UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
(Mark One)
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended JUNE 30, 2003
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
For the transition period from __________ to __________
Commission file number: 000-26227
SSP SOLUTIONS, INC.
(Exact name of small business issuer as specified in its charter)
DELAWARE 33-0757190
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
17861 CARTWRIGHT ROAD, IRVINE, CALIFORNIA 92614
(Address of principal executive offices)
(949) 851-1085
(Issuer's telephone number, including area code)
NOT APPLICABLE.
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months
(or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days. Yes [X] No [ ]
The number of shares outstanding of the registrant's only class of common stock,
$.01 par value, was 25,522,283 on August 14, 2003.
Transitional Small Business Disclosure Format (Check one): Yes [ ] No [X]
PART I
FINANCIAL INFORMATION
Page
----
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of December 31, 2002
and June 30, 2003 (unaudited)..................................F-1
Condensed Consolidated Statements of Operations for the three
and six month periods ended June 30, 2002 and 2003
(unaudited) ....................................................F-2
Condensed Consolidated Statements of Cash Flows for the six
month periods ended June 30, 2002 and 2003 (unaudited).........F-3
Notes to Condensed Consolidated Financial Statements (unaudited)....F-5
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.................................................1
Item 3. Controls and Procedures ............................................ 26
PART II
OTHER INFORMATION
Item 1. Legal Proceedings ...................................................26
Item 2. Changes in Securities and Use of Proceeds ...........................27
Item 3. Defaults Upon Senior Securities .....................................27
Item 4. Submission of Matters to a Vote of Security Holders .................28
Item 5. Other Information ...................................................28
Item 6. Exhibits and Reports on Form 8-K.....................................28
Signatures....................................................................29
Exhibits Filed with this Report...............................................30
2
PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SSP SOLUTIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)
December 31, June 30, 2003
2002 (Unaudited)
---------------------------
ASSETS (note 5)
Current assets:
Cash and cash equivalents .............................................. $ 553 $ 512
Investment in trading securities ....................................... 76 50
Accounts receivable (net of allowance for doubtful accounts of $187
and $162 as of December 31, 2002 and June 30, 2003) ................. 1,584 1,905
Inventories ............................................................ 238 362
Prepaid expenses ....................................................... 315 488
Other current assets ................................................... 173 109
---------- ----------
Total current assets ....................................... 2,939 3,426
Property and equipment, net ............................................ 90 57
Other assets ........................................................... 600 499
Equity investment in affiliate ......................................... 452 --
Goodwill ............................................................... 25,930 25,930
---------- ----------
$ 30,011 $ 29,912
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current installments of long-term debt (note 5) ........................ $ 2,826 $ 4,510
Accounts payable ....................................................... 4,413 3,940
Accrued liabilities .................................................... 1,300 2,994
Deferred revenue ....................................................... 349 66
---------- ----------
Total current liabilities ........................................... 8,888 11,510
Commitments and contingencies (notes 1,4,5,6,and 7)
Subsequent events (note 10)
Shareholders' equity:
Preferred stock, $0.01 par value; Authorized 5,000,000 shares; no
shares issued or outstanding ........................................ -- --
Common stock, $0.01 par value; Authorized 100,000,000 shares; issued
or issuable 24,821,235 and 25,333,111 shares at December 31, 2002 and
June 30, 2003, respectively ......................................... 248 253
Additional paid-in capital ............................................. 129,298 129,794
Note receivable from shareholder ....................................... -- --
Deferred compensation .................................................. (324) (106)
Accumulated deficit .................................................... (108,099) (111,539)
---------- ----------
Total shareholders' equity ....................................... 21,123 18,402
---------- ----------
$ 30,011 $ 29,912
========== ==========
See accompanying notes to condensed consolidated financial statements
F-1
SSP SOLUTIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
Three Months Ended Six Months Ended
June 30, June 30,
2002 2003 2002 2003
--------- --------- --------- ---------
Revenues:
Product .......................................................... $ 1,255 $ 1,244 $ 2,325 $ 2,274
Service .......................................................... 457 2,197 994 3,258
License .......................................................... 623 399 743 1,607
--------- --------- --------- ---------
Total revenues ................................................ 2,335 3,840 4,062 7,139
--------- --------- --------- ---------
Cost of sales:
Product .......................................................... 567 340 1,069 637
Service .......................................................... 136 471 365 441
License .......................................................... 43 12 96 807
--------- --------- --------- ---------
Total cost of sales ........................................... 746 823 1,530 1,885
--------- --------- --------- ---------
Gross margin ........................................................ 1,589 3,017 2,532 5,254
--------- --------- --------- ---------
Operating expenses:
Selling, general and administrative .............................. 2,084 2,678 4,150 4,225
Research and development ......................................... 1,413 947 3,051 2,089
Research and development - Wave Systems Corp. .................... 833 -- 1,667 --
Amortization of goodwill and other intangibles ................... 23 -- 46 --
--------- --------- --------- ---------
Total operating expenses ..................................... 4,353 3,625 8,914 6,314
--------- --------- --------- ---------
Operating income (loss) ............................................. (2,764) (608) (6,382) (1,060)
--------- --------- --------- ---------
Non-operating expenses (income):
Unrealized loss on trading securities ............................ 121 10 122 25
Interest expense, net ............................................ 189 313 315 590
Non-cash interest and financing expense .......................... 368 611 368 1,111
Loss from equity investee ........................................ -- 140 -- 409
Impairment of equity investee .................................... -- 142 -- 142
Other (income) expense, net ...................................... 174 (6) 187 (6)
--------- --------- --------- ---------
Total non-operating expenses .................................. 852 1,210 992 2,271
--------- --------- --------- ---------
Operating loss before income taxes ............................... (3,616) (1,818) (7,374) (3,331)
Provision (benefit) for income taxes ................................ (2) 3 2 3
--------- --------- --------- ---------
Loss from continuing operations ..................................... (3,614) (1,821) (7,376) (3,334)
Loss from discontinued operation .................................... (99) -- (363) (9)
Loss on disposal of discontinued operation (less no applicable taxes) -- -- -- (97)
--------- --------- --------- ---------
Net loss ............................................................ $ (3,713) $ (1,821) $ (7,739) $ (3,440)
========= ========= ========= =========
Loss per share of common stock, basic and diluted ................... $ (0.18) $ (0.07) $ (0.35) $ (0.13)
========= ========= ========= =========
Loss per share from discontinued operation, basic and diluted ....... $ (0.00) $ (0.00) $ (0.02) $ (0.01)
========= ========= ========= =========
Loss per share from continuing operation, basic and diluted ......... $ (0.18) $ (0.07) $ (0.37) $ (0.14)
========= ========= ========= =========
Shares used in per share computations, basic and diluted ............ 20,678 25,169 20,671 25,174
========= ========= ========= =========
See accompanying notes to condensed consolidated financial statements
F-2
SSP SOLUTIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
Six Months Ended
June 30,
2002 2003
-------- --------
Cash flows from operating activities:
Net loss ............................................................... $(7,739) $(3,440)
Adjustments to reconcile net loss to net cash used in operating activities:
Operating activities:
Non-cash interest .................................................... 326 1,111
Loss from equity investee and impairment ............................. -- 409
Impairment of equity investee ........................................ -- 142
Common stock issued for rent expense ................................. -- 57
Common stock issued for interest expense ............................. -- 289
Provision for losses on receivables .................................. 18 (25)
Depreciation and amortization ........................................ 211 36
Discount on note receivable from stockholder ......................... 153 --
Deferred compensation ................................................ 181 96
Unrealized loss on trading securities ................................ 122 26
Changes in assets and liabilities:
Accounts receivable .................................................. 2,131 (296)
Inventories .......................................................... 296 (124)
Prepaid expenses ..................................................... 68 (173)
Other current assets ................................................. (77) 64
Other assets ......................................................... (430) --
Accounts payable ..................................................... (3,199) (472)
Accrued liabilities .................................................. 1,628 1,679
Accrued rent ......................................................... (651) --
Deferred revenue ..................................................... 35 (283)
-------- --------
Net cash (used in) continuing operating activities ................... (6,927) (904)
Net cash provided by (used in) discontinued operation ............ (81) --
-------- --------
Net cash (used in) operating activities .......................... (7,008) (904)
-------- --------
Cash flows used in investing activities:
Purchases of property and equipment .................................. (8) (2)
Investment in equity investee ........................................ -- (100)
Proceeds from sale of property and equipment ......................... -- --
Proceeds from sale of trading securities ............................. 1,120 --
-------- --------
Net cash provided by (used in) investing activities .............. 1,112 (102)
-------- --------
Cash flows from financing activities:
Stock options exercised .............................................. 81 --
Stock issued for services ............................................ 28 15
Borrowings on revolving note payable ................................. 1,452 --
Proceeds on issuance of debt ......................................... 4,000 1,120
Repayment or insurance financing ..................................... (173) --
Principal payments (increases) on revolving line of credit ........... (2,883) 40
Principal borrowings on note payable to related party ................ 347 --
Issuance of common stock ............................................. 681 --
Principal payments on note payable to related party .................. (392) (210)
-------- --------
Net cash provided by financing activities ....................... 3,141 965
-------- --------
Net (decrease) in cash ............................................... (2,755) (41)
Cash and cash equivalents and beginning of period ......................... 3,257 553
-------- --------
Cash and cash equivalents at end of period ................................ $ 502 $ 512
======== ========
Supplemental disclosures of cash flow information
Cash paid during the period for:
Interest ......................................................... 105 117
Income taxes ..................................................... 3 --
See accompanying notes to condensed consolidated financial statements
F-3
SSP SOLUTIONS, INC. AND SUBSIDIARIES
CONDENSED STATEMENTS OF CASH FLOWS (CONTINUED)
(IN THOUSANDS)
(UNAUDITED)
Six Months Ended
June 30,
2002 2003
-------- --------
Supplemental disclosure of non-cash financing activities information:
Exchange of debt for common stock................................. 2,160 --
Debt issuance costs in exchange for warrants...................... 183 --
Debt issuance discount............................................ 5,796 1,190
Payment of interest in common stock............................... -- 289
Payment of rent in common stock................................... -- 57
See accompanying notes to condensed consolidated financial statements.
F-4
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2002 AND 2003
(UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(1) GENERAL INFORMATION
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
In the opinion of the management of SSP Solutions, Inc. (the
"Company"), the accompanying unaudited condensed consolidated financial
statements contain all adjustments (which are normal recurring accruals)
necessary to present fairly the financial position as of June 30, 2003; the
results of operations for the three and six months ended June 30, 2002 and 2003;
and the statements of cash flows for the six months ended June 30, 2002 and
2003. Interim results for the three and six months ended June 30, 2003 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2003. The interim financial statements should be read in
conjunction with the Company's consolidated financial statements for the year
ended December 31, 2002, included in the Company's Form 10-K/A, filed in April
2003.
These condensed consolidated financial statements have been prepared
assuming that the Company will continue as a going concern, which contemplates
the realization of assets and satisfaction of liabilities in the normal course
of business. The Company has incurred significant operating losses, has used
cash in operating activities, has an accumulated deficit, and deficit working
capital. The Company currently anticipates that existing resources will not be
sufficient to satisfy contemplated working capital requirements through December
31, 2003.
DETAILS OF THE DISCONTINUED OPERATION
Through December 31, 2002, the Company had operated in two business
segments: information security solutions and network solutions. During the first
quarter of 2003, the Company discontinued its network solutions segment, which
was conducted through a wholly-owned subsidiary of the Company, Pulsar Data
Systems, Inc. ("Pulsar"), as the Company determined that this segment would not
return to operating profits in a reasonable time period. The total estimated
cost to exit the segment was $106. The network solutions segment assets did not
require an impairment write down as there was no remaining book value of assets
in existence at the date the decision to exit the business was made. As a
result, there is no gain or loss on the discontinued operation relating to the
network solutions segment. In addition, as a result of the discontinuance of the
network solutions segment, the Company now operates in only one reporting
segment.
REVENUE RECOGNITION
Revenue from some data security hardware products contains embedded
software. However, the embedded software is incidental to the hardware product
sale. Data security license revenue is recognized upon delivery if an executed
license exists, a delivery as defined under the license has occurred, the price
is fixed and determinable, and collection is probable. Prior to 2002,
post-contract customer support revenue was not separately identified and priced.
Therefore, sufficient vendor specific objective evidence could not be
established for the value or cost of such services. Furthermore, prior to 2002,
revenue for the entire license, including bundled post-contract customer
support, was recognized ratably over the life of the license. Commencing in
2002, software delivered under a license requires a separate annual maintenance
contract that governs the conditions of post-contract customer support.
Post-contract customer support services can be purchased under a separate
contract on the same terms and at the same pricing, whether purchased at the
time of sale or at a later date. Revenue from these separate maintenance support
contracts is recognized ratably over the maintenance period.
Revenue from cost-plus-award-fee support and development contracts is
recognized on the basis of hours incurred plus other reimbursable contract costs
incurred during the period. Prior to 2002, any award fee earned under a
cost-plus-award-fee contract was not recognized until the award fee notice was
received. Beginning in 2002, for a cost-plus-award-fee support contract, the
Company exercised the contract clause to bill and collect one-half of the award
F-5
fee ratably over the term of the contract. Revenue is recognized concurrently
with the billings based on the performance of the contract requirements and
reasonable assurance of collection. Based upon historical results, the Company
has received final awards in excess of one-half of the full award fees. A
post-contract period performance review conducted by the customer determines the
remaining amount of the award fee to be received, which amount is then
recognized as earned revenue together with interest paid on the unpaid balance.
Award fees under development contracts are recognized when confirmed by the
customer.
Revenue from network deployment products is recognized upon transfer of
title, generally upon verification of delivery to the customer, which represents
evidence delivery has occurred, under a sales order represented by a government
purchase order that contains a fixed purchase price. When the Company fulfills
the elements of the government purchase order, collection of the revenue
recorded is reasonably assured.
Service and license revenues from the Company's JForte fixed-price
contract were recognized in accordance with Statement of Position ("SOP") 81-1,
"Accounting for Performance of Construction-Type and Certain Production-Type
Contracts." The Company recognized this revenue on a percentage of completion
method, based on total cost incurred compared to total estimated cost
(cost-to-cost percentage of completion).
The Company's revenue recognition policies are in accordance with the
Securities and Exchange Commission's Staff Accounting Bulletin No. 101.
NEW ACCOUNTING PRONOUNCEMENTS
In May 2003, the Financial Accounting Standards Board ("FASB") issued
Statement No. 150, entitled "Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity." Statement No. 150 established
the accounting guidance related to how an "issuer" classifies/measures certain
financial instruments where those instruments have characteristics of both
liabilities and equity. The guidance in Statement No. 150 requires
reclassification of certain financial instruments from the equity section of the
balance sheet to the liability section of the balance sheet. Specifically,
Statement No. 150 requires three classes of freestanding financial instruments
to be classified as liabilities: mandatorily redeemable financial instruments,
obligations to repurchase equity shares by transferring assets, and certain
obligations to insure a variable number of shares. Statement No. 150 is
effective for financial instruments entered into after May 31, 2003 and
otherwise effective at the beginning of the first interim period beginning after
June 15, 2003 (July 1, 2003 for SSP) and is to be implemented by reporting a
cumulative effect of a change in accounting principles for financial instruments
created before the May 15, 2003 issuance of Statement No. 150. The Company
expects no material changes to its financial statements upon adoption of
Statement No. 150.
LIQUIDITY AND CAPITAL RESOURCES
At June 30, 2003, the Company had deficit working capital of $8,084,
and the Company incurred a loss from operations for the three months then ended.
The Company expects to continue to incur substantial additional losses in 2003.
Given the June 30, 2003 cash balance and the projected operating cash
requirements, the Company anticipates that existing capital resources will not
be adequate to satisfy cash flow requirements through December 31, 2003. The
Company will require additional funding. The Company's cash flow estimates are
based upon achieving certain levels of sales, reductions in operating expenses
and liquidity available under its accounts receivable financing and new debt
and/or equity financing. During 2002 and through June 30, 2003, the Company
incurred defaults, other than for the payment of principal and interest, under
both the Company's accounts receivable financing and the Company's long-term
convertible notes. The Company was not able to obtain waivers for defaults on
the long-term convertible notes and has therefore classified such notes as
short-term on the balance sheets as of December 31, 2002 and June 30, 2003.
The Company does not expect future fixed obligations to be paid from operations,
and the Company intends to satisfy fixed obligations from additional financings,
use of the accounts receivable financing, extending vendor payments and issuing
stock as payment on obligations.
The Company's current financial condition is the result of several
factors, including the fact that prior period operating results were below
expectations.
The Company currently has a need for a substantial amount of capital to
meet its liquidity requirements. The amount of capital that the Company will
need in the future will depend on many factors including, but not limited, to:
F-6
o the ability to extend terms received from vendors
o the market acceptance of products and services
o the levels of promotion and advertising that will be required to
launch new products and services and attain a competitive position
in the marketplace
o research and development plans
o levels of inventory and accounts receivable
o technological advances
o competitors' responses to the Company's products and services
o relationships with partners, suppliers and customers
o projected capital expenditures
o reduction in the valuation of marketable investment securities
o downturn in economy
o defaults on financing that will impact the availability of
borrowings
In addition to the Company's current deficit working capital situation,
current operating plans show a shortfall of cash during 2003. The Company
intends to mitigate its position through one or more of the following:
o Additional equity capital -- The Company will seek additional
equity capital, if available. Equity capital will most likely be
issued at a discount to market, and require the issuance of
warrants causing a dilution to current shareholders. In addition,
providers of new equity capital may require additional concessions
in order for them to provide needed capital to the Company.
o Additional convertible debt -- Depending upon the market
conditions, the Company may issue an additional debt instrument.
The types of instruments available in the market would likely
contain a provision for the issuance of warrants and may also be
convertible into equity.
o Off balance sheet financing -- The Company's operations are not
relatively capital intensive. However, should the Company need to
add equipment or decide to expand the facilities, the Company may
use an operating lease transaction to acquire the use of capital
assets. An operating lease would not appear on the Company's
balance sheet and would be charged as an expense as payments
accrue. The Company plans to use third party financing for a
subsidiary whereby the subsidiary would become less than
wholly-owned.
o Receivables financing - Effective in October 2002, the Company
executed a new factoring agreement with Bay View Funding ("BVF")
for the financing of the Company's accounts receivable. The Company
also terminated its remaining agreement with Wells Fargo Business
Credit ("WFBC"). The Company plans to continue to generate cash by
financing receivables in conjunction with its BVF agreement.
o Sale of investments - The Company will sell its remaining
investments to generate cash. The market value of trading
securities was approximately $50 at June 30, 2003.
o Negotiate with vendors - The Company has successfully negotiated
extended payment terms with a number of vendors. The Company will
continue to negotiate term-out agreements with vendors to extend
the payment terms of existing accounts payable.
F-7
o Advance payments - Under current or future contracts the Company
may obtain cash deposits toward work to be performed or products to
be delivered. In addition, the Company may offer early payment
discounts to customers whose receivables are not financed under the
BVF agreements.
o Deferral of cash payments - The Company may defer cash payments
through suspension of development projects.
o Issuance of stock as payment for existing and future obligations -
The Company may pay some of its accrued liabilities or accounts
payable through the issuance of common stock. During the three
months ended June 30, 2003, the Company issued 34,600 shares of its
common stock for payments relating to a facility lease.
o Issuance of stock to pay interest - The Company may issue common
stock to pay interest on long-term debt. During the three months
ended June 30, 2003, the Company issued 201,291 shares of its
common stock in the payment of interest expense.
o Reductions in work force - The Company has reduced its workforce
and decreased the cash compensation paid to the remaining
workforce. The Company may be forced to make further reductions in
the future if sales plans are not achieved.
o If the Company does not receive adequate financing, the Company
could be forced to merge with another company or cease operations.
Ultimately, the Company's ability to continue as a going concern is
dependent upon its ability to successfully launch its new products, grow
revenue, attain operating efficiencies, sustain a profitable level of operations
and attract new sources of capital.
While the Company has a history of selling products in government
markets, new products that are just entering production after years of
development have no sales history. Additionally, the Company is entering
commercial markets with products and is still developing acceptance of Company
product offerings. Considerable uncertainty currently exists with respect to the
adequacy of current funds to support the Company's activities beyond August 31,
2003. This uncertainty will continue until the Company achieves a positive
working capital position. Additionally, the Company is uncertain as to the
availability of financing from other sources to fund any cash deficiencies.
The Company continues to evaluate additional financing options and may
therefore attempt to raise capital, from time to time, through equity or debt
financings in order to capitalize on business opportunities and market
conditions and to insure the continued marketing of current product offerings
together with development of new technology, products and services. There can be
no assurance that the Company can raise additional financing in the future.
Based upon forecasted sales and expense levels, the Company currently
anticipates that existing cash, cash equivalents, investments, term-out
arrangements with vendors and the current availability under our BVF factoring
agreement will not be sufficient to satisfy Company contemplated cash
requirements through December 31, 2003. To continue operations the Company must
obtain additional financing. The Company has incurred defaults under its
financing agreements in the past. The BVF agreement states among other things
that a default occurs if the Company is generally not paying debts as they
become due or if the Company is left with unreasonably small capital. The
Company has notified BVF of its failure to make certain payments on a timely
basis and has requested but has not received a waiver of such default. The
Company therefore may not be able to draw funds in the future, which would
affect the Company's ability to fund its operations. Additionally, without a
substantial increase in sales or a reduction in expenses, the Company will
continue to incur net losses.
STOCK-BASED COMPENSATION FOR EMPLOYEES AND NON-EMPLOYEES
The Company accounts for its employee stock option plans using the
intrinsic value method. When stock options are granted to employees with
exercise prices less than the fair value of the underlying common stock at the
date of grant, the difference is recognized as deferred compensation expense,
which is amortized over the vesting period of the options.
F-8
The Company accounts for stock options issued to non-employees using
the fair value method. The associated cost is recorded in the same manner as if
cash were paid.
At June 30, 2003, the Company had three stock-based employee
compensation plans. The Company accounts for those plans under the recognition
and measurement principles of Accounting Principles Board ("APB") Opinion No.
