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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended October 31, 2002
or
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____________ to ________________
Commission file number 0-24015
STEELCLOUD, INC
(Exact name of registrant as specified in its charter)
Commonwealth of Virginia 54-1890464
- ------------------------ ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1306 Squire Court
Dulles, Virginia 20166
- --------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
(703) 450-0400
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12 (b) of the Exchange Act
Title of each class Name of exchange on which registered
- ------------------- ------------------------------------
None.
Securities registered pursuant to Section 12 (g) of the Act:
Title of each class Name of exchange on which registered
- ------------------- ------------------------------------
Common Stock, $.001 par value per share Nasdaq National Market System
Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if there is disclosure of delinquent filers in
response to Item 405 of Regulation S-K contained herein and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. |X|
The aggregate market value of the voting stock held by non-affiliates
of the issuer as of January 27, 2003 was $7,594,523.
ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS
Indicate by check mark whether the registrant has filed all documents
and reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes |_| No |_|
APPLICABLE ONLY TO CORPORATE REGISTRANTS
The number of shares outstanding of the registrant's Common Stock,
$.001 par value per share, on January 27, 2003 was 10,045,611.
Documents incorporated by reference: None
STEELCLOUD, INC
2002 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I Page Number
Item 1. Description of Business.................................................................. 3
Item 2. Description of Properties................................................................ 7
Item 3. Legal Proceedings........................................................................ 7
Item 4. Submission of Matters to a Vote of Security Holders...................................... 8
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.................... 8
Item 6. Selected Financial Data.................................................................. 10
Item 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations............................................................................... 11
Item 7A. Quantitative and Qualitative Disclosures About Market Risk............................... 19
Item 8. Financial Statements and Supplementary Data.............................................. 19
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosures.............................................................................. 19
PART III
Item 10. Directors and Executive Officers of the Registrant....................................... 20
Item 11. Executive Compensation...................................................................
Item 12. Security Ownership of Certain Beneficial Owners and Management...........................
Item 13. Certain Relationships and Related Transactions...........................................
(Item 10 - Item 13 information is incorporated by reference
from portions of the Company's definitive Proxy Statement
to be filed pursuant to Regulation 14A)
Item 14 Controls and Procedures................................................................... 20
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K........................... 20
Signatures............................................................................................. 22
2
ITEM 1. DESCRIPTION OF BUSINESS
General
SteelCloud, Inc. (formerly Dunn Computer Corporation) or (the
"Company") was founded in 1987 as a company that manufactured and marketed
custom computers, primarily to the Federal government.
The company is principally engaged in the design and development of
custom and customized server appliances for software and technology companies.
SteelCloud develops these OEM (original equipment manufacturer) platform
configurations to significantly reduce the end-users' implementation time and
expense. The Company's appliance approach shortens its OEM partners' sales
cycles while allowing them to increase their revenue and reinforce their
branding strategies. SteelCloud sells OEM server appliances to leading software
and technology companies that, in turn, distribute the uniquely "branded"
products through their own direct sales and distribution channels worldwide.
The Company was incorporated as Dunn Computer Corporation in Virginia
on February 26, 1998 in connection with the reorganization of Dunn Computer
Corporation, a Delaware Corporation, which was incorporated on April 22, 1997.
The Company's operating subsidiary, Dunn Computer Operating Company, was
incorporated in Virginia in July 1987. The Company's other subsidiaries are
International Data Products (IDP), acquired May 1998, STMS, Inc (STMS), acquired
September 1997, and Puerto Rico Industrial Manufacturing Operations Acquisition
Corporation (PRIMOA), incorporated in Puerto Rico in May 1998. In October 2002,
the Company determined to discontinue PRIMOA and thereby executed a plan to
dispose of operations at that facility in fiscal 2003. Accordingly, the
operation has been classified as "discontinued" in the financials statements for
all years presented.
On September 25, 2000, the Company began doing business as ("d/b/a")
SteelCloud Company. On October 19, 2000, the Company changed its NASDAQ ticker
symbol from DNCC and began trading as SCLD. On May 15, 2001, the shareholders of
the Company approved the name change of the Company to SteelCloud, Inc.
effective on that date. Unless the context otherwise requires, the "Company" or
"Dunn Computer Corporation" refers to SteelCloud Inc., its predecessor and its
subsidiaries. The principal executive offices are located at 1306 Squire Court,
Dulles, Virginia 20166. The Company's main telephone number is (703) 450-0400.
Inquiries may also be sent to SteelCloud at [email protected] for sales and
general information or [email protected] for investor relations information.
Products and Services
The Company offers network appliances, infrastructure server products,
and consulting services. The Company believes it operates in one segment,
information technology.
Network Server Appliances: SteelCloud partners with leading software
and technology companies to create uniquely branded, ready-to-use turnkey
network server appliance solutions combining both hardware and software.
SteelCloud integrates the partner's software onto a custom designed server
platform, running Linux, FreeBSD, or Microsoft NT/2000. This process results in
an optimized, tested, and certified appliance, unique to the OEM partner, which
is ready to deploy and use when it arrives at the customer site. The company has
leveraged its years of experience, developing and managing custom server
platforms for mission-critical Department of Defense ("DOD") and security
programs, to create a unique methodology for addressing the OEM market. The
appliance becomes a "product" of the respective OEM partner, which in turn
markets the appliance through their normal distribution channels. For its
appliance customers, SteelCloud offers much more than hardware manufacturing.
The Company assembles a package of design, support, and logistical services that
are custom tailored for each particular software company, thereby augmenting the
partner's internal capabilities. In essence, SteelCloud takes responsibility for
those tasks necessary to successfully bring an appliance to market, which are
impractical for its software partners to perform.
The Company believes that its unique approach to the server appliance
market (collaborating with leading software manufacturers and leveraging their
significant product marketing and sales efforts) enables it to realize economies
of scale in development, sales, and marketing far greater than its revenue would
indicate under a more traditional strategy. The Company also believes that risks
relating to R&D (research and development) and inventory are also greatly
reduced through its OEM partnership approach.
3
Infrastructure Products: The Company designs, develops and manufactures
specialized custom servers, which are configured with single, dual, or quad
Intel Pentium III, IV, or Xeon processors. These servers are designed to give
its customers with unique requirements, the highest level of performance,
reliability, and manageability available in the market today. The company
combines its hardware offerings with specialized software integration and
logistics programs to give its custom server customers, unique solutions
unavailable from the traditional hardware-only vendors.
The Company believes that its infrastructure/custom server products are best
suited to address the high volume needs of the federal government. The Company
teams with large federal integrators as its primary channel for delivering its
specialized servers.
Consulting Services: SteelCloud provides an array of consulting
services surrounding the technologies addressed by its server appliances. The
Company's consulting services include network and security analysis, design and
implementation, as well as help desk consulting. These services are primarily
delivered in the form of short-term (less than three months) projects. The
Company's consulting services are performed for a fixed-fee or on an hourly
labor basis at the pre-negotiated price and estimated levels of effort.
SteelCloud acts as a value-added reseller for certain software products that are
delivered as a part of its consulting services. In some cases, SteelCloud
provides its appliance customers with additional technical services that
complement their appliance implementation.
Specific project-based services SteelCloud performs include network
analysis, network design, systems implementation, virus protection, network
security, software migrations, messaging system migrations and complete help
desk implementation and support. SteelCloud maintains expertise in specific
areas and technologies rather than general knowledge in many IT (information
technology) areas. SteelCloud provides highly skilled professionals and services
that leverage our experience for maximum benefit to the client. Project
management is the key component of SteelCloud's operational strategy and success
in project-based engagements to ensure each project is delivered in accordance
with the customer's expectation and the Company's profitability objectives.
SteelCloud also provides network support services in the form of
fixed-rate hourly engineering services. Client contracts range in duration from
one month to three years.. Staffing services consist of placing one or more
network engineers, user support technicians, or programmers on-site with a
client. These professionals perform work as a "virtual" employee for the client
and typically work under the direction of the client's management. Hourly rates
for staffing engagements are normally lower than for project-based engagements;
however, the contracts usually have substantially longer periods of performance.
SteelCloud's success in this area is achieved largely due to contract renewals
and increasing staffing requirements from existing customers.
Government Contracts
In fiscal 2002, the Company derived approximately 21% of its revenues
from sales of hardware and services to the U.S. Federal Government pursuant to
contracts with the General Services Administration (GSA) or other
agency-specific contracts.
GSA Contract. The Company has a multiple award schedule contract with
GSA (the "GSA" Contract). The Company's GSA contract was originally awarded in
April 1996. It was renewed in fiscal 2002 and is valid through March 31, 2007.
The GSA contract enables Government IT purchasers to acquire all of their
requirements from a particular vendor and largely limits the competition to
selected vendors holding GSA contracts. For fiscal year 2002, the Company's GSA
contract had sales of $3.6 million, which accounted for approximately 12% of the
Company's revenues.
4
Commercial Contracts
In fiscal year 2002, SteelCloud derived approximately 79% of its
revenues from sales of hardware and services to the commercial marketplace and
state and local government. The Company's commercial customer base consists of
several Fortune 500 companies as well as medium-size commercial customers. The
Company derived approximately 64% of its revenues from two customers during
fiscal 2002. The Company intends to continue to increase its commercial customer
base in the upcoming fiscal year. The Company's Appliance Partner program and
its own sales and marketing activities are concentrated on expanding the
Company's commercial customer base. Strategic partnerships with industry leading
companies such as Microsoft, Cisco, Network Associates, and Intel enable the
Company to further diversify its product mix and attract high quality customers.
Manufacturing and Production
SteelCloud's production operations are capable of assembling 100,000
systems per year in its existing Dulles, Virginia facility on a three-shift
basis. The Company is currently operating on a single shift basis.
Competition and Marketing
The markets for the Company's products and services are highly
competitive. Many of the Company's competitors offer broader product lines and
have substantially greater financial, technical, marketing and other resources.
These competitors may benefit from component volume purchasing and product and
process technology license arrangements that are more favorable in terms of
pricing and availability than the Company's arrangements.
The Company competes with a large number of computer systems
integrators, custom computer manufacturers, resellers, and IT services
companies. The Company believes it is likely that these competitive conditions
will continue in the future. There can be no assurance the Company will continue
to compete successfully against existing or new competitors that may enter
markets in which the Company operates.
Our principal competitors are general-purpose server manufacturers
including Nokia, Sun Microsystems and Dell. We also compete with system
integrators such as Avnet and Pioneer Standard Electronics. In addition, we
compete with smaller companies such as Network Engines that specialize in
building server products and providing some level of integration services.
Federal Government Market. The emergence of the GSA Schedule, which is
a list of pre-approved vendors from which the Government and/or federal agencies
may purchase goods and services, as a significant procurement vehicle has
enabled traditional mass-market commercial computer companies to be more
responsive to government requirements and become more competitive with the
Company in the Federal Government Market. The Company believes that the
Government's selection criteria for vendor selection consist of price, quality,
familiarity with the vendor, and size and financial capability of the vendor.
The government has increased the amount of information technology products
acquired through the GSA Schedule. Because the company primarily targets custom
computer procurements, it rarely competes with national commercial computer
manufacturers such as Dell Computer Corporation and Hewlett-Packard in the
federal market.
Commercial Market. The information technology industry is highly
competitive. Pricing is very aggressive in the industry and the Company expects
pricing pressures to continue. The industry is also characterized by rapid
changes in technology and customer preferences, short product life cycles and
evolving industry standards.
5
The commercial market for the Company's IT products and services is a highly
fragmented market served by thousands of small value-added resellers and
specialized manufacturers. These companies typically service a small geographic
area and resell national brand computer and/or network hardware. The Company
believes its consulting services group can compete effectively in the
Washington, DC metropolitan market because it provides engineering services in
conjunction with its turnkey server appliances and products from its strategic
partners; e.g., Cisco, Microsoft, and Intel. The Company believes that its
ability to integrate its server systems with networking products also gives its
consulting services group a competitive advantage.
In the OEM server appliance market, the principal elements of
competition are product reliability, quality, customization, price, customer
service, technical support, value-added services, and product availability.
There can be no assurance that the Company will, in the future, be able to
compete effectively against existing and future competitors.
Marketing. The Company markets its products and services to software
manufacturers, their channel partners, select commercial accounts, and the
federal government. The Company uses an in-house sales force and program
managers to market its products and services. SteelCloud markets its products
and services worldwide, either directly through its own sales personnel, or
through the marketing organizations of its appliance partners. The Company
believes that marketing is important for all of its target markets, although
less so in its OEM appliance business because its success relies on the OEM
partner's sales and marketing capabilities.
The Company strives to build a strong relationship with its customers.
The Company believes that a key to building customer loyalty is a team of
knowledgeable and responsive account executives and a knowledgeable technical
and support staff. The Company assigns each customer a trained account
executive, to whom subsequent calls to the Company will be directed. The account
executive is augmented with a program manager for SteelCloud's larger customers.
The Company believes that these strong one-on-one relationships improve the
likelihood that the customer may consider the Company for future purchases. The
Company intends to continue to provide its customers with products and technical
services that offer the customer the best value.
The Company uses electronic commerce technologies in its marketing
efforts and believes that its customers will continue to expand and utilize
these technologies. The Internet is being used by customers to advertise
opportunities and to reference vendor information. The Company maintains a web
site on the Internet referencing its GSA catalogue and product offerings. The
Company is capable of accepting sales and processing payments over the Internet.
Suppliers
The Company devotes significant resources to establishing and
maintaining relationships with its key suppliers. The Company, where possible,
purchases directly from component manufacturers such as Intel, Microsoft and
Cisco among others. The Company also purchases multiple products directly from
large national and regional distributors such as TechData Corporation and Ingram
Micro.
Certain suppliers provide the Company with incentives in the form of
discounts, rebates, credits, and cooperative advertising, and market development
funds. The Company must continue to obtain products at competitive prices from
leading suppliers in order to provide competitively priced products for its
customers. In the event the Company is unable to purchase components from
existing suppliers, the Company has alternative suppliers it can rely upon. The
Company believes its relationships with its key suppliers to be good and
believes that generally, there are multiple sources of supply available should
the need arise.
Patents, Trademarks and Licenses
The Company works closely with computer product suppliers and other
technology developers to stay abreast of the latest developments in computer
technology. While the Company does not believe its continued success depends
upon the rights to a patent portfolio, there can be no assurance that the
Company will continue to have access to existing or new technology for use in
its products.
The Company conducts its business under the trademarks and service
marks of "SteelCloud", "SteelCloud Company", "Dunn Computer Corporation,"
"International Data Products," and "IDP." The Company believes its trademarks
and service marks have significant value and are an important factor in the
marketing of its products.
Because most software used on the Company's computers is not owned by the
Company, the Company has entered into software licensing arrangements with
several software manufacturers.
6
Employees
As of October 31, 2002, the Company had 78 employees. Of this total, 4
were employed in an executive capacity, 10 in sales and marketing, 15 in
administrative capacities, 22 in technical and/or services and 27 in operations.
