SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 2002
OR
___ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from ___________ to ______________
Commission File Number: 0-8354
nSTOR TECHNOLOGIES, INC.
(Exact name of registrant as specified in its Charter)
Delaware 95-2094565
-------- ----------
(State of other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
10140 Mesa Rim Road
San Diego, California 92121
(Address of principal executive offices)
(858)453-9191
(Registrant's telephone number)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days. Yes X No _____
Number of shares outstanding of the Registrant's Common Stock,
par value $.05 per share, as of October 31, 2002: 142,076,947
2
nSTOR TECHNOLOGIES, INC. AND SUBSIDIARIES
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Page
Number
------
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30,
2002 (Unaudited) and December 31, 2001 3
Consolidated Statements of Operations
(Unaudited) for the three and nine months
ended September 30, 2002 and 2001 4
Consolidated Statement of Stockholders'
Equity (Unaudited) for the nine months
ended September 30, 2002 5
Consolidated Statements of Cash Flows
(Unaudited) for the nine months ended
September 30, 2002 and 2001 6-7
Notes to Consolidated Financial Statements
(Unaudited) 8-19
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 19-23
Item 3. Quantitative and Qualitative Disclosures about
Market Risk 23
Item 4. Controls and Procedures 23
Part II. OTHER INFORMATION
Item 1. - Item 5. Not Applicable 24
Item 6. Exhibits and Reports on Form 8-K 24
SIGNATURE 25
CERTIFICATIONS 26-27
3
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
nSTOR TECHNOLOGIES, INC.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
September 30,
2002 December 31,
ASSETS (unaudited) 2001
------ ----------- ------------
Current assets:
Cash and cash equivalents $ 655 $ 857
Accounts receivable, net 1,701 1,925
Inventories 437 1,364
Marketable securities - 4,255
Prepaid expenses and other 343 211
------- -------
Total current assets 3,136 8,612
Property and equipment, net of $6,259 and
$5,641 in accumulated depreciation 706 1,367
Goodwill and other intangible assets, net of
$930 and $808 in accumulated amortization 11,140 1,989
------- -------
$14,982 $11,968
LIABILITIES ======= =======
-----------
Current liabilities:
Bank lines of credit $ 200 $ 2,991
Other borrowings 4,408 1,100
Accounts payable and other 3,198 3,790
Deferred revenue 1,610 -
------- -------
Total current liabilities 9,416 7,881
Long-term debt 3,100 3,600
------- -------
Total liabilities 12,516 11,481
------- -------
STOCKHOLDERS' EQUITY
---------------------
Preferred stock, $.01 par; 1,000,000 shares authorized;
Series L convertible preferred stock, 1,000 and 0
shares outstanding at September 30, 2002 and
December 31, 2001, respectively - -
Common stock, $.05 par; 200,000,000 shares authorized;
137,549,920 and 114,603,144 shares issued and
outstanding at September 30, 2002 and December
31, 2001, respectively 6,877 5,729
Additional paid-in capital 102,143 94,104
Deficit (106,554) (99,346)
------- -------
Total stockholders' equity 2,466 487
------- -------
$14,982 $11,968
======= =======
See accompanying notes to consolidated financial statements.
4
nSTOR TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except per share data)
Three Months Nine Months
Ended September 30, Ended September 30,
------------------- -------------------
2002 2001 2002 2001
(unaudited) (unaudited)
------ ------ ------- -------
Sales $3,494 $4,016 $7,504 $14,187
Cost of sales 2,084 2,617 6,110 10,172
------ ------ ------ -------
Gross margin 1,410 1,399 1,394 4,015
------ ------ ------ -------
Operating expenses:
Selling, general and administrative 1,278 2,344 3,923 8,460
Research and development 1,035 825 2,422 2,796
Depreciation and amortization 392 401 985 1,252
------ ------ ------ -------
Total operating expenses 2,705 3,570 7,330 12,508
------ ------ ------ -------
Loss from operations (1,295) (2,171) (5,936) (8,493)
Realized losses on marketable securities - - (1,123) -
Fair value of option granted to customer - - (670) -
Other income, net 866 1,072 949 723
Interest expense, net (171) (80) (428) (734)
------ ------ ------ -------
Net loss before preferred stock dividends (600) (1,179) (7,208) (8,504)
Preferred stock dividends - (486) - (1,115)
------ ------ ------ -------
Net loss applicable to common shareholders ($ 600) ($1,665) ($7,208) ($9,619)
====== ====== ====== =======
Basic and diluted net loss per common
share ($ .00) ($ .05) ($ .06) ($ .27)
====== ====== ====== =======
Weighted average number of common shares
used in per share computation, basic
and diluted 137,549,920 35,719,022 124,574,356 35,599,196
=========== ========== =========== ==========
See accompanying notes to consolidated financial statements.
5
nSTOR TECHNOLOGIES, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(dollars in thousands)
Preferred Addi-
Common Stock Stock tional
------------------ -------------- Paid-In
Shares Amount Shares Amount Capital Deficit Total
---------- ------- ------ ------- ------- ------- -------
Balances, December
31, 2001 114,603,144 $5,729 - $ - $94,104 ($ 99,346) $ 487
Issuance of common stock:
Acquisition of 100% of
common stock of Stonehouse
Technologies, Inc.
("Stonehouse") 22,500,000 1,125 5,850 6,975
In payment of accrued
dividends on Series D
convertible preferred
stock 446,776 23 116 139
Issuance of Series L
convertible preferred
stock in connection with
acquisition of Stonehouse 1,000 - 1,403 1,403
Fair value of option granted
to customer 670 670
Net loss for the nine months
ended September 30, 2002 (7,208) (7,208)
---------- ------- ------ ------ ------- -------- ------
Balances, September 30,
2002 (unaudited) 137,549,920 $6,877 1,000 $ - $102,143 ($106,554) $2,466
=========== ======= ====== ====== ======== ========== ======
See accompanying notes to consolidated financial statements.
6
nSTOR TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Nine Months
Ended September 30,
-------------------
2002 2001
(unaudited) (unaudited)
--------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss ($7,208) ($8,504)
Adjustments to reconcile net loss to net
cash provided (used) by operating activities:
Proceeds from the sale of marketable
securities 3,132 -
Realized losses on the sale of marketable
securities 1,123 -
Other income (949) (723)
Fair value of option granted to customer 670 -
Depreciation 863 947
Provision for inventory obsolescence (52) 891
Provision for uncollectable accounts 77 797
Amortization of goodwill and other intangible
assets 122 304
Amortization of deferred costs - 235
Changes in assets and liabilities, net of
effects from acquisition:
Decrease in accounts receivable 1,765 1,232
Decrease in inventories 979 225
(Increase) decrease in prepaid expenses and other (31) 385
Decrease in deferred revenue, accounts
payable and other (351) (3,799)
------ ------
Net cash provided (used) by operating activities 140 (8,010)
------ ------
CASH FLOWS FROM INVESTING ACTIVITIES:
Additions to property and equipment (121) (123)
Cash acquired in acquisition 298 -
------ ------
Net cash provided (used) by investing activities 177 (123)
------ ------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net (repayments) borrowings on bank line of credit (2,991) (1,555)
Additions to other borrowings 2,472 10,242
Issuance of preferred stock - 250
Cash paid for preferred stock dividends - (59)
------ ------
Net cash (used) provided by financing activities (519) 8,878
------ ------
Net (decrease) increase in cash and cash
equivalents during the period (202) 745
Cash and cash equivalents at the beginning
of the period 857 37
------ ------
Cash and cash equivalents at the end of
the period $ 655 $ 782
====== ======
See accompanying notes to consolidated financial statements.
