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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, 2004
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
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(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
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None.
Securities registered pursuant to Section 12 (g) of the Act:
Title of each class Name of exchange on which registered
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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 24, 2005 was $29,490,440.
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 24, 2005 was 13,838,264.
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the Definitive Proxy Statement to be filed pursuant to Regulation
14A for SteelCloud, Inc.'s annual meeting for 2004 are incorporated by reference
into Part III of this Form 10-K.
STEELCLOUD, INC
2004 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I Page Number
Item 1. Business ...................................................... 4
Item 2. Properties .................................................... 10
Item 3. Legal Proceedings ............................................. 10
Item 4. Submission of Matters to a Vote of Security Holders ........... 10
PART II
Item 5. Market for Registrant's Common Equity and
Related Stockholder Matters ................................ 11
Item 6. Selected Financial Data ....................................... 13
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations ........................ 14
Item 7A. Quantitative and Qualitative Disclosures About
Market Risk ................................................ 24
Item 8. Financial Statements and Supplementary Data ................... 24
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosures ....................... 24
Item 9A. Controls and Procedures ....................................... 25
PART III
Item 10. Directors and Executive Officers of the Registrant ............ 26
Item 11. Executive Compensation ........................................ 26
Item 12. Security Ownership of Certain Beneficial
Owners and Management ...................................... 26
Item 13. Certain Relationships and Related Transactions ................ 26
Item 14. Principal Accounting Fees and Services ........................ 26
(Item 10 - Item 14 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 ........................................ 26
Signatures .................................................... 28
ITEM 1. BUSINESS
GENERAL
SteelCloud, Inc. (the "Company") was founded in 1987 to manufacture and
market custom computers, primarily to the Federal government. By 2004, the
Company was principally engaged in the delivery of computer products,
specialized servers and appliances, network security solutions and professional
information technology ("IT") services for both the public and private sectors.
The Company's custom, specialized servers are designed, developed and
manufactured for large commercial and government integrators as well as certain
governmental agencies. The specialized servers are designed to meet the precise
needs of volume customers and reduce the customer's investments in engineering
design, logistics, integration and support. The Company enhances its product
development and manufacturing offerings by providing unique supply chain and
logistics support services to its partners.
In addition, the Company develops and manufactures network servers and
hardened (highly secured) appliance products. The network security appliances
are developed in collaboration with some of the industry's premiere software
companies. The Company integrates either its own, its partner's, or other
third-party software onto a SteelCloud-designed, custom-server platform and
manufactures the product under a co-branded name or its partner's brand name. As
a result, the software partners are able to deliver to their customers, complete
turnkey solutions. In addition, the Company is also a value-added reseller for
software products from several of its strategic partners and certain other
software providers.
The Company's also delivers professional consulting services, which
allows its clients to extend their IT organizations on an as-needed basis.
Expert technical services include network analysis, security, design,
troubleshooting and implementation.
SteelCloud has developed proprietary software to optimize the
performance and manageability of its security appliances. In addition, the
Company is creating SteelCloud intellectual property, designing and developing
software and network appliance products.
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 other subsidiaries are International Data Products ("IDP"),
acquired May 1998, and Puerto Rico Industrial Manufacturing Operations
Acquisition Corporation ("PRIMOA"), incorporated in Puerto Rico in May 1998. In
October 2002, the Company discontinued the PRIMOA subsidiary and such subsidiary
has been classified as "discontinued" in the financials statements for all years
presented. On February 17, 2004, the Company acquired the assets of Asgard
Holding, LLC ("Asgard"). The acquisition brought intellectual property (IP),
engineering talent and two pending patents to SteelCloud.
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 delivers computer products, specialized servers and
appliances, network security solutions and professional IT services. The Company
believes it operates in one market 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
which combine both hardware and software. SteelCloud integrates the partner's
software onto a custom designed server platform, running Linux, FreeBSD, or one
of Microsoft's operating systems. This process results in a unique, optimized
and certified appliance which is ready-to-deploy when it arrives at the end
user's site.
The Company is able to create a unique solution for each software
partner by leveraging its years of experience developing and managing custom
server platforms for mission-critical Department of Defense ("DOD") and security
programs. The Company puts together a package of design, support, and logistical
services 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 approach to the server appliance market
(collaborating with leading software developers and leveraging their product
marketing and sales efforts) enables the Company to realize economies of scale
that would not be attainable if SteelCloud used its own resources. The Company
also believes that risks relating to R&D (research and development) and
inventory are also greatly reduced through this approach.
SPECIALIZED SERVERS (INFRASTRUCTURE PRODUCTS)
The Company designs, develops and manufactures specialized custom
servers, which are configured with single, dual, or quad Intel processors. These
servers are designed to give unique solutions to customers with unique
requirements. The Company combines its hardware offerings with specialized
software integration and logistics programs to provide its specialized server
customers with solutions unavailable from the traditional hardware-only vendors.
The Company believes that its specialized/infrastructure 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.
PROFESSIONAL CONSULTING SERVICES
SteelCloud provides an array of consulting services surrounding the
technologies it develops or resells. The Company's consulting services include
network and security analysis, design and implementation, as well as help desk
consulting. Aside from managed services and some annual support contracts, the
services are primarily delivered in the form of short-term projects. These
services are primarily delivered in the form of short-term 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.
SteelCloud provides highly skilled professionals and services that
leverage its experience for maximum benefit to the client. The Company maintains
expertise in specific areas and technologies rather than general knowledge in
many IT areas. SteelCloud project-based services include network analysis,
network design, systems implementation, virus protection, network security,
software migrations, messaging system migrations and complete help desk
implementation and support.
Project management is a key component of SteelCloud's operational
strategy and success in project-based engagements. Following industry-standard
best practices and SteelCloud's own proprietary processes, the Company's project
managers ensure that each project is delivered in accordance with the customer's
expectations and the Company's profitability objectives.
-5-
SteelCloud's fixed-rate hourly engineering services are often sold to
clients under contracts that 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.
GOVERNMENT CONTRACTS
In fiscal 2004, the Company derived approximately 36% of its revenues
from sales of hardware and services to the U.S. Federal, state and local
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 ended 2004, the Company's GSA contract had sales
of $3.8 million, which accounted for approximately 14% of the Company's
revenues.
COMMERCIAL CONTRACTS
In fiscal year ended 2004, SteelCloud derived approximately 64% of its
revenues from sales of hardware, software and services to the commercial
marketplace. The Company's commercial customer base consists of several Fortune
500 companies as well as medium-size commercial customers. The Company generated
approximately $10.9 million or 39% of its total net revenues from contracts and
awards with Lockheed Martin during fiscal year 2004. The Company intends 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 Computer Associates 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. In September 2003, the first set of appliances, featuring eTrust
Antivirus technology, was delivered under this agreement. In April 2004, the
next set of appliances, featuring eTrust Intrusion Detection technology, was
delivered. Over this period, market demand for "point-solution" appliances such
as these has shifted toward multi-function appliances; i.e., appliances that
perform multiple functions such as anti-spam, antivirus, content filtering in
one unit. In June of 2004, the Company announced a multi-function security
platform featuring eTrust Secure Content Manager technology. The co-branded
appliances include proprietary SteelCloud Secure Console (SC2) software. The
business results from this program have not met expectations and appropriate
actions have been taken to align expenses accordingly.
In fiscal 2004, SteelCloud completed deliveries for approximately $2.6
million of specialized servers to Lockheed Martin for the Automated Package
Processing System ("APPS") program. In addition, SteelCloud was selected by
Lockheed Martin to supply custom servers for three major new programs for a
total order value which exceeds $16.4 million. Most of the revenue associated
with these new orders will be realized in fiscal 2005. These new orders are the
result of the Company's performance as a leading supplier for high-performance,
specialized server solutions.
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.
-6-
In May 2004, Microsoft purchased 32 of the Company's Intrusion
Detection Appliances for its Network Management and Security Initiative. In
2004, the SteelCloud systems were featured at Microsoft's Tech-Ed Conference in
San Diego and at their World Wide Partner Conference in Toronto, Canada.
MANUFACTURING AND PRODUCTION
SteelCloud's production operations are capable of assembling up to
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.
As a result of recent increases in contract awards and product backlog, the
Company has decided to move its office and manufacturing facilities to ensure
the appropriate infrastructure exists to support the projected growth. The
Company has executed non-cancelable leases for its headquarters and operations,
which commence occupancy in April 2005. These two new facilities will be located
in close proximity to SteelCloud's current facility.
In April 2004 SteelCloud received ISO 9001:2000 Certification. ISO
Certification is an assurance that a company is dedicated to maintaining a
quality management system, and has procedures in place for continuous quality
improvement in all aspects of the organization's business. The Company believes
this certification was a factor in recent contract wins.
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 earlier market entry, 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, software manufacturers
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 in the specialized server markets
are system integrators as well as smaller companies that specialize in building
server products and providing some level of integration services.
FEDERAL GOVERNMENT MARKET
The GSA's Federal Supply Services Schedule is a list of pre-approved
vendors from which the government and/or federal agencies may purchase goods and
services. SteelCloud's GSA Schedule GS-35F-4085D is a very effective procurement
vehicle for the Company. Sales from this contract have historically exceeded 10%
of the Company's annual net revenues.
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 IT products acquired through the GSA Schedule. Because the Company
primarily targets custom computer procurements, it rarely competes with national
commercial computer manufacturers 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
D.C. and South Florida metropolitan markets because it provides engineering
services in conjunction with its turnkey server appliances and products from its
strategic partners; e.g., Microsoft, Computer Associates, McAfee, Network
General, BMC, Big Fix 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.
-7-
OEM MARKET
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, federal integrators, select commercial
accounts, and state, federal and local government agencies. 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 in all of its
markets, and in particular, its targeted commercial markets.
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 possible return
on investment.
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.