As of January 20, 2003, the Company had 76 employees. None of SteelCloud's
employees are covered by a collective bargaining agreement. SteelCloud considers
its relationships with its employees to be good.
The Company believes that its future success depends in large part upon
its continued ability to attract and retain highly qualified management,
technical, and sales personnel. The computer industry's shortage of trained and
experienced technicians has eased over the past twelve months. SteelCloud has an
in-house training and mentoring program to develop its own supply of highly
qualified technical support specialists. There can be no assurance, however,
that the Company will be able to attract and retain the qualified personnel
necessary for its business.
ITEM 2. DESCRIPTION OF PROPERTY
The Company leases approximately 35,000 square feet at its facility in
Dulles, Virginia, which is used as its principal executive offices, for
manufacturing and administrative services. Pursuant to the lease, which expires
in February 2005, the Company pays approximately $27,000 per month in rent. The
Company also leases 4,800 square feet of warehouse space at an off-site location
in Dulles, Virginia at a rate of $4,015 per month. This warehouse is primarily
used to store and maintain certain inventory and files at a secure off-site
location.
In addition, the Company opened sales offices in California and Massachusetts in
fiscal 2002. The Company does not lease any space for these offices since its
salespersons are based out of their respective residences.
ITEM 3. LEGAL PROCEEDINGS
On July 31, 1998, the Company received notice from the SBA that it was
denying the request of the U.S. Air Force to waive the requirement to terminate
IDP's Desktop V contract for the convenience of the Government upon the change
in control of IDP to the Company. The Company appealed the denial of the SBA to
the SBA's Office of Hearings and Appeals. On August 31, 1999, the SBA denied the
appeal and ruled that the U.S. Air Force must terminate-for-convenience the
Desktop V contract. Prior to this ruling by the SBA, the U.S. Air Force
determined not to exercise any of the remaining option years under the Desktop V
contract on May 1, 1999. In October 1999, the U.S. Air Force issued a
termination-for-convenience letter to the Company. Under a
termination-for-convenience, the government is required generally to reimburse a
contractor for all costs incurred in the performance of the contract. The
Company is in the process of attempting to recover from the government a portion
or all of unreimbursed costs associated with the Desktop V Contract. No
assurances can be given that the Company will be successful in recovering any
costs associated with this matter.
7
Other than the above, there are no material claims pending against the
Company.
There are routine legal claims pending against the Company, but in the
opinion of management, liabilities, if any, arising from such claims will not
have a material adverse effect on the financial condition and results of
operation of the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during
the fourth quarter of the fiscal year covered by this report.
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Market Information
Prior to the quotation of the Company's Common Stock beginning on April
22, 1997, there was no established trading market for the Company's common
stock. The Company's Common Stock is listed on The Nasdaq Stock Market, Inc.'s
National Market System. The Company changed its symbol from "DNCC" to "SCLD" on
October 19, 2000. The following table sets forth the high and low selling prices
as reported by The Nasdaq National Market System for each fiscal quarter during
the fiscal years ended October 31, 2002 and 2001, as well as for the first
quarter of fiscal 2003 through January 27, 2003. These quotations reflect
inter-dealer prices without retail mark-up, mark-down or commission and may not
represent actual transactions.
Fiscal 2001
High Low
-----------------------
First Quarter.............................. $1.38 $0.69
Second Quarter............................. $1.25 $0.50
Third Quarter.............................. $0.75 $0.45
Fourth Quarter............................. $1.05 $0.62
Fiscal 2002
High Low
-----------------------
First Quarter.............................. $3.89 $0.78
Second Quarter............................. $3.34 $2.32
Third Quarter.............................. $3.50 $1.62
Fourth Quarter............................. $2.15 $0.87
Fiscal 2003
High Low
-----------------------
First Quarter (through January 27, 2003)... $1.40 $1.01
On January 27, 2003 the closing price of the Company's Common Stock as
reported on The Nasdaq National Market was $1.02 per share. There were
approximately 5,100 shareholders of the Common Stock of the Company as of such
date.
The Company has not paid cash dividends on its Common Stock and does
not intend to do so in the foreseeable future.
8
Recent Sales of Unregistered Stock
On May 1, 1998, in connection with the IDP acquisition, the Company
acquired all of the issued and outstanding capital stock of IDP Co. and
substantially all of the net assets of PRIMO. In consideration for the IDP
acquisition, the Company paid the former owners an aggregate of $14.9 million in
cash and an aggregate of 750,000 shares of Common Stock. In November 1998, the
Company received 350,000 shares of the stock previously issued to the former
owners of IDP (Fusters) in connection with a Purchase Price Adjustment
Agreement. The shares sold to the Fusters in the IDP acquisition were sold in
reliance upon the exemption from registration afforded by Section 4(2) of the
Securities Act of 1933, as amended.
In March 2000, the Company sold 3,000 shares of its Series A
Convertible Preferred Stock to one investor. In connection with the sale, the
Company received an aggregate of $3,000,000. The shares of preferred stock were
sold in reliance upon the exemption from registration provided by Regulation D
Rule 506 of the Securities Act of 1933, as amended. In August 2001, the Company
redeemed 2,620 shares of the Series A Convertible Preferred Stock which
represented all of the then outstanding Preferred Stock.
In March 2000, the Company issued 225,000 shares of its common stock in
connection with the settlement of a lawsuit with a former employee. The shares
of common stock were issued in reliance upon the exemption from registration
afforded by Section 4(2) of the Securities Act of 1933, as amended.
9
ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL DATA
(In thousands, except per share data)
The following selected consolidated financial data of SteelCloud should
be read in conjunction with the consolidated financial statements and the notes
thereto and "Management's Discussion and Analysis of Financial Condition and
Results of Operations". The consolidated statement of operations data set forth
below with respect to the fiscal years ended October 31, 2000, 2001 and 2002 and
the consolidated balance sheet data as of October 31, 2001 and 2002 is derived
from and is referenced to the audited consolidated financial statements of
SteelCloud included elsewhere in this Annual Report on Form 10-K. The
consolidated statement of income data set forth below with respect to the fiscal
years ended October 31, 1998 and 1999 and the consolidated balance sheet data as
of October 31, 1998, 1999 and 2000 is derived from audited consolidated
financial statements of SteelCloud not included in this annual report.
Year ended October 31,
1998(1) 1999 2000 2001 2002
------- ---- ---- ---- ----
Consolidated Statement of Operations Data: (2)
Net revenues ...................................................... $ 52,011 $ 28,749 $ 22,509 $ 25,791 $ 29,157
Costs of revenues ................................................. 41,420 23,021 17,481 19,407 22,163
Gross profit ...................................................... 10,590 5,729 5,028 6,384 6,994
Selling, general and administrative, and amortization ............. 8,528 36,062 5,510 5,075 6,481
Income (loss) from operations ..................................... 2,062 (30,333) (482) 1,309 513
Other (expense) income, net ....................................... (286) (2,908) (123) (184) (222)
Income (loss) from continuing operations before income taxes and
extraordinary gain .............................................. 1,776 (33,241) (606) 1,125 291
Provision for (benefit from) income taxes ......................... 686 (559) 65 102 (280)
Income (loss) before extraordinary gain and discontinued operations 1,090 (32,683) (671) 1,023 571
Extraordinary gain ................................................ -- -- 750 -- --
Cumulative effect of change in accounting principle ............... -- -- -- (576) --
Preferred stock dividends ......................................... -- -- (625) (112) --
Increase to income available to common stockholders from
repurchase of preferred stock ................................... -- -- -- 721 --
Net income (loss) from discontinued operations .................... (110) (924) 721 (9) (1,686)
Net income (loss) available to common stockholders ................ $ 980 $(33,607) $ 176 $ 1,047 $ (1,115)
Basic earnings (loss) per share (1) ............................... $ 0.14 $ (3.57) $ 0.02 $ 0.10 $ (0.11)
Earning (loss) per share assuming dilution (1) .................... $ 0.13 $ (3.57) $ 0.02 $ 0.08 $ (0.10)
Weighted average shares outstanding (1) ........................... 7,231 9,404 9,581 10,111 9,948
Weighted average shares outstanding assuming dilution (1) ......... 7,492 9,404 9,581 12,463 10,812
Pro forma basic earnings (loss) per share assuming the accounting
change is applied retroactively ................................. $ 0.14 $ (3.57) $ (0.04) $ 0.16 $ (0.11)
Pro forma earnings (loss) per share assuming the accounting change
is applied retroactively, assuming dilution ..................... $ 0.13 $ (3.57) $ (0.04) $ 0.08 $ (0.10)
At October 31,
1998 1999 2000 2001 2002
-------- -------- -------- -------- --------
Consolidated Balance Sheet Data: (2)
Working capital (deficit) ......................................... $ 5,773 $ (1,239) $ 5,839 $ 7,349 $ 3,856
Total assets ...................................................... 62,965 22,287 23,005 17,134 17,633
Long-term debt .................................................... 51 2,845 2,598 3,837 60
Total liabilities ................................................. 24,592 17,470 14,149 9,736 10,876
Stockholders' equity .............................................. 38,373 4,817 8,856 7,398 6,757
- --------
(1) Includes the activity of IDP from May 1, 1998 (date of acquisition).
(2) The selected financial data for each year presented has been restated
to reflect the Company's PRIMO operations as a discontinued operation.
10
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATION
Certain statements contained herein may constitute forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995.
Because such statements include risks and uncertainties, actual results may
differ materially from those expressed or implied by such forward-looking
statements. Factors that could cause actual results to differ materially
include, but are not limited to, risks associated with the integration of
businesses following an acquisition, competitors with broader product lines and
greater resources, emergence into new markets, the termination of any of the
Company's significant contracts, the Company's inability to maintain working
capital requirements to fund future operations or the Company's inability to
attract and retain highly qualified management, technical and sales personnel.
OVERVIEW
Founded in 1987, SteelCloud, Inc, based in Dulles, Virginia, designs, develops
and manufactures customized computer servers and network appliances. The
Company's primary business focus is to develop and manufacture products on an
OEM basis ("Original Equipment Manufacturer") for strategic software,
technology, and managed services partners. With its strategic partners,
SteelCloud creates and uniquely brands ready-to-use turnkey network server
appliance solutions combining both hardware and software. The Company integrates
its partner's, or other third-party software, into a custom designed server
platform. SteelCloud manufactures the resulting product under the partner's
brand name allowing the partner to deliver a complete turnkey solution.
SteelCloud's customer is its OEM partner rather than the end-user. The partner
is responsible for selling and distributing the OEM products developed by
SteelCloud. The Company enhances its product development and manufacturing
capability by providing custom supply chain and logistics support services to
its partners.
In addition to delivering computer products to the OEM market, SteelCloud
develops specialized servers and infrastructure products for large commercial
and government integrators, and certain governmental agencies. The Company is a
value-added reseller for the software products of its strategic partners and
certain other software providers. SteelCloud also provides Information
Technology (IT) support services to both the public sector and commercial
customers.
FISCAL 2002
Discontinued Operations
The Company continually evaluates its operating facilities with regard to its
long-term strategic goals established by management and the Board of Directors.
Operating facilities, which are not expected to contribute to the Company's
future operations are either closed or sold. In October 2002, management, with
the approval of the Board of Directors, determined that its Puerto Rico
Industrial Manufacturing Operation ("PRIMO") would no longer contribute to
future operations and therefore adopted a plan to dispose of that operation
effective on that date. The plan estimates that disposal will be complete within
90 to 120 days from October 31, 2002. Accordingly, the Company has reflected
PRIMO as discontinued operations in the current financial statements. As a
result, prior year amounts have been reclassified to segregate the continuing
operations from the discontinued operations. The Company is pursuing a sale of
the PRIMO business. However, if the suitable buyer is not found in the
foreseeable future, management may chose to shut down the PRIMO operations. The
loss associated with the discontinued operation was approximately $1.6 million.
The Company believes that given the current environment of that market,
discontinuing the operation was the best alternative. Losses from the PRIMO
operation during the period prior to disposal are not expected to be material.
11
Significant Contract
In January 2002, the Company was awarded several contracts by Lockheed Martin
valued at more than $10.5 million for customized servers. The Company commenced
work under the contracts in March 2002 and is expected to complete the contracts
by July 2003. As of October 31, 2002, the Company recognized revenue of
approximately $2.5 million under these contracts. In addition, the Company had
assembled but not shipped approximately $1.8 million of products under this
contract. Pursuant to the contract, the customer was billed for this product,
however, the Company has deferred revenue recognition at October 31, 2002
pending delivery.
The Company's supply agreement with one of its significant customers, Network
Associates, expired on December 31, 2002. The Company is currently discussing
the renewal of such agreements with this customer. No assurances can be given
that such discussions will result in future agreements from this customer. Net
revenues relating to this agreement were $15 million and $10 million for
October 31, 2001 and 2002, respectively.
Settlement of Licensing Claim
In November 1998, International Data Products, Inc. (IDP), a wholly-owned
subsidiary of the Company, entered into a Government Integrator Agreement, as
amended, with Microsoft Corporation (Microsoft) for the licensing of certain
Microsoft software. On October 31, 2000, Microsoft filed suit against the
Company, and its subsidiary IDP, for breach of contract in the amount of
approximately $1.3 million. In response to that suit, the Company submitted a
motion to dismiss the case and filed a counterclaim of fraud on behalf of IDP in
the amount of $500,000. In March 2002, the Company and Microsoft agreed to
settle the dispute. Pursuant to the settlement, the Company and Microsoft
exchanged mutual full releases and the Company agreed to pay Microsoft
approximately $315,000. In accordance with the settlement, the Company paid
approximately $75,000 in cash and executed a two-year promissory note for the
balance of $240,000, maturing in May 2004 and bearing interest at the prime
rate. This will not have an impact on the Company's current operations as this
contingency had been previously accrued in the Company's consolidated financial
statements.
Sales Office Expansion
In December 2001 and March 2002, the Company established sales offices in
California and Boston, respectively, in order to meet the Company's growing
demands. These new office locations allow SteelCloud to expand its customer base
and to develop and deploy new products for its customers to promote future
revenue growth.
Impairment of Goodwill and Other Assets
In fiscal 2002, the Company evaluated its acquired goodwill for possible
permanent impairment. Upon completion of the examination, the Company recorded
an impairment charge of approximately $132,000 related to its remaining goodwill
acquired in the purchase of International Data Products ("IDP"). In addition,
the Company recorded an impairment charge of approximately $165,000 related to
its goodwill acquired in the purchase of Puerto Rico Industrial Manufacturing
Operations ("PRIMO").
During fiscal 2002, the Company became aware of factors that indicated its
investment in Worldwide Internet Solutions Network, Inc. ("WIZnet") was
permanently impaired. Accordingly, the Company recorded a $150,000 charge to
reduce the investment value in WIZnet to $0.
All of these charges are recorded in the Company results for the year ended
October 31, 2002.