7
nSTOR TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(concluded)
Nine Months
Ended September 30,
-----------------------
2002 2001
(unaudited) (unaudited)
----------- -----------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during period for interest $ 235 $ 406
======== ========
SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIES:
Non-Cash Investing Activities:
Acquisition:
Fair value of assets acquired $ 11,081 $ -
Liabilities assumed or incurred (3,001) -
Common stock issued (8,378) -
-------- --------
Cash acquired ($ 298) $ -
======== ========
NON-CASH FINANCING ACTIVITIES:
Issuance of preferred stock in satisfaction
of borrowings $ - $ 11,870
======== ========
See accompanying notes to consolidated financial statements.
8
nSTOR TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of nStor
Technologies, Inc. and all wholly-owned subsidiaries (collectively, the
"Company"). Significant intercompany balances and transactions have been
eliminated in consolidation.
Basis of Presentation
In the opinion of management, the unaudited consolidated financial statements
furnished herein include all adjustments necessary for a fair presentation of
the results of operations for the interim periods presented. These interim
results of operations are not necessarily indicative of results for the entire
year. The consolidated financial statements contained herein should be read in
conjunction with the consolidated financial statements and related notes
contained in the Company's Form 10-K, as amended, for the year ended December
31, 2001.
The accompanying unaudited consolidated financial statements have been prepared
in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required for complete financial statements.
Business
nStor Corporation, Inc., ("nStor"), a wholly-owned subsidiary of the Company, is
a designer, developer and manufacturer of external data storage solutions,
including high density storage enclosures, storage management software and
controller technology. The Company's product line supports a variety of
operating systems, including Windows NT and Windows 2000, Unix, Linux, and
Macintosh. Designed for storage intensive environments such as the Internet or
other mission-critical applications, the Company's products are offered in
various architectures, including Fibre Channel, Fibre-to-SCSI (Small Computer
Systems Interface), and SCSI.
In June 2002, the Company acquired Stonehouse Technologies, Inc. ("Stonehouse" -
see Note 2 to Consolidated Financial Statements). Stonehouse is a provider of
telecommunications software and services solutions that help large enterprises
manage their communications expenses, assets and processes. These solutions
include a suite of modular applications and consulting services, which allow
enterprises to manage voice, data and wireless services by providing a
systematic approach to automate order processing, monitor expenses, manage
vendor invoices, track asset inventory and allocate costs.
Going Concern
The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern. This contemplates the
realization of assets and the satisfaction of liabilities in the normal course
of business. The Company has experienced substantial net losses of $14 million,
$21.9 million and $18.7 million for the years ended December 31, 2001, 2000 and
1999, respectively, and $7.2 million for the nine months ended September 30,
2002. In addition, the Company has negative working capital at September 30,
2002. These matters, among others, raise substantial doubt about the Company's
ability to continue as a going concern.
However, since 2001 the Company has devoted substantial efforts to: (i)
streamline its operations; (ii) establish the foundation for generating positive
cash flow and operating profits; and (iii) obtain sufficient financing to cover
its working capital needs.
9
Since 2001, the Company has significantly reduced its direct sales personnel and
related costs as part of its strategy to expand the Company's indirect customer
channel base (original equipment manufacturers (OEMs), resellers and systems
integrators). Further personnel reductions have been implemented to reflect the
Company's lower sales levels, the Company's recent outsourcing described below
and to provide certain cost efficiencies.
In July 2002, the Company entered into a contract with Varian, Inc. for
outsourcing the production of the Company's 4000S Series of storage enclosures.
The 4000 product family is currently being expanded to become the Company's
universal storage enclosure offering. The Company began to phase out its
manufacturing facility, located in San Diego, California, during the third
quarter of 2002 and effective September 30, 2002, completed the phase out of
that facility. The outsourcing agreement has resulted in a significant
improvement in the Company's operating margins by lowering manufacturing costs
and overall operating costs.
From January 1, 2001 through October 31, 2002, the Company obtained $21.2
million of equity and debt financing from private investors, principally Maurice
Halperin, the Company's Chairman of the Board since August 15, 2001 and a
principal shareholder, or companies controlled by Mr. Halperin (collectively
"Mr. Halperin"), and H. Irwin Levy, the Company's Vice-Chairman of the Board,
Chief Executive Officer and a principal shareholder, or companies controlled by
Mr. Levy (collectively, "Mr. Levy"). In addition, in connection with the
Company's outsourcing contract, Mr. Levy provided collateral for a bank to issue
a $1 million letter of credit for the benefit of Varian.
During February 2002, the Company's bank lender advised that it did not intend
to renew the Company's credit facility. As of July 30, 2002, the Company repaid
the loan in full. In August 2002, the Company entered into an Agreement For
Purchase of Accounts with a financial institution (the "Purchaser"), which
provides for a $750,000 line of credit under which the Company may sell customer
invoices to the Purchaser (see Note 6 to Consolidated Financial Statements). The
Company is currently attempting to obtain additional financing; however, there
can be no assurance that it will be successful in obtaining such financing on
terms acceptable to the Company, if at all.
On June 7, 2002, the Company acquired 100% of the outstanding capital stock of
Stonehouse Technologies, Inc. (see Note 2 to Consolidated Financial Statements).
The Company believes that it has sufficient cash and other financial resources
to effectively operate until it achieves positive cash flows from operations;
however, there is no assurance that the Company will be able to achieve positive
cash flows in the future or that additional financial resources will not be
required.
The consolidated financial statements do not include any adjustments to reflect
the possible future effects of the recoverability and classification of assets
or the amounts and classification of liabilities that may result from the
inability of the Company to continue as a going concern.
Revenue Recognition
nStor
Revenues from the sale of storage products are recognized as of the date
shipments are made to customers, net of an allowance for returns.
Stonehouse
Revenues from computer software sales are recognized when persuasive evidence of
a sales arrangement exists, delivery and acceptance of the software has
occurred, the price is fixed or determinable, and collectability is reasonably
assured. Consulting revenues are recognized when services are performed.
Revenues on long-term development contracts are deferred at time of sale and
using the percentage-of-completion method are recognized based upon hours
incurred as a percentage of estimated total hours. Maintenance revenues for
customer support and product updates are deferred at the time of sale and are
included in income on a straight-line basis over the term of the maintenance
agreement, generally for one year.
10
Use of Estimates
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
Reclassifications
Certain prior year amounts have been reclassified to conform with the current
year's presentation. These reclassifications had no impact on operating results
previously reported.
Net Loss Per Common Share ("EPS")
Basic EPS is calculated by dividing the net loss applicable to common
shareholders by the weighted average number of common shares considered
outstanding for the period, without consideration for common stock equivalents.
Diluted EPS includes the effect of potentially dilutive securities. For the
periods presented, the effect of potentially dilutive securities would have been
antidilutive. Accordingly, basic and dilutive EPS for those periods are the
same.