RESEARCH & PRODUCT DEVELOPMENT
In fiscal 2003, the Company undertook initiatives to enhance its
proprietary product offerings. Accordingly, the Company commenced its research
and development ("R&D") activities associated with the new product offerings in
the second quarter of fiscal 2003.
In June 2003, the Company entered into an agreement with Computer
Associates International, Inc. to deliver a family of co-branded, 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. The AVG product and subsequent SteelCloud/CA appliances
included proprietary SteelCloud Secure Console SC2 software.
In fiscal 2004, following the acquisition of Asgard Holding, the
Company established an Advanced Technology Group for the purpose of developing
proprietary network security software products. These SteelCloud products can be
marketed under the SteelCloud brand exclusively and sold with or without
accompanying SteelCloud designed and manufactured network security appliances.
By investing in product development, the Company believes it will have more
control over the functionality and marketing of its products. The Company also
believes that the resulting intellectual property will increase the
competitiveness of its offerings and improve product margins.
-8-
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. The Company also purchases multiple products directly from large national
and regional distributors such as Arrow Electronics, Synnex, 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. Through the Asgard acquisition, the Company currently has two
patents pending.
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 much of the 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, 2004, the Company had 91 employees. Of this total, 3
were employed in an executive capacity, 11 in sales and marketing, 14 in
administrative capacities, 39 in technical and/or services and 24 in operations.
As of January 24, 2005, the Company had 92 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 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.
-9-
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 April 2005,
the Company pays approximately $29,000 per month in rent which does not include
operating expenses. As a result of recent increases in contract awards and
product backlog, the Company has decided to move its office location to ensure
the appropriate infrastructure exists to support its growth. The Company has
executed non-cancelable leases for its headquarters and operations, which
commence occupancy in April 2005. These two new facilities will be located in
close proximity to SteelCloud's current facility. Monthly rent for both leases,
which expire in August 2009, will be approximately $42,000 inclusive of
operating expenses. In addition, the Company leases office space in Ft.
Lauderdale to house its Advance Technology Group ("ATG"). The monthly rent
associated with this lease, which expires in July 2009, is approximately $5,000.
SteelCloud believes that both of its new facilities will be adequate for its
operations.
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.
-10-
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 24, 2005, for each fiscal
quarter during the fiscal years ended October 31, 2004 and 2003, as well as for
the first quarter of fiscal 2005 through January 24, 2005. These quotations
reflect inter-dealer prices without retail mark-up, mark-down or commission and
may not represent actual transactions.
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...................................... $5.12 $3.75
Second Quarter..................................... $3.81 $2.07
Third Quarter...................................... $3.21 $2.08
Fourth Quarter..................................... $2.46 $1.97
Fiscal 2005
High Low
-----------------------
First Quarter (through January 24, 2005)........... $2.63 $1.85
On January 24, 2005 the closing price of the Company's Common Stock as
reported on The Nasdaq SmallCap Market was $2.50 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.
-11-
RECENT SALES OF UNREGISTERED STOCK
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.
On February 17, 2004, the Company completed its acquisition of the
assets of Asgard Holding, LLC ("Asgard") an internet security product and
service company. In exchange for the assets of Asgard, which included
intellectual property and patent-pending technology, the Company paid cash of
$630,015, issued 575,000 shares of SteelCloud common stock valued at $2,283,900
and incurred approximately $50,000 of direct costs associated with the
transaction. The value of SteelCloud common stock issued was determined in
accordance with SFAS No. 141 by taking the average market price over the 2-day
period before and after the terms of the acquisition were agreed to and
announced.
-12-
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, 2002, 2003 and 2004 and
the consolidated balance sheet data as of October 31, 2003 and 2004 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, 2000 and 2001 and the consolidated balance sheet data as
of October 31, 2000, 2001 and 2002 is derived from audited consolidated
financial statements of SteelCloud not included in this annual report.
YEAR ENDED OCTOBER 31,
2000 2001 2002 2003 2004
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CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Net revenues ...................................................... $ 22,509 $ 25,791 $ 29,157 $ 33,043 $ 28,169
Costs of revenues ................................................. 17,481 19,407 22,163 26,353 21,996
Gross profit ...................................................... 5,028 6,384 6,994 6,690 6,173
Selling, general and administrative, research and development, and
amortization .................................................... 5,510 5,075 6,481 6,321 8,558
(Loss) income from operations ..................................... (482) 1,309 513 369 (2,385)
Other (expense) income, net ....................................... (123) (184) (222) (5) (138)
(Loss) income from continuing operations before income taxes and .. (606) 1,125 291 364 (2,523)
extraordinary gain
Provision (benefit from) for income taxes ......................... 65 102 (280) -- --
(Loss) income before extraordinary gain and discontinued operations (671) 1,023 571 364 (2,523)
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 income (loss) from discontinued operations .................... 721 (9) (1,686) (144) --
Net income (loss) available to common stockholders ................ $ 176 $ (1,115) $ 220 $ (2,523)
$ 1,047
Basic income(loss) per share ...................................... $ 0.02 $ 0.10 $ (0.11) $ 0.04 $ (0.19)
Income (loss) per share assuming dilution ......................... $ 0.02 $ 0.08 $ (0.11) $ 0.03 $ (0.19)
Weighted average shares outstanding ............................... 9,581 10,111 9,948 10,241 13,450
Weighted average shares outstanding assuming dilution ............. 9,581 12,463 9,948 10,962 13,450
Pro forma basic (loss) earnings per share assuming the accounting
change is applied retroactively ................................. $ (0.04) $ 0.16 $ (0.11) $ 0.04 $ (0.19)
Pro forma (loss) earnings per share assuming the accounting
change is applied retroactively, assuming dilution .............. $ (0.04) $ 0.08 $ (0.11) $ 0.03 $ (0.19)
AT OCTOBER 31,
2000 2001 2002 2003 2004
--------------------------------------------------
CONSOLIDATED BALANCE SHEET DATA:
Working capital (deficit) ......................................... $ 5,839 $ 7,349 $ 3,856 $11,998 $ 9,867
Total assets ...................................................... 23,005 17,134 17,633 19,761 22,731
Long-term debt .................................................... 2,598 3,837 60 66 141
Total liabilities ................................................. 14,149 9,736 10,876 5,027 6,892
Stockholders' equity .............................................. 8,856 7,398 6,757 14,734 15,838
- -----------
-13-
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, concentration of revenue from one source,
competitors with broader product lines and greater resources, emergence into new
markets, the termination of any of the Company's significant contracts or
partnerships, 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. 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 ready-to-use
turnkey network server appliance solutions by integrating third-party software
into a custom designed server platform. The Company manufactures the resulting
product under 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.
The Company is also a value-added reseller for the software products of
its strategic channel partners who provide the products and marketing needed to
uncover new prospects. SteelCloud then works with the partner to provide
technical pre-sales support and to close business. In many instances, the sales
include professional IT consulting services from SteelCloud. This business
provides the Company with an entry into major new accounts without having to
invest in major marketing/advertising campaigns. The Company's GSA schedule is
helpful here when the products are sold into to federal, state and local
government customers.
To extend its network security offerings, the Company acquired the
assets of Asgard on February 17, 2004. As a result of the acquisition,
management believes SteelCloud is better positioned to define and control
proprietary product features and services from its own intellectual property.
With this purchase, the Company has also acquired the technical knowledgebase
and resources to design and develop proprietary products.
SteelCloud's Professional IT 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 IT support services to the public
sector as well as commercial customers.
FISCAL 2004
ISSUANCE OF EQUITY
At the end of fiscal year 2003, SteelCloud 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. The Company received gross proceeds
of $7,550,000 in connection with this transaction. The securities were sold
pursuant to an exemption from registration provided by section 4(2) of the
Securities Act.
-14-
ASGARD ACQUISITION
On February 17, 2004, the Company completed its acquisition of the
assets of Asgard, an internet security product and service company. In exchange
for the assets of Asgard, which included intellectual property and
patent-pending technology, the Company paid cash of $630,015, issued 575,000
shares of SteelCloud common stock valued at $2,283,900 and incurred
approximately $50,000 of direct costs associated with the transaction. The value
of SteelCloud common stock issued was determined in accordance with SFAS No. 141
by taking the average market price over the 2-day period before and after the
terms of the acquisition were agreed to and announced.
RESEARCH & PRODUCT DEVELOPMENT
In fiscal 2003, the Company undertook initiatives to enhance its
proprietary product offerings. Accordingly, the Company commenced its research
and development ("R&D") activities associated with the new product offerings in
the second quarter of fiscal 2003.
In June 2003, the Company entered into an agreement with Computer
Associates International, Inc. to deliver a family of co-branded, 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. The AVG product and subsequent SteelCloud/CA appliances
included proprietary SteelCloud Secure Console (SC2) software. First deliveries
were made in September 2003. During fiscal 2003, the Company incurred research
and development costs of approximately $494,087.
In fiscal 2004, following the acquisition of Asgard Holding, the
Company established an Advanced Technology Group for the purpose of developing
proprietary network security software products. These SteelCloud products can be
marketed under the SteelCloud brand exclusively and sold with or without
accompanying SteelCloud designed and manufactured network security appliances.
By investing in product development, the Company believes it will have more
control over the functionality and marketing of its products. The Company also
believes that the resulting intellectual property will increase the
competitiveness of its offerings and improve product margins. During fiscal
2004, the Company incurred research and development costs of $604,667. The
Company will continue to incur costs for Product Development in the future.
ISO CERTIFICATION
In April 2004 SteelCloud received ISO 9001:2000 Certification . ISO
Certification is an assurance that a company is dedicated to maintaining a
quality management system, and has procedures in place for continuous quality
improvement in all aspects of the organization's business. The Company believes
this certification was a factor in recent contract wins.
SIGNIFICANT CONTRACTS
In February 2003, the Company was awarded several contracts by Lockheed
Martin valued at more than $2.7 million for customized servers. The Company
commenced work under the contracts in February 2003, and completed deliveries in
fiscal year 2004. For the fiscal year ended 2004, the Company recognized revenue
of approximately $2.6 million (or approximately 10% of total net revenues) from
the contract awards.
