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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 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 March 31, 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 Number: 0-26494
GSE SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
Delaware 52-1868008
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
9189 Red Branch Road, Columbia Maryland, 21045
(Address of principal executive office and zip code)
Registrant's telephone number, including area code: (410) 772-3500
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Sections 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 May 1, 2004, there were 8,949,706 shares of the Registrant's common stock
outstanding.
GSE SYSTEMS, INC.
QUARTERLY REPORT ON FORM 10-Q
INDEX
PAGE
PART I. FINANCIAL INFORMATION 3
Item 1. Financial Statements:
Consolidated Balance Sheets as of March 31, 2004 3
and December 31, 2003
Consolidated Statements of Operations for the 4
Three Months Ended March 31, 2004 and March 31, 2003
Consolidated Statements of Comprehensive Income (Loss) 5
for the Three Months Ended March 31, 2004 and March 31, 2003
Consolidated Statements of Cash Flows for the 6
Three Months Ended March 31, 2004 and March 31, 2003
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Results of Operations 15
and Financial Condition
Item 3. Quantitative and Qualitative Disclosures About Market Risk 22
Item 4. Controls and Procedures 22
PART II. OTHER INFORMATION 23
Item 1. Legal Proceedings 23
Item 2. Changes in Securities and Use of Proceeds 23
Item 3. Defaults Upon Senior Securities 23
Item 4. Submission of Matters to a Vote of Security Holders 23
Item 5. Other Information 23
Item 6. Exhibits and Reports on Form 8-K 23
SIGNATURES 24
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
Unaudited
March 31, 2004 December 31, 2003
ASSETS
Current assets:
Cash and cash equivalents $ 1,062 $ 1,388
Restricted cash 512 473
Contract receivables 9,209 9,457
Prepaid expenses and other current assets 1,545 1,635
------------ -------------
Total current assets 12,328 12,953
Equipment and leasehold improvements, net 584 643
Software development costs, net 958 946
Goodwill, net 1,739 1,739
Other assets 142 255
------------ -------------
Total assets $ 15,751 $ 16,536
============ =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt $ 34 $ 33
Accounts payable 2,976 2,946
Accrued expenses 1,408 1,518
Accrued compensation and payroll taxes 1,989 1,752
Billings in excess of revenue earned 2,947 3,927
Other current liabilities 236 240
------------ ------------
Total current liabilities 9,590 10,416
Long-term debt - 9
Accrued warranty reserves 434 407
Other liabilities 25 25
------------ ------------
Total liabilities 10,049 10,857
------------ ------------
Commitments and contingencies
Stockholders' equity:
Series A Convertible preferred stock $.01 par value, 2,000,000 shares authorized,
no shares issued and outstanding - -
Common stock $.01 par value, 18,000,000 shares authorized, shares issued
and outstanding 8,949,706 in 2004 and 2003 89 89
Additional paid-in capital 30,815 30,815
Retained earnings (deficit) - at formation (5,112) (5,112)
Retained earnings (deficit) - since formation (19,098) (19,162)
Accumulated other comprehensive loss (992) (951)
------------ ------------
Total stockholders' equity 5,702 5,679
------------ -------------
Total liabilities and stockholders' equity $ 15,751 $ 16,536
============ ============
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(Unaudited)
Three months
ended March 31,
-------------------------------
2004 2003
------------- --------------
Contract revenue $ 7,561 $ 4,975
Cost of revenue 5,784 3,794
------------- --------------
Gross profit 1,777 1,181
------------- --------------
Operating expenses
Selling, general and administrative 1,238 1,237
Administrative charges from GP Strategies 246 -
Depreciation and amortization 69 101
------------- --------------
Total operating expenses 1,553 1,338
------------- --------------
Operating income (loss) 224 (157)
Interest expense, net (143) (51)
Other income (expense), net - (5)
------------- --------------
Income (loss) from continuing operations before income taxes 81 (213)
Provision for income taxes 17 37
------------- --------------
Income (loss) from continuing operations 64 (250)
Loss from discontinued operations - (268)
------------- ---------------
Net income (loss) 64 (518)
Preferred stock dividends - (58)