Effective January 11, 2002, the Company issued an aggregate of 76,884,122 new
common shares (the "New Common Shares") pursuant to shareholder approval of the
Halco Investment (see Note 3 to Consolidated Financial Statements). The Halco
Investment was completed on November 20, 2001, subject to shareholder approval;
accordingly the calculation of basic and diluted EPS assumes that the New Common
Shares were issued as of November 20, 2001.
Recent Authoritative Pronouncements
In October 2001, the Financial Accounting Standards Board (the "FASB") issued
Statement of Financial Accounting Standard No. 144 ("SFAS No. 144"), Accounting
for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 provides
guidance on the accounting for the impairment or disposal of long-lived assets.
The objectives of SFAS No. 144 are to address issues relating to the
implementation of SFAS No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of", and to develop a model for
long-lived assets to be disposed of by sale, whether previously held and used or
newly acquired. SFAS No. 144 was effective for the Company commencing with its
2002 fiscal year and had no impact on the Company's financial position or
results of operations.
In April 2002, the FASB issued Statement of Financial Accounting Standard No.
145 ("SFAS No. 145"), Rescission of SFAS No. 4, 44, and 64, Amendment of SFAS
No. 13, and Technical Corrections. SFAS No. 145 rescinds SFAS No. 4, Reporting
Gains and Losses from Extinguishment of Debt, SFAS No. 44, Accounting for
Intangible Assets of Motor Carriers, and SFAS No. 64, Extinguishments of Debt
Made to Satisfy Sinking-Fund Requirements. SFAS No. 145 requires, among other
things (i) that the modification of a lease that results in a change of the
classification of the lease from capital to operating under the provisions of
SFAS No. 13 be accounted for as a sale-leaseback transaction, and (ii) the
reporting of gains or losses from the early extinguishment of debt as
extraordinary items only if they met the criteria of Accounting Principles Board
Opinion No. 30 ("APB No. 30"), Reporting the Results of Operations. The
amendment of SFAS No. 13 is effective for transactions occurring on or after May
15, 2002. Although the rescission of SFAS No. 4 is effective January 1, 2003,
the FASB has encouraged early application of the provisions of SFAS No. 145.
Effective in the third quarter of 2002, the Company adopted SFAS No. 145 and
determined that gains and losses previously reported as extraordinary items
during 2002 and 2001 no longer meet the criteria as set forth under APB No. 30
and have reported those items as Other Income in the accompanying consolidated
financial statements.
11
In July 2002, the FASB issued Statement of Financial Accounting Standard No. 146
("SFAS No. 146"), Accounting for Costs Associated with Exit or Disposal
Activities (effective January 1, 2003). SFAS No. 146 replaces current accounting
literature and requires the recognition of costs associated with exit or
disposal activities when they are incurred rather than at the date of a
commitment to an exit or disposal plan. The Company does not anticipate the
adoption of this statement will have a material effect on the Company's
financial position or results of operations.
(2) ACQUISITION
Terms of the Acquisition
On June 7, 2002, the Company acquired 100% of the outstanding capital stock of
Stonehouse from Pacific Technology Group, Inc. ("PTG"), a subsidiary of Pacific
USA Holdings Corp ("PUSA")(the "Acquisition"). The purchase price of $8.9
million, including $541,000 in transaction costs, was based upon a market value
of $.31 per share, the average of the Company's closing market prices for the
four days before and after the terms of the Acquisition were agreed to (April
30, 2002), and consisted of the issuance of 22,500,000 shares of the Company's
common stock and 1,000 shares of the Company's Series L Convertible Preferred
Stock. The Series L Convertible Preferred Stock was convertible into 4,527,027
shares of common stock, subject to shareholder approval, which was obtained
effective October 8, 2002, at which time the common shares were issued in
exchange for the Series L Convertible Preferred Stock. In addition, the Company
is obligated to issue up to 8,687,258 shares of common stock based on an
Earn-Out provision, whereby in the event Stonehouse's pretax income (defined in
the Stock Purchase Agreement as "Net Revenues") exceeds $1 million for the four
consecutive calendar quarters beginning on October 1, 2002, the Company will be
required to issue to PTG that number of additional shares of common stock equal
to the product of 27.027 and the amount of Net Revenues in excess of $1 million.
The potential issuance of such shares was also approved by the Company's
shareholders on October 8, 2002.
Reasons for the Acquisition
In an effort to improve the Company's financial condition and future sales
revenues, the Company developed a strategic business relationship with Pacific
Electric Wire & Cable Co., Ltd. ("PEWC"), the parent of PUSA. PEWC is a
Taiwan-based corporation, traded on the Taiwan Stock Exchange. As described in
Note 7 to the Consolidated Financial Statements, effective March 1, 2002, the
Company entered into a Reseller Agreement with another subsidiary of PUSA, and
also granted an option to that subsidiary to purchase up to 30 million common
shares at an exercise price of $.40 per share, which expires on November 30,
2002. Subsequently, the Company began exploring ways to further develop its
relationship with PEWC by combining nStor with Stonehouse.
The Company believed that the Acquisition would have a positive impact on its
operating results from a cash flow standpoint. Further, Stonehouse has an
expansive customer base, including major U.S. corporations and government
agencies, through which the Company may be able to market its computer storage
products, which in turn would have a positive impact on the Company's
operations.
In addition, the Company believed that the increase to its shareholders' equity
resulting from the Acquisition would assist the Company in its efforts to regain
compliance with the continued listing standards of the American Stock Exchange
(see Management's Discussion & Analysis, Liquidity and Capital Resources -
American Stock Exchange).
12
Accounting for the Acquisition
The Acquisition was accounted for under the purchase method of accounting with
assets acquired and liabilities assumed recorded at estimated fair values as of
the Acquisition date in accordance with Statement of Financial Accounting
Standard No. 141 ("SFAS No. 141"), Business Combinations, and the results of
Stonehouse's operations included in the Company's consolidated financial
statements from the Acquisition date. Allocation of the purchase price has been
made on a preliminary basis subject to adjustment should new or additional facts
about the business become known over the ensuing twelve months following the
Acquisition. Based on a valuation analysis completed by an independent valuation
firm during the third quarter of 2002, the allocation of the purchase price
included intangible assets with an aggregate fair value of $2.8 million
(preliminarily valued at $3.2 million as of June 30, 2002) and goodwill of $6.5
million (preliminarily valued at $6.1 million as of June 30, 2002). Intangible
assets with finite useful lives were identified as follows: (i) customer
relationships (approximately $2 million); (ii) software ($531,000); and (iii)
non-compete agreement ($224,000), with corresponding useful lives of ten, five,
and four years, respectively. The excess of the purchase price over the fair
value of net assets acquired (goodwill) will be subject to an annual review for
impairment in accordance with Statement of Financial Accounting Standard No. 142
("SFAS No. 142"), Goodwill and Other Intangible Assets, adopted by the Company
in 2002 (see Note 5 to Consolidated Financial Statements).
About Stonehouse
Stonehouse, based in Plano, Texas, provides software and services solutions that
help large enterprises manage their communications expenses, assets and
processes. These solutions include a suite of modular applications and
consulting services, which allow enterprises to manage voice, data and wireless
services by providing a systematic approach to automate order processing,
monitor expenses, manage vendor invoices, track asset inventory, and allocate
costs.