25, "Accounting for Stock Issued to Employees", and related interpretations. The
following table illustrates the effect on net loss and earnings per share if the
Company had applied the fair value recognition provisions of Statement No. 123:
Three Months Ended Six Months Ended
June 30, June 30,
2002 2003 2002 2003
-------- -------- -------- --------
Net loss, as reported .................................. $ 3,713 $ 1,821 $ 7,739 $ 3,440
Add: Stock compensation cost reported in accordance
with APB Opinion No. 25 .......................... 70 37 159 72
Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effect .......... 309 287 682 666
-------- -------- -------- --------
Pro forma net loss ..................................... 3,952 2,071 8,262 4,034
======== ======== ======== ========
Earnings per share
Net loss per share as reported--basic and diluted . $ (.18) $ (.07) $ (.37) $ (.14)
======== ======== ======== ========
Pro forma net loss per share--basic and diluted ... $ (.19) $ (.08) $ (.40) $ (.16)
======== ======== ======== ========
The fair value of each option grant was estimated on the date of grant
using the Black-Scholes option-pricing model with the following assumptions in
2002 and 2003: risk-free interest rate of 4.92%; dividend yield of 0.00%; and
volatility of 129%. The Black-Scholes model, as well as other currently accepted
option valuation models, was developed to estimate the fair value of
freely-tradable, fully-transferable options without vesting restrictions, which
significantly differ from the Company's stock option plans. These models also
require highly subjective assumptions, including future stock price volatility
and expected time until exercise, which greatly affect the calculated fair value
on the grant date.
A summary of the status of the Company's warrants as of June 30, 2003
and changes during the three and six months ended June 30, 2003 is presented
below :
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2003 JUNE 30, 2003
------------- -------------
NUMBER OF NUMBER OF
UNDERLYING WEIGHTED-AVERAGE UNDERLYING WEIGHTED-AVERAGE
WARRANTS SHARES EXERCISE PRICE SHARES EXERCISE PRICE
-------- ------ -------------- ------ --------------
Outstanding at beginning of period.... 4,586,422 $2.63 4,081,422 $2.82
Granted............................... 120,000 .70 625,000 .91
Cancelled............................. -- -- -- --
Exercised............................. -- -- -- --
---------- ------ ---------- ------
Outstanding at end of period.......... 4,706,422 $2.58 4,706,422 $2.57
========== ====== ========== ======
Warrants exercisable at end of period. 4,706,422 $2.58 4,706,422 $2.57
========== ====== ========== ======
Weighted-average fair value of warrants
granted during..................... $.45 $.55
===== =====
A summary of the status of the Company's warrants as of June 30, 2002
and changes during the three and six months ended June 30, 2002 is presented
below :
F-9
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2002 JUNE 30, 2002
------------- -------------
NUMBER OF NUMBER OF
UNDERLYING WEIGHTED-AVERAGE UNDERLYING WEIGHTED-AVERAGE
WARRANTS SHARES EXERCISE PRICE SHARES EXERCISE PRICE
-------- ------ -------------- ------ --------------
Outstanding at beginning of period.... 393,756 $17.18 393,756 $17.18
Granted............................... 3,588,666 1.29 3,588,666 1.29
Cancelled............................. -- -- -- --
Exercised............................. -- -- -- --
---------- ------ ---------- ------
Outstanding at end of period.......... 3,982,422 $2.63 3,982,422 $2.86
========== ====== ========== ======
Warrants exercisable at end of period. 3,982,422 $2.63 3,982,422 $2.86
========== ====== ========== ======
Weighted-average fair value of warrants
granted during..................... $2.32 $2.32
====== ======
The following table summarizes information about warrants outstanding
at June 30, 2003 (shares in thousands):
WARRANTS OUTSTANDING WARRANTS EXERCISABLE
WEIGHTED-AVERAGE
RANGE OF EXERCISE NUMBER REMAINING WEIGHTED-AVERAGE NUMBER WEIGHTED-AVERAGE
PRICES OUTSTANDING CONTRACTUAL LIFE EXERCISE PRICE EXERCISABLE EXERCISE PRICE
------ ----------- ---------------- -------------- ----------- --------------
$.60 - $ 2.35 4,336,422 2.16 $1.26 4,336,422 $1.26
$2.36 - $18.00 -- -- -- -- --
$18.01- $18.15 370,000 .94 $18.15 370,000 $18.15
--------- ---- ------ --------- ------
4,706,422 2.06 $2.62 4,706,422 $2.57
OPTIONS
A summary of the status of the Company's stock option plans as of June
30, 2003 and changes during the three and six months ended June 30, 2003 is
presented below :
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2003 JUNE 30, 2003
------------- -------------
NUMBER OF NUMBER OF
UNDERLYING WEIGHTED-AVERAGE UNDERLYING WEIGHTED-AVERAGE
OPTIONS SHARES EXERCISE PRICE SHARES EXERCISE PRICE
------- ------ -------------- ------ --------------
Outstanding at beginning of period... 2,436,685 $1.99 2,038,888 $2.40
Granted.............................. -- -- 515,000 .60
Cancelled............................ 89,566 1.89 206,769 2.38
Exercised............................ -- -- -- --
--------- ----- --------- -----
Outstanding at end of period......... 2,347,119 $2.00 2,347,119 $2.00
========= ===== ========= =====
Options exercisable at end of period. 1,157,319 $2.21 1.157,319 $2.21
========= ===== ========= =====
Weighted-average fair value of
options granted during............ $2.52 $2.52
===== =====
F-10
A summary of the status of the Company's stock option plans as of June
30, 2002 and changes during the three and six months ending June 30, 2002 is
presented below :
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2002 JUNE 30, 2002
NUMBER OF NUMBER OF
UNDERLYING WEIGHTED-AVERAGE UNDERLYING WEIGHTED-AVERAGE
OPTIONS SHARES EXERCISE PRICE SHARES EXERCISE PRICE
------- ------ -------------- ------ --------------
Outstanding at beginning of period... 1,535,507 $3.34 1,624,498 $3.22
Granted.............................. 149,000 1.57 205,250 3.28
Cancelled............................ 242,563 3.30 353,726 2.98
Exercised............................ 774 .70 34,852 1.74
--------- ----- --------- -----
Outstanding at end of period......... 1,441,170 $3.16 1,441,170 $3.16
========= ===== ========= =====
Options exercisable at end of period. 705,499 $2.84 705,499 $2.84
========= ===== ========== =====
Weighted-average fair value of options
granted during ................... $1.26 $2.79
===== =====
The following table summarizes information about stock options
outstanding at June 30, 2003:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
NUMBER WEIGHTED-AVERAGE NUMBER
RANGE OF EXERCISE OUTSTANDING AT REMAINING WEIGHTED-AVERAGE EXERCISABLE WEIGHTED-AVERAGE
PRICES 6/30/03 CONTRACTUAL LIFE EXERCISE PRICE AT 6/30/03 EXERCISE PRICE
------ ------- ---------------- -------------- ---------- --------------
$ .60-$1.51 1,348,925 10 $1.01 547,258 $1.08
$1.52-$2.42 437,234 8 $2.05 367,792 $2.07
$2.43-$3.34 333,752 8 $3.02 98,028 $2.95
$3.35-$4.25 69,708 8 $3.66 43,483 $3.69
$4.26-$5.17 3,000 8 $4.81 1,200 $4.81
$5.18-$7.91 111,000 7 $6.81 68,258 $6.81
$7.92-$8.83 26,000 7 $8.75 20,800 $8.75
$8.84-$9.75 17,500 6 $9.75 10,500 $9.75
--------- - ----- --------- -----
2,347,119 9 $2.00 1,157,319 $2.21
========= ====== ========= ======
The weighted average remaining contractual life of stock options outstanding at
June 30, 2003 was 9 years.
BIZ ACQUISITION
In accordance with Statement No. 142, the Company had until June 30,
2002 to complete the initial test for impairment as of January 1, 2002, the
adoption date of Statement No. 142. In accordance with the transition provisions
of Statement No. 142, the Company conducted the first step of the impairment
tests. The Company assessed the fair value of its two reporting units by
considering their projected cash flows, using risk-adjusted discount rates.
Given consideration of relevant factors, the Company concluded that as of
December 31, 2001, an impairment write-down of $36,299 was required related to
the BIZ acquisition. Subsequently, the Company reviewed the assumptions used in
the original analysis as of March 31, 2002, June 30, 2002, September 30, 2002
concluded that such analyses continued to be adequate and that no additional
write-down was required. In accordance with Statement No. 142, the Company
stopped amortizing goodwill in 2002. Accordingly, the Company does not
anticipate there to be any amortization expense for the next five years related
to intangible assets. The following table provides a reconciliation of the
reported net loss adjusted for amortization charges for each respective three
and six month periods:
F-11
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------ ------------------
2002 2003 2002 2003
-------- -------- -------- --------
Reported net (loss).......................... $(3,713) $(1,821) $(7,739) $(3,440)
Add back goodwill amortization:........... 23 -- 46 --
-------- -------- -------- --------
Adjusted net loss......................... $(3,690) $(1,821) $(7,693) $(3,440)
======== ======== ======== ========
Basic earnings per share:
Reported net (loss)......................... $ (.18) $ (.07) $ (.37) $ (.14)
Add back goodwill amortization:........... -- -- -- --
Adjusted net loss......................... $ (.18) $ (.07) $ (.37) $ (.14)
The Company performed an assessment of the fair value of the goodwill
of its information security products and services reporting unit as of December
31, 2002 using a multi-period discounted cash flow method, a variation of the
income forecast approach. The process is used to determine the fair value of an
asset by estimating its future cash flows and then discounting the cash flows to
present day utilizing a discount rate that reflects the time value of money and
the risk inherent in the asset. The present value of the cash flows was
determined using a discount rate of 30%, which was found to be the weighted
average cost of capital for the Company. The results of the analysis indicated
that there was no impairment as of the valuation date of December 31, 2002.
The Company believes that its daily market stock price does not provide
a reliable indicator of the fair value of its equity. Due to the absence of any
research coverage, the market is generally unaware of the Company's new
technology advancements. This lack of research coverage is evidenced by a
limited trading activity and irregular price behavior of the Company's thinly
traded stock. Consequently, the daily closing price of the Company's stock does
not provide a meaningful benchmark for its fair value at any one point in time.
While the Company's stock price was considered as part of the review process,
the Company deemed it more appropriate to assess the fair value of its
goodwill by using a multi-period discounted cash flow method, discussed above.
The Company is required to perform reviews for impairment at least
annually that may result in future write-downs. Tests for impairment between
annual tests may be required if events occur or circumstances change that would
more likely than not reduce the fair value of the net carrying amount.
As the markets for the Company's products are characterized by rapidly
changing technology, evolving industry standards, and the frequent introduction
of new products and enhancements, it is reasonably possible in the near-term
that the estimates of the anticipated future gross revenues, the remaining
estimated economic life, or both will be reduced. Reasonably possible is defined
as more than remote but less than likely. As a result, the remaining goodwill of
$25,930 at June 30, 2003, may be reduced within the next year.
RECLASSIFICATIONS
Certain reclassifications were made to the 2002 consolidated financial
statements to conform to the 2003 presentation and reclassifications were made
to conform with the presentation of discontinued operations.
(2) INVESTMENTS
The Company has an investment that is classified as trading securities.
The securities are comprised of Class A Common Stock of Wave Systems Corp., par
value $0.01, received in the BIZ acquisition. As of June 30, 2003, the Company
owned 57,000 shares with an aggregate value of $50. For the three months ended
June 30, 2003 and 2002, the Company recorded realized loss on trading securities
of $10 and $121, respectively.
F-12
(3) INVENTORIES
A summary of inventories follows:
DECEMBER 31, JUNE 30,
2002 2003
---------- ---------
Raw materials................................... $ 23 $ 218
Work-in-process................................. 82 39
Finished goods.................................. 133 105
----- -----
$ 238 $ 362
===== =====
(4) EQUITY INVESTMENT IN AFFILIATE
In January 2002, the Company formed a wholly-owned subsidiary, now
known as SSP Gaming, LLC, a Nevada limited liability company ("SSP Gaming"). The
entity was formed to conduct all business and any required financing activities
relative to the gaming industry. In June 2002, SSP Gaming and the Venetian
Casino Resort, LLC, a Nevada limited liability company based in Las Vegas,
Nevada, ("Venetian"), executed an operating agreement to form Venetian
Interactive, LLC, a Nevada limited liability company ("VI", with SSP Gaming and
Venetian being "Members"). The purpose of VI is to provide management services,
consulting services, financial services, intellectual property licensing
services, and equipment to the online gaming industry in venues where such
activity complies with all regulatory requirements, and to develop and operate
Venetian branded casino sites.
To begin the process of developing online casino sites, engage vendors
to construct the sites and obtain the required licenses in the regulated venues
where such operations are authorized, VI began hiring employees in July 2002,
including one employee from the Company who was subsequently terminated by VI in
January 2003. The VI staff forecasted development and operational costs, which
are updated as new information becomes available. A VI related entity, V.I.
Ltd., was awarded both an Interactive Gaming License and an Electronic Betting
Center License by the Alderney Gambling Control Commission. The licenses permit
V.I. Ltd. to conduct Internet gaming activities under the name "Venetian
Interactive."
The current VI development budget estimates costs of $4,000 to bring
the Venetian Casino to live status, and an additional $2,200 to support startup
operations. Since beginning development in July 2002, VI has expensed all
operating costs and capitalized third party software development costs incurred
under a fixed price contract. As of June 30, 2003 capitalized development costs
totaled $1.3 million. The VI operating agreement calls for SSP Gaming to fund
two-thirds of the development costs and for Venetian to fund the remaining
one-third of the costs. As of March 31, 2003, SSP had invested $800 in SSP
Gaming, with those funds being invested in VI. In June 2003, the VI Managers
determined to re-assess the entire project in view of changes in the current
regulatory environment and market conditions, including updated competitive
analysis. The re-assessment is to include site development costs. The
re-assessment has not yet been completed. At the end of June 2003, the Venetian
made demand on SSP Gaming to fund the balance of its commitment even though a
re-assessment is in process and the outcome is not yet known. SSP Gaming
declined to contribute additional capital, thereby giving VI the ability to
declare SSP Gaming in default. If terminated, the VI operating agreement
provides that the Members may look solely to the assets of VI for return of
their contributed capital. Should the assets of VI be insufficient to pay all VI
obligations and return a Member's capital contributions, the Member has no
recourse against other Members.
The Venetian Casino site is currently under development, and until the
re-assessment is completed, it is unknown when the site will go live.
In the three months ended June 30, 2003, SSP Gaming recorded $269 as
loss from equity investee, which represents its pro rata portion of the VI net
loss. This amount is included in non-operating expenses in the condensed
consolidated statement of operations for the three months ended June 30, 2003,
and as a reduction of the equity investment in affiliate. In view of the
re-assessment in process and SSP Gaming declining to contribute additional
capital, the Company recorded an impairment charge of $142 relative to the
remaining carrying value of SSP Gaming's investment in VI.
F-13
The following represents summarized financial information for VI:
BALANCE SHEET
JUNE 30, 2003
(UNAUDITED)
-----------
Current Assets $ - Current Liabilities $ -
Site Development 1,313 Members' Equity 1,313
------ ------
Total Members' Equity
Total Assets $1,313 & Liabilities $1,313
====== ======
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2003 JUNE 30, 2003
(UNAUDITED) (UNAUDITED)
Selling, general & administrative $142 $546
---- ----
Net loss $142 $546
---- ----
SSP Gaming's ownership interest decreases over time based upon the
distribution of cashflow from VI. The operating agreement provides for SSP
Gaming to receive two-thirds of the distributable cashflow until SSP Gaming
receives the return of the full amount of capital invested in VI. After
receiving the return of its invested capital, SSP Gaming is to receive the
following portions of distributable cashflow: 50% of the first $2,000, 40% of
the next $2,000 and 20% thereafter. Based upon forecasted operations, the
ownership and distribution percentage held by SSP Gaming should be reduced to
the 20% level within the first two full years of operation. Venetian and SSP
Gaming each appoint three managers to oversee general management of VI, with an
additional Manager appointed by mutual consent of the parties. Members owning at
least 75% of the percentage interests of VI must approve defined major
decisions. Based upon this forecasted scenario and the fact that Venetian will
have voting control upon achieving forecasted operations, the Company deems
control to be temporary, and therefore, the Company is accounting for SSP
Gaming's interest in VI using the equity method, and is not consolidating VI
operating results into the records of SSP Gaming. The operating agreement
commits SSP Gaming to fund up to $2,000 dollars. As of June 30, 2003, SSP Gaming
had funded $800. The carrying value of this investment has been reduced to zero
based upon the recording through equity accounting of development stage expenses
since inception through June 30, 2003 of $658 and through the recording of an
impairment charge of $142 in the quarter ended June 30, 2003.
SSP Gaming is currently in negotiations with financial sources to
provide interim and long-term funding to satisfy the VI investment requirements,
pending the outcome of the VI re-assessment. If the negotiations are successful,
SSP Gaming would become a less than wholly-owned subsidiary. If the negotiations
are not successful, SSP Gaming's percentage interest in the VI may be reduced.
The amounts invested by SSP in SSP Gaming have been reduced to zero dollars as
of June 30, 2003.
In January 2003, the FASB issued Interpretation 46, "Consolidation of
Variable Interest Entities, and Interpretation of ARB No. 51." Interpretation 46
addresses consolidation by business enterprises of variable interest entities
which have one or both of the following characteristics: (1) the equity
investment at risk is not sufficient to permit the entity to finance its
activities without additional support from other parties, which is provided
through other interests that will absorb some or all of the expected losses of
the entity; (2) the equity investors lack one or more of the following essential
characteristics of a controlling financial interest: (a) the direct or indirect
ability to make decisions about the entity's activities through voting rights or
similar rights, (b) the obligation to absorb the expected losses of the entity
if they occur, which makes it possible for the entity to finance its activities,
or (c) the right to receive the expected residual returns of the entity, if they
occur, which is the compensation for the risk of absorbing expected losses.
Interpretation 46 applies immediately to variable interest entities created
after January 31, 2003, and to variable interest entities in which an enterprise
obtains an interest after that date. It applies in the first fiscal year or
interim period beginning after June 15, 2003, to variable interest entities in
which an enterprise holds a variable interest that it acquired before February
1, 2003. The Company is currently assessing the impact of Interpretation 46. The
Company has, however, identified VI as an entity that may be required to be
consolidated beginning in the third quarter of 2003. Due to the re-assessment
started in the quarter ended June 30, 2003, and the Venetian demand for
additional capital relative to VI, the Company recorded an impairment loss of
$142 related to any remaining net investment in affiliate, as such, there was
zero balance in equity investment as of June 30, 2003. The Company currently
adjusts the carrying value of the investment in affiliate for any losses
incurred by the entity through earnings. The Company has not yet determined if
it will need to be consolidated.
F-14
(5) LONG -TERM DEBT
A summary of long-term debt follows:
DECEMBER 31, JUNE 30,
2002 2003
------- -------
Secured convertible promissory notes with an interest rate of 10% per annum,
interest payable quarterly, due December 31, 2005 ....................... $5,796 $5,796
Secured convertible promissory notes with an interest rate of 30% per annum,
interest payable quarterly, due November 14, 2003 ....................... 500 500
Note payable related to restructuring of facilities leases due in
installments on or before September 19, 2003, without interest .......... 425 300
Promissory note due July 18, 2003 with interest at 6.75% per annum, interest
payable at maturity ..................................................... 429 429
Promissory note due July 18, 2003 without interest ......................... 27 27
Note payable secured by interest in SSP Gaming, payable in monthly
installments of $15,000, including interest at 6% per annum ............. 196 110
Bay View Funding accounts receivable financing, discount rate of 1.25% of
the receivables factored, interest payable upon payment of receivable ... 259 299
Secured promissory note with an interest rate of 15% per annum, interest
payable quarterly, due on or before December 31, 2005 ................... -- 500
Secured promissory notes at various interest rates from 15% to 60% per
annum, interest payable quarterly, due in July 2003 ..................... -- 380
Secured promissory note with an interest rate of 18% per annum, interest
payable and principal due on or before in July 31, 2003 ................. -- 240
------- -------
7,632 8,581
Less unamortized value of warrants related to debt issued .................. 4,806 4,071
------- -------
Long-term debt, net of debt discounts of $4,806 at December 31, 2002 and
$4,058 at June 30, 2003 ................................................. 2,826 4,510
Less current installments .................................................. 2,826 4,510
------- -------
Long-term debt, net of debt discounts of $4,806 at December 31, 2002 and
$4,058 at June 30, 2003 ................................................. $ -- $ --
======= =======
The Company is in default on notes relative to the timely payment of
obligations as they come due. The noteholders have not granted waivers of the
default. This means the noteholders have the right to declare the Company in
default and call all of their debt due and immediately payable. With the
potential of the notes being called for payment, the Company classified the
related debt as short-term debt in the condensed consolidated balance sheets as
of December 31, 2002 and June 30, 2003.
SECURED SUBORDINATED CONVERTIBLE NOTES
On April 16, 2002, the Company raised $5,000 in cash through the
issuance of $4,000 in 10% secured convertible promissory notes ("10% Convertible
Notes"), $653 in unsecured non-convertible promissory notes ("Non-convertible
Notes", $153 held by co-chairman Kris Shah and $500 held by co-chairman Marvin
Winkler) and the pre-payment of a $500 note receivable due to the Company from
Kris Shah, less an early payment discount of $153. In connection with the
issuance of the 10% Convertible Notes, the Company incurred approximately $626
of issuance costs, which primarily consisted of amortization of warrant costs,
investment banking fees and legal and other professional fees. These notes
mature December 31, 2005 and bear interest at a rate of 10% per annum to be paid
quarterly in cash, or at the Company's discretion, in common shares based upon
the trailing 30-day average prior to the interest due date. The $4,000 in 10%
Convertible Notes are convertible, in whole or in part, at the option of the
F-15
holder into an aggregate of 4,000,000 shares of the Company's common stock at
any time prior to maturity, at a conversion price of $1.00 per share, subject to
adjustment under certain conditions, and have detachable warrants exercisable
for three years to purchase up to an additional 2,400,000 shares at $1.30 per
share, subject to adjustment under certain conditions. In conjunction with the
closing of the sale of the 10% Convertible Notes, $1,750 of principal and $46 of
accrued interest of the Subordinated Notes were exchanged for the 10%
Convertible Notes and detachable warrants to purchase 1,077,667 shares at $1.30
per share.
The 10% Convertible Notes automatically convert prior to maturity if
the Company's common shares trade at or above $3.00 per share with average
volume of 100,000 shares per day for 20 consecutive trading days. The Company is
subject to restrictive covenants related to the 10% Convertible Notes and
Non-convertible Notes that prevent the Company from pledging intellectual
property as collateral. In June 2002, Kris Shah and Marvin Winkler exchanged
their Non-convertible Notes, together with accrued interest, for 119,000 and
391,000 shares, respectively, of the Company's common stock based upon an
above-market exchange price of $1.30 per common share.
