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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
COMMISSION FILE NUMBER 29947
INTEGRATED INFORMATION SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 86-0624332
(State of Incorporation) (IRS Employer I.D. No.)
1480 SOUTH HOHOKAM DRIVE
TEMPE, ARIZONA 85281
(Address of principal executive offices)
(480) 317-8000
(Registrant's telephone number)
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 [ ]
The registrant has not been subject to the filing requirements of Sections 13 or
15(d) of the Securities Exchange Act of 1934 for the past 90 days.
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, not including shares held in treasury:
AS OF OCTOBER 30, 2002, THERE WERE 16,550,688 SHARES OF COMMON STOCK,
$0.001 PAR VALUE, OUTSTANDING.
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
TABLE OF CONTENTS
PAGE
----
PART I FINANCIAL INFORMATION........................................................................ 3
ITEM 1 UNAUDITED FINANCIAL STATEMENTS........................................................... 3
Condensed Consolidated Balance Sheets as of September 30, 2002
and December 31, 2001.................................................................... 3
`
Condensed Consolidated Statements of Operations for the Three and Nine
Months Ended September 30, 2002 and 2001................................................. 4
Condensed Consolidated Statements of Cash Flows for the Nine
Months Ended September 30, 2002 and 2001................................................. 5
Notes to Condensed Consolidated Financial Statements..................................... 6
ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS...................................................... 15
ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK.............................................................................. 22
ITEM 4 CONTROLS AND PROCEDURES ................................................................. 28
PART II OTHER INFORMATION............................................................................ 28
ITEM 1 LEGAL PROCEEDINGS........................................................................ 28
ITEM 6 EXHIBITS AND REPORTS ON FORM 8-K......................................................... 29
SIGNATURES .............................................................................................. 31
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
SEPTEMBER 30, DECEMBER 31,
2002 2001
------------- ------------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents ....................................... $ 580 $ 5,235
Restricted cash ................................................. 417 1,125
Accounts receivable, net of allowance of $957 and $6,830,
at September 30, 2002 and December 31, 2001, respectively .. 3,054 4,688
Unbilled revenues on contracts .................................. 40 174
Prepaid expenses and other current assets ....................... 295 550
-------- --------
Total current assets ................................... 4,386 11,772
Property and equipment, net ....................................... 4,018 8,018
Goodwill .......................................................... 4,745 3,187
Other assets ...................................................... 909 1,402
-------- --------
$ 14,058 $ 24,379
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable and accrued expenses ........................... $ 6,975 $ 7,476
Current installments of capital lease obligations ............... 1,700 3,253
Deferred revenues on contracts .................................. 290 750
-------- --------
Total current liabilities .............................. 8,965 11,479
Note payable to bank .............................................. 4,666 --
Other non-current liabilities ..................................... 267 --
Capital lease obligations, less current installments .............. 378 902
-------- --------
Total liabilities ...................................... 14,276 12,381
Commitments and contingencies
Stockholders' equity (deficit):
Common stock, $.001 par value, authorized 100,000,000
shares; issued and outstanding 16,550,688
shares at September 30, 2002 and December 31, 2001 ......... 16 16
Additional paid-in capital .................................... 94,154 94,154
Accumulated deficit ........................................... (89,077) (76,836)
Accumulated other comprehensive loss .......................... (29) (54)
-------- --------
5,064 17,280
Treasury stock, at cost, 4,951,800 shares at September 30, 2002
and December 31, 2001 ...................................... (5,282) (5,282)
-------- --------
Total stockholders' equity (deficit) ................... (218) 11,998
-------- --------
$ 14,058 $ 24,379
======== ========
See accompanying notes to condensed consolidated financial statements.
3
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2002 2001 2002 2001
-------- -------- --------- ---------
(Unaudited) (Unaudited)
Revenues ............................... $ 4,491 $ 6,248 $ 19,887 $ 25,454
Cost of revenues.......................... 3,208 5,890 14,849 23,964
Other charges............................. -- -- -- 2,162
-------- -------- --------- ---------
Gross profit (loss)................ 1,283 358 5,038 (672)
-------- -------- --------- ---------
Operating Expenses
Selling and marketing................ 912 1,408 2,682 4,343
General and administrative........... 2,200 7,881 11,092 23,538
Asset impairment and restructuring
charges............................ (2,773) 47 111 9,191
--------- -------- --------- ---------
Total operating expenses........... 339 9,336 13,885 37,072
-------- -------- --------- ---------
Income (Loss) from operations...... 944 (8,978) (8,847) (37,744)
Interest income (expense), net............ (31) 207 (207) 801
-------- -------- --------- ---------
Income (Loss) before income taxes
and cumulative effect of a change
in accounting principle.......... 913 (8,771) (9,054) (36,943)
Provision for income taxes................ -- -- -- --
--------- -------- --------- ---------
Income (Loss) before cumulative
effect of a change in accounting
principle........................ 913 (8,771) (9,054) (36,943)
Cumulative effect of a change in
accounting principle.................. -- -- (3,187) --
-------- -------- --------- ---------
Net Income (Loss).................. $ 913 $ (8,771) $ (12,241) $ (36,943)
======== ======== ========= =========
Income (Loss) per share:
Income (Loss) before cumulative effect of
a change in accounting principle.......... $ .06 $ (0.52) $ (0.55) $ (1.96)
Cumulative effect of a change in
accounting principle.................. -- -- $ (0.19) --
--------- -------- --------- ---------
Net Income (Loss) per share,
Basic and diluted................ $ .06 $ (0.52) $ (0.74) $ (1.96)
======== ======== ========= =========
Weighted average common shares
outstanding........................... 16,551 16,888 16,551 18,824
======== ======== ========= =========
See accompanying notes to condensed consolidated financial statements.
4
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
NINE MONTHS ENDED
SEPTEMBER 30,
2002 2001
-------- --------
(Unaudited)
Cash flows provided by (used in) operating activities:
Net loss ............................................... $(12,241) $(36,943)
Adjustments to reconcile net loss to net cash
used in operating activities:
Cumulative effect of a change in accounting principle 3,187 --
Depreciation and amortization ........................ 3,400 6,399
Other charges ........................................ -- 2,162
Asset impairment and restructuring charges ........... 111 9,191
Provisions for doubtful accounts ..................... (26) 28
Change in assets and liabilities, net of acquisitions:
Accounts receivable ................................ 2,266 2,903
Income tax receivable .............................. -- 111
Unbilled revenues on contracts ..................... 134 353
Prepaid expenses and other current assets .......... 255 197
Other assets ....................................... 513 (420)
Accounts payable and accrued expenses .............. (951) (635)
Deferred revenues on contracts ..................... (539) (247)
-------- --------
Net cash used in operating activities ........... (3,891) (16,901)
-------- --------
Cash flows provided by (used in) investing activities:
Capital expenditures ................................... (162) (2,870)
Proceeds from disposition of assets .................... 97 --
Cash paid for acquisitions ............................. (400) (2,442)
-------- --------
Net cash used in investing activities ........... (465) (5,312)
-------- --------
Cash flows provided by (used in) financing activities:
Restricted cash ........................................ 708 (2,117)
Repayments of capital lease obligations ................ (1,032) (3,290)
Issuance of common stock and exercise of stock options . -- 160
Repurchase of common stock ............................. -- (5,215)
-------- --------
Net cash used in financing activities .............. (324) (10,462)
-------- --------
Effect of exchange rate on cash ............................ 25 (15)
-------- --------
Decrease in cash and cash equivalents ...................... (4,655) (32,690)
Cash and cash equivalents, at beginning of period .......... 5,235 46,541
-------- --------
Cash and cash equivalents, at end of period ................ $ 580 $ 13,851
======== ========
See accompanying notes to condensed consolidated financial statements.
5
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION
We have prepared the accompanying unaudited condensed consolidated financial
statements pursuant to the rules and regulations of the Securities and Exchange
Commission regarding interim financial reporting. (In this report, "we" or "the
Company" means Integrated Information Systems, Inc.) Accordingly, they do not
include all of the information and notes required by accounting principles
generally accepted in the United States of America for complete financial
statements and should be read in conjunction with the consolidated financial
statements and notes thereto included in the Company's Annual Report on Form
10-K for the year ended December 31, 2001. The accompanying condensed
consolidated financial statements reflect all adjustments (consisting solely of
normal, recurring adjustments), which are, in the opinion of management,
necessary for a fair presentation of results for the interim periods presented.
The results of operations for the three and nine month periods ended September
30, 2002 are not necessarily indicative of the results to be expected for any
future period or the full fiscal year.
We operate in a highly competitive, consolidating market. The information
technology services industry has experienced rapid growth followed by rapid and
significant contraction over a relatively short economic cycle. In past periods,
our rapid growth phase had required significant investments in infrastructure,
facilities, computer and office equipment, human resources and working capital
in order to meet the perceived demand. The increased demand did not materialize,
and since the third quarter of 2000, the market for our services has changed and
declined significantly.
Our condensed consolidated financial statements are prepared using accounting
principles generally accepted in the United States of America applicable to a
going concern, which contemplate the realization of assets and satisfaction of
liabilities in the normal course of business. However, the Company's auditors
issued their independent auditors' report dated February 15, 2002 stating the
Company has suffered negative cash flows from operations and has an accumulated
deficit, that raise substantial doubt about our ability to continue as a going
concern. We incurred negative cash flows from operations for each of the three
years ended December 31, 2001 and for the nine months ended September 30, 2002.
The Company also has an accumulated deficit of $89,077,000 through September 30,
2002.
Management responded to these challenges by closing unprofitable offices and
reducing staff in remaining offices. We have recorded expenses and charges
(asset impairment and restructuring charges) associated with impairments of
assets and idle facilities and their related estimated costs of settlement. We
continue to closely monitor staff utilization and other operating expenses in
order to improve cash flow from operations. In May 2002, we implemented a
financial restructuring plan designed to settle obligations for vacated
facilities, excess equipment leases, accounts payable and accrued expenses
related to those facilities and types of services we were no longer offering to
clients in a manner which would achieve the highest possible recoveries for all
creditors and stockholders consistent with our ability to pay and to continue
our operations. This restructuring was successfully completed on October 15,
2002. See Note 5, "Asset Impairment, Restructuring and Other Charges," and Note
11, "Subsequent Events and Related Party Transactions" for information regarding
the restructuring and its impact on the Company and its financial position. As a
part of the restructuring, cash receipts have been accelerated through accounts
receivable-backed financing to pay settlements, support growth opportunities,
support working capital needs and address unanticipated contingencies. To obtain
this financing, we pledged substantially all of our assets to the bank as
collateral. Additional needed financing may not be available on terms favorable
to us, if at all. If we are unable to raise additional capital and significantly
reduce operating losses, our business activities may be significantly curtailed.
The condensed consolidated financial statements do not include any adjustments
that might result from the outcome of this uncertainty.
2. USE OF ESTIMATES
The preparation of these financial statements requires us to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues and
expenses, and related disclosure of contingent assets and liabilities. On an
on-going basis, we evaluate estimates, including those related to long-term
service contracts, intangible assets, income taxes, bad debts, restructuring,
contingencies and litigation. We base our estimates on historical experience and
on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
6
the carrying values of assets and liabilities that may not be readily apparent
from other sources. Actual results may differ from these estimates under
different assumptions or conditions.
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our condensed
consolidated financial statements. We recognize revenue and profit as work
progresses on long-term, fixed price contracts using the
percentage-of-completion method, which relies on estimates of total expected
contract revenues and costs. We follow this method because reasonably dependable
estimates of the revenues and costs applicable to various stages of a contract
can be made. Recognized revenues and profit are subject to revisions as the
contracts progress to completion.
Revisions in profit estimates are charged to income in the period in which the
facts that give rise to the revision become known. We maintain allowances for
doubtful accounts for estimated losses resulting from the inability of our
customers to make required payments. If the financial condition of our customers
were to deteriorate, resulting in an impairment of their ability to make
payments, additional allowances may be required.
We recorded goodwill and other intangible assets from acquisitions during 2001
and 2002. Future adverse changes in market conditions or poor operating results
could result in an inability to recover the carrying value of the investment,
thereby possibly requiring an impairment charge in the future as required by
recently issued financial standards.
We record a valuation allowance to reduce our deferred tax assets to the amount
that is more likely than not to be realized. In the event we were to determine
that we would be able to realize our deferred tax assets in the future in excess
of our net recorded amount, an adjustment to the deferred tax asset would
increase net income in the period such determination was made.
We recorded accruals for the estimated future cash expenditures required from
closing vacated offices and disposal of leases for unused equipment. The
accruals include estimates of future rent payments and settlements until the
obligations are canceled. When actual cash expenditures differed from our
estimates, revisions to the estimated liability for closing vacated offices and
terminating leases were recorded.
We evaluate the requirement for future cash expenditures resulting from
contingencies and litigation. We record an accrual for contingencies and
litigation when exposures can be reasonably estimated and are considered
probable. Should the actual results differ from our estimates, revisions to the
estimated liability for contingencies and litigation would be required.
