10 in sales and marketing, 11 in
administrative capacities, 47 in technical and/or services and 16 in operations.
As of January 20, 2004, the Company had 91 employees. None of the Company's
employees are covered by a collective bargaining agreement. The Company
considers its relationships with its employees to be good.
The Company believes that its future success depends in large part upon
its continued ability to attract and retain highly qualified management,
technical, and sales personnel. The computer industry's shortage of trained and
experienced technicians has eased over the past twelve months. The company has
an in-house training and mentoring program to develop its own supply of highly
qualified technical support specialists. There can be no assurance, however,
that the Company will be able to attract and retain the qualified personnel
necessary for its business.
-8-
ITEM 2. PROPERTIES
The Company leases approximately 35,000 square feet at its facility in
Dulles, Virginia, which is used as its principal executive offices, for
manufacturing and administrative services. Pursuant to the lease, which expires
in February 2005, the Company pays approximately $29,000 per month in rent.
SteelCloud believes that its facilities are adequate for its current and future
operations.
In addition, we maintain sales offices in California and Massachusetts.
We do not lease any space for these offices as our salespersons are based out of
their respective residences.
ITEM 3. LEGAL PROCEEDINGS
On July 31, 1998, the Company received notice from the SBA that it was
denying the request of the U.S. Air Force to waive the requirement to terminate
IDP's Desktop V contract for the convenience of the Government upon the change
in control of IDP to the Company. The Company appealed the denial of the SBA to
the SBA's Office of Hearings and Appeals. On August 31, 1999, the SBA denied the
appeal and ruled that the U.S. Air Force must terminate-for-convenience the
Desktop V contract. Prior to this ruling by the SBA, the U.S. Air Force
determined not to exercise any of the remaining option years under the Desktop V
contract on May 1, 1999. In October 1999, the U.S. Air Force issued a
termination-for-convenience letter to the Company. Under a
termination-for-convenience, the government is required generally to reimburse a
contractor for all costs incurred in the performance of the contract. The
Company is in the process of attempting to recover from the government a portion
or all of unreimbursed costs associated with the Desktop V Contract. No
assurances can be given that the Company will be successful in recovering any
costs associated with this matter.
Other than the above, there are no material claims pending against the
Company.
There are routine legal claims pending against the Company, but in the
opinion of management, liabilities, if any, arising from such claims will not
have a material adverse effect on the financial condition and results of
operation of the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during
the fourth quarter of the fiscal year covered by this report.
-9-
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
Prior to the quotation of the Company's Common Stock beginning on April
22, 1997, there was no established trading market for the Company's common
stock. The Company's Common Stock is listed on The Nasdaq Stock Market, Inc.'s
SmallCap Market. The Company changed its symbol from "DNCC" to "SCLD" on October
19, 2000. The following table sets forth the high and low selling prices as
reported by The Nasdaq National Market System through June 30, 2003 and on the
Nasdaq SmallCap Market from July 1, 2003 to January 23, 2004, for each fiscal
quarter during the fiscal years ended October 31, 2003 and 2002, as well as for
the first quarter of fiscal 2004 through January 23, 2004. These quotations
reflect inter-dealer prices without retail mark-up, mark-down or commission and
may not represent actual transactions.
FISCAL 2002
HIGH LOW
----------------------
First Quarter.......................................... $3.89 $0.78
Second Quarter......................................... $3.34 $2.32
Third Quarter.......................................... $3.50 $1.62
Fourth Quarter......................................... $2.15 $0.87
FISCAL 2003
HIGH LOW
----------------------
First Quarter.......................................... $1.40 $1.01
Second Quarter......................................... $1.68 $0.97
Third Quarter.......................................... $3.47 $1.26
Fourth Quarter......................................... $5.36 $3.14
FISCAL 2004
HIGH LOW
----------------------
First Quarter (through January 23, 2004)............... $5.12 $3.87
On January 23, 2004 the closing price of the Company's Common Stock as
reported on The Nasdaq SmallCap Market was $3.98 per share. There were
approximately 5,100 shareholders of the Common Stock of the Company as of such
date.
The Company has not paid cash dividends on its Common Stock and does
not intend to do so in the foreseeable future.
-10-
RECENT SALES OF UNREGISTERED STOCK
In March 2000, the Company sold 3,000 shares of its Series A
Convertible Preferred Stock to one investor. In connection with the sale, the
Company received an aggregate of $3,000,000. The shares of preferred stock were
sold in reliance upon the exemption from registration provided by Regulation D
Rule 506 of the Securities Act of 1933, as amended. In August 2001, the Company
redeemed 2,620 shares of the Series A Convertible Preferred Stock which
represented all of the then outstanding Preferred Stock.
In March 2000, the Company issued 225,000 shares of its common stock in
connection with the settlement of a lawsuit with a former employee. The shares
of common stock were issued in reliance upon the exemption from registration
afforded by Section 4(2) of the Securities Act of 1933, as amended.
On October 24, 2003, SteelCloud, Inc. sold 1,887,500 shares of its
common stock to private and institutional investors in a private placement
transaction at a price of $4.00 per share. SteelCloud, Inc. received gross
proceeds of $7,550,000 in connection with this transaction. Brean Murray & Co.,
Inc. and Ferris, Baker Watts, Incorporated acted as co-placement agents in
connection with this private offering. The co-placement agents received an
aggregate of $437,500 and 107,422 warrants to purchase shares of our common
stock as commissions in connection with this offering. Additionally, in
connection with this transaction SteelCloud, Inc. issued an aggregate of 493,359
and 85,938 warrants at an exercise price of $5.81 and $4.00 per share,
respectively, which are exercisable until October 24, 2008. The securities were
sold pursuant to an exemption from registration provided by section 4(2) of the
Securities Act.
-11-
ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL DATA
(IN THOUSANDS, EXCEPT PER SHARE DATA)
The following selected consolidated financial data of SteelCloud should
be read in conjunction with the consolidated financial statements and the notes
thereto and "Management's Discussion and Analysis of Financial Condition and
Results of Operations". The consolidated statement of operations data set forth
below with respect to the fiscal years ended October 31, 2001, 2002 and 2003 and
the consolidated balance sheet data as of October 31, 2002 and 2003 is derived
from and is referenced to the audited consolidated financial statements of
SteelCloud included elsewhere in this Annual Report on Form 10-K. The
consolidated statement of income data set forth below with respect to the fiscal
years ended October 31, 1999, 2000 and 2001 and the consolidated balance sheet
data as of October 31, 1999, 2000 and 2001 is derived from audited consolidated
financial statements of SteelCloud not included in this annual report.
YEAR ENDED OCTOBER 31,
1999 2000 2001 2002 2003
---------------------------------------------------------
CONSOLIDATED STATEMENT OF OPERATIONS DATA: (2)
Net revenues ............................................... $ 28,749 $ 22,509 $ 25,791 $ 29,157 $ 33,043
Costs of revenues .......................................... 23,021 17,481 19,407 22,163 26,353
Gross profit ............................................... 5,729 5,028 6,384 6,994 6,690
Selling, general and administrative,
and amortization ......................................... 36,062 5,510 5,075 6,481 6,321
(Loss) income from operations .............................. (30,333) (482) 1,309 513 369
Other (expense) income, net ................................ (2,908) (123) (184) (222) (5)
(Loss) income from continuing operations
before income taxes and extraordinary gain ............... (33,241) (606) 1,125 291 364
(Benefit from) provision for income taxes .................. (559) 65 102 (280) --
(Loss) income before extraordinary gain and
discontinued operations .................................. (32,683) (671) 1,023 571 364
Extraordinary gain ......................................... -- 750 -- -- --
Cumulative effect of change in accounting principle ........ -- -- (576) -- --
Preferred stock dividends .................................. -- (625) (112) -- --
Increase to income available to common stockholders from
repurchase of preferred stock ............................ -- -- 721 -- --
Net (loss) income from discontinued operations ............. (924) 721 (9) (1,686) (144)
Net (loss) income available to common stockholders ......... $(33,607) $ 176 $ 1,047 $ (1,115) $ 220
Basic (loss) income per share (1) .......................... $ (3.57) $ 0.02 $ 0.10 $ (0.11) $ 0.04
(Loss) income per share assuming dilution (1) .............. $ (3.57) $ 0.02 $ 0.08 $ (0.10) $ 0.03
Weighted average shares outstanding (1) .................... 9,404 9,581 10,111 9,948 10,241
Weighted average shares outstanding assuming dilution (1) .. 9,404 9,581 12,463 10,812 10,962
Pro forma basic (loss) earnings per share
assuming the accounting change is applied retroactively .. $ (3.57) $ (0.04) $ 0.16 $ (0.11) $ 0.04
Pro forma (loss) earnings per share assuming the accounting
change is applied retroactively, assuming dilution ....... $ (3.57) $ (0.04) $ 0.08 $ (0.10) $ 0.03
AT OCTOBER 31,
1999 2000 2001 2002 2003
---------------------------------------------------------
CONSOLIDATED BALANCE SHEET DATA: (2)
Working (deficit) capital .................................. $ (1,239) $ 5,839 $ 7,349 $ 3,856 $ 11,883
Total assets ............................................... 22,287 23,005 17,134 17,633 19,761
Long-term debt ............................................. 2,845 2,598 3,837 60 60
Total liabilities .......................................... 17,470 14,149 9,736 10,876 5,027
Stockholders' equity ....................................... 4,817 8,856 7,398 6,757 14,734
- ------------
(1) Includes the activity of IDP from May 1, 1998 (date of acquisition).
(2) The selected financial data for each year presented has been restated
to reflect the Company's PRIMO operations as a discontinued operation.
-12-
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATION
Certain statements contained herein may constitute forward-looking
statements within the meaning of the Private Securities Litigation Reform Act of
1995. Because such statements include risks and uncertainties, actual results
may differ materially from those expressed or implied by such forward-looking
statements. Factors that could cause actual results to differ materially
include, but are not limited to, risks associated with the integration of
businesses following an acquisition, competitors with broader product lines and
greater resources, emergence into new markets, the termination of any of the
Company's significant contracts, the Company's inability to maintain working
capital requirements to fund future operations or the Company's inability to
attract and retain highly qualified management, technical and sales personnel.
OVERVIEW
Founded in 1987, SteelCloud, Inc, based in Dulles, Virginia, designs,
develops and manufactures customized computer servers and network appliances.
The Company's custom computer servers are designed to meet the precise needs of
volume customers to reduce the customer's investments in logistics, integration
capacity and support. The Company's network security appliances are developed in
collaboration with some of the world's premiere software companies. In addition,
the Company develops proprietary software to optimize the performance of its
security appliances. The Company's appliances are specially designed and
optimized to deliver a dedicated network service such as antivirus gateway
protection, intrusion detection and secure content management.
In fiscal 2003, SteelCloud began focusing its efforts on the network
security marketplace and on the creation of additional SteelCloud intellectual
property. The Company is in the process of creating its own family of hardened
(highly secured) appliances to be delivered as co-branded appliances with its
software partners. With its strategic partners, SteelCloud creates and uniquely
brands ready-to-use turnkey network server appliance solutions combining both
hardware and software. The Company integrates its own, its partner's, or other
third-party software, into a custom designed server platform. The Company
manufactures the resulting product either under a co-branded name or its
partner's brand name allowing the partner to deliver a complete turnkey
solution. The Company enhances its product development and manufacturing
capability by providing custom supply chain and logistics support services to
its partners.
SteelCloud's consulting services organization provides clients with a
seamless extension of their own IT organizations. Expert technical services
include network analysis, security, design, troubleshooting and implementation.
The Company provides Information Technology (IT) support services to the public
sector as well as commercial customers. The Company is also a value-added
reseller for the software products of its strategic partners and certain other
software providers.
FISCAL 2003
PRODUCT DEVELOPMENT
In fiscal 2003, the Company undertook initiatives to enhance its
product offerings and improve its margins. SteelCloud is developing a family of
hardened (highly secured operating system) security appliances that will be
offered as SteelCloud product or as co-branded appliances with its software
partners. Accordingly, the Company commenced its research and development
("R&D") activities associated with these new product offerings in the second
quarter of fiscal 2003. The result of this work has been new appliance platforms
that can be easily tailored to the needs of a particular software package or
technology and SC2, SteelCloud's new proprietary secure management software.
With the Company's goal of increasing margins, the Company expanded its
appliance business model to encompass more direct control in the development and
marketing of its appliances. Product packaging, including the appliance chassis,
has become a major differentiating factor in the marketing of an appliance
server. SteelCloud has increased its capability to develop both custom and
standard chassis offerings for its clients. The Company believes that the
intellectual property that it has developed will enable SteelCloud to be more
competitive from a packaging perspective while decreasing the costs necessary to
bring a product to market. During fiscal 2003, the Company incurred research and
development costs of approximately $494,087 in support of its new business
strategy. SteelCloud will continue to incur these costs as these products are
brought to market. These products are different from previous SteelCloud
appliances in that they are branded solutions integrated with its proprietary
SteelCloud Secure Console (SC2) software.