The 10% Convertible Notes contain a beneficial conversion feature. When
a convertible security contains a conversion price that is less than the quoted
trading price of a company's common stock at the date of commitment, then the
difference between the conversion price and the common stock price is called a
beneficial conversion feature. Emerging Issues Task Force ("EITF") Issue No.
00-27, which amends EITF Issue No. 98-5, requires both recordation of a discount
to recognize the intrinsic value of the conversion feature and amortization of
the amount recorded over the term of the security.
Of the aggregate $5,796 in 10% Convertible Notes issued, the Company
allocated approximately $2,644 to the value of the warrants and the remaining
$3,152 to the beneficial conversion feature of the debt instruments, which were
ascribed to these components on a pro rata basis of fair values calculated for
the warrants using a Black Scholes valuation model and the intrinsic value of
the beneficial conversion feature. These amounts have been recorded as discounts
from the face value of the debt, with an equal increase to additional paid-in
capital. Based on EITF No. 00-27, the governing accounting pronouncement, the
discounts are being amortized over the period from the date of issuance to the
maturity date of the notes. Amortization expense of the discounts totaled $ 781
and $391 for the six and three months ended June 30, 2003.
In connection with issuances of the 10% Convertible Notes and warrants,
the Company incurred approximately $741 of debt issuance costs comprised of
legal and professional fees, in addition to $182 in value calculated for the
110,000 warrants issued to the placement agent in the transaction. These costs,
which are included in other assets, are being amortized over the term of the 10%
Convertible Notes. Amortization expense of these costs totaled $100 and $50 for
the six and three months ended June 30, 2003.
As of June 30, 2003, the Company was in violation of certain provisions
of the 10% Convertible Notes. These violations are related to the Company's
failure to pay debts and obligations as they become due. During the first
quarter of 2003, the Company requested waivers for each of the aforementioned
violations for past and for anticipated future events of default through
December 31, 2003, but has not been granted such waivers.
On April 16, 2002, with the exception of Mr. Winkler and Mr. Shah, the
holders of the Subordinated Notes issued in December 2002, converted their
Subordinated Notes into 10% Subordinated Notes. In June 2002, Mr. Winkler and
Mr. Shah exchanged their Non-convertible Notes and their Subordinated Notes
issued in December 2002, together with accrued but unpaid interest, for shares
of the Company's common stock at an above market per share price of $1.30.
SECURED PROMISSORY NOTES
On January 22, 2003, the Company issued to Richard P. Kiphart a $500
promissory note that bears interest at a rate of 15% per year, with a minimum
interest charge of $50. Accrued interest is payable quarterly in arrears
beginning March 31, 2003. Principal and accrued but unpaid interest are due
upon the earlier of December 31, 2005 and the Company's closing of $5,000 or
more in equity or debt financing. Mr. Kiphart has the right to exchange the
principal and outstanding interest on the note for securities that the Company
issues in such an equity or debt financing. The Company had not repaid the note
prior to June 30, 2003. Accordingly, the Company is required to issue to Mr.
Kiphart a three-year warrant to purchase up to 125,000 shares of common stock at
an exercise price of $1.30 per share and to register for resale the shares of
common stock underlying the warrant. The note is secured by all of the
unencumbered assets of SSP and its subsidiaries, including without limitation,
intellectual property assets and any and all receivables due to the Company from
SSP Gaming.
F-16
On March 18, 2003 and March 19, 2003, the Company issued to each of
Crestview Capital Fund II, L.P. and Richard P. Kiphart $100 promissory notes
that are secured by all of the Company's assets, including SSP Gaming and any
rights belonging to SSP Gaming. In addition, on March 28, 2003, Marvin Winkler
agreed to pledge 350,000 shares of common stock held by JAW Financial, L.P., an
entity controlled by Mr. Winkler, as security for the notes the Company issued
on March 18, March 19 and March 28, 2003. The notes bear interest in an amount
equal to the following percentage of the principal balance: 10%, if the notes
are repaid within 30 days; 12%, if the notes are repaid within 60 days; 15%, if
the notes are repaid within 90 days; and 20%, if the notes are repaid at
maturity. Principal and interest under the notes are due upon the sooner of 120
days from the dates of the notes and the Company's raising of at least $3,500 in
equity or debt financing. Each note was accompanied by a five-year warrant to
purchase up to 50,000 shares of common stock at an exercise price of $0.60. The
Company will be required to issue to each holder warrants to purchase up to an
additional 50,000 shares of common stock upon repayment of the notes, depending
upon the date of repayment. The exercise price of the warrants and the number of
shares underlying the warrants are subject to anti-dilution adjustments in
connection with dividends or distributions of assets to holders of our common
stock and subdivisions or combinations of our common stock. The warrants contain
a cashless exercise provision. The shares of common stock underlying the
warrants bear registration rights, including penalties for late registration.
On March 28, 2003, the Company issued to Richard P. Kiphart, Crestview
Capital Fund II, L.P., Kris Shah and Marvin Winkler promissory notes in the
aggregate principal amount of $440, of which $180 was funded prior to March 31,
2003. The notes are secured by all of the Company's assets and the assets of SSP
Gaming. In addition, Mr. Winkler agreed to pledge 350,000 shares of common stock
held of record by JAW Financial, L.P. as security for the notes the Company
issued on March 18, March 19 and March 28, 2003. The notes bear interest at the
rate of 18% per year, with interest payable in cash monthly in arrears. The
Company is required to use the proceeds of the notes only for payment of
operating expenses. Principal and accrued but unpaid interest under the notes
are due upon the sooner of July 26, 2003 and the Company's raising of $3,500 in
equity or debt financing. The notes were accompanied by five-year warrants to
purchase up to an aggregate of 230,000 shares of common stock. The exercise
price of the warrants has not yet been fixed. The exercise price will be equal
to the greater of $0.70 per share or the conversion price of securities the
Company may issue in a proposed financing, not to exceed $1.30 per share. The
exercise price of the warrants and the number of shares underlying the warrants
will be subject to anti-dilution adjustments in connection with dividends or
distributions of assets to holders of the Company's common stock and
subdivisions or combinations of the Company's common stock. The warrants contain
a cashless exercise provision. The notes were not re-paid as of the filing date
of this report.
On April 1, 2003, the Company issued to Richard P. Kiphart a $240
promissory note dated March 28, 2003 that bears interest at a rate of 18% per
annum. Principal and accrued but unpaid interest are due upon the earliest of
July 31, 2003 or the Company obtaining $3.5 million in equity or debt financing.
The note also contains a provision to issue a warrant to purchase 120,000 shares
of the Company's common stock at an exercise price equal to the greater of $.70
or the conversion price of proposed financing, not to exceed $1.30 per share.
The note was not re-paid as of the filing of this report. Of the $240, the
Company allocated approximately $54 to the value of the warrant that was
ascribed based upon fair values calculated for the warrant using a Black Scholes
valuation model. This amount has been recorded as a discount from the face value
of the debt, with an equal increase to additional paid-in capital. The discount
is being amortized over the period from the date of issuance to the maturity
date of the note. Amortization expense of the discount totaled $42 for the six
and three months ended June 30, 2003.
NOTE PAYABLE FOR RESTRUCTURING FACILITY LEASE
In restructuring existing facility lease agreements, the Company agreed
to pay $500 in installments without interest. The first payment of $75 was made
as scheduled in December 2002, with additional payments scheduled of $100 due in
March 2003, $150 due in June 2003 and a final payment of $175 due in September
2003. While the Company tendered in August 2003 the remaining balance of the
$150 payment that was due in June 2003 Research Venture claimed a default under
the facilities settlement agreement. On August 11, 2003, Research Venture
obtained a judgment against the Company per prior stipulation in the amount of
$2.7 million and as of August 18, 2003, Research Venture had not executed the
entered judgment. The Company is filing a motion to reduce the entered judgment.
Separately, the Company is in negotiations with Research Venture to resolve the
situation. However, we there is no assurance that the discussions will lead to a
successful resolution of the entered judgment. As such, the Company recorded a
$1.3 million accrued liability for the three months ended June 30, 2003. The
$1.3 million charge consists of the original judgment amount of $3.1 million
less $456 of cash previously paid and $1.4 million of shares previously issued.
NOTE TO REPURCHASE INTEREST IN SSP GAMING
In October 2002, the Company entered into a mutual settlement and
release regarding the default by a party that had contracted to finance the
investment of SSP Gaming, a then wholly-owned subsidiary. The party defaulted
under the financing agreement. To preserve the underlying business
relationships, the Company and the other party executed an agreement whereby the
Company repurchased the party's interest by issuing a note for $250, the amount
invested by the party, and agreed to repay such amount by making an initial $40
payment and additional monthly payments of $15 per month, including interest at
6%, until paid in full. The note is secured by the Company's interest in SSP
Gaming, and includes an acceleration clause whereby the then principal balance
will be paid upon separate SSP Gaming financing of $2,000 or more. Until the
re-assessment of the VI is completed (Note 4), the Company does not intend to
make the last six monthly payments of $15 each.
F-17
SECURED CONVERTIBLE NOTES
In November 2002, the Company issued Mr. Kiphart, Crestview Capital
Fund, L.P. and Crestview Capital Fund II, L.P. three one-year notes totaling
$500, bearing interest at 30% per annum ("Secured Convertible Notes"), which
have detachable warrants exercisable for five years to purchase up to an
additional 500,000 shares (depending upon the date of repayment) at $1.30 per
share subject to adjustment under certain conditions. SSP Gaming used the
proceeds for investment into the joint venture with Venetian. Since May 14,
2003, the Secured Convertible Notes have been convertible into the Company's
common stock at a conversion price of $1.30 per share. The Secured Convertible
Notes are due upon a Company financing of $3,500 or more, and are secured behind
the Secured Subordinated Convertible Notes described above.
The fair value of the detachable warrants associated with the Secured
Convertible Notes were estimated at $154 using the Black Scholes valuation
model, based on the following assumptions: risk-free interest rate of 4.85%;
dividend yield of 0.00%; and volatility of 119%. The amounts have been recorded
as discounts from the face value of the debt with an equal increase to
additional paid-in capital. The relative fair value of the warrants have been
allocated as a debt discount and is being amortized over the period from the
date of issuance to the maturity date of the Secured Convertible Notes.
Amortization expense of the discounts totaled $187 and $128 for six and three
months ended June 30, 2003.
PROMISSORY NOTES
In April 2002, the Company issued two promissory notes due in July 2003
as payment for goods sold by Pulsar's network solutions business. The note, with
an original balance of $679, bears interest at 6.75% per annum, with interest
payable at maturity on July 18, 2003. The note in the amount of $27 does not
bear interest and was due on July 18, 2003. The Notes were not repaid on the due
date. The holder of the Notes filed an action to initiate collection of the
balances due.
In March 2003, the Company executed documents to settle the action
brought against the Company by Integral Systems, Inc. As part of the settlement,
the Company entered into a Forbearance Agreement dated March 12, 2003 with
Integral Systems that would allow Integral Systems to enter a judgment against
the Company should the Company default in the $20 per month payments due under
the agreement. The Company also issued to Integral Systems a warrant exercisable
for three years to purchase 150,000 at an exercise price of $1.30 per common
share. Additionally, if the Company did not pay off the agreed to obligation at
a discount by June 30, 2003, the Company agreed to place 400,000 shares of its
common stock in a third party escrow as additional security for its performance
under the Forbearance Agreement. Subsequent to June 30, 2003, the Company placed
400,000 shares of its common stock in a third party escrow (Note 10).
ACCOUNTS RECEIVABLE FINANCING
During November 2001, both the Company and Pulsar entered into separate
financing agreements with WFBC, which provided for the factoring of accounts
receivable. The agreements contained no limit on the dollar volume of receivable
financing, but provided for WFBC's approval of credit limits for non-government
customers. The agreements contained a discount rate of 1.25% of the gross
receivable factored, which would be increased by .0625% per day for accounts
that extended beyond the 30-day period from the date the account was purchased.
At the time of purchase, terms called for WFBC to advance 85% of the gross
receivable, with the balance remitted after collection of the invoice less the
discount and any other charges. The combined agreements contained minimum
quarterly fees and discounts totaling $63. In July 2002, the Company signed
amendments to the financing agreements, which increased the discount rate
charged to 1.95% of the gross receivable and revised the daily rate to .063% for
accounts extending beyond 30 days. The minimum quarterly fees and discounts were
also reduced to $15. All other terms and conditions remained. During the third
quarter of 2002, the Company terminated the WFBC agreement related to Pulsar.
In October 2002, the Company terminated its remaining financing
arrangement with WFBC and entered into a new financing arrangement with BVF. The
new factoring agreement contains a maximum advance of $750, and was for an
initial term of three months, which at the Company's option, is renewable for
additional three-month periods, which has been renewed by the Company. The
agreement contains a factoring fee, which is based on 1.25% of the gross face
value of the purchased receivable for every 30 day period from the date of
F-18
purchase by BVF until the invoice is paid in full. For invoices outstanding more
than the 30 day period, a finance fee will be charged at the rate of .063% of
the gross face value of the purchased receivable for every one day period beyond
the 30th day from the original date of purchase. At the time of purchase, terms
call for BVF to advance 85% of the gross receivable, with the balance remitted
after collection of the invoice less the factoring and finance fee, if
applicable. The agreement contains certain representations, warranties and
covenants and requires a monthly minimum fee, including the factoring and
financing fees, of .25% of the maximum advance of $750, or approximately $2 per
month. The BVF states among other things that a default occurs if we do not pay
debts as they become due or if we maintain unreasonably small capital. We have
notified BVF of our failure to make certain payments on a timely basis and have
therefore recently requested but not yet received a waiver of such default.
Gross receivables transferred to WFBC and WFBC/BVF amounted to $2,105
and $2,873 during the six month periods ended June 30, 2002 and 2003,
respectively. The Company is obligated to repurchase certain accounts receivable
under the program and, therefore, the transaction does not qualify as a sale.
Factored receivables included in the accounts receivable balance as of
December 31, 2002 and June 30, 2003 were $314 and $371, respectively.
(6) RELATED PARTY TRANSACTIONS
KRDS REAL PROPERTY LEASE
In 1999, the primary shareholders of SSP (then known as "Litronic
Inc.") formed KRDS, Inc., ("KRDS") for the sole purpose of purchasing real
estate property. KRDS's operations primarily consisted of a mortgage obligation,
interest, depreciation and rental income from the Company related to the real
estate property.
In February 2000, KRDS leased a building to the Company for its
corporate headquarters. The lease expires in February 2007. The facility has an
annual rent of approximately $429. In April 2002, the Company and KRDS entered
into an agreement whereby upon 60 days' notice, either party may cancel the
remaining balance of the facility lease with no future liability. Neither party
has exercised the exit clause.
NOTE RECEIVABLE FROM SHAREHOLDER
The note receivable from shareholder consists of a note acquired as
part of the BIZ acquisition. The $500 note was received by BIZ from the
Company's co-chairman, Kris Shah, in conjunction with the issuance of BIZ common
shares prior to the BIZ acquisition, and therefore was shown as a reduction of
shareholders' equity until paid. The note had a stated interest rate of 5% per
annum and was due on July 24, 2005. On April 12, 2002, in a transaction approved
the Company's board of directors, Mr. Shah prepaid the note by paying to the
Company $347, and the Company recorded a discount of $153 which was charged
against income in the second quarter of 2002. The discount was computed based
upon a present value calculation using a discount rate of 20%.
FACILITIES RELATED PARTY LEASING
During 2001, the Company arranged for the lease of two buildings
approximating 63 square feet that were under construction and were subsequently
completed. In October 2002, the Company restructured its lease obligations with
landlord, Research Venture, LLC, for the two buildings located in the Spectrum
area of Irvine, California. This restructuring and settlement provided the basis
for revising the estimate of costs relative to resolving the liability incurred
under the original leases. In 2001 the Company recorded an estimated liability
of $2,171, which was net of then anticipated offsetting sublease income. As a
result of the restructuring and settlement, the Company increased stockholders'
equity by $1,650 through the issuance of common stock valued for financial
reporting purposes at $956 and recorded a gain of $700 for the year ended
December 31, 2002. The settlement required the Company to issue 959,323 shares
of common stock, pay $500 in cash over a one-year period, cancel the lease on
one building approximating 23 square feet, and take occupancy of the other
F-19
building under a seven-year operating lease for the facility with approximately
40 square feet for an initial monthly rental rate of $55, plus common area costs
beginning in December 2002. The monthly rental rate on the seven-year lease is
scheduled to increase to $73, plus common area costs, at the beginning of the
third year. The Company records rent expense on a straight-line basis. At the
Company's option, a portion of the rental rate may be paid either in stock or in
cash during the first two years of the lease under certain circumstances through
conversion of a $360 subordinated convertible promissory note that the Company
issued as prepaid rent. In August 2002, Mr. Shah surrendered his 25% ownership
interest in the entity that owns the two buildings. At the time of surrendering
his interest, the buildings were encumbered by one or more construction loans
for which the lender required personal guarantees for renewal of the financing.
As there was little, if any, equity in the project and Mr. Shah was unwilling to
personally guarantee the loans, Mr. Shah chose to surrender his membership
interest. As of the August 14, 2003, 96,919 shares have been issued in payment
of rent (Note 9).
(7) CONCENTRATION OF CREDIT RISK AND SIGNIFICANT CUSTOMERS
Financial instruments that potentially subject the Company to
concentration of credit risk are trade receivables. Credit risk on trade
receivables is limited as a result of the Company's customer base and their
dispersion across different industries and geographic regions. As of December
31, 2002 and June 30, 2003, accounts receivable included $133 and $781,
respectively, due from the U.S. government and related agencies. Sales to the
U.S. government and related agencies accounted for 21.4% and 44% of total
revenues for the six months ended June 30, 2002 and 2003, respectively.
The Company had sales to two customers that represented 30% and 15% of
the total revenues for the six months ended June 30, 2002. The Company had sales
to two customers that represented 33% and 22% of total revenues for the six
months ended June 30, 2003. No other customers accounted for more than 10% of
total revenues during the six months ended June 30, 2002 and June 30, 2003.
Trade accounts receivable totaled $165 and $545 from these major customers as of
December 31, 2002 and June 30, 2003, respectively.
Some key components used in the manufacture of the Company's products
can only be obtained from single sources.
(8) LOSS PER SHARE
The calculation of diluted net loss per share excludes potential common
shares if the effect is anti-dilutive. Potential common shares are composed of
incremental shares of common stock issuable upon the exercise of stock options
and warrants. The following table sets forth potential common shares that were
excluded from the diluted net loss per share calculation for the three and six
months ended June 30, 2002 and 2003 because they are anti-dilutive for the
periods indicated (shares in thousands):
THREE MONTHS THREE MONTHS
ENDED ENDED SIX MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2002 JUNE 30, 2003 JUNE 30, 2002 JUNE 30, 2003
------------- ------------- ------------- -------------
Warrants........................... 394 4,706 394 4,706
Stock options.................... 1,535 2,393 1,535 2,393
----- ----- ----- -----
1,929 7,099 1,929 7,099
===== ===== ===== =====
(9) CONTINGENT LIABILITIES
Because the Company provides engineering and other services to various
government agencies, it is subject to retrospective audits, which may result in
adjustments to amounts recognized as revenues, and the Company may be subject to
investigation by governmental entities. Failure to comply with the terms of any
governmental contracts could result in civil and criminal fines and penalties,
as well as suspension from future government contracts. The Company is not aware
of any adjustments, fines or penalties, which could have a material adverse
effect on its financial position or results of operations.
The Company has cost reimbursable type contracts with the federal
government. Consequently, the Company is reimbursed based upon the direct
expenses attributable to the contract, plus a percentage based upon overhead,
material handling, and general administrative expenses. The overhead, material
handling, and general administrative rates are estimates. Accordingly, if the
actual rates as determined by the Defense Contract Audit Agency are below the
Company's estimates, a refund for the difference would be due to the federal
government. It is management's opinion that no material liability will result
from any contract audits.
The Company is involved from time to time in various litigation matters
that arise in the ordinary course of business. Except as specifically disclosed,
the Company is unable to estimate a potential loss or potential range of loss
associated with any of the pending claims described herein.
F-20
In November 2000, the Company executed an Alliance Agreement with
Electronic Data Systems Corporation ("EDS") for the marketing of Company
products to EDS customers ("Alliance"). The Alliance calls for a joint working
relationship between the two companies, which is non-exclusive and has a term of
ten years. In February 2001, the Company and EDS executed an engagement letter
for EDS to provide certain information technology and consulting services for
both the Company's organizational structure and for a specific customer project.
On August 27, 2001, EDS and the Company executed a letter of intent and
temporary working agreement whereby EDS supplied software and hardware for
resale to Pulsar customers ("Pulsar Agreement"). Under the Pulsar Agreement, as
of December 31, 2002, $1,049 remained outstanding and unpaid to EDS for
purchases of hardware and software and is recorded in accounts payable in the
consolidated balance sheet.
The Company and EDS executed a Master Services Agreement ("MSA") dated
as of November 14, 2001, whereby beginning December 1, 2001 and ending December
31, 2006, the Company and EDS established a strategic teaming relationship to
implement, sell and deliver a set of secure transaction processing offerings
based upon a Trust Assurance Network ("TAN"). The MSA task order ("Task Order")
requires that the Company pay a monthly fee of $44 for account, test and lab
management services beginning January 1, 2002. On June 30, 2003, EDS and the
Company entered into a Termination and General Release Agreement ("TGRA")
regarding the MSA and Task Order whereby the Company agreed to pay $231 in six
monthly installments. As of June 30, 2003, the Company carried in accounts
payable the $231 due under the TGRA. The Company has made the first payment but
has not paid any other amounts due as required under the TGRA.
On January 16, 1998, G2 Resources Inc. ("G2") filed a complaint against
Pulsar in the Fifteenth Judicial Circuit in Palm Beach County, Florida. G2
claimed that Pulsar breached a contract under which G2 agreed to provide
services related to the monitoring of government contracts available for bid and
the preparation and submission of bids on behalf of Pulsar. The contract
provided that Pulsar pay G2 $500 in 30 monthly installments of $16 and an
additional fee of 2% of the gross dollar amount generated by awards. In its
complaint, G2 alleged that Pulsar failed to make payments under the contract and
claimed damages in excess of $525 plus interest, costs and attorneys fees. In
the course of discovery G2 asserted that its losses/costs arising out of its
claim amounted to approximately $10,300. Pulsar asserted that G2 failed to
perform the services required under the contract and Pulsar filed a claim for
compensatory damages, interest and attorneys' fees against G2. Classical
Financial Services, LLC ("Classical") intervened in the case. Classical claimed
that G2 assigned its accounts receivable to Classical under a financing program
and that Pulsar breached its obligations to Classical by failing to make
payments under the contract with G2. Pulsar asserted defenses to Classical's
claim. On April 20, 2001, a court hearing was held and G2's complaint against
Pulsar was dismissed without prejudice on the basis of no prosecution activity
for more than 12 months. On May 22, 2001, G2 filed a new complaint against
Pulsar. In August 2002, the case was moved from Division AF to Division AH of
the Fifteenth Judicial Circuit in Palm Beach County Court, Civil Division. In
April 2003. the court stayed all matters in the case pending the outcome of
litigation between G2 and Classical. The Company believes that the claims made
by G2 and Classical against Pulsar are without merit and intends to vigorously
defend against these claims.