3. REVENUE RECOGNITION
We recognize revenue when each of the following four criteria are met:
o Persuasive evidence of an arrangement exists;
o Delivery has occurred or services have been rendered;
o The seller's price to the buyer is fixed or determinable; and
o Collectibility is reasonably assured.
Subject to the above listed criteria, revenues for time-and-material contracts
are recognized as the services are rendered. Revenues pursuant to fixed fee
contracts are recognized as services are rendered on the
percentage-of-completion method of accounting (based on the ratio of labor hours
incurred to total estimated labor hours). Revenues from maintenance or
post-contract support agreements are recognized as earned over the terms of the
agreements. Revenues from recurring services such as application management and
hosting operations are recognized as services are provided each month. Revenues
for services rendered are not recognized until collectibility is reasonably
assured.
Provisions for estimated losses on uncompleted contracts are made on a
contract-by-contract basis and are recognized in the period in which such losses
are determined. Unbilled revenues on contracts are comprised of earnings on
certain contracts in excess of contractual billings on such contracts. Billings
in excess of earnings are classified as deferred revenues on contracts.
In 2001, the Emerging Issues Task Force of the Financial Accounting Standards
Board (FASB) concluded that reimbursements for "out of pocket" expenses should
be classified as revenue and, correspondingly, cost of services, in the income
statement. The new accounting treatment is applicable to us in 2002 and requires
that comparative financial statements for prior periods be reclassified in order
to ensure consistency for all periods presented. Accordingly, in our
7
condensed consolidated statements of operations, we included revenues and cost
of sales from the reimbursements of expenses incurred of $129,000 and $76,000
for the quarters ended September 30, 2002 and 2001, respectively and $550,000
and $190,000 for the nine month periods ended September 30, 2002 and 2001,
respectively.
4. ACQUISITIONS
In order to more effectively address the general economic business climate and
the slowdown in the IT professional services market, in 2001 we developed and
began implementing an aggressive growth strategy focused on acquiring
like-minded peer consultancies. The acquisition target companies ideally have
leading competitive positions in regional and vertical markets, a proven track
record of providing Microsoft-based solutions, a booked backlog of project work
for premier clients, managers in place who are capable of leading a regional
division for the Company, a working culture and ethic similar to ours and are
owned by consultants who remain active in the business.
On August 20, 2001, we completed a series of transactions with K2 Digital, Inc.
("K2"), a publicly held digital services firm based in New York City. In that
transaction, 24 management and consulting employees of K2 were hired, certain
related fixed assets were acquired and the lease agreement for office space of
K2 in New York City was assumed. The total purchase price consisted of cash
payments of $544,000 for certain K2 assets and the assumption of $709,000 of
liabilities. In the purchase price allocation, $927,000 was recorded as
goodwill. Due to continuing weak economic conditions subsequent to September 11,
2001, generally weak demand for IT services and other factors in the New York
market, management closed the New York K2 operations in July 2002.
On September 28, 2001, a similar series of transactions was completed with STEP
Technology, Inc. ("STEP"), a Portland, Oregon-based information technology
consulting firm. In that transaction, 54 management and consulting personnel of
STEP were hired, certain related assets were acquired and a portion of STEP's
office space in Portland was assumed. The total purchase price consisted of cash
payments of $1,140,000 for certain STEP assets and for the assumption of
$1,041,000 of liabilities. In the purchase price allocation, $1,433,000 was
recorded as goodwill. In addition to the cash consideration, under the purchase
agreement, if in 2002, 2003, and 2004 annual earnings from STEP operations are
positive, STEP is entitled to additional consideration from this transaction
based on a percentage of the revenues generated and limited to an agreed upon
percentage of earnings.
On October 31, 2001, a series of transactions was completed with INTEFLUX, Inc.
("INTEFLUX"), a privately-owned international technology consulting firm based
in Phoenix, Arizona, with operations in New York City and London, England. In
that transaction, 19 management and consulting employees of INTEFLUX were hired,
certain related assets were acquired and the lease agreements for INTEFLUX's
office space in Phoenix and London were assumed. The total purchase price
consisted of cash payments of $50,000, the issuance of common stock totaling
$187,000 for certain INTEFLUX assets and $319,000 assumed of liabilities. In the
purchase price allocation, $346,000 was recorded as goodwill. In addition to the
cash and common stock consideration, under the purchase agreement, if in 2002,
2003 and 2004 annual earnings from INTEFLUX operations are positive, INTEFLUX is
entitled additional consideration from this transaction based on a percentage of
the revenues generated and limited to an agreed upon percentage of earnings or
dollar amount.
On November 16, 2001, a series of transactions was completed with Winfield
Allen, Inc. ("Winfield Allen"), a Denver, Colorado-based information technology
consulting firm. In that transaction, 24 management and consulting personnel of
Winfield Allen were hired, certain related assets were acquired and the lease
agreement for Winfield Allen's office space in Colorado was assumed. The total
purchase price consisted of cash payments of $84,000 and the issuance of common
stock totaling $136,000 for certain Winfield Allen assets, the assumption of a
note payable for $103,000 and the assumption of $173,000 of liabilities. In the
purchase price allocation, $358,000 was recorded as goodwill. In addition to the
cash and common stock consideration, under the purchase agreement, if in 2002,
2003, and 2004 annual earnings from Winfield Allen operations are positive,
Winfield Allen is entitled to additional consideration from this transaction
based on a percentage of the revenues generated and limited to an agreed upon
percentage of earnings or dollar amount.
In connection with a recently issued accounting standard, we were required to
assess the impairment of our recorded goodwill relating to the above
acquisitions. As discussed in Note 9, all of the above goodwill totaling
$3,064,000 and related acquisition costs of $123,000 were written off as a
non-cash, cumulative effect of a change in accounting principle.
On January 25, 2002, we completed a series of transactions with Goliath
Networks, Inc. ("Goliath"), a Madison, Wisconsin-based information technology
consultancy. In that transaction, 81 management and consulting personnel of
8
Goliath were hired, certain related assets acquired and the lease agreements for
office space of Goliath in Madison and Milwaukee, Wisconsin were assumed. In the
purchase price allocation, $4,745,000 was recorded as goodwill and intangibles.
The transaction was paid for with a combination of cash payments totaling
$400,000, the issuance of a note payable for $4,750,000 to a bank and the
assumption of $567,000 of liabilities. The note payable bears interest at 7% per
year. Payments on the note are interest only for the first year. Principal and
interest payments for the second, third and fourth years will be based on a
ten-year amortization schedule. The unpaid principal will be paid in full at the
end of the fourth year. The note payable is collateralized by computer equipment
and office equipment owned by the Company.
As part of these acquisitions, intangible assets totaling $607,000 were acquired
consisting of non-compete agreements of $250,000 and employee agreements of
$357,000. The intangible assets originating from non-compete agreements are
amortized over their contractual lives, which are generally five years. The
intangible assets arising from employee agreements were amortized over their
contractual lives, which were less than one year. It is estimated that most of
the goodwill will be deductible for tax purposes, subject to the utilization of
the Company's net operating losses.
In connection with these acquisitions, we acquired accounts receivable of
$1,305,000 and fixed assets of $471,000. The Company issued 507,108 shares of
common stock valued at $365,000.
Our condensed consolidated financial statements reflect the results of
operations for each acquisition from the transaction date. The following
summary, prepared on a pro forma basis, presents the results of operations as if
the acquisitions of K2, STEP, INTEFLUX, Winfield Allen and Goliath had been
completed as of January 1, 2001 (amounts in thousands, except per share
amounts):
NINE MONTHS ENDED
SEPTEMBER 30,
2002 2001
-------- --------
(Unaudited)
Revenues .................... $ 20,653 $ 52,525
Operating loss .............. (8,784) (46,540)
Net loss .................... (12,232) (46,500)
Net loss per share .......... (0.74) (2.41)
The pro forma results are not indicative of what actually would have occurred if
the transactions had been completed as of January 1, 2001. In addition, they are
not intended to be a projection of future results and do not reflect any
synergies that might be achieved from combined operations.
5. ASSET IMPAIRMENT, RESTRUCTURING AND OTHER CHARGES
During 2001, we recorded asset impairments and restructuring charges totaling
$14,882,000. These charges included a $9,191,000 charge in the second quarter of
2001, related to underutilized computer equipment and leasehold improvements at
our data center used for application outsourcing services and a $5,691,000
charge in the fourth quarter of 2001 for expenses incurred in connection with
the closing and consolidating of six office locations and abandoned leasehold
improvements in an unoccupied seventh location. The charge for closing and
consolidating offices consisted of an impairment charge totaling $3,556,000 and
an accrual for future cash expenditures, primarily rent-related obligations net
of estimated future sublease income, totaling $2,135,000. Additionally, we
recorded other charges related to the impairment of inventoried software
licenses of $2,162,000 in the second quarter of 2001.
During the first quarter of 2002, commercial real estate markets in some areas
continued to be weaker than anticipated, and, accordingly, we re-evaluated our
accrual for future cash expenditures for closed office locations. In addition,
we executed a series of cost control initiatives to close and consolidate three
additional office locations. These activities resulted in asset impairment and
restructuring charges totaling $2,751,000 for the first quarter of 2002. The
charges consisted of an increase in the accrual to terminate and exit closed
facilities totaling $1,108,000, an accrual totaling $1,039,000 for future cash
expenditures attributable to closing and consolidating three office locations,
impairment charges to fixed assets totaling $482,000 and impairment charges to
rent deposits totaling $122,000. In the second quarter of 2002, the Company
recorded additional asset impairment charges totaling $133,000 relating to the
closure of an office.
9
During the third quarter of 2002, negotiations with the landlords of each of the
closed facilities and the remaining facilities resulted in certain favorable
settlements ultimately consummated in October 2002. Accordingly, we again
re-evaluated our accrual for closed office locations resulting in a reduction of
asset impairment and restructuring charges of $2,773,000.
As of September 30, 2002, we had accrued liabilities for the future cash
expenditures attributable to these restructuring charges totaling $1,636,000. Of
this obligation, $1,407,000 is classified as current accounts payable and
accrued liabilities and $229,000 is classified as other non-current liabilities.
The activity for the nine months ended September 30, 2002 is summarized as
follows:
Closed Asset Total
Facilities Impairment Restructuring
Reserves Charges Charges
-------- ---------- -------
Balance, December 31, 2001 $ 2,583,000
Accrual for new activities 2,147,000 $ 737,000 $ 2,884,000
Changes in previous estimates (2,773,000) (2,773,000)
Cash payments (321,000)
----------- ------------ -------------
Balance September 30, 2002 1,636,000 $ 737,000 $ 111,000
============ =============
Less current portion 1,407,000
-----------
Long-term portion $ 229,000
===========
6. RECLASSIFICATIONS
Certain reclassifications have been made to the prior periods' condensed
consolidated financial statement amounts to conform to the current period
presentations. See Note 3, "Revenue Recognition," regarding reclassification of
out-of-pocket expenses reimbursed by client.
7. RESTRICTED CASH
In October 1999, we signed a lease for a new 71,000 square foot headquarters
facility to be constructed as part of a multi-tenant, mixed-use property in
Tempe, Arizona. In March and May 2001, we deposited a total of $2,500,000 into a
construction escrow account. Through December 31, 2001 and September 30, 2002,
$2,091,000 of the restricted cash had been used to fund the build-out of tenant
improvements at the new facility. In December 2001, in accordance with
provisions of the lease, we terminated our lease for this facility based on
construction delays. See additional information under the caption "Legal
Proceedings" in Part II, Item 1. No additional amounts are expected to be
authorized to be spent from the interest bearing escrow account, and we are
currently attempting to recover costs invested in this facility and the
construction escrow account balance of approximately $417,000. A liability was
recorded in the fourth quarter of 2001 for the escrow account balance, and the
leasehold expenditures were written off in December 2001 as part of the asset
impairment charges.
In June 2001, we deposited approximately $1,000,000 into a restricted
certificate of deposit account. The funds in this account served as collateral
against various letters of credit totaling $1,000,000. During the fourth quarter
of 2001 and the first, second and third quarters of 2002, $300,000, $227,000,
$465,000 and $19,000, respectively, was used in connection with our closures of
excess office space and other obligations.
At September 30, 2002, the restricted cash of $417,000 was on deposit in the
construction escrow account, for which an offsetting reserve for loss is
recorded in accounts payable and accrued expenses.