The following unaudited pro forma results of operations assume the Acquisition
occurred at the beginning of the nine months ended September 30, 2002 and 2001
(in thousands, except per share data):
2002 2001
------------------------ ----------------------
Pro Pro
Historical(b) forma Historical forma
Combined Combined(a)
----------- ---------- ---------- ----------
Sales $7,504 $10,318 $14,187 $18,987
Net loss before preferred
stock dividends ($7,209) ($ 7,229) ($ 8,504) ($11,530)
Net loss applicable to
common shareholders ($7,209) ($ 7,229) ($ 9,619) ($12,586)
Basic and diluted net loss
per common share ($ .06) ($ .05) ($ .27) ($ .22)
Weighted average number of
common shares used in per
share computation, basic
and diluted 124,574 137,514 35,599 58,099
(a) The 2001 pro forma combined net loss reflects the implementation of a
revised business plan by Stonehouse, beginning in February 2001, by a
newly-employed business team, which contemplated substantial increases to
marketing, sales and administrative programs, in order to significantly expand
future revenues. Stonehouse subsequently determined that the new plan was not in
its best interests and, as a result, during the fourth quarter of 2001, this
plan was discontinued. Stonehouse's previous top executive reassumed the chief
executive officer duties and the new business team and certain other employees
were terminated in the fourth quarter of 2001 or early 2002. Significant
operating expenses related to the discontinued business plan were incurred in
2001.
13
(b) Historical amounts include Stonehouse's results of operations for the four
months ended September 30, 2002.
The following table shows the amount assigned to each of Stonehouse's major
assets and liabilities at the date of Acquisition (in thousands):
ASSETS
------
Cash $ 298
Accounts receivable 1,618
Prepaid expenses 101
-------
Total current assets 2,017
Property and equipment 89
Goodwill 6,473
Other intangible assets 2,800
-------
$11,379
======
LIABILITIES
-----------
Bank line of credit $ 200
Accounts payable and other liabilities 556
Deferred revenue 1,704
-------
Total current liabilities 2,460
Purchase Price 8,919
-------
$11,379
=======
(3) HALCO INVESTMENT
On November 20, 2001 (the "Closing Date"), the Company completed a transaction
in which Halco Investments L.C. (Halco), a company controlled by Mr. Halperin,
acquired a 34% equity interest in, and made certain loans to, the Company for an
aggregate investment of $12.1 million (the Halco Investment). On the Closing
Date, Halco acquired 8,970 shares of the Company's newly created Series K
Convertible Preferred Stock (the "Series K Preferred Stock"), with a face amount
of approximately $9 million and the Company issued a $3.1 million, 5-year, 8%
note (the "Halco Note"). Halco invested $6 million in cash and marketable
securities having a quoted market value of $6.1 million, based on the closing
price for such securities on November 19, 2001.
Mr. Halperin first submitted an investment proposal to the Company on June 26,
2001. The Company subsequently negotiated the terms of the offer from July to
November 2001, during which time, Halco made short-term working capital loans to
the Company in the aggregate amount of $5 million at an interest rate of 8% per
annum. Of that amount, at the Closing Date, $3.1 million was converted into the
Halco Note and the remaining amount was applied to the cash paid by Halco for
the Series K Preferred Stock. In connection with Mr. Halperin's proposal and the
interim financing provided by Halco, on August 15, 2001, the Company's board of
directors elected Mr. Halperin as Chairman, replacing the then Chairman, Mr.
Levy, who became Vice Chairman and who is continuing to serve as Chief Executive
Officer of the Company.
14
In connection with and as conditions to the Halco Investment, it was agreed that
an aggregate of 76,884,122 New Common Shares were to be issued as follows: (i)
the Series K Preferred Stock, owned by Halco, was to be automatically converted
into 39,000,000 shares of the Company's common stock, based upon a conversion
price of $.23 per share, upon approval of the Company's shareholders; (ii) all
of the holders of the Company's other convertible preferred stock (the "Other
Preferred Stock") agreed to convert their shares of preferred stock into common
stock (20,877,432 shares of common stock, including 10,752,527 to Mr. Levy);
(iii) the Company and the holders of the Other Preferred Stock agreed to the
issuance of: (a) 12,993,072 shares of common stock, including 6,651,488 to Mr.
Levy, to induce those holders to convert their shares, all of which were
entitled to periodic dividends, into shares of common stock, which had never
received a dividend (the "Inducement Shares"), and (b) 3,263,618 shares of
common stock, including 1,658,064 to Mr. Levy, (the "Dividend Shares") in
satisfaction of an aggregate of $1.5 million of accrued dividends (including $.7
million to Mr. Levy) on the date of conversion (the Inducement Shares and
Dividend Shares were based upon a conversion price of $.45 per share); and (iv)
Mr. Levy agreed to the receipt of 750,000 shares of the Company's common stock
in exchange for $.3 million owed by the Company to Mr. Levy (the "Note Shares")
based upon a conversion price of $.40 per share.
On the Closing Date, shareholders who owned in excess of 50% of the Company's
voting stock executed proxies to vote in favor of the foregoing transactions.
However, formal shareholder approval of the transactions was required before the
Company could issue the common stock necessary for the conversion of the Series
K Preferred Stock, the Note Shares, the Inducement Shares and the Dividend
Shares. On January 10, 2002, shareholder approval was received and the Company
issued the New Common Shares effective January 11, 2002. Accordingly, to
appropriately reflect the financial position of the Company in the accompanying
consolidated financial statements, the foregoing transactions, as shown in the
following table, were assumed to have occurred as of November 20, 2001, the
Closing Date of the Halco Investment.
Balances at January 10, 2002 New Common Shares
(Considered Converted to New Common Shares Issued Effective January 11, 2002
at December 31, 2001) (Considered Outstanding at December 31, 2001)
- --------------------------------------------- --------------------------------------------------
Aggregate Accrued Total
Preferred Number of Stated Value Dividends Conversion Inducement Dividend New Common
Series Shares (in thousands) Shares Shares Shares Shares
- --------- --------- ---------------------- ----------- ---------- --------- -----------
E 3,500 $ 3,500 $ 405 1,166,666 1,166,666 899,665 3,232,997
H 5,100 5,100 383 7,083,333 4,250,000 850,776 12,184,109
I 9,092 9,092 681 12,627,433 7,576,406 1,513,177 21,717,016
K 8,970 8,970 - 39,000,000 - - 39,000,000
-------- ------ ---------- ---------- --------- -----------
$26,662 $1,469 59,877,432 12,993,072 3,263,618 76,134,122
======== ====== ========== ========== =========
Note Shares 750,000
-----------
Total New Common Shares issued effective January 11, 2002 76,884,122
Common shares outstanding at December 31, 2001 37,719,022
-----------
Common shares outstanding at January 11, 2002
(considered outstanding at December 31, 2001) 114,603,144
===========
(4) TRADING MARKETABLE SECURITIES
In connection with the Halco Investment (see Note 3 to Consolidated Financial
Statements) on November 20, 2001, the Company received marketable securities
with a quoted market value of $6.1 million, including approximately 434,000
shares of American Realty Investors Inc. ("ARL"), a New York Stock Exchange
listed company, with a quoted market value of $5.2 million. Unrealized losses at
December 31, 2001 on the ARL shares were $897,000.