In May 2004, the Company was awarded a contract by Lockheed Martin
valued at more than $12 million for customized servers. The contract included
options for the government integrator to purchase a substantial number of
additional appliances. Additional contract options were exercised early in
fiscal year 2005 and the total contract value exceeds $18 million. The Company
began making shipments under the initial contract during the three-month period
ending July 31, 2004 (the Company's fiscal third quarter). The Company continued
to make deliveries during the fourth quarter of fiscal year 2004 and into the
first half of fiscal year 2005. The estimated completion date for deliveries
under this contract is January 2005. In addition, contract options have been
exercised and deliveries under those options will begin after January 2005. For
the fiscal year 2004, the Company recognized revenue associated with this
contract of approximately $7.6 million. Given the nature of the products
manufactured by the Company as well as the delivery schedules established by its
partners, revenue and accounts receivable concentration by any single customer
will fluctuate from quarter to quarter. Future revenues and results of
operations could be adversely affected should this customer reduce its
purchases, eliminate product lines or choose not to continue to buy products and
services from SteelCloud.
-15-
FACILITIES EXPANSION
As a result of recent increases in contract awards and product backlog,
the Company has decided to move its office and manufacturing facilities to
ensure the appropriate infrastructure exists to support the projected growth.
The Company has executed non-cancelable leases for its headquarters and
operations, which commence occupancy in April 2005. These two new facilities
will be located in close proximity to SteelCloud's current facility.
TERMINATION OF ACQUISITION
On August 11, 2004, the Company signed a definitive merger agreement to
acquire all of the issued and outstanding capital stock of V-ONE Corporation, a
network security company based in Germantown, Maryland. The Boards of Directors
of both V-ONE and SteelCloud determined it was in the best interest of their
respective shareholders, customers, suppliers, and employees to terminate the
Merger Agreement. On September 29, 2004, SteelCloud, Inc. and V-ONE Corporation
announced that the termination of this Agreement and Plan of Merger dated August
11, 2004. Each company no longer has any further obligations to the other with
respect to the anticipated merger.
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. 104, Revenue Recognition in Financial Statements, corrected copy
(SAB 104). Generally, SAB 104 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 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.
SEGMENT REPORTING
FASB Statement No. 131, Disclosures about Segments of an Enterprise and
Related Information, establishes standards for reporting information about
operating segments. Operating segments are defined as components of an
enterprise about which separate financial information is available that is
evaluated regularly by the chief operating decision maker, or decision making
group, in deciding how to allocate resources and in assessing performance. FASB
Statement No. 131, Disclosures about Segments of an Enterprise and Related
Information, also establishes a quantitative threshold, whereby an enterprise
should report separately information about an operating segment if its reported
revenue is 10% or more of the combined revenue of all reported operating
segments. The Company is organized on the basis of products and services.
However, the Company does not evaluate the performance of its segments based on
earnings. The Company's chief operating decision maker is the Company's Chief
Operating Officer. While the Chief Operating Officer is apprised of a variety of
financial metrics and information, the Chief Operating Officer makes decisions
regarding how to allocate resources and assess performance based on a single
operating unit.
-16-
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In December 2004, the FASB issued SFAS No.123 (revised 2004),
"Share-Based Payment". Statement 123(R) will provide investors and other users
of financial statements with more complete and neutral financial information by
requiring that the compensation cost relating to share-based payment
transactions be recognized in financial statements. That cost will be measured
based on the fair value of the equity or liability instruments issued. Statement
123(R) covers a wide range of share-based compensation arrangements including
share options, restricted share plans, performance-based awards, share
appreciation rights, and employee share purchase plans. Statement 123(R)
replaces FASB Statement No. 123, Accounting for Stock-Based Compensation, and
supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees.
Statement 123, as originally issued in 1995, established as preferable a
fair-value-based method of accounting for share-based payment transactions with
employees. However, that Statement permitted entities the option of continuing
to apply the guidance in Opinion 25, as long as the footnotes to financial
statements disclosed what net income would have been had the preferable
fair-value-based method been used. Public entities (other than those filing as
small business issuers) will be required to apply Statement 123(R) as of the
first interim or annual reporting period that begins after June 15, 2005. The
Company is currently evaluating the financial statement impact of the adoption
of SFAS 123(R).
In November 2004, the FASB issued SFAS No. 151 "Inventory Costs, an
amendment of ARB No. 43, Chapter 4. The amendments made by Statement 151 clarify
that abnormal amounts of idle facility expense, freight, handling costs, and
wasted materials (spoilage) should be recognized as current-period charges and
require the allocation of fixed production overheads to inventory based on the
normal capacity of the production facilities. The guidance is effective for
inventory costs incurred during fiscal years beginning after June 15, 2005.
Earlier application is permitted for inventory costs incurred during fiscal
years beginning after November 23, 2004. The Company is currently evaluating the
financial statement impact of the adoption of SFAS 151.
In December 2003, SAB 104, "Revenue Recognition," was issued which
supersedes SAB 101, "Revenue Recognition in Financial Statements." The primary
purpose of SAB 104 is to rescind accounting guidance contained in SAB 101
related to multiple element revenue arrangements, superseded as a result of the
issuance of the FASB's Emerging Issues Task Force ("EITF") Issue No. 00-21,
"Accounting for Revenue Arrangements with Multiple Deliverables." Additionally,
SAB 104 rescinds the SEC's "Revenue Recognition in Financial Statements
Frequently Asked Questions and Answers" (the "FAQ") issued with SAB 101 that had
been codified in SEC Topic 13, "Revenue Recognition." Selected portions of the
FAQ have been incorporated into SAB 104. While the wording of SAB 104 has
changed to reflect the issuance of EITF 00-21, the revenue recognition
principles of SAB 101 remain largely unchanged by the issuance of SAB 104. The
adoption of SAB 104 had no impact on the Company's financial statements.
In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46),
"Consolidation of Variable Interest Entities." This Interpretation clarifies the
application of Accounting Research Bulletin No. 51, "Consolidated Financial
Statements," to certain entities in which equity investors do not have the
characteristics of a controlling financial interest or do not have sufficient
equity at risk for the entity to finance its activities without additional
subordinated financial support from other parties. FIN 46 requires an enterprise
to consolidate a variable interest entity if that enterprise will absorb a
majority of the entity's expected losses, is entitled to receive a majority of
the entity's expected residual returns, or both. FIN 46 also requires
disclosures about unconsolidated variable interest entities in which an
enterprise holds a significant variable interest. Application of FIN 46, as
revised in December 2003, is required for financial statements of public
entities that have interest in variable interest entities, or potential variable
interest entities commonly referred to as special-purpose entities for periods
ending after December 15, 2003. Application by public companies for all other
types of entities is required in financial statements for periods ending after
March 15, 2004. Adoption of FIN 46 did not have a material effect on the
Company's financial statements.
-17-
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.
Adoption of EITF 00-21 did not have a material impact on the Company's financial
statements.
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, 2004, the Company has recorded a valuation allowance of
approximately $14.1 million against the total deferred tax asset of $14.5
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.
-18-
RESULTS OF OPERATIONS
The following table sets forth for the fiscal years ended October 31,
2000, 2001, 2002, 2003 and 2004, certain income and expense items of SteelCloud
as a percentage of net revenues.
2000 2001 2002 2003 2004
---------------------------------------------------------
Net revenues .................................... 100.00% 100.00% 100.00% 100.00% 100.00%
Costs of revenues ............................... 77.66% 75.25% 76.01% 79.76% 78.09%
Gross profit .................................... 22.34% 24.75% 23.99% 20.24% 21.91%
Selling, general and administrative, research and
development, and amortization ........... 24.48% 19.68% 22.23% 19.13% 30.38%
(Loss) income from operations ................... (2.14)% 5.08% 1.76% 1.11% (8.47)%
Other (expense) income .......................... (0.55)% (0.71)% (0.76)% 0.01% (0.49)%
(Loss) income before income taxes ............... (2.69)% 4.36% 1.00% 1.00% (8.96)%
(Benefit from) provision for income taxes ....... 0.29% 0.40% (0.96)% 0.00% 0.00%
(Loss) income from discontinued operations ...... 3.20% (0.03)% (5.78)% (0.44)% 0.00%
Net (Loss) income to common stockholders ........ 0.78% 4.06% (3.82)% 0.67% (8.96)%
FISCAL YEAR ENDED OCTOBER 31, 2004 COMPARED TO FISCAL YEAR ENDED
OCTOBER 31, 2003
Net revenues of SteelCloud for fiscal year ended October 31, 2004
("fiscal 2004") decreased approximately 15% to $28.2 million from $33.0 million
for fiscal year ended October 31, 2003 ("fiscal 2003"). Product revenues
decreased to $24,155,872 for the fiscal year 2004 from $29,753,623 for the same
period in fiscal 2003, a decrease of $5,597,751 or 18.9%. As a result of the
completion of numerous contracts relating to the Company's GSA schedule during
fiscal 2003, revenues associated with these contracts decreased by approximately
$3.2 million, respectively, for fiscal year 2004 as compared to fiscal year
2003. In addition, the Company's OEM revenues decreased by approximately
$921,000 from fiscal year 2003 to fiscal year 2004, due to the reallocation of
resources to support the Company's security appliances. Even though the Company
realigned its resources to focus on the new security appliances, revenues
associated from the Company's security appliances were significantly lower than
expected due to delays in third party software availability during fiscal year
2004. The decrease in revenue is also attributable to certain organizational and
restructuring changes within one of the Company's reselling partners, Network
Associates, during fiscal 2004 which significantly impacted the Company's
reselling activities. As a result, reselling revenues decreased by $2.3 million
for fiscal year 2004 as compared to fiscal year 2003. The aforementioned
decreases in revenue were partially offset by deliveries under the new Lockheed
Martin contracts. Valued at approximately $12 million, the Company generated
revenue of approximately $7.6 million during fiscal year 2004 under these
contracts. The Company anticipates an estimated completion date of January 2005.