8. NET LOSS PER SHARE
The following table sets forth the computation of shares used in computing basic
and diluted net gain (loss) per share (in thousands, except per share amounts):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2002 2001 2002 2001
-------- -------- -------- --------
Net income (loss) ............... $ 913 $ (8,771) $(12,241) $(36,943)
======== ======== ======== ========
Weighted average outstanding
common shares ................... 16,551 16,888 16,551 18,824
Effect of dilutive securities:
Stock options and warrants .. - 132 64 162
Antidilutive effect of
securities .................. - (132) (64) (162)
-------- -------- -------- --------
Weighted average and common
equivalent shares outstanding ... 16,551 16,888 16,551 18,824
======== ======== ======== ========
Net income (loss): .............. $ .06 $ (0.52) $ (0.74) $ (1.96)
======== ======== ======== ========
10
9. GOODWILL
In September 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standard No. 142, Goodwill and Other
Intangible Assets (SFAS 142). SFAS 142 became effective for us on January 1,
2002 and requires, among other things, the cessation of the amortization of
goodwill. In addition, the standard includes provisions for the reassessment of
the useful lives of existing recognized intangibles, a new method of measuring
reported goodwill for impairment and the identification of reporting units for
purposes of assessing potential future impairments of goodwill. We had recorded
$7,932,000 of goodwill relating to the five acquisitions completed after the
effective date of SFAS 141, and there has been no amortization expense recorded
in the accompanying financial statements. Among other requirements, SFAS 142
required us to complete a transitional goodwill impairment test on or before
June 30, 2002.
In connection with SFAS 142's transitional goodwill impairment evaluation, the
Statement required us to perform an assessment of whether there was an
indication that goodwill is impaired as of the date of the Company's adoption.
To accomplish this, we were required to identify the Company's reporting units
and determine the carrying value of each reporting unit by assigning the assets
and liabilities, including the existing goodwill and intangible assets, to those
reporting units as of January 1, 2002. Using the guidance provided in SFAS 142,
management determined that it has only one reporting unit. We were required to
determine the fair value of our reporting unit and compare it to the carrying
amount of the reporting unit within six months of January 1, 2002. To the extent
the carrying amount of a reporting unit exceeded the fair value of the reporting
unit, an indication existed that the reporting unit's goodwill may be impaired
and we would be required to perform the second step of the transitional
impairment test. In this step, we are required to compare the implied fair value
of the reporting unit goodwill with the carrying amount of the reporting unit
goodwill, both of which must be measured as of the date of adoption. The implied
fair value of goodwill is determined by allocating the fair value of the
reporting unit to all of the assets (recognized and unrecognized) and
liabilities of the reporting unit in a manner similar to a purchase price
allocation, in accordance with SFAS 141. The residual fair value after this
allocation will be the implied fair value of the reporting unit goodwill. If the
implied fair value of this reporting unit exceeds the carrying amount, we are
required to recognize an impairment loss.
The fair value of our reporting unit and the related implied fair value of its
respective goodwill was established using a market capitalization approach
supported by a discounted cash flow approach.
In June 2002, we completed the transitional goodwill impairment test in
accordance with SFAS 142, which resulted in a non-cash charge of $3,187,000 and
is reported in the caption "Cumulative effect of a change in accounting
principle" in the Company's condensed consolidated statements of operations. All
of the charge was related to the Company's acquisitions completed in 2001. The
primary factors that resulted in the impairment charge were the difficult
economic environment in the IT professional services sector and the doubt about
the Company's ability to continue as a going concern.
In accordance with SFAS 142, the fair value and carrying value of the remaining
goodwill of $4,745,000, relating to the acquisition we completed in the first
quarter of 2002, will be tested on the Company's annual measurement date in the
fourth quarter of 2002.
10. RECENTLY ISSUED FINANCIAL STANDARDS
In September 2001, the FASB issued Statement of Financial Accounting Standard
No. 141, Business Combinations (SFAS 141). SFAS 141 became effective for us as
of July 1, 2001. It establishes new standards for accounting and reporting
requirements for business combinations and requires the purchase method of
accounting be used for all business combinations initiated after June 30, 2001.
The adoption of SFAS 141 did not have a material impact on our condensed
consolidated financial statements.
In August 2001, the FASB issued Statement of Financial Accounting Standard No.
143, Accounting for Asset Retirement Obligations (SFAS 143), which addresses
financial accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and for the associated asset retirement
costs. SFAS 143 requires an enterprise to record the fair value of an asset
retirement obligation as a liability in the period in which it incurs a legal
obligation associated with the retirement of tangible long-lived assets that
result from the acquisition, construction, development and/or normal use of the
assets. The enterprise also is to record a corresponding increase to the
carrying amount of the related long-lived assets and to depreciate that cost
over the life of the asset. The liability is changed at the end of each period
to reflect the passage of time (i.e., accretion expense) and changes in the
estimated future cash flows underlying the initial fair value measurement.
11
The provisions of SFAS 143 are effective for us on January 1, 2003 and are to be
applied prospectively. The adoption of SFAS 143 is not expected to have a
material impact on our condensed consolidated financial statements.
In August 2001, the FASB issued Statement of Financial Accounting Standard No.
144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144)
that addresses financial accounting and reporting for the impairment or disposal
of long-lived assets, including discontinued operations. While SFAS 144
supercedes Statement of Financial Accounting Standard No. 121, Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,
it retains many of the fundamental provisions of that Statement. SFAS 144 also
supercedes certain provisions of ABP Opinion No. 30, Reporting the Results of
Operations-Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for
the disposal of a segment of a business. The provisions of SFAS 144 were
effective for us on January 1, 2002 and are to be applied prospectively. The
adoption of SFAS 144 did not have a material impact on our condensed
consolidated financial statements.
In November 2001, the Emerging Issues Task Force of the FASB concluded that
reimbursements for "out of pocket" expenses should be classified as revenue and,
correspondingly, cost of services, in the income statement. The new accounting
treatment is applicable to IIS in the first quarter 2002 and requires that
comparative financial statements for prior periods be reclassified in order to
ensure consistency for all periods presented. Accordingly, in the attached
statements of operations, we included revenues from the reimbursements of
expenses incurred of $129,000 and $76,000 for the quarters ended September 30,
2002 and 2001, respectively, and $550,000 and $190,000 for the nine month
periods ended September 30, 2002 and 2001, respectively.
In April 2002, the FASB issued Statement of Financial Accounting Standard No.
145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections (SFAS 145), which addresses
financial accounting and reporting for reporting gains and losses from
extinguishment of debt, accounting for intangible assets of motor carriers and
accounting for leases. SFAS 145 requires that gains and losses from the early
extinguishment of debt should not be classified as extraordinary, as previously
required. SFAS 145 also rescinds Statement 44, which was issued to establish
accounting requirements for the effects of transition to the provisions of the
Motor Carrier Act of 1980 (Public Law 96-296, 96th Congress, July 1, 1980).
Those transitions are completed; therefore, Statement 44 is no longer necessary.
Statement 145 also amends Statement 13 to require sale-leaseback accounting for
certain lease modifications that have economic effects that are similar to
sale-leaseback transactions. Statement 145 also makes various technical
corrections to existing pronouncements. Those corrections are not substantive in
nature. The provisions of this statement relating to Statement 4 are applicable
in fiscal years beginning after May 15, 2002. The provisions of this Statement
related to Statement 13 are effective for transactions occurring after May 15,
2002. All other provisions of this Statement are effective for financial
statements issued on or after May 15, 2002. The adoption of the provisions of
SFAS 145 relating to Statement 4 are not expected to have a material impact on
our condensed consolidated financial statements. The adoption of the provisions
of SFAS 145 relating to Statement 13 do not have a material impact on our
condensed consolidated financial statements.
In June 2002, the FASB issued Statement of Financial Accounting Standards SFAS
No. 146, Accounting for Exit or Disposal Activities (SFAS 146). SFAS 146
addresses the recognition, measurement and reporting of costs associated with
exit and disposal activities, including restructuring activities. SFAS 146 also
addresses recognition of certain costs related to terminating a contract that is
not a capital lease, costs to consolidate facilities or relocate employees and
termination of benefits provided to employees that are involuntarily terminated
under the terms of a one-time benefit arrangement that is not an ongoing benefit
arrangement or an individual deferred compensation contract. SFAS 146 is
effective for exit or disposal activities that are initiated after December 31,
2002. The Company is in the process of evaluating the adoption of SFAS 146 and
its impact on the financial position or results of operations of the Company.
In November 2002, the Emerging Issues Task Force of the FASB outlined the
criteria that would require a revenue arrangement with multiple deliverables to
be divided into separate units of accounting and, if separation is appropriate,
how the arrangement consideration should be allocated to the identified
accounting units. The new accounting treatment is applicable to IIS in the first
quarter 2003. We have not yet determined the impact, if any, of adoption on our
condensed consolidated financial statements.
11. SUBSEQUENT EVENTS AND RELATED PARTY
On October 15, 2002, we completed a restructuring which satisfied the
obligations for certain real estate and equipment leases, certain trade payables
and accrued expenses for less than their recorded value. The Company agreed to
immediately
12
pay $1,995,000 in cash and $1,221,000 in periodic payments over the next five
years satisfying $2,896,000 of recorded accounts payable and accrued expenses,
$3,074,000 of capital lease obligations and $229,000 of other non-current
liabilities. As a result of the comprehensive settlement, a total of
approximately $23.0 million of contractual obligations were satisfied. The
effect of the settlement to stockholders' equity was an increase of $5.3
million, of which $2.8 million was recorded as of September 30, 2002 due to the
change in estimation of restructuring charges. The completion of the
comprehensive settlement with creditors was funded by a revolving bank credit
facility of $4,200,000 funded through the sale of accounts receivable at a
discount of 1.95%, of which $2,481,000 was used to fund the settlement,
including a $422,000 cash reserve account related to the receivables financing.
To obtain the financing, we pledged substantially all of our assets to the bank
as collateral. Additionally, the Company's key-man life insurance policy of
$5,000,000 was assigned to the bank, and the bank was given a warrant to
purchase 300,000 shares our common stock at $1.00 per share. Our Chief Executive
Officer gave a $1.0 million personal guaranty to the bank as credit support,
and, in consideration of his guaranty, we have agreed to make quarterly payments
to him at an annual rate of 3% of the average outstanding balance under the
facility and to issue him, quarterly, warrants to acquire 20,000 shares of our
common stock for each $1.0 million in average outstanding balance under the
facility during the quarter. The warrants will have an exercise price of $1.00
per share and will remain exercisable as long as any amount is guaranteed and
for a period of one year thereafter, but for not less than five years from
issuance. See Note 5, "Asset Impairment, Restructuring and Other Charges."
On November 13, 2002, we executed a definitive agreement with Cunningham
Technology Group, Inc. ("CTG"), a Phoenix, Arizona-based information technology
consulting firm. The agreement required the hiring of approximately 25
management and consulting employees of CTG, the purchase of certain related
fixed assets and the assumption of certain liabilities, including the lease
agreement for office space of CTG in Phoenix in exchange for the issuance of
750,000 shares of our common stock.
13
The following pro forma balance sheet gives effect to the set of transactions
consummated on October 15, 2002 as of September 30, 2002 and the acquisition of
a peer consultancy:
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED PRO FORMA BALANCE SHEET
(In thousands)
SEPTEMBER 30, PRO FORMA SEPTEMBER 30,
2002 ADJUSTMENTS 2002
--------------- -------------- --------------
ASSETS Unaudited Pro Forma
Current assets........................................
Cash and cash equivalents........................ $ 580 (1,994) (a) $ 645
2,059 (b)
Restricted cash.................................. 417 422 (b) 839
Accounts receivable, net of allowance $1,664..... 3,054 (2,481) (b) 573
Unbilled revenues on contracts................... 40 40
Prepaid expenses and other current assets........ 295 31 (a) 326
------------- ------------
Total current assets.......................... 4,386 2,423
Property and equipment, net........................... 4,018 215 (c) 4,233
Goodwill.............................................. 4,745 205 (c) 4,950
Other assets.......................................... 909 909
------------- ------------
$ 14,058 $ 12,515
============= ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses............ $ 6,975 (3,436) (a) $ 3,599
60 (c)
Current installments of capital lease and 1,700 (1,642) (a) 58
other obligations.............................
Deferred revenues on contracts................... 290 290
------------- ------------
Total current liabilities................... 8,965 3,947
Note payable to bank.................................. 4,666 4,666
Other non-current liabilities......................... 267 963 (a) 1,230
Capital lease obligations, less current installments.. 378 (358) (a) 20
------------- ------------
Total liabilities........................... 14,276 9,863
Stockholders' equity (deficit):....................... (218) 2,510 (a) 2,652
360 (c)
------------- ------------
$ 14,058 $ 12,515
============= ============
- -------------------------------------------------------------------------------
(a) Reflects the comprehensive settlement resulting in the elimination of or
reduction of real estate and equipment lease obligations and certain
accounts payable for cash and periodic payments over five years.
(b) Reflects the sale of $2,481,000 of accounts receivable in accordance with
the terms of the credit facility.
(c) Reflects the acquisition of the assets and certain liabilities and the
issuance of 750,000 shares of company stock, for pro forma purposes, valued
at $.0.48 per share.
14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD-LOOKING STATEMENTS
The following discussion contains forward-looking statements based on current
expectations, and we assume no obligation to update these statements. Because
actual results may differ materially from expectations, we caution readers not
to place undue reliance on these statements. These statements are based on our
estimates, projections, beliefs, and assumptions, and are not guarantees of
future performance. A number of factors could cause future results to differ
materially from historical results, or from results or outcomes currently
expected or sought by us. These factors include: a reduced demand for
Information Technology (IT) services; an inability to raise capital or further
reduce operating losses; an inability to increase our market share; difficulties
in maintaining our technology alliances; and a continued downturn in economic
conditions.