15
Due to ARL's low trading volume, the Company's ability to sell or borrow against
the ARL holdings had been extremely limited. From November 2001 through March
19, 2002, the Company had been able to sell only 56,300 shares in the public
market, generating cash proceeds of $442,000. To assist in funding the Company's
working capital requirements, in February and March 2002, the Company and a
company controlled by Mr. Levy, Hilcoast Development Corp. ("Hilcoast"), entered
into agreements whereby Hilcoast purchased 195,000 shares of ARL with an
aggregate quoted value of approximately $1.5 million on the respective purchase
dates for an aggregate purchase price of approximately $1.2 million. In
connection therewith, Hilcoast granted the Company four-month options to
repurchase all or a portion of those shares based on the price Hilcoast paid
plus 10% per annum (the "Options"). In February and March 2002, the Company sold
183,000 additional shares, representing all of its remaining holdings in ARL, to
Mr. Halperin for an aggregate purchase price of approximately $1.3 million,
which approximated ARL's quoted value on the respective purchase dates. In April
2002, the Company received $206,000 in cash proceeds from the exercise of the
Options. As a result of the ARL sales in 2002, the Company realized a loss of
$1.1 million during the nine months ended September 30, 2002, net of the
$206,000 Options proceeds.
(5) GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill, representing the excess of the cost of an acquired business over the
fair value of net assets acquired, is carried at cost and, through December 31,
2001, was amortized under the straight line method over seven years.
Effective January 1, 2002, the Company adopted SFAS No. 142, which requires that
goodwill and certain intangible assets no longer be amortized, but instead be
tested at least annually for impairment. Accordingly, there was no goodwill
amortization recognized during the three and nine months ended September 30,
2002, as compared to $103,000 and $304,000 in the corresponding 2001 periods,
respectively.
In accordance with SFAS No. 142, prior period amounts are not permitted to be
restated. A reconciliation of reported net loss to net loss adjusted for the
exclusion of amortization of goodwill for the three and nine months ended
September 30, 2001 follows (in thousands, except per share):
Three Month Nine Month
Period Period
---------------------------
Reported net loss applicable to common
shareholders ($ 1,665) ($ 9,619)
Less goodwill amortization 103 304
----------- -----------
Adjusted net loss ($ 1,562) ($ 9,315)
=========== ===========
Weighted average number of common shares
outstanding 35,719,022 35,599,196
=========== ===========
Basic and diluted net loss per common share
as reported ($ 0.05) ($ 0.27)
=========== ===========
Adjusted net loss per common share ($ 0.04) ($ 0.26)
=========== ===========
During 2002, the Company engaged an independent valuation firm to prepare an
impairment analysis of the Company's goodwill, including goodwill acquired in
the Stonehouse Acquisition. Based on this analysis, the Company's goodwill is
not considered to be impaired as of January 1, 2002. The Company continues to
review the impact of SFAS No. 142 and will make any necessary adjustments, as
appropriate.
As of September 30, 2002, the carrying amount of goodwill and other intangible
assets was approximately $8.5 million and $2.7 million, respectively, of which
$6.5 million of goodwill and $2.7 million of other intangible assets were
acquired in June 2002 in connection with the Stonehouse Acquisition (see Note 2
to Consolidated Financial Statements). Amortization of other intangible assets
for the three and nine months ended September 30, 2002 was $92,000 and $122,000,
respectively.
16
(6) BORROWINGS
Revolving Bank Credit Facilities
At December 31, 2001, the Company had a revolving bank credit facility (the
"Bank Line of Credit"), which provided for borrowings principally based on the
lesser of $10 million or 85% of eligible accounts receivable. The Bank Line of
Credit bore interest at prime plus 2.5%, was scheduled to mature on April 30,
2002, was collateralized by substantially all of the Company's assets, and
provided for certain financial covenants, including minimum net worth and net
income requirements.
Since the fourth quarter of 2000, the Company had not been in compliance with
its minimum net worth and net income requirements under the Bank Line of Credit.
Effective February 4, 2002, the bank increased the interest rate to prime plus
3.5% and advised the Company that it did not intend to renew the Bank Line of
Credit. As of July 30, 2002, the entire outstanding balance was repaid.
In August 2002, the Company entered into an Agreement For Purchase of Accounts
with a financial institution (the "Purchaser") which provides for a $750,000
line of credit under which the Company may sell customer invoices to the
Purchaser. The Purchaser advances 80% of the net face amount of qualified
invoices and remits the remaining 20%, less its fees, upon collection of the
invoice in full. The Company is obligated to repay the Purchaser for invoices
not paid within 90 days. The Purchaser's fees are based on a rate of .07% per
day. At September 30, 2002, the uncollected balance of customer invoices sold to
the Purchaser amounted to approximately $255,000.
The Company is currently attempting to obtain additional financing; however,
there is no assurance that it will be successful in obtaining such financing on
terms acceptable to the Company, if at all.
Stonehouse has a revolving bank credit facility (the "Stonehouse Revolver")
under which Stonehouse may borrow up to the lesser of $500,000 or specified
percentages of eligible accounts receivable, payable upon demand, with interest
at prime plus 1% (5.75% at September 30, 2002). Borrowings under the Stonehouse
Revolver are collateralized by accounts receivable and certain other assets of
Stonehouse. At September 30, 2002, the outstanding principal balance under the
Stonehouse Revolver was $200,000.
Other Borrowings
The Company's other borrowings consisted of the following (in thousands):
September 30, December 31,
2002 2001
------------ ------------
Current:
Notes payable to Mr. Levy, interest ranging
from 8%-10% per annum, maturing on various
dates from December 2002 through June
2003 (b)(d) $3,122 $ 650
Other notes payable, interest ranging
from 8%-10% per annum, maturing on various
dates from December 2002
through June 2003 (c) 1,286 450
------ ------
$4,408 $1,100
====== ======
Long-term:
Note payable to Halco, interest at 8% per annum,
maturing on November 20, 2006 (a) $3,100 $3,100
Other - 500
------ ------
$3,100 $3,600
====== ======
17
(a) As a condition to the closing of the Stonehouse Acquisition, the Company
issued an 8% convertible subordinated promissory note (the "New Halco Note") to
Halco in the principal amount of $3.1 million. The New Halco Note replaced the
Halco Note dated November 20, 2001, in the principal amount of $3.1 million (see
Note 3 to Consolidated Financial Statements). The New Halco Note is convertible
at the Company's option at any time prior to maturity on November 20, 2006 and
after the earlier of: (i) May 31, 2002 or (ii) the date on which the Company
receives a notice of delisting from the AMEX, in each case, only to the extent
deemed necessary to maintain the Company's listing on AMEX, at a per share
conversion price equal to 85% of the closing bid price of the Company's common
stock on AMEX on the trading day immediately prior to the date of conversion.
The New Halco Note is convertible at the holder's option at any time after May
31, 2003 and prior to maturity at a per share conversion price equal to 110% of
the closing bid price of the common Stock on AMEX on the trading day immediately
prior to the date of conversion.
