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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
---------------
FORM 10-Q
(Mark one)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended April 30, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________ to ________
Commission File No. 0-24015
STEELCLOUD, INC
(Exact name of registrant as specified in its charter)
VIRGINIA
(State or other jurisdiction of incorporation or
organization)
54-1890464
(I.R.S. Employer Identification No.)
1306 Squire Court, Dulles, VA 20166
(Address of principal executive offices) (Zip code)
(703) 450-0400
(Registrant's telephone number, including area code)
(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 Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No __
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes__ No X
As of June 1, 2004 there were 13,738,420 shares of the registrant's common stock
outstanding.
SteelCloud, Inc.
Form 10-Q Index
For the Quarterly period ended April 30, 2004
Description Page
Part I. Financial Information
Item 1. Financial Statements 1
Consolidated Balance Sheets as of
October 31, 2003 and April 30, 2004 1
Consolidated Statements of Operations for the three
and six month periods ended April 30, 2003 and 2004 2
Consolidated Statements of Cash Flows for the six month
periods ended April 30, 2003 and 2004 3
Consolidated Statements of Stockholders' Equity
for the six month periods ended April 30, 2003
and 2004 4
Notes to the Consolidated Financial Statements 5-8
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 8
Item 3. Quantitative and Qualitative Disclosures
About Market Risks 14
Item 4. Controls and Procedures 14
Part II. Other Information 15
Item 1. Legal Proceedings 15
Item 2. Changes in Securities, Use of Proceeds and Issuer
Purchases of Equity Securities 15
Item 3. Defaults Upon Senior Securities 15
Item 4. Submission of Matters to a Vote of Security Holders 15
Item 5. Other Information 15
Item 6. Exhibits and Reports on Form 8-K 16
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
STEELCLOUD, INC.
CONSOLIDATED BALANCE SHEET
OCTOBER 31, APRIL 30,
2003 2004
------------------ --------------------
ASSETS (UNAUDITED)
Current assets
Cash and cash equivalents $8,098,221 $7,547,105
Accounts receivable, net of allowance for doubtful accounts of
$293,000 and $13,428 as of October 31, 2003 and April 30, 2004,
respectively 5,332,549 3,288,516
Inventory, net 2,880,944 3,109,526
Prepaid expenses and other current assets 239,812 520,895
Deferred contract costs 7,053 725,149
------------------ --------------------
Total current assets 16,558,579 15,191,191
Property and equipment, net 477,111 388,427
Equipment on lease, net 335,935 452,487
Goodwill and other intangible assets, net 1,778,059 4,767,816
Deferred tax asset - long term 400,000 400,000
Other assets 211,155 243,539
------------------ --------------------
Total assets $19,760,839 $21,443,460
================== ====================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable $3,202,195 $2,455,588
Accrued expenses 1,369,145 1,540,509
Notes payable, current 96,133 70,195
Unearned revenue 293,363 1,135,219
------------------ --------------------
Total current liabilities 4,960,836 5,201,511
Note payable, long-term 59,952 156,517
Other liabilities 6,415 -
------------------ --------------------
Total long-term liabilities 66,367 156,517
Stockholders' equity
Common stock, $.001 par value: 50,000,000 shares authorized,
13,008,553 and 13,953,420 shares issued at October 31, 2003 and
April 30, 2004, respectively 13,009 13,953
Additional paid in capital 47,307,036 50,579,916
Treasury stock, 400,000 shares at October 31, 2003 and
April 30, 2004, respectively (3,432,500) (3,432,500)
Accumulated deficit (29,153,909) (31,075,937)
------------------ --------------------
Total stockholders' equity 14,733,636 16,085,432
------------------ --------------------
Total liabilities and stockholders' equity $19,760,839 $21,443,460
================== ====================
The accompanying notes are an integral part of these consolidated financial
statements.
-1-
STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
APRIL 30, APRIL 30,
2003 2004 2003 2004
--------------- ---------------- ---------------- -----------------
Revenues
Products $7,448,132 $4,636,361 $14,328,522 $7,931,674
Services 771,738 1,155,403 1,525,516 2,023,787
--------------- ---------------- ---------------- ------------------
Total revenues 8,219,870 5,791,764 15,854,038 9,955,461
--------------- ---------------- ---------------- ------------------
Cost of revenues
Products 5,776,316 3,338,071 11,253,318 6,140,158
Services 605,546 716,861 1,220,375 1,285,977
--------------- ---------------- ---------------- ------------------
Total cost of revenues 6,381,862 4,054,932 12,473,693 7,426,135
--------------- ---------------- ---------------- ------------------
Gross profit 1,838,008 1,736,832 3,380,345 2,529,326
Selling and marketing 336,225 514,530 634,949 984,815
Research and product development 110,595 124,973 110,595 275,417
General and administrative 1,247,092 1,411,661 2,375,820 3,202,767
--------------- ---------------- ---------------- ------------------
Income (loss)from continuing operations 144,096 (314,332) 258,981 (1,933,673)
Interest expense (income), net 7,899 1,597 13,739 (11,645)
--------------- ---------------- ---------------- ------------------
Net income (loss) from continuing operations 136,197 (315,929) 245,242 (1,922,028)
Loss from discontinued operations 26,954 - 56,455 -
--------------- ---------------- ---------------- ------------------
Net income (loss) $ 109,243 $ (315,929) $ 188,787 $(1,922,028)
=============== ================ ================ ==================
Earnings (loss) per share (basic and diluted):
Earnings (loss) from continuing operations $ 0.01 $ (0.02) $ 0.02 $ (0.14)
Discontinued operations - - - -
--------------- ---------------- ---------------- ------------------
Net earnings (loss) per share $ 0.01 $ (0.02) $ 0.02 $ (0.14)
=============== ================ ================ ==================
Weighted-average shares outstanding, basic 10,070,309 13,431,893 10,058,236 13,351,257
Weighted-average shares outstanding, diluted 10,459,199 13,431,893 10,433,425 13,351,257
The accompanying notes are an integral part of these consolidated financial
statements.