These factors and the other matters discussed below under the heading "Factors
That May Affect Future Results and Our Stock Price" may cause future results to
differ materially from historical results, or from results or outcomes we
currently expect or seek.
OVERVIEW
Since the third quarter of 2000, the market for IT services has changed
dramatically and the demand has declined significantly. As part of our effort to
adjust our structure to better address the general economic business climate and
the slowdown in the IT professional services market, we have closed
underperforming or vacant regional offices, reduced staff in remaining offices,
recorded material charges related to underutilized data center facility computer
equipment and leasehold improvements and developed and began implementing an
aggressive growth strategy through acquiring like-minded peer consultancies. We
completed four such acquisitions in 2001, a fifth such transaction during
January 2002 and will close a sixth transaction in November 2002 and anticipate
additional, similar transactions, in future periods.
We have operated at a loss for each of the last four years with the exception of
the third quarter of the current year. The losses, combined with the current
market for IT services, have raised substantial doubt about our ability to
continue as a going concern. We continue to reduce our operating expenses in
order to improve cash flow from operations. During 2002, we were in default of
certain operating and capital lease provisions for failure to make timely
payment, had received several default notices during 2002 and had been named in
a number of related lawsuits. In May 2002, we implemented a financial
restructuring plan designed to settle obligations for vacated facilities, excess
equipment leases and accounts payable related to those facilities and types of
services we were no longer offering to clients in a manner which would achieve
the highest possible recoveries for all creditors and stockholders consistent
with our ability to pay and to continue our operations. In October 2002, we
completed a restructuring which satisfied the obligations for the related real
estate and equipment leases and for certain trade payables for less than their
recorded value. We agreed to pay $2.0 million in cash at the close of the
restructuring and $1.2 million in periodic payments over the next five years
satisfying $2.9 million of recorded accounts payable and accrued expenses, $3.1
million of capital lease obligations and $229,000 of other non-current
liabilities. As a result of the restructuring, a total of approximately $23.0
million of future contractual obligations were satisfied. We funded the
restructuring by selling all of our current accounts receivable, totaling $2.5
million, through a new bank credit facility at a discount of 1.95% and can sell
up to $1.7 million more in current accounts receivable under the same
arrangement. To obtain the financing, we pledged substantially all of our assets
to the bank and we gave the bank a warrant to purchase 300,000 shares of our
common stock at $1.00 per share. Additionally, the Company's key-man life
insurance policy of $5,000,000 was assigned to the bank. Our Chief Executive
Officer gave a $1.0 million personal guaranty to the bank as credit support,
and, in consideration of his guaranty, we have agreed to make quarterly payments
to him at an annual rate of 3% of the average outstanding balance under the
facility and to issue him, quarterly, warrants to acquire 20,000 shares of our
common stock for each $1.0 million in average outstanding balance under the
facility during the quarter. The warrants will have an exercise price of $1.00
per share and will remain exercisable as long as any amount is guaranteed and
for a period of one year thereafter, but for not less than five years from
issuance.
We believe that closing the restructuring reduced the risk that we might not be
able to continue as a going concern. The remaining unused balance on the credit
facility of $1.7 million is available to fund future acquisitions and to support
working capital needs; however, availability is dependent upon our ability to
generate additional revenues and increase our accounts receivable base.
Accordingly, notwithstanding the restructuring, if we are unable to raise
additional capital, increase revenues and significantly further reduce operating
losses, our business activities may be significantly curtailed.
15
We derive our revenues primarily from the delivery of professional services. We
offer our services to clients under time and materials contracts or under fixed
fee contracts. For time and material projects, we recognize revenues based on
the number of hours worked by consultants at a rate per hour agreed upon with
our clients. We recognize revenues from fixed-price contracts on a
percentage-of-completion method based on project hours worked. The percentage of
our revenues from fixed-price contracts was approximately 25.5% and 28.1% in the
three and nine months ended September 30, 2002 and 11.0% and 8.3% in the
corresponding periods of 2001. We provide our application outsourcing services
for a minimum monthly fee and charge extra fees for services that exceed
agreed-upon parameters. Revenues from these services are recognized as services
are provided. Revenues for services rendered are not recognized until
collectibility is reasonably assured.
Our cost of revenues consists primarily of employee compensation, outside
consulting services and benefits. Selling and marketing expenses consist
primarily of compensation and benefits. General and administrative expenses
consist primarily of compensation and benefits for our executive management and
our finance, administration, legal, information technology, and human resources
personnel. General and administrative expenses also include research and
development expense, depreciation, bad debt expense and operating expenses such
as rent, insurance, telephones, office supplies, travel, outside professional
services, training, and facilities costs.
We have historically derived and believe that we may continue to derive a
significant portion of our revenues from a limited number of clients who may
change from period to period (see related discussion below in "Results of
Operations"). Any cancellation, deferral, or significant reduction in work
performed for our principal clients could harm our business and cause our
operating results to fluctuate significantly from period to period. While the
Company's overall reliance on a small number of clients has decreased, during
the nine months ended September 30, 2002, revenues from two separate clients
represented, when added together, approximately 13.4% of our revenues. The
revenues from each of these clients declined significantly, starting in the
third quarter of 2002, due to the completion of current engagements.
As a result of our investments in infrastructure, recent decreases in revenues
and increases in operating expenses, we incurred a net loss in each of the last
four years. Our quarterly revenue, cost of revenues, and operating results have
varied in the past due to fluctuations in the utilization of project personnel
and are likely to vary significantly in the future. Therefore, we believe that
period-to-period comparisons of our operating results may not be indicative of
future performance and should not necessarily be relied upon.
RECENT ACQUISITIONS
As part of our effort to adjust our structure to better address a rapidly
changing and declining IT services market, we developed and began implementing
an aggressive growth strategy through acquiring like-minded peer consultancies.
The acquisition target companies ideally have leading competitive positions in
regional and vertical markets, a proven track record of providing
Microsoft-based solutions, a booked backlog of project work for premier clients,
managers in place who are capable of leading a regional division for the
Company, a working culture and ethic similar to our own and are owned by
consultants who remain active in the business. We completed the acquisition of
four such consultancies in 2001, a fifth consultancy during January 2002 and
will close a sixth transaction in November 2002 and anticipate additional,
similar transactions in 2003.
On August 20, 2001, we completed a series of transactions with K2 Digital, Inc.
("K2"), a publicly held digital services firm based in New York City. In that
transaction, we hired 24 management and consulting employees of K2, acquired
certain related fixed assets and assumed the lease for office space of K2 in New
York City. The transactions were paid for with cash and the assumption of
certain operating expenses of K2. Due to continuing weak economic conditions
subsequent to September 11, 2001, generally weak demand for IT services and
other factors in the New York market, management closed the New York K2
operations in July 2002.
On September 28, 2001, we completed a similar series of transactions with STEP
Technology, Inc. ("STEP"), a Portland, Oregon-based information technology
consulting firm. In that transaction, we hired 54 management and consulting
personnel of STEP, acquired certain related assets and assumed the lease for a
portion of STEP's office space in Portland. The transaction was paid for with
cash and the assumption of certain liabilities of STEP.
On October 31, 2001, we completed a similar series of transactions with
INTEFLUX, Inc. ("INTEFLUX"), a Phoenix, Arizona-based information technology
consultancy with international operations in London, England. In that
transaction, we hired 19 management and consulting personnel of INTEFLUX,
acquired certain related assets and assumed the leases for
16
office space of INTEFLUX in Phoenix and London. The transaction was paid for
with a combination of cash and restricted shares of our common stock, as well as
the assumption of certain liabilities of INTEFLUX.
On November 16, 2001, we completed a similar series of transactions with
Winfield Allen, Inc. ("Winfield Allen"), a Denver, Colorado-based information
technology consultancy. In that transaction, we hired 24 management and
consulting personnel of Winfield Allen, acquired certain related assets, and
assumed their leases for office space. The transaction was paid for with a
combination of cash, a promissory note and restricted shares of our common
stock, as well as the assumption of certain liabilities of Winfield Allen.
On January 25, 2002, we completed a series of transactions to hire the executive
management and key professional staff and acquire certain related assets of
Goliath Networks, Inc. ("Goliath"), a Madison, Wisconsin-based information
technology consulting and services firm. In that transaction, we hired 81
management and consulting personnel of Goliath, acquired certain related assets,
and assumed the leases for office space in Madison and Milwaukee, Wisconsin. The
transaction was paid for with a combination of cash and issuance of a note
payable to a bank.
We anticipate closing on a series of transactions in November 2002 to hire the
executive management and key professional staff and acquire certain related
assets of Cunningham Technology Group ("CTG"), a Phoenix, Arizona-based
information technology consulting and services firm. In this transaction, we
will hire approximately 25 management and consulting personnel of CTG acquire
and certain related assets. The transaction will be paid by the assumption of
certain liabilities and issuance of stock.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our discussion and analysis of our financial condition and results of operations
are based upon our condensed consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosure of contingent assets and
liabilities. On an on-going basis, we evaluate our estimates, including those
related to long-term service contracts, bad debts, intangible assets, income
taxes, restructuring, and contingencies and litigation. We base our estimates on
historical experience and on various other assumptions that are believed to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions.
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our condensed
consolidated financial statements. We recognize revenue and profit as work
progresses on long-term, fixed price contracts using the
percentage-of-completion method, which relies on estimates of total expected
contract revenue and costs. We follow this method because reasonably dependable
estimates of the revenue and costs applicable to various stages of a contract
can be made. Recognized revenues and profit are subject to revisions as the
contract progresses to completion. Revisions in profit estimates are charged to
income in the period in which the facts that give rise to the revision become
known. We maintain allowances for doubtful accounts for estimated losses
resulting from the inability of our customers to make required payments. If the
financial condition of our customers were to deteriorate, resulting in an
impairment of their ability to make payments, additional allowances may be
required. We review acquired businesses on a periodic basis to determine that
the fair value is deemed adequate to support the carrying value of goodwill and
other intangible assets. Future adverse changes in market conditions or poor
operating results could result in an inability to recover the carrying value of
the investments, thereby possibly requiring an impairment charge in the future.
We record a valuation allowance to reduce our deferred tax assets to the amount
that is more likely than not to be realized. In the event we were to determine
that we would be able to realize our deferred tax assets in the future in excess
of its net recorded amount, an adjustment to the deferred tax asset would
increase income in the period such determination was made. We record accruals
for the estimated future cash expenditures required from closing vacated
offices. The accruals include estimates of future rent payments and settlements
until the obligation is canceled. Should actual cash expenditures differ from
our estimates, revisions to the estimated liability for closing vacated offices
would be required. We evaluate the requirement for future cash expenditures from
contingencies and litigation and record an accrual for contingencies and
litigation when exposures can be reasonably estimated and are considered
probable. Should the actual results differ from our estimates, revisions to the
estimated liability for contingencies and litigation would be required.
17
RESULTS OF OPERATIONS
REVENUES. For the three months ended September 30, 2002, revenues decreased
27.4% to $4.5 million compared to $6.2 million in the corresponding period of
2001. For the first nine months ended September 30, 2002, revenues decreased
22.0% to $19.9 million compared to $25.5 million in the corresponding period of
2001. The decrease in revenues for the third quarter primarily resulted from a
decrease in billed hours of 37.8% to 46,000 hours compared to 74,000 hours for
the corresponding quarter in 2001. This decrease in revenues for the third
quarter was partially offset by an increase in our average hourly bill rate of
22.7% to $92 compared to $75 in the corresponding quarter in 2001. The increase
in our bill rate has resulted from the decline in lower-end service consulting.
The decrease in revenues for the nine months ended September 30, 2002 resulted
from a decrease in billed hours of 30.5% to 182,000 hours compared to 262,000,
which was partially offset by an increase in our average hourly bill rate of
14.9% to $100 compared to $87 for the corresponding period in 2001.
We have substantially reduced our dependency for revenues on a few clients. For
the three months ended September 30, 2002, revenues from our largest client were
only 8.2% compared to 15.2% during the corresponding period of 2001. For the
three months ended September 30, 2002, revenue was generated from 240 clients
compared to 129 during the corresponding period of 2001. For the nine months
ended September 30, 2002 revenues from our largest client were only 7.2%
compared to 25.2% during the corresponding period of 2001. For the nine months
ended September 30, 2002, we generated revenues from 498 clients compared to 215
during the corresponding period of 2001.