In May 2002, Contemporary Services Corporation filed an action against
the Company alleging breach of contract, fraud, negligent misrepresentation and
violation of California Corporations Code section 25400. The action related to a
term sheet that the Company signed in October 2001 in connection with a
potential strategic relationship between the plaintiff and the Company. The
Company filed an answer and cross-complaint. In February 2003, the Company
reached an agreement to settle the case for $45, which was paid by the Company's
insurance carrier and the Company during the quarter ended June 30, 2003. The
Company's estimated portion of the settlement was accrued in the results of the
year ended December 31, 2002.
In May 2002, Integral Systems, Inc. filed an action against us in the
Circuit Court for Montgomery County, Maryland, Case No. 232706, alleging that we
breached a promissory note for the payment of $390. Integral Systems then
obtained a confessed judgment against us for approximately $327 and amounts
related the judgment have been accrued in the financial statements for the year
ended December 31, 2002. In March 2003, we executed settlement papers that
would permit Integral Systems to file a stipulated judgment against us in the
amount of the unpaid balance if we default on a payment schedule that requires
us to make payments of $20 per month until the balance is paid in full. If an
F-21
agreed upon amount was not paid in full by June 30,2003, the Company was
required to place 400,000 common shares into a third party escrow. The Company
did not make the payment and deposited the shares into escrow in July 2003. In
March 2003 we also issued a warrant to purchase up to 150,000 shares of our
common stock at an exercise price of $1.30 per share as part of the settlement.
The warrant has a three-year term and contains a cashless exercise provision.
The shares of common stock underlying the warrants bear registration rights.
In July 2002, Synnex Technology ("Synnex") filed a lawsuit against the
Company in the Superior Court of Orange County, alleging that the Company failed
to pay $121 for products purchased by us for resale. The Company and Synnex
agreed to settle the matter by payment of ten equal installments of $12
pursuant to a stipulation for entry of judgment that was to be held by counsel
for Synnex and not filed with the court absent breach by the Company. The last
payment due on or before June 9, 2003, was paid and the action was dismissed.
In restructuring existing facility lease agreements (Note 6) and to
Resolve litigation brought by Research Venture, LLC ("Research Venture"), the
Company agreed to pay Research Venture $500 in installments without interest.
The first payment of $75 was made as scheduled in December 2002, with additional
payments scheduled of $100 due in March 2003, $150 due in June 2003 and a final
payment of $175 due in September 2003. The Company did not timely make the full
$150 payment that was due in March 2003. While the Company subsequently tendered
the balance of the March payment due, the Company did not pay the full $150 due
in June 2003. While the Company subsequently paid the balance of the payment
due, Research Venture claimed a default under the facilities settlement
agreement. On August 11, 2003, Research Venture obtained a judgment against the
Company per prior stipulation in the amount of $2.7 million and as of August 18,
2003, Research Venture had not executed the entered judgment. The Company is
filing a motion to reduce the entered judgment. Separately, the Company is in
negotiations with Research Venture to resolve the situation. However, we there
is no assurance that the discussions will lead to a successful resolution of the
entered judgment. As such, the Company recorded a $1.3 million accrued liability
for the three months ended June 30, 2003. The $1.3 million charge consists of
the original judgment amount of $3.1 million less $456 of cash previously paid
and $1.4 million of shares previously issued.
At the end of June 2003, the Venetian sent a demand letter to our
subsidiary demanding funding, or alternatively taking action to terminate the
operating agreement for failure of our subsidiary to meet its funding commitment
(Note 4). The Venetian threatened to take action against our subsidiary in the
matter, but this obligation, if any, is limited to our subsidiary. Other than
the subsidiary's investment in VI, it has no other assets.
The Company currently holds multiple contracts with the federal
government for the resale of network deployment products. In particular, three
of these contracts permit the Company to provide goods and services to various
federal government agencies. An administrative agency recently informed the
Company that one of the contracts would not be renewed unless purchase activity
was conducted under the contract. The Company is negotiating with a party for
the sale of the contract. It is possible the other contracts may not be renewed
or may be cancelled by the federal government due to the Company's inability to
perform as required under the contracts.
The Company is currently in negotiations with the various government
agencies that it contracts with to initiate and implement the corrective
measures necessary to insure the uninterrupted continuity of the contracts.
Although there is no assurance that the contracts will be renewed or that they
will not be cancelled, the Company has reason to believe they will be renewed.
However, if the contracts are not renewed or if they are cancelled, then a
significant portion of the Company's revenues will be lost, which would have a
significant adverse impact on the Company's financial condition, results of
operations and liquidity.
As of June 30, 2003, accounts payable totaled $3,940. Of that amount,
$2,608 is aged at least 90 days. Unless payment is made or satisfactory payment
plans agreed to, it is likely that the vendors will eventually initiate legal
actions to collect the amounts owed to them. Currently, the Company has the
intent to satisfy its vendor obligations through a combination of payment
negotiations, which include extending the terms over time, partial payments of
the obligations due as payment in full and converting obligations to long term
notes payable.
(10) SUBSEQUENT EVENTS
Subsequent to June 30, 2003, the Company placed 400,000 share of its
common stock in a third party escrow as additional security for the Company's
performance under the Forbearance Agreement, which the Company entered into in
March 2003 as part of a settlement of an action brought against the Company by
Integral Systems, Inc. (Note 5).
Subsequent to June 30, 2003, Control Break International ("CBI"), a
holder of two promissory notes with current outstanding balances of $429 and $27
each due in July 2003 filed an action in Florida to initiate collection of the
$456 of balances due (Note 5). The Company intends to defend against the action
and to file a motion to dismiss based upon lack of jurisdiction. The Company has
held discussions with CBI to resolve the matter, but there can be no assurance
on the outcome of those discussions.
On July 31, 2003, the Company issued stock options to purchase a total
of 2.2 million common shares to employees and certain independent contractors.
The grant were made, subject to the approval of the board, and would vest 20%
upon issuance, and 1/48 per month thereafter.
F-22
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction
with our condensed consolidated financial statements and notes to financial
statements included elsewhere in this report. This report contains
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended, or the Securities Act, and Section 21E of the
Securities Exchange Act of 1934, as amended, or the Exchange Act. We intend that
the forward-looking statements be subject to the safe harbors created by those
sections.
The forward-looking statements generally include our management's plans
and objectives for future operations, including plans, objectives and
expectations relating to our future economic performance, business prospects,
revenues, working capital, liquidity, ability to obtain financing, generation of
income and actions of secured parties not to foreclose on our assets. The
forward-looking statements may also relate to our current beliefs regarding
revenues we might earn if we are successful in implementing our business
strategies. The forward-looking statements generally can be identified by the
use of the words "believe," "intend," "plan," "expect," "forecast," "project,"
"may," "should," "could," "seek," "pro forma," "estimates," "continues,"
"anticipate" and similar words. The forward-looking statements and associated
risks may include, relate to, or be qualified by other important factors,
including, without limitation:
o anticipated trends in our financial condition and results of
operations (including expected changes in our gross margin and
general, administrative and selling expenses);
o the projected growth or contraction in the information
security products and services markets in which we operate;
o our ability to finance our working capital and other cash
requirements;
o our business strategy for expanding our presence in the
Internet data security market; and
o our ability to distinguish ourselves from our current and
future competitors.
We do not undertake to update, revise or correct any forward-looking
statements. The forward-looking statements are based largely on our current
expectations and are subject to a number of risks and uncertainties. Actual
results could differ materially from these forward-looking statements. Important
factors to consider in evaluating forward-looking statements include:
o the shortage of reliable market data regarding the Internet
data security market;
o changes in external competitive market factors or in our
internal budgeting process that might impact trends in our
results of operations;
o changes in our business strategy or an inability to execute
our strategy due to unanticipated changes in the contract
support services markets; and
o various other factors that may prevent us from competing
successfully in the marketplace.
The information contained in this report is not a complete description
of our business or the risks associated with an investment in our common stock.
Before deciding to buy or maintain a position in our common stock, you should
carefully review and consider the various disclosures we made in this report,
and in our other materials filed with the Securities and Exchange Commission
that discuss our business in greater detail and that disclose various risks,
uncertainties and other factors that may affect our business, results of
operations or financial condition. In particular, you should review the "Risk
Factors" section of this report.
Any of the factors described above or in the "Risk Factors" section of
this report could cause our financial results, including our net income (loss)
or growth in net income (loss) to differ materially from prior results, which in
turn could, among other things, cause the price of our common stock to fluctuate
substantially.
1
OVERVIEW
We provide professional Internet data security services and develop and
market software and microprocessor-based products needed to secure electronic
commerce and communications over the Internet and other communications networks
based on Internet protocols. Our primary technology offerings use public key
infrastructure, or PKI, which is the standard technology for securing
Internet-based commerce and communications. In addition, Pulsar, one of our
wholly-owned subsidiaries, is a computer and networking product reseller that
focused on resales to government agencies, large corporate accounts and state
and local governments. We acquired Pulsar in June 1999 in exchange for 2,169,938
shares of our common stock. Due to the intensive capital requirements and low
margin returns, subsequent to December 31, 2002, we decided to exit the Pulsar
line of business and as a result, we are not accepting new orders and we are
currently in the final stages of completing a wind down of the Pulsar
operations.
Before 1990, we were solely a provider of electronic interconnect
products to government and commercial entities. In 1990, we formed our data
security division, which is the basis of our operations today. The data security
division was engaged primarily in research and development until 1993, when it
began to generate meaningful revenue. In September 1997, we sold our Intercon
division, which consisted of the assets relating to our interconnect operations,
for cash to Allied Signal Inc., an unrelated publicly traded company.
Our lack of liquidity and shortage of working capital has limited our
operations. If we do not raise additional capital within the next several
months, we face the prospect of filing for protection to reorganize our debts
and financial obligations. To date, creditors and vendors generally have
cooperated with us, which has given us time to reduce our operating expenses and
realize increases in revenues in our core business. We have done both in the
last two quarters of our operations. If we are unable to make payments on the
extended term agreements or pay our current vendors, or if holders of our notes
declare us in default and call their notes, we would not have the financial
resources to satisfy all of these obligations. The results of our operations and
liquidity discussions in this section of this report contain further comments on
our limited resources and our dependency on continued creditor cooperation for
us to continue our operations.
To meet our existing obligations, we will need to continue improving
our sales and continue controlling our operating expenses. We will also require
time to realize the financial benefits of improved operating results together
with the continued cooperation of our creditors. We are in discussions with
several financing sources regarding additional capital financing of up to $15
million that would have a dilutive effect. However, investors may fail to
provide the financing or may impose substantially more dilutive terms than
currently proposed. There is no assurance that investors will close a
transaction. If a proposed transaction does not close, we will seek other
sources of funding, explore the sale of product lines or intellectual property
rights, or evaluate merger partners. We may be forced to sell company assets or
merge at a price below what we might otherwise realize. We are at a critical
juncture for the continued survival of our company.
CRITICAL ACCOUNTING POLICIES
This "Management's Discussion and Analysis of Financial Condition and
Results of Operations" section of this report discusses our condensed
consolidated financial statements, which have been prepared in accordance with
accounting principles generally accepted in the United States. The preparation
of these financial statements requires us to make estimates and assumptions that
affect the reported amounts of assets and liabilities, revenues and expenses,
and related disclosure of contingent assets and liabilities at the date of our
financial statements.
We based our estimates and judgments on historical experience and on
various other factors that we believe to be reasonable under the circumstances,
the results of which form the basis for making judgments about the carrying
values of assets and liabilities that are not readily apparent from other
sources. Actual results may differ from these estimates under different
assumptions or conditions.
Critical accounting policies are defined as those that are reflective
of significant judgments and uncertainties, and potentially result in materially
different results under different assumptions and conditions. We believe the
following critical accounting policies, among others, affect significant
judgments and estimates used in the preparation of our condensed consolidated
financial statements. For a detailed discussion of the application of these and
other accounting policies, see the notes to our condensed consolidated financial
statements included in this report.
2
o REVENUE RECOGNITION. We recognize revenue from product sales,
including hardware (with embedded software) and software, upon
shipment unless contract terms call for a later date. Revenue from
network deployment products is recognized upon transfer of title,
generally upon delivery. Revenue from our high assurance token
contract is recognized under the cost-to-cost method of percentage
of completion. We record an allowance to cover estimated warranty
costs in cost of sales. Customers do not have the right of return
except for product defects, and product sales are not contingent
upon customer testing, approval and/or acceptance. The costs of
providing post-contract customer support are not significant.
Revenue under service and development contracts is recorded as
services are rendered. Revenue from time and material, network
deployment service contracts is recognized on the basis of hours
incurred plus other reimbursable contract costs incurred during
the period.
o ALLOWANCE FOR DOUBTFUL ACCOUNTS. We maintain an allowance for
doubtful accounts for estimated losses resulting from the
inability of our customers to make payments for services. We
analyze accounts receivable, customer credit-worthiness, current
economic trends and changes in our customer payment terms when
evaluating the adequacy of the allowance for doubtful accounts. If
the financial condition of our customers deteriorates, resulting
in an impairment of their ability to make payments, additional
allowances may be required.
o VALUATION OF GOODWILL AND OTHER INTANGIBLE ASSETS. In accordance
with Statement of Financial Accounting Standards Nos. 141 and 142,
we assess the impairment of goodwill and other intangible assets
whenever events or changes in circumstances indicate that the
carrying value may not be recoverable, at least annually. Factors
we consider important which could trigger an impairment review
include significant underperformance relative to expected
historical or projected future operating results, significant
changes in the manner of our use of the acquired assets or the
strategy for our overall business, and significant negative
industry or economic trends. The net carrying value of goodwill
and other intangible assets not recoverable is reduced to fair
value.
We accounted for our August 2001 acquisition of BIZ as a purchase.
Under the purchase method of accounting, the purchase price was allocated to the
fair value of the identifiable tangible and intangible assets and liabilities
that we acquired from BIZ. The excess of the purchase price over BIZ's tangible
net assets resulted in goodwill and other intangible assets.
In July 2001, the FASB issued Statement No. 142, "Goodwill and Other
Intangible Assets." We adopted this statement effective January 1, 2002. Under
this statement, goodwill is no longer amortized and is subject to annual testing
for impairment beginning January 1, 2002. The provisions of this statement
require us to perform a two-step test to assess goodwill for impairment. In the
first step, we compare the fair value of each reporting unit to its carrying
value. If the fair value exceeds the carrying value, then goodwill is not
impaired and we need not proceed to the second step. If the carrying value of a
reporting unit exceeds its fair value, then we must determine and compare the
implied fair value of the reporting unit's goodwill to the carrying value of its
goodwill. If the carrying value of the reporting unit's goodwill exceeds its
implied fair value, then we will record an impairment loss in the amount of the
excess. With regard to a reporting unit's goodwill balance at January 1, 2002,
we were required to perform the first step of the annual testing for impairment
by June 30, 2002. If the results of that step indicated that goodwill may be
impaired, we were then required to complete the second step as soon as possible,
but no later than December 31, 2002.
As of December 31, 2001, we assessed the fair value of our two
reporting units by comparing the book value of our equity interests to the fair
value of our equity interests based upon the terms of a financing we completed
in April 2002. Given consideration of this comparison and relevant factors, we
concluded that as of December 31, 2001, an impairment write-down of
approximately $36.3 million was required. We reviewed the assumptions used in
the original analysis performed as of December 31, 2001 for dates of March 31,
2002, June 30, 2002, and September 30, 2002 and concluded that such analyses
continued to be adequate and no additional write-down was required.
We later performed an assessment to measure the fair value of the
remaining goodwill as of December 31, 2002 using a multi-period discounted cash
flow method. The results of the analysis indicated that no additional write-down
was required as of December 31, 2002. We reviewed the assumptions used in the
analysis performed as of December 31, 2002 for dates of March 31, 2003 and June
30, 2003 and concluded that such analyses continued to be adequate and no
additional write-down was required.
3
We believe that our daily market stock price does not provide a
reliable indicator of the fair value of our equity. Due to the absence of any
research coverage, the market is generally unaware of our new technology
advancements. This lack of research coverage is evidenced by a limited trading
activity and irregular price behavior of our thinly traded stock. Consequently,
the daily closing price of our stock does not provide a meaningful benchmark for
our fair value at any one point in time. While the Company's stock price was
considered as part of the review process we deemed it more appropriate to assess
the fair value of our goodwill by using a multi-period discounted cash flow
method, discussed above. However, based on the weighted average stock price
for the second quarter, there does not appear to be an impairment of goodwill
as of June 30, 2003.
As indicated above, we are required to perform tests for impairment at
least annually. Tests for impairment between annual tests may be required if
events occur or circumstances change that would more likely than not reduce the
fair value of the net carrying amount. No such events have occurred as of June
30, 2003. We cannot predict whether or when there will be additional impairment
charges, or the amount of any such charges.
RESULTS OF OPERATIONS - COMPARISON OF THREE MONTHS ENDED JUNE 30, 2002 AND 2003
The following table sets forth the percentage of total revenues
represented by selected items from the unaudited condensed consolidated
statements of operations. This table should be read in conjunction with the
condensed consolidated financial statements and notes included elsewhere in this
report.
Percentage of Total Revenues
----------------------------------------------------------------------------------------------------------------------------
Three Months Ended June 30, Six Months Ended June 30,
------------------------------ ----------------------------
2002 2003 2002 2003
----------- ---------- ---------- ---------
Revenues:
Product 53.7 % 32.4 % 57.2 % 31.9 %
Service 19.6 57.2 24.5 45.6
License 26.7 10.4 18.3 22.5
----------- ---------- ---------- ---------
Total revenues 100.0 100.0 100.0 100.0
----------- ---------- ---------- ---------
Cost of sales:
Product 24.3 8.9 26.3 8.9
Service 5.8 12.3 9.0 6.2
License 1.8 0.2 2.4 11.3
----------- ---------- ---------- ---------
Total cost of sales 31.9 21.4 37.7 26.4
----------- ---------- ---------- ---------
Gross Margin 68.1 78.6 62.3 73.6
----------- ---------- ---------- ---------
Operating expenses:
Selling, general and administrative 89.3 69.7 102.2 59.2
Research and development 60.5 24.7 75.1 29.1
Research and development - Wave Systems Corp. 35.7 -- 41.0 --
Amortization of intangibles 1.0 -- 1.1 --
----------- ---------- ---------- ---------
Total operating expenses 186.5 94.4 219.4 88.4
----------- ---------- ---------- ---------
Operating income (loss) (118.4) (15.8) (157.1) (14.8)
----------- ---------- ---------- ---------
Non-operating expenses:
Unrealized loss (gain) on trading securities 5.2 0.3 3.0 0.4
Interest expense, net 8.0 8.2 7.8 8.3
Non-cash interest and financing expense 15.8 15.9 9.0 15.6
Equity loss from investee -- 3.6 -- 5.7
Impairment of equity investee -- 3.7 -- 2.0
Other (income) expense, net 7.5 (0.2) 4.6 (0.1)
----------- ---------- ---------- ---------
Total non-operating expenses 36.5 31.5 24.4 31.9
----------- ---------- ---------- ---------
(continued)
4
Three Months Ended June 30, Six Months Ended June 30,
------------------------------ ----------------------------
2002 2003 2002 2003
----------- ---------- ---------- ---------
Loss before income taxes (154.9) (47.3) (181.5) (46.7)
----------- ---------- ---------- ---------
Provision for income taxes (0.1) 0.1 -- --
----------- ---------- ---------- ---------
Loss from continuing operations (154.7) (47.4) (181.6) (46.7)
Loss from discontinued operations (4.2) -- (8.9) (0.1)
Loss on disposal of discontinued operations -- -- -- (1.4)
----------- ---------- ---------- ---------
Net loss (159.0) % (47.4) % (190.5) % (48.2) %
=========== ========== ========== =========
TOTAL REVENUES. Total revenues increased 64.5% from $2.3 million during
the three months ended June 30, 2002 to $3.8 million during the three months
ended June 30, 2003. The change was attributable to an increase in service
revenues of $1.7 million offset by a decrease in license revenues of $224,000
and a decrease in product revenues of $11,000. We expect total revenues to
continue to increase during the remainder of 2003 due to the delivery of
products under existing contracts and new contracts that were not existing
previously.
During the three months ended June 30, 2002, we derived 33.4%, 11.0%
and 8.6% of our revenues from sales to General Dynamics ("GD"), an agency of the
Department of Defense ("DoD") and Micron PC, LLC, respectively. During the three
months ended June 30, 2003, we derived 32.0% and 25.0% of our revenues from
sales to GD and DoD. Sales to government agencies accounted for approximately
21.5% and 38.7% of our sales during the three months ended June 30, 2002 and
2003, respectively. We expect our revenues to be heavily concentrated with a few
key customers and concentrated in government projects throughout 2003.
PRODUCT REVENUES. Product revenues decreased $11,000, or .9%, from
$1,255,000 during the three months ended June 30, 2002 to $1,244,000 during the
three months ended June 30, 2003. The decrease was primarily attributable to our
inability to fulfill certain orders due to the lack of sufficient capital
required to purchase products from vendors. We expect modest increases in
product revenues during the remainder of 2003 based on a shift of customer
purchases to newer product models.
.
SERVICE REVENUES. Service revenues increased by $1.7 million, or 380.7%
from $457,000 during the three months ended June 30, 2002 to $2.2 million during
the three months ended June 30, 2003. The increase was primarily attributable to
a $670,000 increase in revenues associated with a new contract to add a Java
operating system to our USA Card(TM), also referred to as the JForte ("JForte")
for the DoD, a $437,000 increase in revenues associated with an existing
contract for the next generation PKI infrastructure and a $502,000 increase in
revenues associated with as an additional new contract for the next generation
PKI infrastructure support. We expect service revenues to continue to increase
during 2003 as a result of newly signed and existing service contracts.