12
Fiscal 1999 Termination of a Significant Contract
On July 31, 1998, the Company received notice from the SBA that it was denying
the request of the U.S. Air Force to waive the requirement to terminate IDP's
Desktop V contract for the convenience of the Government upon the change in
control of IDP to the Company. The Company appealed the denial of the SBA to the
SBA's Office of Hearings and Appeals. On August 31, 1999, the SBA denied the
appeal and ruled that the U.S. Air Force must terminate-for-convenience the
Desktop V contract. On May 1, 1999, prior to the SBA ruling, the U.S. Air Force
determined not to exercise any of the remaining option years under the Desktop V
contract and terminated the contract for all participating vendors. Initially
awarded to IDP, the Desktop V contract was the Company's largest contract.
Management believed at the date of the IDP acquisition, the contract would be
renewed by the government through fiscal year 2003 and would generate over $100
million in revenues during that period. As a result of the termination of this
contract, the recoverability of the Company's goodwill associated with the IDP
acquisition was significantly impaired. Accordingly, management recorded an
impairment charge of approximately $21 million during fiscal 1999.
In October 1999, the U.S. Air Force issued a termination-for-convenience letter
to the Company. Under a termination-for-convenience, the government is required
generally to reimburse a contractor for all costs incurred in the performance of
the contract. The Company is in the process of attempting to recover from the
government a portion or all of unreimbursed costs associated with the Desktop V
Contract.
Critical Accounting Policies
The Company believes the following represent its critical accounting policies:
Revenue Recognition
The Company recognizes revenue in accordance with SEC Staff Accounting Bulletin
No. 101, Revenue Recognition in Financial Statements (SAB 101), as amended by
SAB 101A and 101B. SAB 101 requires that four basic criteria must be met before
revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2)
delivery has occurred or services rendered; (3) the fee is fixed and
determinable: and (4) collectibility is reasonably assured. Determination of
criteria (3) and (4) are based on management's judgments regarding the fixed
nature of the fee charged for services rendered and products delivered and the
collectibility of those fees. Should changes in conditions cause management to
determine these criteria are not met for certain future transactions, revenue
recognized for any reporting period could be adversely affected.
Hardware products sold are generally covered by a warranty for periods ranging
from one to three years. The Company accrues a warranty reserve for estimated
costs to provide warranty services. The Company's estimate of costs to service
its warranty obligations is based on historical experience and expectation of
future conditions. To the extent the Company experiences increased warranty
claim activity or increased costs associated with servicing those claims, its
warranty accrual will increase resulting in decreased gross profit.
For technology support services under time and material contracts, the Company
recognizes revenue as services are provided based on contracted rates and
materials are delivered.
13
Impairment of Goodwill and Other Assets
We periodically evaluate acquired businesses for potential impairment
indicators. Our judgments regarding the existence of impairment indicators are
based on legal factors, market conditions and operational performance of our
acquired businesses. Future events could cause us to conclude that impairment
indicators exist and that goodwill associated with our acquired businesses is
impaired. Any resulting impairment loss could have a material adverse impact on
our financial condition and results of operations. As previously mentioned, the
Company recorded impairment charges of approximately $297,000 in fiscal 2002
related to its goodwill and other assets.
Accounting for Income Taxes
The Company accounts for income taxes using the liability method. In doing so,
the future tax consequences of temporary differences and net operating losses
result in deferred tax assets and liabilities, subject to a valuation allowance
against deferred tax assets when realization is uncertain. As of October 31,
2002, the Company has recorded a valuation allowance of approximately $4.0
million against the total deferred tax asset of $4.4 million, based upon its
evaluation of future estimates of taxable income. The Company's evaluation
included consideration of historical earnings (excluding non-recurring charges)
as well as projected near-term earnings based on its backlog, customer
relationships and operating environment.
Results of Operations
The following table sets forth for the fiscal years ended October 31, 1998,
1999, 2000, 2001 and 2002, certain income and expense items of SteelCloud as a
percentage of net revenues.
1998 1999 2000 2001 2002
--------------------------------------------------------
Net revenues......................................... 100.00% 100.00% 100.00% 100.00% 100.00%
Costs of revenues.................................... 79.64% 80.08% 77.66% 75.25% 76.01%
Gross profit......................................... 20.36% 19.93% 22.34% 24.75% 23.99%
Selling, general and administrative and amortization. 16.40% 125.43% 24.48% 19.68% 22.23%
Income (loss) from operations........................ 3.96% (105.51)% (2.14)% 5.08% 1.76%
Other (expense) income............................... (0.55)% (10.12)% (0.55)% (0.71)% (0.76)%
Income (loss) before income taxes.................... 3.41% (115.62)% (2.69)% 4.36% 1.00%
Provision for (benefit from) income taxes............ 1.32% (1.94)% 0.29% 0.40% (0.96)%
Income (loss) from discontinued operations........... (0.21%) (3.21%) 3.20% (0.03)% (5.78)%
Net income (loss) to common stockholders............. 1.88% (116.90)% 0.78% 4.06% (3.82)%
14
Fiscal Year Ended October 31, 2002 Compared to Fiscal Year Ended October 31,
2001
Net revenues of SteelCloud for fiscal year ended October 31, 2002 ("fiscal
2002") increased approximately 13% to $29.2 million from $25.8 million for
fiscal year ended October 31, 2001 ("fiscal 2001"). The increase was due to the
commencement of a significant contract with Lockheed Martin in January 2002. The
Company recognized approximately $2.5 million under the $10.5 million contract.
The Company anticipates completion of this contract in July 2003; however, the
Company is discussing other contracts with this customer, which could result in
additional orders. No assurances can be given that such discussions will result
in follow-on orders from this customer. As of October 31, 2002, the Company had
unearned revenue of approximately $4.5 million, which primarily consisted of
goods associated with the Lockheed Martin contract for which the Company has
received milestone payments. In addition, the Company experienced growth in its
OEM sales, consulting services sales and Federal Government sales in fiscal 2002
as a result of its focus on those markets. During Fiscal 2002, the Company
derived approximately 64% of its revenues from two customers.
During fiscal 2002, the Company's revenues from its reselling activities
increased to approximately $2.4 million from approximately $2.1 million in
fiscal 2001. The increase is a result of the Company's continued partnerships
with certain software companies.
Gross profit for fiscal 2002 increased by approximately 10% to approximately
$7.0 million from $6.4 million in fiscal 2001. The increase was the result of
the Company's revenue growth as both sales and gross profit had double digit
increases in fiscal 2002. Gross profit as a percentage of net revenues during
the same periods slightly decreased to 24.0% from 24.8%, which was the result of
a downward economy and the Company's effort to be more aggressive in its
margins. In addition, gross margin in fiscal 2002 was negatively impacted by
$526,000 for inventory obsolescence and shrinkage.
Selling and marketing expense significantly increased in fiscal 2002 by 64% to
approximately $1.2 million from approximately $725,000 for fiscal 2001. During
fiscal 2002, the Company opened regional sales offices in California and
Massachusetts in its efforts to expand markets and produce revenue growth.
Selling and marketing expense as a percentage of net revenues, increased 1% in
fiscal 2002 to 4% from 3% in fiscal 2001.
General and administrative expense for fiscal 2002 increased 21% to $4.8 million
from $4.0 million for fiscal 2001. As a percentage of net revenues, general and
administrative expense slightly increased to 16% for fiscal 2002 from 15% for
fiscal 2001. This increased was a result of the Company's revenue growth in
fiscal 2002. In addition, fiscal 2001 general and administrative expenses were
significantly reduced as the Company settled certain liabilities for amounts
less than previously recorded. Accordingly, all previously recorded accruals
were reversed as the result of the settlement, which reduced general and
administrative expenses. The Company will continue to manage general and
administrative costs relative to its net revenue and gross margin.
In fiscal 2002 the Company recorded an impairment charge of approximately
$132,000 related to its remaining goodwill of International Data Products
("IDP") as the Company had determined that it was permanently impaired. The
remaining goodwill related to certain contracts, which had matured/expired in
fiscal 2002. In addition, the Company recorded an impairment charge of
approximately $165,000 related to its goodwill acquired in the purchase of
Puerto Rico Industrial Manufacturing Operations ("PRIMO") as that operation was
discontinued in October 2002. The impairment charge for PRIMO goodwill was
included in discontinued operations.
Other expense, including interest, for fiscal 2002 increased to approximately
$222,000 from approximately $184,000 for fiscal 2001. Interest expense, net
decreased by approximately 54% to $73,000 in fiscal 2002 from $158,000 in fiscal
2001. This was a result of the Company's significant reduction in its
outstanding debt as well as a continual decline in short-term borrowing rates
throughout fiscal 2002. In fiscal 2002, the Company recorded a one-time charge
of $150,000, to reflect the permanent decline in market value for its investment
in WIZnet, a private entity, based on its current year performance.
15
Net income available to common shareholders decreased approximately 207% in
fiscal 2002 to $(1,115,186) from $1,047,041 in fiscal 2001. Included in net
income is approximately $279,800 of income tax benefit. The Company currently
has approximately $11 million in Net Operating Loss ("NOL") carryforwards, which
may be used to offset future income. The $11 million deferred tax asset was
fully reserved prior to October 31, 2002. As of October 31, 2002, a deferred tax
asset of $400,000 was recognized based on fiscal 2003 estimated taxable income
for which it may offset. A portion of the resulting tax benefit associated with
the tax deductions relating to stock options exercised was credited to
stockholders equity. Approximately $10.6 million of NOLs remain fully reserved
as of October 31, 2002. This reserve will be released in future periods as the
Company continues to generate taxable income for which the asset will be used to
offset.
Fiscal 2001 net income available to common shareholders includes certain
one-time and non-recurring increases to income available to common stockholders
of $721,816 relating to the Series A Convertible Preferred Stock private
placement with Briarcliff Investors LLC, which closed in March 2000 and the
redemption of those preferred shares in August 2001 for $2.5 million. Net income
available to common shareholders is also comprised of the accumulating 5%
dividends on the Series A Convertible Preferred Stock for the period those
shares were outstanding.
Fiscal Year Ended October 31, 2001 Compared to Fiscal Year Ended October 31,
2000
Net revenues of SteelCloud for fiscal year ended October 31, 2001 ("fiscal
2001") increased approximately 15% to $25.8 million from $22.5 million for
fiscal year ended October 31, 2000 ("fiscal 2000"). The increase was primarily
due to Company's growth with their OEM arrangements, consulting services and
server appliance sales. The Company began its focus on the OEM and server
appliance market in fiscal 2001. During Fiscal 2001, the Company derived
approximately 51% of its revenues from three customers.
During fiscal 2001, the Company's revenues from its reselling activities
increased to approximately $2.1 million from approximately $176,000 in fiscal
2000. The increase is a result of the Company's partnerships with certain
software companies.
Gross profit for fiscal 2001 increased by approximately 27% to $6.4 million from
$5.0 million. The increase is the result of the Company's successful efforts in
developing and deploying customized server appliances to the commercial
marketplace. Gross profit as a percentage of net revenues during the same
periods increased to 24.8% from 22.3%.
Selling and marketing expense significantly decreased for fiscal 2001 by 28% to
approximately $724,000 from approximately $1.0 million for fiscal 2000. During
fiscal 2001, the Company continued to reduce its expensive marketing programs
and increased its marketing efforts through the use of cooperative marketing
dollars, which contributed to the overall decrease. In addition, the Company's
OEM business strategy relies more heavily on combined sales and marketing
efforts by the Company and the software and technology partner.
General and administrative expense for fiscal 2001 decreased 4% to approximately
$4.0 million from approximately $4.1 million for fiscal 2000. As a percentage of
net revenues, general and administrative expense slightly decreased to 15.3% for
fiscal 2001 from 18.3% for fiscal 2000. The decrease from fiscal 2000 resulted
primarily from the Company's efforts to manage general and administrative costs
relative to its net revenue and gross margin.
16
Other expense, including interest, for fiscal 2001 increased to approximately
$184,000 from approximately $124,000 for fiscal 2000. This was the result a
continual decrease in the short-term borrowing rates throughout fiscal 2001
offset by gains of $228,000 recognized on the sale of assets.
Cumulative Effect of Accounting Change. During 2001, the Company implemented
Emerging Issues Task Force Issue No. 00-27, Application of EITF Issue No. 98-5,
"Accounting for Convertible Securities with Beneficial Conversion Features or
Contingently Adjustable Conversion Ratios," to Certain Convertible Instruments
(EITF 00-27). Issue 1 of EITF 00-27 modified the calculation of beneficial
conversion feature discounts for convertible securities issued with detachable
instruments for all transactions subject to EITF Issue No. 98-5. As a result of
implementation of EITF 00-27, the beneficial conversion feature discount
associated with the Company's Series A Convertible Preferred Stock increased by
$576,001. This non-cash item has been recorded by the Company as a cumulative
effect of a change in accounting principle in accordance with EITF 00-27.
Net income available to common shareholders includes certain one-time and
non-recurring increases to income available to common stockholders of $721,816
relating to the Series A Convertible Preferred Stock private placement with
Briarcliff Investors LLC, which closed in March 2000 and the redemption of those
preferred shares in August 2001 for $2.5 million. Net income available to common
shareholders is also comprised of the accumulating 5% dividends on the Series A
Convertible Preferred Stock for the period those shares were outstanding. For
fiscal 2000, dividends to preferred stockholders included a non-cash deemed
dividend of $529,411 for the beneficial conversion feature discount associated
with the private placement of the preferred stock and $95,417 for the 5%
dividend on the convertible preferred stock for the period those shares were
outstanding. Net income available to common shareholders increased approximately
495% to $1,047,041 in fiscal 2001 from $175,837 in fiscal 2000. The increase is
attributable to the growth in gross margins, which resulted from the Company
moving away from its low margin legacy business and increasing its focus on the
customized server appliance market. In addition, the Company has managed its
selling, general and administrative costs relative to its net revenues and gross
margin thereby increasing net income in fiscal 2001.
Liquidity and Capital Resources
In fiscal 2002, the Company generated approximately $5.6 million in cash flow
from continuing operations. The Company generated cash from the collection of
income tax receivables of approximately $1.3 million and the increase in its
cash collected relating to unearned revenue of approximately $4.3 million. The
cash generated was used to reduce accounts payable by approximately $454,000,
accrued expenses by approximately $53,000 and payment of contract costs incurred
but not recognized of approximately $2.0 million. The Company generally attempts
to structure its customer sales and collection terms to minimize its dependency
on outside financing of accounts receivable and material purchases. The
Company's investing activities consisted of the purchases of approximately
$704,000 for property and equipment, primarily for lease transactions with its
customers.
The Company's financing activities during fiscal 2002 were provided by the
Company's bank line of credit with First Union/Wachovia Bank. The line of credit
expires on March 31, 2003 and currently bears interest at the lower of (a) prime
or (b) the LIBOR Market Index Rate plus two and one-half percent. As of December
31, 2002, the Company had an outstanding balance on the line of credit of
approximately $0 and available borrowing capacity of approximately $2.8 million.
For the quarter ended October 31, 2002, the Company was not in compliance with
one of its financial covenants. On January 21, 2002, the Company's bank issued a
waiver to allow the Company to continue borrowing as needed on its line of
credit.