COST OF REVENUES. Cost of revenues decreased 45.8% to $3.2 million for the three
months ended September 30, 2002 compared to $5.9 million for the corresponding
period of 2001. Cost of revenues decreased 38.3% to $14.8 million for the nine
months ended September 30, 2002 compared to $24.0 million for the corresponding
period of 2001. The decrease in cost of revenues for the third quarter resulted
from a decrease in overall firm staffing, improved utilization and
implementation of hourly and variable pay plans in certain offices. Utilization
of consultants in the third quarter increased 8.9 percent to 57.4%, compared to
52.7% for the corresponding quarter in 2001. The decrease in cost of revenues
for the nine months ended September 30, 2002 resulted from a decrease in overall
firm staffing, improved utilization of 26.4 percent to 60.9% compared to 48.2%
for the corresponding period in 2001 and implementation of hourly and variable
pay plans in certain offices. We also incurred less depreciation expense for our
data center during the nine months ended September 30, 2002 as compared to the
corresponding 2001 period primarily due to the $9.2 million charge in the second
quarter of 2001 related to underutilized computer equipment and leasehold
improvements. This data center was closed during the second quarter of 2002.
OTHER CHARGES. During the second quarter of 2001, we recorded a $2.2 million
non-cash charge due to the impairment of inventoried software licenses.
SELLING AND MARKETING EXPENSES. Selling and marketing expenses decreased 34.9%
to $912,000 for the three months ended September 30, 2002, compared to $1.4
million for the corresponding period of 2001. Selling and marketing expenses
decreased 37.2% to $2.7 million for the nine months ended September 30, 2002
compared to $4.3 million for the corresponding period of 2001. The decrease was
due primarily to reductions of dedicated sales and marketing personnel and to a
lesser extent, decreases in spending for advertising and promotion in the three
and nine months ended September 30, 2002.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
decreased 72.2% to $2.2 million for the three months ended September 30, 2002,
compared to $7.9 million for the corresponding period of 2001. General and
administrative expenses decreased 52.8% to $11.1 million for the nine months
ended September 30, 2002 compared to $23.5 million for the corresponding period
of 2001. These decreases were primarily attributable to recovery of bad debt,
reductions in general and administrative personnel, facility rent expense and
depreciation expense from closed offices and $350,000 of insurance proceeds
related to a litigation settlement recorded in the second quarter 2002. Non-cash
charges included $919,000 and $3.4 million of depreciation expense in the three
and nine month periods ended September 30, 2002, respectively, compared with
$1.4 million and $6.4 million for the three and nine month periods ended
September 30, 2001, respectively.
ASSET IMPAIRMENT AND RESTRUCTURING CHARGES. During the second and third quarters
of 2001, we recorded asset impairment and restructuring charges totaling
$9,144,000 and $47,000 respectively, related to underutilized computer equipment
and leasehold improvements at our data center used for application outsourcing
services and a $5,691,000 charge in the fourth quarter of 2001 for expenses
incurred in connection with the closing and consolidating of six office
locations
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and abandoned leasehold improvements in an unoccupied seventh location. The
charge for closing and consolidating offices consisted of an impairment charge
totaling $3,556,000 and an accrual for future cash expenditures, primarily
rent-related obligations net of estimated future sublease income, totaling
$2,135,000.
During the first quarter of 2002, as a result of weaker than anticipated
commercial real estate markets, we re-evaluated our accrual for future cash
expenditures for closed office locations. In addition, we executed a series of
cost control initiatives to close and consolidate three additional office
locations. These activities resulted in asset impairments and restructuring
charges totaling $2,751,000 for the first quarter of 2002. The charges consisted
of an increase in the accrual to terminate and exit closed facilities totaling
$1,108,000, an accrual totaling $1,039,000 for future cash expenditures
attributable to closing and consolidating three office locations, impairment
charges to fixed assets totaling $482,000 and impairment charges to rent
deposits totaling $122,000. In the second quarter of 2002, the Company recorded
additional asset impairment charges totaling $133,000 relating to the closure of
an office.
During the third quarter of 2002, negotiations with the landlords of each of the
closed facilities and the remaining facilities resulted in certain favorable
settlements ultimately consummated in October 2002. Accordingly, we re-evaluated
our accrual for closed office locations resulting in a net reduction of asset
impairment and restructuring charges of $2,773,000.
INTEREST INCOME (EXPENSE), NET. We incurred interest expense, net of interest
income, totaling $31,000 for the three months ended September 30, 2002 compared
to earning interest income, net of interest expense, of $207,000 for the
corresponding period of 2001. We incurred interest expense, net of interest
income totaling, $207,000 for the nine months ended September 30, 2002 compared
to earning interest income, net of interest expense, of $801,000 for the
corresponding period of 2001. These changes were primarily attributable to less
cash available for investment during 2002 as compared to the corresponding
period in 2001.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, we have funded our operations and investments in property and
equipment through capital lease financing arrangements, bank borrowings, and
equity financings.
We operate in a highly competitive market. The information technology services
industry has experienced rapid growth followed by rapid and significant
contraction over a relatively short economic cycle. Our rapid growth phase
required significant investments in infrastructure, facilities, computer and
office equipment, human resources and working capital in order to meet perceived
demand. Since the third quarter of 2000, the market for our services has changed
and declined significantly. We incurred negative cash flows from operations for
each of the three years ended December 31, 2001 and for the nine months ended
September 30, 2002. Our auditors issued their independent auditors' report dated
February 15, 2002 stating the Company has suffered negative cash flows from
operations and has an accumulated deficit, that raise substantial doubt about
our ability to continue as a going concern.
In October 2002, we completed a restructuring which satisfied the obligations
for the related real estate and equipment leases, certain trade payables and
accrued expenses for less than their recorded value. We agreed to pay $2.0
million in cash at the close of the restructuring and $1.2 million in periodic
payments over the next five years satisfying $2.9 million of recorded accounts
payable and accrued expenses, $3.1 million of capital lease obligations and
$229,000 of other non-current liabilities. As a result of the restructuring, a
total of approximately $23.0 million of future contractual obligations were
satisfied. We funded the restructuring by selling all of our current accounts
receivable, totaling $2.5 million, through a new bank credit facility at a
discount of 1.95% and can sell up to $1.7 million more in current accounts
receivable under the same arrangement.
We believe that closing the restructuring reduced the risk that we might not be
able to continue as a going concern. The remaining unused balance on the credit
facility of $1.7 million is available to fund future acquisitions and to support
working capital needs; however, availability is dependent upon our ability to
generate additional revenues and increase our accounts receivable base.
Accordingly, notwithstanding the restructuring, if we are unable to raise
additional capital and significantly reduce operating losses, our business
activities may be significantly curtailed.
Our management is currently pursuing various options in order to provide
necessary financing for future operations. Potential means of resolving near
term cash flow issues include the following:
o A private placement of equity financing;
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o Projected improvement of operating results;
o Improved collections of accounts receivable; and
o The sale of excess equipment and intellectual property.
We continue to reduce operating expenses by reducing staff, minimizing the
number of outside IT consultants and eliminating unnecessary general and
administrative expenses and believe that these actions taken will improve cash
flow from operations.
We believe if we can improve operating results, we will generate sufficient
resources to ensure uninterrupted performance of our operating obligations. Our
continuance as a going concern is dependent upon our ability to generate
sufficient cash flow to meet obligations in a timely manner, to obtain
additional financing as required and ultimately to attain profitability. There
can be no assurance, however, that these sources will be available to us on
acceptable terms or when necessary, or that we will be successful in our efforts
to improve our operating results.
At September 30, 2002, we had approximately $580,000 in cash and cash
equivalents and a deficiency of working capital of approximately $4.6 million,
as compared to $5.2 million in cash and cash equivalents and $293,000 in working
capital at December 31, 2001.
For the nine months ended September 30, 2002 and 2001, net cash used in
operating activities was $3.9 million and $16.9 million, respectively. Cash used
in operating activities in each of these periods was the result of net losses,
adjusted for non-cash items primarily related to depreciation and amortization,
non-cash asset impairment and restructuring charges and fluctuations in accounts
receivable, prepaid expenses and other current assets, and accounts payable and
accrued expenses. Our collections of accounts receivable improved in the second
and third quarters of 2002 with trade receivables averaging 42 days sales
outstanding, compared to 53 days sales outstanding for the corresponding period
of 2001. Additionally, the percentage of receivables over 90 days as of
September 30, 2002 was reduced to 33.2% compared to 59.3% as of September 30,
2001. We continue to reduce the amount of receivables over 90 days and expect
our diligence in the collection of receivables to be a source of cash for us in
the near term. We recovered a net of $358,000 of bad debt during the quarter
ended September 30, 2002.
For the nine months ended September 30, 2002 and 2001, net cash used in
investing activities was $465,000 and $5.3 million, respectively. Capital
expenditures to support growth in our infrastructure during the nine months
ended September 30, 2002 and 2001 totaled $162,000 and $2.9 million,
respectively. Cash used as part of the price to acquire the assets of other
companies during the nine months ended September 30, 2002 and 2001 totaled
$400,000 and $2.4 million, respectively.
For the nine months ended September 30, 2002, net cash used in financing
activities was $324,000, compared to net cash used in financing activities for
the nine months ended September 30, 2001 of $10.5 million. During the first nine
months of 2002, net repayments of capital lease obligations totaled
approximately $1.0 million. We also used $708,000 of our restricted cash during
the first nine months of 2002 in connection with the Company's closure of excess
office space. For the nine months ended September 30, 2001, we repurchased
4,851,800 shares of our common stock for approximately $5.2 million and
allocated $2.1 million to restricted cash. Our net repayments of capital lease
obligations during the nine months ended September 30, 2001 totaled
approximately $3.3 million.
Non-cash investing and financing activities for the nine months ended September
30, 2002 consisted of the issuance of a note payable to a bank of approximately
$4.7 million, in conjunction with the acquisition of Goliath and $362,000 of new
capital lease obligations for property and equipment, resulting from a renewal
of an expired lease. Non-cash investing and financing activities for the nine
months ended September 30, 2001 consisted of new capital lease obligations for
property and equipment of $150,000.
As of September 30, 2002, we have a note payable to a bank for approximately
$4.7 million issued in connection with an acquisition. The note payable bears
interest at 7% per year. Payments on the note are interest only for the first
year. Principal and interest payments for the second, third and fourth years
will be based on a ten-year amortization schedule. The unpaid principal will be
paid in full at the end of the fourth year. The note payable is collateralized
by computer equipment and office equipment owned by the Company.
20
In June 2001, we deposited approximately $1.0 million into a restricted
certificate of deposit account. The funds in this account served as collateral
against various letters of credit. During the fourth quarter of 2001 and the
first, second and third quarters of 2002, $300,000, $227,000, $465,000 and
$19,000, respectively, was used in connection with our closure of excess office
space and other obligations. At September 30, 2002, $417,000 of the restricted
cash was on deposit in the construction escrow account established for tenant
improvements at the headquarters facility. See Note 7, "Restricted Cash."
RECENTLY ISSUED FINANCIAL STANDARDS
In June 2001, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standard No. 141, Business Combinations (SFAS 141), and
Statement of Financial Accounting Standard No. 142, Goodwill and Other
Intangible Assets (SFAS 142). SFAS 141 became effective for us as of July 1,
2001. It establishes new standards for accounting and reporting requirements for
business combinations and requires the purchase method of accounting be used for
all business combinations initiated after June 30, 2001. SFAS 142 became
effective for us on January 1, 2002 and requires, among other things, the
cessation of the amortization of goodwill. In addition, the standard includes
provisions for the reassessment of the useful lives of existing recognized
intangibles, a new method of measuring reported goodwill for impairment and the
identification of reporting units for purposes of assessing potential future
impairments of goodwill.
We have recorded $7.9 million of goodwill relating to the five acquisitions
completed after the effective date of SFAS 141, and there has been no
amortization expense recorded in the accompanying financial statements. As
discussed in Note 9 to our condensed consolidated financial statements, in
connection with SFAS 142's transitional goodwill impairment evaluation, the
Company recorded a non-cash charge of $3.2 million, relating to all of the
goodwill recorded in connection with the four acquisitions completed during
2001, and is reported in the caption "Cumulative effect of a change in
accounting principle." All of the charge was related to the Company's
acquisitions completed in 2001. The primary factors that resulted in the
impairment charge were the difficult economic environment in the IT professional
services sector and the doubt about the Company's ability to continue as going
concern. In accordance with SFAS 142, the fair value and carrying value of the
remaining goodwill of $4.7 million, relating to our acquisition, which we
completed in the first quarter of 2002, will be tested on the Company's annual
measurement date in the fourth quarter of 2002.
In August 2001, the FASB issued Statement of Financial Accounting Standard No.
143, Accounting for Asset Retirement Obligations (SFAS 143), which addresses
financial accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and for the associated asset retirement
costs. SFAS 143 requires an enterprise to record the fair value of an asset
retirement obligation as a liability in the period in which it incurs a legal
obligation associated with the retirement of tangible long-lived assets that
result from the acquisition, construction, development and/or normal use of the
assets. The enterprise also is to record a corresponding increase to the
carrying amount of the related long-lived assets and to depreciate that cost
over the life of the asset. The liability is changed at the end of each period
to reflect the passage of time (i.e., accretion expense) and changes in the
estimated future cash flows underlying the initial fair value measurement. The
provisions of SFAS 143 are effective for us on January 1, 2003 and are to be
applied prospectively. The adoption of SFAS 143 is not expected to have a
material impact on our consolidated financial statements.