-2-
STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
SIX MONTHS ENDED
APRIL 30,
2003 2004
---------------------------------------
OPERATING ACTIVITIES
Net income (loss) $188,787 $(1,922,028)
Loss from discontinued operations 56,455 -
---------------------------------------
Net income (loss) from continuing operations 245,242 (1,922,028)
Adjustments to reconcile net income (loss) to net
cash provided by operating activities:
Depreciation and amortization 176,843 287,241
Changes in operating assets and liabilities, net of effects of acquisition:
Accounts receivable 1,781,248 2,115,967
Inventory 334,932 (295,161)
Prepaid expenses and other assets (115,234) (135,012)
Deferred contract costs 804,931 (718,096)
Accounts payable (810,526) (841,607)
Accrued expenses (28,133) 150,041
Unearned revenue and other liabilities (2,641,394) 841,856
---------------------------------------
Net cash (used in) provided by operating activities (252,091) (516,799)
INVESTING ACTIVITIES
Purchase of property and equipment (43,060) (295,111)
Cash paid in acquisition - (630,015)
---------------------------------------
Net cash used by investing activities (43,060) (925,126)
FINANCING ACTIVITIES
Proceeds from issuance of common stock 56,166 718,714
Proceeds from exercise of common stock options 9,432 271,785
Payments on notes payable (317,815) (99,690)
---------------------------------------
Net cash (used in) provided by financing activities (252,217) 890,809
Net decrease in cash and cash equivalents of continuing operations
(547,368) (551,116)
Net cash provided by operating activities of discontinued operations
357,512 -
Cash and cash equivalents at beginning of period 751,323 8,098,221
---------------------------------------
Cash and cash equivalents at end of period $561,467 $7,547,105
=======================================
SUPPLEMENTAL CASH FLOW INFORMATION
Common stock issued in acquisition $- $2,283,900
Interest paid $8,914 $1,646
Income taxes paid $- $-
The accompanying notes are an integral part of these consolidated financial
statements.
-3-
STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(UNAUDITED)
ADDITIONAL RETAINED
PREFERRED STOCK COMMON STOCK PAID-IN TREASURY EARNINGS
SHARES AMOUNT SHARES AMOUNT CAPITAL STOCK (ACCUMULATED TOTAL
DEFICIT)
--------------------------------------------------------------------------------------------------------
BALANCE AT
OCTOBER 31, 2002 -- -- 10,447,611 $ 10,448 $ 39,553,017 $ (3,432,500) $(29,373,897) $ 6,757,068
Issuance of common
stock in connection
with exercise of
employee incentive
stock option plan -- -- 73,947 74 65,524 -- -- 65,598
Net Income -- -- -- -- -- -- 188,787 188,787
--------------------------------------------------------------------------------------------------------
BALANCE AT
APRIL 30, 2003 -- -- 10,521,558 $ 10,522 $ 39,618,541 $ (3,432,500) $(29,185,110) $ 7,011,453
========================================================================================================
--------------------------------------------------------------------------------------------------------
BALANCE AT
OCTOBER 31, 2003 -- -- 13,008,553 $ 13,009 $ 47,307,036 $ (3,432,500) $(29,153,909) $ 14,733,636
--------------------------------------------------------------------------------------------------------
Issuance of common
stock in connection
with exercise of
employee incentive
stock option plan -- -- 122,342 122 271,089 -- -- 271,211
Issuance of common
stock in connection
with exercise of
warrants -- -- 247,525 247 718,466 -- -- 718,713
Issuance of common
stock in connection
with acquisition -- -- 575,000 575 2,283,325 -- -- 2,283,900
Net Income -- -- -- -- -- -- (1,922,028) (1,922,028)
--------------------------------------------------------------------------------------------------------
BALANCE AT
APRIL 30, 2004 -- -- 13,953,420 $ 13,953 $ 50,579,916 $ (3,432,500) $(31,075,937) $ 16,085,432
========================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements.
-4-
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF BUSINESS AND BASIS OF PRESENTATION
Founded in 1987, SteelCloud, Inc, based in Dulles, Virginia, designs, develops
and manufactures customized computer servers and network appliances. The
Company's custom computer servers are designed to meet the precise needs of
volume customers to reduce the customer's investments in logistics, integration
capacity and support. SteelCloud's consulting services organization provides
clients with technical services, including network analysis, security, design,
troubleshooting and implementation. The Company is also a value-added reseller
for the software products of its strategic partners and certain other software
providers.
The consolidated financial statements for the three and six month periods ended
April 30, 2004 and 2003 are unaudited and include all adjustments which, in the
opinion of management, are necessary to present fairly the results of operations
for the periods then ended. All such adjustments are of a normal and recurring
nature. These consolidated financial statements should be read in conjunction
with the Annual Report on Form 10-K of SteelCloud, Inc. (the "Company") which
includes consolidated financial statements and notes thereto for the years ended
October 31, 2003 and 2002.
2. EMPLOYEE STOCK OPTIONS
The Company accounts for employee stock option grants using the intrinsic method
in accordance with Accounting Principles Board (APB) Opinion No. 25 "Accounting
for Stock Issued to Employees" and accordingly associated compensation expense,
if any, is measured as the excess of the underlying stock price over the
exercise price on the date of grant. The Company complies with the disclosure
option of Statement of Financial Accounting Standards (SFAS) No. 123 "Accounting
for Stock Based Compensation", and SFAS No. 148 "Accounting for Stock-Based
Compensation--Transition and Disclosure" which requires pro-forma disclosure of
compensation expense associated with stock options under the fair value method.