Additional contract options have been exercised and deliveries for that option
period will commence in January 2005.
Service revenues increased to $4,013,333 during fiscal year 2004 from
$3,289,376 during fiscal year 2003, an increase of $723,957 or 22.0%. The
increase in service revenues for fiscal year 2004 as compared to fiscal year
2003 is primarily the result of continuing efforts to leverage existing customer
relationships and diversify revenue sources through sales of additional products
and complementary services. In addition, the acquisition of Asgard, an internet
security product and service company, yielded approximately $375,000 of service
revenue in fiscal year 2004.
Gross profit for fiscal 2004 decreased by approximately 8% to
approximately $6.2 million from $6.7 million in fiscal 2003. The decrease was
primarily the result of the Company's decrease in its GSA, OEM and reselling
activities during fiscal 2004. Gross profit as a percentage of net revenues
during the same periods increased to 21.9% from 20.2% and is primarily
attributable to the increase in the Company's higher margin service revenues
associated with its services and improved reselling revenues margins.
-19-
Selling and marketing expense increased in fiscal 2004 by 68% to
approximately $2.14 million from approximately $1.28 million for fiscal 2003.
The increase reflects significant additions in resources and compensation, and
tradeshows that were incurred in fiscal year 2004 as compared to fiscal year
2003. These additional marketing and advertising expenditures were associated
with the Company's new branded products. Accordingly, selling and marketing
expense as a percentage of net revenues increased to 8% from 4% in fiscal 2004
and fiscal 2003 respectively. The Company anticipates selling and marketing
expenditures to remain consistent with fiscal year 2004.
Research and product development expenses increased in fiscal 2004 by
22% to approximately $605,000 from $494,000 for fiscal 2003. The large increase
is primarily the result of a full year of development activity as the Company
commenced its research and product development efforts during the second quarter
of fiscal 2003. The Company primarily incurs research and development costs
relating to services and product purchases. In order to meet the Company's
strategic goals, the Company expects to continue to incur additional research
and product development costs in future quarters as new products are brought to
market. In addition, the Company acquired the assets of Asgard Holding, LLC in
February 2004 and, as a result, established an Advanced Technology Group ("ATG")
in Ft. Lauderdale. This group is now responsible for designing and developing
proprietary SteelCloud software products.
General and administrative expense for fiscal 2004 increased 26% to
$5.71 million from $4.55 million for fiscal 2003. As a percentage of net
revenues, general and administrative expense increased to 20% for fiscal 2004
from 14% for fiscal 2003. The general and administrative expense increase during
fiscal 2004 was attributable to the Company's diversification of its revenue
base and the corresponding costs associated with entering new markets and
expanding its scope in existing markets. Primarily, compensation expense
increased in fiscal 2004 by $350,000. An additional $129,000 of depreciation
associated with the Company's internal infrastructure was incurred in fiscal
year 2004. Expenditures were also incurred in fiscal year 2004 for incremental
tax filings of approximately $60,000 and severance costs of approximately
$100,000 that were not required in fiscal year 2003. Finally, a prior year
contingency of $250,000 was settled in fiscal year 2003 for less than originally
expected, resulting in lower expenses in fiscal year 2003 compared to fiscal
year 2004. Although general and administrative costs increased as a percentage
of net revenues, the Company continues to monitor and manage general and
administrative costs relative to its net revenue and gross margin. The Company
also incurred approximately $101,000 of amortization expense primarily
associated with the acquisition of Asgard intangible assets.
Other expense, including interest, for fiscal 2004 increased to
approximately $138,500 from approximately $4,700 for fiscal 2003. The increase
was due to terminated merger costs of approximately $169,000 associated with the
Company's attempted acquisition of V-One. This increase was partially offset by
additional interest income of approximately $50,000 earned in fiscal 2004
compared to fiscal 2003 due to Company's cash position.
Net income available to common shareholders decreased in fiscal 2004 to
$(2,523,848) from $219,988 in fiscal 2003. The Company currently has
approximately $36.0 million in Net Operating Loss ("NOL") carryforwards, which
may be used to offset future income. As of October 31, 2004, a deferred tax
asset of $400,000 was recognized based on fiscal 2005 estimated taxable income
for which it may offset. Approximately $36.0 million of NOLs remain fully
reserved as of October 31, 2004. This reserve may 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, 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"). Product revenues
increased to $29,753,623 for the fiscal year 2003 from $26,722,140 for the same
period in fiscal 2002, an increase of $3,031,483 or 11.34%. 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 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.
-20-
Service revenues increased to $3,289,376 during fiscal year 2003 from
$2,435,228 during fiscal year 2002, an increase of $854,148 or 35.01%. The
increase in service revenues for fiscal year 2003 as compared to fiscal year
2002 is attributable to the Company leveraging existing customer relationships
and diversifying revenue sources through sales of additional products and
complementary services.
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.
Research and product development expenses increased in fiscal 2003 by
100% to approximately $494,087 from $0 for fiscal 2002. 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.
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 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.
-21-
LIQUIDITY AND CAPITAL RESOURCES
As of October 31, 2004, the Company had cash and cash equivalents of
approximately $3.1 million and working capital of approximately $9.9 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 2005.
In fiscal 2004, the Company used approximately $5,100,000 in cash flow
for operating activities. The Company generated a net loss from continuing
operations of approximately $2.5 million, increased accounts receivable by
approximately $4.2 million, due to higher fourth quarter sales in fiscal year
2004 compared to the prior year, and increased purchases of inventory by
approximately $750,000. The increase in accounts receivable includes a reduction
in the allowance for doubtful accounts from $293,000 to $86,000 in,
respectively, fiscal year 2003 and fiscal year 2004. The inventory reserve was
decreased from $360,000 in fiscal 2003 to $255,000 in fiscal year 2004 and is
reflected in the inventory increase. The Company generated cash primarily by
increasing accounts payable and accrued expenses of approximately $1.75 million.
In addition, allowance for doubtful accounts decreased from $293,000 to $86,000
in, respectively, fiscal year 2003 and fiscal year 2004
The Company's investing activities consisted of the purchases of
approximately $502,000 for property and equipment and $726,000 for the
acquisition of Asgard.
The Company's financing activities during fiscal 2004 were provided
primarily by the Company's issuance of common stock in conjunction with the
exercise of warrants, proceeds from the exercise of common stock options and
issuance of stock associated with the Company's Employee Stock Purchase Plan
("ESPP"). Issuance of the Company's common stock in conjunction with the
exercise of warrants generated approximately $719,000, net of expenses. Proceeds
from the exercise of common stock options and the Employee Stock Purchase Plan
were approximately $493,000 and $133,000 respectively. The Company did not rely
on its bank line of credit during fiscal 2004. The line of credit expires on
March 31, 2005 and currently bears interest at the LIBOR Market Index Rate plus
one and one-quarter percent (1.25%). As of December 31, 2004, the Company had an
outstanding balance on the line of credit of approximately $0 and available
borrowing capacity of approximately $3.5 million.
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 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.
On February 17, 2004, the Company completed its acquisition of the
assets of Asgard, an internet security product and service company. In exchange
for the assets of Asgard, the Company paid cash of $630,015, issued 575,000
shares of SteelCloud common stock valued at $2,283,900 and incurred
approximately $50,000 of direct costs associated with the transaction. The value
of SteelCloud common stock issued was determined in accordance with SFAS No. 141
by taking the average market price over the 2-day period before and after the
terms of the acquisition were agreed to and announced.
In fiscal 2004, the Company received proceeds from the exercise of
stock options of approximately $493,000. Approximately 327,000 shares of common
stock were issued upon the exercise of these stock options. The Company issued
approximately 56,000 shares of common stock and received proceeds of
approximately $133,000 associated with the Employee Stock Purchase Plan.
The Company has obligations under its operating lease commitments of
approximately $628,099 for fiscal year 2005.
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.
-22-
OFF-BALANCE SHEET ARRANGEMENTS
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
The Company's significant contractual obligations as of October 31,
2004 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, 2004, 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 $ 71,176 $ 71,176 -- -- --
- --------------------------- ----------------- ---------------- --------------- ------------- -------------
Notes payable - long term 120,660 -- 106,033 14,657 --
- --------------------------- ----------------- ---------------- --------------- ------------- -------------
Operating lease 2,830,449 628,099 1,157,858 1,044,492 --
- --------------------------- ----------------- ---------------- --------------- ------------- -------------
-23-
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 Registered Public
Accounting Firm ............................................... F-1
Consolidated Balance Sheets............................................ F-2
Consolidated Statements of Operations.................................. F-3
Consolidated Statements of Stockholders' Equity........................ F-4
Consolidated Statements of Cash Flows.................................. F-5
Notes to the Consolidated Financial Statements......................... F-6
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.
-24-
ITEM 9A. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. Our management, with
the participation of our principal executive officer, principal operating
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, Chief Operating 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.
LIMITATIONS. A control system, no matter how well designed and
operated, can provide only reasonable, not absolute, assurance that the control
system's objectives will be met. Further, the design of a control system must
reflect the fact that there are resource constraints, and the benefits of
controls must be considered relative to their costs. Because of the inherent
limitations in all control systems, no evaluation of controls can provide
absolute assurance that all control issues and instances of fraud, if any,
within the Company have been detected. These inherent limitations include the
realities that judgments in decision-making can be faulty, and that breakdowns
can occur because of simple errors or mistakes. Controls can also be
circumvented by the individual acts of some persons, by collusion of two or more
people, or by management override of the controls. The design of any system of
controls is based in part upon certain assumptions about the likelihood of
future events, and there can be no assurance that any design will succeed in
achieving its stated goals under all potential future conditions. Over time,
controls may become inadequate because of changes in conditions or deterioration
in the degree of compliance with its policies or procedures. Because of the
inherent limitations in a cost-effective control system, misstatements due to
error or fraud may occur and not be detected. We continuously evaluate our
internal controls and make changes to improve them.