------------- ---------------
Net income (loss) attributed to
common shareholders $ 64 $ (576)
============== ===============
Basic earnings (loss) per common share:
Continuing operations $ 0.01 $ (0.05)
Discontinued operations - (0.05)
------------- ----------------
Net income (loss) $ 0.01 $ (0.10)
============= ================
Diluted earnings (loss) per common share
Continuing operations $ 0.01 $ (0.05)
Discontinued operations - (0.05)
------------- ---------------
Net income (loss) $ 0.01 $ (0.10)
============== ===============
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands)
(Unaudited)
Three months
ended March 31,
------------------------------
2004 2003
------------- -------------
Net income (loss) $ 64 $ (518)
Foreign currency translation adjustment (41) 3
------------ --------------
Comprehensive income (loss) $ 23 $ (515)
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
Three months
ended March 31,
--------------------------
2004 2003
----------- ------------
Cash flows from operating activities:
Net income (loss) $ 64 $ (518)
Loss from discontinued operations - (268)
---------- -----------
Income (loss) from continuing operations 64 (250)
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 154 167
Changes in assets and liabilities:
Contract receivables 248 (597)
Prepaid expenses and other assets 203 27
Accounts payable, accrued compensation and accrued expenses 130 280
Billings in excess of revenues earned (980) (63)
Accrued warranty reserves 51 (26)
Other liabilities (28) (24)
----------- -------------
Net cash used in continuing operations (158) (486)
Net cash provided by discontinued operations - 1,291
----------- -------------
Net cash provided by (used in) operating activities (158) 805
----------- -------------
Cash flows from investing activities:
Capital expenditures (16) (13)
Capitalized software development costs (97) (209)
Restrictions of cash as collateral under line of credit (39) (15)
Other cash used in discontinued operations, net - (205)
------------ -------------
Net cash used in investing activities (152) (442)
------------ -------------
Cash flows from financing activities:
Decrease in borrowings under lines of credit - (1,778)
Other financing activities, net (8) (7)
------------ ------------
Net cash used in financing activities (8) (1,785)
----------- -----------
Effect of exchange rate changes on cash (8) 14
----------- -----------
Net decrease in cash and cash equivalents (326) (1,408)
Cash and cash equivalents at beginning of year 1,388 1,617
---------- -----------
Cash and cash equivalents at end of period $ 1,062 $ 209
========== ===========
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Three Months ended March 31, 2004 and 2003
(Unaudited)
1. Basis of Presentation and Revenue Recognition
The consolidated financial statements included herein have been
prepared by GSE Systems, Inc. (the "Company") without independent audit. In
the opinion of the Company's management, all adjustments and
reclassifications of a normal and recurring nature necessary to present
fairly the financial position, results of operations and cash flows for the
periods presented have been made. Certain information and footnote
disclosures normally included in financial statements prepared in
accordance with accounting principles generally accepted in the United
States have been condensed or omitted. These consolidated financial
statements should be read in conjunction with the consolidated financial
statements and notes thereto included in the Company's Annual Report on
Form 10-K for the period ended December 31, 2003 filed with the Securities
and Exchange Commission on April 14, 2004.
With the sale of the Company's Process business, the Company has only
one reportable segment. The Company has a wide range of knowledge of
simulation systems and the processes those systems are intended to control
and model. The Company's knowledge is concentrated heavily in the power
generation industry. The Company is primarily engaged in simulation for the
power generation industry and simulation for the process industries, with
the vast majority of customers being in the nuclear power industry.
Contracts typically range from 18 months to three years. The Power business
is comprised of three divisions: Power Simulation, Process Simulation and
Emergency Management Simulation. At March 31, 2004 GP Strategies
Corporation ("GP Strategies") owned 58% of the Company's common stock.