In February 2002, the Company executed a promissory note in conjunction with
their line of credit in the amount of $725,000. The note bears interest at the
lower of (a) the Lender's Prime Rate per annum or (b) the LIBOR Market Index
Rate plus 2.5% and matures in July 5, 2003. The Company makes monthly principal
payments of approximately $43,000. The outstanding balance on the promissory
note at December 31, 2002 was approximately $299,000.
17
In fiscal 2002, the Company received proceeds from the exercise of stock options
of approximately $273,000. Approximately 228,000 shares of common stock were
issued upon the exercise of these stock options. The Company recorded $119,000
of income tax expense associated with the benefit received for the stock option
exercises.
In fiscal 1999, SteelCloud's subsidiary, IDP, had borrowing agreements with
Deutsche Financial Services (DFS) for an aggregate of $25 million. The
outstanding balance as of October 31, 1999 was approximately $4.7 million. In
fiscal 2000, the Company executed an agreement terminating the borrowing
arrangement whereby $3.25 million was repaid to DFS prior to December 31, 1999.
Of the remaining outstanding balance, approximately $832,000 was converted to a
24-month note accruing interest at the prime rate and $750,000 was forgiven by
DFS. The Company recorded the $750,000 as an extraordinary gain on the early
extinguishment of debt in fiscal 2000.
As of October 31, 2002, the Company had working capital of approximately $3.9
million. The Company believes the bank facility, together with cash on hand,
projected cash generated from operations and income tax refunds due will provide
sufficient financial resources to finance the current operations of the Company
through fiscal 2003.
The Company has obligations under its operating lease commitments of
approximately $578,000 for fiscal 2003. In addition, the Company will receive
approximately $328,000 in rental income, which will be used to offset its lease
commitments.
From time to time, the Company may pursue strategic acquisitions or mergers
which may require significant additional capital. In such event, the Company may
seek additional financing of debt and/or equity.
OFF-BALANCE SHEET ARRANGEMENTS
Contractual Obligations and Commercial Commitments
The Company's significant contractual obligations as of October 31, 2002 are for
debt and operating leases. Debt by year of maturity and future rental payments
under operating lease agreements are presented below. As of October 31, 2002,
the Company does not have an outstanding balance on its line of credit and does
not have any purchase obligations. The Company has not engaged in off-balance
sheet financing, commodity contract trading or significant related party
transactions.
- --------------------------- ------------ ------------ ----------- ---------- ---------
Contractual Obligations Payments Due by Period
- --------------------------- ------------ ------------ ----------- ---------- ---------
Total Less than 1 1-3 years 4-5 years After 5
year years
- --------------------------- ------------ ------------ ----------- ---------- ---------
Notes payable - current $ 503,824 $ 503,824 - - -
Notes payable - long term 60,000 - 60,000 - -
Operating lease 1,033,365 578,263 455,102 - -
- --------------------------- ------------ ------------ ----------- ---------- ---------
The Company will receive $327,947 in aggregate sublease income through fiscal
2003.
18
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to market risk related to fluctuations in interest rates
on its debt. Increase in prevailing interest rates could increase the Company's
interest payment obligations relating to variable rate debt. For example, a 100
basis point increase in interest rates would increase annual interest expense by
$38,000.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Financial Statements of SteelCloud, Inc.
Page
-----
Report of Grant Thornton LLP, Independent Auditors.............. F-1
Report of Ernst & Young LLP, Independent Auditors............... F-2
Consolidated Balance Sheets..................................... F-3
Consolidated Statements of Operations........................... F-4
Consolidated Statements of Stockholders' Equity................. F-5
Consolidated Statements of Cash Flows........................... F-6
Notes to the Consolidated Financial Statements.................. F-7
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL ISSUES
On October 10, 2002, SteelCloud, Inc. (the "Company") dismissed Ernst & Young
LLP ("E&Y") as its independent certified public accountants. During the fiscal
years ended October 31, 2001 and 2000 the reports by Ernst & Young LLP on the
financial statements of the Company did not contain an adverse opinion or a
disclaimer of opinion, or was qualified or modified as to uncertainty, audit
scope, or accounting principles. During the Company's two most recent fiscal
years and subsequent period up to October 10, 2002, there were no disagreements
with the former accountant on any matter of accounting principles or practices,
financial statement disclosure, or auditing scope or procedure, which
disagreements if not resolved to their satisfaction would have caused them to
make reference in connection with their opinion to the subject matter of the
disagreement, other than the matter discussed below.
As discussed on the Company's quarterly financial conference call held on June
6, 2002, during the quarter ended April 30, 2002, the Company and Ernst & Young
LLP had a difference of opinion with respect to revenue recognition relating to
a contractual arrangement between the Company and one of its customers for the
delivery of assembled computer units. The arrangement provides the customer with
the ability to order and pay for certain components to be included in the units
prior to delivery of the completed units. Ernst & Young LLP concluded that the
payments received from the customer relating to such components should be
deferred and recognized as revenue concurrent with the delivery of the completed
units as delivery of the components had not yet occurred, and there remained
services to be rendered and obligations to be satisfied. Ernst & Young LLP
discussed this matter with members of the Audit Committee and members of the
Board of Directors. After management discussed Ernst & Young LLP's opinion with
members of the Company's Audit Committee, the Company accepted Ernst & Young
LLP's opinion and adopted the accounting treatment suggested by Ernst & Young
LLP with respect to revenue recognition in connection with this matter and does
not continue to have a difference of opinion with Ernst & Young with respect to
this matter.
On October 11, 2002, upon receipt of approval of the Audit Committee of the
Company's Board of Directors, the Company engaged Grant Thornton LLP to serve as
the Company's independent certified public accountants. During the Company's two
most recent fiscal years, and during any subsequent period through October 11,
2002, the Company did not consult with Grant Thornton LLP on any accounting or
auditing issues.
The Company has authorized Ernst & Young LLP to respond fully to any
inquiries of Grant Thornton LLP concerning the subject matter discussed above.
19
PART III
The Notice and Proxy Statement for the 2001 Annual Meeting of Stockholders to be
filed pursuant to Regulation 14A under the Securities and Exchange Act of 1934,
as amended, which is incorporated by reference in this Annual Report on Form
10-K pursuant to General Instruction G (3) of Form 10-K, will provide the
information required under Part III, including Item 10 (directors and executive
officers of the Company), Item 11 (Executive Compensation), Item 12 (security
ownership of certain beneficial owners and management), and Item 13 (certain
relationships and related transactions), which will be filed within 120 days
after the end of the fiscal year covered by this Form 10-K.
ITEM 14. Controls and Procedures
Within the 90 days prior to the date of this report, the Company carried out an
evaluation, under the supervision and with the participation of the Company's
management, including the Company's Chief Executive Officer and Chief Financial
Officer, of the effectiveness of the design and operation of the Company's
disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based
upon that evaluation, the Chief Executive Officer and Chief Financial Officer
concluded that the Company's disclosure controls and procedures are effective.
There were no significant changes in the Company's internal controls or in other
factors that could significantly affect these controls subsequent to the date of
their evaluation.
ITEM 15. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report
1. Financial Statements
SteelCloud, Inc.
Report of Grant Thornton LLP, Independent Auditors
Report of Ernst & Young LLP, Independent Auditors
Consolidated Balance Sheets as of October 31, 2001 and 2002
Consolidated Statements of Operations for the three years
ended October 31, 2002
Consolidated Statements of Stockholders' Equity for the three
years ended October 31, 2002
Consolidated Statements of Cash Flows for the three years
ended October 31, 2002
Notes to Consolidated Financial Statements
2. Financial Statement Schedules
Schedule II Valuation and Qualifying Accounts
Statements not listed above have been omitted because they are not
applicable or the information required to be set forth therein is included in
the Consolidated Financial Statements or the notes thereto under Item 8.
3. Exhibits.
Exhibit
Number Description
- ---------- ------------
3.1 Articles of Incorporation of the Company, dated February 25, 1998,
and effective as of February 26, 1998. (Filed as Exhibit 3.1 to the
Company's Registration Statement on Form S-1, Amendment No. 1, dated
April 23, 1998 (File No. 333-47631) and hereby incorporated by
reference.)
3.2 By-laws of the Company, effective as of March 5, 1998. (Filed as
Exhibit 3.2 to the Company's Registration Statement on Form S-1,
Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and
hereby incorporated by reference.)
4.1 Specimen common stock certificate for the Company. (Filed as Exhibit
4.1 to the Company's Registration Statement on Form S-1, Amendment
No. 2, dated April 23, 1998 (File No. 333-47631) and hereby
incorporated by reference.)
10.8 Employment Agreement by and between Dunn and Thomas P. Dunne (Filed
as Exhibit 99.2 to Dunn's Registration Statement on Form SB-2,
Amendment 2, dated April 4, 1997 (File No. 333-19635) and hereby
incorporated by reference).
20
10.10 Deed of Lease, dated February 7, 1997, between APA Properties No. 6
L.P. and STMS, Inc. and First Amendment thereto, dated July 23, 1997
(Filed as Exhibit 10.10 to Dunn's Form 10-KSB, dated January 30,
1998 (File No. 0-22263) and hereby incorporated by reference).
10.11 1997 Stock Option Plan, as amended. (Filed as Exhibit 10.11 to the
Company's Registration Statement on Form S-1, Amendment No. 2, dated
April 23, 1998 (File No. 333-47631) and hereby incorporated by
reference.)
10.13 Agreement, dated May 5, 1997, by and between International Data
Products, Corp. and the U.S. Air Force, the Desktop V Contract.
(Filed as Exhibit 10.13 to the Company's Registration Statement on
Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631)
and hereby incorporated by reference.)
10.16 Deed of Lease, dated July 15, 1994, between Puerto Rico Industrial
Development Company and Puerto Rico Industrial Manufacturing
Operations, Corp. (Filed as Exhibit 10.16 to the Company's
Registration Statement on Form S-1, Amendment No. 2, dated April 23,
1998 (File No. 333-47631) and hereby incorporated by reference.)
10.22 Employee Stock Purchase Plan.
10.25 Termination agreement, Promissory Note, dated December 29, 1999 by
and between Dunn and Deutsche Financial Services.
10.26 Loan and Security Agreement, dated May 27, 1999 by and between Dunn
and First Union Commercial Corporation.
10.27 Modification Agreement dated February 11, 2000 by and between Dunn
and First Union National Bank.
10.29 Modification Agreement dated January 18, 2002 by and between
SteelCloud, Inc. and First Union National Bank.
*11.1 Statement of Computation of Earnings Per Share.
*21.1 List of Subsidiaries.
*23.1 Consent of Grant Thornton LLP, Independent Auditors.
*23.2 Consent of Ernst & Young LLP, Independent Auditors.
*99.1 Certification of CEO pursuant to section 906 of the Sarbanes - Oxley
Act of 2002
*99.2 Certification of CFO pursuant to section 906 of the Sarbanes - Oxley
Act of 2002
- -----------
* Filed herewith
(b) Reports on Form 8-K
On October 17, 2002, the Company filed a report on Form 8-K pursuant to
Item 4 change in Registrants Certifying Accountants.
21
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
STEELCLOUD, INC.
Date: January 29, 2003 By:
/s/ Thomas P. Dunne
-----------------------
Thomas P. Dunne
Chief Executive Officer
Pursuant to and in accordance with the requirements of the Securities
Exchange Act of 1934, this report has been signed by the following persons on
behalf of the registrant and in the capacities and on the dates indicated.
Name Title Date
---- ----- ----
/s/ Thomas P. Dunne
- ---------------------------------
Thomas P. Dunne Chief Executive Officer and Director January /29/, 2003
/s/ Edward Spear
- ---------------------------------
Edward Spear President, Chief Operating Officer and January /29/, 2003
Director
/s/ Kevin Murphy
- ---------------------------------
Kevin Murphy Vice President, Finance January /29/, 2003
- ---------------------------------
VADM E. A. Burkhalter USN (Ret.) Director January /29/, 2003
- ---------------------------------
James Bruno Director January /29/, 2003
/s/ Jay Kaplowitz
- ---------------------------------
Jay Kaplowitz Director January /29/, 2003
/s/ Benjamin Kreiger
- ---------------------------------
Benjamin Kreiger Director January /29/, 2003
/s/ Richard Prins
- ---------------------------------
Richard Prins Director January /29/, 2003
22
CERTIFICATION BY THOMAS DUNNE PURSUANT TO
SECURITIES EXCHANGE ACT RULE 13A-14
I, Thomas Dunne, certify that:
1. I have reviewed this annual report on Form 10-K of SteelCloud;
2. Based on my knowledge, this annual 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 annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this annual
report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: January 29, 2003
------------------------
/s/ Thomas P. Dunne
-----------------------------------
Chief Executive Officer and Director
23
CERTIFICATION BY EDWARD SPEAR PURSUANT TO
SECURITIES EXCHANGE ACT RULE 13A-14
I, Edward Spear, certify that:
1. I have reviewed this annual report on Form 10-K of SteelCloud;
2. Based on my knowledge, this annual 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 annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this annual
report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: January 29, 2003
------------------------
/s/ Edward Spear
-----------------------------------
President, Chief Operating Officer
and Director
24
CERTIFICATION BY KEVIN MURPHY PURSUANT TO
SECURITIES EXCHANGE ACT RULE 13A-14
I, Kevin Murphy, certify that:
1. I have reviewed this annual report on Form 10-K of SteelCloud;
2. Based on my knowledge, this annual 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 annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this annual
report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: January 29, 2003
------------------------
/s/ Kevin Murphy
-----------------------------------
Vice President, Finance
25
Index to Financial Statements
SteelCloud, Inc (a Virginia Corporation)
Report of Grant Thornton LLP, Independent Auditors......................................................... F-1
Report of Ernst & Young LLP, Independent Auditors.......................................................... F-2
Consolidated Balance Sheets as of October 31, 2001 and 2002................................................ F-3
Consolidated Statements of Operations for the three years ended October 31, 2002........................... F-4
Consolidated Statements of Stockholders' Equity for the three years ended October 31, 2002................. F-5
Consolidated Statements of Cash Flows for the three years ended October 31, 2002........................... F-6
Notes to Consolidated Financial Statements................................................................. F-7
26
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders
SteelCloud, Inc.
We have audited the accompanying consolidated balance sheet of SteelCloud, Inc.
as of October 31, 2002, and the related consolidated statement of operations,
stockholders' equity, and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.
We conducted our audit in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of SteelCloud, Inc. as of October
31, 2002, and the results of its operations and its cash flows for the year then
ended in conformity with accounting principles generally accepted in the United
States of America.
As described in Note 3, the financial statements have been restated to reflect
discontinued operations. We audited the adjustments described in Note 3 that
were applied to restate the 2000 and 2001 financial statements. In our opinion,
such adjustments are appropriate and have been properly applied. However, we
were not engaged to audit, review, or apply any procedures to the 2000 and 2001
financial statements of the Company other than with respect to such adjustments
and, accordingly, we do not express an opinion or any other form of assurance on
the 2000 and 2001 financial statements taken as a whole.
/s/ Grant Thornton LLP
Vienna, VA
January 14, 2003
F-1
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
Board of Directors
SteelCloud, Inc.