The Company's pro forma information follows:
THREE MONTHS ENDED SIX MONTHS ENDED
APRIL 30, APRIL 30,
2003 2004 2003 2004
--------- ----------- --------- -------------
Net earnings (loss), as reported .................... $ 109,243 $ (315,929) $ 188,787 $ (1,922,028)
Less: Total stock based employee compensation expense
determined under the fair-value based method ........ 103,314 59,251 211,407 154,873
--------- ----------- --------- -------------
Pro-Forma net earnings (loss) ....................... $ 5,929 $ (375,180) $ (22,620) $ (2,076,901)
========= =========== ========= =============
Basic earnings (loss) per share as reported ......... $ 0.01 $ (0.03) $ 0.02 $ (0.16)
========= =========== ========= =============
Basic pro-forma net earnings (loss) per share ....... $ 0.00 $ (0.03) $ 0.00 $ (0.16)
========= =========== ========= =============
Diluted earnings (loss) per share as reported ....... $ 0.01 $ (0.03) $ 0.02 $ (0.16)
========= =========== ========= =============
Diluted pro-forma net earnings (loss) per share ..... $ 0.00 $ (0.03) $ 0.00 $ (0.16)
========= =========== ========= =============
-5-
3. MERGERS AND ACQUISITIONS
On February 17, 2004, the Company completed its previously announced acquisition
of the assets of Asgard Holding, LLC (Asgard), an internet security product and
service company. As a result of the acquisition, management believes SteelCloud
is better positioned to define and control proprietary product features and
services from its own intellectual property. The acquisition was accounted for
as a purchase; therefore, the accompanying financial statements include the
results of operations from the acquisition date forward.
In exchange for the assets of Asgard, which included intellectual property and
patent-pending technology, the Company paid cash of $630,015 and issued 575,000
shares of SteelCloud common stock valued at $2,283,900. The value of SteelCloud
common stock issued was determined in accordance with SFAS No. 141 by taking the
average market price over the 2-day period before and after the terms of the
acquisition were agreed to and announced. In addition, the Company assumed
$170,138 of Asgard's debt.
The following table summarizes the estimated fair values of the assets acquired
and liabilities assumed at the date of acquisition:
AT FEBRUARY 17,
2004
---------------
Current assets .......... $ 99,929
Intangible assets ....... 345,339
Goodwill ................ 2,664,417
Noncurrent assets ....... 69,368
-----------
Total assets acquired ... 3,179,053
-----------
Current liabilities ..... (96,986)
Noncurrent liabilities .. (118,151)
-----------
Total liabilities assumed
(215,137)
-----------
Net assets acquired ..... $ 2,963,916
===========
Of the $345,339 assigned to acquired intangible assets, $238,207 was assigned to
SecureNet software technology developed by Asgard, and $107,132 was assigned to
customer relationships acquired in conjunction with the acquisition of the
assets of Asgard. Both the SecureNet software technology and the customer
relationships will be amortized over estimated useful lives of 3 years. The
$2,664,417 assigned to goodwill in connection with the acquisition will not be
amortized, but will be tested at least annually for impairment.
4. DEBT
On February 17, 2004, the Company executed two three-year promissory notes in
conjunction with the purchase of the assets of Asgard Holding, LLC (Asgard) for
an aggregate amount of $170,138. The promissory notes bear interest at 4% and
mature in February 2007. The Company makes monthly aggregate payments of $4,726
plus accrued interest. The outstanding balance on the two notes at April 30,
2004 was $160,686.
On January 22, 2004, the Company amended its bank line of credit that allows the
Company to borrow an amount to the lesser of its collateralized cash on hand or
$3.5 million. The line of credit bears interest at the LIBOR Market Index rate
plus 1.25%. The line of credit is secured by all assets of the Company and
expires on March 31, 2005. There were no outstanding borrowings on the line of
credit at October 31, 2003 and April 30, 2004.
-6-
On April 1, 2002, the Company executed a two-year promissory note in conjunction
with a litigation settlement for approximately $240,000. The promissory note
bears interest at the prime rate and matures in May 2004. The Company makes
monthly payments of $10,000 plus accrued interest. In December 2003, the Company
paid the debt thereby extinguishing its obligations under this note. The
outstanding balance on the note at October 31, 2003 and April 30, 2004 was
approximately $60,000 and $0, respectively.
5. DEFERRED CONTRACT REVENUE
For the three months ended April 30, 2004, the Company had deferred contract
revenue of approximately $750,000 related to Lockheed Martin server appliance
contracts, which were awarded in February of 2003. The deferred revenue
represents payments received for milestones achieved prior to recognition of
revenue. This revenue will be recognized over the remaining life of the
contracts as units are shipped under the contracts, which are scheduled for
completion in December of 2004.
6. EARNINGS PER SHARE
Basic earnings per share is based on the weighted average number of common
shares outstanding during the period and is calculated by dividing the net
earnings (loss) by the weighted average number of common shares outstanding.
Diluted earnings per share is based on the weighted average number of common
shares outstanding plus common stock equivalents associated with stock options
and warrants and is calculated by dividing net earnings (loss) by the weighted
average number of common shares outstanding used in the basic earnings per share
calculation plus the common stock equivalent of stock options and warrants. For
the three and six months ended April 30, 2004, the Company's common stock
equivalent shares outstanding from stock options and warrants of 883,555 and
1,040,934, respectively, have been excluded from the diluted earnings per share
calculation as their effect is antidilutive.