In August 2001, the FASB issued Statement of Financial Accounting Standard No.
144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144)
that addresses financial accounting and reporting for the impairment or disposal
of long-lived assets, including discontinued operations. While SFAS 144
supercedes Statement of Financial Accounting Standard No. 121, Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,
it retains many of the fundamental provisions of that Statement. SFAS 144 also
supercedes certain provisions of ABP Opinion No. 30, Reporting the Results of
Operations--Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for
the disposal of a segment of a business. The provisions of SFAS 144 are
effective for us on January 1, 2003 and are to be applied prospectively. The
adoption of SFAS 144 is not expected to have a material impact on our
consolidated financial statements.
In November 2001, the Emerging Issues Task Force of the FASB concluded that
reimbursements for "out of pocket" expenses should be classified as revenue and,
correspondingly, cost of services, in the income statement. The new accounting
treatment is applicable to us in the first quarter of 2002 and requires that
comparative financial statements for prior periods be reclassified in order to
ensure consistency for all periods presented. Accordingly, in the attached
statements of operations, we included revenues and cost of sales from the
reimbursements of expenses incurred of $129,000 and $76,000 for the quarters
ended September 30, 2002 and 2001, respectively and $550,000 and $190,000 for
the nine month periods ended September 30, 2002 and 2001, respectively.
21
In April 2002, the FASB issued Statement of Financial Accounting Standard No.
145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections (SFAS 145), which addresses
financial accounting and reporting for reporting gains and losses from
extinguishment of debt, accounting for intangible assets of motor carriers and
accounting for leases. SFAS 145 requires that gains and losses from the early
extinguishment of debt should not be classified as extraordinary, as previously
required. SFAS 145 also rescinds Statement 44, which was issued to establish
accounting requirements for the effects of transition to the provisions of the
Motor Carrier Act of 1980 (Public Law 96-296, 96th Congress, July 1, 1980).
Those transitions are completed; therefore, Statement 44 is no longer necessary.
Statement 145 also amends Statement 13 to require sale-leaseback accounting for
certain lease modifications that have economic effects that are similar to
sale-leaseback transactions. Statement 145 also makes various technical
corrections to existing pronouncements. Those corrections are not substantive in
nature. The provisions of this statement relating to Statement 4 are applicable
in fiscal years beginning after May 15, 2002. The provisions of this Statement
related to Statement 13 are effective for transactions occurring after May 15,
2002. All other provisions of this Statement are effective for financial
statements issued on or after May 15, 2002. The adoption of the provisions of
SFAS 145 relating to Statement 4 are not expected to have a material impact on
our consolidated financial statements. The adoption of the provisions of SFAS
145 relating to Statement 13 did not have a material impact on our condensed
consolidated financial statements.
In June 2002, the FASB issued Statement of Financial Accounting Standards issued
SFAS No. 146, Accounting for Exit or Disposal Activities (SFAS 146). SFAS 146
addresses the recognition, measurement and reporting of costs associated with
exit and disposal activities, including restructuring activities. SFAS 146 also
addresses recognition of certain costs related to terminating a contract that is
not a capital lease, costs to consolidate facilities or relocate employees and
termination of benefits provided to employees that are involuntarily terminated
under the terms of a one-time benefit arrangement that is not an ongoing benefit
arrangement or an individual deferred compensation contract. SFAS 146 is
effective for exit or disposal activities that are initiated after December 31,
2002. The Company is in the process of evaluating the adoption of SFAS 146 and
its impact on the financial position and results of operations of the Company.
In November 2002, the Emerging Issues Task Force of the FASB outlined the
criteria that would require a revenue arrangement with multiple deliverables to
be divided into separate units of accounting and if separation is appropriate,
how the arrangement consideration should be allocated to the identified
accounting units based on their relative fair values. The new accounting
treatment is applicable to IIS in the first quarter 2003. We have not yet
determined the impact, if any, of adoption on our condensed consolidated
financial statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
To date, we have not utilized derivative financial instruments or derivative
commodity instruments. We do not expect to employ these or other strategies to
hedge market risk in 2002. We invest our cash in money market funds, which are
subject to minimal credit and market risk. We believe that the market risks
associated with these financial instruments are immaterial.
All of our revenues are realized currently in U.S. dollars and are from
customers primarily in the United States. Therefore, we do not believe that we
currently have any significant direct foreign currency exchange rate risk.
FACTORS THAT MAY AFFECT FUTURE RESULTS AND OUR STOCK PRICE
This Quarterly Report on Form 10-Q includes forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Act of 1934. Forward-looking statements give our current expectations
or forecasts of future events. Words such as "expect," "may," "anticipate,"
"intend," "would," "will," "plan," "believe," "estimate," "should," and similar
expressions identify forward-looking statements. Forward-looking statements in
this Form 10-Q include express or implied statements concerning our future
revenues, expenditures, capital or other funding requirements, the adequacy of
our current cash and working capital balances to fund our present and planned
operations and financing needs, expansion of and demand for our service
offerings, and the growth of our business and operations, as well as future
economic and other conditions both generally and in our specific geographic and
product and services markets. These statements are based on our estimates,
projections, beliefs, and assumptions and are not guarantees of future
performance. From time to time, we also may provide oral or written
forward-looking statements in other materials we release to the public.
We caution that the following important factors, among others, could cause our
actual results to differ materially from those expressed in forward-looking
statements made by or on behalf of us in filings with the Securities and
Exchange
22
Commission, press releases, communications with investors, and oral statements.
Any of these factors, among others, could also negatively impact our operating
results and financial condition and cause the trading price of our common stock
to decline or fluctuate significantly. We undertake no obligation to publicly
update any forward-looking statements, whether as a result of new information,
future events or otherwise. You are advised, however, to consult any further
disclosures we make in our reports filed with the Securities and Exchange
Commission and in future public statements and press releases.
THE COMPANY IS SEEKING ADDITIONAL FINANCING WHICH, IF NOT AVAILABLE TO US, COULD
JEOPARDIZE OUR ONGOING OPERATIONS AND WHICH, IF AVAILABLE AND RAISED, COULD
DILUTE YOUR OWNERSHIP INTEREST IN US.
We incurred negative cash flows from operations in 2001 and continue to do so in
2002. If we are unable to obtain financing on terms acceptable to us, or at all,
we may choose or be required to limit or reduce our scope of operations, cease
looking for consultancies to consolidate with our business, or, under the worst
of circumstances, pursue strategic alternatives such as a sale, merger or
recapitalization or seek protection under reorganization, insolvency or similar
laws. The acceleration of receipts through accounts receivable financing
permitted us to close the restructuring and make settlement payments. However,
that funding did not provide us with additional working capital, and the pledge
of assets to secure the financing may reduce our ability to obtain new
financing. We are also pursuing sources of additional funds in order to take
advantage of acquisition or expansion opportunities, develop new services and
address unanticipated contingencies. If the best available financing is raising
additional capital through the sale of equity securities or through taking on
debt with an equity component, whether for funding settlements and working
capital needs or for growth through acquisitions, your investment in us would be
diluted. The inability to settle obligations on favorable terms, raise financing
for the settlements or for working capital or other needs would materially and
adversely affect the Company and would likely cause our stock price to further
decline.
WE HAVE A CONDITIONAL LISTING ON THE NASDAQ SMALLCAP MARKET; IF WE ARE UNABLE TO
MAINTAIN A LISTING ON THE NASDAQ SMALLCAP MARKET, OUR COMMON STOCK MAY BECOME
EVEN MORE ILLIQUID AND THE VALUE OF OUR SECURITIES MAY DECLINE FURTHER.
In June 2002, the listing of our common stock was transferred from The Nasdaq
National Market to The Nasdaq SmallCap Market and in September 2002 we presented
our appeal of a delisting notice to a Listing Qualifications Panel. In October
2002, the Listing Qualifications Panel determined that we had presented a
definitive plan for compliance with continued listing requirements and continued
the listing of our common stock pursuant to a series of exceptions, including
seeking stockholder approval for a reverse split of our common stock to satisfy
the $1.00 minimum bid price requirement and regaining compliance with the
requirement of $2.5 million in stockholders equity at various points. If we are
unable to meet all of the requirements of the exceptions, Nasdaq will delist our
common stock. If this occurs, our common stock will likely trade in the
over-the-counter market on the National Association of Securities Dealers' OTC
Bulletin Board, or its successor, or in the so-called "pink sheets" maintained
by Pink Sheets LLC. Such alternative trading markets are generally considered
less liquid and efficient than Nasdaq, and although trading in our stock is
already relatively thin and sporadic, the liquidity of our common stock may
decline further because smaller quantities of shares would likely be bought and
sold, transactions could be delayed and news media coverage of us would
diminish. These factors could result in lower prices and larger spreads in the
bid and ask prices for our common stock. Reduced liquidity may reduce the value
of our common stock and our ability to generate additional funding.
WE HAVE EXPERIENCED OPERATING LOSSES AND MAY INCUR OPERATING LOSSES IN FUTURE
PERIODS, WHICH COULD CAUSE THE PRICE OF OUR COMMON STOCK TO DECLINE FURTHER.
We had a net loss of approximately $12.2 million for the first nine months of
2002, a net loss of approximately $49.4 million for the year ended December 31,
2001, a net loss of $25.4 million for the year ended December 31, 2000 and a net
loss of approximately $1.4 million for the year ended December 31, 1999. We
expect to continue to incur cash losses during 2002. The Company's auditors
issued their independent auditors' report dated February 15, 2002 stating the
Company has suffered negative cash flows from operations and has an accumulated
deficit that raise substantial doubt about our ability to continue as a going
concern. If we do not achieve revenue growth, and are not able to reduce our
obligations for equipment and facilities that we no longer need or use, we could
experience operating losses greater than already anticipated in 2002 or for
periods after 2002. These losses or any fluctuation in our operating results
could cause the market value of our common stock to decline further.
23
WE ANTICIPATE ACQUIRING MORE BUSINESSES, AND WE MAY INCUR INCREASED OPERATING
EXPENSES WITHOUT CORRESPONDING INCREASED REVENUES, WHICH MAY LIMIT OUR ABILITY
TO ACHIEVE OR MAINTAIN PROFITABILITY AND CAUSE THE PRICE OF OUR COMMON STOCK TO
DECLINE.
A key component of our current business strategy is to acquire like-minded peer
consultancies in geographic areas where we do not have a strong presence. We
also look for acquisition opportunities, without focusing on increasing our
geographic diversity, if there is an opportunity to strengthen a current service
offering or add a service offering which complements our current service
offerings. The risks of acquisitions include retaining clients, retaining key
employees, incurring higher than anticipated transaction expenses and other
unexpected expenses and diverting management's attention from daily operations
of our business. Acquiring businesses, especially in markets in which we have
limited prior experience, is risky. If we do not implement this strategy
successfully, we may incur increased operating expenses without increased
revenues, which could materially harm our operating results and stock price.
BECAUSE THE MARKET FOR OUR SERVICES MAY NOT GROW DURING 2002, WE MAY BE UNABLE
TO BECOME PROFITABLE.
We offer services in the IT services market. The IT services market began
contracting in the second half of 2000 and has not rebounded. We do not
anticipate any meaningful growth in the IT services market in the remainder of
2002. While we have taken steps to reduce our costs, if demand for our services
does not grow in the future, or if we do not capture sufficient market share for
these services, we may be unable to achieve profitability.
OUR RESULTS OF OPERATIONS MAY VARY FROM QUARTER TO QUARTER IN FUTURE PERIODS
AND, AS A RESULT, WE MAY NOT MEET THE EXPECTATIONS OF OUR INVESTORS AND
ANALYSTS, WHICH COULD CAUSE OUR STOCK PRICE TO FLUCTUATE OR DECLINE.
Our revenues and results of operations have fluctuated significantly in the past
and could fluctuate significantly in the future. We realized a net income of
$913,000 in the third quarter of 2002, a net loss of $2.5 million in the second
quarter of 2002, a net loss of $10.7 million in the first quarter of 2002 and
net losses of $8.2 million, $20.0 million, $8.8 million and $12.5 million in the
first, second, third, and fourth quarters of 2001, respectively.
Our results may fluctuate due to the factors described in this Form 10-Q, as
well as: the loss of or failure to replace any significant clients; variation in
demand for our services; higher than expected bad debt write-offs; changes in
the mix of services that we offer; and variation in our operating expenses.
A substantial portion of our operating expense is related to personnel costs and
overhead, which cannot be adjusted quickly and is, therefore, relatively fixed
in the short term. Our operating expenses are based, in significant part, on our
expectations of future revenues. If actual revenues are below our expectations,
we may not achieve our anticipated operating results. Moreover, it is possible
that in some future periods our results of operations may be below the
expectations of investors and analysts. In this event, the market price of our
common stock is likely to decline.
IF WE FAIL TO KEEP PACE WITH THE RAPID TECHNOLOGICAL CHANGES THAT CHARACTERIZE
OUR INDUSTRY, OUR COMPETITIVENESS WOULD SUFFER, CAUSING US TO LOSE PROJECTS OR
CLIENTS AND CONSEQUENTLY REDUCING OUR REVENUES AND THE PRICE OF OUR COMMON
STOCK.