We have audited the accompanying consolidated balance sheet of
SteelCloud, Inc. (a Virginia Corporation) as of October 31, 2001, and the
related consolidated statements of operations, stockholders' equity and cash
flows for each of the two years in the period ended October 31, 2001 prior to
restatement for the discontinued operations described in Note 3. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the consolidated
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the consolidated financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
SteelCloud, Inc. as of October 31, 2001, and the consolidated results of its
operations and its cash flows for each of the two years in the period ended
October 31, 2001, in conformity with accounting principles generally accepted in
the United States.
As discussed in Note 2 of the Notes to the Consolidated Financial
Statements, in 2001 the Company changed its method of accounting for convertible
securities with beneficial conversion features.
/s/ ERNST & YOUNG LLP
December 21, 2001
McLean, Virginia
F-2
STEELCLOUD, INC.
CONSOLIDATED BALANCE SHEETS
OCTOBER 31,
----------------------------
2001 2002
------------ ------------
ASSETS
Current assets:
Cash and cash equivalents ................................... $ 282,318 $ 751,323
Accounts receivable, net of allowance
for doubtful accounts of $100,000 and
$293,000 as of October 31, 2001 and 2002 respectively ..... 5,657,093 6,082,340
Inventory, net of reserves of $1,087,906 and $1,038,020 as of
October 31, 2001 and 2002, respectively ................... 4,298,270 4,180,812
Deferred tax asset .......................................... -- 400,000
Income tax receivable ....................................... 1,400,424 55,392
Prepaid expenses and other current assets ................... 153,998 208,892
Deferred contract costs ..................................... -- 2,039,339
Assets held for sale ........................................ 1,456,785 953,320
------------ ------------
Total current assets ........................................... 13,248,888 14,671,418
Property and equipment, net .................................... 266,381 304,081
Equipment on lease, net ........................................ 597,202 574,272
Goodwill and other intangible assets, net ...................... 2,770,572 1,778,059
Investments .................................................... 150,000 --
Other assets ................................................... 101,504 304,922
------------ ------------
Total assets ................................................... $ 17,134,547 $ 17,632,752
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ............................................ $ 3,166,421 $ 3,620,580
Accrued expenses ............................................ 1,728,815 1,542,277
Notes payable, current portion .............................. 114,564 503,823
Liabilities held for sale ................................... 676,208 641,145
Unearned revenue ............................................ 213,385 4,507,859
------------ ------------
Total current liabilities ...................................... 5,899,393 10,815,684
Notes payable, long-term portion ............................... -- 60,000
Line of credit, long term ...................................... 3,836,754 --
Stockholders' equity:
Common stock, $.001 par value; 50,000,000 shares
authorized, 10,214,545 and 10,447,611 shares
issued and outstanding at October 31, 2001
and 2002, respectively ....................................... 10,215 10,448
Additional paid-in capital ..................................... 39,079,397 39,553,017
Treasury stock, 400,000 shares at October 31, 2001
and 2002, respectively ....................................... (3,432,500) (3,432,500)
Accumulated deficit ............................................ (28,258,712) (29,373,897)
------------ ------------
Total stockholders' equity ..................................... 7,398,400 6,757,068
------------ ------------
Total liabilities and stockholders' equity ..................... $ 17,134,547 $ 17,632,752
============ ============
See accompanying notes.
F-3
STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED OCTOBER 31,
--------------------------------------------
2000 2001 2002
------------ ------------ ------------
Net revenues ......................................... $ 22,508,713 $ 25,791,082 $ 29,157,368
Costs of revenues .................................... 17,480,750 19,406,836 22,163,435
------------ ------------ ------------
Gross profit ......................................... 5,027,963 6,384,246 6,993,933
Selling and marketing ................................ 1,002,620 724,337 1,184,406
General and administrative ........................... 4,113,134 3,956,293 4,769,552
Impairment of goodwill ............................... -- -- 132,644
Amortization of goodwill ............................. 394,216 394,216 394,216
------------ ------------ ------------
(Loss) income from operations ........................ (482,007) 1,309,400 513,115
Other income (expense):
Interest income ................................... 34,276 87,961 5,525
Interest expense .................................. (479,305) (245,532) (78,734)
Gain on sale of assets ............................ 228,062 -- --
Other, net ........................................ 93,354 (26,396) (149,183)
------------ ------------ ------------
(Loss) income from continuing
operations before income tax ....................... (605,620) 1,125,433 290,723
Provision for (benefit from) income taxes ............ 65,000 102,276 (279,800)
------------ ------------ ------------
(Loss) income from continuing operations ............. (670,620) 1,023,157 570,523
Gain (loss) from discontinued operations, net of tax . 721,285 (9,431) (1,685,708)
------------ ------------ ------------
Income (loss) before extraordinary gain and cumulative
effect of accounting change ........................ $ 50,665 $ 1,013,726 $ (1,115,185)
Extraordinary gain - early extinguishment of debt .... 750,000 -- --
Cumulative effect of change in accounting principle .. -- (576,001) --
------------ ------------ ------------
Net income (loss) .................................... $ 800,665 $ 437,725 $ (1,115,185)
Dividends to preferred stockholders .................. (624,828) (112,500) --
Increase to income available to common stockholders
from repurchase of preferred stock .............. -- 721,816 --
------------ ------------ ------------
Net (loss) income available to common stockholders ... $ 175,837 $ 1,047,041 $ (1,115,185)
============ ============ ============
Earnings (loss) per share, basic
Earnings (loss) from continuing operations ........... $ (0.14) $ 0.10 $ 0.06
Discontinued operations .............................. 0.08 -- (0.17)
Extraordinary gain ................................... 0.08 -- --
------------ ------------ ------------
Net earnings (loss) per share ........................ $ 0.02 $ 0.10 $ (0.11)
============ ============ ============
Earnings (loss) per share, fully diluted
Earnings (loss) from continuing operations ........... $ (0.14) $ 0.08 $ 0.05
Discontinued operations .............................. 0.08 -- (0.15)
Extraordinary gain ................................... 0.08 -- --
------------ ------------ ------------
Net earnings (loss) per share ........................ $ 0.02 $ 0.08 $ (0.10)
============ ============ ============
Pro forma amounts assuming the
accounting change is applied retroactively:
Net income (loss) to common stockholders ............. $ (400,164) $ 1,623,042 $ (1,115,185)
============ ============ ============
Net earnings (loss) per share, basic ................. $ (0.04) $ 0.16 $ (0.11)
============ ============ ============
Net earnings (loss) per share, fully diluted ......... $ (0.04) $ 0.08 $ (0.10)
============ ============ ============
See accompanying notes.
F-4
STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Retained
Additional Earnings
Preferred Stock Common Stock Paid-In Treasury (Accumulated
Shares Amount Shares Amount Capital Stock Deficit) Total
---------- ------ ------- ------ ---------- --------- ------------ ------
Balance at
October 31, 1999 ..... 9,419,509 9,420 37,721,749 (3,432,500) (29,481,590) 4,817,079
Issuance of Common
Stock in connection
with exercise of
employee incentive
stock option plan .... -- -- 4,900 5 15,308 -- -- 15,313
Issuance of Series A
Convertible
Preferred Stock ...... 3,000 3 -- -- 2,716,711 -- -- 2,716,714
Issuance of
Common Stock ......... -- -- 225,000 225 597,420 -- -- 597,645
Paid in Capital and
Deemed Dividend on
Preferred Stock ...... -- -- -- -- 529,411 -- (529,411) --
Conversion of
Series A
Convertible
Preferred Stock ...... (150) -- 153,150 153 (153) -- --
Conversion of
Preferred Stock
dividends to
shares of
Common Stock ......... -- -- 4,403 4 4,398 -- -- 4,402
Dividend Declared
on Series A
Convertible
Preferred Stock ...... (95,417) (95,417)
Net Income ........... -- -- -- -- -- -- 800,665 800,665
-----------------------------------------------------------------------------------------------------
Balance at
October 31, 2000 ..... 2,850 3 9,806,962 9,807 41,584,844 (3,432,500) (29,305,753) 8,856,401
Conversion of
Series A
Convertible
Preferred Stock ...... (230) -- 390,267 391 (391) -- -- --
Conversion of
Preferred Stock
dividends to
shares of
Common Stock ......... -- -- 17,316 17 10,019 -- -- 10,036
Dividend Declared
on Series A
Convertible
Preferred Stock ...... -- -- -- -- -- -- (112,500) (112,500)
Cumulative effect of
change in accounting
principle ............ -- -- -- -- 576,001 -- (576,001) --
Redemption of
preferred Stock ...... (2,620) (3) -- -- (3,091,076) -- 721,816 (2,369,263)
Net Income ........... -- -- -- -- -- -- 1,013,726 1,013,726
-----------------------------------------------------------------------------------------------------
Balance at
October 31, 2001 ..... 10,214,545 $10,215 $ 39,079,397 $ (3,432,500) $(28,258,712) $ 7,398,400
Issuance of common
stock in connection
with exercise of
employee incentive
stock option plan .... -- -- 227,826 228 272,465 -- -- 272,693
Issuance of common
stock for services ... -- -- 5,240 5 17,495 -- -- 17,500
Tax benefit associated
with exercise of
employee stock
options .............. -- -- -- -- 119,000 -- -- 119,000
Compensation expense
associated with the
issuance of stock
options .............. -- -- -- -- 64,660 -- -- 64,660
Net Income ........... -- -- -- -- -- -- (1,115,185) (1,115,185)
-----------------------------------------------------------------------------------------------------
Balance at
October 31, 2002 ..... 10,447,611 $10,448 $ 39,553,017 $ (3,432,500) $(29,373,897) $ 6,757,068
=====================================================================================================
See accompanying notes.
F-5
STEELCLOUD, INC
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED OCTOBER 31,
------------------------------------------
2000 2001 2002
----------- ----------- -----------
Operating activities
Net (loss) income .................................. $ 800,665 $ 437,725 $(1,115,185)
(Gain) on early extinguishments of debt ............ (750,000) -- --
Cumulative effect of change in
accounting principle.............................. -- 576,001 --
(Income) loss from discontinued operations, net..... (721,285) 9,431 1,685,708
----------- ----------- -----------
(Loss) income applicable from continuing
operations........................................ (670,620) 1,023,157 570,523
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Depreciation and amortization of property and
equipment...................................... 2,754,190 1,301,588 683,860
Amortization of goodwill and other intangibles... 394,216 394,216 394,216
Impairment of goodwill .......................... -- -- 132,644
Impairment charge - investment .................. -- -- 150,000
Provision for bad debt .......................... -- -- 161,030
(Gain) loss on sale of assets ................... (228,062) -- 4,196
(Gain) on settlement of litigation .............. (495,709) (343,087) --
Stock compensation expense ...................... -- -- 82,160
Changes in operating assets and liabilities:
Accounts receivable, net ...................... 1,459,048 (2,258,763) (586,275)
Income tax receivable ......................... 355,088 (1,169,743) 1,345,032
Inventory ..................................... 1,368,752 (267,972) 117,458
Prepaid expenses and other assets ............. (62,883) 38,236 41,688
Deferred contract costs ....................... -- -- (2,039,339)
Deferred tax asset (credit) ................... -- 1,282,695 (279,800)
Accounts payable .............................. (1,547,930) 600,954 454,159
Accrued expenses .............................. (1,563,912) 213,513 53,462
Unearned revenue and other liabilities ........ (956,772) 77,695 4,294,474
----------- ----------- -----------
Net cash provided by (used in) operating activities
of continuing operations ........................... 805,406 892,489 5,579,488
Investing activities
Purchases of property and equipment ................ (509,737) (518,956) (704,030)
Proceeds from sale of assets ....................... 784,838 -- --
----------- ----------- -----------
Net cash (used in) provided by investing activities 275,101 (518,956) (704,030)
Financing activities
Proceeds from issuance of preferred stock .......... 2,716,714 -- --
Payments made to redeem preferred stock ............ -- (2,562,739) --
Proceeds from exercise of common stock options ..... 15,313 -- 272,693
Proceeds on notes payable .......................... -- -- 725,000
Payments on notes payable .......................... (323,296) (430,022) (515,742)
Proceeds from (repayments on)
lines of credit, net ............................... (2,857,502) 1,353,551 (3,836,754)
----------- ----------- -----------
Net cash provided by (used in) financing ........... (448,771) (1,639,210) (3,354,803)
activities
Net increase (decrease) in cash and cash equivalents
of continuing operations............................ 631,736 (1,265,677) 1,520,655
Net cash (used in) provided by operating activities
of discontinued operations ......................... (910,620) 1,231,288 (1,051,650)
Cash and cash equivalents at beginning of year ..... 595,591 316,707 282,318
----------- ----------- -----------
Cash and cash equivalents at end of year ........... $ 316,707 $ 282,318 $ 751,323
=========== =========== ===========
Supplemental cash flow information
Interest paid ...................................... $ 654,329 $ 336,128 $ 129,287
----------- ----------- -----------
Income taxes paid .................................. $ 116,630 $ 185,210 $ 1,200
=========== =========== ===========
See accompanying notes
F-6
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
OCTOBER 31, 2000, 2001 AND 2002
1. Organization
Dunn Computer Corporation was incorporated on July 27, 1987 under the
laws of the Commonwealth of Virginia. On January 3, 1997, Dunn Computer
Corporation, a Delaware corporation, was formed as a holding company for the
stock of Dunn Computer Corporation, the Virginia corporation. On February 26,
1998, Dunn Computer Corporation was incorporated in Virginia in connection with
the reorganization of Dunn Computer Corporation, the Delaware Corporation. The
Company's subsidiaries are International Data Products ("IDP") acquired May
1998, STMS, Inc (STMS) acquired September 1997 and Puerto Rico Industrial
Manufacturing Operations Acquisition Corporation, (PRIMOA), incorporated in
Puerto Rico on May 1, 1998. Unless the context otherwise requires, the "Company"
or "Dunn Computer Corporation" refers to SteelCloud, its predecessor and its
subsidiaries.
On September 25, 2000 the Company began doing business as ("dba")
SteelCloud Company. On October 19, 2000, the Company changed its NASDAQ ticker
symbol from DNCC and began trading as SCLD.
On May 15, 2001, the shareholders approved an amendment to the
Company's articles of incorporation to change the corporate name from Dunn
Computer Corporation to SteelCloud, Inc. The name change became effective as of
July 30, 2001 pursuant to a certificate of amendment issued by the Virginia
State Corporation Commission.
On October 25, 2002, management, with the approval of the Board of
Directors, determined that its Puerto Rico Industrial Manufacturing Operation
("PRIMO") would no longer contribute to the Company's future operations and
therefore adopted a plan to cease that operation effective on that date. The
plan calls for management to sell these operations or close them within 90 to
120 days from October 31, 2002. Although management's intent at this time is to
sell these operations, management will evaluate these options on a case by case
basis and may opt to cease operations (see Note 3).