7. SEGMENT REPORTING
FASB Statement No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED
INFORMATION, establishes standards for reporting information about operating
segments. Operating segments are defined as components of an enterprise about
which separate financial information is available that is evaluated regularly by
the chief operating decision maker, or decision making group, in deciding how to
allocate resources and in assessing performance. The Company's chief operating
decision maker is the Company's Chief Operating Officer. While the Chief
Operating Officer is apprised of a variety of financial metrics and information,
the Chief Operating Officer makes decisions regarding how to allocate resources
and assess performance based on a single operating unit.
8. RECLASSIFICATION
Certain prior years amounts have been reclassified to conform to current year
presentation.
9. DISCONTINUED OPERATIONS
The Company continually evaluates its operating facilities with regard to its
long-term strategic goals established by management and the Board of Directors.
Operating facilities that are not expected to contribute to the Company's future
operations are either closed or sold. In fiscal 2002, management, with the
approval of the Board of Directors, adopted a plan to dispose of the Puerto Rico
Industrial Manufacturing Operation Acquisition, Corp ("PRIMOA"). The plan was
completed in fiscal 2003 whereby the remaining assets were sold and remaining
warranty liabilities and obligations were contracted to a local service
provider. The Company believes that there will be no additional costs incurred
related to this operation.
-7-
The loss associated with discontinued operations for the three months ended
April 30, 2003 and 2004 was $26,954 and $0, respectively. Net revenues
associated with discounted operations for the three months ended April 30, 2003
and 2004 was $36,348 and $0, respectively. The loss associated with discontinued
operations for the six months ended April 30, 2003 and 2004 was $56,455 and $0,
respectively. Net revenues associated with discounted operations for the six
months ending April 30, 2003 and 2004 was $80,992 and $0, respectively.
10. SUBSEQUENT EVENTS
On May 20, 2004, the Company announced that it had signed a letter of intent to
acquire V-ONE Corporation (V-One) in an all-stock transaction valued at
approximately $16 million inclusive of transaction expenses. The letter of
intent contemplates that V-ONE common shareholders would receive one SteelCloud
common share in exchange for approximately 8.5 V-ONE common shares. The
management and respective Boards of Directors of SteelCloud and V-One have
approved the transaction pending due diligence and subject to completion of a
definitive purchase agreement and shareholder approval. The Company anticipates
that the acquisition will be consummated by August 31, 2004.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Certain statements contained herein may constitute forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995. The
words or phrases "would be," "will allow," "intends to," "will likely result,"
"are expected to," "will continue," "is anticipated," "estimate," "project," or
similar expressions are intended to identify "forward-looking statements".
Because such statements include risks and uncertainties, actual results may
differ materially from those expressed or implied by such forward-looking
statements. Factors that could cause actual results to differ materially
include, but are not limited to, risks associated with the integration of
businesses following an acquisition, competitors with broader product lines and
greater resources, emergence into new markets, the termination of any of the
Company's significant contracts, the Company's inability to maintain working
capital requirements to fund future operations, or the Company's inability to
attract and retain highly qualified management, technical and sales personnel.
Statements made herein are as of the date of the filing of this Form 10-Q with
the Securities and Exchange Commission and should not be relied upon as of any
subsequent date. Unless otherwise required by applicable law, the Company does
not undertake, and the Company specifically disclaims, any obligation to update
any forward-looking statements to reflect occurrences, developments,
unanticipated events or circumstances after the date of such statement.
The following discussion should be read in conjunction with the consolidated
financial statements and notes thereto included in Item 1 in this Quarterly
Report on Form 10-Q and our Annual Report on Form 10-K for the fiscal year ended
October 31, 2003 filed by the Company with the Securities and Exchange
Commission.
OVERVIEW
Founded in 1987, SteelCloud, Inc, based in Dulles, Virginia, designs, develops
and manufactures customized computer servers and network appliances. The
Company's custom computer servers are designed to meet the precise needs of
volume customers to reduce the customer's investments in logistics, integration
capacity and support. The Company's network security appliances are developed in
collaboration with some of the world's premiere software companies. In addition,
the Company develops proprietary software to optimize the performance of its
security appliances. The Company's appliances are specially designed and
optimized to deliver a dedicated network service such as antivirus gateway
protection, intrusion detection and secure content management.
-8-
In fiscal 2003, SteelCloud began focusing its efforts on the network security
marketplace and on the creation of additional SteelCloud intellectual property.
The Company has created its own family of hardened (highly secured) appliances
to be delivered as co-branded appliances with its software partners. With its
strategic partners, SteelCloud creates and uniquely brands ready-to-use turnkey
network server appliance solutions combining both hardware and software. The
Company integrates its own, its partner's, or other third-party software, into a
custom designed server platform. The Company manufactures the resulting product
either under a co-branded name or its partner's brand name allowing the partner
to deliver a complete turnkey solution. The Company enhances its product
development and manufacturing capability by providing custom supply chain and
logistics support services to its partners.
To extend its network security offerings, the Company acquired the assets of
Asgard Holding, LLC in February 2004 through the payment of $630,015 in cash,
the issuance of 575,000 shares of common stock valued at $2,283,900 and
assumption of debt totaling $170,138. As a result of the acquisition, management
believes SteelCloud is better positioned to define and control proprietary
product features and services from its own intellectual property. With this
purchase, the Company has also acquired the technical knowledgebase and
resources to design and develop proprietary products.