Our market and the enabling technologies used by our clients are characterized
by rapid, frequent, and significant technological changes. If we fail to respond
in a timely or cost-effective way to these technological developments, we may
not be able to meet the demands of our clients, which would affect our ability
to generate revenues and achieve profitability. We have derived, and expect to
continue to derive, a large portion of our revenues from creating solutions that
are based upon today's leading and developing technologies and which are capable
of adapting to future technologies. Our historical results of operations may not
reflect our new service offerings and may not give you an accurate indication of
our ability to adapt to these future technologies.
OUR FAILURE TO MEET CLIENT EXPECTATIONS OR DELIVER ERROR-FREE SERVICES COULD
DAMAGE OUR REPUTATION AND HARM OUR ABILITY TO COMPETE FOR NEW BUSINESS OR RETAIN
OUR EXISTING CLIENTS, WHICH MAY LIMIT OUR ABILITY TO GENERATE REVENUES AND
ACHIEVE OR MAINTAIN PROFITABILITY.
Many of our engagements involve the delivery of information technology services
that are critical to our clients' businesses. Any defects or errors in these
services or failure to meet clients' specifications or expectations could result
in: delayed or lost revenues due to adverse client reaction; requirements to
provide additional services to a client at no or a limited charge;
24
refunds of fees for failure to meet obligations; negative publicity about us and
our services; and claims for substantial damages against us.
In addition, we sometimes implement critical functions for high profile clients
or for projects that have high visibility and widespread usage in the
marketplace. If these functions experience difficulties, whether or not as a
result of errors in our services, our name could be associated with these
difficulties and our reputation could be damaged, which would harm our business.
WE MAY LOSE MONEY ON FIXED-PRICE CONTRACTS BECAUSE WE MAY FAIL TO ACCURATELY
ESTIMATE AT THE BEGINNING OF PROJECTS THE TIME AND RESOURCES REQUIRED TO FULFILL
OUR OBLIGATIONS UNDER OUR CONTRACTS; THE ADDITIONAL EXPENDITURES THAT WE MUST
MAKE TO FULFILL THESE CONTRACT OBLIGATIONS MAY CAUSE OUR PROFITABILITY TO
DECLINE OR PREVENT US FROM ACHIEVING PROFITABILITY AND COULD REDUCE THE PRICE OF
OUR COMMON STOCK.
Although we provide consulting services primarily on a time and materials
compensation basis, approximately 27% of our consulting revenue was derived from
fixed-price, fixed-time engagements during the three months ended September 30,
2002, 28% of our consulting revenue was derived from fixed-price, fixed-time
engagements for the nine months ended September 30, 2002, 14% of our consulting
revenue was derived from fixed-price, fixed-time engagements in 2001, and
approximately 5% of revenues were derived from fixed-price, fixed-time
engagements in 2000. The percentage of our revenues derived from fixed-price,
fixed time engagements will fluctuate and may increase in the future, as
influenced by changes in demand and market conditions. Our failure to accurately
estimate the resources required for a fixed-price, fixed-time engagement or our
failure to complete our contractual obligations in a manner consistent with our
projections or contractual commitments could harm our overall profitability and
our business. From time to time, we have been required to commit unanticipated
additional resources to complete some fixed-price, fixed-time engagements,
resulting in losses on these engagements. We believe that we may experience
similar situations in the future. In addition, we may negotiate a fixed price
for some projects before the design specifications are finalized, resulting in a
fixed price that is too low and causing a decline in our operating results.
OUR LACK OF LONG-TERM CONTRACTS WITH CLIENTS AND OUR CLIENTS' ABILITY TO
TERMINATE CONTRACTS WITH LITTLE OR NO NOTICE REDUCES THE PREDICTABILITY OF OUR
REVENUES AND INCREASES THE POTENTIAL VOLATILITY OF OUR STOCK PRICE.
Our clients generally retain us on an engagement-by-engagement basis, rather
than under long-term contracts. In addition, our current clients can generally
reduce the scope of or cancel their use of our services without penalty and with
little or no notice. As a result, our revenues are difficult to predict. Because
we incur costs based on our expectations of future revenues, our failure to
predict our revenues accurately may cause our expenses to exceed our revenues,
which could cause us to incur increased operating losses. Although we try to
design and build complete integrated information systems for our clients, we are
sometimes retained to design and build discrete segments of the overall system
on an engagement-by-engagement basis. Since the projects of our large clients
can involve multiple engagements or stages, there is a risk that a client may
choose not to retain us for additional stages of a project or that the client
will cancel or delay additional planned projects. These cancellations or delays
could result from factors related or unrelated to our work product or the
progress of the project, including changing client objectives or strategies, as
well as general business or financial considerations of the client. If a client
defers, modifies, or cancels an engagement or chooses not to retain us for
additional phases of a project, we may not be able to rapidly re-deploy our
employees to other engagements and may suffer underutilization of employees and
the resulting harm to our operating results. Our operating expenses are
relatively fixed and cannot be reduced on short notice to compensate for
unanticipated variations in the number or size of engagements in progress. The
slowing in spending on business and IT consulting initiatives that began in the
second half of 2000 continues, and if current or potential clients cancel or
delay their IT initiatives, our business and results of operations could be
materially adversely affected.
WE MAY NOT BE SUCCESSFUL IN RETAINING OUR CURRENT TECHNOLOGY ALLIANCES OR
ENTERING INTO NEW ALLIANCES, WHICH COULD HAMPER OUR ABILITY TO MARKET OR DELIVER
SOLUTIONS, NEEDED OR DESIRED BY OUR CLIENTS AND LIMIT OUR ABILITY TO INCREASE OR
SUSTAIN OUR REVENUES AND ACHIEVE OR MAINTAIN PROFITABILITY.
We rely on vendor alliances for client referral and marketing opportunities,
access to advanced technology and training as well as other important benefits.
These relationships are non-exclusive and the vendors are free to enter into
similar or more favorable relationships with our competitors. Whether written or
oral, many of the agreements underlying our relationships are general in nature,
do not legally bind the parties to transact business with each other or to
provide specific client referrals, cross-marketing opportunities, or other
intended benefits to each other, have indefinite terms, and may be ended at
25
the will of either party. We may not be able to maintain our existing strategic
relationships and may fail to enter into new relationships. If we are unable to
maintain these relationships, the benefits that we derive from these
relationships, including the receipt of important sales leads, cross-marketing
opportunities, access to emerging technology training and certifications, and
other benefits, may be lost. Consequently, we may not be able to offer desired
solutions to clients, which would result in a loss of revenues and our inability
to effectively compete for clients seeking emerging or leading technologies
offered by these vendors.
BECAUSE WE OPERATE IN A HIGHLY COMPETITIVE AND RAPIDLY CHANGING INDUSTRY,
COMPETITORS COULD CAUSE US TO LOSE BUSINESS OPPORTUNITIES AND LIMIT OUR ABILITY
TO INCREASE OR SUSTAIN REVENUE LEVELS.
Although our industry experienced significant consolidation in 2001 and
continues to do so in 2002, the business areas in which we compete remain
intensely competitive and subject to rapid change. We expect competition to
continue and to intensify. Our competitors currently fall into several
categories and include a range of entities providing both general management and
information technology consulting services and Internet services. Many of our
competitors have longer operating histories, larger client bases, and greater
brand or name recognition, as well as greater financial, technical, marketing,
and public relations resources. Our competitors may be able to respond more
quickly to technological developments and changes in clients' needs. Further, as
a result of the low barriers to entry, we may face additional competition from
new entrants into our markets. We do not own any technologies that preclude or
inhibit competitors from entering the general business areas in which we
compete. Existing or future competitors may independently develop and patent or
copyright technologies that are superior or substantially similar to our
technologies, which may place us at a competitive disadvantage. All of these
factors could lead to competitors winning new client engagements for which we
compete. If this occurs, our ability to generate increased revenues may be
limited and we may not achieve profitability.
WE MAY NOT BE ABLE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS AND, AS A RESULT,
WE COULD LOSE COMPETITIVE ADVANTAGES WHICH DIFFERENTIATE OUR SOLUTIONS AND OUR
ABILITY TO ATTRACT AND RETAIN CLIENTS.
Our success is dependent, in part, upon our intellectual property rights. We
rely upon a combination of trade secrets, confidentiality and nondisclosure
agreements, and other contractual arrangements, as well as copyright and
trademark laws to protect our proprietary rights. We have no significant patents
and no pending patent applications. We enter into confidentiality agreements
with our employees, we generally require that our consultants and clients enter
into these agreements, and we attempt to limit access to and distribution of our
proprietary information. Nevertheless, we may be unable to deter
misappropriation of our proprietary information or to detect unauthorized use
and take appropriate steps to enforce our intellectual property rights or
proprietary information.
We attempt to retain significant ownership or rights to use our internally
developed software applications which we can market and adapt through further
customization for other client projects. Under some of our client contracts, all
of our project developments are the property of the client and we have no right
or only limited rights to reuse or provide these developments in other client
projects. To the extent that we are unable to negotiate contracts, which permit
us to reuse code and methodologies, or to the extent that we have conflicts with
our clients regarding our ability to do so, we may be unable to provide services
to some of our clients within price and timeframes acceptable to these clients.
Although we believe that our services, trade or service names, and products do
not infringe upon the intellectual property rights of others, claims could be
asserted against us in the future. If asserted, we may be unable to successfully
defend these claims, which could cause us to cease providing some services or
products and limit any competitive advantage we derive from our trademarks or
names.
If any of these events occur, our ability to differentiate ourselves and compete
effectively could be limited and we may lose revenue opportunities.
WE OCCASIONALLY AGREE NOT TO PERFORM SERVICES FOR OUR CLIENTS' COMPETITORS,
WHICH MAY LIMIT OUR ABILITY TO GENERATE FUTURE REVENUES AND INHIBIT OUR BUSINESS
STRATEGY.
In order to secure particularly large engagements or engagements with industry
leading clients, we have agreed on limited occasions not to perform services, or
not to utilize some of our intellectual property rights developed for clients,
for competitors of those clients for limited periods of time ranging from one to
three years. In our agreement with American Express, our largest client in 2001
and 2000, we have agreed not to perform services for competitors of American
Express for one year after each project completion date and not to assign
consultants who have worked on American Express
26
projects to other clients' competitive projects for six months after completing
work for American Express. These non-compete provisions reduce the number of our
prospective clients and our potential sources of revenue. These agreements also
may limit our ability to execute a part of our business strategy of leveraging
our business expertise in discreet industry segments by attracting multiple
clients competing in those industries. In addition, these agreements increase
the significance of our client selection process because some of our clients
compete in markets where only a limited number of companies gain meaningful
market share. If we agree not to perform services or to utilize intellectual
property rights for a particular client's competitors or competitive projects,
we are unlikely to receive significant future revenues in that particular
market.
THE LOSS OF MR. JAMES G. GARVEY, JR., OUR FOUNDER, CHAIRMAN, CHIEF EXECUTIVE
OFFICER AND PRESIDENT, MAY HARM OUR ABILITY TO OBTAIN AND RETAIN CLIENT
ENGAGEMENTS, MAINTAIN A COHESIVE CULTURE, OR COMPETE EFFECTIVELY.
Our success will depend in large part upon the continued services of James G.
Garvey, Jr., our founder, Chairman, Chief Executive Officer and President. We
have an employment contract with Mr. Garvey. Mr. Garvey is precluded under his
agreement from competing against us for one year should he leave us. The loss of
Mr. Garvey's services could harm us and cause a loss of investor confidence in
our business, which could cause the trading price of our stock to decline. In
addition, if Mr. Garvey resigns to join a competitor or to form a competing
company, the loss of Mr. Garvey and any resulting loss of existing or potential
clients to any competitor could harm our business. If we lose Mr. Garvey, we may
be unable to prevent the unauthorized disclosure or use by other companies of
our technical knowledge, practices, or procedures. In addition, due to the
substantial number of shares of our common stock owned by Mr. Garvey, the loss
of Mr. Garvey's services could cause investor or analyst concern that Mr. Garvey
may sell a large portion of his shares, which could cause a rapid and
substantial decline in the trading price of our common stock. We have a
$5,000,000 key-man life insurance policy on Mr. Garvey, but we have assigned the
policy to a bank in connection with the $4.2 million bank facility.
THE SALE OF A SUBSTANTIAL NUMBER OF SHARES OF OUR COMMON STOCK IN THE PUBLIC
MARKET COULD ADVERSELY AFFECT THEIR MARKET PRICE, NEGATIVELY IMPACTING YOUR
INVESTMENT.
There are a substantial number of shares of our common stock potentially
available for sale in the public market. The sale of a substantial number of
shares in the public market could depress the market price of our common stock
and could impair our ability to raise capital through the sale of additional
equity securities.