-13-
In June 2003, the Company entered into an agreement with Computer
Associates International, Inc. to deliver a family of hardened, ready-to-deploy
enterprise-class security appliance for intrusion detection and antivirus
gateway protection based on Computer Associates' eTrust technology. Computer
Associates is one of the largest software companies in the world and delivers
software and services that enable organizations to manage their IT environments.
In July 2003, SteelCloud announced its first co-branded, anti-virus gateway
(AVG, network security product in collaboration with Computer Associates
International, Inc (CA) which was made available in September 2003. In August
2003, SteelCloud expanded its agreement with Computer Associates to include the
marketing of its security appliances in Europe, Asia Pacific, Africa and the
Middle East.
DISCONTINUED OPERATIONS
The Company continually evaluates operating facilities with regard to
the Company's long-term strategic goals established by management and the Board
of Directors. Operating facilities, which are not expected to contribute to the
Company's future operations are either closed or sold. On October 25, 2002, the
Company's management, with the approval of the Board of Directors, determined
that the Puerto Rico Industrial Manufacturing Operation Acquisition, Corp
("PRIMOA") would no longer contribute to future operations and therefore adopted
a plan to dispose of that operation effective on that date. In September 2003,
the Company sold the assets of the operation and contracted with a local firm to
fulfill its warranty obligations through the end of the fiscal year.
Accordingly, the Company has reflected PRIMO as discontinued operations in the
current financial statements. As a result, prior year amounts have been
reclassified to segregate the continuing operations from the discontinued
operations. The loss associated with the discontinued operation was
approximately $48,000 and $134,000 for the three and twelve-month periods ended
October 31, 2003. The loss associated with the sale of PRIMO was approximately
$10,000. The Company does not anticipate additional losses associated with this
operation in future periods. We believe that given the current environment of
that market, discontinuing the operation was the best alternative.
SIGNIFICANT CONTRACTS
In January 2002, the Company was awarded several contracts by Lockheed
Martin valued at more than $10.5 million for customized servers. The Company
commenced work under the contracts in March 2002 and completed the contracts in
October 2003. For the three and twelve month periods ended October 31, 2003, the
Company recognized revenue of approximately $1.2 million and $8.1 million under
these contracts, respectively (or approximately 13% and 24%, respectively, of
total net revenues). In addition, for the year ended October 31, 2003, the
Company had other contracts with this same customer totaling approximately
$663,000 or 2% of its net revenues.
In July 2003, SteelCloud was selected by Lockheed Martin to supply
specialized servers to the Automated Package Processing System (APPS) program
that will upgrade the existing parcel processing capability of the U.S. Postal
Service. The servers will be installed in more than 74 postal service locations.
SteelCloud's contract has an initial estimated value of more than $2.8 million
with contract options for an additional $3.2 million. The Company has shipped
initial delivery orders for more than 100 systems and full production is
expected to begin in fiscal 2004. Two of Lockheed Martin's subcontractors on the
APPS program have also ordered approximately $250,000 in systems and have
indicated plans to order additional systems.
In July 2003, SteelCloud signed an OEM agreement with Microsoft
Corporation under which its new line of branded security appliances developed
around its proprietary SC2 software will utilize a special embedded version of
Microsoft's Windows server. SteelCloud's contract with Microsoft protects our
intellectual property interest in the SC2 software.
In September 2003, the Company entered into an agreement to sell its
hardened security appliances to reseller customers in North America through a
distributor, Arrow Electronics, Inc. The Company anticipates that Arrow will
provide its US Channel Partners with an efficient and effective means to
purchase our security appliances. Additionally, the Company anticipates that
Arrow's supply-chain services will provide its reseller organizations in North
America with all the tools they need to market our security appliances, from
online ordering and reporting to financial services to product launch support.
-14-
SALES OFFICE EXPANSION
The Company continues to maintain sales offices in California and
Boston in order to meet the Company's growing demands. These office locations
allow SteelCloud to expand its customer base and to develop and deploy new
products for its customers to promote future revenue growth.
IMPAIRMENT OF GOODWILL AND OTHER ASSETS
In fiscal 2003, the Company evaluated its acquired goodwill in
accordance with Financial Accounting Standards Board (FASB) Statement No. 142
for possible permanent impairment. As a result of the evaluation, the Company
determined that no impairment charge was warranted.
Fiscal 1999 Termination of a Significant Contract
On July 31, 1998, the Company received notice from the SBA that it was
denying the request of the U.S. Air Force to waive the requirement to terminate
IDP's Desktop V contract for the convenience of the Government upon the change
in control of IDP to the Company. The Company appealed the denial of the SBA to
the SBA's Office of Hearings and Appeals. On August 31, 1999, the SBA denied the
appeal and ruled that the U.S. Air Force must terminate-for-convenience the
Desktop V contract. On May 1, 1999, prior to the SBA ruling, the U.S. Air Force
determined not to exercise any of the remaining option years under the Desktop V
contract and terminated the contract for all participating vendors. Initially
awarded to IDP, the Desktop V contract was the Company's largest contract.
Management believed at the date of the IDP acquisition, the contract would be
renewed by the government through fiscal year 2003 and would generate over $100
million in revenues during that period. As a result of the termination of this
contract, the recoverability of the Company's goodwill associated with the IDP
acquisition was significantly impaired. Accordingly, management recorded an
impairment charge of approximately $21 million during fiscal 1999.
In October 1999, the U.S. Air Force issued a termination-for-
convenience letter to the Company. Under a termination-for-convenience, the
government is required generally to reimburse a contractor for all costs
incurred in the performance of the contract. The Company is in the process of
attempting to recover from the government a portion or all of unreimbursed costs
associated with the Desktop V Contract.
CRITICAL ACCOUNTING POLICIES
The Company believes the following represent its critical accounting
policies:
REVENUE RECOGNITION
The Company recognizes revenue in accordance with SEC Staff Accounting
Bulletin No. 101, REVENUE RECOGNITION IN FINANCIAL STATEMENTS (SAB 101), as
amended by SAB 101A and 101B. SAB 101 requires that four basic criteria must be
met before revenue can be recognized: (1) persuasive evidence of an arrangement
exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and
determinable: and (4) collectibility is reasonably assured. Determination of
criteria (3) and (4) are based on management's judgments regarding the fixed
nature of the fee charged for services rendered and products delivered and the
collectibility of those fees. Should changes in conditions cause management to
determine these criteria are not met for certain future transactions, revenue
recognized for any reporting period could be adversely affected.
Hardware products sold are generally covered by a warranty for periods
ranging from one to three years. The Company accrues a warranty reserve for
estimated costs to provide warranty services. The Company's estimate of costs to
service its warranty obligations is based on historical experience and
expectation of future conditions. To the extent the Company experiences
increased warranty claim activity or increased costs associated with servicing
those claims, its warranty accrual will increase resulting in decreased gross
profit.
For technology support services under time and material contracts, the
Company recognizes revenue as services are provided based on contracted rates
and materials are delivered.
-15-
SEGMENT REPORTING
The company operates as one segment. The chief operating decision maker
reviews the operations of the company as a whole in deciding how to allocate
resources, and assess performance. In accordance with Financial Accounting
Standards (SFAS No. 131) "Disclosures about Segments of an Enterprise and
Related Information", the Company does not disclose segment information.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In January 2003, the FASB issued Interpretation Number 46,
Consolidation of Variable Interest Entities ("FIN 46"). This interpretation of
Accounting Research Bulletin No. 51, Consolidated Financial Statements,
addresses consolidation by business enterprises of variable interest entities.
Under current practice, two enterprises generally have been included in
consolidated financial statements because one enterprise controls the other
through voting interests. FIN 46 defines the concept of "variable interests" and
requires existing unconsolidated variable interest entities to be consolidated
by their primary beneficiaries if the entities do not effectively disperse risks
among the parties involved. This interpretation applies immediately to variable
interest entities created after January 31, 2003. It applies in the first fiscal
year or interim period beginning after June 15, 2003, to variable interest
entities in which an enterprise holds a variable interest that it acquired
before February 1, 2003. The interpretation may be applied prospectively with a
cumulative-effect adjustment as of the date on which it is first applied or by
restating previously issued financial statements for one or more years with a
cumulative-effect adjustment as of the beginning of the first year restated.
Adoption of this standard is not expected to have a material effect on the
Company's financial statements.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement
133 on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies accounting and reporting for derivative instruments and hedging
activities under SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities." SFAS No. 149 is effective for derivative instruments and
hedging activities entered into or modified after June 30, 2003, except for
certain forward purchase and sale securities. For these forward purchase and
sale securities, SFAS No. 149 is effective for both new and existing securities
after June 30, 2003. Adoption is not expected to have a material impact on the
Company's financial statements.
In May 2003, the Financial Accounting Standards Board (FASB) issued
SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics
of both Liabilities and Equity." SFAS No. 150 establishes standards for issuer
classification and measurement of certain financial instruments with
characteristics of both liabilities and equity. Instruments that fall within the
scope of SFAS No. 150 must be classified as a liability. Most of the guidance in
SFAS 150 is effective for financial instruments entered into or modified after
May 31, 2003, and otherwise is effective at the beginning of the first interim
period beginning after June 15, 2003. On November 7, 2003, the provisions of
SFAS 150, relating to mandatorily redeemable non-controlling interest, were
deferred indefinitely. Adoption of this standard is not expected to have a
material effect on the Company's financial statements.
In December 2002, the EITF issued EITF 00-21, Revenue Arrangements with
Multiple Deliverables. This Issue addresses certain aspects of the accounting by
a vendor for arrangements under which it will perform multiple
revenue-generating activities. In some arrangements, the different
revenue-generating activities (deliverables) are sufficiently separable, and
there exists sufficient evidence of their fair values to separately account for
some or all of the deliverables (that is, there are separate units of
accounting). In other arrangements, some or all of the deliverables are not
independently functional, or there is not sufficient evidence of their fair
values to account for them separately. This Issue addresses when and, if so, how
an arrangement involving multiple deliverables should be divided into separate
units of accounting. This Issue does not change otherwise applicable revenue
recognition criteria. The provisions of EITF 00-21 are effective for revenue
arrangements entered into in fiscal periods beginning after June 15, 2003.
Management is currently assessing the impact of the adoption of EITF 00-21 on
the Company's financial statements.
-16-
ACCOUNTING FOR INCOME TAXES
The Company accounts for income taxes using the liability method. In
doing so, the future tax consequences of temporary differences and net operating
losses result in deferred tax assets and liabilities, subject to a valuation
allowance against deferred tax assets when realization is uncertain. As of
October 31, 2003, the Company has recorded a valuation allowance of
approximately $13 million against the total deferred tax asset of $13.4 million,
based upon its evaluation of future estimates of taxable income. The Company's
evaluation included consideration of historical earnings (excluding
non-recurring charges) as well as projected near-term earnings based on its
backlog, customer relationships and operating environment.
-17-
RESULTS OF OPERATIONS
The following table sets forth for the fiscal years ended October 31,
1999, 2000, 2001, 2002 and 2003, certain income and expense items of SteelCloud
as a percentage of net revenues.
1999 2000 2001 2002 2003
---------------------------------------------------------
Net revenues........................................ 100.00% 100.00% 100.00% 100.00% 100.00%
Costs of revenues................................... 80.08% 77.66% 75.25% 76.01% 79.76%
Gross profit........................................ 19.93% 22.34% 24.75% 23.99% 20.24%
Selling, general and administrative and amortization 125.43% 24.48% 19.68% 22.23% 19.13%
(Loss) income from operations....................... (105.51)% (2.14)% 5.08% 1.76% 1.11%
Other (expense) income.............................. (10.12)% (0.55)% (0.71)% (0.76)% 0.01%
(Loss) income before income taxes................... (115.62)% (2.69)% 4.36% 1.00% 1.00%
(Benefit from) provision for income taxes........... (1.94)% 0.29% 0.40% (0.96)% 0.00%
(Loss) income from discontinued operations.......... (3.21%) 3.20% (0.03)% (5.78)% (0.44)%
Net (Loss) income to common stockholders............ (116.90)% 0.78% 4.06% (3.82)% 0.67%
FISCAL YEAR ENDED OCTOBER 31, 2003 COMPARED TO FISCAL YEAR ENDED
OCTOBER 31, 2002
Net revenues of SteelCloud for fiscal year ended October 31, 2003
("fiscal 2003") increased approximately 13% to $33.0 million from $29.2 million
for fiscal year ended October 31, 2002 ("fiscal 2002"). The increase was
primarily the result of increased deliveries on the Company's $10 million server
appliance contract with Lockheed Martin. Revenues under this contract were
approximately $8.1 million in fiscal 2003 compared to $2.4 million in fiscal
2002. This contract was completed in October 2003. The Company is anticipating
additional orders under this contract in fiscal 2004; however, no assurances can
be given that the Company will receive such orders. During fiscal 2003, the
Company derived approximately 24% of its revenues from Lockheed Martin. In
addition, revenues under the Company's GSA schedule increased by approximately
$3.8 million in fiscal 2003. The Company also experienced revenue growth in its
OEM products, reselling activities and consulting services during fiscal 2003.