LICENSE REVENUES. License revenues decreased by $224,000, or 36% from
$623,000 during the three months ended June 30, 2002 to $399,000 during the
three months ended June 30, 2003. The decrease was primarily attributable to a
$224,000 decrease of sales under our contract with GD. We expect licensing
revenues to increase during 2003 based on incremental sales under the Common
Access Card ("CAC") program coupled with increased sales of our Profile
Manager(TM) ("PM") software.
PRODUCT GROSS MARGIN. Product gross margin increased as a percentage of
net product revenues from 54.8% during the three months ended June 30, 2002 to
72.7% during the three months ended June 30, 2003. The increase was primarily
attributable to reduced costs of products sold during the quarter. We expect
product gross margins to remain at similar levels for the remainder of 2003.
SERVICE GROSS MARGIN. Service gross margin increased as a percentage of
net service revenues from 70.2% during the three months ended June 30, 2002 to
78.6% during the three months ended June 30, 2003. The margin percentage
increase was primarily attributable to higher margins obtained in our new
service contracts. We expect service gross margin percentages to decrease
somewhat in 2003 due to the addition of the JForte project. Certain compensation
costs formerly considered research and development expense prior to 2003 would
be included as cost of sales in 2003 due to the JForte contract.
LICENSE GROSS MARGIN. License gross margin increased as a percentage of
net license revenues from 93.1% during the three months ended June 30, 2002 to
96.9% during the six months ended June 30, 2003. The margin percentage increase
was primarily attributable to higher margins obtained under the CAC program. We
expect the annual license gross margin percentages during 2003 to remain at 2002
levels based on our projected sales mix for 2003.
5
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative ("S,G&A") expenses increased by $594,000, or 28.5% from $2.1
million during the three months ended June 30, 2002 to $2.7 million during the
three months ended June 30, 2003. The increase was primarily attributable to a
$1.3 million one-time charge related to ongoing litigation with Research
Venture, LLC, (further discussed below) offset by reductions in workforce, a
reduction in compensation levels and reductions in professional fees during the
three months ended June 30, 2003. As a percentage of total revenues, SG&A
expenses decreased from 89.3% during the three months ended June 30, 2002 to
69.7% during the three months ended June 30, 2003. The percentage decrease was
the result of our success in increasing total revenues by $1.5 million while
increasing S,G&A expenses by $594,000. The $1.3 million charge was a one-time
expense and therefore we expect SG&A to decrease for the remainder of 2003.
RESEARCH AND DEVELOPMENT EXPENSES. Research and development ("R&D")
expenses decreased $466,000 million or 33.0% from $1.4 million during the three
months ended June 30, 2002 to $947,000 during the three months ended June 30,
2003. The decrease was primarily attributable to reductions in work force and
compensation levels during the three months ended June 30, 2003. As a percentage
of total revenues, R&D expenses decreased from 60.5% during the three months
ended June 30, 2002 to 24.7% during the three months ended June 30, 2003. As
noted in the discussion of Service Gross Margin above, certain compensation
costs formerly considered R&D expenses prior to 2003 are being be included as
cost of sales in 2003, as such, we expect R&D to decrease for the remainder of
2003.
RESEARCH AND DEVELOPMENT EXPENSES - WAVE SYSTEMS CORP. Effective August
31, 2002, we terminated a development contract with Wave Systems Corp. By
canceling the development contract, we no longer incur the monthly development
charge of $278,000. This caused a reduction of $833,000 in expenses during the
three months ended June 30, 2003 as compared to the three months ended June 30,
2002.
AMORTIZATION OF INTANGIBLES. As described under the heading "Critical
Accounting Policies", amortization of intangibles ceased with the adoption of
Statement No. 142.
UNREALIZED LOSS ON TRADING SECURITIES. Unrealized loss on trading
securities decreased from $121,000 during the three months ended June 30, 2002
to $10,000, during the three months ended June 30, 2003. The loss is
attributable to our holding in Wave Systems Corp., which decreased from
80,000 shares at June 30, 2002 to 57,000 shares at June 30, 2003. We expect to
sell the remaining shares of Wave during the remainder of 2003.
INTEREST EXPENSE, NET. Interest expense, net increased from $189,000
during the three months ended June 30, 2002 to $313,000 during the three months
ended June 30, 2003. The increase was primarily attributable to the increase in
accrued interest from notes payable and interest expense related to settlement
with certain vendors. We expect interest expense to continue to remain at the
current levels until the level of debt is reduced.
NON-CASH INTEREST AND FINANCING EXPENSE. Non-cash interest and
financing expense increased from $368,000 for the three months ended June 30,
2002 to $611,000 during the three months ended June 30, 2003. The increase
related to the issuance of common stock in lieu of cash interest payments on
convertible secured promissory notes issued on April 16, 2002, and amortization
of other debt issue costs. Based on the current outstanding notes, we expect
non-cash interest and financing expense to remain at or above the second quarter
levels for the remainder of 2003.
The convertible secured promissory notes issued on April 16, 2002,
contain a beneficial conversion feature. When a convertible security contains a
conversion price that is less than quoted trading price of a company's common
stock at the date of commitment, then the difference between the conversion
price and the common stock price is called a beneficial conversion feature.
Emerging Issues Task Force ("EITF") Issue No. 00-27, which revises EITF Issue
No. 98-5, requires both the recording of a discount to recognize the computed
value of the conversion feature and amortization of the amount recorded over the
term of the security.
Of the aggregate $5.8 million convertible secured promissory notes
issued on April 16, 2002, we allocated approximately $2.6 million to the value
of the warrants and the remaining $3.2 million to the beneficial conversion
feature of the debt instruments, which were ascribed to these components on a
pro-rata basis of fair values calculated for the warrants using a Black Scholes
6
valuation model and the intrinsic value of the beneficial conversion feature.
The amounts have been recorded as discounts from the face value of the debt with
an equal increase to additional paid-in capital. Based on EITF No. 00-27, the
governing accounting pronouncement, the discounts are being amortized over the
period from the date of issuance to the maturity date of the notes. Accretion of
the discounts totaled $518,000 for the quarter ended June 30, 2003.
In connection with issuances of the April 16, 2002 convertible secured
promissory notes and warrants, we incurred approximately $741,000 of debt
issuance costs comprised of legal and professional fees, in addition to $183,000
in value calculated for the 110,000 warrants issued to the placement agent in
the transaction. These costs, which are included in other assets, are being
amortized over the term of the convertible secured promissory notes.
Amortization of these costs totaled $50,000 for the quarter ended June 30, 2003.
OTHER(INCOME) EXPENSE, NET. Other (income) expense, net, improved from
$174,000 of other expense, net, during the three months ended June 30, 2002 to
$6,000 of other income during the three months ended June 30, 2003. During the
three months ended June 2002, there were expenses associated with the unoccupied
Spectrum building of 50,000, a $71,000 reduction of estimated liabilities
related to revisions of estimates, a $153,000 note discount associated with the
repayment of a note from our co-chairman, and a $42,000 write-off of interest
receivable with the same note. There were no such transactions during the six
months ended June 30, 2003.
INCOME TAXES. Tax expense increased from $2,000 tax benefit for the
three months ended June 30, 2002 to $3,000 tax expense for the three months
ended June 30, 2003. The tax expense for the three months ended June 30, 2003,
related to minimum franchise taxes for the State of California.
LOSS FROM DISCONTINUED OPERATION. Loss from discontinued operation
decreased from $99,000 for the three months ended June 30, 2002 to zero dollars
for the three months ended June 30, 2003. During the first quarter of 2003,
management decided to discontinue the Pulsar operations and to focus solely on
the core business of information security products and services. We expect
minimal, if any, further losses from discontinued operations for the
remainder of 2003.
RESULTS OF OPERATIONS - COMPARISON OF SIX MONTHS ENDED JUNE 30, 2002 AND 2003
TOTAL REVENUES. Total revenues increased by $3.1 million or 75.8% from
$4.1 million during the six months ended June 30, 2002 to $7.1 million during
the six months ended June 30, 2003. The change was attributable to increases in
license revenues and service revenues of $2.5 million and $613,000,
respectively, offset by a decrease in product revenues of $51,000. We expect
total revenues to continue to increase during the remainder of 2003 due to the
delivery of products under existing contracts and new contracts that were not
existing previously.
During the six months ended June 30, 2002, we derived 29.9%, 15.4% and
9.1% of our revenues from sales to GD, DoD and U.S. Army Corps. of Engineers
("USACE"), respectively. During the six months ended June 30, 2003, we derived
32.0% and 35.0% of our revenues from sales to GD and DoD. Sales to government
agencies accounted for approximately 21.4% and 43.9% of our sales during the six
months ended June 30, 2002 and 2003, respectively. We expect our revenues to be
heavily concentrated with a few key customers and concentrated in government
projects throughout 2003.
PRODUCT REVENUES. Product revenues decreased by $51,000, or 2.2%, from
$2,325,000 during the six months ended June 30, 2002 to $2,274,000 during the
six months ended June 30, 2003. The decrease was primarily attributable to our
inability to fulfill certain orders due to the lack of sufficient capital
required to purchase products from vendors. We expect modest increases in
product revenues during the remainder of 2003 based on a shift of customer
purchases to newer product models.
SERVICE REVENUES. Service revenues increased by $2.3 million or 227.8%
from $994,000 during the six months ended June 30, 2002 to $3.2 million during
the six months ended June 30, 2003. The increase was primarily attributable a
$1.0 million increase in revenues associated with a new contract for the
development of JForte, a $552,000 increase in revenues associated with an
additional new contract for the next generation PKI infrastructure, a $246,000
increase in revenues associated with an existing contract for the next
7
generation PKI infrastructure support and a $261,000 increase in revenues
associated with an existing contract for Fortezza support. We expect service
revenues to continue to increase during 2003 as a result of newly signed and
existing service contracts.
LICENSE REVENUES. License revenues increased by $864,000, or 116.3%,
from $743,000 during the six months ended June 30, 2002 to $1.6 million during
the six months ended June 30, 2003. The increase was primarily attributable to a
$720,000 increase in revenues associated with the purchased licenses related to
the new contract for JForte and a $96,000 increase in revenues associated with a
new contract for the next generation PKI infrastructure. We expect licensing
revenues to continue to increase during 2003 based on incremental sales under
the CAC program coupled with increased sales of our PM software.
PRODUCT GROSS MARGIN. Product gross margin increased as a percentage of
net product revenues from 54.0% during the six months ended June 30, 2002 to
72.0% during the six months ended June 30, 2003. The increase was primarily
attributable to reduced costs of products sold during the quarter. We expect
product gross margins to remain at similar levels for the remainder of 2003.
SERVICE GROSS MARGIN. Service gross margin increased as a percentage of
net service revenues from 63.3% during the six months ended June 30, 2002 to
86.5% during the six months ended June 30, 2003. The margin percentage increase
was primarily attributable to higher margins obtained in our new service
contracts. We expect service gross margin percentages to decrease somewhat in
2003 due to the addition of the JForte project. We also expect that certain
compensation costs formerly considered research and development expense prior to
2003 would be included as cost of sales in 2003 due to the JForte contract.
LICENSE GROSS MARGIN. License gross margin decreased as a percentage of
net license revenues from 87.1% during the six months ended June 30, 2002 to
50.2% during the six months ended June 30, 2003. The margin percentage decrease
was primarily attributable to higher margins obtained under the CAC program. We
expect the annual license gross margin percentages during 2003 to remain at 2002
levels based on our projected sales mix for remainder of 2003.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. S,G&A expenses increased
by $75,000 or 1.8% from $4.1 million during the six months ended June 30, 2002
to $4.2 million during the six months ended June 30, 2003. The increase was
primarily attributable to a $1.3 million one-time charge related to ongoing
litigation with Research Venture, LLC, (further discussed below) offset by
reductions in work force, a reduction in compensation levels and reductions in
professional fees during the six months ended June 30, 2003. As a percentage of
total revenues, S,G&A expenses decreased from 102.2% during the six months ended
June 30, 2002 to 59.2% during the six months ended June 30, 2003. The percentage
decrease was the result of our success in increasing total revenues by $3.1
million while increasing S,G&A expenses by $75,000. The $1.3 million charge was
a one-time expense and therefore we expect SG&A to decrease for the remainder of
2003.
RESEARCH AND DEVELOPMENT EXPENSES. R&D expenses decreased $962,000 or
31.5% from $3.1 million during the six months ended June 30 2002 to $2.1 million
during the six months ended June 30, 2003. The decrease was primarily
attributable to reductions in work force and compensation levels during the six
months ended June 30, 2003. As a percentage of total revenues, R&D expenses
decreased from 75.1% during the six months ended June 30, 2002 to 29.2% during
the six months ended June 30, 2003. As noted in the discussion of Service Gross
Margin above, certain compensation costs formerly considered R&D expenses prior
to 2003 are being be included as cost of sales in 2003, as such, we expect R&D
to decrease for the remainder of 2003.
RESEARCH AND DEVELOPMENT EXPENSES - WAVE SYSTEMS CORP. Effective August
31, 2002, we terminated a development contract with Wave Systems Corp. By
canceling the development contract, we no longer incur the monthly development
charge of $278,000. This caused a reduction of $1.7 million in expenses during
the six months ended June 30, 2003 as compared to the six months ended June 30,
2002.
AMORTIZATION OF INTANGIBLES. Amortization of intangibles ceased with
the adoption of Statement No. 142. Accordingly, during the six months ended June
30, 2002, we had amortization expense of $46,000 as compared to zero dollars in
the six months ended June 30, 2003.
UNREALIZED LOSS ON TRADING SECURITIES. There was an unrealized loss on
trading securities during the six months ended June 30, 2003 of $25,000, which
pertained to our holding in Wave Systems Corp., which decreased from 80,000
shares at June 30, 2002 to 57,000 shares at June 30, 2003. We expect to sell the
remaining shares of Wave during the remainder of 2003.
8
INTEREST EXPENSE, NET. Interest expense, net increased from $315,000
during the six months ended June 30, 2002 to $590,000 during the six months
ended June 30, 2003. The increase was primarily attributable to the increase in
accrued interest from notes payable and interest expense related to settlement
with certain vendors. The increase in interest expenses is expected to continue
until the level of debt is reduced.
NON-CASH INTEREST AND FINANCING EXPENSE. Non-cash interest and
financing expense increased by $743,000 or 201.9% from $368,000 for the six
months ended June 30, 2002 to $1.1 million during the six months ended June 30,
2003. The increase related to the issuance of common stock in lieu of cash
interest payments on convertible secured promissory notes issued on April 16,
2002, and amortization of other debt issue costs. Based on the current
outstanding notes, we expect non-cash interest and financing expense to remain
at or above the second quarter levels for the remainder of 2003.
The beneficial conversion feature methodology and related dollar
amounts allocated to the warrants and beneficial conversion feature is discussed
in the non-cash interest and financing expense in the three month period above.
Accretion of the discounts totaled $968,000 for the six months ended June 30,
2003.
In connection with issuances of the April 16, 2002 convertible secured
promissory notes and warrants, we incurred approximately $741,000 of debt
issuance costs comprised of legal and professional fees, in addition to $183,000
in value calculated for the 110,000 warrants issued to the placement agent in
the transaction. These costs, which are included in other assets, are being
amortized over the term of the convertible secured promissory notes.
Amortization of these costs totaled $100,000 for the six months ended June 30,
2003.
OTHER(INCOME) EXPENSE, NET. Other (income) expense, net, improved from
$187,000 of other expense, net during the six months ended June 30, 2002 to
$6,000 of other income during the six months ended June 30, 2003. During the six
months ended June 2002, there were expenses associated with the unoccupied
Spectrum building of $64,000, a $71,000 reduction of estimated liabilities
related to revisions of estimates, a $153,000 note discount associated with the
repayment of a note from our co-chairman and a $42,000 write-off of interest
receivable with the same note. There were no such transactions during the six
months ended June 30, 2003.
INCOME TAXES. Tax expense increased from $2,000 for the six months
ended June 30, 2002 to $3,000 for the six months ended June 30, 2003. The tax
expense for the three months ended June 30, 2003, related to minimum franchise
taxes for the State of California.
LOSS FROM DISCONTINUED OPERATION AND LOSS ON DISPOSAL OF DISCONTINUED
OPERATION. Loss from discontinued operation decreased by $354,000, or 97.5%,
from $363,000 for the six months ended June 30, 2002 to $9,000 for the six
months ended June 30, 2003. Loss on Disposal of discontinued operation increased
from zero dollars for the six months ended June 30, 2002 to $97,000 for the six
months ended June 30, 2003. During to the first quarter of 2003, management
decided to discontinue the Pulsar operations and to focus solely on the core
business of information security products and services. We expect minimal, if
any, further losses from discontinued operations for the remainder of 2003.
LIQUIDITY AND CAPITAL RESOURCES
At June 30, 2003, we had a working capital deficit of $8.1 million. We
incurred net losses of $1.8 million and $3.4 million for the three and six
months then ended, respectively. We expect to continue to incur additional
losses in the current year. Given our June 30, 2003 cash balance of $512,000 and
our projected operating cash requirements, we anticipate that existing capital
resources will not be adequate to satisfy cash flow requirements through
December 31, 2003. We will require additional funding. Our cash flow estimates
are based upon achieving certain levels of sales, reductions in operating
expenses, liquidity available under our accounts receivable financing, as well
as additional debt or equity financing. We will continue to seek other sources
of funding, explore the sale of product lines or intellectual property rights,
or evaluate merger partners.
In October 2002, we executed a new factoring agreement with Bay View
Funding ("BVF"). During the quarter ended June 30, 2003, we incurred defaults
for other than payment of principal or interest under both our accounts
receivable financing with BVF and our long-term convertible notes. We requested
waivers from the holders of the notes, but the noteholders did not grant such
9
waivers. This means the noteholders have the right to declare us in default and
call all of their debt due and immediately payable. With the potential of the
notes being called for payment, we re-classified what would have otherwise been
long-term debt as short-term debt in the consolidated balance sheets as of June
30, 2003 and December 31, 2002. The BVF agreement states among other things that
a default occurs if we are generally not paying debts as they become due or if
we are left with unreasonably small capital. We have notified BVF of our failure
to make certain payments on a timely basis and have therefore requested, but
have not received, a waiver of such default.
Cash used in operations for the six months ended June 30, 2003 was
$904,000 compared to $7.0 million during the same period last year. The decrease
in cash used in operations was primarily attributable to a reduction in
operating loss for the six month period and smaller reductions of $472,000,
$283,000 and $296,000 in accounts payable, deferred revenue and accounts
receivable, respectively. Also, the decrease was partially offset by an increase
of $1.7 million in accrued liabilities. At June 30, 2003 the balance in accounts
receivable was $1.9 million and the balance in accounts payable was $3.9
million, of which approximately $2.6 million has aged 90 days or more. As of
June 30, 2003, $371,000 in accounts receivable was factored under our
arrangement with BVF. As a result, sufficient amounts of accounts receivable
will not be available to provide us with cash to meet our future cash needs and
we will need to continue using cash to reduce accounts payable. We expect to
continue to use cash in operations due to existing current liabilities that will
need to be paid in 2003.
Cash used in investing activities for the six months ended June 30,
2003 was $102,000 compared to $1.1 million cash provided by investing activities
for the same period in 2002. The change in cash used in investing activities
during the six months ended June 30, 2003 was primarily attributable to our
having made no sales of trading securities during the six months ended June 30,
2003. Cash provided by investing activities during the six months ended June 30,
2002 was primarily attributable to proceeds from the sale of trading securities
of $1.1 million. The market value of trading securities held at June 30, 2003
was approximately $50,000. As of August 14, 2003, we have sold the remainder of
the investment securities for an approximate amount of $171,000. We do not
expect any significant increases or decreases from cash provided by or used in
investing activities in the remainder of 2003.
Cash provided by financing activities for the six months ended June 30,
2003 was $965,000 compared to $3.1 million during the six months ended June 30,
2002. The cash provided by financing activities during the six months ended June
30, 2003 was primarily attributable to additional borrowings of $1.1 million
required for working capital issued under notes payable partially offset by
principal payments on note payables to related party of $210,000. We expect to
have increases in cash provided by financing activities in 2003 due to our
efforts to obtain additional working capital.
As of June 30, 2003, the balance of trading securities decreased from
$76,000 as of December 31, 2002 to $50,000 due to a decline in the market value
of Wave shares, and our recognition of approximately $25,000 in losses from this
decline. As of August 14, 2003, we have sold the remainder of the investment
securities for an approximate amount of $171,000. As of June 30, 2003, accounts
receivable totaled $1.9 million as compared to $1.6 million as of December 31,
2002. This increase was mainly attributable to increased revenues for the
quarter primarily associated with the funded JForte development project.
Accounts payable of $3.9 million as of June 30, 2003 decreased from $4.4 million
as of December 31, 2002. The decrease is attributable primarily to payments on
balances due to vendors. Accrued liabilities increased from $1.3 million at
December 31, 2002 to $3 million as of June 30, 2003. This increase in accrued
liabilities was mainly attributable to increases in accruals for deferred
compensation and interest expense. An accrual was also recorded for the
remaining rent payments associated with the former Pulsar operations in the
amount of $97,000. We anticipate the trend of lower accounts receivable,
accounts payable and accrued liabilities to continue until sales increase and
the increased operations require an expanded workforce.
We have experienced net losses and negative cash flows from operations
for the last several years, and as of June 30, 2003, we had an accumulated
deficit of $111 million. We have financed our past operations principally
through the issuance of common stock in a public offering and the issuance of
convertible debt. The net proceeds from our public offering were approximately
$35.3 million. The proceeds from the issuance of convertible debt for the year
ended December 31, 2002 were $4.8 million. We raised $1.1 million through the
issuance of secured convertible promissory notes during the six months ended
June 30, 2003. We have also issued notes and common stock to settle or
restructure previously executed agreements.
10
Over the past three years, we have spent substantial sums on R&D
activities. During that time period, we incurred substantial losses from
continuing operations. While we believe the R&D expenditures created significant
future revenue producing opportunities, some of the related products are just
entering production. We are currently involved in sales pursuits relative to
these products that, if successful, will generate significant revenues. However,
unless we receive orders for these new products and receive significant
financing, we can no longer support the current level of R&D activity. While we
have reduced our staffing levels, if sales fail to materialize, we will need to
further reduce expenses through additional reductions in staff.
The combination of reduced accounts receivable financing availability
and the unwillingness of primary vendors of our now discontinued network
deployment business to sell additional product to us on open account because of
significant past due amounts caused a substantial reduction in the sales and
related cost of sales during the year ended December 31, 2002, which in turn
reduced cash flow. The reduced cash flow impaired our ability to meet vendor
commitments as they became due. Due to the intensive capital requirements and
low margin returns, during the quarter ended March 31, 2003 we decided to exit
the Pulsar line of business and as a result, we are not accepting new orders and
we are currently in the final stages of completing a wind down of the Pulsar
operations.