(b) Effective June 14, 2002, the Company issued a 10% convertible subordinated
promissory note (the "New Levy Note") to Mr. Levy in the amount of $650,000. The
New Levy Note replaced three previously issued 10% notes, aggregating $650,000
and is convertible at the Company's option at any time prior to maturity on June
14, 2003 and after the date on which (i) the Company receives notice of
delisting from AMEX, and (ii) the New Halco Note has been converted into shares
of the Company's common stock and in each case, only to the extent deemed
necessary to maintain the Company's listing on AMEX, at a per share conversion
price equal to 85% of the closing bid price of the Company's common stock on the
trading day immediately prior to the date of conversion.
(c) The holder of a $450,000 note, payable December 15, 2002, has the right at
any time prior to maturity, to convert the note into shares of the Company's
common stock based on a fixed conversion price of $.40 per share.
(d) In connection with the Company's outsource contract, Mr. Levy provided
collateral for a bank to issue a $1 million letter of credit for the benefit of
Varian. The letter of credit expires on March 15, 2003.
(7) FAIR VALUE OF OPTION GRANTED TO CUSTOMER
Effective March 1, 2002, the Company entered into a Reseller Agreement with a
wholly-owned subsidiary of PEWC. The Agreement grants the subsidiary of PEWC the
right to market and sell the Company's products for a period of two (2) years in
Mainland China and Taiwan on an exclusive basis, and in the United States and
Europe on a non-exclusive basis. The exclusivity right is conditioned, among
other items, upon minimum purchases by PEWC of $5 million through February 28,
2003 and $10 million during the subsequent year.
In connection with its efforts to develop further strategic business
relationships with PEWC, effective March 1, 2002, the Company granted a
subsidiary of PEWC an option to purchase up to thirty (30) million newly issued
shares of the Company's common stock for a purchase price of $.40 per share,
expiring on November 30, 2002. The option was valued at $670,000 as of the date
of grant based on the Black-Scholes option-pricing model and other provisions of
Statement of Financial Accounting Standard No. 123, Accounting for Stock Based
Compensation, and related Emerging Issues Task Force ("EITF") guidance. This
amount was recorded as an expense in the accompanying Statement of Operations
for the nine months ended September 30, 2002.
18
(8) OTHER INCOME, NET
Other income, net of other expenses consisted of the following (in thousands):
Three Months Nine Months
Ended September 30, Ended September 30,
------------------- -------------------
2002 2001 2002 2001
------- -------- ------- --------
Reduction in carrying value of
liability to reflect the
appropriate amount due $ 627 $ - $ 627 $ -
Reclassification of reserves
previously required in connection
with service contracts for which
the Company no longer has an
obligation 239 - 239 -
Negotiated discounts with vendors - 1,082 136 1,082
Loss on extinguishment of debt - - - (362)
Other(expenses)income, net - (10) (53) 3
------ ------ ------ ------
$ 866 $1,072 $ 949 $ 723
====== ====== ====== ======
(9) INCOME TAXES
The Company accounts for income taxes in accordance with SFAS 109, which
requires recognition of deferred tax assets and liabilities for the expected
future tax consequences of events that have been included in the financial
statements or tax returns. Under the SFAS 109 asset and liability method,
deferred tax assets and liabilities are determined based upon the difference
between the financial statement and tax bases of assets and liabilities using
enacted tax rates in effect for the year(s) in which the differences are
expected to reverse.
As of December 31, 2001, there were unused net operating loss carryforwards (the
NOL's) for regular federal income tax purposes of approximately $54.8 million
and for California tax purposes of approximately $11.5 million expiring from
2012 through 2021 and 2002 through 2011, respectively. In addition, the Company
has research and development tax credit carryforwards of approximately $1.2
million, which expire from 2002 through 2018 and in conjunction with the
Alternative Minimum Tax (AMT) rules, the Company has available AMT credit
carryforwards of approximately $800,000, at December 31, 2001, which may be used
indefinitely to reduce regular federal income taxes.
The usage of approximately $8 million of the NOL's and approximately $2 million
of the California NOL's is limited annually to approximately $400,000 due to an
acquisition, which caused a change in ownership for income tax purposes under
Internal Revenue Code Section 382.
At September 30, 2002 and December 31, 2001, a 100% valuation allowance has been
provided on total deferred tax assets because it is more likely than not that
the NOL's will not be realized based on recent operating results.
(10) SEGMENT INFORMATION AND SIGNIFICANT CUSTOMERS
Prior to the Acquisition in June 2002, the Company operated predominantly in one
business segment, information storage solutions ("Storage Solutions"). The
Company's customers include end users, OEMs, systems integrators and value added
resellers.
Following the Acquisition, the Company began operating under a second business
segment, telecommunication software/services ("Telecommunications"). Stonehouse
offers telemanagement solutions targeted to large corporations, educational
institutions, state governments and other large public, private and hybrid
communications networks.
19
Financial instruments, which potentially subject the Company to concentrations
of credit risk, are primarily accounts receivable. The Company performs ongoing
credit evaluations of its customers, generally requires no collateral and
maintains allowances for potential credit losses and sales returns. During the
three months ended September 30, 2002, sales to three customers accounted for
48%, 12% and 11% of the Company's Storage Solutions sales and sales to one
customer accounted for 28% of Telecommunications sales. During the nine months
ended September 30, 2002, sales to two customers accounted for 40% and 10% of
the Company's Storage Solutions sales and sales to one customer accounted for
28% of Telecommunications sales. In the three and nine months ended September
30, 2001, no single customer accounted for greater than 10% of the Company
sales. Sales to geographic areas other than the United States have not been
significant.
Presented below for the three and nine months ended September 30, 2002 is
selected financial information for the two segments in which the Company now
operates (in thousands). The Storage Solutions segment includes all corporate
revenues and expenses except those specifically attributable to the
Telecommunications segment. Since the Acquisition occurred in June 2002, segment
information is not applicable for the 2001 periods.
Three Months Ended Nine Months Ended
September 30, 2002 September 30, 2002
------------------------------ ------------------------------
Storage Storage
Solutions Telecommunications Solutions Telecommunications(a)
--------- ------------------ -------- -------------------
Revenues $2,197 $1,297 $5,784 $1,720
Gross margin $ 717 $ 693 $ 505 $ 890
Net loss applicable to common stock ($ 401) ($ 199) ($7,032) ($ 176)
(a) Includes results of operations for Stonehouse for the four months since the
Acquisition in June 2002.
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
With the exception of discussions regarding historical information,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" contains forward-looking statements. Such statements inherently
involve risks and uncertainties that could cause actual results of operations to
differ materially from the forward-looking statements. Factors that would cause
or contribute to such differences include, but are not limited to, our inability
to increase sales to current customers and to expand our customer base,
continued acceptance of our products in the marketplace, timing and volume of
sales orders, our inability to improve the gross margin on our products,
material cost fluctuations, competitive factors, dependence upon third-party
vendors, our future cash flows and ability to obtain sufficient financing, level
of operating expenses, conditions in the technology industry and the economy in
general, legal proceedings and other risks detailed in our periodic report
filings with the Securities and Exchange Commission (SEC). Historical results
are not necessarily indicative of the operating results for any future period.
Subsequent written and oral forward looking statements attributable to us or
persons acting on our behalf are expressly qualified in their entirety by
cautionary statements in this Form 10-Q and in other reports we file with the
SEC The following discussion should be read in conjunction with the Consolidated
Financial Statements and the Notes thereto included elsewhere in this filing.