These increases offset the decrease in revenue from one of the Company's
significant customers in the previous fiscal year, Network Associates, for which
its supply agreement expired on December 31, 2002. Revenues from this agreement
were approximately $10 million in fiscal 2002 compared to $527,000 in fiscal
2003. The increase in revenues was the result of the Company's efforts to expand
its sales force and diversify its revenue sources.
Gross profit for fiscal 2003 decreased by approximately 4% to
approximately $6.7 million from $7.0 million in fiscal 2002. The decrease was
primarily the result of the Company's increase in its reselling activities
during fiscal 2003, which yield lower margins. Gross profit as a percentage of
net revenues during the same periods decreased to 20.2% from 24.0%, which was
also primarily attributable to the increase in the Company's reselling
activities.
Selling and marketing expense increased moderately in fiscal 2003 by 7%
to approximately $1.28 million from approximately $1.2 million for fiscal 2002.
The increase reflects additional marketing and advertising expenditures
associated with the Company's new branded products. Selling and marketing
expense as a percentage of net revenues was unchanged, at 4% in fiscal 2003 and
fiscal 2002 respectively.
General and administrative expense for fiscal 2003 decreased 5% to
$4.55 million from $4.77 million for fiscal 2002. As a percentage of net
revenues, general and administrative expense slightly decreased to 14% for
fiscal 2003 from 16% for fiscal 2002. This decrease was a result of the
Company's revenue growth in fiscal 2003. The general and administrative expense
decrease during fiscal 2003 was attributable to the reversal of a previously
accrued contingency of approximately $250,000. The Company continues to manage
general and administrative costs relative to its net revenue and gross margin.
In fiscal 2002 the Company recorded an impairment charge of
approximately $132,000 related to its remaining goodwill of International Data
Products ("IDP") as the Company had determined that it was permanently impaired.
The remaining intangible assets related to certain contract rights, which have
been fully amortized. The useful life of those contracts has expired. In
addition, the Company recorded an impairment charge of
-18-
approximately $165,000 related to its goodwill acquired in the purchase of
Puerto Rico Industrial Manufacturing Operations ("PRIMO") as that operation was
discontinued in October 2002. The impairment charge for PRIMO goodwill was
included in discontinued operations. In fiscal 2003, the Company did not record
any impairment charges related to its remaining goodwill.
Other expense, including interest, for fiscal 2003 decreased to
approximately $4,700 from approximately $222,000 for fiscal 2002. The decrease
was a result of the Company's ability to fund operations through cash generated
from operations, and not from utilizing the Company's line of credit. In fiscal
2002, the Company recorded a one-time charge of $150,000, to reflect the
permanent decline in market value of its investment in WIZnet, a private entity,
based on its performance.
Net income available to common shareholders increased in fiscal 2003 to
$219,988 from $(1,115,186) in fiscal 2002. Fiscal 2002 net income included a
loss from discontinued operations of approximately $1.7 million, and
approximately $279,800 of income tax benefit. The Company currently has
approximately $32.6 million in Net Operating Loss ("NOL") carryforwards, which
may be used to offset future income. The $13.4 million deferred tax asset was
fully reserved prior to October 31, 2003. As of October 31, 2003, a deferred tax
asset of $400,000 was recognized based on fiscal 2004 estimated taxable income
for which it may offset. Approximately $32.6 million of NOLs remain fully
reserved as of October 31, 2003. This reserve will be released in future periods
if and when the Company determines it is more likely than not that additional
deferred tax assets will be recovered.
FISCAL YEAR ENDED OCTOBER 31, 2002 COMPARED TO FISCAL YEAR ENDED
OCTOBER 31, 2001
Net revenues of SteelCloud for fiscal year ended October 31, 2002
("fiscal 2002") increased approximately 13% to $29.2 million from $25.8 million
for fiscal year ended October 31, 2001 ("fiscal 2001"). The increase was due to
the commencement of a significant contract with Lockheed Martin in January 2002.
The Company recognized approximately $2.5 million under the $10.5 million
contract. The Company anticipates completion of this contract in July 2003;
however, the Company is discussing other contracts with this customer, which
could result in additional orders. No assurances can be given that such
discussions will result in follow-on orders from this customer. As of October
31, 2002, the Company had unearned revenue of approximately $4.5 million, which
primarily consisted of goods associated with the Lockheed Martin contract for
which the Company received milestone payments. In addition, the Company
experienced growth in its OEM sales, consulting services sales and Federal
Government sales in fiscal 2002 as a result of its focus on those markets.
During Fiscal 2002, the Company derived approximately 64% of its revenues from
two customers.
During fiscal 2002, the Company's revenues from its reselling
activities increased to approximately $2.4 million from approximately $2.1
million in fiscal 2001. The increase is a result of the Company's partnerships
with certain software companies.
Gross profit for fiscal 2002 increased by approximately 10% to $7.0
million from $6.4 million in fiscal 2001. The increase is the result of the
Company's revenue growth as both sales and gross profit had double digit
increases in fiscal 2002. Gross profit as a percentage of net revenues during
the same periods decreased slightly to 24.0% from 24.8%, which was the result of
a downward economy and the Company's effort to be more aggressive in its
margins. In addition, gross margin in fiscal 2002 was negatively impacted by
$526,000 for inventory obsolescence and shrinkage.
Selling and marketing expense significantly increased in fiscal 2002 by
64% to approximately $1.2 million from approximately $725,000 for fiscal 2001.
During fiscal 2002, the Company opened regional sales offices in California and
Massachusetts in its efforts to expand markets and produce revenue growth.
Selling and marketing expense as a percentage of net revenues, increased 1% in
fiscal 2002 to 4% from 3% in fiscal 2001.
General and administrative expense for fiscal 2002 increased 21% to
$4.8 million from $4.0 million for fiscal 2001. As a percentage of net revenues,
general and administrative expense slightly increased to 16% for fiscal 2002
from 15% for fiscal 2001. This increase was a result of the Company's revenue
growth in fiscal 2002. In addition, fiscal 2001 general and administrative
expenses were significantly reduced as the Company settled certain liabilities
for amounts less than previously recorded. Accordingly, all previously recorded
accruals were reversed as a result of the settlement, which reduced general and
administrative expenses. The Company will continue to manage general and
administrative costs relative to its net revenue and gross margin.
-19-
In fiscal 2002 the Company recorded an impairment charge of
approximately $132,000 related to its remaining goodwill of International Data
Products ("IDP") as the Company had determined that it was permanently impaired.
The remaining goodwill related to certain contracts, which had matured/expired
in fiscal 2002. In addition, the Company recorded an impairment charge of
approximately $165,000 related to its goodwill acquired in the purchase of
Puerto Rico Industrial Manufacturing Operations ("PRIMO") as that operation was
discontinued in October 2002. The impairment charge for PRIMO goodwill was
included in discontinued operations.
Other expense, including interest, for fiscal 2002 increased to
approximately $222,000 from approximately $184,000 for fiscal 2001. Interest
expense, net decreased by approximately 54% to $73,000 in fiscal 2002 from
$158,000 in fiscal 2001. This was a result of the Company's significant
reduction in its outstanding debt as well as a continual decline in short-term
borrowing rates throughout fiscal 2002. In fiscal 2002, the Company recorded a
one-time charge of $150,000, to reflect the permanent decline in market value
for its investment in WIZnet, a private entity, based on its current
performance.
Net income available to common shareholders decreased approximately
207% in fiscal 2002 to $(1,115,185) from $1,047,041 in fiscal 2001. Included in
net income is approximately $279,800 of income tax benefit. The Company has
approximately $11 million in Net Operating Loss ("NOL") carryforwards, which may
be used to offset future income. The $11 million deferred tax asset was fully
reserved prior to October 31, 2002. As of October 31, 2002, a deferred tax asset
of $400,000 was recognized based on fiscal 2003 estimated taxable income for
which it may offset. A portion of the resulting tax benefit associated with the
tax deductions relating to stock options exercised were credited to stockholders
equity. Approximately $10.6 million of NOLs remain fully reserved as of October
31, 2002. This reserve will be released in future periods as the company
continues to generate taxable income for which the asset will be used to offset.
Fiscal 2001 net income available to common shareholders includes
certain one-time and non-recurring increases to income available to common
stockholders of $721,816 relating to the Series A Convertible Preferred Stock
private placement with Briarcliff Investors LLC, which closed in March 2000 and
the redemption of those preferred shares in August 2001 for $2.5 million. Net
income available to common shareholders is also comprised of the accumulating 5%
dividends on the Series A Convertible Preferred Stock for the period those
shares were outstanding.
LIQUIDITY AND CAPITAL RESOURCES
As of October 31, 2003, the Company had cash and cash equivalents of
approximately $8.1 million and working capital of approximately $11.9 million.
The Company believes cash on hand together with cash generated from operations
will provide sufficient financial resources to finance current operations of the
Company through fiscal 2004.
In fiscal 2003, the Company generated approximately $140,000 in cash
flow from operating activities of continuing operations. The Company generated
net income from continuing operations of approximately $364,000 collected
accounts receivable of approximately $750,000, sold inventory of approximately
$1.4 million and recognized deferred contract costs of approximately $2.0
million. The cash generated was used primarily to pay accounts payable and
accrued expenses of approximately $488,000. In addition, the Company recognized
deferred revenue of approximately $4.2 million.
The Company's investing activities consisted of the purchases of
approximately $228,000 for property and equipment.
The Company's financing activities during fiscal 2003 were provided
primarily by the Company's issuance of common stock, and proceeds from the
exercise of common stock options. Issuance of the Company's common stock
generated approximately $7.4 million, net of expenses. Proceeds from the
exercise of common stock options generated approximately $366,000. The Company
did not materially rely on its bank line of credit during fiscal 2003. The line
of credit expires on March 31, 2004 and currently bears interest at the lower of
(a) prime or (b) the LIBOR Market Index Rate plus two and one-half percent. As
of December 31, 2003, the Company had an outstanding balance on the line of
credit of approximately $0 and available borrowing capacity of approximately
$3.5 million.
-20-
In February 2002, the Company executed a promissory note in conjunction
with its line of credit in the amount of $725,000. The note's interest was at
the lower of (a) the Lender's Prime Rate per annum or (b) the LIBOR Market Index
Rate plus 2.5% and matured on July 5, 2003. The Company made monthly principal
payments of approximately $43,000. In July 2003, the Company extinguished its
debt and repaid the loan in its entirety.
On October 24, 2003, the Company sold 1,887,500 shares of its common
stock to private and institutional investors in a private placement transaction
at a price of $4.00 per share. SteelCloud, Inc. received gross proceeds of
$7,550,000 in connection with this transaction. Brean Murray & Co., Inc. and
Ferris, Baker Watts, Incorporated acted as co-placement agents in connection
with this private offering. The co-placement agents received an aggregate of
$437,500 and 107,422 warrants to purchase shares of our common stock as
commissions in connection with this offering. Additionally, in connection with
this transaction the Company issued an aggregate of 493,359 and 85,938 warrants
at an exercise price of $5.81 and $4.00 per share, respectively, which are
exercisable until October 24, 2008. The securities were sold pursuant to an
exemption from registration provided by section 4(2) of the Securities Act.
In fiscal 2003, the Company received proceeds from the exercise of
stock options of approximately $366,000. Approximately 570,000 shares of common
stock were issued upon the exercise of these stock options.
The Company has obligations under its operating lease commitments of
approximately $363,549 for fiscal 2004.
From time to time, the Company may pursue strategic acquisitions or
mergers, which may require significant additional capital. In such event, the
Company may seek additional financing of debt and/or equity.
OFF-BALANCE SHEET ARRANGEMENTS
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
The Company's significant contractual obligations as of October 31,
2003 are for debt and operating leases. Debt by year of maturity and future
rental payments under operating lease agreements are presented below. As of
October 31, 2003, the Company does not have an outstanding balance on its line
of credit and does not have any purchase obligations. The Company has not
engaged in off-balance sheet financing, commodity contract trading or
significant related party transactions.
- -------------------------- ------------------------------------------------------------------------------
CONTRACTUAL OBLIGATIONS PAYMENTS DUE BY PERIOD
- -------------------------- ------------------------------------------------------------------------------
Total Less than 1 1-3 years 4-5 years After 5
year years
- -------------------------- ----------------- ---------------- --------------- ------------- -------------
Notes payable - current $ 96,133 $ 96,133 - - -
- -------------------------- ----------------- ---------------- --------------- ------------- -------------
Notes payable - long term 59,922 - 45,224 14,698 -
- -------------------------- ----------------- ---------------- --------------- ------------- -------------
Operating lease 455,103 363,549 91,554 - -
- -------------------------- ----------------- ---------------- --------------- ------------- -------------
-21-
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to market risk related to fluctuations in
interest rates on its debt. Increase in prevailing interest rates could increase
the Company's interest payment obligations relating to variable rate debt. For
example, a 100 basis point increase in interest rates would increase annual
interest expense by $38,000.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
FINANCIAL STATEMENTS OF STEELCLOUD, INC.