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.
-25-
PART III
The Notice and Proxy Statement for the 2004 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), Item 13 (certain relationships and related transactions) and Item
14 (principle accounting fees and services), 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 Registered Public Accounting
Firm Consolidated Balance Sheets as of October 31, 2003 and 2004
Consolidated Statements of Operations for the three years ended October
31, 2004 Consolidated Statements of Stockholders' Equity for the three
years ended October 31, 2004 Consolidated Statements of Cash Flows for
the three years ended October 31, 2004 Notes to Consolidated Financial
Statements
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 29, 2004, the Company filed a report on Form 8-K pursuant
to Item 1.02 "Termination of a Material Definitive Agreement" and Item
9.01 "Financial Statements and Exhibits".
On September 14, 2004, the Company filed a report on Form 8-K pursuant
to Item 2.02 "Results of Operations and Financial Condition" and Item
9.01 "Financial Statements and Exhibits".
On August 11, 2004, the Company filed a report on Form 8-K pursuant to
Item 5 "Other Events and Required FD Disclosure" and Item 7 "Financial
Statements, Pro Forma Financial Information and Exhibits".
(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).
-26-
**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
SteelCloud, 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.
**10.31 Mutual Termination Agreement by and between SteelCloud, Inc. and
V-One Corporation dated September 28, 2004 (Filed as Exhibit 10.1 of
SteelCloud's 8-K, dated September 28, 2004 and hereby incorporated
by reference).
*10.32 Employment Agreement by and between SteelCloud, Inc. and Kevin
Murphy, dated June 8, 2004.
*10.33 Employment Agreement by and between SteelCloud, Inc. and Brian
Hajost, dated June 8, 2004.
*10.34 Asset Purchase Agreement by and between SteelCloud, Inc. and Asgard
Holding, LLC, dated February 17, 2004.
*10.35 Sublease by and between SteelCloud and NEC America Inc., dated
September 28, 2004.
*11.1 Statement of Computation of Earnings Per Share.
*21.1 List of Subsidiaries.
*23.1 Consent of Grant Thornton LLP, Independent Registered Public
Accounting Firm.
*31.1 Certification of Chief Executive Officer Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
*31.2 Certification of Chief Operating Officer Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
*31.3 Certification of Chief Financial Officer 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.
*32.3 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.
-27-
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 26, 2005 By:
/s/ Thomas P. Dunn
------------------
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 26, 2005
/s/Kevin Murphy
Kevin Murphy Chief Financial Officer January 26, 2005
/s/Brian Hajost
Brian Hajost Chief Operating Officer January 26, 2005
/s/VADM E.A. Burkhalter
VADM E. A. Burkhalter USN (Ret.) Director January 26, 2005
/s/James Bruno
James Bruno Director January 26, 2005
/s/ Jay Kaplowitz
Jay Kaplowitz Director January 26, 2005
/s/Benjamin Krieger
Benjamin Krieger Director January 26, 2005
INDEX TO FINANCIAL STATEMENTS
STEELCLOUD, INC (A VIRGINIA CORPORATION)
Report of Grant Thornton LLP, Independent Registered Public
Accounting Firm ................................................ F-1
Consolidated Balance Sheets as of October 31, 2003 and 2004............. F-2
Consolidated Statements of Operations for the three years ended
October 31, 2004 ............................................... F-3
Consolidated Statements of Stockholders' Equity for the three years
ended October 31, 2004 ......................................... F-4
Consolidated Statements of Cash Flows for the three years
ended October 31, 2004 ......................................... F-5
Notes to Consolidated Financial Statements ............................. F-6
-28-
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
SteelCloud, Inc.
We have audited the accompanying consolidated balance sheets of
SteelCloud, Inc. as of October 31, 2004 and 2003, and the related consolidated
statements of operations, stockholders' equity, and cash flows for each of the
three years in the period ended October 31, 2004. 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 of the Public Company Accounting Oversight Board (United States). 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 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 financial position of SteelCloud,
Inc. as of October 31, 2004 and 2003, and the results of its operations and its
cash flows for each of the three years in the period ended October 31, 2004 in
conformity with accounting principles generally accepted in the United States of
America.
/s/ Grant Thornton LLP
- ----------------------
Vienna, VA
December 17, 2004
F-1
STEELCLOUD, INC.
CONSOLIDATED BALANCE SHEETS
OCTOBER 31,
----------------------------
2003 2004
------------ ------------
ASSETS
Current assets:
Cash and cash equivalents ................................. $ 8,098,221 $ 3,108,941
Accounts receivable, net of allowance for doubtful
accounts of $293,000 and $86,000 as of
October 31, 2003 and 2004, respectively .............. 5,332,549 9,532,770
Inventory, net ............................................ 2,880,944 3,629,685
Income tax receivable ..................................... 55,392 --
Prepaid expenses and other current assets ................. 184,420 307,427
Deferred contract costs ................................... 7,053 40,085
------------ ------------
Total current assets ......................................... 16,958,579 16,618,908
Property and equipment, net .................................. 477,111 454,928
Equipment on lease, net ...................................... 335,935 373,590
Goodwill and other intangible assets, net .................... 1,778,059 4,687,105
Deferred tax asset - long term ............................... 400,000 400,000
Other assets ................................................. 211,155 196,244
------------ ------------
Total assets ................................................. $ 19,760,839 $ 22,730,775
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable .......................................... $ 3,202,195 $ 4,866,079
Accrued expenses .......................................... 1,369,145 1,441,350
Notes payable, current portion ............................ 96,133 71,176
Unearned revenue .......................................... 293,363 373,017
------------ ------------
Total current liabilities .................................... 4,960,836 6,751,622
Notes payable, long-term portion ......................... 59,952 120,660
Other .................................................... 6,415 20,083
------------ ------------
Total long-term liabilities .................................. 66,367 140,743
Stockholders' equity:
Preferred stock, $.001 par value; 2,000,000 shares authorized,
0 and 0 shares issued and outstanding at
October 31, 2003 and 2004, respectively
Common stock, $.001 par value; 50,000,000 shares authorized,
13,008,553 and 14,213,514 shares issued and
outstanding at October 31, 2003 and 2004, respectively 13,009 14,214
Additional paid-in capital ................................... 47,307,036 50,934,453
Treasury stock, 400,000 shares at October 31, 2003 and 2004, . (3,432,500) (3,432,500)
respectively
Accumulated deficit .......................................... (29,153,909) (31,677,757)
------------ ------------
Total stockholders' equity ................................... 14,733,636 15,838,410
------------ ------------
Total liabilities and stockholders' equity ................... $ 19,760,839 $ 22,730,775
============ ============
See accompanying notes
F-2
STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED OCTOBER 31,
--------------------------------------------
2002 2003 2004
------------ ------------ ------------
Products ........................................... 26,722,140 29,753,623 24,155,872
Services ........................................... 2,435,228 3,289,376 4,013,333
------------ ------------ ------------
Net revenues ....................................... $ 29,157,368 $ 33,042,999 $ 28,169,205
Products ........................................... 20,700,647 23,871,952 19,506,384
Services ........................................... 1,462,788 2,481,510 2,490,097
------------ ------------ ------------
Costs of revenues .................................. 22,163,435 26,353,462 21,996,481
------------ ------------ ------------
Gross profit ....................................... 6,993,933 6,689,537 6,172,724
------------ ------------ ------------
------------ ------------ ------------
Selling and marketing .............................. 1,184,406 1,276,386 2,141,495
General and administrative ......................... 4,769,552 4,550,414 5,711,218
Research and product development ................... -- 494,087 604,667
Impairment of goodwill ............................. 132,644 -- --
Amortization of goodwill and other intangible assets 394,216 -- 100,710
------------ ------------ ------------
Income (loss) from operations ...................... 513,115 368,650 (2,385,366)
Other income (expense):
Interest income ................................. 5,525 5,661 55,005
Interest expense ................................ (78,734) (22,800) (24,474)
Other, net ...................................... (149,183) 12,421 (169,013)
------------ ------------ ------------
Income (loss) from continuing operations
before income tax .......................... 290,723 363,932 (2,523,848)
Benefit from income taxes .......................... (279,800) -- --
------------ ------------ ------------
Income (loss) from continuing operations ........... 570,523 363,932 (2,523,848)
(Loss) from discontinued operations, net of tax .... (1,685,708) (134,367) --
(Loss) on disposal of discontinued operations,
net of tax ................................ -- (9,577) --
------------ ------------ ------------
Net (loss) income available to common stockholders . $ (1,115,185) $ 219,988 $ (2,523,848)
============ ============ ============
Earnings (loss) per share, basic
Earnings (loss) from continuing operations ......... $ 0.06 $ 0.04 $ (0.19)
(Loss) from discontinued operations ................ (0.17) (0.01) --
------------ ------------ ------------
Net (loss) earnings per share ...................... $ (0.11) $ 0.03 $ (0.19)
============ ============ ============
Earnings (loss) per share, fully diluted
Earnings (loss) from continuing operations ......... $ 0.05 $ 0.03 $ (0.19)
(Loss) from discontinued operations ................ (0.15) (0.01) --
------------ ------------ ------------
Net (loss) earnings per share ..................... $ (0.10) $ 0.02 $ (0.19)
============ ============ ============
See accompanying notes.