THE HOLDINGS OF MR. GARVEY MAY LIMIT YOUR ABILITY TO INFLUENCE THE OUTCOME OF
DIRECTOR ELECTIONS AND OTHER MATTERS SUBJECT TO A STOCKHOLDER VOTE, INCLUDING A
SALE OF OUR COMPANY ON TERMS THAT MAY BE ATTRACTIVE TO YOU.
James G. Garvey, Jr., our founder, Chairman, Chief Executive Officer and
President, currently owns approximately 64% of our outstanding common stock. Mr.
Garvey's stock ownership and management positions enable him to exert
considerable influence over our Company, including the election of directors and
the approval of other actions submitted to our stockholders. In addition,
without the consent of Mr. Garvey, we may be prevented from entering into
transactions that could be viewed as beneficial to other stockholders, including
a sale of the Company. This could prevent you from selling your stock to a
potential acquirer at prices that exceed the market price of our stock, or could
cause the market price of our common stock to decline.
OUR CHARTER DOCUMENTS COULD MAKE IT MORE DIFFICULT FOR A THIRD PARTY TO ACQUIRE
US, WHICH COULD LIMIT YOUR ABILITY TO SELL YOUR STOCK TO AN ACQUIRER AT A
PREMIUM PRICE OR COULD CAUSE OUR STOCK PRICE TO DECLINE.
Our certificate of incorporation and by-laws may make it difficult for a third
party to acquire control of us, even if a change in control would be beneficial
to stockholders. Our certificate of incorporation authorizes our board of
directors to issue up to 5,000,000 shares of "blank check" preferred stock.
Without stockholder approval, the board of directors has the authority to attach
special rights, including voting and dividend rights, to this preferred stock.
With these rights, preferred stockholders could make it more difficult for a
third party to acquire our Company.
Our by-laws do not permit any person other than at least three members of our
board of directors, our President, the Chairman of the Board, or holders of at
least a majority of our stock to call special meetings of the stockholders. In
addition, a stockholder's proposal for an annual meeting must be received within
a specified period in order to be placed on the agenda. Because stockholders
have limited power to call meetings and are subject to timing requirements in
submitting stockholder proposals for consideration at meetings, any third-party
takeover or other matter that stockholders wish to vote on that is not supported
by the board of directors could be subject to significant delays and
difficulties.
27
If a third party finds it more difficult to acquire us because of these
provisions, you may not be able to sell your stock at a premium price that may
have been offered by the acquirer, and the trading price of our stock may be
lower than it otherwise would be if these provisions were not in effect.
OUR STOCK REPURCHASE PLAN MAY ADVERSELY AFFECT THE TRADING VOLUME AND LIQUIDITY
OF OUR COMMON STOCK AND COULD CAUSE OUR STOCK PRICE TO DECLINE.
In December 2000, our board authorized a stock repurchase plan which authorized
us to purchase up to $2 million of our common stock on the open market in
compliance with applicable SEC regulations. In August 2001, our board authorized
an increase in the maximum amount from $2 million to $7 million. During 2001, we
repurchased 4,951,800 shares of our common stock at a cost of approximately $5.3
million. We currently have no plan to repurchase additional shares of our common
stock. However, if we do repurchase more shares of our common stock under this
plan, the number of shares of our common stock outstanding will decrease. This
decrease would likely reduce the trading volume of our common stock and could
adversely impact the liquidity and value of our common stock.
ITEM 4. Controls and Procedures
Within the 90 days prior to the date of this quarterly report on Form 10-Q, we
carried out an evaluation, under the supervision and with the participation of
our management, including our Chief Executive Officer and Chief Financial
Officer, of the effectiveness of the design and operation of our disclosure
controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that
evaluation, our Chief Executive Officer and Chief Financial Officer concluded
that our disclosure controls and procedures are effective in timely alerting
them to material information required to be disclosed by us in our periodic
reports to the Securities and Exchange Commission. There have been no
significant changes in our internal controls or in other facts that could
significantly affect our disclosure controls subsequent to the date of their
evaluation.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
During July and August 2001, four purported class action lawsuits were filed in
the United States District Court for the Southern District of New York against
us, certain of our current and former officers and directors (the "Individual
Defendants") and the members of the underwriting syndicate involved in our
initial public offering (the "Underwriter Defendants"). All four lawsuits have
been transferred to Judge Scheindlin for coordination with more than 300 similar
cases. The suits generally allege that: (1) the Underwriter Defendants allocated
shares of our initial public offering to their customers in exchange for higher
than standard commissions on transactions in other securities; (2) the
Underwriter Defendants allocated shares of our initial public offering to their
customers in exchange for the customers' agreement to purchase additional shares
of our common stock in the after-market at pre-determined prices; (3) we and the
Individual Defendants violated section 10(b) of the Securities Exchange Act of
1934 and/or section 11 of the Securities Act of 1933; and (4) the Individual
Defendants violated section 20 of the Securities Exchange Act of 1934 and/or
section 15 of the Securities Act of 1933. The plaintiffs seek unspecified
compensatory damages and other relief. We have sought indemnification from the
underwriters of our initial public offering. The plaintiffs filed a consolidated
amended complaint in April 2002. In July 2002, we, as part of the group of
issuers of shares named in the consolidated litigation and the Individual
Defendants, filed a motion to dismiss the consolidated amended complaints. The
Underwriter Defendants filed motions to dismiss as well. Also in July 2002, the
plaintiffs offered to dismiss the Individual Defendants, without prejudice, in
exchange for a Reservation of Rights and Tolling Agreement from each Individual
Defendant. All of the Individual Defendants in our four lawsuits have entered
into such an agreement. On November 1, 2002, Judge Scheindlin heard oral
arguments on the motions to dismiss. Due to the inherent uncertainties of
litigation and because the litigation is at a preliminary stage, we cannot
accurately predict the ultimate outcome of the motions or the hearing on the
motions. We believe that the claims against us are unfounded and without merit
and intend to vigorously defend this matter.
In December 2001, we terminated a lease with MCW Brickyard Commercial, L.L.C.
("MCW") for new office space at 699 South Mill Avenue in Tempe, Arizona as a
result of MCW's failure to deliver the leased premises in a timely manner and
filed suit against MCW in Superior Court in Maricopa County, Arizona to recover
damages we incurred in preparing to move to the premises and funds remaining in
a construction escrow account, now approximately $417,000. MCW filed an answer,
denying all liability and alleging that we caused delays in delivery of the
leased premises. During March 2002, MCW filed an amended answer and supplemental
counterclaim for lost rent, lost parking income, lost expense income,
commissions and unpaid construction costs. MCW also asks for indemnity for
construction costs and its attorneys' fees and interest. We believe that the
counterclaims are without merit, intend vigorously to prosecute our claim
against MCW and to defend against MCW's counterclaim. In August 2002, MCW filed
a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy
Code, and our state court litigation is stayed during their bankruptcy.
In February 2002, we filed suit against Oracle Corporation ("Oracle") in
Superior Court in Maricopa County, Arizona for breach of contract, breach of
implied covenant of good faith and fair dealing, negligent misrepresentation and
fraud. We joined Fleet Business Credit, L.L.C. ("Fleet") as a necessary party.
Oracle filed, and in September 2002 the court granted as to Oracle, a motion to
dismiss the suit for improper venue, but the court left the action pending as
against Fleet. We have settled the suit with Fleet and funded payment of the
settlement in connection with the set of transactions which satisfied the
28
obligations of certain real estate and equipment leases and for certain trade
payables for less than their recorded value. Please see "Liquidity and Capital
Resources" for additional information about that set of transactions.
In connection with our restructuring, we have settled all litigation with
landlords of vacated facilities and the action we brought against Comerica Bank
- - California and Comerica Leasing Corporation. Please see "Liquidity and Capital
Resources" for additional information about that set of transactions consummated
on October 15, 2002.
Additionally, we are, from time to time, party to various legal proceedings
arising in the ordinary course of business. We evaluate such claims on a
case-by-case basis, and our policy is to vigorously contest any such claims
which we believe are without merit.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
4.4 Anchor Bank Warrant
10.49 Settlement Agreement with Action Performance Companies, Inc.
10.50 Sublease Agreement with Action Performance Companies, Inc.
10.51 Settlement Agreement with Comerica Bank
10.52 General Business Security Agreement with AnchorBank, fsb
10.53 Modification of Subordinated Note to AnchorBank, fsb
10.54 25 Corporate Drive Lease Termination - 4/10/02
10.55 Las Vegas Lease Termination - 8/02/02
10.56 Irvine lease Termination and Settlement - 9/30/02
10.57 New York Stipulation of Settlement - 10/14/02
10.58 Englewood Lease Termination and Release - 10/15/02
10.59 Alpharetta Lease Surrender and Termination - 10/16/02
10.60 Santa Monica Lease Termination - 10/14/02
10.61 Portland Lease Amendment - 10/4/02
99.1 Certification of James G. Garvey, Jr., Chairman, Chief
Executive Officer and President
99.2 Certification of William A. Mahan, EVP, Chief Financial Officer
and Treasurer
(b) Reports on Form 8-K
o Form 8-K filed August 15, 2002, to file as exhibit 99.1 a press
release titled "IIS Reports Results for Second Quarter 2002" and,
as exhibit 99.2, a press release titled "Integrated Information
Systems, Inc. Announces NASDAQ Delisting Notice."
o Form 8-K filed August 23, 2002, to file as exhibit 99.1 a press
release titled "Integrated information Systems, Inc. Announces
Appeal of NASDAQ Delisting."
o Form 8-K filed September 19, 2002 reporting, under Item 5 that on
September 18, 2002, NASDAQ informed the Company that its common
stock had not maintained the $1,000,000 minimum market
29
value of publicly held shares for the last thirty consecutive
trading days.
o Form 8-K filed October 22, 2002, to file as exhibit 99.1 a press
release titled "IIS Completed Comprehensive Financial
Restructuring and Obtains Bank Credit Facility Enabling Organic
Growth and Consolidation Strategies."
o Form 8-K filed October 25, 2002, to file as exhibit 99.1 a press
release titled "NASDAQ Grants IIS Reasonable Period of Time to
Achieve and Sustain Compliance."
30
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.
INTEGRATED INFORMATION SYSTEMS, INC.
Dated: November 14, 2002
/s/ William A. Mahan
-------------------------------------
William A. Mahan
Executive Vice President,
Chief Financial Officer and Treasurer
31
CERTIFICATION OF THE PRINCIPAL EXECUTIVE OFFICER
PURSUANT TO SECTION 302
OF THE SARBANES-OXLEY ACT OF 2002
I, James G. Garvey, Jr., hereby certify that:
1. I have reviewed this quarterly report on Form 10-Q of Integrated
Information Systems, Inc. (the Registrant);
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The Registrant's other certifying officers and I are responsible for
establishing and maintaining internal controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-l4) for the Registrant and have:
a. designed such internal controls and procedures to ensure that
material information relating to the Registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;
b. evaluated the effectiveness of the Registrant's internal controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c. presented in this quarterly report our conclusions about the
effectiveness of the internal controls and procedures based on our evaluation as
of the Evaluation Date;
5. The Registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the Registrant's auditors and the audit
committee of Registrant's board of directors (or persons performing the
equivalent functions):
a. all significant deficiencies in the design or operation of internal
controls which could adversely affect the Registrant's ability to record,
process, summarize and report financial data and have identified for the
Registrant's auditors any material weaknesses in internal controls; and
b. any fraud, whether or not material, that involves management or
other employees who have a significant role in the Registrant's internal
controls; and
6. The Registrant's other certifying officers and I have indicated in this
quarterly report whether there were significant changes in internal controls or
in other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ James G. Garvey, Jr.
------------------------
James G. Garvey, Jr.
Chairman, Chief Executive Officer and President
(Principal Executive Officer)
32
CERTIFICATION OF THE PRINCIPAL FINANCIAL OFFICER
PURSUANT TO SECTION 302
OF THE SARBANES-OXLEY ACT OF 2002
I, William A. Mahan, hereby certify that:
1. I have reviewed this quarterly report on Form 10-Q of Integrated
Information Systems, Inc. (the Registrant);
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The Registrant's other certifying officers and I are responsible for
establishing and maintaining internal controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-l4) for the Registrant and have:
a. designed such internal controls and procedures to ensure that
material information relating to the Registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;
b. evaluated the effectiveness of the Registrant's internal controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c. presented in this quarterly report our conclusions about the
effectiveness of the internal controls and procedures based on our evaluation as
of the Evaluation Date;
5. The Registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the Registrant's auditors and the audit
committee of Registrant's board of directors (or persons performing the
equivalent functions):
a. all significant deficiencies in the design or operation of internal
controls which could adversely affect the Registrant's ability to record,
process, summarize and report financial data and have identified for the
Registrant's auditors any material weaknesses in internal controls; and
b. any fraud, whether or not material, that involves management or
other employees who have a significant role in the Registrant's internal
controls; and
6. The Registrant's other certifying officers and I have indicated in this
quarterly report whether there were significant changes in internal controls or
in other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ William A. Mahan
-------------------------------
William A. Mahan
Executive Vice President, Chief Financial Officer
and Treasurer
(Principal Financial Officer)
33