PAGE
Report of Grant Thornton LLP, Independent Auditors...................... F-1
Report of Ernst & Young LLP, Independent Auditors....................... F-2
Consolidated Balance Sheets............................................. F-3
Consolidated Statements of Operations................................... F-4
Consolidated Statements of Stockholders' Equity......................... F-5
Consolidated Statements of Cash Flows................................... F-6
Notes to the Consolidated Financial Statements.......................... F-7
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL ISSUES
On October 10, 2002, SteelCloud, Inc. (the "Company") dismissed Ernst &
Young LLP ("E&Y") as its independent certified public accountants. During the
fiscal years ended October 31, 2001 and 2000 the reports by Ernst & Young LLP on
the financial statements of the Company did not contain an adverse opinion or a
disclaimer of opinion, or was qualified or modified as to uncertainty, audit
scope, or accounting principles. During the Company's two most recent fiscal
years and subsequent period up to October 10, 2002, there were no disagreements
with the former accountant on any matter of accounting principles or practices,
financial statement disclosure, or auditing scope or procedure, which
disagreements if not resolved to their satisfaction would have caused them to
make reference in connection with their opinion to the subject matter of the
disagreement, other than the matter discussed below.
As discussed on the Company's quarterly financial conference call held
on June 6, 2002, during the quarter ended April 30, 2002, the Company and Ernst
& Young LLP had a difference of opinion with respect to revenue recognition
relating to a contractual arrangement between the Company and one of its
customers for the delivery of assembled computer units. The arrangement provides
the customer with the ability to order and pay for certain components to be
included in the units prior to delivery of the completed units. Ernst & Young
LLP concluded that the payments received from the customer relating to such
components should be deferred and recognized as revenue concurrent with the
delivery of the completed units as delivery of the components had not yet
occurred, and there remained services to be rendered and obligations to be
satisfied. Ernst & Young LLP discussed this matter with members of the Audit
Committee and members of the Board of Directors. After management discussed
Ernst & Young LLP's opinion with members of the Company's Audit Committee, the
Company accepted Ernst & Young LLP's opinion and adopted the accounting
treatment suggested by Ernst & Young LLP with respect to revenue recognition in
connection with this matter and does not continue to have a difference of
opinion with Ernst & Young with respect to this matter.
On October 11, 2002, upon receipt of approval of the Audit Committee of
the Company's Board of Directors, the Company engaged Grant Thornton LLP to
serve as the Company's independent certified public accountants. Prior to
October 11, 2002, the Company did not consult with Grant Thornton LLP on any
accounting or auditing issues.
-22-
ITEM 9A. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. Our management, with
the participation of our principal executive officer and principal financial
officer, has evaluated the effectiveness of our disclosure controls and
procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934, as amended (the "Exchange Act")) pursuant to
Rule 13a-15(c) under the Exchange Act as of the end of the period covered by
this Annual Report on Form 10-K. Based on this evaluation, our Chief Executive
Officer and Chief Financial Officer have concluded that, as of such date, our
disclosure controls and procedures are effective to provide reasonable assurance
that information required to be disclosed by us in reports that we file or
submit under the Exchange Act is recorded, processed, summarized and reported
within the time periods specified in applicable SEC rules and forms.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING. There was no
change in our internal control over financial reporting (as defined in Rules
13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the period
covered by this Annual Report on Form 10-K that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.
-23-
PART III
The Notice and Proxy Statement for the 2003 Annual Meeting of
Stockholders to be filed pursuant to Regulation 14A under the Securities and
Exchange Act of 1934, as amended, which is incorporated by reference in this
Annual Report on Form 10-K pursuant to General Instruction G (3) of Form 10-K,
will provide the information required under Part III, including Item 10
(directors and executive officers of the Company), Item 11 (Executive
Compensation), Item 12 (security ownership of certain beneficial owners and
management), and Item 13 (certain relationships and related transactions), which
will be filed within 120 days after the end of the fiscal year covered by this
Form 10-K.
ITEM 15. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report
1. Financial Statements SteelCloud, Inc.
Report of Grant Thornton LLP, Independent Auditors
Report of Ernst & Young LLP, Independent Auditors
Consolidated Balance Sheets as of October 31, 2002 and 2003
Consolidated Statements of Operations for the three years ended
October 31, 2003
Consolidated Statements of Stockholders' Equity for the three
years ended October 31, 2003
Consolidated Statements of Cash Flows for the three years ended
October 31, 2003
Notes to Consolidated Financial Statements
2. Financial Statement Schedules
Schedule II Valuation and Qualifying Accounts
Statements not listed above have been omitted because they are not
applicable or the information required to be set forth therein is
included in the Consolidated Financial Statements or the notes thereto
under Item 8.
(b) Reports on Form 8-K
On September 11, 2003, the Company filed a report on Form 8-K pursuant
to Items 7 and 12. On October 28, 2003, the Company filed a report on
Form 8-K pursuant to Items 5 and 7. On October 29, 2003, the Company
filed a report on Form 8-K pursuant to Item 7.
(c) Exhibits.
EXHIBIT DESCRIPTION
NUMBER
**3.1 Articles of Incorporation of the Company, dated February 25, 1998, and
effective as of February 26, 1998. (Filed as Exhibit 3.1 to the
Company's Registration Statement on Form S-1, Amendment No. 1, dated
April 23, 1998 (File No. 333-47631) and hereby incorporated by
reference.)
**3.2 By-laws of the Company, effective as of March 5, 1998. (Filed as
Exhibit 3.2 to the Company's Registration Statement on Form S-1,
Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby
incorporated by reference.)
**4.1 Specimen common stock certificate for the Company. (Filed as Exhibit
4.1 to the Company's Registration Statement on Form S-1, Amendment No.
2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated
by reference.)
**10.8 Employment Agreement by and between Dunn and Thomas P. Dunne (Filed as
Exhibit 99.2 to Dunn's Registration Statement on Form SB-2, Amendment
2, dated April 4, 1997 (File No. 333-19635) and hereby incorporated by
reference).
-24-
**10.10 Deed of Lease, dated February 7, 1997, between APA Properties No. 6
L.P. and STMS, Inc. and First Amendment thereto, dated July 23, 1997
(Filed as Exhibit 10.10 to Dunn's Form 10-KSB, dated January 30, 1998
(File No. 0-22263) and hereby incorporated by reference).
**10.11 1997 Stock Option Plan, as amended. (Filed as Exhibit 10.11 to the
Company's Registration Statement on Form S-1, Amendment No. 2, dated
April 23, 1998 (File No. 333-47631) and hereby incorporated by
reference.)
**10.13 Agreement, dated May 5, 1997, by and between International Data
Products, Corp. and the U.S. Air Force, the Desktop V Contract. (Filed
as Exhibit 10.13 to the Company's Registration Statement on Form S-1,
Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby
incorporated by reference.)
**10.16 Deed of Lease, dated July 15, 1994, between Puerto Rico Industrial
Development Company and Puerto Rico Industrial Manufacturing
Operations, Corp. (Filed as Exhibit 10.16 to the Company's
Registration Statement on Form S-1, Amendment No. 2, dated April 23,
1998 (File No. 333-47631) and hereby incorporated by reference.)
**10.22 Employee Stock Purchase Plan.
**10.25 Termination agreement, Promissory Note, dated December 29, 1999 by and
between Dunn and Deutsche Financial Services.
**10.26 Loan and Security Agreement, dated May 27, 1999 by and between Dunn
and First Union Commercial Corporation.
**10.27 Modification Agreement dated February 11, 2000 by and between Dunn and
First Union National Bank.
**10.29 Modification Agreement dated January 18, 2002 by and between
SteelCloud, Inc. and First Union National Bank.
**10.30 Second Modification Agreement dated March 31, 2003, by and between
Steel Cloud, Inc., a Virginia Corporation, Dunn Computer Corporation,
a Delaware corporation, International Data Products, Corp., STMS,
Inc., Puerto Rico Industrial Manufacturing Operations Acquisition,
Corp. and Dunn Computer Operating Company (collectively, the
"Borrower") and Wachovia Bank, National Association, formerly known as
First Union National Bank.
*11.1 Statement of Computation of Earnings Per Share.
*21.1 List of Subsidiaries.
*23.1 Consent of Grant Thornton LLP, Independent Auditors.
*23.2 Consent of Ernst & Young LLP, Independent Auditors.
*31.1 Certification of Chief Executive Officer Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002
*31.2 Certification of Vice President, Finance Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002
*32.1 Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes - Oxley Act of 2002
*32.2 Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes - Oxley Act of 2002
- -----------
* Filed herewith
** Previously filed.
-25-
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
STEELCLOUD, INC.
Date: January 29, 2004 By: /S/ THOMAS P. DUNNE
-------------------
Thomas P. Dunne
CHIEF EXECUTIVE OFFICER
Pursuant to and in accordance with the requirements of the Securities
Exchange Act of 1934, this report has been signed by the following persons on
behalf of the registrant and in the capacities and on the dates indicated.
NAME TITLE DATE
/S/ THOMAS DUNNE Chief Executive Officer
Thomas P. Dunne and Director January 29, 2004
/S/KEVIN MURPHY
Kevin Murphy Chief Financial Officer January 29, 2004
/S/ VADM E.A. BURKHALTER
VADM E. A. Burkhalter USN (Ret.) Director January 29, 2004
/S/JAMES BRUNO
James Bruno Director January 29, 2004
/S/ JAY KAPLOWITZ
Jay Kaplowitz Director January 29, 2004
/S/BENJAMIN KRIEGER
Benjamin Krieger Director January 29, 2004
/S/ RICHARD PRINS
Richard Prins Director January 29, 2004
-26-
INDEX TO FINANCIAL STATEMENTS
STEELCLOUD, INC (A VIRGINIA CORPORATION)
Report of Grant Thornton LLP, Independent Auditors ....................... F-1
Report of Ernst & Young LLP, Independent Auditors ........................ F-2
Consolidated Balance Sheets as of October 31, 2002 and 2003 .............. F-3
Consolidated Statements of Operations for the
three years ended October 31, 2003 .................................... F-4
Consolidated Statements of Stockholders' Equity
for the three years ended October 31, 2003 ............................ F-5
Consolidated Statements of Cash Flows for the
three years ended October 31, 2003 .................................... F-6
Notes to Consolidated Financial Statements ............................... F-7
-27-
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders
SteelCloud, Inc.
We have audited the accompanying consolidated balance sheets of
SteelCloud, Inc. as of October 31, 2003 and 2002, and the related consolidated
statements of operations, stockholders' equity, and cash flows for the years
then ended. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of SteelCloud,
Inc. as of October 31, 2003 and 2002, and the results of its operations and its
cash flows for the years then ended in conformity with accounting principles
generally accepted in the United States of America.
As discussed in note 5 to the consolidated financial statements the
Company adopted Statement of Financial Accounting Standards No. 142, GOODWILL
AND OTHER INTANGIBLE ASSET on November 1, 2002
/s/ Grant Thornton LLP
- -----------------------
Vienna, VA
December 19, 2003
F-1
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
Board of Directors
SteelCloud, Inc.
We have audited the accompanying consolidated statements of operations,
stockholders' equity and cash flows of SteelCloud, Inc. (a Virginia Corporation)
for the year ended October 31, 2001. These consolidated financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the consolidated
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the consolidated financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation. We believe that our
audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated results of operations
of SteelCloud, Inc. and its cash flows for the year ended October 31, 2001, in
conformity with accounting principles generally accepted in the United States.
As discussed in Note 2 of the Notes to the Consolidated Financial
Statements, in 2001 the Company changed its method of accounting for convertible
securities with beneficial conversion features.
/s/ ERNST & YOUNG LLP
---------------------
December 21, 2001
McLean, Virginia
F-2
STEELCLOUD, INC.