In November 2000, we executed an alliance agreement with EDS for the
marketing of our products to EDS customers. This alliance called for a joint
working relationship between the two companies, was non-exclusive and had a term
of ten years. On August 27, 2001, EDS and we executed a letter of intent and
temporary working agreement whereby EDS supplied software and hardware for
re-sale to Pulsar customers. Under this agreement, as of December 31, 2002, $1.0
million remained outstanding and unpaid to EDS for purchases of hardware and
software. EDS and we executed a Master Services Agreement dated as of November
14, 2001 ("MSA") whereby beginning December 1, 2001 and ending December 31,
2006, EDS and we established a strategic teaming relationship to implement, sell
and deliver a set of secure transaction processing offerings based upon a trust
assurance network ("TAN"). The MSA task order required that we pay a monthly fee
of $44,000 for account, test and lab management services beginning January 1,
2002. As of June 30, 2003, EDS and we executed a Termination and General Release
Agreement ("TGRA") whereby the MSA has been terminated effective December 31,
2002. Pursuant to the TGRA, we agreed to pay EDS a total of $230,579 prior to
December 1, 2003 related to past due charges and accordingly EDS and we released
each other from further obligation, thereby terminating the MSA.
During 2001, we arranged for the lease of two buildings approximating
63,000 square feet that were under construction and were subsequently completed
in the Spectrum area of Irvine, California from an entity that was partially
owned by our co-chairman, Mr. Shah. On one building totaling approximately
23,000 square feet, we sublet one-half of the building on terms and conditions
matching the underlying lease. The sublease was with a related party company
owned by our co-chairman, Mr. Winkler. While that company made a lease deposit,
it did not make any monthly rent payments. In October 2002, we restructured our
lease obligations with our landlord, Research Venture, LLC, for the two
buildings. This restructuring and settlement revised the estimate of anticipated
costs relative to the disposition of one of the building leases that was
recorded in 2001 in the amount of $2.2 million, which was net of anticipated
offsetting sublease income. As a result of the restructuring and settlement, we
increased stockholders' equity by $1.7 million through the issuance of common
stock valued for financial reporting purposes at $956,000 and recorded a gain of
$700,000 for the year ended December 31, 2002. The settlement required us to
issue 959,323 shares of common stock, pay $500,000 in cash over a one-year
period, cancel the lease on one building approximating 23,000 square feet, and
take occupancy of the other building under a seven-year operating lease for the
facility with approximately 40,000 square feet for an initial monthly rental
rate of $55,000 plus common area costs beginning in December 2002. The first
payment of $75,000 toward the $500,000 was made as scheduled in December 2002,
with additional payments scheduled of $100,000 due in March 2003, $150,000 due
in June 2003 and a final payment of $175,000 due in September 2003. We did not
timely make the full $150,000 payment that was due in March 2003. Although we
subsequently paid the balance of the March payment due, we did not pay the
full $150,000 due in June 2003. Although we subsequently tendered the full
amount due, the late payment means we are currently in default under the
facilities settlement agreement. On August 11, 2003, Research Venture obtained
a judgment against us per prior stipulation in the amount of $2.7
million and as of August 18, 2003, Research Venture had not executed the
entered judgment. We are filing a motion to reduce the entered judgment.
Separately, we are in negotiations with Research Venture to resolve the
situation. However, we there is no assurance that the discussions will lead to
a successful resolution of the entered judgment. As such, we have recorded
11
a $1.3 million accrued liability for the three months ended June 30, 2003.
The $1.3 million accrual consists of the original judgment amount of $3.1
million less $456,000 of cash previously paid and $1.4 million of shares
previously issued. The monthly rental rate on the seven-year lease is scheduled
to increase to $73,000 plus common area costs, at the beginning of the third
year. We record rent expense on a straight-line basis. At our option, a portion
of the rental rate may be paid either in stock or in cash during the first two
years of the lease under certain circumstances through conversion of a $360,000
subordinated convertible promissory note that we issued as prepaid rent. In
August 2002, Mr. Shah surrendered his 25% ownership interest in the entity that
owns the two buildings. At the time of surrendering his interest, the buildings
were encumbered by one or more construction loans for which the lender required
personal guarantees for renewal of the financing. As there was little, if any,
equity in the project and Mr. Shah was unwilling to personally guarantee the
loans, Mr. Shah chose to surrender his membership interest.
In October 2002, we terminated our accounts receivable financing
arrangement with Wells Fargo Business Credit, Inc. and entered into a factoring
agreement with BVF. The new factoring agreement contains a maximum advance of
$750,000, was for an initial term of three months, and automatically renews for
successive three-month periods. We may terminate this agreement at any time
without the payment of any early termination fees, provided that we give at
least thirty days written notice to BVF prior to the end of any renewal term.
The agreement contains a factoring fee, which is based on 1.25% of the gross
face value of the purchased receivable for every 30-day period from the date of
purchase by BVF until the invoice is paid in full. For invoices outstanding more
than the 30-day period, a finance fee will be charged at the rate of .063% of
the gross face value of the purchased receivable for every one day period beyond
the 30th day from the original date of purchase. At the time of purchase, terms
call for BVF to advance 85% of the gross receivable, with the balance remitted
after collection of the invoice less the factoring and finance fee, if
applicable. The agreement contains representations, warranties, and covenants
and requires a monthly minimum fee, including the factoring and financing fees,
of .25% of the maximum advance of $750,000 or approximately $2,000 per month.
The agreement states among other things that a default occurs if we are
generally not paying debts as they become due or if we are left with
unreasonably small capital. We have notified BVF of our failure to make certain
payments on a timely basis and have therefore recently requested a waiver of
such default, but have not yet received such a waiver, and thus remain in
default.
Our significant fixed commitments with respect to term debt, leases and
inventory purchases as of June 30, 2003 were as follows:
PAYMENTS FOR THE YEARS ENDING DECEMBER 31,
----------------------------------------------------------------------
TOTAL 2003 2004 & 2005 2006 & 2007 2008 & AFTER
----- ---- ----------- ----------- ------------
CONTRACTUAL OBLIGATIONS
Convertible Notes Term Debt....... $ 8,282,000 $ 1,964,000 $6,319,000 $ -- $ --
Operating Leases.................. 6,356,000 747,000 2,483,000 2,282,000 844,000
Unconditional Purchase Obligations 488,000 488,000 -- -- --
----------------------------------------------------------------------------------------------------------
Total Contractual Cash Obligations $ 15,126,000 $ 3,199,000 $8,802,000 $2,282,000 $ 844,000
We currently have a need for a substantial amount of capital to meet
our liquidity requirements. The amount of capital that we will need in the
future will depend on many factors including, but not limited, to:
o the ability to extend terms of payment to vendors;
o the market acceptance of our products and services;
o the levels of promotion and advertising that will be required
to launch new products and services and attain a competitive
position in the market place;
o research and development plans;
o levels of inventory and accounts receivable;
o technological advances;
12
o competitors' responses to our products and services;
o relationships with partners, suppliers and customers;
o projected capital expenditures;
o national and international economic conditions, and events;
o periodic analysis of our goodwill valuation that may require
us to take additional write-downs in future periods;
o defaults on financing that will impact the availability of
borrowings, or result in notes being declared immediately due
and payable; and
o reductions in the valuation of investment in trading
securities.
Our current financial condition is the result of several factors
including the following:
o our operating results were below expectations;
o sales of products into the commercial markets are taking
longer to develop than originally anticipated and our alliance
with EDS did not produce expected revenues;
o lower than expected margins and reduced revenues from our
Pulsar subsidiary ultimately led us to limit sales orders and
eventually discontinue that operation;
o entering into the lease for additional facilities was a poor
decision that burdened us with additional fixed expenses that
are a drain on operating results; and
o Investment in our subsidiary, SSP Gaming, formed to conduct
business and activities relative to the gaming industry has
been a financial drain.
In addition to our current deficit working capital situation, current
operating plans show a shortfall of cash for the remainder of 2003. We intend to
mitigate our position through one or more of the following:
o Additional Equity Capital. We will seek additional equity
capital, if available. Equity capital will most likely be
issued at a discount to market and will require the issuance
of warrants, which will cause dilution to current
stockholders. In addition, providers of new equity capital may
require additional concessions.
o Additional Convertible Debt. Depending upon the market
conditions, we may issue additional debt instruments. The
types of instruments available in the market would likely
contain a provision for the issuance of warrants and may also
be convertible into equity.
o Off Balance Sheet Financing. If we need to add equipment or
decide to expand our facilities, we may use an operating lease
transaction to acquire the use of capital assets. An operating
lease would not appear on our balance sheet and would be
charged as an expense as payments accrue.
o Financing of Receivables. We plan to generate cash by
financing receivables as allowed under the BVF agreement.
o Sale of Investments. We may sell investments to generate cash.
The market value of trading securities was $50,000 at June 30,
2003. Since that date, we have sold the remainder of the
investment securities for an approximate amount of $171,000.
o Negotiate with Vendors. We have executed settlement and/or
term-out agreements with a number of vendors. We will continue
to negotiate with vendors regarding payment of existing
accounts payable over extended terms of up to 48 months.
o Deferral of Cash Payments. We may defer cash payments through
suspension of certain development projects.
13
o Issuance of Stock as Payment for Existing and Future
Obligations. We may pay portions of accounts payable and
accrued liabilities through issuances of common stock.
o Issuance of Stock to Pay Interest. During 2002, we issued
105,861 shares 127,035 shares and 211,727 shares as payment of
interest due on our April 16, 2002 secured convertible
promissory notes for the three month periods ended June 30,
2002, September 30, 2002, and December 31, 2002, respectively.
During the quarter ended June 30, 2003, we issued 201,291 as
payment for interest due for the three months ended March 31,
2003. We will issue additional stock in the future to pay
interest on long-term debt.
o Reductions in Work Force. We reduced our work force in 2002
and decreased the cash compensation paid to the remaining
workforce. We may be forced to make similar reductions in the
future if we do not realize our projected sales plans.
If we do not receive adequate financing, we could be forced to merge
with another company or cease operations.
While we have a history of selling products in government markets, our
new products that are just entering production after years of development have
no sales history. Additionally, we are entering commercial markets with our
products and are still developing acceptance of our offerings. Considerable
uncertainty currently exists with respect to the adequacy of current funds to
support our activities beyond June 30, 2003. This uncertainty will continue
until a positive cash flow from operations is achieved. Additionally, we are
uncertain as to the availability of financing from other sources to fund any
cash deficiencies.
In order to reduce this uncertainty, we continue to evaluate additional
financing options and may therefore elect to raise capital, from time to time,
through equity or debt financings in order to capitalize on business
opportunities and market conditions and to insure the continued marketing of
current product offerings together with development of new technology, products
and services. There can be no assurance that we can raise additional financing
in the future.
Based upon forecasted sales and expense levels, we currently anticipate
that existing cash, cash equivalents, investments, term-out arrangements with
vendors and the current availability under our BVF factoring agreement will not
be sufficient to satisfy our contemplated cash requirements through December 31,
2003. However, our forecast is based upon certain assumptions, which may differ
from actual future outcomes. We have incurred defaults under our financing
agreements in the past. As discussed above, the BVF agreement states among other
things that a default occurs if we are generally not paying debts as they become
due or if we are left with unreasonably small capital. We have notified BVF of
our failure to make certain payments on a timely basis and have therefore
requested a waiver of such default. We therefore may not be able to draw funds
in the future, which would affect our ability to fund our operations.
Additionally, without a substantial increase in sales or a reduction in
expenses, we will continue to incur operating losses.
RISK FACTORS
AN INVESTMENT IN SHARES OF OUR COMMON STOCK INVOLVES A HIGH DEGREE OF
RISK. IN ADDITION TO THE OTHER INFORMATION CONTAINED OR INCORPORATED BY
REFERENCE IN THIS REPORT, YOU SHOULD CAREFULLY CONSIDER THE FOLLOWING RISK
FACTORS BEFORE DECIDING TO INVEST OR MAINTAIN AN INVESTMENT IN SHARES OF OUR
COMMON STOCK. THIS REPORT CONTAINS OR INCORPORATES BY REFERENCE FORWARD-LOOKING
STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. OUR ACTUAL RESULTS COULD DIFFER
MATERIALLY FROM THOSE ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS AS A
RESULT OF CERTAIN FACTORS, INCLUDING THOSE SET FORTH IN THE FOLLOWING RISK
FACTORS AND ELSEWHERE IN THIS REPORT. IF ANY OF THE FOLLOWING RISKS ACTUALLY
OCCURS, IT IS LIKELY THAT OUR BUSINESS, FINANCIAL CONDITION AND OPERATING
RESULTS WOULD BE HARMED. AS A RESULT, THE TRADING PRICE OF OUR COMMON STOCK
COULD DECLINE, AND YOU COULD LOSE PART OR ALL OF YOUR INVESTMENT.
WE HAVE A HISTORY OF LOSSES AND MAY INCUR FUTURE LOSSES THAT MAY ADVERSELY
IMPACT OUR BUSINESS AND OUR STOCKHOLDERS BY, AMONG OTHER THINGS, MAKING IT
DIFFICULT FOR US TO RAISE ADDITIONAL DEBT OR EQUITY FINANCING TO THE EXTENT
NEEDED FOR OUR CONTINUED OPERATIONS OR FOR PLANNED EXPANSION.
14
We may not become profitable or significantly increase our revenue. We
incurred net losses of $8.6 million for the year ended December 31, 2002 and
$3.4 million for the six months ended June 30, 2003. To achieve profitability,
we will need to generate and sustain sufficient revenues while maintaining
reasonable cost and expense levels. We expect to continue to incur significant
operating expenses primarily to support research and development and expansion
of our sales and marketing efforts. These expenditures may not result in
increased revenues or customer growth. We do not know when or if we will become
profitable. We may not be able to sustain or increase profitability on a
quarterly or annual basis.
Our losses from operations, our use of cash in operating activities,
and our accumulated deficit and working capital deficiency at December 31, 2002
and 2001, among other factors, raised substantial doubt about our ability to
continue as a going concern and led our independent auditors to include in their
opinions contained in our consolidated financial statements as of December 31,
2002 and 2001 and for each of the years in the three-year period ended December
31, 2002 an explanatory paragraph related to our ability to continue as a going
concern. Analysts and investors generally view reports of independent auditors
questioning a company's ability to continue as a going concern unfavorably.
These reports may make it difficult for us to raise additional debt or equity
financing to the extent needed for our continued operations or for planned
expansion, particularly if we are unable to attain and maintain profitable
operations in the future. Consequently, future losses may adversely affect our
business, prospects, financial condition, results of operations and cash flows.
We urge potential investors to review the reports of our independent auditors
and our consolidated financial statements before making a decision to invest in
our company.
WE MAY BE UNABLE TO OBTAIN ADDITIONAL FUNDING ON SATISFACTORY TERMS, WHICH
COULD INTERFERE WITH OUR EXISTING AND PLANNED OPERATIONS, DILUTE OUR
STOCKHOLDERS OR IMPOSE BURDENSOME FINANCIAL RESTRICTIONS ON OUR BUSINESS.
Historically, we have relied upon cash from financing activities to
fund a significant portion of the cash requirements of our operating and
investing activities, and there is no assurance we will be able to generate
sufficient cash from our operating activities in the future. We do not expect
future fixed obligations to be paid from operations during 2003 and intend to
satisfy fixed obligations by obtaining additional debt and/or equity financing,
using accounts receivable financing, extending vendor payments, selling
investments and issuing stock as payment on obligations.
Some of our secured convertible promissory notes contain the grant of a
continuing security interest in substantially all of our assets and restrict our
ability to obtain debt and/or equity financing. In addition, deteriorating
global economic conditions and the effects of military actions may cause
prolonged declines in investor confidence in and accessibility to capital
markets.
Any future financing may cause significant dilution to existing
stockholders. Any debt financing or other financing of securities senior to
common stock will likely include financial and other covenants that will
restrict our flexibility. At a minimum, we expect these covenants to include
restrictions on our ability to pay dividends on our common stock. Any failure to
comply with these covenants would adversely affect our business, prospects,
financial condition, results of operations and cash flows. Financing
arrangements to raise additional funds may require us to relinquish rights to
certain technologies, products or marketing territories. Our failure to raise
capital when needed and on terms acceptable to us could adversely affect our
business, operating results, financial condition and prospects by impairing our
ability to fund our existing and planned operations.
DEFAULTS UNDER OUR SECURED CREDIT ARRANGEMENTS COULD RESULT IN A
FORECLOSURE ON OUR ASSETS BY OUR CREDITORS.
All of our assets are pledged as collateral to secure portions of our
debt. We were not able to obtain waivers for past covenant defaults, and we may
in the future default under certain covenants of these credit arrangements. This
means that if we are unable to obtain waivers in the future or if we incur a
monetary default on our secured debt obligations, our indebtedness could become
immediately due and payable and the lenders could foreclose on our assets.
WE HAVE NOT GENERATED ANY SIGNIFICANT SALES OF OUR PRODUCTS WITHIN THE
COMPETITIVE COMMERCIAL MARKET NOR HAVE WE ESTABLISHED A SUFFICIENT SALES
AND MARKETING FORCE TO PROMOTE OUR PRODUCTS TO POTENTIAL COMMERCIAL
CUSTOMERS, WHICH MAKES IT DIFFICULT TO EVALUATE OUR CURRENT BUSINESS
PERFORMANCE AND FUTURE PROSPECTS.
15
Although we have had some success in selling our security solutions to
government agencies, we are just beginning to enter the complex and competitive
commercial market for digital commerce and communications security solutions. We
believe that many potential customers in our target markets are not fully aware
of the need for security products and services in the digital economy.
Historically, only enterprises that had substantial resources developed or
purchased security solutions for delivery of digital content over the Internet
or through other means. Also, there is a perception that security in delivering
digital content is costly and difficult to implement. Therefore, we will not
succeed unless we can educate our target markets about the need for security in
delivering digital content and convince potential customers of our ability to
provide this security in a cost-effective and easy-to-use manner.
Even if we convince our target markets about the importance of and need
for such security, we do not know if this will result in the sale of our
products. We may be unable to establish sales and marketing operations at levels
necessary for us to grow this portion of our business, especially if we are
unsuccessful at selling this product into vertical markets. We may not be able
to support the promotional programs required by selling simultaneously into
several markets. If we are unable to develop an efficient sales system, or if
our products or components do not achieve wide market acceptance, then our
operating results will suffer and our earnings per share will be adversely
affected.
WE FACE INTENSE COMPETITION AND PRICING PRESSURES FROM A NUMBER OF SOURCES,
WHICH MAY REDUCE OUR AVERAGE SELLING PRICES AND GROSS MARGINS.
The markets for our products and services are intensely competitive. As
a result, we face significant competition from a number of sources. We may be
unable to compete successfully because many of our competitors are more
established, benefit from greater name recognition and have substantially
greater financial, technical and marketing resources than we have. In addition,
there are several smaller and start-up companies with which we compete from time
to time. We expect competition to increase as a result of consolidation in the
information security technology and product reseller industries.
The average selling prices for our products may decline as a result of
competitive pricing pressures, promotional programs and customers who negotiate
price reductions in exchange for longer term purchase commitments. The pricing
of products depends on the specific features and functions of the products,
purchase volumes and the level of sales and service support required. We expect
competition to increase in the future. As we experience pricing pressure, we
anticipate that the average selling prices and gross margins for our products
will decrease over product lifecycles. These same competitive pressures may
require us to write down the carrying value of any inventory on hand, which
would adversely impact our operating results and adversely affect our earnings
per share.
WE DERIVE A SUBSTANTIAL PORTION OF OUR REVENUE FROM A SMALL NUMBER OF
CUSTOMERS, AND THE LOSS OF ONLY ONE OF THOSE CUSTOMERS COULD ADVERSELY
IMPACT OUR OPERATING RESULTS.
We depend on a limited number of customers for a substantial portion of
our revenue. During the three months ended June 30, 2003 and the year ended
December 31, 2002, we derived 32% and 26%, respectively, of our consolidated net
revenue for that period from an individual customer. Many of our contracts with
our significant customers are short-term contracts. The non-renewal of any
significant contract upon expiration, or a substantial reduction in sales to any
of our significant customers, would adversely affect our business unless we were
able to replace the revenue we received from those customers.
OUR RELIANCE ON THIRD PARTY TECHNOLOGIES FOR THE DEVELOPMENT OF SOME OF OUR
PRODUCTS AND OUR RELIANCE ON THIRD PARTIES FOR MANUFACTURING MAY DELAY
PRODUCT LAUNCH, IMPAIR OUR ABILITY TO DEVELOP AND DELIVER PRODUCTS OR HURT
OUR ABILITY TO COMPETE IN THE MARKET.
Our ability to license new technologies from third parties is and will
continue to be critical to our ability to offer a complete suite of products
that meets customer needs and technological requirements. Some of our licenses
do not run for the full duration of the third party's patent for the licensed
technology. We may not be able to renew our existing licenses on favorable
terms, or at all. If we lose the rights to a patented technology, we may need to
stop selling or may need to redesign our products that incorporate that
technology, and we may lose a competitive advantage. In addition, competitors
could obtain licenses for technologies for which we are unable to obtain
licenses, and third parties may develop or enable others to develop a similar
solution to digital communication security issues, either of which events could
erode our market share. Also, dependence on the patent protection of third
parties may not afford us any control over the protection of the technologies
upon which we rely. If the patent protection of any of these third parties were
compromised, our ability to compete in the market also would be impaired.
16
THIRD PARTIES COULD OBTAIN ACCESS TO OUR PROPRIETARY INFORMATION OR COULD
INDEPENDENTLY DEVELOP SIMILAR TECHNOLOGIES BECAUSE OF THE LIMITED
PROTECTION FOR OUR INTELLECTUAL PROPERTY.
Despite the precautions we take, third parties may copy or obtain and
use our proprietary technologies, ideas, know-how and other proprietary
information without authorization or may independently develop technologies
similar or superior to our technologies. In addition, the confidentiality and
non-competition agreements between us and our employees, distributors and
clients may not provide meaningful protection of our proprietary technologies or
other intellectual property in the event of unauthorized use or disclosure.
Policing unauthorized use of our technologies and other intellectual property is
difficult, particularly because the global nature of the Internet makes it
difficult to control the ultimate destination or security of software or other
data transmitted. Furthermore, the laws of other jurisdictions may afford little
or no effective protection of our intellectual property rights. Our business,
financial condition and operating results could be adversely affected if we are
unable to adequately protect our intellectual property rights.