F-3
STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Additional
Preferred Stock Common Stock Paid-In Treasury Accumulated
Shares Amount Shares Amount Capital Stock Deficit Total
--------------------------------------------------------------------------------------------------------
BALANCE AT
OCTOBER 31, 2002 ...... -- -- 10,447,611 $ 10,448 $39,553,017 $(3,432,500) $(29,373,897) $ 6,757,068
Issuance of common stock
in connection with
exercise of employee
incentive stock option
plan .................. -- -- 673,442 673 789,882 -- -- 790,555
Issuance of common stock 6,966,025
under private placement -- -- 1,887,500 1,888 6,964,137 -- --
Net Income .............. -- -- -- -- -- -- 219,988 219,988
--------------------------------------------------------------------------------------------------------
BALANCE AT
OCTOBER 31, 2003 ...... 13,008,553 $ 13,009 $ 47,307,036 $(3,432,500) $(29,153,909) 14,733,636
Issuance of common stock
in connection with
exercise of employee
incentive stock option
plan .................. -- -- 326,899 327 493,066 -- -- 493,393
Issuance of common stock
in connection with
exercise of
warrants .............. -- -- 247,252 248 718,466 -- -- 718,714
Issuance of common stock
in connection with
employee stock purchase -- -- 55,537 56 132,559 -- -- 132,615
plan
Issuance of common stock
in connection with .... -- -- 575,000 575 2,283,325 -- -- 2,283,900
purchase of Asgard
Net (Loss) .............. -- -- -- -- -- -- (2,523,848) (2,523,848)
========================================================================================================
BALANCE AT
OCTOBER 31, 2004 ...... -- -- 14,213,514 $ 14,214 $50,934,453 $(3,432,500) $(31,677,757) 15,834,410
========================================================================================================
See accompanying notes.
F-4
STEELCLOUD, INC
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED OCTOBER 31,
-----------------------------------------
2002 2003 2004
----------- ----------- -----------
OPERATING ACTIVITIES
Net (loss) income ................................. $(1,115,185) $ 219,988 $(2,523,848)
Loss from discontinued operations, net ............ 1,685,708 143,944 --
----------- ----------- -----------
Income applicable from continuing operations ...... 570,523 363,932 (2,523,848)
Adjustments to reconcile net income (loss)
to net cash provided by (used in)
operating activities:
Depreciation and amortization of
property and equipment ................... 683,860 331,553 486,974
Amortization of goodwill and other ............. 394,216 -- 100,710
intangibles
Impairment of goodwill ......................... 132,644 -- --
Impairment charge - investment ................. 150,000 -- --
Loss on sale of assets ......................... 4,196 -- --
Stock compensation expense ..................... 82,160 -- --
Changes in operating assets and liabilities:
Accounts receivable, net ..................... (425,245) 749,791 (4,200,221)
Income tax receivable ........................ 1,345,032 -- --
Inventory .................................... 117,458 1,336,334 (748,741)
Prepaid expenses and other assets ............ 41,688 29,394 (52,706)
Deferred contract costs ...................... (2,039,339) 2,032,286 (33,032)
Deferred tax asset (credit) .................. (279,800) -- --
Accounts payable ............................. 454,159 (321,574) 1,663,884
Accrued expenses ............................. 53,462 (166,718) 82,404
Unearned revenue and other liabilities ....... 4,294,474 (4,214,496) 83,123
----------- ----------- -----------
Net cash provided by (used in) operating activities
of continuing operations .................. 5,579,488 140,502 (5,141,453)
INVESTING ACTIVITIES
Purchases of property and equipment ............... (704,030) (228,177) (502,446)
Cash paid in acquisition .......................... -- -- (725,854)
----------- ----------- -----------
Net cash (used in) investing activities ........... (704,030) (228,177) (1,228,300)
FINANCING ACTIVITIES
Proceeds from issuance of common stock,
net of expenses ........................... -- 7,390,559 718,714
Proceeds from exercise of common stock options .... 272,693 366,021 626,008
Proceeds on notes payable ......................... 725,000 -- --
Payments on notes payable ......................... (515,742) (538,436) 35,751
Net payments on lines of credit ................... (3,836,754) -- --
----------- ----------- -----------
Net cash (used in) provided by
financing activities ...................... (3,354,803) 7,218,144 1,380,473
Net increase (decrease) in cash and
cash equivalents of
continuing operations ..................... 1,520,655 7,130,469 (4,989,280)
Net cash (used in) provided by
operating activities
of discontinued operations ................ (1,051,650) 216,429 --
Cash and cash equivalents at
beginning of year ......................... 282,318 751,323 8,098,221
----------- ----------- -----------
Cash and cash equivalents at end of year .......... $ 751,323 $ 8,098,221 $ 3,108,941
=========== =========== ===========
SUPPLEMENTAL CASH FLOW INFORMATION
Interest paid ..................................... $ 129,287 $ 23,345 $ 24,473
----------- ----------- -----------
Income taxes paid ................................. $ 1,200 -- --
=========== =========== ===========
F-5
STEELCLOUD, INC
CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
YEARS ENDED OCTOBER 31,
---------------------------------------
2002 2003 2004
---- ---- ----
NON-CASH INVESTING ACTIVITIES
Issuance of stock and debt assumption in purchase of
Asgard assets ...................................... $-- $-- $(2,454,038)
---- ---- -----------
Non-cash investing activities ...................... $-- $-- $(2,454,038)
==== ==== ===========
See accompanying notes
F-6
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
OCTOBER 31, 2002, 2003 AND 2004
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.
Accordingly, the Company has reflected this operation as discontinued in the
accompanying financial statements.
On February 17, 2004, to extend its network security offerings, the
Company acquired the assets of Asgard Holding, LLC. As a result of the
acquisition, management believes SteelCloud is better positioned to define and
control proprietary product features and services from its own intellectual
property. With this purchase, the Company has also acquired the technical
knowledgebase and resources to design and develop proprietary products.
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 AND CONCENTRATION OF CREDIT RISK
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.
Financial instruments that potentially subject the Company to concentrations of
credit risk consist primarily of cash 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 possible credit losses. The carrying amount of the receivables
approximates their 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 and other identifiable intangible 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 and 2004,
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, 2002, 2003, and 2004 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,
----------------------------------------------
2002 2003 2004
----------------------------------------------
Net (loss) income applicable to common
shareholders ................................... $ (1,115,185) $ 219,988 $ (2,523,848)
Deduct: Total stock-based compensation expense
determined under fair value based
method ......................................... $ 453,594 $ 630,932 $ 524,265
----------------------------------------------
Net (loss) - pro forma ........................... $ (1,568,779) $ (410,944) $ (3,048,113)
----------------------------------------------
Earnings per share:
(Loss) Earnings per share basic - as reported $ (0.11) $ 0.03 $ (0.19)
(Loss) Earnings per share diluted - as ...... $ (0.11) $ 0.02 $ (0.19)
reported
(Loss) per share basic - pro forma .......... $ (0.16) $ (0.04) $ (0.23)
(Loss) per share diluted - pro forma ......... $ (0.16) $ (0.04) $ (0.23)
Weighted average common shares outstanding:
Basic weighted average shares
outstanding
9,947,675 10,240,630 13,450,140
Fully diluted weighted average shares
outstanding ................................ 9,947,675 10,962,050 13,450,140
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 2002, 2003 and 2004: dividend
yield of 0%, expected volatility of 87%, 114% and 108%, respectively; risk-free
interest rates of 4.27%, 4.73% and 3.75% respectively; and expected life of the
option term of five years. The weighted average fair values of the options
granted in 2002, 2003 and 2004 with a stock price equal to the exercise price is
$0.98, $1.31 and $1.86 respectively.
F-10
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REVENUE RECOGNITION
The Company recognizes revenue in accordance with SEC Staff Accounting
Bulletin No. 104, Revenue Recognition in Financial Statements, corrected copy
(SAB 104). Generally, SAB 104 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 implementation revenue.
For product sales the Company generally recognizes revenue at the time
of shipment when title and risk of loss transfers to the customer. 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.
For services revenue under time and material contracts, the Company
recognizes revenue as services are provided.
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 implementation 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, 2002, 2003 and 2004, the Company had
revenues from the Federal government, which represented 21%, 46% and 36%,
respectively, of total revenue. As of October 31, 2003 and 2004, accounts
receivable from agencies of the Federal government represented 44%, and 23%,
respectively, of total accounts receivable.
During fiscal 2002 the Company's significant customers were Lockheed
Martin and Network Associates both of which were third parties. During fiscal
2002, Lockheed revenues were 10% and Network Associates revenues were 54% of
total revenues. During fiscal year 2003, the Company's significant customers
were Lockheed Martin and General Services Administration, representing 26% and
11% of the Company's total net revenues, respectively. During fiscal year 2004,
the Company's significant customer was Lockheed Martin representing 39% of the
Company's total net revenues. Accounts receivable balances as of October 31,
2003 included amounts due from Lockheed Martin, 13% and General Services
Administration, 11%. Lockheed Martin comprised 63% of the accounts receivable
balance at October 31, 2004.
F-11
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
ADVERTISING EXPENSES
The Company expenses advertising costs as incurred. Advertising costs
consisted of expenditures for tradeshows, Web site maintenance and charges
associated with the dissemination of important Company news and product features
to the public. These costs amounted to approximately $50,000, $57,000 and
$273,000 during fiscal 2002, 2003, and 2004, respectively.
RESEARCH AND PRODUCT DEVELOPMENT EXPENSES
The Company expenses research and product development expenses as
incurred. These costs consist primarily of labor charges associated with
development of the Company's security appliances. These expenses amounted to
approximately $0, $494,000 and $605,000 during fiscal 2002, 2003, and 2004,
respectively.
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.
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
and warrants.
RECLASSIFICATIONS
Certain reclassifications have been made in prior periods to conform to the
current year presentation. Such reclassifications do not affect results of
operations as previously reported.
F-12
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
RECENT PRONOUNCEMENTS
In December 2004, the FASB issued SFAS No.123 (revised 2004),
"Share-Based Payment". Statement 123(R) will provide investors and other users
of financial statements with more complete and neutral financial information by
requiring that the compensation cost relating to share-based payment
transactions be recognized in financial statements. That cost will be measured
based on the fair value of the equity or liability instruments issued. Statement
123(R) covers a wide range of share-based compensation arrangements including
share options, restricted share plans, performance-based awards, share
appreciation rights, and employee share purchase plans. Statement 123(R)
replaces FASB Statement No. 123, Accounting for Stock-Based Compensation, and
supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees.