CONSOLIDATED BALANCE SHEETS
OCTOBER 31,
----------------------------
2002 2003
------------ ------------
ASSETS
Current assets:
Cash and cash equivalents .................................................. $ 751,323 $ 8,098,221
Accounts receivable, net of allowance for
doubtful accounts of $293,000 as of
October 31, 2002 and 2003 ............................................. 6,082,340 5,332,549
Inventory, net ............................................................. 4,180,812 2,880,944
Deferred tax asset ......................................................... 400,000 400,000
Income tax receivable ...................................................... 55,392 55,392
Prepaid expenses and other current assets .................................. 208,892 184,420
Deferred contract costs .................................................... 2,039,339 7,053
Assets held for sale ....................................................... 953,320 --
------------ ------------
Total current assets .......................................................... 14,671,418 16,958,579
Property and equipment, net ................................................... 304,081 477,111
Equipment on lease, net ....................................................... 574,272 335,935
Goodwill and other intangible assets, net ..................................... 1,778,059 1,778,059
Other assets .................................................................. 304,922 211,155
------------ ------------
Total assets .................................................................. $ 17,632,752 $ 19,760,839
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ........................................................... $ 3,620,580 $ 3,202,195
Accrued expenses ........................................................... 1,542,277 1,369,145
Notes payable, current portion ............................................. 503,823 96,133
Liabilities held for sale .................................................. 641,145 --
Unearned revenue ........................................................... 4,507,859 293,363
------------ ------------
Total current liabilities ..................................................... 10,815,684 4,960,836
Notes payable, long-term portion .......................................... 60,000 59,952
Other ..................................................................... -- 6,415
------------ ------------
Total long-term liabilities ................................................... 60,000 66,367
Stockholders' equity:
Common stock, $.001 par value;
50,000,000 shares authorized,
10,447,611 and 13,008,553 shares issued
and outstanding at October 31, 2002 and 2003,
respectively ............................................................... 10,448 13,009
Additional paid-in capital .................................................... 39,553,017 47,307,036
Treasury stock, 400,000 shares at October 31, 2002
and 2003, respectively ..................................................... (3,432,500) (3,432,500)
Accumulated deficit ........................................................... (29,373,897) (29,153,909)
------------ ------------
Total stockholders' equity .................................................... 6,757,068 14,733,636
------------ ------------
Total liabilities and stockholders' equity .................................... $ 17,632,752 $ 19,760,839
============ ============
SEE ACCOMPANYING NOTES
F-3
STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED OCTOBER 31,
--------------------------------------------
2001 2002 2003
------------ ------------ ------------
Net revenues ...................................... $ 25,791,082 $ 29,157,368 $ 33,042,999
Costs of revenues ................................. 19,406,836 22,163,435 26,353,462
------------ ------------ ------------
Gross profit ...................................... 6,384,246 6,993,933 6,689,537
Selling and marketing ............................. 724,337 1,184,406 1,276,386
General and administrative ........................ 3,956,293 4,769,552 4,550,414
Research and product development .................. -- -- 494,087
Impairment of goodwill ............................ -- 132,644 --
Amortization of goodwill .......................... 394,216 394,216 --
------------ ------------ ------------
Income from operations ............................ 1,309,400 513,115 368,650
Other income (expense):
Interest income ................................ 87,961 5,525 5,661
Interest expense ............................... (245,532) (78,734) (22,800)
Other, net ..................................... (26,396) (149,183) 12,421
------------ ------------ ------------
Income from continuing operations before income tax 1,125,433 290,723 363,932
Provision for (benefit from) income taxes ......... 102,276 (279,800) --
------------ ------------ ------------
Income from continuing operations ................. 1,023,157 570,523 363,932
(Loss) from discontinued operations, net of tax ... (9,431) (1,685,708) (134,367)
(Loss) on disposal of discontinued operations,
net of tax ..................................... -- -- (9,577)
------------ ------------ ------------
Income (loss) before cumulative effect of ......... $ 1,013,726 $ (1,115,185) $ 219,988
accounting change
Cumulative effect of change in accounting principle (576,001) -- --
------------ ------------ ------------
Net income (loss) ................................. $ 437,725 $ (1,115,185) $ 219,988
Dividends to preferred stockholders ............... (112,500) -- --
Increase to income available to common stockholders
from repurchase of preferred stock ........... 721,816 -- --
------------ ------------ ------------
Net income (loss) available to common stockholders $ 1,047,041 $ (1,115,185) $ 219,988
============ ============ ============
Earnings (loss) per share, basic
Earnings from continuing operations ............... $ 0.10 $ 0.06 $ 0.04
(Loss) from discontinued operations ............... -- (0.17) (0.01)
------------ ------------ ------------
Net earnings (loss) per share ..................... $ 0.10 $ (0.11) $ 0.03
============ ============ ============
Earnings (loss) per share, fully diluted
Earnings (loss) from continuing operations ........ $ 0.08 $ 0.05 $ 0.03
(Loss) from discontinued operations ............... -- (0.15) (0.01)
------------ ------------ ------------
Net earnings (loss) per share ..................... $ 0.08 $ (0.10) $ 0.02
============ ============ ============
Pro forma amounts assuming the
accounting change is applied retroactively:
Net income (loss) to common stockholders .......... $ 1,623,042 $ (1,115,185) $ 219,988
============ ============ ============
Net earnings (loss) per share, basic .............. $ 0.16 $ (0.11) $ 0.03
============ ============ ============
Net earnings (loss) per share, fully diluted ...... $ 0.08 $ (0.10) $ 0.02
============ ============ ============
SEE ACCOMPANYING NOTES.
F-4
STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
ADDITIONAL
PREFERRED STOCK COMMON STOCK PAID-IN
SHARES AMOUNT SHARES AMOUNT CAPITAL
-------------------------------------------------------------------------
BALANCE AT
OCTOBER 31, 2000 ..... 2,850 3 9,806,962 9,807 41,584,844
Conversion of
Series A Convertible
Preferred Stock ...... (230) -- 390,267 391 (391)
Conversion of
Preferred Stock
dividends to shares
of Common Stock ...... -- -- 17,316 17 10,019
Dividend Declared on
Series A Convertible
Preferred Stock ...... -- -- -- -- --
Cumulative effect of
change in accounting
principle ............ -- -- -- -- 576,001
Redemption of
preferred Stock ...... (2,620) (3) -- (3,091,076) --
Net Income ........... -- -- -- -- --
-------------------------------------------------------------------------
BALANCE AT ........... 10,214,545 $ 10,215 $ 39,079,397
OCTOBER 31, 2001
Issuance of
common stock
in connection
with exercise
of employee
incentive
stock option
plan ................. -- -- 227,826 228 272,465
Issuance of
common stock
for services ......... -- -- 5,240 5 17,495
Tax benefit associated
with exercise of
employee
stock options ........ -- -- -- -- 119,000
Compensation expense
associated with the
issuance of stock
options .............. -- -- -- -- 64,660
Net Income ........... -- -- -- -- --
-------------------------------------------------------------------------
BALANCE AT ........... 10,447,611 $ 10,448 $ 39,553,017
OCTOBER 31, 2002
Issuance of
common stock
in connection
with exercise
of employee
incentive
stock option
plan ................. -- -- 673,442 673 789,882
Issuance of
common stock ......... 6,966,025
under private
placement ............ -- -- 1,887,500 1,888 6,964,137
Net Income ........... -- -- -- -- --
-------------------------------------------------------------------------
BALANCE AT ........... 13,008,553 $ 13,009 $ 47,307,036
OCTOBER 31, 2003
=========================================================================
RETAINED
TREASURY EARNINGS
STOCK (ACCUMULATED TOTAL
DEFICIT)
-------------------------------------------
BALANCE AT
OCTOBER 31, 2000 ..... (3,432,500) (29,305,753) 8,856,401
Conversion of
Series A Convertible
Preferred Stock ...... -- -- --
Conversion of
Preferred Stock
dividends to shares
of Common Stock ...... -- -- 10,036
Dividend Declared on
Series A Convertible
Preferred Stock ...... -- (112,500) (112,500)
Cumulative effect of
change in accounting
principle ............ -- (576,001) --
Redemption of
preferred Stock ...... 721,816 (2,369,263)
Net Income ........... -- 1,013,726 1,013,726
-------------------------------------------
BALANCE AT ........... $ (3,432,500) $(28,258,712) $ 7,398,400
OCTOBER 31, 2001
Issuance of
common stock
in connection
with exercise
of employee
incentive
stock option
plan ................. -- -- 272,693
Issuance of
common stock
for services ......... -- -- 17,500
Tax benefit associated
with exercise of
employee
stock options ........ -- -- 119,000
Compensation expense
associated with the
issuance of stock
options .............. -- -- 64,660
Net Income ........... -- (1,115,185) (1,115,185)
-------------------------------------------
BALANCE AT ........... $ (3,432,500) $(29,373,897) $ 6,757,068
OCTOBER 31, 2002
Issuance of
common stock
in connection
with exercise
of employee
incentive
stock option
plan ................. -- -- 790,555
Issuance of
common stock .........
under private
placement ............ -- --
Net Income ........... -- 219,988 219,988
-------------------------------------------
BALANCE AT ........... $ (3,432,500) $(29,153,909) 14,733,636
OCTOBER 31, 2003
===========================================
SEE ACCOMPANYING NOTES.
F-5
STEELCLOUD, INC
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED OCTOBER 31,
-----------------------------------------
2001 2002 2003
----------- ----------- -----------
OPERATING ACTIVITIES
Net income (loss) .............................. $ 437,725 $(1,115,185) $ 219,988
Cumulative change in accounting principle ...... 576,001 -- --
Loss from discontinued operations, net ......... 9,431 1,685,708 143,944
----------- ----------- -----------
Income applicable from continuing operations ... 1,023,157 570,523 363,932
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization of property and 1,301,588 683,860 331,553
equipment
Amortization of goodwill and other .......... 394,216 394,216 --
intangibles
Impairment of goodwill ...................... -- 132,644 --
Impairment charge - investment .............. -- 150,000 --
Provision for bad debt ...................... -- 161,030 --
(Gain) loss on sale of assets ............... -- 4,196 --
(Gain) on settlement of litigation .......... (343,087) -- --
Stock compensation expense .................. -- 82,160 --
Changes in operating assets and liabilities:
Accounts receivable, net .................. (2,258,763) (586,275) 749,791
Income tax receivable ..................... (1,169,743) 1,345,032 --
Inventory ................................. (267,972) 117,458 1,336,334
Prepaid expenses and other assets ......... 38,236 41,688 29,394
Deferred contract costs ................... -- (2,039,339) 2,032,286
Deferred tax asset (credit) ............... 1,282,695 (279,800) --
Accounts payable .......................... 600,954 454,159 (321,574)
Accrued expenses .......................... 213,513 53,462 (166,718)
Unearned revenue and other liabilities .... 77,695 4,294,474 (4,214,496)
----------- ----------- -----------
Net cash provided by operating
activities of continuing operations ............ 892,489 5,579,488 140,502
INVESTING ACTIVITIES
Purchases of property and equipment ............ (518,956) (704,030) (228,177)
----------- ----------- -----------
Net cash (used in) investing activities ........ (518,956) (704,030) (228,177)
FINANCING ACTIVITIES
Proceeds from issuance of common stock, net of . -- -- 7,390,559
expenses
Payments made to redeem preferred stock ........ (2,562,739) -- --
Proceeds from exercise of common stock options . -- 272,693 366,021
Proceeds on notes payable ...................... -- 725,000 --
Payments on notes payable ...................... (430,022) (515,742) (538,436)
Net proceeds from (repayments on)
lines of credit, net ........................... 1,353,551 (3,836,754) --
----------- ----------- -----------
Net cash (used in) provided by financing ....... (1,639,210) (3,354,803) 7,218,144
activities
Net (decrease) increase in cash
and cash equivalents
of continuing operations ....................... (1,265,677) 1,520,655 7,130,469
Net cash provided by (used in)
operating activities of discontinued
operations ..................................... 1,231,288 (1,051,650) 216,429
Cash and cash equivalents at beginning of ...... 316,707 282,318 751,323
year
----------- ----------- -----------
Cash and cash equivalents at end of year ....... $ 282,318 $ 751,323 $ 8,098,221
=========== =========== ===========
SUPPLEMENTAL CASH FLOW INFORMATION
Interest paid .................................. $ 336,128 $ 129,287 $ 23,345
----------- ----------- -----------
Income taxes paid .............................. $ 185,210 $ 1,200 --
=========== =========== ===========
SEE ACCOMPANYING NOTES
F-6
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
OCTOBER 31, 2001, 2002 AND 2003
1. ORGANIZATION
Founded in 1987, SteelCloud, Inc, based in Dulles, Virginia, designs,
develops and manufactures customized computer servers and network appliances.
The Company's custom computer servers are designed to meet the precise needs of
volume customers to reduce the customer's investments in logistics, integration
capacity and support. The Company's network security appliances are developed in
collaboration with some of the world's premiere software companies. In addition,
the Company develops proprietary software to optimize the performance of its
security appliances. The Company's appliances are specially designed and
optimized to deliver a dedicated network service such as antivirus gateway
protection, intrusion detection and secure content management.
On May 15, 2001, the shareholders approved an amendment to the
Company's articles of incorporation to change the corporate name from Dunn
Computer Corporation to SteelCloud, Inc.
On October 25, 2002, management, with the approval of the Board of Directors,
determined that its Puerto Rico Industrial Manufacturing Operation ("PRIMO")
would no longer contribute to the Company's future operations and therefore
adopted a plan to cease that operation effective on that date. In September
2003, the Company sold the assets of the operation. Accordingly, the Company has
reflected this operation as discontinued in the accompanying financial
statements.
F-7
2. SIGNIFICANT ACCOUNTING POLICIES
USE OF ESTIMATES
The preparation of the consolidated financial statements in conformity
with accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the consolidated financial statements and the
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.
CASH AND CASH EQUIVALENTS
The Company maintains demand deposits with several financial
institutions. At times, deposits exceed federally insured limits, but management
does not consider this a significant concentration of credit risk. The Company
considers all highly liquid investments with a maturity of three months or less
at the time of purchase to be cash equivalents.
FINANCIAL INSTRUMENTS
The carrying value of the Company's financial instruments including
cash and cash equivalents, accounts receivable, accounts payable, accrued
liabilities, notes payable and its line of credit approximates fair value.
INVENTORY AND DEFERRED CONTRACT COSTS
Inventory consists of materials and components used in the assembly of
the Company's products and is stated at the lower of cost or market as
determined by the first-in first-out (FIFO) method. The Company periodically
evaluates its inventory obsolescence reserve to ensure inventory is recorded at
its net realizable value.
Deferred contract costs represents costs associated with products where
title has transferred but revenue has been deferred in accordance with the
Company's revenue recognition policy.