WE MAY FACE HARMFUL CLAIMS OF INFRINGEMENT OF PROPRIETARY RIGHTS, WHICH
COULD REQUIRE US TO DEVOTE SUBSTANTIAL TIME AND RESOURCES TOWARD MODIFYING
OUR PRODUCTS OR OBTAINING APPROPRIATE LICENSES.
There is a risk that our products infringe the proprietary rights of
third parties. Regardless of whether our products infringe on proprietary rights
of third parties, infringement or invalidity claims may be asserted or
prosecuted against us and we could incur significant expenses in defending them.
If any infringement claims or actions are asserted against us, we may be
required to modify our products or seek licenses for these intellectual property
rights. We may not be able to modify our products or obtain licenses on
commercially reasonable terms, in a timely manner or at all. Our failure to do
so could adversely affect our business by preventing us from selling some or all
of our products.
OUR INABILITY TO MAINTAIN AND DEVELOP NEW STRATEGIC RELATIONSHIPS WITH
PARTNERS AND SUPPLIERS COULD IMPACT OUR ABILITY TO OBTAIN OR SELL OUR
PRODUCTS, AND PREVENT US FROM GENERATING SALES REVENUES.
We obtain and sell many of our products through strategic alliance and
supplier agreements. The loss of any of our existing strategic relationships, or
the inability to create new strategic relationships in the future, could
adversely affect our ability to develop and market our products.
We depend upon our partners to develop and market products and to fund
and perform their obligations as contemplated by our agreements with them. We do
not control the time and resources devoted by our partners to these activities.
These relationships may not continue or may require us to spend significant
financial, personnel and administrative resources from time to time. We may not
have the resources available to satisfy our commitments, which may adversely
affect our strategic relationships. Further, our products and services may
compete with the products and services of our strategic partners. This
competition may adversely affect our relationships with our strategic partners,
which could adversely affect our business.
If alliance or supplier agreements are cancelled, modified or delayed,
if alliance or supplier partners decide not to purchase our products or to
purchase only limited quantities of our products, or if we are unable to enter
into additional alliance or supplier agreements, our ability to produce and sell
our products and to generate sales revenues could be adversely affected.
ANY COMPROMISE OF PKI TECHNOLOGY WOULD ADVERSELY AFFECT OUR BUSINESS BY
REDUCING OR ELIMINATING DEMAND FOR MANY OF OUR DATA SECURITY PRODUCTS.
Many of our products are based on public key infrastructure, or PKI,
technology, which is the standard technology for securing Internet-based
commerce and communications. The security afforded by this technology depends on
the integrity of a user's private key, which depends in part on the application
of algorithms, or advanced mathematical factoring equations. The occurrence of
any of the following could result in a decline in demand for our data security
products:
o any significant advance in techniques for attacking PKI
systems, including the development of an easy factoring method
or faster, more powerful computers;
o publicity of the successful decoding of cryptographic messages
or the misappropriation of private keys; and
17
o government regulation limiting the use, scope or strength of
PKI.
A SECURITY BREACH OF OUR INTERNAL SYSTEMS OR THOSE OF OUR CUSTOMERS DUE TO
COMPUTER HACKERS OR CYBER TERRORISTS COULD HARM OUR BUSINESS BY ADVERSELY
AFFECTING THE MARKET'S PERCEPTION OF OUR PRODUCTS AND SERVICES.
Since we provide security for Internet and other digital communication
networks, we may become a target for attacks by computer hackers. The ripple
effects throughout the economy of terrorist threats and attacks and military
activities may have a prolonged effect on our potential commercial customers, or
on their ability to purchase our products and services. Additionally, because we
provide security products to the United States government, we may be targeted by
cyber terrorist groups for activities threatened against United States-based
targets.
We will not succeed unless the marketplace is confident that we provide
effective security protection for Internet and other digital communication
networks. Networks protected by our products may be vulnerable to electronic
break-ins. Because the techniques used by computer hackers to access or sabotage
networks change frequently and generally are not recognized until launched
against a target, we may be unable to anticipate these techniques. Although we
have not experienced any act of sabotage or unauthorized access by a third party
of our internal network to date, if an actual or perceived breach of security
for Internet and other digital communication networks occurs in our internal
systems or those of our end-user customers, regardless of whether we caused the
breach, it could adversely affect the market's perception of our products and
services. This could cause us to lose customers, resellers, alliance partners or
other business partners.
WE MAY BE EXPOSED TO SIGNIFICANT LIABILITY FOR ACTUAL OR PERCEIVED FAILURE
TO PROVIDE REQUIRED PRODUCTS OR SERVICES.
Products as complex as those we offer may contain undetected errors or
may fail when first introduced or when new versions are released. Despite our
product testing efforts and testing by current and potential customers, it is
possible that errors will be found in new products or enhancements after
commencement of commercial shipments. The occurrence of product defects or
errors could result in adverse publicity, delay in product introduction,
diversion of resources to remedy defects, loss of or a delay in market
acceptance, or claims by customers against us, or could cause us to incur
additional costs, any of which could adversely affect our business.
Because our customers rely on our products for critical security
applications, we may be exposed to claims for damages allegedly caused to an
enterprise as a result of an actual or perceived failure of our products. An
actual or perceived breach of enterprise network or data security systems of one
of our customers, regardless of whether the breach is attributable to our
products or solutions, could adversely affect our business reputation.
Furthermore, our failure or inability to meet a customer's expectations in the
performance of our services, or to do so in the time frame required by the
customer, regardless of our responsibility for the failure, could:
o result in a claim for substantial damages against us by the
customer;
o discourage customers from engaging us for these services; and
o damage our business reputation.
IF USE OF THE INTERNET AND OTHER COMMUNICATION NETWORKS BASED ON INTERNET
PROTOCOLS DOES NOT CONTINUE TO GROW, DEMAND FOR OUR PRODUCTS MAY NOT
INCREASE.
Increased demand for our products largely depends on the continued
growth of the Internet and Internet protocol-based networks and the widespread
acceptance and use of these mediums for electronic commerce and communications.
Because electronic commerce and communications over these networks are evolving,
we cannot predict the size of the market and its sustainable growth rate. A
number of factors may affect market size and growth rate, including increases in
governmental regulation and the continued ability of the Internet infrastructure
and communications services to support growing demands, which ability could be
adversely affected by, among other things, delays in development or adoption of
new standards and protocols to handle increased levels of activity. If the use
of electronic commerce and communications does not increase, or increases more
slowly than we expect, demand for our products and services will be adversely
impacted.
18
IF WE DO NOT RESPOND TO RAPID TECHNOLOGICAL CHANGES, OUR PRODUCT AND
SERVICE OFFERINGS COULD BECOME OBSOLETE.
The markets we serve are characterized by rapidly changing technology,
emerging industry standards and frequent introduction of new products. The
introduction of products embodying new technologies and the emergence of new
industry standards may render our products obsolete or less marketable. The
process of developing our products and services is extremely complex and
requires significant continuing development efforts. If we are unable to modify
existing products and develop new products and services that are responsive to
changing technology and standards and to meet customer needs in a timely and
cost effective manner, our business could be adversely affected because we would
be unable to sell our product and service offerings that have become obsolete.
DOING BUSINESS WITH THE UNITED STATES GOVERNMENT ENTAILS MANY RISKS THAT
COULD ADVERSELY AFFECT US BY DECREASING THE PROFITABILITY OF GOVERNMENTAL
CONTRACTS WE ARE ABLE TO OBTAIN AND INTERFERING WITH OUR ABILITY TO OBTAIN
FUTURE GOVERNMENTAL CONTRACTS.
Sales to United States government agencies accounted for 39% and 22% of
our consolidated revenues for the three months ended June 30, 2003 and the year
ended December 31, 2002, respectively and 44% and 21% of our consolidated
revenues for the six months ended June 30, 2003 and 2002, respectively. Our
sales to these agencies are subject to risks that include:
o early termination of our contracts;
o disallowance of costs upon audit; and
o the need to participate in competitive bidding and proposal
processes, which are costly and time consuming and may result
in unprofitable contracts.
In addition, the government may be in a position to obtain greater
rights with respect to our intellectual property than we would grant to other
entities. Government agencies also have the power, based on financial
difficulties or investigations of their contractors, to deem contractors
unsuitable for new contract awards. Because we engage in the governmental
contracting business, we have been and will be subject to audits and may be
subject to investigation by governmental entities. Failure to comply with the
terms of any of our governmental contracts could result in substantial civil and
criminal fines and penalties, as well as our suspension from future governmental
contracts for a significant period of time, any of which could adversely affect
our business by requiring us to spend money to pay the fines and penalties and
prohibiting us from earning revenues from governmental contracts during the
suspension period.
DELAYS IN DELIVERIES FROM OUR SUPPLIERS OR DEFECTS IN GOODS OR COMPONENTS
SUPPLIED BY OUR VENDORS COULD CAUSE OUR REVENUES AND GROSS MARGINS TO
DECLINE.
We rely on a limited number of vendors for certain components for the
products we are developing. Any undetected flaws in components supplied by our
vendors could lead to unanticipated costs to repair or replace these parts. We
currently purchase some of our components from a single supplier, which presents
a risk that the components may not be available in the future on commercially
reasonable terms or at all. For example, Atmel Corporation has completed
development of a specially designed Forte microprocessor that we have
incorporated into a Forte PKI card. Commercial acceptance of the Forte
microprocessor will be dependent on continued development of applications to
service customer requirements. Any inability to receive or any delay in
receiving adequate supplies of the Forte microprocessor, whether as a result of
delays in development of applications or otherwise, would adversely affect our
ability to sell the Forte PKI card.
We do not anticipate maintaining a supply agreement with Atmel
Corporation for the Forte microprocessor. If Atmel Corporation were unable to
deliver the Forte microprocessor for a lengthy period of time or were to
terminate its relationship with us, we would be unable to produce the Forte PKI
card until we could design a replacement computer chip for the Forte
microprocessor. We anticipate this would take substantial time and resources to
complete, which could result in delays or reductions in product shipments that
could adversely affect our business by requiring us to expend resources while
preventing us from selling the Forte PKI card.
Also, if we are unable to obtain or generate sufficient funds to
sustain our operations, we may damage our relationships with our vendors. Slow
and delinquent payments may cause vendors not to sell products to us, or only
with advance payment. If this occurs, we will not have components and services
19
available for our products. We may not be able to replace any of our supply
sources on economically advantageous terms. Further, if we experience price
increases for the components for our products, we will experience declines in
our gross margins.
OUR SUCCESS DEPENDS ON OUR ABILITY TO RETAIN OUR CURRENT MANAGEMENT TEAM.
Our founder, co-chairman and co-chief executive officer, Kris Shah, has
been with us since 1970, and our co-chairman and co-chief executive officer,
Marvin Winkler, co-founded one of our wholly-owned subsidiaries. Their
experience, expertise, industry knowledge and historical company knowledge would
be extremely difficult to replace if we were to lose the services of either of
them. The precise impact of the loss of services of either of them is difficult
to predict, but would likely result in, at a minimum, significant costs to
recruit, hire and retain a successor and impaired operating results while the
successor was being recruited and transitioning into the position. We do not
currently maintain life insurance on the lives of either of these officers.
THERE IS SIGNIFICANT COMPETITION IN OUR INDUSTRY FOR HIGHLY SKILLED
EMPLOYEES, AND OUR FAILURE TO ATTRACT AND RETAIN TECHNICAL PERSONNEL WOULD
ADVERSELY AFFECT OUR BUSINESS BY IMPAIRING OUR ABILITY TO EFFICIENTLY
CONDUCT OUR OPERATIONS.
We may not be able to attract or retain highly skilled employees. Our
inability to hire or retain highly qualified individuals may impede our ability
to develop, install, implement and service our software and hardware systems, to
retain existing customers and attract new customers, or to efficiently conduct
our operations, all of which would adversely affect our business. A high level
of employee mobility characterizes the data security and networking solution
industries, and the market for highly qualified individuals in computer-related
fields is intense. This competition means there are fewer highly qualified
employees available to hire, and the costs of hiring and retaining these
individuals are high. Even if we are able to hire these individuals, we may be
unable to retain them. Furthermore, the hiring and retention of technical
employees necessitates the issuance of stock options and other equity interests,
which may dilute earnings per share.
OUR EFFORTS TO EXPAND OUR INTERNATIONAL OPERATIONS ARE SUBJECT TO A NUMBER
OF RISKS, ANY OF WHICH COULD ADVERSELY AFFECT OUR FUTURE INTERNATIONAL
SALES.
We have obtained approvals to export certain of our products and we
plan to increase our international sales. Our inability to obtain or maintain
federal or foreign regulatory approvals relating to the import or export of our
products on a timely basis could adversely affect our ability to expand our
international business. Additionally, our international operations could be
subject to a number of risks, any of which could adversely affect our future
international sales, including:
o increased collection risks;
o trade restrictions;
o export duties and tariffs;
o uncertain political, regulatory and economic developments; and
o inability to protect our intellectual property rights.
WE ARE UNABLE TO PREDICT THE EXTENT TO WHICH THE RESOLUTION OF LAWSUITS
PENDING AGAINST US AND OUR SUBSIDIARY COULD ADVERSELY AFFECT OUR BUSINESS
BY, AMONG OTHER THINGS, SUBJECTING US TO SUBSTANTIAL COSTS AND LIABILITIES
AND DIVERTING MANAGEMENT'S ATTENTION AND RESOURCES.
G2 Resources, Inc. and Classical Financial Services, LLC have filed
complaints against Pulsar Data Systems, Inc., or Pulsar, alleging that Pulsar
breached a contract by failing to make payments to G2 Resources, Inc. in
connection with services allegedly provided by G2 Resources, Inc. In April 2001,
the court dismissed, for lack of prosecution activity for more than twelve
months, the original complaint that G2 Resources, Inc. had filed against Pulsar
in January 1998. G2 Resources, Inc. re-filed the action in May 2001. In 2002,
the court moved this case into the same division handling other matters related
to G2 and Classic Financial Services, LLC. The Company intends to vigorously
defend against the plaintiffs' claims and has asserted defenses and
counterclaims.
20
In May 2002, Integral Systems, Inc. filed an action against us alleging
that we breached a promissory note for the payment of $389,610, Integral then
obtained a confessed judgment for approximately $327,250. In March 2003 we
executed settlement papers that would permit Integral Systems to file a
stipulated judgment against us in the amount of the unpaid balance if we default
on a payment schedule that requires us to make payments of $20,000 per month
until the balance is paid in full. We placed 400,000 shares of our common stock
into a third party escrow as security until the balance is paid in full.
In June 2002, Research Venture, LLC filed two lawsuits against us
alleging unlawful detainer and seeking possession of two leased properties,
alleged damages and lost rent. We surrendered possession of both properties and
negotiated a restructuring of our obligations under the leases. Under the
restructuring arrangement, we agreed to make cash payments to Research Venture
aggregating $500,000, and we issued 959,323 shares of common stock and a
subordinated convertible promissory note in the principal amount of $360,000
that represents prepaid rent on a property we are leasing from Research Venture
and is convertible into an aggregate of up to 276,923 shares of common stock.
Research Venture will be entitled to entry of the stipulated judgment in the
maximum aggregate amount of $3.1 million, less consideration we pay prior to any
entry of the judgment, if we do not comply with the terms of the restructuring
arrangement through December 2004. On August 11, 2003, Research Venture obtained
a judgment against us per prior stipulation in the amount of $2.7 million and as
of August 18, 2003, Research Venture had not executed the entered judgment. We
are filing a motion to reduce the entered judgment. Separately, we are in
negotiations with Research Venture to resolve the situation. However, we there
is no assurance that the discussions will lead to a successful resolution of the
entered judgment. As such, we have recorded a $1.3 million accrued liability for
the three months ended June 30, 2003. The $1.3 million charge consists of the
original judgment amount of $3.1 million less $456,000 of cash previously paid
and $1.4 million of shares previously issued.
In July 2003 Control Break International ("CBI"), a holder of two
promissory notes with current outstanding balances of $429 and $27 each due in
July 2003 filed an action in Florida to initiate collection of the $456 of
balances due. The Company intends to defend against the action and to file a
motion to dismiss based upon lack of jurisdiction. The Company has held
discussions with CBI to resolve the matter, but there can be no assurance on the
outcome of those discussions.
At the end of June 2003, the Venetian sent a demand letter to our
subsidiary demanding funding, or alternatively taking action to terminate the
operating agreement for failure of our subsidiary to meet its funding commitment
(Note 4). The Venetian threatened to take action against our subsidiary in the
matter, but this obligation, if any, is limited to our subsidiary.
Any or all of these litigation matters could subject us to substantial
costs and liabilities and divert our management's attention and resources during
our current and future financial reporting periods. If we believe it is probable
that we will incur an estimable amount of expenses in connection with a
litigation matter, we will include the estimated amount of expenses in accounts
payable or accrued liabilities. If we feel unable to make a reasonable judgment
as to the ultimate outcome of, or to assess or quantify our exposure relating
to, a litigation matter, we will not include in our financial statements an
estimated amount of expenses for that matter. Consequently, if we are unable
during any financial reporting period to accurately estimate our potential
liability in connection with a litigation matter, our financial condition and
results of operations in future financial reporting periods may be adversely
affected when we record any unreserved costs or liabilities we actually have
incurred in connection with a litigation matter.
A NUMBER OF VENDORS HAVE FILED OR THREATENED TO FILE LAWSUITS TO COLLECT
AMOUNTS DUE FROM US. IF WE ARE UNABLE TO REACH A FAVORABLE RESOLUTION OF
THESE MATTERS, WE MAY HAVE TO DEFEND OURSELVES IN COSTLY LITIGATION AND BE
SUBJECT TO SUBSTANTIAL MONETARY JUDGMENTS.
During 2002, several vendors filed or threatened to file suits against
us related to outstanding account balances that are included within our accounts
payable. We reached oral agreement with several vendors, including one vendor
who had filed suit against us. We are making payments on the amount owed to the
vendor who filed suit against us and executed an agreement to extend the terms
of the existing accounts payable balance. However, if we fail to make the
required payments and the collection suit goes to judgment, there would be an
adverse impact on our financial condition and liquidity.
21
GOVERNMENTAL REGULATIONS AFFECTING SECURITY OF INTERNET AND OTHER DIGITAL
COMMUNICATION NETWORKS COULD LIMIT THE MARKET FOR OUR PRODUCTS AND
SERVICES.
The United States government and foreign governments have imposed
controls, export license requirements and restrictions on the import or export
of some technologies, including encryption technology. Any additional
governmental regulation of imports or exports or failure to obtain required
export approval of encryption technologies could delay or prevent the acceptance
and use of encryption products and public networks for secure communications and
could limit the market for our products and services. In addition, some foreign
competitors are subject to less rigorous controls on exporting their encryption
technologies. As a result, they may be able to compete more effectively than us
in the United States and in international security markets for Internet and
other digital communication networks. In addition, governmental agencies such as
the Federal Communications Commission periodically issue regulations governing
the conduct of business in telecommunications markets that may negatively affect
the telecommunications industry and us.
BIZ ACQUISITION-RELATED ACCOUNTING CHARGES MAY CONTINUE TO DELAY OR REDUCE
OUR PROFITABILITY AND CAUSE THE MARKET PRICE OF OUR COMMON STOCK TO
DECLINE.
We accounted for our August 2001 acquisition of BIZ as a purchase.
Under the purchase method of accounting, the purchase price was allocated to the
fair value of the identifiable tangible and intangible assets and liabilities
that we acquired from BIZ. The excess of the purchase price over BIZ's tangible
net assets resulted in goodwill and other intangible assets.
In July 2001, the FASB issued Statement No. 142, "Goodwill and Other
Intangible Assets." We adopted this statement effective January 1, 2002. Under
this statement, goodwill is no longer amortized and is subject to annual testing
for impairment beginning January 1, 2002. The provisions of this statement
require us to perform a two-step test to assess goodwill for impairment. In the
first step, we compare the fair value of each reporting unit to its carrying
value. If the fair value exceeds the carrying value, then goodwill is not
impaired and we need not proceed to the second step. If the carrying value of a
reporting unit exceeds its fair value, then we must determine and compare the
implied fair value of the reporting unit's goodwill to the carrying value of its
goodwill. If the carrying value of the reporting unit's goodwill exceeds its
implied fair value, then we will record an impairment loss in the amount of the
excess. With regard to a reporting unit's goodwill balance at January 1, 2002,
we were required to perform the first step of the annual testing for impairment
by June 30, 2002. If the results of that step indicated that goodwill may be
impaired, we would then be required to complete the second step as soon as
possible, but no later than December 31, 2002.
As of December 31, 2001, we assessed the fair value of our two
reporting units by comparing the book value of our equity interests to the fair
value of our equity interests based upon the terms of a financing we completed
in April 2002. Given consideration of this comparison and relevant factors, we
concluded that as of December 31, 2001, an impairment write-down of
approximately $36.3 million was required. We reviewed the assumptions used in
the original analysis performed as of December 31, 2001 for dates of March 31,
2002, June 30, 2002, and September 30, 2002 and concluded that such analyses
continued to be adequate and no additional write-down was required.
We later performed an assessment to measure the fair value of the
remaining goodwill as of December 31, 2002 using a multi-period discounted cash
flow method. The results of the analysis indicated that no additional write-down
was required as of December 31, 2002. We reviewed the assumptions used in the
analysis performed as of December 31, 2002 for dates of March 31, 2003 and June
30, 2003 and concluded that such analyses continued to be adequate and no
additional write-down was required.
We believe that our daily market stock price does not provide a
reliable indicator of the fair value of our equity. Due to the absence of any
research coverage, the market is generally unaware of our new technology
advancements. This lack of research coverage is evidenced by a limited trading
activity and irregular price behavior of our thinly traded stock. Consequently,
the daily closing price of our stock does not provide a meaningful benchmark for
our fair value at any one point in time. While the Company's stock price was
considered as part of the review process we deemed it more appropriate to assess
the fair value of our goodwill by using a multi-period discounted cash flow
method, discussed above.
We are required to perform tests for impairment at least annually.
Tests for impairment between annual tests may be required if events occur or
circumstances change that would more likely than not reduce the fair value of
the net carrying amount no such events have occurred as of June 30, 2003. We
cannot predict whether or when there will be additional impairment charges, or
the amount of any such charges. If the charges are significant, they could cause
the market price of our common stock to decline.
22
WE MAY RELOCATE A PORTION OF OUR SOFTWARE DEVELOPMENT TO INDIA, WHICH COULD
PROVE TO BE UNPROFITABLE DUE TO RISKS INHERENT IN INTERNATIONAL BUSINESS
ACTIVITIES.