Results of Operations
For the three months ended September 30, 2002, net loss applicable to common
shareholders decreased to $600,000 from $1.7 million during the corresponding
quarter of 2001. The 2002 third quarter included Other Income of $866,000,
principally consisting of a reduction in the carrying value of certain
liabilities to reflect the appropriate amount due, and a reclassification of
certain reserves previously required in connection with service contracts for
which the Company no longer has an obligation. The 2001 third quarter included
Other Income of $1.1 million realized from negotiated discounts on purchases
with vendors.
20
We also incurred net losses applicable to common shareholders of $7.2 million
and $9.6 million for the nine month periods ended September 30, 2002 and 2001,
respectively. Included in the net loss for the 2002 nine month period was $1.1
million in realized losses on marketable securities, and a $670,000 charge for
the fair value of an option granted to a customer, partially offset by $949,000
in Other Income, principally resulting from the aforementioned reduction in the
carrying value of certain liabilities and reclassification of certain reserves.
The 2001 nine-month period included Other Income of $723,000 resulting from $1.1
million in negotiated discounts on purchases with vendors, partially offset by a
$362,000 loss from debt extinguishment.
Sales
Sales for the three and nine months ended September 30, 2002 decreased to $3.5
million and $7.5 million, respectively, from $4 million and $14.2 million for
the same periods in 2001, respectively. Included in sales for the 2002 periods
was $1.3 million and $1.7 million, respectively, attributable to our
Telecommunications business following our June 2002 Acquisition of Stonehouse.
The significant decrease in our Storage Solutions sales during the three and
nine month periods reflects the economic downturn, which has caused customer
delays in purchasing technology and other equipment.
During the nine months ended September 30, 2002, indirect sales to OEMs,
value-added resellers (VARs) and other channel business represented 65% of our
Storage Solutions revenues, compared to 33% for direct sales to end users.
During the corresponding period in 2001, indirect, direct and service revenues
represented 22%, 61%, and 17%, respectively, of our sales revenues. Sales during
the 2001 periods included $.6 million related to the sale of inventory to a
customer, who also purchased substantially all of our storage servicing business
in August 2001. See also Note 10 to Consolidated Financial Statements for a
discussion of Sales to Significant Customers.
Cost of Sales/Gross Margins
Gross margins realized by our Storage Solutions business during both third
quarter periods remained relatively constant (33% for the 2002 third quarter
compared to 35% for the quarter ended September 30, 2001). However, the current
quarter's gross margin represents a substantial improvement over the 0% gross
margins realized during the first six months of 2002. This improvement reflects
significantly lower material costs attributable to the commencement during the
current quarter of (i) shipments of our new 4000 Series storage systems and (ii)
outsourcing the manufacturing of our products, in addition to the recovery of
certain inventory reserves resulting from third quarter sales. In connection
with outsourcing our production, our manufacturing facility in San Diego,
California was phased out during the third quarter of 2002. Our
Telecommunications business realized gross margins of 53% for the 2002 third
quarter representing a 5% increase over gross margins realized by Stonehouse
during 2002 prior to the June 2002 Acquisition.
Gross margins realized by our Storage Solutions business for the nine months
ended September 30, 2002 decreased to 9% from 28% for the corresponding period
in 2001. The decrease was primarily due to (i) economies of scale attributable
to the level of fixed costs inherent in our operations, coupled with
significantly lower sales revenues, and (ii) the price we paid for materials
prior to the introduction of our new 4000 Series storage systems and the
commencement of our manufacturing outsource agreement. Our Telecommunications
business experienced a 52% gross margin for the four months since our
Acquisition.
Our gross margins are dependent, in part, on material costs and product mix,
which fluctuates from time to time.
21
Operating Expenses
Selling, General and Administrative
Selling, general and administrative (SG&A) expenses decreased to $1.3 million
and $3.9 million for the three and nine months ended September 30, 2002,
respectively, from $2.3 million and $8.5 million for the same periods in 2001,
representing a $1.1 million and $4.5 million decline for the respective periods.
The significant decrease resulted principally from the reduction of our overall
workforce and related costs (including occupancy), partially offset by $601,000
in SG&A costs incurred by our Telecommunications business since the Stonehouse
Acquisition in June 2002.
Research and Development
Research and development (R&D) expenses for the three months ended September 30,
2002 increased to $1 million from $825,000 for the 2001 third quarter, primarily
as a result of $307,000 in R&D expenses attributable to our Telecommunications
business. For the nine months ended September 30, 2002, R&D expenses decreased
to $2.4 million from $2.8 million in the 2001 period, primarily attributable to
a decrease in costs following the development of our 4000 Series product line,
partially offset by $330,000 in R&D expenses attributable to our
Telecommunications business.
R&D costs are expensed as incurred and may fluctuate considerably from time to
time depending on a variety of factors. These costs are substantially incurred
in advance of related revenues, or in certain situations, may not result in
generating revenues.
Depreciation and Amortization
Depreciation and amortization for the three and nine months ended September 30,
2002 was $392,000 and $985,000, respectively, as compared to $401,000 and $1.3
million for the same periods in 2001. The decrease primarily reflects the
discontinuation of amortization of goodwill pursuant to the adoption of SFAS No.
142 effective January 1, 2002 (see Note 5 to Consolidated Financial Statements),
partially offset by amortization of $92,000 and $122,000, respectively, of other
intangible assets of $2.8 million resulting from the Stonehouse Acquisition.
During the three and nine months ended September 30, 2001, amortization of
goodwill amounted to $103,000 and $304,000 respectively.
Interest Expense
Interest expense amounted to $171,000 and $80,000 for the three months ended
September 30, 2002 and 2001, respectively. The increase is primarily due to
higher average borrowings for the 2002 period. For the nine months ended
September 30, 2002, interest expense decreased to $428,000 from $734,000 for the
comparable 2001 period, primarily attributable to a combination of significantly
lower average borrowings and lower interest rates.
Preferred Stock Dividends
Preferred stock dividends were $486,000 and $1.1 million, for the three and nine
months ended September 30, 2001, respectively. Effective November 20, 2001, all
of the Company's then remaining convertible preferred stock was converted to
common stock pursuant to the Halco Investment (see Note 3 to Consolidated
Financial Statements). Accordingly, there were no preferred stock dividends in
2002.
The Series L Convertible Preferred Stock issued in connection with the
Stonehouse Acquisition in June 2002 was not entitled to receive dividends and
was converted to common stock effective October 8, 2002, following approval by
our shareholders.
22
Liquidity and Capital Resources
The accompanying consolidated financial statements have been prepared assuming
that we will continue as a going concern. This contemplates the realization of
assets and the satisfaction of liabilities in the normal course of business. We
incurred net losses of $14 million, $21.9 million and $18.7 million for the
years ended December 31, 2001, 2000 and 1999, respectively, and $7.2 million for
the nine months ended September 30, 2002. In addition, we have negative working
capital as of September 30, 2002. These matters, among others, raise substantial
doubt about our ability to continue as a going concern.
However, since 2001 we have devoted substantial efforts to: (i) streamline our
operations; (ii) establish the foundation for generating positive cash flow and
operating profits; and (iii) obtain sufficient financing to cover our working
capital needs. For a description of these efforts, see Notes 1 and 2 to
Consolidated Financial Statements.