F-8
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
IMPAIRMENT OF LONG-LIVED ASSETS
In accordance with SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-lived Assets", long-lived assets are reviewed by the Company to
determine whether any events or changes in circumstances indicate that the
carrying amount of the asset may not be recoverable. The Company bases its
evaluation on such impairment indicators as the nature of the assets, the future
economic benefit of the assets, any historical or future profitability
measurements, as well as other external market conditions or factors that may be
present. If such impairment indicators are present or other factors exist that
indicate that the carrying amount of the asset may not be recoverable, the
Company determines whether an impairment has occurred through the use of an
undiscounted cash flows analysis of assets at the lowest level for which
identifiable cash flow exists. If an impairment has occurred, the Company
recognizes a loss for the difference between the carrying amount and the
estimated value of the asset. During fiscal year 2002, management determined
that the remaining amount of goodwill associated with the purchase of IDP and
PRIMO was impaired and recorded impairment charges of $132,645 and $165,652
(which is recorded in discontinued operations) for IDP and PRIMO respectively.
(See note 5).
GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill and other intangibles represent the unamortized excess of the
cost of acquiring subsidiary companies over the fair values of such companies'
net tangible assets at the dates of acquisition. Goodwill related to the
Company's STMS acquisition as described in Note 5 has been amortized on a
straight-line basis using a twenty-year life. Effective November 1, 2002 the
Company adopted SFAS No. 142 "Accounting for Goodwill and Other Intangible
Assets", and as a result, the Company no longer amortizes goodwill. Instead,
management regularly assesses the continuing value of goodwill to measure for
possible impairment. As of October 31, 2003, the Company has not recorded any
additional impairment of its goodwill.
F-9
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
STOCK COMPENSATION
Statement of Accounting Standards No. 123, "Accounting for Stock Based
Compensation" (SFAS 123) encourages, but does not require, companies to record
compensation cost for stock-based employee compensation plans at fair value. The
Company has chosen to account for stock-based compensation using the intrinsic
value method prescribed in Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees", and related Interpretations.
Accordingly, compensation cost for stock options is measured as the excess, if
any, of the estimated fair value of the Company's stock at the date of the grant
over the amount an employee must pay to acquire the stock. The Company has
adopted the disclosure only alternative described in SFAS 123 and SFAS 148,
which require pro forma disclosures of net income and earning per share as if
the fair value method of accounting had been applied.
Had compensation expense related to the stock options been determined
based on the fair value at the grant date for options granted during the years
ended October 31, 2001, 2002, and 2003 consistent with the provisions of SFAS
123, the Company's net income and earnings per share would have been as follows:
YEAR ENDED OCTOBER 31,
---------------------------------------------
2001 2002 2003
---------------------------------------------
Net (loss) income applicable to common
shareholders .............................. $ 1,047,041 $ (1,115,185) $ 219,988
Deduct: Total stock-based compensation
expense determined under fair
value based method ........................ $ 543,597 $ 453,594 $ 630,932
---------------------------------------------
Net income (loss) - pro forma .............. $ 503,444 $ (1,568,779) $ (410,944)
---------------------------------------------
Earnings per share:
Earnings per share basic - as reported . $ 0.10 $ (0.11) $ 0.03
Earnings per share diluted - as reported $ 0.08 $ (0.10) $ 0.02
Earnings per share basic - pro forma ... $ 0.05 $ (0.16) $ (0.04)
Earnings per share diluted - pro forma .. $ 0.04 $ (0.15) $ (0.04)
Weighted average common shares
outstanding:
Basic weighted average shares
outstanding
10,111,364 9,947,675 10,240,630
Fully diluted weighted average shares
outstanding ............................. 12,463,232 10,811,510 10,962,050
The effect of applying SFAS 123 on pro forma net income as stated above
is not necessarily representative of the effects on reported net income for
future years due to, among other things, the vesting period of the stock options
and the fair value of additional options in the future years.
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes option-pricing fair value model with the following
weighted- average assumptions used for grants in 2001, 2002 and 2003: dividend
yield of 0%, expected volatility of 152%, 87% and 114%, respectively; risk-free
interest rates of 4.50%, 4.27% and 4.73% respectively; and expected life of the
option term of five years. The weighted average fair values of the options
granted in 2001 2002, and 2003 with a stock price equal to the exercise price is
$0.74, $0.98 and $0.98 respectively.
F-10
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REVENUE RECOGNITION
The Company recognizes revenue in accordance with Staff Accounting
Bulletin No, 101, "Revenue Recognition in Financial Statements" (SAB101) as
amended by SAB 101A and 101B. SAB 101 requires that four basic criteria must be
met before revenue can be recognized: (1) persuasive evidence of an arrangement
exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and
determinable: and (4) collectibility is reasonably assured.
The Company derives its revenue from the following sources: Product
revenue, information technology support services, software license as a reseller
and support revenue and software training and customization revenue.
For product sales the Company generally recognizes revenue at the time
of shipment when both title and risk of loss transfers to the customer. For
technology support services under time and material contracts, the Company
recognizes revenue as services are provided. Revenue from hardware leased to
customers under operating lease arrangements is recognized over the contract
term. When product and installation services that are not essential to the
functionality of the product are sold as part of a bundled agreement, the fair
value of the installation services, based on the price charged for the services
when sold separately, is deferred and recognized when the services are
performed. The products sold are generally covered by a warranty for periods
ranging from one to three years. The Company accrues an estimated warranty
reserve in the period of sale to provide for estimated costs to provide warranty
services.
The Company is a value-added reseller for certain software products.
When resold software licenses, and related maintenance, customization and
training services are all provided together to an individual customer the
Company recognizes revenue for the arrangement after the Company has delivered
the software license and the customer has approved all customization and
training services provided. In instances were the Company only resells the
software license and maintenance to the customer, the Company recognizes revenue
after the customer has acknowledged and accepted delivery of the software. The
software manufacturer is responsible for providing software maintenance.
Accordingly, revenue from maintenance contracts is recognized upon delivery or
acceptance, as the Company has no future obligation to provide the maintenance
services and no right of return exists.
The Company incurs shipping and handling costs, which are recorded in
cost of revenues.
During the years ended October 31, 2001, 2002 and 2003, the Company had
revenues from the Federal government, which represented 21%, 21% and 46%,
respectively, of total revenue. As of October 31, 2002 and 2003, accounts
receivable from agencies of the Federal government represented 47%, and 44%,
respectively, of total accounts receivable. During fiscal 2001 and 2002 the
Company's significant customers were Lockheed Martin, Network Associates and
Modus Media all of which are third parties. During those years, Lockheed
revenues were 3% and 10%, respectively, Network Associates revenues were 38% and
54%, respectively, and Modus Media revenues were 21% and 0%, respectively.
During fiscal year 2003, the Company's significant customers were Lockheed
Martin and General Services Administration, representing 26% and 11% of the
Company's net revenues, respectively. As for accounts receivable balances at
October 31, 2002, Lockheed Martin comprised of 28%, Network Associates comprised
of 9% and Modus Media comprised of 0%. Accounts receivable balances as of
October 31, 2003 included amounts due from Lockheed Martin (13%) and General
Services Administration (1%).
F-11
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
ADVERTISING EXPENSES
The Company expenses advertising costs as incurred. Advertising costs
amounted to approximately $65,000, $50,000 and $57,000 during fiscal 2001, 2002,
and 2003, respectively.
RESEARCH AND PRODUCT DEVELOPMENT EXPENSES
The Company expenses research and product development expenses as
incurred.
INCOME TAXES
The Company recognizes deferred tax liabilities and assets for the
expected future tax consequences of temporary differences between the carrying
amounts and the tax bases of certain assets and liabilities. A valuation
allowance is established, as necessary, to reduce deferred income tax assets an
amount expected to be realized in future periods.
CHANGE IN ACCOUNTING PRINCIPLE
During 2001, the Company implemented Emerging Issues Task Force Issue
No. 00-27, Application of EITF Issue No. 98-5, "Accounting for Convertible
Securities with Beneficial Conversion Features or Contingently Adjustable
Conversion Ratios," to Certain Convertible Instruments ("EITF 00-27"). Issue 1
of EITF 00-27 modified the calculation of beneficial conversion features for
convertible securities issued with detachable instruments for all transactions
subject to EITF Issue No. 98-5. In accordance with the transition provision of
EITF 00-27 companies are required to report any changes in a beneficial
conversion feature as a result of applying Issue 1 of EITF 00-27 as a cumulative
effect of a change in accounting principle at the time of implementation in
accordance with APB Opinion No. 20, "Accounting Changes". As a result of the
implementation of EITF 00-27, the Company has recorded a charge representing an
additional allocation of value to the beneficial conversion feature of $576,001,
or $0.06 per share, as a cumulative effect of a change in accounting principle.
SUPPLEMENTAL INFORMATION OF NON-CASH INVESTING AND FINANCING ACTIVITIES:
YEAR ENDED OCTOBER 31,
----------------------------------
2001 2002 2003
========= ======== =========
Common stock issued in connection
with legal settlement .................. -- -- --
========= ======== =========
Deemed dividend on preferred stock ....... $ 112,500 -- $ --
========= ======== =========
Increase to income to common
shareholders for repurchase
of preferred stock ..................... $ 721,816 -- $ --
========= ======== =========
Conversion of preferred stock and
accrued dividends to common stock ...... $ 10,036 -- $ --
========= ======== =========
Cumulative effect of change in
accounting principle ................... $ 576,001 -- $ --
========= ======== =========
Non cash stock compensation .............. -- $ 82,160 $ --
========= ======== =========
Tax benefit associated with exercise
of stock options ....................... -- $119,000 $ --
========= ======== =========
F-12
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
EARNINGS PER SHARE
The Company follows the provisions of Statement of Financial Accounting
Standards No. 128, EARNINGS PER SHARE ("SFAS 128") which requires the Company to
present basic and fully diluted earnings per share. Basic earnings per share is
based on the weighted average shares outstanding during the period. Diluted
earnings per share increases the shares used in the basic share calculation by
the dilutive effect on net income from continuing operations of stock options,
warrants and convertible preferred stock.
FINANCIAL INSTRUMENTS AND CONCENTRATION OF CREDIT RISK
Financial instruments that potentially subject the Company to
concentrations of credit risk consist primarily of cash, investments and
accounts receivable. The cash is held by high credit quality financial
institutions. For accounts receivable, the Company performs ongoing credit
evaluations of its customers' financial condition and generally does not require
collateral. The Company maintains reserves for credit losses. The concentration
of credit risk is mitigated by the amount of receivables due by the Federal
government. The carrying amount of the receivables approximates their fair
value.
RECENT PRONOUNCEMENTS
In January 2003, the FASB issued Interpretation Number 46,
Consolidation of Variable Interest Entities ("FIN 46"). This interpretation of
Accounting Research Bulletin No. 51, Consolidated Financial Statements,
addresses consolidation by business enterprises of variable interest entities.
Under current practice, two enterprises generally have been included in
consolidated financial statements because one enterprise controls the other
through voting interests. FIN 46 defines the concept of "variable interests" and
requires existing unconsolidated variable interest entities to be consolidated
by their primary beneficiaries if the entities do not effectively disperse risks
among the parties involved. This interpretation applies immediately to variable
interest entities created after January 31, 2003. FASB Staff Position 46-6,
which was issued in October 2003, delayed the effective date of FIN 46 to the
first reporting period ending after December 15, 2003 for variable interest
entities in which an enterprise holds a variable interest that it acquired
before February 1, 2003.. The interpretation may be applied prospectively with a
cumulative-effect adjustment as of the date on which it is first applied or by
restating previously issued financial statements for one or more years with a
cumulative-effect adjustment as of the beginning of the first year restated.
Adoption of this standard is not expected to have a material effect on the
Company's financial statements.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement
133 on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies accounting and reporting for derivative instruments and hedging
activities under SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities." SFAS No. 149 is effective for derivative instruments and
hedging activities entered into or modified after June 30, 2003, except for
certain forward purchase and sale securities. For these forward purchase and
sale securities, SFAS No. 149 is effective for both new and existing securities
after June 30, 2003. The adoption of this standard did not have a material
impact on the Company's financial statements.
In May 2003, the Financial Accounting Standards Board (FASB) issued
SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics
of both Liabilities and Equity." SFAS No. 150 establishes standards for issuer
classification and measurement of certain financial instruments with
characteristics of both liabilities and equity. Instruments that fall within the
scope of SFAS No. 150 must be classified as a liability. SFAS No. 150 is
effective for financial instruments entered into or modified after May 31, 2003.
For financial instruments issued on or before May 31, 2003, SFAS No. 150 is
effective for the Company in the first quarter of fiscal year 2004. Adoption of
this standard is not expected to have a material effect on the Company's
financial statements.
F-13
3. DISCONTINUED OPERATIONS
The Company continually evaluates its operating facilities with regard
to its long-term strategic goals established by management and the Board of
Directors. Operating facilities, which are not expected to contribute to the
Company's future operations are either closed or sold. On October 25, 2002,
management, with the approval of the Board of Directors, determined that its
Puerto Rico Industrial Manufacturing Operation Acquisition Corp ("PRIMOA") would
no longer contribute to future operations and therefore adopted a plan to
dispose of that operation effective on that date. On September 12, 2003, the
Company sold the assets of its Puerto Rican operation for approximately $30,000.