Statement 123, as originally issued in 1995, established as preferable a
fair-value-based method of accounting for share-based payment transactions with
employees. However, that Statement permitted entities the option of continuing
to apply the guidance in Opinion 25, as long as the footnotes to financial
statements disclosed what net income would have been had the preferable
fair-value-based method been used. Public entities (other than those filing as
small business issuers) will be required to apply Statement 123(R) as of the
first interim or annual reporting period that begins after June 15, 2005. The
Company is currently evaluating the financial statement impact of the adoption
of SFAS 123(R).
In November 2004, the FASB issued SFAS No. 151 "Inventory Costs, an
amendment of ARB No. 43, Chapter 4. The amendments made by Statement 151 clarify
that abnormal amounts of idle facility expense, freight, handling costs, and
wasted materials (spoilage) should be recognized as current-period charges and
require the allocation of fixed production overheads to inventory based on the
normal capacity of the production facilities. The guidance is effective for
inventory costs incurred during fiscal years beginning after June 15, 2005.
Earlier application is permitted for inventory costs incurred during fiscal
years beginning after November 23, 2004. The Company is currently evaluating the
financial statement impact of the adoption of SFAS 151.
In December 2003, SAB 104, "Revenue Recognition," was issued which
supersedes SAB 101, "Revenue Recognition in Financial Statements." The primary
purpose of SAB 104 is to rescind accounting guidance contained in SAB 101
related to multiple element revenue arrangements, superseded as a result of the
issuance of the FASB's Emerging Issues Task Force ("EITF") Issue No. 00-21,
"Accounting for Revenue Arrangements with Multiple Deliverables." Additionally,
SAB 104 rescinds the SEC's "Revenue Recognition in Financial Statements
Frequently Asked Questions and Answers" (the "FAQ") issued with SAB 101 that had
been codified in SEC Topic 13, "Revenue Recognition." Selected portions of the
FAQ have been incorporated into SAB 104. While the wording of SAB 104 has
changed to reflect the issuance of EITF 00-21, the revenue recognition
principles of SAB 101 remain largely unchanged by the issuance of SAB 104. The
adoption of SAB 104 had no impact on the Company's financial position or results
of operations.
In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46),
"Consolidation of Variable Interest Entities." This Interpretation clarifies the
application of Accounting Research Bulletin No. 51, "Consolidated Financial
Statements," to certain entities in which equity investors do not have the
characteristics of a controlling financial interest or do not have sufficient
equity at risk for the entity to finance its activities without additional
subordinated financial support from other parties. FIN 46 requires an enterprise
to consolidate a variable interest entity if that enterprise will absorb a
majority of the entity's expected losses, is entitled to receive a majority of
the entity's expected residual returns, or both. FIN 46 also requires
disclosures about unconsolidated variable interest entities in which an
enterprise holds a significant variable interest. Application of FIN 46, as
revised in December 2003, is required for financial statements of public
entities that have interest in variable interest entities, or potential variable
interest entities commonly referred to as special-purpose entities for periods
ending after December 15, 2003. Application by public companies for all other
types of entities is required in financial statements for periods ending after
March 15, 2004. Adoption of FIN 46 did not have a material effect on the
Company's financial statements.
F-13
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
RECENT PRONOUNCEMENTS
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.
Adoption of EITF 00-21 did not have a material impact on the Company's financial
statements.
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.
PRIMOA's revenues, costs and expenses have been reported as
discontinued operations. 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,
2002 2003 2004
----------------------------------
Net revenues ............................. $ 1,613,864 $ 228,143 $--
Gross (loss)profit ....................... (506,620) 78,470 --
(Loss) from discontinued operations ...... (1,685,708) (134,367) --
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 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,
--------------------------
2003 2004
----------- -----------
Computer and office equipment .................... $ 1,641,813 $ 1,893,526
Furniture and fixtures ........................... 271,070 271,070
Leasehold improvements ........................... 455,724 468,022
Other ............................................ 423,089 440,880
----------- -----------
2,791,696 3,073,498
Less accumulated depreciation and amortization ... (2,314,585) (2,618,570)
----------- -----------
$ 477,111 $ 454,928
=========== ===========
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 $1,221,390 and $936,578 at October 31, 2004 and 2003,
respectively. The related accumulated depreciation on the equipment was $847,800
and $605,905 at October 31, 2004 and 2003, respectively.
5. GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill and other intangible assets were comprised of:
OCTOBER 31,
----------------------------
2003 2004
----------- -----------
Goodwill and other intangibles:
Goodwill .................................. $ 2,397,288 $ 5,061,705
Other intangibles ......................... 600,000 945,339
----------- -----------
Total goodwill and other intangibles ......... 2,997,288 6,007,044
Less accumulated amortization:
Goodwill .................................. 639,229 639,229
Other intangibles ......................... 580,000 680,710
----------- -----------
Total accumulated amortization ............... (1,219,229) (1,319,939)
----------- -----------
$ 1,778,059 $ 4,687,105
=========== ===========
The Company has amortized goodwill using 20-year lives through October
31, 2002. Beginning November 1, 2002, the Company no longer amortized goodwill
as a result of adopting SFAS 142 "Goodwill and Other Intangible Assets" and
instead periodically tests goodwill for impairment. In fiscal 2002, the Company
recorded amortization expense associated with Goodwill of $394,216. Had
amortization expense not been recorded in fiscal 2002, net loss would have been
($720,969) and basic and fully diluted loss per share would have been $(0.07).
F-15
5. GOODWILL AND OTHER INTANGIBLE ASSETS (CONTINUED)
On February 17, 2004, the Company completed its acquisition of the
assets of Asgard Holding, LLC (Asgard), an internet security product and service
company. As a result of the acquisition, SteelCloud acquired $345,339 of
intangible assets. Of this total, $238,207 was assigned to SecureNet software
technology developed by Asgard, and $107,132 was assigned to customer
relationships acquired in conjunction with the acquisition of the assets of
Asgard. Both the SecureNet software technology and the customer relationships
will be amortized over estimated useful lives of 3 years. The $2,664,417
assigned to goodwill in connection with the acquisition will not be amortized,
but will be tested at least annually for impairment. As of October 31, 2004, the
Company had incurred $80,710 of amortization expense associated with the
intangible assets acquired from Asgard. For fiscal year 2003, the impact of
Asgard would have created pro forma revenue, net income, basic earnings per
share and diluted earnings per share of $33,795,499, $371,530, $0.03 and $0.03,
respectively. Asgard would have had an immaterial impact on pro forma 2004
results of operations if financial activity from the beginning of fiscal year
was included.
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 and 2004.
F-16
6. BANK LINES OF CREDIT AND NOTES PAYABLE
OPERATING LINE OF CREDIT
On January 22, 2004, the Company amended 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 and expires on March 31, 2005. There were no outstanding borrowings on
the line of credit at October 31, 2003 and October 31, 2004.
NOTES PAYABLE
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, 2003 and 2004 was approximately $60,000 and
$0, respectively. In December 2003, the Company paid the debt thereby
extinguishing its obligations under this note.
On February 17, 2004, the Company executed two three-year promissory
notes in conjunction with the purchase of the assets of Asgard Holding, LLC
(Asgard) for an aggregate amount of $170,138. The promissory notes bear interest
at 4% and mature in February 2007. The Company makes monthly aggregate payments
of $4,726 plus accrued interest. The outstanding balance on the two notes at
October 31, 2004 was $132,330.
Notes payable consisted of the following:
OCTOBER 31,
--------------------
2003 2004
-------- ---------
Bank term notes, bearing interest at the prime rate;
payable in monthly installments of $10,000 and $5,389
plus accrued interest, maturing in May
2004, and February 2004, respectively............................... $ 81,555 $ --
Asset loans, bearing interest at annual interest rates
from 0.0% 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 $ 59,506
Promissory notes issued in conjunction with the purchase
of the assets of Asgard Holding, LLC (Asgard), bearing
an annual interest rate of 4%; payable in monthly
installments of $4,726 plus accrued interest,
maturing in February 2007........................................... $ -- $132,330
-------- --------
156,085 191,836
Less current portion.................................................. 96,133 71,176
-------- --------
Notes payable, long-term.............................................. $ 59,952 $120,660
======== ========
F-17
7. COMMITMENTS
OPERATING LEASES
The Company leases office space for its corporate headquarters under a
non-cancelable operating lease agreement. The lease agreement expires in April
2005. The Company has executed non-cancelable leases for its headquarters and
operations which commence occupancy in April 2005. The operation expenses
associated with these facilities are included in the monthly rent expense. Both
leases expire in August 2009. The Company also has entered into a non-cancelable
lease agreement for its Florida satellite office associated with the Asgard
acquisition that expires in July 2009. Additionally, the Company leases office
equipment and other office space under non-cancelable operating leases which
expire through December of 2009. Rent expense under all leases, which is
recorded on a straight-line basis over the life of each lease, was approximately
$411,000, $352,000 and $411,000 for the years ended October 31, 2002, 2003, and
2004, respectively.
Future minimum lease expenditures under noncancelable operating leases
including the lease assumed in the Asgard acquisition and the new headquarters
and operations leases, at October 31, 2004 are as follows:
2005.................................................... 628,099
2006.................................................... 578,929
2007.................................................... 578,929
2008.................................................... 578,929
2009.................................................... 465,563
-----------
Total................................................... $2,830,449
===========
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.
The Company also has employment contracts for certain key executives.
The agreements have terms of 2 to 3 years, expire in June of 2007 and February
2006, and automatically renew for additional one-year terms unless terminated by
either the Company or the employee.
9. STOCKHOLDERS' EQUITY
EQUITY TRANSACTIONS
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(d) of the Securities Act.