The Company is engaged in the design and development of original
equipment manufacturer (OEM) server appliances for software and technology
companies. SteelCloud augments the capabilities of its OEM customers by
providing them a quick and cost-effective approach to introducing new appliances
to the marketplace. The Company also works with major integrators to address the
custom hardware needs of its public sector customers. In addition, the Company
provides Information Technology (IT) support and consulting services to both the
commercial and public sector clients. Although SteelCloud operates in a
competitive environment subject to technological change and the emergence of new
technologies, the Company believes that its products and services are, or would
be, compatible or upgradeable to new technologies. Management operates the
Company as one segment and does not evaluate its product and services as
separate segments.
F-7
2. Significant Accounting Policies
Use of Estimates
The preparation of the consolidated financial statements in conformity
with accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the consolidated financial statements and the
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.
Principles of Consolidation
The consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries. All significant intercompany accounts
and transactions have been eliminated.
Cash and Cash Equivalents
The Company maintains demand deposits with several financial
institutions. At times, deposits exceed federally insured limits, but management
does not consider this a significant concentration of credit risk. The Company
considers all highly liquid investments with a maturity of three months or less
at the time of purchase to be cash equivalents.
Financial Instruments
The carrying value of the Company's financial instruments including
cash and cash equivalents, accounts receivable, accounts payable, accrued
liabilities, notes payable and its line of credit approximates fair value.
Investments
At October 31, 2001, investments consisted of shares of common stock of
a privately held internet company, Worldwide Internet Solutions Network, Inc.
("WIZnet"), with a cost basis of approximately $150,000. The Company accounted
for this investment using the cost method since the Company's investment
represented less than 20% of the privately held internet company's outstanding
stock and the Company does not exert significant influence over WIZnet's
operations. During fiscal year 2002, the Company determined that its investment
was permanently impaired as a result of its current year performance and
wrote-off the investment and recorded an impairment charge in the amount of
$150,000. At October 31, 2002, the Company had no investments.
Inventory and Deferred Contract Costs
Inventory consists of materials and components used in the assembly of
the Company's products and is stated at the lower of cost or market as
determined by the first-in first-out (FIFO) method. The Company periodically
evaluates its inventory obsolescence reserve to ensure inventory is recorded at
net realizable value.
Deferred contract costs represents costs associated with products where
title has transferred but revenue has been deferred in accordance with the
Company's revenue recognition policy.
F-8
2. Significant Accounting Policies (continued)
Impairment of Long-Lived Assets
Each year, management determines whether any property and equipment or
any other assets have been impaired based on the criteria established in
Statement of Financial Accounting Standards No. 121 (SFAS 121), "Accounting for
the Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed of."
The carrying amount of a long-lived asset is considered impaired when the
estimated undiscounted cash flow from each asset is less than its carrying
amount. In that event, the Company records a loss equal to the amount by which
the carrying amount exceeds the fair value of the long-lived asset. During
fiscal year 2002, management determined that the remaining amount of goodwill
associated with the purchase of IDP and PRIMO was impaired and recorded
impairment charges of $132,645 and $165,652 (which is recorded in discontinued
operations) for IDP and PRIMO respectively. (see note 5).
Goodwill and Other Intangible Assets
Goodwill and other intangibles represent the unamortized excess of the
cost of acquiring subsidiary companies over the fair values of such companies'
net tangible assets at the dates of acquisition. Goodwill related to the
Company's STMS acquisition as described in Note 5 has been amortized on a
straight-line basis using a twenty-year life. Effective November 1, 2002, the
Company will no longer amortize goodwill. Instead, management will regularly
assess the continuing value of goodwill to measure for possible impairment.
Other intangibles, including contracts, are being amortized on a straight-line
basis over a five-year period.
Acquisition-Related Liabilities
During fiscal year 1998, the Company recorded $1,376,000 of
acquisition-related liabilities in connection with the IDP Acquisition. These
liabilities were recorded after certain actions had been identified, quantified
and approved by management of the Company having authority to commit the Company
to the plan. Those certain actions included closing the IDP facility in
Maryland, integrating IDP and the Company's production, warehouse, sales,
marketing and administrative functions, eliminating duplicative jobs and
expanding space in the Company's office space in Virginia. The
acquisition-related liabilities remaining at October 31, 2001 and 2002 amounted
to $250,000.
Stock Compensation
Standards Board issued Statement of Financial Accounting Standards No.
123 (SFAS 123), "Accounting for Stock-Based Compensation" allows companies to
account for stock-based compensation under either the provisions of SFAS 123 or
the provisions of Accounting Principles Board Opinion No. 25 (APB 25),
"Accounting for Stock Issued to Employees," but requires pro forma disclosure in
the footnotes to the consolidated financial statements as if the measurement
provisions of SFAS 123 had been adopted. The Company continues accounting for
its stock-based compensation in accordance with the provisions of APB 25.
F-9
2. Significant Accounting Policies (continued)
Revenue Recognition (continued)
The Company recognizes revenue in accordance with Staff Accounting
Bulletin No, 101, "Revenue Recognition in Financial Statements" (SAB101) as
amended by SAB 101A and 101B. SAB 101 requires that four basic criteria must be
met before revenue can be recognized: (1) persuasive evidence of an arrangement
exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and
determinable: and (4) collectibility is reasonably assured. The Company adopted
SAB 101 during the fourth quarter of fiscal year 2001. The adoption has not had
a material effect on the Company's financial position, results of operations or
cash flows.
The Company derives its revenue from the following sources: Product
revenue, information technology support services, software license and support
revenue and software training and customization revenue.
For product sales the Company generally recognizes revenue at the time
of shipment when both title and risk of loss transfers to the customer. For
technology support services under time and material contracts, the Company
recognizes revenue as services are provided. Revenue from hardware leased to
customers under operating lease arrangements is recognized over the contract
term. When product and installation services that are not essential to the
functionality of the product are sold as part of a bundled agreement, the fair
value of the installation services, based on the price charged for the services
when sold separately, is deferred and recognized when the services are
performed. The products sold are generally covered by a warranty for periods
ranging from one to three years. The Company accrues a warranty reserve for
revenues recognized during the year to record estimated costs to provide
warranty services.
The Company is a value-added reseller for certain software products.
When resold software licenses, and related maintenance, customization and
training services are all provided together to an individual customer the
Company recognizes revenue for the arrangement after the Company has delivered
the software license and the customer has approved all customization and
training services provided. In instances were the Company only resells the
software license and maintenance to the customer, the Company recognizes revenue
after the customer has acknowledged delivery of the software. The software
manufacturer is responsible for providing software maintenance. Accordingly,
revenue from maintenance contracts is recognized upon delivery or acceptance, as
the Company has no future obligation to provide the maintenance services.
The Company incurs shipping and handling costs, which are recorded in
cost of revenues.
During the years ended October 31, 2000, 2001 and 2002, the Company had
revenues from the Federal government, which represented 48%, 21%, and 21%,
respectively, of total revenue. As of October 31, 2001 and 2002, accounts
receivable from agencies of the Federal government represented 23%, and 47%,
respectively, of total accounts receivable. During fiscal 2000, 2001 and 2002
the Company's significant customers were Lockheed Martin, Network Associates and
Modus Media all of which are third parties. During those years, Lockheed
revenues were 2%, 3% and 10%, respectively. Network Associates revenues were
17%, 38% and 54%, respectively. Modus Media revenues were 7%, 21% and 0%,
respectively. As for accounts receivable balances at October 31, 2001 and 2002,
Lockheed Martin comprised of 0% and 28%, Network Associates comprised of 33%,
and 9% and Modus Media comprised of 34% and 0% respectively. The Company's
supply agreement with one of its significant customers, Network Associates,
expired on December 31, 2002. The Company is currently discussing the renewal of
such agreements with this customer. No assurances can be given that such
discussions will result in future agreements from this customer.
F-10
2. Significant Accounting Policies (continued)
Advertising Expenses
The Company expenses advertising costs as incurred. Advertising costs
amounted to approximately $41,000, $65,000 and $50,000 during fiscal 2000, 2001,
and 2002, respectively.
Income Taxes
The Company provides for income taxes in accordance with the liability
method.
Change in Accounting Principle
During 2001, the Company implemented Emerging Issues Task Force Issue
No. 00-27, Application of EITF Issue No. 98-5, "Accounting for Convertible
Securities with Beneficial Conversion Features or Contingently Adjustable
Conversion Ratios," to Certain Convertible Instruments ("EITF 00-27"). Issue 1
of EITF 00-27 modified the calculation of beneficial conversion features for
convertible securities issued with detachable instruments for all transactions
subject to EITF Issue No. 98-5. In accordance with the transition provision of
EITF 00-27 companies are required to report any changes in a beneficial
conversion feature as a result of applying Issue 1 of EITF 00-27 as a cumulative
effect of a change in accounting principle at the time of implementation in
accordance with APB Opinion No. 20, "Accounting Changes". As a result of the
implementation of EITF 00-27, the Company has recorded a charge representing an
additional allocation of value to the beneficial conversion feature of $576,001,
or $0.06 per share, as a cumulative effect of a change in accounting principle.
Supplemental Information of Non-Cash Investing and Financing Activities:
Year Ended October 31,
--------------------------------
2000 2001 2002
--------- --------- --------
Common stock issued in connection with legal settlement ... $ 597,645 -- --
--------- --------- --------
Deemed dividend on preferred stock ........................ $ 529,411 $ 112,500 --
--------- --------- --------
Increase to income to common shareholders for repurchase of
preferred stock ...................................... -- $ 721,816 --
--------- --------- --------
Conversion of preferred stock and accrued dividends to ....
common stock ......................................... $ 4,404 $ 10,036 --
--------- --------- --------
Cumulative effect of change in accounting principle ....... -- $ 576,001 --
--------- --------- --------
Non cash stock compensation ............................... -- -- $ 82,160
--------- --------- --------
Tax benefit associated with exercise of stock options ..... -- -- $119,000
--------- --------- --------
F-11
2. Significant Accounting Policies (continued)
Earnings Per Share
The Company follows the provisions of Statement of Financial Accounting
Standards No. 128, Earnings Per Share ("SFAS 128") which requires the Company to
present basic and fully diluted earnings per share. Basic earnings per share is
based on the weighted average shares outstanding during the period. Diluted
earnings per share increases the shares used in the basic share calculation by
the dilutive effect on income from continuing operations of stock options,
warrants and convertible preferred stock. For fiscal year 2000, the Company's
common stock equivalent shares outstanding from stock options, warrants and
convertible preferred stock are excluded from the diluted earnings per share
calculation as their effect is antidilutive to net income (loss) to common
stockholders before extraordinary items.
Financial Instruments and Concentration of Credit Risk
Financial instruments that potentially subject the Company to
concentrations of credit risk consist primarily of cash, investments and
accounts receivable. The cash is held by high credit quality financial
institutions. For accounts receivable, the Company performs ongoing credit
evaluations of its customers' financial condition and generally does not require
collateral. The Company maintains reserves for credit losses. The concentration
of credit risk is mitigated by the amount of receivables due by the Federal
government. The carrying amount of the receivables approximates their fair
value.
Recent Pronouncements
In June 2001, the FASB issued SFAS No. 141, "Business Combinations",
which requires the purchase method of accounting for business combinations
initiated after June 30, 2001 and eliminates the pooling-of-interests method.
Currently, the Company does not believe the adoption of SFAS No. 141 will have
any impact on its financial statements
In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other
Intangible Assets", effective for fiscal years beginning after December 15,
2001. Under the new rules, goodwill and intangible assets deemed to have
indefinite lives will no longer be amortized but will be subject to annual
impairment tests. In addition, the statement includes provisions for the
reclassification of certain existing recognized intangibles to goodwill,
reassessment of the useful lives of existing recognized intangibles,
reclassification of certain intangibles out of previously reported goodwill and
the identification of reporting units for purposes of assessing potential future
impairments of goodwill. Goodwill and other intangibles, acquired prior to July
1, 2001, are amortized until the adoption of the statement. The Company is
required to apply the new rules on accounting for goodwill and other intangible
assets beginning in the first quarter of the fiscal year ending October 31,
2003. Beginning in fiscal year 2003, the Company anticipates a reduction in
goodwill amortization in the amount of approximately $659,000. The Company is
currently assessing, but does not believe the adoption of SFAS No. 142 will have
a significant impact on its financial statements.
F-12
In July 2001, the FASB issued SFAS 143, "Accounting for Asset
Retirement Obligations." The statement provides accounting standards for
retirement obligations associated with tangible long-lived assets, with adoption
required by January 1, 2003. SFAS 143 requires that the fair value of a
liability for an asset retirement obligation be recorded in the period in which
it is incurred. The associated asset retirement cost is capitalized as part of
the carrying amount of the long-lived asset. Over time the capitalized costs are
depreciated and the present value of the asset retirement liability increases,
resulting in a period expense. Upon retirement, a gain or loss will be recorded
if the cost to settle the retirement obligation differs from the carrying
amount. The Company does not believe there will be a material effect from the
adoption of this standard
In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets", effective for fiscal years
beginning after December 15, 2001. The new rules on asset impairment supersede
FASB Statement No. 121 and provide a single accounting model for long-lived
assets to be disposed of. Although retaining many of the fundamental recognition
and measurement provisions of Statement 121, the new rules significantly change
the criteria that would have to be met to classify an asset as held-for-sale.
Under SFAS No. 144, assets to be disposed of are stated at the lower of their
fair values or carrying amounts and depreciation is no longer recognized.
Statement 144 also supersedes the provisions of APB Opinion 30 with regard to
reporting the effects of a disposal of a segment of a business and require
expected future operating losses from discontinued operations to be displayed in
discontinued operations in the period(s) in which the losses are incurred
(rather than as of the measurement date as presently required by APB 30). In
addition, the criterion for discontinued operation presentation is changed to a
component of the business rather than a segment of the business. The Company is
required to adopt Statement 144 in the first quarter of the fiscal year ending
October 31, 2003. The Company early adopted FAS No. 144 in accounting for
PRIMO's discontinued operations during the fourth quarter of fiscal 2002 (See
Note 3).
In April 2002, the FASB issued FAS 145, "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." FAS 145 rescinds FAS 4 and FAS 64, which addressed the accounting
for gains and losses from extinguishment of debt, rescinds FAS 44 which set
forth industry-specific transitional guidance, amends FAS 13 to require that
certain lease modifications that have economic effects similar to sale-leaseback
transactions be accounted for in the same manner as sale-leaseback transactions
and makes technical corrections to certain existing pronouncements that are not
substantive in nature. The Company does not believe there will be a material
effect from the adoption of this standard.
In July 2002, the FASB issued FAS 146, "Accounting for Exit or Disposal
Activities." FAS 146 addresses the recognition, measurement and reporting of
costs associated with exit and disposal activities, including restructuring
activities that are currently accounted for pursuant to the guidance set forth
in Emerging Issues Task Force ("EITF") Issue No. 94-3, "Liability Recognition
for Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)." The scope of FAS 146
includes costs related to terminating a contract that is not a capital lease,
costs to consolidate facilities or relocate employees, and certain termination
benefits provided to employees who are involuntarily terminated. SFAS 146 is
effective for exit or disposal activities initiated after December 31, 2002. The
Company does not believe there will be a material effect from the adoption of
this standard.