The majority of the Company's revenue is derived through the sale of
uniquely designed systems containing hardware, software and other materials
under fixed-price contracts. In accordance with Statement of Position 81-1
Accounting for Performance of Construction-Type and Certain Production-Type
Contracts, the revenue under these fixed-price contracts is accounted for
on the percentage-of-completion method. This methodology recognizes income
as work progresses on the contract and is based on an estimate of the
income earned to date, less income recognized in earlier periods. The
Company bases its estimate of the degree of completion of the contract by
reviewing the relationship of costs incurred to date to the expected total
costs that will be incurred on the project. Estimated contract earnings are
reviewed and revised periodically as the work progresses, and the
cumulative effect of any change is recognized in the period in which the
change is identified. Estimated losses are charged against earnings in the
period such losses are identified.
As the Company recognizes revenue under the percentage-of-completion
method, it provides an accrual for estimated future warranty costs based on
historical and projected claims experience. The Company's long-term
contracts generally provide for a one-year warranty on parts, labor and any
bug fixes as it relates to software embedded in the systems.
The Company's system design contracts do not provide for "post
customer support service" (PCS) in terms of software upgrades, software
enhancements or telephone support. In order to obtain PCS, the customers
must purchase a separate contract. Such PCS arrangements are generally for
a one-year period renewable annually and include customer support,
unspecified software upgrades, and maintenance releases. The Company
recognizes revenue from these contracts ratably over the life of the
agreements in accordance with Statement of Position 97-2 "Software Revenue
Recognition".
Revenues from certain consulting or training contracts are recognized
on a time-and-material basis. For time-and-material type contracts, revenue
is recognized based on hours incurred at a contracted labor rate plus
expenses.
Contract receivables unbilled of $5.5 million and $4.4 million as of
March 31, 2004 and December 31, 2003, respectively, are typically billed
within sixty days. In April, the Company billed $1.2 million of the
unbilled amounts.
2. Basic and Diluted Earnings (loss) Per Common Share
Basic earnings (loss) per share is based on the weighted average
number of outstanding common shares for the period. Diluted earnings (loss)
per share adjusts the weighted average shares outstanding for the potential
dilution that could occur if stock options, warrants or convertible
preferred stock were exercised or converted into common stock. The number
of common shares and common share equivalents used in the determination of
basic and diluted earnings (loss) per share were as follows:
(in thousands, except for per share amounts) Three months
ended March 31,
------------------------
2004 2003
----------- ----------
Numerator:
Net income (loss) $ 64 $ (518)
Preferred stock dividends - (58)
---------- -----------
Net income (loss) attributed to
common stockholders $ 64 $ (576)
=========== ===========
Denominator:
Weighted-average shares outstanding for basic
earnings per share 8,949,706 5,880,805
Effect of dilutive securities:
Employee stock options, warrants and
options outside the plan 67,399 -
--------- ------------
Adjusted weighted-average shares outstanding
and assumed conversions for diluted
earnings per share 9,017,105 5,880,805
========= =========
Shares related to dilutive securities excluded
because inclusion would be anti-dilutive: 1,728,276 3,538,956
========== =========
The difference between the basic and diluted number of weighted
average shares outstanding for the quarter ended March 31, 2004 represents
dilutive stock options and warrants to purchase shares of common stock
computed under the treasury stock method, using the average market price
during the period. The net loss for the quarter ended March 31, 2003 was
increased by preferred stock dividends of $58,000 in calculating the per
share amounts. Conversion of the stock options, warrants and convertible
preferred stock was not assumed for the three months ended March 31, 2003
because the impact was anti-dilutive.
3. Discontinued Operations
In September 2003, the Company completed the sale of substantially all
of the assets of GSE Process Solutions, Inc. (Process) to Novatech, LLC
(Novatech) pursuant to an Asset Purchase Agreement, effective as of
September 25, 2003, by and between the Company, Process and Novatech. The
Company received $5.5 million in cash, subject to certain adjustments. The
Company recognized a loss on this transaction of $262,000. In conjunction
with the transaction, Novatech purchased certain assets with a book value
of $11.7 million and assumed certain operating liabilities totaling
approximately $6.8 million. The Company incurred approximately $865,000 of
closing costs associated with the transaction. Results of operations for
the three months ended March 31, 2003 have been restated to classify the
net loss, assets and liabilities of the Process business as discontinued
operations.