F-18
9. STOCKHOLDERS' EQUITY (CONTINUED)
EQUITY TRANSACTIONS (CONTINUED)
On February 17, 2004, the Company completed its acquisition of the
assets of Asgard Holding, LLC (Asgard), an internet security product and service
company. In exchange for the assets of Asgard, which included intellectual
property and patent-pending technology, the Company paid cash of $630,015,
issued 575,000 shares of SteelCloud common stock valued at $2,283,900 and
incurred approximately $50,000 of direct costs associated with the transaction.
The value of SteelCloud common stock issued was determined in accordance with
SFAS No. 141 by taking the average market price over the 2-day period before and
after the terms of the acquisition were agreed to and announced.
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. In May 2004, the Company's shareholders approved an amendment
to the Company's 2002 Stock option Plan to increase the number of options
available under the plan from 750,000 to 1,500,000. 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 terms of the options are five or ten
years.
F-19
9. Stockholders' Equity (continued)
Stock Options (continued)
Common stock option activity was as follows:
Weighted-Average
Shares Exercise Price
--------------------------------
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
Options granted ............................. 930,000 2.34
Options exercised ........................... (326,725) 1.51
Options canceled or expired ................. (84,750) 2.76
---------- --------
Outstanding at October 31, 2004 ................ 3,005,360 $ 3.25
---------- --------
Exercisable at October 31, 2004 ............... 1,265,610 $ 1.73
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, 2003 and 2004, there were 193,578 and 344,640 options
available for future grants under the 1998 Option Plan, respectively and 750,000
and 1,500,000 options available for future grants under the 2002 Option Plan,
respectively.
The following table summarizes information about fixed-price stock
options outstanding at October 31, 2004:
AVERAGE WEIGHTED-
REMAINING AVERAGE
RANGE OF EXERCISE PRICES NUMBER CONTRACTUAL EXERCISE
OUTSTANDING LIFE PRICE
--------- --------- -----------
$0.55-$1.75 .................... 1,059,301 1.74 $ 0.97
$1.76-$4.50 .................... 1,346,059 4.10 2.60
$4.51-$8.75 .................... 600,000 3.50 8.75
--------- ------- --------
$0.55-$8.75 .................... 3,005,360 3.15 $ 3.25
========= ======= ========
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, 2002, 2003, and 2004 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,
----------------------------------------
2002 2003 2004
----------------------------------------
Net (loss) - pro forma ..................... $(1,568,779) $(410,944) $(3,048,113)
Net (loss) per share - pro forma ........... $ (0.16) $ (0.04) $ (0.23)
Net (loss) per share - assuming dilution pro
forma .................................... $ (0.16) $ (0.04) $ (0.23)
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 2002, 2003 and 2004: dividend
yield of 0%, expected volatility of 87%, 114% and 108%, respectively; risk-free
interest rates of 4.27%, 4.73% and 3.75% respectively; and expected life of the
option term of five years. The weighted average fair values of the options
granted in 2002, 2003 and 2004 with a stock price equal to the exercise price is
$0.98, $1.31 and $1.86 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,
-----------------------------
2003 2004
------------ ------------
Deferred tax asset:
Current portion:
Accrued expenses ..................... $ 167,138 $ 129,970
Asset reserves ....................... 252,358 131,725
Other ................................ 57,930 58,149
------------ ------------
Total current portion ..................... 477,426 319,844
------------ ------------
Long term portion:
Net operating loss carryforwards ..... 12,585,543 13,911,730
Depreciation ......................... 323,461 265,415
------------ ------------
Total long term portion ................... 12,909,004 14,177,145
------------ ------------
Total deferred tax asset ..................... 13,386,430 14,496,989
------------ ------------
Deferred tax credit:
Valuation allowance ....................... (12,986,430) (14,096,989)
------------ ------------
Net deferred tax asset ....................... $ 400,000 $ 400,000
============ ============
As of October 31, 2004, the Company had approximately $36.0 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, 2004, the Company has
recorded a valuation allowance of approximately $14.1 million against the total
deferred tax asset of $14.5 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.
F-22
10. INCOME TAXES (CONTINUED)
Components of the provision for income taxes are as follows:
YEARS ENDED OCTOBER 31,
------------------------------
2002 2003 2004
--------- ------- -------
Current tax expense (benefit):
Federal .................................... $ 1,200 $ -- $ --
--------- ------- -------
State ....................................... -- -- --
--------- ------- -------
1,200 -- --
Deferred tax expense:
Federal ..................................... $(247,000) $ -- $ --
State ....................................... (34,000) -- --
--------- ------- -------
(281,000) -- --
--------- ------- -------
Total provision for (benefit from) income taxes $(279,800) $ -- $ --
========= ======= =======
The reconciliation of income tax from the Federal statutory rate of 34%
is:
YEARS ENDED OCTOBER 31,
-----------------------------------------
2002 2003 2004
----------- ----------- -----------
Tax at statutory rates: ................ $ 98,845 $ 74,796 $ (858,108)
Non-deductible (income)expenses, net ... (4,199) (9,110,660) (128,780)
Valuation allowance and other .......... (387,877) 9,025,701 1,103,490
State income tax, net of federal benefit 13,431 10,163 (116,602)
----------- ----------- -----------
$ (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 $13,000 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. The Company match is equal to 50% of employee contributions up to
6%. Company contributions vest over 5 years. In fiscal 2002, 2003 and 2004, the
Company contributed approximately $71,000, $72,000 and $93,000 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,
------------------------------------------
2002 2003 2004
------------ ------------ ------------
Numerator:
Net income (loss) from continuing operations ...... $ 570,523 $ 363,930 $ (2,523,848)
------------ ------------ ------------
Net income from continuing operations ............. 570,523 363,930 (2,523,848)
============ ============ ============
Denominator:
Denominator for basic earnings per share-
weighted-average shares ............................ 9,947,675 10,240,630 13,450,140
Effect of dilutive securities:
Employee stock options ............................ 863,835 721,420 --
------------ ------------ ------------
Dilutive potential common shares .................. 863,853 721,420 --
------------
Denominator for diluted earnings per share - adjusted
weighted-average shares and assumed conversions ... 10,811,510 10,962,050 13,450,140
------------ ------------ ------------
Earnings (loss) per share from continuing operations,
basic ................................................ $ 0.06 $ 0.04 $ (0.19)
============ ============ ============
Earnings (loss) per share from continuing operations,
diluted .............................................. $ 0.05 $ 0.03 $ (0.19)
============ ============ ============
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. Segment Reporting
FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related
Information, establishes standards for reporting information about operating
segments. Operating segments are defined as components of an enterprise about
which separate financial information is available that is evaluated regularly by
the chief operating decision maker, or decision making group, in deciding how to
allocate resources and in assessing performance. FASB Statement No. 131,
Disclosures about Segments of an Enterprise and Related Information, also
establishes a quantitative threshold, whereby an enterprise should report
separately information about operating segments if its reported revenue is 10%
or more of the combined revenue of all reported operating segments. The Company
is organized on the basis of products and services. However, the Company does
not evaluate the performance of its segments based on earnings. The Company's
chief operating decision maker is the Company's Chief Operating Officer. While
the Chief Operating Officer is apprised of a variety of financial metrics and
information, the Chief Operating Officer makes decisions regarding how to
allocate resources and assess performance based on a single operating unit.
F-25
15. Quarterly Financial Information (unaudited)
Quarterly financial information for fiscal 2004 and 2003 is presented
in the following tables:
1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter (1)
------------ ------------ ------------ ------------
2004
Revenue ............................. $ 4,163,697 $ 5,791,764 $ 6,600,296 $ 11,613,448
Gross Profit ........................ 792,494 1,736,832 1,139,745 2,503,653
Net income (loss) available to
common shareholders ............ (1,606,099) (315,929) (1,076,927) 475,107
Per Share Data
Net (loss) income share
Basic ............................... (0.13) (0.02) (0.08) 0.03
Diluted ............................. (0.13) (0.02) (0.08) 0.03
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
(Loss) from discontinued operations . (29,501) (26,954) (30,071) (57,418)
------------ ------------ ------------ ------------
Net income available to
Common shareholders ............ 79,544 109,243 10,308 20,893
Per Share Data
Net income
Basic ............................... 0.01 0.01 0.01 0.01
Diluted ............................. 0.01 0.01 0.01 0.01
In the fourth quarter of fiscal year 2004, the Company recorded certain
adjustments of approximately $275,000 to adjust accruals related to accounting
and legal expenses for less than initial estimates. Additionally, the company
incurred costs associated with the terminated V-One merger of approximately
$169,000. The aggregate effect of such adjustments was to increase net income by
approximately $106,000.
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 settlement of a
previously accrued contingency for less than was originally expected. 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-26
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
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 17, 2004, which is
included in the Annual Report on Form 10-K, we have also audited Schedule II for
the each of the three years in the period ended October 31, 2004. 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 17, 2004
F-27
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, 2002 ..... $ 100,000 $ 203,000 $ 10,000(1) $ 293,000
Year ended October 31, 2003 ..... $ 293,000 $ -- $ -- $ 293,000
Year ended October 31, 2004 ..... $ 293,000 $ 83,000(2) $ 290,000(2) $ 86,000
Inventory reserve:
Year ended October 31, 2002 ..... $ 1,207,562 $ 864,435(4) $ 1,486,360(3) $ 585,637
$ 99,222(4)
Year ended October 31, 2003 ..... $ 585,637 $ 360,007(5) $ 684,859(3) $ 360,007
Year ended October 31, 2004 ..... $ 360,007 $ -- $ 105,007(5) $ 255,000
Deferred tax valuation allowance:
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
Year ended October 31, 2004 ..... $12,986,430 $ 1,110,559 $ -- $14,096,989
- ----------
(1) Write-offs of accounts receivable
(2) Adjust reserve for specific receivables
(3) Write-offs of inventory
(4) Provision for inventory obsolescence
(5) Reclassification of reserve for defective and/or returned inventory
F-28