We may relocate portions of our software development activities to
India in an effort to reduce our operating expenses. We are subject to a number
of risks associated with international business activities that could adversely
affect any operations we may develop in India and could slow our growth. These
risks generally include, among others:
o difficulties in managing and staffing our Indian operations;
o difficulties in obtaining or maintaining regulatory approvals
or in complying with Indian laws;
o reduced or less certain protection for intellectual property
rights;
o differing technological advances, preferences or requirements;
o trade restrictions;
o foreign currency fluctuations; and
o general economic conditions, including instability, in the
Indian market.
Any of these risks could adversely affect our business and results of
operations.
CONFLICTS INVOLVING INDIA COULD ADVERSELY AFFECT ANY OPERATIONS WE MAY
ESTABLISH IN INDIA, WHICH COULD INTERFERE WITH OUR ABILITY TO CONDUCT ANY
OR ALL OF OUR OTHER OPERATIONS.
South Asia has from time to time experienced civil unrest and
hostilities among neighboring countries, including India and Pakistan. In April
1999, India and Pakistan conducted long-range missile tests. Since May 1999,
military confrontations between India and Pakistan have occurred in disputed
regions. In October 1999, the leadership of Pakistan changed as a result of a
coup led by the military. Additionally, recent events have significantly
heightened the tensions between India and Pakistan. If a major armed conflict or
nuclear war involving India and any of its neighboring countries occurs, it
could, among other things, prevent us from establishing or maintaining
operations in India. If the successful conduct of operations in India becomes
critical to any or all of our other operations, our business would be harmed to
the extent we are unable to establish or maintain operations in India.
WE ARE EXPOSED TO LIABILITY FOR ACTIONS TAKEN BY OUR DOMESTIC EMPLOYEES
WHILE ON ASSIGNMENT AND MAY ALSO BE EXPOSED TO LIABILITY FOR ACTIONS TAKEN
BY ANY FOREIGN EMPLOYEES WE MAY HIRE.
As a professional services provider, a portion of our business involves
employing people and placing them in the workplace of other businesses.
Therefore, we are exposed to liability for actions taken by our employees while
on assignment. In addition, to the extent we hire employees in India or other
foreign locations, we may also be exposed to liability for actions taken by
those employees in the scope of their employment.
NASDAQ MAY DELIST OUR COMMON STOCK, WHICH COULD DECREASE THE MARKET PRICE
OF OUR COMMON STOCK AND MAKE IT MORE DIFFICULT FOR OUR STOCKHOLDERS TO
DISPOSE OF OR OBTAIN QUOTATIONS FOR OUR COMMON STOCK AND FOR US TO OBTAIN
FINANCING.
The quantitative listing standards of The Nasdaq National Market
require, among other things, that listed companies maintain a minimum bid price
of $1.00. In November 2002, we received a notice from Nasdaq indicating that our
common stock had failed to maintain the required minimum bid price of $1.00 for
the last 30 consecutive trading days and that, therefore, we had until February
20, 2003 to regain compliance with that requirement. We did not timely regain
compliance with that requirement. In March 2003, we received a notice from
Nasdaq that the period to regain compliance with the $1.00 minimum bid price had
been extended an additional 90 days, through May 21, 2003. On May 22, 2003, we
23
received a Nasdaq staff determination that we failed to timely regain compliance
with the minimum bid price requirement and that our stock was subject to
delisting. We appealed the staff's determination to a listing qualifications
panel for consideration. On August 14, 2003, we received the findings of the
panel, which allowed us through October 31, 2003 to evidence a closing bid price
of at least $1.00 per share, with the requirement to have a closing bid price
immediately thereafter of at least $1.00 per share for ten consecutive trading
days. We may be permitted to submit an application to transfer the listing of
our common stock to The Nasdaq SmallCap Market if we satisfy the continued
inclusion requirements for The Nasdaq SmallCap Market. The successful transfer
of the listing of our common stock to The Nasdaq SmallCap Market would make
available an extended grace period for the minimum $1.00 bid price requirement
and would make available an additional 180 calendar day grace period if we
meet the initial listing criteria for The Nasdaq SmallCap Market.
In addition to minimum bid price requirements, Nasdaq's qualification
standards require, among other things, that issuers apply for initial inclusion
on Nasdaq following a change of control. Nasdaq looks at many factors in
determining whether a change of control has occurred, including without
limitation, changes in the management, board of directors, voting power and
ownership of a company. Depending on the terms and conditions of any future
financings or other transactions we may enter into, if Nasdaq determines that a
change of control has occurred, we would need to file a new listing application
if we want to maintain our Nasdaq listing. We do not know whether, at the time,
if any, that we would file a new listing application with Nasdaq, we would meet
the initial listing standards of either The Nasdaq National Market or The Nasdaq
SmallCap Market.
If we are delisted from The Nasdaq National Market, our stock price
could decline further and the ability of any potential or future investors to
achieve liquidity from our common stock could be severely limited, particularly
if we are unable to transfer the listing of our common stock to The Nasdaq
SmallCap Market. This could inhibit, if not preclude, our ability to raise
additional working capital on acceptable terms, if at all.
THE NON-CASH INTEREST EXPENSE REQUIRED IN CONNECTION WITH THE DETACHABLE
WARRANTS AND BENEFICIAL CONVERSION FEATURES OF OUR APRIL 2002 FINANCING MAY
ADVERSELY AFFECT OUR STOCK PRICE.
The secured convertible promissory notes we issued in April 2002 are
convertible into shares of our common stock at a conversion price below the
market price of our common stock at the commitment date for the notes. In
addition, the notes were accompanied by common stock purchase warrants with an
exercise price below the market price of our common stock at the commitment
date. Accordingly, under accounting guidelines, we were required to record a
substantial non-cash charge as interest expense, with an offsetting increase to
our paid-in-capital. While recording this entry had no effect on our
stockholders' equity, the entry substantially increased our reported loss for
the year ended December 31, 2002 and may cause a decline in our stock price.
OUR COMMON STOCK PRICE IS SUBJECT TO SIGNIFICANT VOLATILITY, WHICH COULD
RESULT IN SUBSTANTIAL LOSSES FOR INVESTORS AND IN LITIGATION AGAINST US.
The stock market as a whole and individual stocks historically have
experienced extreme price and volume fluctuations, which often have been
unrelated to the performance of the related corporations. During the 52-week
period ended August 12, 2003, the high and low closing sale prices of our common
stock were $1.54 and $.50, respectively. The market price of our common stock
may exhibit significant fluctuations in the future in response to various
factors, many of which are beyond our control and which include:
o variations in our annual or quarterly financial results, which
variations could result from, among other things, the timing,
size, mix and customer acceptance of our product and service
offerings and those of our competitors, and the timing and
magnitude of required capital expenditures;
o company-issued earnings announcements that vary from consensus
analyst estimates;
o changes by financial research analysts in their
recommendations or estimates of our earnings;
o conditions in the economy in general or in the information
technology service sector in particular;
o announcements of technological innovations or new products or
services by us or our competitors; and
o unfavorable publicity or changes in applicable laws and
regulations, or their judicial or administrative
interpretations, affecting the information technology service
sector and us.
24
If our operating results in future quarters fall below the expectations
of market makers, securities analysts and investors, the price of our common
stock likely will decline, perhaps substantially. In the past, securities class
action litigation often has been brought against a company following periods of
volatility in the market price of its securities. We may in the future be the
target of similar litigation. Securities litigation could result in substantial
costs and liabilities and could divert management's attention and resources.
Consequently, the price at which investees purchase shares of our common stock
may not be indicative of the price that will prevail in the trading market.
Investees may be unable to sell their shares of common stock at or above their
purchase price, which may result in substantial losses.
A SIGNIFICANT NUMBER OF SHARES OF OUR COMMON STOCK ARE OR WILL BECOME
ELIGIBLE FOR PUBLIC SALE, AND SALES OF LARGE NUMBERS OF OUR SHARES COULD
ADVERSELY AFFECT THEIR MARKET PRICE AND MAKE IT DIFFICULT FOR US TO RAISE
ADDITIONAL CAPITAL THROUGH SALES OF EQUITY SECURITIES.
As of August 14, 2003, we had issued and outstanding 25,522,283 shares
of common stock, a majority of which were unrestricted, were eligible for resale
without registration under Rule 144 of the Securities Act of 1933, or were
registered for resale or issued with registration rights. Our common stock
historically has been thinly traded. Our average daily trading volume between
August 13, 2002 and August 12, 2003 was 11,699 shares. If our stockholders seek
to sell numbers of shares significantly in excess of our typical volume, the
market price of our shares may decline. Any adverse effect on the market price
for our common stock could make it more difficult for us to sell equity
securities at a time and at a price that we deem appropriate.
THE MARKET PRICE OF OUR COMMON STOCK COULD SUBSTANTIALLY DECLINE IF ALL OR
A SIGNIFICANT PORTION OF OUR OUTSTANDING DERIVATIVE SECURITIES WERE
CONVERTED INTO OR EXERCISED FOR SHARES OF OUR COMMON STOCK AND RESOLD INTO
THE MARKET, OR IF A PERCEPTION EXISTS THAT A SUBSTANTIAL NUMBER OF SHARES
WILL BE ISSUED UPON CONVERSION OR EXERCISE AND THEN RESOLD INTO THE MARKET.
As of August 14, 2003, we had outstanding 25,522,283 shares of common
stock and also had outstanding options, warrants and promissory notes that were
exercisable for or convertible into approximately 14,506,000 shares of our
common stock. If the conversion or exercise prices at which our outstanding
derivative securities are converted or exercised are lower than the market price
immediate dilution will occur. In addition, sales of a substantial number of
shares of common stock issued upon conversion or exercise of our outstanding
derivative securities, or even the perception that such sales could occur, could
adversely affect the market price of our common stock. Therefore a substantial
decline in the value of our shares could result from both the actual and
potential conversion or exercise of our outstanding derivative securities and
the actual and potential resale of the underlying shares into the market.
IF OUR SECURITY HOLDERS ENGAGE IN SHORT SALES OF OUR COMMON STOCK,
INCLUDING SALES OF SHARES TO BE ISSUED UPON CONVERSION OR EXERCISE OF
DERIVATIVE SECURITIES, THE PRICE OF OUR COMMON STOCK MAY DECLINE.
Selling short is a technique used by a security holder to take
advantage of an anticipated decline in the price of a security. A significant
number of short sales or a large volume of other sales within a relatively short
period of time can create downward pressure on the market price of a security.
The decrease in market price would allow holders of our derivative securities
that have conversion or exercise prices based upon a discount on the market
price of our common stock to convert or exercise their derivative securities
into or for an increased number of shares of our common stock. Further sales of
common stock issued upon conversion or exercise of our derivative securities
could cause even greater declines in the price of our common stock due to the
number of additional shares available in the market, which could encourage short
sales that could further undermine the value of our common stock.
IF WE ARE UNSUCCESSFUL IN COMPLYING WITH OUR REGISTRATION OBLIGATIONS, WE
MAY BE IN DEFAULT UNDER OUR SECURED CONVERTIBLE PROMISSORY NOTES AND
LITIGATION SETTLEMENTS AND COULD FACE SIGNIFICANT PENALTIES AND A
SUBSTANTIAL STIPULATED JUDGMENT.
The agreements we entered into in connection with our issuance of
secured convertible promissory notes and related warrants and in connection with
settlement of litigation require us to, among other things, register for resale
the shares of common stock issued or issuable under those arrangements and to
maintain the effectiveness of the registration statements for an extended period
of time. If we are unable to timely obtain and maintain effectiveness of the
required registration statements or obtain appropriate waivers or if we default
under the arrangements for any other reason, then the holders of the notes
25
could, among other things, require us to pay substantial penalties, require us
to repay the notes at a premium and/or foreclose upon their security interest in
our assets, and the parties to the settlement arrangements could take action
against us that could include the filing of a substantial stipulated judgment.
Any of these events would adversely affect our business, operating results,
financial condition, and ability to service our other indebtedness by negatively
impacting our cash flows.
A SMALL NUMBER OF STOCKHOLDERS, WHO INCLUDE CERTAIN OF OUR OFFICERS AND
DIRECTORS, HAVE THE ABILITY TO CONTROL STOCKHOLDER VOTES AND TO TAKE ACTION
BY WRITTEN CONSENT WITHOUT A MEETING OF STOCKHOLDERS.
As of June 30, 2003, our co-chairmen, Kris Shah and Marvin Winkler and
certain of their family members and affiliates owned, in the aggregate,
approximately 53.6% of our outstanding common stock. Those stockholders, if
acting together, have the ability to elect our directors and to determine the
outcome of corporate actions requiring stockholder approval, irrespective of how
our other stockholders may vote. Further, those stockholders have the ability to
take action by written consent on those matters without a meeting of
stockholders. Those matters could include the election of directors, changes in
the size and composition of the board of directors, and mergers and other
business combinations involving our company. In addition, through control of the
board of directors and voting power, they may be able to control certain
decisions, including decisions regarding the qualification and appointment of
officers, dividend policy, access to capital (including borrowing from
third-party lenders and the issuance of additional equity securities), and the
acquisition or disposition of our assets. Also, the concentration of voting
power in the hands of those individuals could have the effect of delaying or
preventing a change in control of our company, even if the change in control
would benefit our stockholders, and may adversely affect the market price of our
common stock.
ITEM 3. CONTROLS AND PROCEDURES
(a) Our co-chief executive officers and chief financial officer (our
principal executive officer and principal financial officer, respectively) have
concluded, based on their evaluation as of June 30, 2003, that the design and
operation of our "disclosure controls and procedures" (as defined in Rule
13a-15(e) under the Securities Exchange Act of 1934, as amended ("Exchange
Act")) are effective to ensure that information required to be disclosed by us
in the reports filed or submitted by us under the Exchange Act is accumulated,
recorded, processed, summarized and reported to our management, including our
co-chief executive officers and chief financial officer, as appropriate to allow
timely decisions regarding whether or not disclosure is required.
(b) During the quarter ended June 30, 2003, there were no changes in
our "internal controls over financial reporting" (as defined in Rule 13a-15(f)
under the Exchange Act) that have materially affected, or are reasonably likely
to materially affect, our internal controls over financial reporting.
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Research Venture, LLC filed a complaint against us on June 4, 2002 and
filed first amended complaints against us on August 6 and August 7, 2002 in the
Superior Court for the State of California, County of Orange, Central Justice
Center (Case Nos. 02CC10109 and 02CC10111) alleging unlawful detainer and
seeking possession of two leased properties, alleged damages and lost rent. We
surrendered possession of both properties and negotiated a restructuring of our
obligations under the leases. The restructuring involved, among other terms, our
entry on October 23, 2002 into a stipulation for entry of judgment that will
permit Research Venture, LLC to file a judgment against us in the maximum
aggregate amount of $3.1 million, less consideration we pay prior to any entry
of the judgment, if we do not comply with the terms of the restructuring
arrangement for the next two years. We have issued 959,323 shares of common
stock with an agreed upon value of $1.2 million as payment toward the maximum
aggregate amount. The first payment of $75,000 was made as scheduled in December
2002, with additional payments scheduled of $100,000 due in March 2003, $150,000
26
due in June 2003 and a final payment of $175,000 due in September 2003.
We did not timely make the full $150,000 payment that was due in March 2003. We
subsequently paid the balance of the March payment due but did not pay the full
$150,000 due in June 2003. Research Venture claimed a default under the
facilities settlement agreement. On August 11, 2003, Research Venture obtained a
judgment against the Company per prior stipulation in the amount of $2.7 million
and as of August 18, 2003, Research Venture had not executed the entered
judgment. We are filing a motion to reduce the entered judgment. Separately, we
are in negotiations with Research Venture to resolve the situation. However, we
there is no assurance that the discussions will lead to a successful resolution
of the entered judgment. As such, we have recorded a $1.3 million accrued
liability for the three months ended June 30, 2003. The $1.3 million charge
consists of the original judgment amount of $3.1 million less $456,000 of cash
previously paid and $1.4 million of shares previously issued.
Subsequent to June 30, 2003, Control Break International ("CBI"), a
holder of two promissory notes with current outstanding balances of $429 and $27
each due in July 2003 filed an action in Florida to initiate collection of the
$456 of balances due. We intend to defend against the action and to file a
motion to dismiss based upon lack of jurisdiction. We have held discussions with
CBI to resolve the matter, but there can be no assurance on the outcome of those
discussions.
Subsequent to June 30, 2003 we issued 400,000 shares to a third party
escrow relative to the Integral matter (see Item 2 below).
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
In May 2002, Integral Systems, Inc. filed an action against us in the
Circuit Court for Montgomery County, Maryland, Case No. 232706, alleging that we
breached a promissory note for the payment of $389,610. Integral Systems then
obtained a confessed judgment against us for approximately $327,250, and amounts
related the judgment have been accrued in the financial statements for the year
ending December 31, 2002. In March 2003, we executed settlement papers that
would permit Integral Systems to file a stipulated judgment against us in the
amount of the unpaid balance if we default on a payment schedule that requires
us to make payments of $20,000 per month until the balance is paid in full. If
an agreed upon amount not paid in full by June 30, 2003, the Company was
required to place 400,000 common shares into a third party escrow. The Company
did not make the payment and deposited the shares into escrow in July 2003. In
March 2003 we also issued a warrant to purchase up to 150,000 shares of our
common stock at an exercise price of $1.30 per share as part of the settlement.
The warrant has a three-year term and contains a cashless exercise provision.
The shares of common stock underlying the warrants bear registration rights.
In April 2003, we issued an aggregate of 201,291 shares of common stock
to four entities and two individuals upon conversion of $142,918 of interest due
to them on 10% secured convertible promissory notes due December 31, 2005.
In each of April, May, and June of 2003, we issued 11,538 shares of
common stock to Research Venture, LLC as payment of a portion the monthly rent
due under a facility lease with an aggregate value of $44,296.
Exemption from the registration provisions of the Securities Act of
1933 for the transactions described above is claimed under Section 4(2) of the
Securities Act of 1933, among others, on the basis that such transactions did
not involve any public offering and the purchasers were sophisticated or
accredited with access to the kind of information registration would provide. In
each case, appropriate investment representations were obtained and stock
certificates were issued with restricted stock legends.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
We entered into a factoring agreement with BVF as further described
elsewhere in this report. During the current quarter ended June 30, 2003, we
were in violation of the covenant to pay debts and obligations as they come due,
which is not related to the payment of principal or interest under our
obligations for long-term and short-term debt.
During the quarter ended June 30, 2003, we incurred defaults not
related to payment of principal or interest under both our accounts receivable
financing with BVF and our obligations for long-term and short-term debt due
December 31, 2005. We requested waivers from the holders of the notes, but the
noteholders declined to grant such waivers. This means the noteholders have the
right to declare us in default and call all of their debt due and immediately
payable. With the potential of the notes being called for payment, we
re-classified what would have otherwise been long-term debt as short-term debt
in our consolidated balance sheets as of December 31, 2002 and June 30, 2003.
The agreement with BVF states among other things that a default occurs if we are
generally not paying debts as they become due or if we are left with
unreasonably small capital. We have notified BVF of our failure to make certain
payments on a timely basis and have therefore requested but have not received a
waiver of such default.
27
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
Exhibit
Number Description
------ -----------
10.1 Non-disclosure of Information letter dated July 17, 2003 to
SSP Solutions, Inc. from the Department of Defense, Maryland
Procurement Office
10.2 Termination and General Release Agreement dated as of June 30,
2003 by and between SSP Solutions, Inc., and each of
Electronic Data Systems Corporation and EDS Information
Services L.L.C.
10.3 Certificate of Assistant Secretary regarding the Unanimous
Written Consent of the Board of Directors of SSP Solutions,
Inc., a Delaware corporation, dated December 31, 2001,
approving amendments to the Corporation's 2001 Employee Stock
Purchase Plan
31.1 Certifications required by Rule 13a-14(a) of the Securities
Exchange Act of 1934, as amended, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
32.1 Certification of Co-Chief Executive Officers and Chief
Financial Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002
-----------
(#) Management contract or compensatory plan, contract or arrangement
required to be filed as an exhibit.
(b) Reports on Form 8-K.
--------------------
On April 16, 2003, we filed a Form 8-K for April 9, 2003 that contained
Item 7 - Financial Statements, Pro Forma Financial Information and Exhibits and
Item 12 - Results of Operations and Financial Condition. The Form 8-K included
as an exhibit an April 9, 2003 press release discussing our financial condition
and results of operations for the year ended December 31, 2002. We filed an
amendment to the Form 8-K on July 18, 2003 to add additional disclosures
regarding non-GAAP financial measures.
On May 30, 2003, we filed a Form 8-K for May 29, 2003 that contained
Item 5 - Other Events and Item 7 - Financial Statements, Pro Forma Financial
Information and Exhibits. The Form 8-K included as an exhibit a May 29, 2003
press release discussing the status of our Nasdaq listing.
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SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
Date: August 19, 2003 SSP SOLUTIONS, INC.
By: /s/ MARVIN J. WINKLER
---------------------
Marvin J. Winkler
CO-CHAIRMAN OF THE BOARD OF DIRECTORS,
DIRECTOR AND CO-CHIEF EXECUTIVE OFFICER
(PRINCIPAL EXECUTIVE OFFICER)
By: /s/ KRIS SHAH
-------------
Kris Shah
CO-CHAIRMAN OF THE BOARD OF DIRECTORS,
DIRECTOR AND CO-CHIEF EXECUTIVE OFFICER
(PRINCIPAL EXECUTIVE OFFICER)
By: /s/ THOMAS E. SCHIFF
--------------------
Thomas E. Schiff
EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER
(PRINCIPAL FINANCIAL OFFICER AND
PRINCIPAL ACCOUNTING OFFICER)
29
EXHIBITS FILED WITH THIS REPORT
Exhibit
Number Description
------ -----------
10.1 Non-disclosure of Information letter dated July 17, 2003 to
SSP Solutions, Inc. from the Department of Defense, Maryland
Procurement Office
10.2 Termination and General Release Agreement dated as of June 30,
2003 by and between SSP Solutions, Inc., and each of
Electronic Data Systems Corporation and EDS Information
Services L.L.C.
10.3 Certificate of Assistant Secretary regarding the Unanimous
Written Consent of the Board of Directors of SSP Solutions,
Inc., a Delaware corporation, dated December 31, 2001,
approving amendments to the Corporation's 2001 Employee Stock
Purchase Plan
31.1 Certifications required by Rule 13a-14(a) of the Securities
Exchange Act of 1934, as amended, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
32.1 Certification of Co-Chief Executive Officers and Chief
Financial Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002
30