F-13
3. Discontinued Operations
The Company continually evaluates its operating facilities with regard
to its long-term strategic goals established by management and the Board of
Directors. Operating facilities, which are not expected to contribute to the
Company's future operations are either closed or sold. On October 25, 2002,
management, with the approval of the Board of Directors, determined that its
Puerto Rico Industrial Manufacturing Operation ("PRIMO") would no longer
contribute to future operations and therefore adopted a plan to dispose of that
operation effective on that date. The plan calls for management to sell these
operations within 90 to 120 days from October 31, 2002. Accordingly, the Company
made provisions to reduce certain assets to its estimated net realizable values
that are included in other costs and expenses. Similarly, provisions to reduce
all other assets to their net realizable value are included in cost of goods
sold. Accordingly, the Company has reclassified the Consolidated Financial
Statements of SteelCloud, Inc for the periods ended October 31, 2002, 2001 and
2000, to reflect the discontinued operations of PRIMO. As a result, revenues,
costs and expenses have been reported as discontinued operations and PRIMO's
assets and liabilities have been reported as assets and liabilities held for
sale on the Company's consolidated balance sheet. A summary of the financial
information for the discontinued operation is as follows:
YEARS ENDED OCTOBER 31,
2000 2001 2002
----------- ----------- -----------
Net revenues ............................. $17,257,680 $ 4,347,296 $ 1,613,864
Gross profit ............................. 2,102,019 1,244,155 (506,620)
Income (loss) from discontinued operations 721,285 (9,431) (1,685,708)
OCTOBER 31,
2001 2002
---------- ----------
Accounts receivable, net ........................... $ 544,528 $ 682,978
Inventory, net ..................................... 801,166 188,698
Other assets ...................................... 111,091 81,644
---------- ----------
Total assets ....................................... 1,456,785 953,320
Accrued expenses ................................... $ 549,178 $ 590,526
Accounts payable and other liabilities.............. 127,030 50,619
---------- ----------
Total liabilities .................................. 676,208 641,145
F-14
4. Property and Equipment and Equipment on Lease
Property and equipment, including leasehold improvements, are stated at
cost. Property and equipment are depreciated and amortized using the
straight-line method over the estimated useful lives ranging from three to five
years. Leasehold improvements are amortized over the lesser of the related lease
term or the useful life.
Property and equipment consisted of the following:
October 31,
--------------------------
2001 2002
----------- -----------
Computer and office equipment ................ $ 1,531,503 $ 1,683,702
Furniture and fixtures ....................... 271,070 271,070
Leasehold improvements ....................... 406,364 446,714
Other ........................................ 223,288 336,681
----------- -----------
2,432,225 2,738,167
Less accumulated depreciation and amortization (2,165,844) (2,434,086)
----------- -----------
$ 266,381 $ 304,081
=========== ===========
The Company owns equipment that is currently at customer sites under
operating lease agreements (See Note 2 Revenue Recognition). The cost of the
equipment was $1,602,713 and $6,309,864 at October 31, 2002 and 2001,
respectively. The related accumulated depreciation on the equipment was
$1,028,441 and $5,712,662 at October 31, 2002 and 2001, respectively.
5. Goodwill and Other Intangible Assets
Goodwill and other intangible assets were comprised of:
October 31,
--------------------------
2001 2002
----------- -----------
Goodwill and other intangibles:
Goodwill ........................ $ 3,485,855 $ 2,397,288
Other intangibles ............... 600,000 600,000
----------- -----------
Total goodwill and other intangibles 4,085,855 2,997,288
Less accumulated amortization:
Goodwill ........................ 855,283 639,229
Other intangibles ............... 460,000 580,000
----------- -----------
Total accumulated amortization ..... (1,315,283) (1,219,229)
----------- -----------
$ 2,770,572 $ 1,778,059
=========== ===========
The Company has amortized goodwill using 20 year lives through October 31, 2002.
Beginning November 1, 2002, the Company will no longer amortize goodwill as a
result of adopting SFAS 142 "Goodwill and Other Intangible Assets" but will
instead periodically test goodwill for impairment. Other intangibles are
amortized over 5 year lives.
F-15
5. Goodwill and Other Intangible Assets (continued)
Impairment of Goodwill (continued)
Statement of Financial Accounting Standards No. 121 (SFAS 121)
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of," requires that long-lived assets and certain identifiable
intangibles to be held and used by an entity be reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable.
In May 1999, the U.S. Government determined not to exercise the
remaining option years on one of the Company's significant contracts. This
contract was a significant component of the Company's acquisition of IDP. The
Company anticipated that the contract would have generated future revenues of
approximately $65 million had all option years been renewed. The former IDP
operations have been substantially curtailed as a result of this contract loss.
In addition, significant future business is not expected from IDP operations as
the majority of its sales force has separated from the Company.
The Company determined that these factors indicated that the carrying
amount of goodwill associated with the IDP and PRIMO acquisition may not be
recoverable. The Company performed an analysis of the goodwill in accordance
with SFAS 121 and determined that the fair value of the remaining goodwill
(estimated using the present value of expected future cash flows) was
approximately $1.1 million at the time of the analysis. Accordingly, the Company
recorded an impairment charge of approximately $20.6 million during fiscal year
1999.
During fiscal year 2002, the Company completed all contracts relating
to the purchase of IDP. In addition, the Company determined to dispose of
operations at its Puerto Rico facility. As a result, the Company believes that
the carrying amount of goodwill associated with the IDP and PRIMO acquisitions
is not recoverable. The Company performed an analysis of the goodwill in
accordance with SFAS 121 and determined that the fair value of the remaining
goodwill (estimated using the present value of expected future cash flows) was
$0. Accordingly, the Company recorded impairment charges of $132,000 and
$166,000 (which is recorded in discontinued operations) for IDP and PRIMO
respectively during fiscal year 2002.
6. Bank Lines of Credit and Notes Payable
IDP Line of Credit
In conjunction with the purchase of IDP, the Company assumed a credit
facility of $25,000,000 secured by inventory and accounts receivable of IDP. On
November 8, 1999, the Company executed an agreement with the financial
institution to terminate this facility. Under the terms of the agreement, the
Company repaid approximately $3.0 million of the principal outstanding at
October 31, 1999 prior to December 31, 1999. In addition, outstanding principal
totaling approximately $832,000 was converted to a term note bearing interest at
the prime rate and maturing in January 2002. The outstanding balance on this
term note at October 31, 2002 was $0. The remaining amount of approximately
$750,000 was forgiven by the financial institution and has been reflected as an
extraordinary gain on early extinguishment of debt in fiscal year 2000.
F-16
6. Bank Lines of Credit and Notes Payable (continued)
Operating Line of Credit
The Company has a line of credit agreement, as amended, with a bank that allows
the Company to borrow an amount limited to the minimum of its borrowing base or
$7.5 million. The line of credit bears interest at the lower of (a) the Lender's
Prime Rate per annum or (b) the LIBOR Market Index Rate plus 2.5%. The line of
credit expires and is subject to renewal on March 31, 2003.
As of October 31, 2001 and 2002, the Company's borrowing base, which is based on
certain percentages of total accounts receivables less over due accounts, was
approximately $4.7 million and $4.6 million, respectively.
As of October 31, 2001 and 2002, the Company had borrowed approximately $3.8
million and $0 million, respectively, against this line of credit facility and
had an unused borrowing capacity of approximately $800,000 and $4,600,000,
respectively. The line of credit is secured by all assets of the Company.
For the quarter ended October 31, 2002, the Company was not in compliance with
one of its financial covenants. On January 21, 2003, the Company's bank issued a
waiver to allow the Company to continue borrowing as needed on its line of
credit.
Notes Payable
On February 1, 2002, the Company executed a promissory note in conjunction with
its line of credit in the amount of $725,000. The note bears interest at the
lower of (a) the Lender's Prime Rate per annum or (b) the LIBOR Market Index
Rate plus 2.5% and matures on July 5, 2003. The Company makes monthly principal
payments of approximately $43,000. The outstanding balance on the promissory
note at October 31, 2002 was approximately $384,000.
On April 1, 2002, the Company executed a two-year promissory note in conjunction
with a litigation settlement for approximately $240,000. The promissory note
bears interest at the prime rate and matures in May 2004. The Company makes
monthly payments of $10,000 plus accrued interest. The outstanding balance on
the note at October 31, 2002 was approximately $180,000.
Notes payable consisted of the following:
October 31,
-------------------
2001 2002
-------- --------
Bank term notes, bearing interest at the prime rate; payable in monthly
installments of $34,652, $42,647 and $10,000 plus accrued interest, maturing
in January 2002, July 2003 and May 2004, respectively ....................... $103,233 $563,824
Asset loans, bearing interest at annual interest rates of 7.9% due in aggregate
monthly payments of $1,303 due in August 2002 secured by certain assets of
the Company ................................................................. 11,331 --
-------- --------
114,564 563,824
Less current portion .......................................................... 114,564 503,824
-------- --------
Notes payable, long-term ...................................................... $ -- $ 60,000
======== ========
F-17
7. Commitments
Operating Leases
The Company leases office space for its corporate headquarters under a
noncancelable operating lease agreement. The lease agreement was renewed in
October 1999 and expires in February 2005. Additionally, the Company leases
various office equipment and other office space under non-cancelable operating
leases. Rent expense under all leases was approximately $330,000, $284,000 and
$411,000 for the years ended October 31, 2000, 2001, and 2002, respectively.
Future minimum lease payments under noncancelable operating leases,
including the leases assumed in the STMS and IDP acquisitions, at October 31,
2002 are as follows:
2003 ........................... 578,263
2004 ........................... 363,548
2005 ........................... 91,554
----------
Total........................... $1,033,365
==========
The Company will receive $327,947 in aggregate sublease income through
fiscal 2003.
8. Employment Agreements
The Company has an employment agreement with Thomas P. Dunne, the
Company's Chairman and Chief Executive Officer. The agreement for Mr. Dunne has
a term of three years commencing April 1997 and automatically renews for
additional one-year terms unless terminated by either the Company or the
employee.
All other employment agreements the company had with certain key
executives expired in September 2000.
9. Stockholders' Equity
Equity Transactions
On March 3, 2000, the Company executed a settlement for a judgment in
favor of a former employee relating to an employment contract. Under the terms
of the settlement, the Company paid $1 million and issued 225,000 shares of its
common stock to the former employee.
On March 13, 2000, the Company sold 3,000 shares of its Series A
Convertible Preferred Stock in a private placement, which is exempt from
registration provided by Regulation D Rule 506 promulgated by the Securities and
Exchange Commission under the Securities Act of 1933, as amended. The Company
received net proceeds of approximately $2.7 million, which was used to fund
current and future operations. In addition, the Company issued warrants to the
preferred investor and the broker of the transaction in the amount of 247,525
and 75,000 to purchase shares of the Company's common stock at $3.64 and $4.57
per share, respectively. The warrants expire on March 13, 2005.
F-18
9. Stockholders' Equity (continued)
Equity Transactions (continued)
The holders of the preferred shares were entitled to cumulative
dividends of 5% of the liquidation preference of $1,000 per share plus accrued
but unpaid dividends whether or not declared. For fiscal year 2000 and 2001 the
Company accrued dividend of $95,417 and $112,500, respectively and no dividends
were unpaid as of October 31, 2001. Each holder of preferred shares was entitled
to voting rights equal to the number of shares of common stock into which such
preferred shares were convertible.
The Series A Convertible Preferred Stock were convertible at the
shareholders option into common stock at the price equal to the lesser of 85% of
the average of the three lowest closing bid prices of the common stock for the
25 days prior to the conversion date or $3.64. In fiscal year 2000, the Company
recorded a non-cash deemed dividend of $529,411 for the beneficial conversion
feature. The transaction was reported as "Dividend to Preferred Stockholders" on
the Company's 2000 Consolidated Statement of Operations.
In August 2001, the Company completed a transaction with its Preferred
Shareholders to redeem all of its outstanding Series A Convertible Preferred
stock for $2,500,000 in cash. Under the redemption agreement, the Preferred
Shareholders retained approximately 247,000 warrants previously issued. As a
result of the transaction, the Company recorded an increase to income available
to common stockholders of $721,816, representing the excess of the carrying
value of the preferred stock plus the beneficial conversion feature discount
over the repurchase price.
Stock Options
On January 6, 1997, the Company adopted the 1998 Stock Option Plan (the
1998 Option Plan), which permits the Company to grant up to 600,000 options to
officers, directors and employees, who contribute materially to the success of
the Company. In September 1997, the Company increased the number of options
available for grant under the plan to 2,200,000. In June 1999, the Company
increased the number of options available for grant under the plan to 2,500,000.
In May 2002, the Company increased the number of options available for grant
under the 1998 Plan to 2,750,000. In addition, the Company established the 2002
Stock Option Plan (the 2002 Option Plan) in May 2002 which permits the Company
to grant up to 750,000 options to officers, directors and employees under that
Plan. Stock options are generally granted at the fair market value of its common
stock at the date of grant. However, in fiscal 2002, the Company granted 106,000
options with exercise prices of $1.20 when the underlying value of the Company's
common stock was $1.81. The Company recorded a charge for compensation expense
associated with these options of $64,660. The options vest ratably over a stated
period of time not to exceed four years. The contractual term of the options is
five years.
F-19
9. Stockholders' Equity (continued)
Stock Options (continued)
Common stock option activity was as follows:
Weighted-Average
Shares Exercise Price
---------- ---------------
Outstanding at November 1, 1999 ............. 1,882,433 $ 5.22
Options granted ........................... 1,147,000 1.26
Options exercised ......................... (4,900) 3.13
Options canceled or expired ............... (582,600) 2.74
---------- -----
Outstanding at October 31, 2000 ............. 2,441,933 $ 3.95
Options granted ........................... 984,000 0.74
Options canceled or expired ............... (387,599) 3.20
---------- -----
Outstanding at October 31, 2001 .............. 3,038,334 3.01
Options granted ........................... 323,500 1.21
Options exercised ......................... (227,826) 1.20
Options canceled or expired ............... (258,836) 1.96
---------- -----
Outstanding at October 31, 2002 .............. 2,875,172 3.04
---------- -----
Exercisable at October 31, 2002.............. 1,537,115 $1.83
========== =====
The total options outstanding include 600,000 options granted to the
former IDP stockholders that are not included in the Option Plan.
As of October 31, 2002, there were 474,828 options available for future
grants under the 1998 Option Plan and 750,000 options available for future
grants under the 2002 Option Plan.
During fiscal 1999, the Company repriced certain stock options granted
to certain executives in accordance with their employment agreements, of which,
approximately 547,000 remain outstanding at October 31, 2002.