In addition, the Company contracted with a local service firm to complete its
service and warranty obligations. The Company believes that there will be no
additional costs incurred related to this operation.
Accordingly, the Company has reclassified the Consolidated Financial
Statements of SteelCloud, Inc for the periods ended October 31, 2001, 2002 and
2003, to reflect the discontinued operations of PRIMOA. As a result, revenues,
costs and expenses have been reported as discontinued operations and PRIMOA's
assets and liabilities have been reported as assets and liabilities held for
sale on the Company's consolidated balance sheet. A loss on the sale of the
discontinued operation in the amount of $9,577 was recorded in fiscal year 2003.
A summary of the financial information for the discontinued operation is as
follows:
YEARS ENDED OCTOBER 31,
2001 2002 2003
-----------------------------------------
Net revenues .............................. $ 4,347,296 $ 1,613,864 $ 228,143
Gross profit .............................. 1,244,155 (506,620) 78,470
(Loss) from discontinued operations ....... (9,431) (1,685,708) (134,367)
OCTOBER 31,
2002 2003
-------------------------
Accounts receivable, net .................. $ 682,978 $ --
Inventory, net ............................ 188,698 --
Other assets .............................. 81,644 --
-------------------------
Total assets .............................. 953,320 --
Accrued expenses .......................... $ 590,526 $ --
Accounts payable and other liabilities .... 50,619 --
-------------------------
Total liabilities ......................... 641,145 --
F-14
4. PROPERTY AND EQUIPMENT AND EQUIPMENT ON LEASE
Property and equipment, including leasehold improvements, are stated at
cost. Property and equipment are depreciated and amortized using the
straight-line method over the estimated useful lives ranging from three to five
years. Leasehold improvements are amortized over the lesser of the related lease
term or the useful life.
Property and equipment consisted of the following:
OCTOBER 31,
------------------------------
2002 2003
----------- -----------
Computer and office equipment ............ $ 1,683,702 $ 1,831,986
Furniture and fixtures ................... 271,070 271,070
Leasehold improvements ................... 446,714 455,724
Other .................................... 336,681 423,089
----------- -----------
2,738,167 2,981,869
Less accumulated depreciation
and amortization ....................... (2,434,086) (2,504,758)
----------- -----------
$ 304,081 $ 477,111
=========== ===========
The Company owns equipment that is currently at customer sites under
operating lease agreements (See Note 2 - Revenue Recognition). The cost of the
equipment was $1,162,744 and $1,602,713 at October 31, 2003 and 2002,
respectively. The related accumulated depreciation on the equipment was $826,809
and $1,028,441 at October 31, 2003 and 2002, respectively.
5. GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill and other intangible assets were comprised of:
OCTOBER 31,
----------------------------
2002 2003
----------- -----------
Goodwill and other intangibles:
Goodwill .................................. $ 2,397,288 $ 2,397,288
Other intangibles ......................... 600,000 600,000
----------- -----------
Total goodwill and other intangibles ......... 2,997,288 2,997,288
Less accumulated amortization:
Goodwill .................................. 639,229 639,229
Other intangibles ......................... 580,000 580,000
----------- -----------
Total accumulated amortization ............... (1,219,229) (1,219,229)
----------- -----------
$ 1,778,059 $ 1,778,059
=========== ===========
The Company has amortized goodwill using 20-year lives through October
31, 2002. Beginning November 1, 2002, the Company no longer amortizes goodwill
as a result of adopting SFAS 142 "Goodwill and Other Intangible Assets" and
instead periodically tests goodwill for impairment. In fiscal 2001 and 2002, the
Company recorded amortization expense associated with Goodwill of $394,216 and
$394,216, respectively. Had amortization expense not been recorded in fiscal
2001 and 2002, net income (loss) would have been $1,441,257 and ($720,969),
respectively. Basic and fully diluted earnings per share in fiscal 2001 and 2002
would have been basic 0.14 and fully diluted 0.12, and basic (0.07) and diluted
(0.07), respectively.
F-15
5. GOODWILL AND OTHER INTANGIBLE ASSETS (CONTINUED)
IMPAIRMENT OF GOODWILL (CONTINUED)
Statement of Financial Accounting Standards No. 121 (SFAS 121)
"ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO
BE DISPOSED OF," requires that long-lived assets and certain identifiable
intangibles to be held and used by an entity be reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable.
During fiscal year 2002, the Company completed all contracts relating
to the purchase of IDP. In addition, the Company determined to dispose of
operations at its Puerto Rico facility. As a result, the Company determined that
the carrying amount of goodwill associated with the IDP and PRIMO acquisitions
was not recoverable. The Company performed an analysis of the goodwill in
accordance with SFAS 121 and determined that the fair value of the remaining
goodwill (estimated using the present value of expected future cash flows) was
$0. Accordingly, the Company recorded impairment charges of $132,000 and
$166,000 (which is recorded in discontinued operations) for IDP and PRIMO
respectively during fiscal year 2002. The Company did not record any impairment
charges in fiscal 2003.
F-16
6. BANK LINES OF CREDIT AND NOTES PAYABLE
OPERATING LINE OF CREDIT
The Company has a line of credit agreement, as amended, with a bank
that allows the Company to borrow an amount limited to the minimum of its
borrowing base or $3.5 million. The line of credit bears interest at the lower
of (a) the Lender's Prime Rate per annum or (b) LIBOR Market Index Rate plus
2.5%. The line of credit expires and is subject to renewal on March 31, 2004. As
of October 31, 2002 and 2003, the Company had no borrowing on this line of
credit facility. The line of credit is secured by all assets of the Company.
As of October 31, 2003, the Company's borrowing base, which is based on
certain percentages of total accounts receivables less over due accounts, was
$3.5 million.
For the quarter ended October 31, 2002, the Company was not in
compliance with one of its financial covenants. On January 21, 2003, the
Company's bank issued a waiver to allow the Company to continue borrowing as
needed on its line of credit.
On January 22, 2004, the Company modified its bank line of credit that
allows the Company to borrow an amount to the lesser of its collateralized cash
on hand or $3.5 million. The line of credit bears interest at the LIBOR Market
Index rate plus 1.25%. The line of credit is secured by all assets of the
Company. As of January 22, 2004, there were no outstanding borrowings on the
line of credit.
NOTES PAYABLE
On February 1, 2002, the Company executed a promissory note in
conjunction with its line of credit in the amount of $725,000. The note bears
interest at the lower of (a) the Lender's Prime Rate per annum or (b) the LIBOR
Market Index Rate plus 2.5% and matures on July 5, 2003. The Company makes
monthly principal payments of approximately $43,000. In July 2003, the Company
repaid the debt thereby extinguishing its obligations under this note. As of
October 31, 2002 and 2003 the outstanding balance on the promissory note at
October 31, 2003 was approximately $384,000 and $0, respectively.
On April 1, 2002, the Company executed a two-year promissory note in
conjunction with a litigation settlement for approximately $240,000. The
promissory note bears interest at the prime rate and matures in May 2004. The
Company makes monthly payments of $10,000 plus accrued interest. The outstanding
balance on the note at October 31, 2002 and 2003 was approximately $180,000 and
$60,000, respectively. In December 2003, the Company paid the debt thereby
extinguishing its obligations under this note.
Notes payable consisted of the following:
OCTOBER 31,
--------------------
2002 2003
-------- -------
Bank term notes, bearing interest at the prime rate;
payable in monthly installments of $34,652, $42,647,
$10,000 and $5,389 plus accrued interest,
maturing in January 2002, July 2003, May 2004,
and February 2004, respectively........................ $563,823 $81,555
Asset loans, bearing interest at annual interest
rates from %0 to 7.9% due in aggregate monthly
payments of $479, $348, and $359 due in December
2008, July 2008, and July 2008, respectively,
secured by certain assets of the Company............... -- $74,530
-------- -------
563,823 156,085
Less current portion..................................... 503,823 96,133
-------- -------
Notes payable, long-term................................. $ 60,000 $ 59,952
======== ========
F-17
7. COMMITMENTS
OPERATING LEASES
The Company leases office space for its corporate headquarters under a
noncancelable operating lease agreement. The lease agreement was renewed in
October 1999 and expires in February 2005. Additionally, the Company leases
various office equipment and other office space under non-cancelable operating
leases which expire through July of 2004. Rent expense under all leases, which
is recorded on a straight-line basis over the life of each lease, was
approximately $284,000, $411,000 and $352,000 for the years ended October 31,
2001, 2002, and 2003, respectively.
Future minimum lease payments under noncancelable operating leases,
including the leases assumed in the STMS and IDP acquisitions, at October 31,
2003 are as follows:
2004............................. 363,549
2005............................. 91,554
--------
Total............................ $455,103
========
8. EMPLOYMENT AGREEMENTS
The Company has an employment agreement with Thomas P. Dunne, the
Company's Chairman and Chief Executive Officer. The agreement for Mr. Dunne has
a term of three years commencing April 1997 and automatically renews for
additional one-year terms unless terminated by either the Company or the
employee.
9. STOCKHOLDERS' EQUITY
EQUITY TRANSACTIONS
On March 13, 2000, the Company sold 3,000 shares of its Series A
Convertible Preferred Stock in a private placement, which is exempt from
registration provided by Regulation D Rule 506 promulgated by the Securities and
Exchange Commission under the Securities Act of 1933, as amended. The Company
received net proceeds of approximately $2.7 million, which was used to fund
current and future operations. In addition, the Company issued warrants to the
preferred investor and the broker of the transaction in the amount of 247,525
and 75,000 to purchase shares of the Company's common stock at $3.64 and $4.57
per share, respectively. The warrants expire on March 13, 2005.
F-18
9. STOCKHOLDERS' EQUITY (CONTINUED)
EQUITY TRANSACTIONS (CONTINUED)
The holders of the preferred shares were entitled to cumulative
dividends of 5% of the liquidation preference of $1,000 per share plus accrued
but unpaid dividends whether or not declared. For fiscal year 2001, the Company
accrued dividends of $112,500 and no dividends were unpaid as of October 31,
2001. Each holder of preferred shares was entitled to voting rights equal to the
number of shares of common stock into which such preferred shares were
convertible.
In August 2001, the Company completed a transaction with its Preferred
Shareholders to redeem all of its outstanding Series A Convertible Preferred
stock for $2,500,000 in cash. Under the redemption agreement, the Preferred
Shareholders retained approximately 247,000 warrants previously issued. As a
result of the transaction, the Company recorded an increase to income available
to common stockholders of $721,816, representing the excess of the carrying
value of the preferred stock plus the beneficial conversion feature discount
over the repurchase price.
On October 24, 2003, SteelCloud, Inc. issued 1,887,500 shares of its
common stock to investors in a private placement transaction. Net proceeds after
costs and expenses associated with this private placement were approximately
$7.2 million. SteelCloud, Inc. received gross proceeds of $7,550,000 in
connection with this transaction. Additionally, SteelCloud, Inc. issued an
aggregate of 493,359 and 85,938 warrants at an exercise price of $5.81 and $4.00
per share, respectively, which are exercisable until October 24, 2008. The
securities were sold pursuant to an exemption from registration provided by
section 4(2) of the Securities Act.
STOCK OPTIONS
On January 6, 1997, the Company adopted the 1998 Stock Option Plan (the
1998 Option Plan), under the 1998 Option Plan the Company can grant up to
2,750,000 options to officers, directors and employees, who contribute
materially to the success of the Company. In addition, the Company established
the 2002 Stock Option Plan (the 2002 Option Plan) in May 2002, which permits the
Company to grant up to 750,000 options to officers, directors and employees
under that Plan. Stock options are generally granted at the fair market value of
its common stock at the date of grant. However, in fiscal 2002, the Company
granted 106,000 options with exercise prices of $1.20 when the underlying value
of the Company's common stock was $1.81. The Company recorded a charge for
compensation expense associated with these options of $64,660. The options vest
ratably over a stated period of time not to exceed four years. The contractual
term of the options is five years.
F-19
9. STOCKHOLDERS' EQUITY (CONTINUED)
STOCK OPTIONS (CONTINUED)
Common stock option activity was as follows:
SHARES WEIGHTED-
AVERAGE
EXERCISE
PRICE
------------------------
Outstanding at October 31, 2000 ............... 2,441,933 $ 3.95
Options granted ............................. 984,000 0.74
Options canceled or expired ................. (387,599) 3.20
---------- --------
Outstanding at October 31, 2001 ................ 3,038,334 $ 3.01
Options granted ............................. 323,500 1.21
Options exercised ........................... (227,826) 1.20
Options canceled or expired ................. (258,836) 1.96
---------- --------
Outstanding at October 31, 2002 ................ 2,875,172 $ 3.04
---------- --------
Exercisable at October 31, 2002 ............... 1,537,115 $ 1.83
Options granted ............................. 281,250 1.49
Options exercised ........................... (570,453) 1.19
Options canceled or expired ................. (99,134) 1.38
---------- --------
Outstanding at October 31, 2003 ................ 2,486,835 $ 3.34
---------- --------
Exercisable at October 31, 2003 ............... 1,350,670 $ 1.81
The total options outstanding include 600,000 options granted to the
former IDP stockholders that are not included in the Option Plan.