In May of 2004, the Company announced its intent to purchase all of the
outstanding shares of V-ONE Corporation (V-ONE). Under the terms of the letter
of intent, SteelCloud would acquire V-ONE in an all-stock transaction valued at
approximately $16 million inclusive of transaction expenses. The transaction
contemplates that V-ONE common shareholders would receive one SteelCloud common
share in exchange for approximately 8.5 V-ONE common shares. SteelCloud
management believes that the acquisition of V-ONE will further its plan to
transform SteelCloud into a network security solutions provider by integrating
V-ONE's SSL VPN patented technology with proprietary software acquired in
connection with the acquisition of the assets of Asgard. V-ONE has invested over
$65 million in developing patented standards-based products, and currently holds
eight technology patents. V-ONE technology is currently deployed in critical
homeland security applications by U.S. government agencies including the
National Security Agency and the Federal Bureau of Investigations, where their
technology programs secure over 100,000 users of the FBI LEO/RISS (Law
Enforcement Online - Regional Information Sharing System). V-ONE technology is
also currently deployed in the Departments of Defense, the U.S. Treasury, and
major commercial companies in healthcare, banking and finance, transportation
and high-tech.
SteelCloud's consulting services organization provides clients with a seamless
extension of their own IT organizations. Expert technical services include
network analysis, security, design, troubleshooting and implementation. The
Company provides Information Technology (IT) support services to the public
sector as well as commercial customers. The Company is also a value-added
reseller for the software products of its strategic partners and certain other
software providers.
CRITICAL ACCOUNTING POLICIES
The Company believes the following represent its critical accounting policies:
SIGNIFICANT CUSTOMER CONTRACT
In February 2003, the Company was awarded several contracts by Lockheed Martin
valued at more than $2.7 million for customized servers. The Company commenced
work under the contracts in February 2003, and is expected to complete the
contracts by December 2004. For the six months ended April 30, 2004, the Company
recognized revenue of approximately $1.6 million (or approximately 16% of total
net revenues) from the contract awards and has deferred contract revenue and
deferred contract costs of approximately $834,000 and $643,000, respectively
that will be recognized over the life of the contracts as units are shipped.
Deferred contract revenue and costs associated with the contract do not
necessarily reflect final revenues and costs associated with specific units to
be shipped.
-9-
In May 2004, the Company was awarded a contract by a government integrator
valued at more than $12 million for customized servers. The contract includes
options for the government integrator to purchase a substantial number of
additional appliances. Provided all contract options are exercised, the total
contract value may exceed $20 million. Given the nature of the products
manufactured by the Company as well as the delivery schedules established by its
partners, revenue and accounts receivable concentration by any single customer
will fluctuate from quarter to quarter. Future revenues and results of
operations could be adversely affected should this customer reduce its
purchases, eliminate product lines or choose not to continue to buy products and
services from SteelCloud.
REVENUE RECOGNITION
The Company recognizes revenue in accordance with Staff Accounting Bulletin No,
104, "Revenue Recognition in Financial Statements" (SAB104). SAB 104 requires
that four basic criteria be met before revenue can be recognized: (1) persuasive
evidence of an arrangement exists; (2) delivery has occurred or services have
been rendered; (3) the seller's price to the buyer is fixed or determinable; and
(4) collectibility is reasonably assured.
The Company derives its revenue from the following sources: Product revenue,
information technology support services, software license as a reseller and
maintenance support, software training and customization revenue associated with
software license reselling activity.
For product sales to commercial customers, the Company recognizes revenue at the
time of shipment (shipping FOB shipping point) when both title and risk of loss
transfers to the customer. For product sales to government customers, the
Company recognizes revenue when customer receipt of goods is confirmed (shipping
FOB destination) and risk of loss transfers to the customer. For technology
support services under time and material contracts, the Company recognizes
revenue as services are provided. Revenue from hardware leased to customers
under operating lease arrangements is recognized over the contract term. When
product and installation services that are not essential to the functionality of
the product are sold as part of a bundled agreement, the fair value of the
installation services, based on the price charged for the services when sold
separately, is deferred and recognized when the services are performed. The
products sold are generally covered by a warranty for periods ranging from one
to three years. The Company accrues an estimated warranty reserve in the period
of sale to provide for estimated costs for warranty services.
The Company is a value-added reseller for certain software products. When resold
software licenses, and related maintenance, customization and training services
are all provided together to an individual customer, the Company recognizes
revenue for the arrangement after the Company has delivered the software license
and the customer has approved all customization and training services provided.
In instances were the Company only resells the software license and maintenance
to the customer, the Company recognizes revenue after the customer has
acknowledged and accepted delivery of the software. The software manufacturer is
responsible for providing software maintenance. Accordingly, revenue from
maintenance contracts is recognized upon delivery or acceptance, as the Company
has no future obligation to provide the maintenance services and no right of
return exists.
The Company incurs shipping and handling costs, which are recorded in cost of
revenues.
RESULTS OF OPERATIONS
FOR THE THREE AND SIX MONTHS ENDED APRIL 30, 2004 COMPARED TO THE THREE AND
SIX MONTHS ENDED APRIL 30, 2003
Product revenues decreased to $4,636,361 for the three months ended April 30,
2004 from $7,448,132 for the same period in fiscal 2003, a decrease of
$2,811,771 or 37.8%. Product revenues decreased to $7,931,674 for the six months
ended April 30, 2004 from $14,328,522 for the same period in fiscal 2003, a
decrease of $6,396,848 or 44.6%. The decreases are primarily attributable to the
completion of two major contracts in fiscal 2003. A contract with Lockheed
Martin was completed during fiscal 2003, which resulted in a change in revenues
of approximately $1.6 million and $2.8 million, respectively, for the three and
six-month periods ended April 30, 2004 as compared to the same periods in fiscal
2003. A contract associated with the Company's GSA schedule was also completed
in fiscal 2003, which resulted in a change in revenues of approximately $1.3
million and $1.9 million, respectively, for the three and six month periods
ended April 30, 2004 as compared to the same periods in fiscal 2003. The
decrease in revenues for the six months ended April 2004 as compared to the same
period in fiscal 2003 is also the result of approximately a $750,000 decrease in
revenues associated with reseller product as a result of the company's efforts
to focus sales resources on higher-margin products and services. Other revenue
decreases associated with the Company's OEM business for the three and six month
periods ended April 30, 2004 as compared to the same periods in fiscal 2003 were
partially offset by increases in revenue from the Company's security appliances.