The following table summarizes information about fixed-price stock options
outstanding at October 31, 2002:
Average Weighted-
Remaining Average
Range of Exercise Prices Number Contractual Exercise
Outstanding Life Price
----------------- ------------------ -----------------
$0.55-$1.75................. 1,626,088 3.14 $0.93
$2.00-$4.50................. 649,084 4.42 3.05
$5.00-$8.75................. 600,000 5.50 8.75
----------------- ------------------ -----------------
$0.55-$8.75................. 2,875,172 3.92 $3.04
================= ================== =================
F-20
9. Stockholders' Equity (continued)
Stock Options (continued)
Had compensation expense related to the stock options been determined
based on the fair value at the grant date for options granted during the years
ended October 31, 2000, 2001, and 2002 consistent with the provisions of SFAS
123, the Company's net income and earnings per share would have been as follows:
Year ended October 31,
--------------------------------------------------
2000 2001 2002
---------------------------------------------------
Net income (loss) - pro forma ................. $ (491,904) $ 503,444 $ (1,568,779)
Net income (loss) per share - pro forma ....... $ (0.05) $ 0.05 $ (0.16)
Net income (loss) per share - assuming dilution
pro forma ................................... $ (0.05) $ (0.01) $ (0.15)
The effect of applying SFAS 123 on pro forma net income as stated
above is not necessarily representative of the effects on reported net income
for future years due to, among other things, the vesting period of the stock
options and the fair value of additional options in the future years.
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes option-pricing fair value model with the following
weighted- average assumptions used for grants in 2000, 2001 and 2002: dividend
yield of 0%, expected volatility of 159% 152%, and 87% respectively; risk-free
interest rates of 6.01% 4.50%, and 4.27% respectively; and expected life of the
option term of five years. The weighted average fair values of the options
granted in 2000 2001, and 2002 with a stock price equal to the exercise price is
$1.26 $0.74, and $0.98 respectively.
F-21
10. Income Taxes
Deferred income taxes reflect the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes.
Components of the Company's net deferred tax asset balance are as follows:
October 31,
--------------------------
2001 2002
----------- -----------
Deferred tax asset:
Accrued expenses ............... $ 401,752 $ 314,051
Net operating loss carryforwards 3,052,019 2,931,442
Depreciation ................... 540,680 601,029
Asset reserves ................. 284,617 514,207
Other .......................... 69,539 --
----------- -----------
Total deferred tax asset .......... 4,348,607 4,360,729
----------- -----------
Deferred tax credit:
Valuation allowance ............ (4,348,607) (3,960,729)
----------- -----------
Net deferred tax asset ............ $ -- $ 400,000
=========== ===========
As of October 31, 2002, the Company had approximately $7.6 million in
net operating loss carryforwards, which expire between 2012 and 2020.
Approximately $2.3 million of those net operating loss carryforwards relate to
IDP and may be significantly limited under Section 382 of the Internal Revenue
Service Code and the SRLY rules. Given that the Company has wound down its
operations related to IDP, it is currently unlikely that the Company will
benefit from this portion of the Company's net operating loss carryforwards. As
of October 31, 2002, the Company has recorded a valuation allowance of
approximately $4.0 million against the total deferred tax asset of $4.4 million,
based upon its evaluation of future estimates of taxable income. The Company's
evaluation included consideration of historical earnings (excluding
non-recurring charges) as well as projected near-term earnings based on its
backlog, customer relationships and operating environment.
The components of the provision for income taxes are as follows:
Years ended October 31,
----------------------------------
2000 2001 2002
--------- --------- ---------
Current tax expense (benefit):
Federal ....................... -- $ 27,400 $ 1,200
--------- --------- ---------
State .......................... -- -- --
--------- --------- ---------
-- 27,400 1,200
Deferred tax expense:
Federal ........................ $ 49,000 $ 55,532 $(247,000)
State .......................... 16,000 19,344 (34,000)
--------- --------- ---------
65,000 74,876 (281,000)
--------- --------- ---------
Total provision for (benefit from)
income taxes ................... $ 65,000 $ 102,276 $(279,800)
========= ========= =========
F-22
10. Income Taxes (continued)
The reconciliation of income tax from the Federal statutory rate of 34% is:
Years ended October 31,
-----------------------------------
2000 2001 2002
--------- --------- ---------
Tax at statutory rates: ................ $ 49,089 $ 380,291 $ 98,845
Non-deductible expenses (income), net .. 68,966 143,141 (4,199)
Valuation allowance and other .......... (69,097) (492,621) (387,877)
State income tax, net of federal benefit 16,042 71,465 13,431
--------- --------- ---------
$ 65,000 $ 102,276 $(279,800)
========= ========= =========
In May 1998, the Company acquired the stock of IDP in a tax-free
exchange. The acquisition was accounted for using the purchase method. Deferred
tax assets include differences between the assigned values and tax bases of the
assets and liabilities acquired, as well as net operating loss carryforwards
acquired. To the extent these deferred tax assets are subsequently realized, the
resulting tax benefit will be applied to reduce goodwill recorded in connection
with the acquisitions and there will be no impact on income tax expense.
11. Retirement Plans
401(k) Plans
The Company maintains a 401(k) (the "Plan") for all current employees.
Under the Plan, employees are eligible to participate after completing 90 days
of service and attaining the age of 18. Employees can defer up to 15% of
compensation. Employee contributions are subject to Internal Revenue Service
limitations. All employees who contributed to the Plan are eligible to share in
discretionary Company matching contributions. Company contributions vest over 5
years. In fiscal 2001 and 2002, the Company contributed approximately $60,000
and $71,000 to the participants of the 401(k), respectively.
Defined Benefit Plan
On October 31, 1999, the Company amended and terminated its Defined
Benefit Plan. Under the termination, no additional benefits accrued to
participants in the Plan after that date. In addition, all existing participants
in the Plan became 100% vested in their accrued benefits in the Plan as of that
date. No gain or loss was recognized as a result of the termination of the
Pension Plan. The Company began to distribute the vested benefits to the
participants in fiscal year 2000 and completed the distributions in fiscal 2001.
F-23
12. Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per
share:
Years ended October 31,
--------------------------------------------
2000 2001 2002
------------ ------------ ------------
Numerator:
Net (loss) income from continuing operations .............. $ (670,620) $ 1,023,157 $ 570,523
Preferred Stock dividends ................................. (624,828) (112,500) --
Redemption of preferred stock ............................. -- 721,816 --
Cumulative effect of change in accounting principle ...... -- (576,001) --
------------ ------------ ------------
Net (loss) income from continuing operations
available to common stockholders before
extraordinary gain ....................................... (1,295,448) 1,056,472 570,523
============ ============ ============
Denominator:
Denominator for basic earnings per share-
weighted-average shares .................................... 9,580,112 10,111,364 9,947,675
Effect of dilutive securities:
Employee stock options .................................... -- 36,899 863,835
Convertible preferred stock ............................... -- 2,314,969 --
------------ ------------ ------------
Dilutive potential common shares .......................... -- 2,351,868 863,853
------------ ------------ ------------
Denominator for diluted earnings per share - adjusted
weighted-average shares and assumed conversions ........... 9,580,112 12,463,232 10,811,510
------------ ------------ ------------
Loss (earnings) per share from continuing operations,
basic: ....................................................... $ (0.14) $ 0.10 $ 0.06
============ ============ ============
Loss (earnings) per share from continuing operations, diluted:
$ (0.14) $ 0.08 $ 0.05
============ ============ ============
13. Contingencies
IDP Acquisition
On July 31, 1998 the Company received notice from the SBA that it was
denying the request of the U.S. Air Force to waive the requirement to terminate
IDP's Desktop V contract for the convenience of the Government upon the change
in control of IDP to the Company. The Company appealed the denial by the SBA to
the SBA's Office of Hearings and Appeals. On August 31, 1999, the SBA denied the
appeal and ruled that the U.S. Air Force must terminate-for-convenience the
Desktop V contract. Under a termination-for-convenience, the Government shall
reimburse the Company for all costs incurred in the performance of the contract.
The Company expects to recover from the Government a portion or all of its
unreimbursed costs. The Company is currently in negotiations with the Government
regarding this matter. No assurances can be given that the Company will
successfully recover any costs related to this matter.
F-24
13. Contingencies (continued)
Microsoft Licensing Agreement
In November 1998, IDP entered into a Government Integrator Agreement,
as amended, with Microsoft Corporation (Microsoft) for the licensing of certain
Microsoft software. During 1999, Microsoft asserted that IDP owed approximately
$800,000 under this agreement due primarily to amended billing by Microsoft
concerning sales by IDP to the U.S. Air Force in conjunction with the Desktop V
contract. On October 31, 2000, Microsoft filed suit against the Company, and its
subsidiary IDP, for breach of contract. In conjunction with the filing of the
claim, Microsoft further amended the original billings, which resulted in a
claim against the Company of approximately $1.3 million. Subsequent to October
31, 2000, the Company submitted a motion to dismiss the case and filed a
counterclaim of fraud on behalf of IDP in the amount of $500,000. In March 2002,
the Company and Microsoft agreed to settle the dispute. Pursuant to the
settlement, the Company and Microsoft exchanged mutual full releases and the
Company agreed to pay Microsoft approximately $315,000. In accordance with the
settlement, the Company paid approximately $75,000 in cash and executed a
two-year promissory note for the balance of $240,000, maturing in May 2004 and
bearing interest at the prime rate. This will not have an impact on the
Company's current operations as this contingency was previously accrued in the
Company's consolidated financial statements.
Trademark Infringement
On October 19, 2000, the Company received a cease and desist letter
from LoudCloud, Inc. alleging that the use of the "SteelCloud" mark and name
would constitute an infringement of LoudCloud's rights to its "LoudCloud" mark
and name and family of "Cloud" marks, that use of "SteelCloud" would dilute the
distinctiveness and fame of the LoudCloud mark and name and, that such acts by
the Company violated federal and state law regarding unfair competition. In
response, the Company filed a declaratory judgment action in the U.S. District
Court for the Eastern District of Virginia, seeking a judicial determination
that its use of the "SteelCloud" mark and name would not violate the proprietary
rights of LoudCloud nor dilute the alleged fame and distinctiveness of the
"LoudCloud" mark and name. In this action, the Company also alleged a new claim
that LoudCloud, Inc. has violated federal law through its misuse of the
trademark provisions under the Lanham Act as amended in 1988. A hearing has been
held on the LoudCloud motion to dismiss and the court has taken the matter under
advisement. On January 10, 2001, the U.S. District Court for the Eastern
District of Virginia dismissed the case.
Professional Services Malpractice Claim
In August of 2000, the Company's former legal counsel filed a claim
against the Company for approximately $343,087 plus accrued interest for legal
fees and costs. In response to the claim, the Company filed a counter claim for
professional malpractice and breach of fiduciary duty in the amount of
$1,568,000. In June 2001, the Company reached a settlement agreement with its
former legal counsel whereby both parties agreed to relinquish all claims
against the other, release each other from liability and waiver the payment of
outstanding claims. The Company reversed the liability that was previously
accrued for the legal fees and costs, reducing general and administrative
expenses for fiscal 2001 by $343,087.
F-25
14. Quarterly Financial Information (unaudited)
Quarterly financial information for fiscal 2002 and 2001 is presented in the
following tables:
1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter (1)
------------- -------------- -------------- -------------
2002
- ----
Revenue .................................. $ 9,354,066 $ 7,626,045 $ 6,390,414 $ 5,786,843
Gross Profit ............................. 2,514,202 2,124,639 1,797,579 557,513
Net income (loss) from
continuing operations .................... 753,974 493,043 147,317 (823,811)
(Loss) from discontinued operations ...... (267,468) (143,736) (46,144) (1,228,360)
Net income (loss) available to
common shareholders ................. 753,974 493,043 147,317 (2,509,519)
Per Share Data
- --------------
Net income (loss)
Basic .................................... 0.07 0.05 0.02 (0.25)
Diluted .................................. 0.07 0.04 0.02 (0.23)
2001
- ----
Revenue .................................. $ 6,517,766 $ 4,537,923 $ 6,849,652 $ 7,885,741
Gross Profit ............................. 1,521,744 1,163,584 1,807,720 1,891,198
Net income (loss) from continuing
operations ............................. 164,376 (182,656) 739,901 301,536
Income (loss) from discontinued operations (57,153) 349,747 (196,071) (105,954)
Net income (loss) available to
common shareholders.................. (506,279) 129,590 506,330 917,400
Per Share Data
- --------------
Net income (loss)
Basic .................................... (0.05) 0.01 0.05 0.09
Diluted .................................. (0.05) 0.01 0.04 0.08
During the quarter, the Company recorded certain adjustments of approximately
$298,000 relating to goodwill impairment, approximately $526,000 relating to
inventory shrinkage and obsolescence, a $280,000 tax benefit relating to
deferred tax assets.
F-26
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS ON
SUPPLEMENTAL INFORMATION
Board of Directors and Stockholders
SteelCloud, Inc.
In connection with our audit of the consolidated financial statements of
SteelCloud, Inc. referred to in our report dated January 14, 2003, which is
included in the Annual Report on Form 10-K, we have also audited Schedule II for
the year ended October 31, 2002. In our opinion, this schedule presents fairly,
in all material respects, the information required to be set forth therein.
/s/ Grant Thornton LLP
Vienna, Virginia
January 14, 2003
S-1
REPORT OF ERNST & YOUNG, LLP, INDEPENDENT AUDITORS
The Board of Directors
SteelCloud, Inc.
We have audited the consolidated financial statements of SteelCloud, Inc.
(a Virginia corporation) as of October 31, 2001, and for each of the two years
in the period ended October 31, 2001 prior to restatement for the discontinued
operations described in Note 3 and have issued our report thereon dated December
21, 2001 (included elsewhere in this Form 10-K). Our audits also included the
consolidated financial statement schedule for each of the two years in the
period ended October 31, 2001 listed in Item 14 of this Form 10-K. The schedule
is the responsibility of the Company's management. Our responsibility is to
express an opinion based on our audits.
In our opinion, the consolidated financial statement schedule for each of
the two years in the period ended October 31, 2001 referred to above, when
considered in relation to the basic consolidated financial statements taken as a
whole, presents fairly in all material respects, the information set forth
herein.
/s/ Ernst & Young LLP
McLean, Virginia
December 21, 2001
S-2
SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS
STEELCLOUD, INC.
Balance at Balance
Beginning of at End of
Classification Year Additions Deductions Year
- -------------- --------------- ---------- ---------- --------------
Allowance for doubtful accounts:
Year ended October 31, 2000.................... $100,000 $0 $0 $100,000
Year ended October 31, 2001.................... $100,000 $0 $0 $100,000
Year ended October 31, 2002.................... $100,000 $203,000 $10,000(1) $293,000
Inventory reserve:
Year ended October 31, 2000.................... $2,129,000 $0 $575,000(2) $1,554,000
Year ended October 31, 2001.................... $1,554,000 $120,000 $466,438(2) $1,207,562
Year ended October 31, 2002.................... $1,207,562 $864,435 $1,486,360(2) $585,637
Deferred tax valuation allowance:
Year ended October 31, 2000.................... $5,966,306 $0 $954,741 $5,011,565
Year ended October 31, 2001.................... $5,011,565 $0 $662,958 $4,348,607
Year ended October 31, 2002.................... $4,348,607 $0 $387,878 $3,960,729
- -----------
(1) Write-offs of accounts receivable
(2) Write-offs of inventory
S-3