For the three months ended March 31, 2003, contract revenue and net
loss for the discontinued Process business was $4.3 million and $268,000,
respectively.
4. Software Development Costs
Certain computer software development costs are capitalized in the
accompanying consolidated balance sheets. Capitalization of computer
software development costs begins upon the establishment of technological
feasibility. Capitalization ceases and amortization of capitalized costs
begins when the software product is commercially available for general
release to customers. Amortization of capitalized computer software
development costs is included in cost of revenue and is determined using
the straight-line method over the remaining estimated economic life of the
product, not to exceed five years.
Software development costs capitalized were $97,000 and $208,000 for
the quarters ended March 31, 2004 and 2003, respectively. Total
amortization expense was $86,000 and $66,000 for the quarters ended March
31, 2004 and 2003, respectively.
5. Stock Compensation
The Company applies the intrinsic-value-based method of accounting
prescribe by Accounting Principles Board (APB) Opinion No. 25, Accounting
for Stock issued to Employees, and related interpretations including FASB
Interpretation No. 44, Accounting for Certain Transactions involving Stock
Compensation, and interpretation of APB Opinion No. 25, issued in March
2000, to account for its fixed-plan stock options. Under this method,
compensation expense is recorded on the date of grant only if the current
market price of the underlying stock exceeds the exercise price. SFAS No.
123, Accounting for Stock-Based Compensation, established accounting and
disclosure requirements using a fair-value-based method of accounting for
stock based employee compensation plans. As allowed by SFAS No. 123, the
Company has elected to continue to apply the intrinsic-value-based method
of accounting describe above, and has adopted only the disclosure
requirements of SFAS No. 123.
If the computed values of all the Company's stock based awards were
calculated and expensed (over the vesting period of the awards) using the
fair value method specified under SFAS 123, net income (loss) would have
been as follows:
(in thousands, except per share data) Three months
ended March 31,
------------------------------
2004 2003
----------- ------------
Net income (loss) attributed to
common stockholders, as reported $ 64 $ (576)
Add stock-based employee compensation expense
included in reported net loss, net of tax - -
Deduct total stock-based employee compensation
expense determined under fair-value-method
for all awards, net of tax (15) (67)
------------ -------------
Pro forma net income (loss) $ 49 $ (643)
============ ===========
Net income (loss) per share, as reported:
Basic $ 0.01 $ (0.10)
Diluted $ 0.01 $ (0.10)
Net loss per share, as adjusted:
Basic $ 0.01 $ (0.11)
Diluted $ 0.01 $ (0.11)
No employee stock options were issued in the first quarter of 2004 or
2003.
6. Long-term Debt
The Company's long-term debt consists of the following notes payable
and other financing arrangements:
(in thousands) March 31, December 31,
2004 2003
------------ ---------------
Line of credit with bank $ - $ -
Note payable, other 34 42
------------ ---------------
Total notes payable and financing arrangements 34 42
Less amounts payable within one year 34 33
------------ ---------------
Long-term portion $ - $ 9
============ ===============
Line of Credit
General Physics Corporation is a wholly owned subsidiary of GP
Strategies. On March 30, 2004, the Company was added as an additional
borrower under the Financing and Security Agreement between General Physics
Corporation and a financial institution. Under the terms of the agreement,
$1.5 million of General Physics' available credit facility has been carved
out for use by GSE. The line is collateralized by substantially all of the
Company's assets and provides for borrowings up to 80% of eligible accounts
receivable and 80% of eligible unbilled receivables. The interest rate on
this line of credit is based upon the LIBOR Market Index Rate plus 3%
(4.09% as of March 31, 2004), with interest only payments due monthly. At
March 31, 2004, the Company's available borrowing base was $1.5 million,
none of which had been utilized. The credit facility expires on August 23,
2005.
The credit facility requires the Company to comply with certain
financial ratios. At March 31, 2004, the Company was in compliance with its
financial ratio covenants.