As of October 31, 2002 and 2003, there were 474,828 and 193,578 options
available for future grants under the 1998 Option Plan, respectively and 750,000
options available for future grants under the 2002 Option Plan.
The following table summarizes information about fixed-price stock
options outstanding at October 31, 2003:
AVERAGE WEIGHTED-
REMAINING AVERAGE
RANGE OF EXERCISE PRICES NUMBER CONTRACTUAL EXERCISE
OUTSTANDING LIFE PRICE
-------------------------------------------
$0.55-$1.75 .................... 1,309,176 2.73 $ 0.98
$1.76-$4.50 .................... 577,659 3.61 3.08
$4.51-$8.75 .................... 600,000 4.50 8.75
--------- ---- --------
$0.55-$8.75 .................... 2,486,835 3.36 $ 3.34
========= ==== ========
F-20
9. STOCKHOLDERS' EQUITY (CONTINUED)
STOCK OPTIONS (CONTINUED)
Had compensation expense related to the stock options been determined
based on the fair value at the grant date for options granted during the years
ended October 31, 2001, 2002, and 2003 consistent with the provisions of SFAS
123, the Company's net income and earnings per share would have been as follows:
YEAR ENDED OCTOBER 31,
--------------------------------------
2001 2002 2003
--------------------------------------
Net income (loss) - pro forma ........ $ 503,444 $(1,568,779) $ (410,944)
Net income (loss) per share - pro forma $ 0.05 $ (0.16) $ (0.04)
Net income (loss) per share -
assuming dilution pro forma ......... $ 0.04 $ (0.15) $ (0.04)
The effect of applying SFAS 123 on pro forma net income as stated above
is not necessarily representative of the effects on reported net income for
future years due to, among other things, the vesting period of the stock options
and the fair value of additional options in the future years.
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes option-pricing fair value model with the following
weighted- average assumptions used for grants in 2001, 2002 and 2003: dividend
yield of 0%, expected volatility of 152%, 87% and 114%, respectively; risk-free
interest rates of 4.50%, 4.27% and 4.73% respectively; and expected life of the
option term of five years. The weighted average fair values of the options
granted in 2001 2002, and 2003 with a stock price equal to the exercise price is
$0.74, $0.98 and $0.98 respectively.
F-21
10. INCOME TAXES
Deferred income taxes reflect the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes.
Components of the Company's net deferred tax asset balance are as
follows:
OCTOBER 31,
-----------------------------
2002 2003
------------ ------------
Deferred tax asset:
Current portion:
Accrued expenses ..................... $ 314,051 $ 167,138
Asset reserves ....................... 514,207 252,358
Other ................................ -- 57,930
------------ ------------
Total current portion ..................... 828,258 477,426
------------ ------------
Long term portion:
Net operating loss carryforwards ..... 2,931,442 12,585,543
Depreciation ......................... 601,029 323,461
------------ ------------
Total long term portion ................... 3,532,471 12,909,004
------------ ------------
Total deferred tax asset ..................... 4,360,729 13,386,430
------------ ------------
Deferred tax credit:
Valuation allowance ....................... (3,960,729) (12,986,430)
------------ ------------
Net deferred tax asset ....................... $ 400,000 $ 400,000
============ ============
As of October 31, 2003, the Company had approximately $32.6 million in
net operating loss carryforwards, which expire between 2012 and 2023. The
Company submitted amended tax filings resulting in an increase to net operating
loss carryforwards of approximately $30 million relating to a worthless stock
deduction for its investment in IDP. As of October 31, 2003, the Company has
recorded a valuation allowance of approximately $13 million against the total
deferred tax asset of $13.4 million, based upon its evaluation of future
estimates of taxable income. The Company's evaluation included consideration of
historical earnings (excluding non-recurring charges) as well as projected
near-term earnings based on its backlog, customer relationships and operating
environment.
Components of the provision for income taxes are as follows:
YEARS ENDED OCTOBER 31,
----------------------------------------------
2001 2002 2003
--------- --------- -------------------
Current tax expense (benefit):
Federal ..................... $ 27,400 $ 1,200 $ --
--------- --------- -------------------
State ........................ -- -- --
--------- --------- -------------------
27,400 1,200 --
Deferred tax expense:
Federal ...................... $ 55,532 $(247,000) $ --
State ........................ 19,344 (34,000) --
--------- --------- -------------------
74,876 (281,000) --
--------- --------- -------------------
Total provision for
(benefit from) income taxes .. $ 102,276 $(279,800) $ --
========= ========= ===================
F-22
10. INCOME TAXES (CONTINUED)
The reconciliation of income tax from the Federal statutory rate of 34%
is:
YEARS ENDED OCTOBER 31,
-----------------------------------------
2001 2002 2003
----------- ----------- -----------
Tax at statutory rates: ................ $ 380,291 $ 98,845 $ 74,796
Non-deductible expenses (income), net .. 143,141 (4,199) (9,110,660)
Valuation allowance and other .......... (492,621) (387,877) 9,025,701
State income tax, net of federal benefit 71,465 13,431 10,163
----------- ----------- -----------
$ 102,276 $ (279,800) $ --
=========== =========== ===========
11. RETIREMENT PLANS
401(K) PLANS
The Company maintains a 401(k) (the "Plan") for all current employees.
Under the Plan, employees are eligible to participate the first calendar day of
the month following their first day of service and attaining the age of 18.
Employees can defer up to the lower of 15% or $12,000 of compensation. Employee
contributions are subject to Internal Revenue Service limitations. All employees
who contributed to the Plan are eligible to share in discretionary Company
matching contributions. Company contributions vest over 5 years. In fiscal 2001,
2002 and 2003, the Company contributed approximately $60,000, $71,000 and
$72,000 to the participants of the 401(k), respectively.
F-23
12. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted
earnings per share:
YEARS ENDED OCTOBER 31,
--------------------------------------------
2001 2002 2003
------------ ------------ ------------
Numerator:
Net income from continuing operations $ 1,023,157 $ 570,523 $ 363,930
Preferred Stock dividends ............ (112,500) -- --
Redemption of preferred stock ........ 721,816 -- --
Cumulative effect of change in
accounting principle ............. (576,001) -- --
------------ ------------ ------------
Net income from continuing
operations available to
common stockholders before
extraordinary gain .................. 1,056,472 570,523 363,930
============ ============ ============
Denominator:
Denominator for basic earnings per share-
weighted-average shares ............... 10,111,364 9,947,675 10,240,630
Effect of dilutive securities:
Employee stock options ............... 36,899 863,835 721,420
Convertible preferred stock .......... 2,314,969 -- --
------------ ------------ ------------
Dilutive potential common shares ..... 2,351,868 863,853 721,420
------------ ------------ ------------
Denominator for diluted earnings
per share - adjusted weighted-average
shares and assumed conversions ....... 12,463,232 10,811,510 10,962,050
------------ ------------ ------------
Earnings per share from continuing
operations, basic: .................... $ 0.10 $ 0.06 $ 0.04
============ ============ ============
Earnings per share from continuing
operations, diluted: .................. $ 0.08 $ 0.05 $ 0.03
============ ============ ============
13. CONTINGENCIES
IDP ACQUISITION
On July 31, 1998 the Company received notice from the SBA that it was
denying the request of the U.S. Air Force to waive the requirement to terminate
IDP's Desktop V contract for the convenience of the Government upon the change
in control of IDP to the Company. The Company appealed the denial by the SBA to
the SBA's Office of Hearings and Appeals. On August 31, 1999, the SBA denied the
appeal and ruled that the U.S. Air Force must terminate-for-convenience the
Desktop V contract. Under a termination-for-convenience, the Government shall
reimburse the Company for all costs incurred in the performance of the contract.
The Company expects to recover from the Government a portion or all of its
unreimbursed costs. The Company is currently in negotiations with the Government
regarding this matter. No assurances can be given that the Company will
successfully recover any costs related to this matter.
F-24
14. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
Quarterly financial information for fiscal 2003 and 2002 is presented
in the following tables:
1ST 2ND 3RD 4TH
QUARTER QUARTER QUARTER QUARTER (1)
----------- ----------- ----------- -----------
2003
Revenue ................... $ 7,634,168 $ 8,219,870 $ 8,156,414 $ 9,031,141
Gross Profit .............. 1,542,337 1,838,008 1,657,931 1,651,261
Net income from
continuing operations ... 109,045 136,197 40,379 78,311
Total (loss) from
discontinued operations . (29,501) (26,954) (30,071) (57,418)
Net income (loss) available
to common shareholders .. 79,544 109,243 10,308 20,893
PER SHARE DATA
Net income (loss)
Basic ..................... 0.01 0.01 0.01 0.01
Diluted ................... 0.01 0.01 0.01 0.01
2002
Revenue ................... $ 9,354,066 $ 7,626,045 $ 6,390,414 $ 5,786,843
Gross Profit .............. 2,514,202 2,124,639 1,797,579 557,513
Net income (loss) from
continuing operations ... 753,974 493,043 147,317 (823,811)
(Loss) from discontinued
operations .............. (267,468) (143,736) (46,144) (1,228,360)
----------- ----------- ----------- -----------
Net income (loss) available
to common shareholders .. 486,506 349,307 101,173 (2,052,171)
PER SHARE DATA
Net income (loss)
Basic ..................... 0.07 0.05 0.02 (0.25)
Diluted ................... 0.07 0.04 0.02 (0.23)
During fourth quarter FY03, the Company recorded certain adjustments of
approximately $484,000 relating to the write-off of obsolete contract-specific
inventory, approximately $259,000 relating to the reduction of contract specific
warranty reserve and approximately $250,000 relating to the reversal of a
previously accrued contingency. The aggregate effect of such adjustments was to
increase net income by approximately $25,000.
Earnings per share data are rounded to the nearest penny each quarter;
therefore, aggregate quarterly earnings per share may not agree to the fiscal
year earnings per share reported on the Consolidated Statement of Operations.
F-25
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS ON SUPPLEMENTAL INFORMATION
Board of Directors and Stockholders
SteelCloud, Inc.
In connection with our audit of the consolidated financial statements
of SteelCloud, Inc. referred to in our report dated December 19, 2003, which is
included in the Annual Report on Form 10-K, we have also audited Schedule II for
each of the two years in the period ended October 31, 2003. In our opinion, this
schedule, when considered in relation to the basic financial statements taken as
a whole, presents fairly, in all material respects, the information set forth
therein.
/s/ Grant Thornton LLP
- ----------------------
Vienna, Virginia
December 19, 2003
S-1
REPORT OF ERNST & YOUNG, LLP, INDEPENDENT AUDITORS
The Board of Directors
SteelCloud, Inc.
We have audited the consolidated financial statements of SteelCloud, Inc.
(a Virginia corporation) for the year ended October 31, 2001 and have issued our
report thereon dated December 21, 2001 (included elsewhere in this Form 10-K).
Our audit also included the consolidated financial statement schedule for the
year ended October 31, 2001 listed in Item 14 of this Form 10-K. The schedule is
the responsibility of the Company's management. Our responsibility is to express
an opinion based on our audit.
In our opinion, the consolidated financial statement schedule for the year
ended October 31, 2001 referred to above, when considered in relation to the
basic consolidated financial statements taken as a whole, presents fairly in all
material respects, the information set forth herein.
/s/ Ernst & Young LLP
- -----------------------
McLean, Virginia
December 21, 2001
S-2
SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS
STEELCLOUD, INC.
BALANCE AT BALANCE
BEGINNING OF AT END OF
CLASSIFICATION YEAR ADDITIONS DEDUCTIONS YEAR
- ---------------------------------------------------------------------------------------------
Allowance for doubtful accounts:
Year ended October 31, 2001 ..... $ 100,000 $ -- $ -- $ 100,000
Year ended October 31, 2002 ..... $ 100,000 $ 203,000 $ 10,000(1) $ 293,000
Year ended October 31, 2003 ..... $ 293,000 $ -- $ -- $ 293,000
Inventory reserve:
Year ended October 31, 2001 ..... $ 1,554,000 $ 120,000(3) $ 466,438(2) $ 1,207,562
Year ended October 31, 2002 ..... $ 1,207,562 $ 864,435(3) $ 1,486,360(2) $ 585,637
99,222(3)
Year ended October 31, 2003 ..... $ 585,637 $ 360,007(4) $ 684,859(2) $ 360,007
Deferred tax valuation allowance:
Year ended October 31, 2001 ..... $ 5,011,565 $ -- $ 662,958 $ 4,348,607
Year ended October 31, 2002 ..... $ 4,348,607 $ -- $ 387,878 $ 3,960,729
Year ended October 31, 2003 ..... $ 3,960,729 $ 9,025,701 $ -- $12,986,430
- -----------
(1) Write-offs of accounts receivable
(2) Write-offs of inventory
(3) Provision for inventory obsolescence
(4) Reclassification of reserve for defective and/or returned inventory
S-3