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Service revenues increased to $1,155,403 for the three months ended April 30,
2004 from $771,738 for the same period in fiscal 2003, an increase of $383,665
or 49.7%. Service revenues increased to $2,023,787 for the six months ended
April 30, 2004 from $1,525,516 for the same period in fiscal 2003, an increase
of $498,271 or 32.7%. The increase in service revenues for the three and six
months ended April 30, 2004 as compared to the same periods in fiscal 2003 is
primarily the result of growth in the Company's consulting services and managed
service revenues generated through customer relationships acquired through the
purchase of the assets of Asgard. The increase in revenue for the Company's
consulting services is the result of continuing efforts to leverage existing
customer relationships, bundle our product lines with complementary services,
invest in additional resources, and capitalize on the technical knowledgebase
acquired from Asgard.
Gross margin, as a percentage of net revenues, increased to 30% for the three
months ended April 30, 2004 from 22.4% for the same period in fiscal 2003. Gross
margin, as a percentage of net revenues, increased to 25.4% for the six months
ended April 30, 2004 from 21.3% for the same period in fiscal 2003. The increase
in gross margin for the three and six months ended April 30, 2004 as compared to
the same periods in fiscal 2003 is the result of an increase in sales revenue
from the Company's higher-margin revenue sources: security appliances and
consulting and network services. The Company is beginning to experience the
anticipated higher gross margins from sales of its co-branded security
appliances as well as from its consulting and managed services. The increase in
gross margin from consulting services is principally the result of improved
utilization of the Company's consulting service resources, and the integration
and utilization of the technical knowledgebase acquired from Asgard. Growth in
consulting service demand and backlog has enhanced management's ability to match
consulting demand with consulting resources immediately following resource
availability. While the Company expects gross margin as a percentage of net
revenues to increase as it continues to grow its higher-margin revenue sources,
gross margin is expected to fluctuate from quarter to quarter.
Sales and marketing expenses increased to $514,530 for the three months ended
April 30, 2004 from $336,225 for the same period in fiscal 2003, an increase of
$178,305 or 53%. Sales and marketing expenses increased to $984,815 for the six
months ended April 30, 2004 from $634,949 for the same period in fiscal 2003, an
increase of $349,866 or 55.1%. The increase is primarily attributable to an
increase in sales and marketing efforts for the Company's new security
appliances as well as its services.
Research and product development expenses increased to $124,973 for the three
months ended April 30, 2004 from $110,595 for the same period in fiscal 2003, an
increase of $14,378 or 13%. The increase is primarily attributable to increases
in labor associated with the Company's ongoing efforts to develop intellectual
property and its own network security products. Research and product development
expenses increased to $275,417 for the six months ended April 30, 2004 from
$110,595 for the same period in fiscal 2003, an increase of $164,822 or 149%.
The large increase is primarily the result of incurring no research and product
development expenses during the first quarter of fiscal 2003, as research and
product development efforts did not commence until the second quarter of fiscal
2003. The Company expects to incur additional research and product development
costs in future quarters as new products are brought to market.
General and administrative expenses increased to $1,411,661 for the three months
ended April 30, 2004 from $1,247,092 for the same period in fiscal 2003, an
increase of $164,569 or 13.2%. As a percentage of revenue, general and
administrative expenses increased to 24% from 15% for the same period in fiscal
2003. The increase is largely attributable to increased personnel costs of
approximately $55,000, and depreciation and rent expense of approximately
$60,000. For the six month period ended April 30, 2004 general and
administrative expenses increased to $3,202,767 from $2,375,820 for the same
period in fiscal 2003, an increase of $826,947 or 34.8%. As a percentage of
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revenue, general and administrative expenses increased to 32% from 15% for the
same period in fiscal 2003. The increase is largely attributable to increased
personnel costs of approximately $395,000, and increased professional services,
depreciation, and insurance costs of approximately $215,000. In addition, the
Company incurred approximately $85,000 in non-recurring professional services
related to analysis associated with amending the Company's Net Operating Loss
carryforward. The increases associated with general and administrative expenses
for the three and six months ended April 30, 2004 is primarily the result of
growing administrative requirements necessary to transform the Company into a
network security solutions provider. In addition, expenses have increased due to
the Company incurring additional expenses associated with workforce and facility
leases acquired from Asgard. Although the Company continues to manage its costs
relative to its revenues and gross margins, additional resources will be
required in order to support its new product lines and successfully transition
the Company into a network security company.
Interest expense (income) decreased to an expense of $1,597 for the three months
ended April 30, 2004 from expense of $7,899 for the same period in fiscal 2003,
a decrease of $6,302 or 79.8%. Interest expense (income) decreased to income of
$11,645 for the six months ended April 30, 2004 from expense of $13,739 for the
same period in fiscal 2003, a decrease of $25,384 or 185%. The decrease in
interest expense (income) is the direct result of the Company's reduction in its
outstanding debt and increase in cash during the three and six months ended
April 30, 2004 as compared to the same periods in fiscal 2003.
The Company reported a net loss of $315,929 for the three months ended April 30,
2004, as compared to net income of $109,243 for the same period in fiscal 2003.
The Company reported a net loss of $1,922,028 for the six months ended April 30,
2004, as compared to net income of $188,787 for the same period in fiscal 2003.