Consolidated Statements of Cash Flows
Operating Activities
Net cash provided by operating activities amounted to $140,000 for the nine
months ended September 30, 2002. The most significant use of cash was our loss
from operations (before changes in assets and liabilities) of $2.2 million,
which was more than offset by cash generated from the net collections of
accounts receivable and net inventory reductions of $2.7 million. Net cash used
by operating activities amounted to $8 million for the nine months ended
September 30, 2001 with the most significant use of cash being our loss from
operations (before changes in assets and liabilities) of $6.1 million. In
addition, we used cash of $3.8 million in the reduction of accounts payable and
other liabilities, which was partially offset by net collections of accounts
receivable of $1.2 million.
Investing Activities
The most significant component of net cash provided by investing activities for
the nine months ended September 30, 2002 consisted of $298,000 of cash acquired
in the Stonehouse Acquisition.
Financing Activities
Net cash used in financing activities for the nine months ended September 30,
2002 was $519,000 consisting of a $3 million net reduction of our Bank Line of
Credit, partially offset by $2.5 million of borrowings from Mr. Levy.
Net cash provided by financing activities for the nine months ended September
30, 2001 amounted to $8.9 million and primarily consisted of borrowings of $10.2
million from private investors (including $3.9 million from Mr. Halperin and
$3.3 million from Mr. Levy), of which $4.4 million was satisfied by the issuance
of convertible preferred stock in April 2001, partially offset by a $1.6 million
net reduction of our Bank Line of Credit.
American Stock Exchange ("AMEX")
On May 28, 2002, we received correspondence from AMEX regarding the potential
delisting of our common stock from AMEX due to our failure to meet certain of
AMEX's continued listing standards, related to minimum shareholders' equity and
our ability to continue operations and/or meet our obligations as they mature.
On June 26, 2002, we submitted a plan and supporting documentation (the "Plan")
to AMEX to demonstrate our ability to regain compliance. On August 13, 2002,
AMEX notified us that it had accepted our Plan and granted us an extension
through June 20, 2003 within which we must regain compliance, subject to
periodic review by AMEX's Staff. Failure to make progress consistent with the
Plan or to regain compliance with the continued listing standards by the end of
the extension period could result in our being delisted. We believe that we will
be successful in regaining compliance, although there can be no assurance that
we will remain listed on AMEX.
23
Critical Accounting Policies and Estimates
Revenues from the sale of products is recognized as of the date shipments are
made to customers, net of an allowance for returns. Revenues from computer
software sales are recognized upon execution of a contract and shipment of the
software provided that the product is accepted by the customer. Consulting
revenues are recognized when services are performed. Revenues on long-term
development contracts are deferred at time of sale, and using the
percentage-of-completion method are recognized based upon hours incurred as a
percentage of estimated total hours. Maintenance revenues for customer support
and product updates are deferred at the time of sale and are included in income
on a straight-line basis over the term of the maintenance agreement, generally
for one year.
Our preliminary allocation of the Stonehouse purchase price included $6.5
million in goodwill and $2.8 million in other intangible assets in accordance
with SFAS No. 141. These values were based on a valuation analysis completed by
an independent valuation firm. In addition, we have unamortized goodwill of $2
million that arose from an acquisition in 2000. Goodwill will be tested for
possible impairment at least on an annual basis in accordance with SFAS No. 142
(see Note 5 to Consolidated Financial Statements).
The preparation of financial statements, in conformity with accounting
principles generally accepted in the United States, requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from these estimates.
Results for the interim periods presented in this report are not necessarily
indicative of results that may be reported for any other interim period or for
the entire fiscal year.
Effect of Inflation
Inflation has not had an impact on our operations and we do not expect that it
will have a material impact in 2002.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We have debt in the amount of $200,000 that is tied to floating interest rates.
Therefore, we are subject to a certain amount of risk arising from increases to
the prime rate.
Item 4. CONTROLS AND PROCEDURES
(a) Within 90 days prior to filing this report on Form 10-Q (the "Evaluation
Date"), our Chief Financial Officer and Chief Executive Officer evaluated our
disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c)
promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange
Act")). Based on that evaluation, these officers have concluded that as of the
Evaluation Date, our disclosure controls and procedures were effective in timely
alerting them to material information relating to us (including our consolidated
subsidiaries) required to be included in our reports filed or submitted by us
under the Exchange Act.
(b) There have been no significant changes in our internal controls or in other
factors that could significantly affect internal controls subsequent to the time
of such evaluation.
24
Part II - OTHER INFORMATION
Item 1. Legal Proceedings
Not Applicable
Item 2. Recent Sales of Unregistered Securities and Use of Proceeds
Not Applicable
Item 3. Defaults Upon Senior Securities
Not applicable
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable
Item 5. Other Information
Not applicable
Item 6. Exhibits and Reports on Form 8-K:
(a) Exhibits:
3.1 Certificate of Amendment to the Restated Certificate of
Incorporation of Registrant filed with the State of Delaware
on October 9, 2002.
3.2 Certificate Eliminating Reference to Series of Shares of
Stock from the Restated Certificate of Incorporation of
Registrant filed October 9, 2002.
3.3 Restated Certificate of Incorporation of Registrant filed
with the State of Delaware on October 9, 2002.
99.1 Certification Pursuant to 18 U.S.C. Section 1350, As Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,
signed by Registrant's Chief Executive Officer, H. Irwin Levy
on November 12, 2002.
99.2 Certification Pursuant to 18 U.S.C. Section 1350, As Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,
signed by Registrant's Chief Financial Officer, Thomas L.
Gruber on November 11, 2002.
(b) Reports on Form 8-K:
A report on Form 8-K dated August 14, 2002 was filed on August 14,
2002, reporting under Item 7 - Financial Statements, Pro Forma
Financial Information and Exhibits in which the Registrant filed
Officer Certifications dated August 14, 2002 pursuant to the
Sarbanes-Oxley Act of 2002.
A report on Form 8-K/A dated March 1, 2002 was filed August 13, 2002,
reporting under Item 7 - Financial Statements, Pro Forma Financial
Information and Exhibits, in which the Registrant reported historical
financial statements of Stonehouse Technologies, Inc. and Pro Forma
financial information.
25
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
nSTOR TECHNOLOGIES, INC.
(Registrant)
/s/ Thomas L. Gruber
November 11, 2002 -------------------------------------
Thomas L. Gruber
Acting President, Chief Operating and
Financial Officer
26
CERTIFICATIONS
I, H. Irwin Levy, certify that:
1. I have reviewed this quarterly report on Form 10-Q of nStor
Technologies, Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including
its consolidated subsidiaries, is made known to us by others
within those entities, particularly during the period in which
this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and
the audit committee of registrant's board of directors (or persons
performing the equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes
in internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: November 12, 2002
/s/ H. Irwin Levy
-----------------------
H. Irwin Levy
Chief Executive Officer
27
CERTIFICATIONS
I, Thomas L. Gruber, certify that:
1. I have reviewed this quarterly report on Form 10-Q of nStor
Technologies, Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including
its consolidated subsidiaries, is made known to us by others
within those entities, particularly during the period in which
this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and
the audit committee of registrant's board of directors (or persons
performing the equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes
in internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: November 11, 2002
/s/ Thomas L. Gruber
-----------------------
Thomas L. Gruber
Chief Financial Officer