The decrease in net income for the three and six months ended April 30, 2004 as
compared to the same periods in fiscal 2003 is primarily attributable to the
Company's increased costs associated with its efforts to acquire and develop
intellectual property and to produce, manufacture, and market its network
security products in conjunction with a slower than expected increase in
revenues associated with the Company's network security products. While the
Company is experiencing a slower than expected increase in revenues associated
with its network security products, the Company is beginning to realize higher
gross margins resulting from sales of its security appliances. In addition, the
Company continued to experience increases in consulting service revenue as a
result of continuing efforts to leverage existing customer relationships, bundle
our product lines with complementary services, invest in additional resources
and capitalize on the technical knowledgebase acquired from Asgard.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents decreased to $7,547,105 at April 30, 2004 from
$8,098,221 at October 31, 2003, a decrease of 6.8%. Working capital decreased to
$9,989,680 at April 30, 2004 from $11,597,743 at October 31, 2003, a decrease of
13.9%. The decrease in cash and working capital is primarily attributable to
cash paid of $630,015 in connection with the acquisition of the assets of Asgard
Holdings, LLC, and the reclassification of the Company's $400,000 deferred tax
asset from a short-term asset to a long-term asset. The Company believes cash on
hand together with cash generated from operations will provide sufficient
financial resources to finance current operations of the Company through fiscal
2004.
For the six months ended April 30, 2004, the Company used $516,799 in cash flow
from continuing operations. The Company generated cash from the collection of
its accounts receivables of $2,115,967, and experienced an increase in unearned
revenue and other liabilities of $841,856. The cash generated was primarily used
to pay accounts payable of $841,607 and purchase inventory of $295,161. In
addition, the Company experienced an increase in deferred contract costs of
$718,096.
For the six months ended April 30, 2004, the Company invested $295,111 in
property and equipment. In addition, the Company invested $630,015 to purchase
the assets of Asgard Holding, LLC (Asgard).
For the six months ended April 30, 2004, the Company generated $890,809 from
financing activities. Cash provided by the Company's financing activities
resulted primarily from proceeds received in connection with the exercise of
warrants and options to purchase the Company's common stock of $990,499. The
Company did not rely on its bank line of credit for the six months ended April
30, 2004.
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On February 17, 2004, the Company completed its acquisition of the assets of
Asgard Holding, LLC (Asgard), an internet security product and service company.
In exchange for the assets of Asgard, which included intellectual property and
patent-pending technology, the Company paid cash of $630,015 and issued 575,000
shares of SteelCloud common stock valued at $2,283,900. The value of SteelCloud
common stock issued was determined in accordance with SFAS No. 141. In addition,
the Company assumed $170,138 of Asgard's debt by executing two three-year
promissory notes. The promissory notes bear interest at 4% and mature in
February 2007. The Company makes monthly aggregate payments of $4,726 plus
accrued interest. The outstanding balance on the two notes at April 30, 2004 was
approximately $160,686.
On January 22, 2004, the Company modified its bank line of credit that allows
the Company to borrow an amount to the lesser of its collateralized cash on hand
or $3.5 million. The line of credit bears interest at the LIBOR Market Index
rate plus 1.25%. The line of credit is secured by all assets of the Company. As
of April 30, 2004, there were no outstanding borrowings on the line of credit.
The line of credit expires on March 31, 2005.
In May of 2004, the Company announced its intent to purchase all of the
outstanding shares of V-ONE Corporation (V-ONE). Under the terms of the letter
of intent, SteelCloud would acquire V-ONE in an all-stock transaction valued at
approximately $16 million, inclusive of transaction expenses. The transaction
contemplates that V-ONE common shareholders would receive one SteelCloud common
share in exchange for approximately 8.5 V-ONE common shares. The management and
respective Boards of Directors of SteelCloud and V-One have approved the
transaction subject to completion of a definitive purchase agreement and
shareholder approval. If a definitive purchase agreement is signed and the
acquisition is consummated, the Company will incur legal, accounting, printing
and other related transaction expenses. In addition, additional working capital
may be required if this acquisition is consummated in order to exploit the
benefits of this merger.
From time to time, the Company may pursue strategic acquisitions or mergers,
which may require significant additional capital, and additional capital may be
required to satisfy unusual or infrequent expenses. In such event, the Company
may seek additional financing of debt and/or equity.
Contractual Obligations and Commercial Commitments:
The Company's significant contractual obligations as of April 30, 2004 are for
debt and operating leases. Debt by year of maturity and future rental payments
under operating lease agreements are presented below. The Company does not have
any purchase obligations, capital lease obligations or any material commitments
for capital expenditures as of April 30, 2004. The Company has not engaged in
off-balance sheet financing, commodity contract trading or significant related
party transactions.
- ----------------------------------- ----------------------------------------------------------------------
Contractual Obligations Payments Due by Period
- ----------------------------------- --------------- -------------- -------------- ----------- ------------
Less than 1 More than
Total year 1-3 years 3-5 years 5 years
- ----------------------------------- --------------- -------------- -------------- ----------- ------------
Notes Payable - Current $ 70,195 $ 70,195 - - -
- ----------------------------------- --------------- -------------- -------------- ----------- ------------
Long Term Debt $ 156,517 - $ 149,587 $ 6,930 -
- ----------------------------------- --------------- -------------- -------------- ----------- ------------
Operating Lease $ 335,854 $ 335,854 - - -
- ----------------------------------- --------------- -------------- -------------- ----------- ------------
Management believes that these commitments will be satisfied with current
operating cash flow.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to market risk related to fluctuations in interest rates
on its debt. Increase in prevailing interest rates could increase the Company's
interest payment obligations relating to variable rate debt. For example, a 100
basis point increase in interest rates would increase annual interest expense by
$35,000.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of SteelCloud's Disclosure Controls and Internal Controls
SteelCloud evaluated the effectiveness of the design and operation of its
disclosure controls and procedures, or "Disclosure Controls," as of the end of
the period covered by this quarterly report on Form 10-Q. This evaluation, or
"Controls Evaluation" was performed under the supervision and with the
participation of management, including our Chairman of the Board, Chief
Executive Officer and Director ("CEO"), our Chief Operating Officer ("COO"), and
our Chief Financial Officer ("CFO").
CEO, COO and CFO Certifications
The certifications of the CEO, COO, and the CFO required by Rule 13a-15(e) of
the Securities Exchange Act of 1934, as amended, or the "Rule 13a-15(e)
Certifications" are filed as Exhibit 31 of this quarterly report on Form 10-Q.
This Controls and Procedures section of the quarterly report includes the
information concerning the Controls Evaluation referred to in the Rule 13a-15(e)
Certifications and it should be read in conjunction with the Rule 13a-15(e)
Certifications for a more complete understanding of the topics presented.
Disclosure Controls and Internal Control over Financial Reporting
Disclosure Controls are controls and other procedures designed to ensure that
information required to be disclosed in our reports filed under the Exchange
Act, such as this quarterly report, is recorded, processed, summarized and
reported within the time periods specified in the U.S. Securities and Exchange
Commission's rules and forms. Disclosure Controls include, without limitation,
controls and procedures designed to ensure that information required to be
disclosed in our reports filed under the Exchange Act is accumulated and
communicated to our management, including our CEO, COO, and CFO, or persons
performing similar functions, as appropriate to allow timely decisions regarding
required disclosure.
Internal control over financial reporting is a process designed to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles and includes those policies and
procedures that (1) pertain to the maintenance of records that in reasonable
detail accurately and fairly reflect the transactions and dispositions of our
assets; (2) provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in accordance with
generally accepted accounting principles, and that our receipts and expenditures
are being made only in accordance with authorizations of our management and
directors; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use or disposition of our assets that
could have a material effect on the financial statements.
Limitations on the Effectiveness of Controls
Our management, including our CEO, COO, and CFO, does not expect that our
Disclosure Controls or our internal controls will prevent all error and all
fraud. A control system, no matter how well designed and operated, can provide
only reasonable, not absolute, assurance that the control system's objectives
will be met. Further, the design of a control system must reflect the fact that
there are resource constraints, and the benefits of controls must be considered
relative to their costs. Because of the inherent limitations in all control
systems, no evaluation of controls can provide absolute assurance that all
control issues and instances of fraud, if any, within SteelCloud have been
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detected. These inherent limitations include the realities that judgments in
decision-making can be faulty, and that breakdowns can occur because of simple
error or mistake. Controls can also be circumvented by the individual acts of
some persons, by collusion of two or more people, or by management override of
the controls. The design of any system of controls is based in part upon certain
assumptions about the likelihood of future events, and there can be no assurance
that any design will succeed in achieving its stated goals under all potential
future conditions. Over time, controls may become inadequate because of changes
in conditions or deterioration in the degree of compliance with associated
policies or procedures. Because of the inherent limitations in a cost-effective
control system, misstatements due to error or fraud may occur and not be
detected.
Conclusions
Based upon the Controls Evaluation, our CEO, COO, and CFO have concluded that,
subject to the limitations noted above, our Disclosure Controls are effective to
ensure that material information relating to SteelCloud is made known to
management, including the CEO, COO, and CFO, particularly during the period when
our periodic reports are being prepared.
During the period covered by this quarterly report on Form 10-Q, there were no
changes in our internal control over financial reporting that have materially
affected or are reasonably likely to materially affect our internal control over
financial reporting.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
There are routine legal claims pending against the Company that occur in the
ordinary course of business, but in the opinion of management, liabilities, if
any, arising from such claims will not have a material adverse effect on the
financial condition and results of operation of the Company.
Other than the items previously disclosed, we are not a party in any other
material legal proceedings.
ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF
EQUITY SECURITIES
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
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
Exhibit 11.1 Statement of computation of earnings per share.
Exhibit 31 Rule 13a-14(a)/15d-14(a) Certifications.
Exhibit 32.1 Certification by the Chief Executive Officer Relating to a
Periodic Report Containing Financial Statements.*
Exhibit 32.2 Certification by the Chief Operating Officer Relating to a
Periodic Report Containing Financial Statements.*
Exhibit 32.3 Certification by the Chief Financial Officer Relating to a
Periodic Report Containing Financial Statements.*
- ------
* The Exhibit attached to this Form 10-Q shall not be deemed "filed" for
purposes of Section 18 of the Securities Exchange Act of 1934 (the "Exchange
Act") or otherwise subject to liability under that section, nor shall it be
deemed incorporated by reference in any filing under the Securities Act of 1933,
as amended, or the Exchange Act, except as expressly set forth by specific
reference in such filing.
(b) Reports on Form 8-K
On March 11, 2004, the Company filed a report on Form 8-K pursuant to Item 7
"Financial Statements and Exhibits", Item 9 "Regulation FD Disclosure" and Item
12 "Results of Operations and Financial Condition".
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SIGNATURES
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.
June 10, 2004 STEELCLOUD, INC.
By: /S/ THOMAS P. DUNNE
-------------------------------
Name: Thomas P. Dunne
Title: Chief Executive Officer
By: /S/ BRIAN HAJOST
-------------------------------
Name: Brian Hajost
Title: Chief Operating Officer
By: /S/ KEVIN MURPHY
-------------------------------
Name: Kevin Murphy
Title: Chief Financial Officer
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