In March, 2003, GP Strategies extended their $1.8 million limited
guarantee of the Company's bank facility. In consideration for the
extension of the guarantee, the Company issued 150,000 shares of its common
stock to GP Strategies. The number of shares was calculated based upon a
10% fee divided by the closing price of GSE's common stock on March 21,
2003. The Company recorded the value of $180,000 as deferred financing cost
with a corresponding credit to common stock and additional paid-in capital.
The deferred costs were amortized over the one-year life of the guarantee.
Notes Payable, other
The Company has an unsecured promissory note to a former employee with
a remaining balance of $34,000 which expires March 31, 2005.
7. Series A Convertible Preferred Stock
The Series A convertible preferred stock has no voting rights and
bears dividends at the rate of 6% per annum payable quarterly. Dividends
will accumulate if not paid quarterly and compounded interest will accrue
on any unpaid dividends. On October 23, 2003, ManTech International Corp.
elected to convert all of its 39,000 shares of preferred stock to common
stock in conjunction with the sale of its ownership in the Company to GP
Strategies. Thus, as of March 31, 2004 and December 31, 2003 there are no
shares of preferred stock outstanding. The Company had accrued dividends
payable of $366,000 as of March 31, 2004 and December 31, 2003.
8. Letters of Credit and Performance Bonds.
As of March 31, 2004, the Company was contingently liable for six
letters of credit totaling approximately $541,000. All of these letters of
credit represent payment bonds on contracts and have been cash
collateralized and are classified as restricted cash in the consolidated
balance sheet. In addition, the Company was contingently liable at March
31, 2004 for approximately $61,000 under a performance bond on one
contract, which was secured by a bank guarantee of the Company's foreign
subsidiary.
9. Income Taxes
The Company's effective tax rate was 21.0% and 7.7% for the three
months ended March 31, 2004 and March 31, 2003, respectively. The increase
in the effective tax rate is attributable primarily to taxes on income
earned by the Company's Swedish subsidiary. For 2004, the Company's
combined U.S. Federal and State effective tax rate is projected to be 5%
and the Swedish effective tax rate is projected to be 28%.
10. Administrative Charges from GP Strategies
On January 1, 2004, the Company entered into a Management Services
Agreement with GP Strategies Corporation in which GP Strategies agreed to
provide corporate support services to GSE, including accounting, finance,
human resources, legal, network support and tax. GSE will pay an annual fee
of $685,000 ($171,250 per quarter) for these services. The term of the
agreement is one year, subject to earlier termination only upon the mutual
consent of the parties to the agreement. The agreement can be renewed for
successive one-year terms.
In December 2003, GSE's Board of Directors elected John Moran, a GP
Strategies executive with experience in the power industry and simulation
technology, as Chief Executive Officer. Mr. Moran will continue as a GP
Strategies employee, however, Mr. Moran will devote 100% of his time to the
performance of his duties as CEO of GSE. For 2004, GSE will reimburse GP
Strategies $300,000 ($75,000 per quarter) for his compensation and
benefits.
11. New Accounting Standards
In December 2003, the FASB issued Interpretation No. 46R,
Consolidation of Variable Interest Entities, which requires the
consolidation of entities meeting certain criteria. The Company does not
participate in any variable interest entities.
GSE SYSTEMS, INC. AND SUBSIDIARIES
FORM 10-Q
For the Three Months ended March 31, 2004 and 2003
Item 2. Management's Discussion and Analysis of Results of Operations and
Financial Condition
In September 2003, the Company completed the sale of substantially all of
the assets of GSE Process Solutions, Inc. (Process) to Novatech, LLC (Novatech)
pursuant to an Asset Purchase Agreement, effective as of September 25, 3004, by
and between the Company, Process and Novatech. The Company received $5.5 million
in cash, subject to certain adjustments. The operating results of the Company's
Process business have been classified as discontinued operations in the
Consolidated Statements of Operations for the three months ended March 31, 2003.
Following the sale of Process, the Company operates only in the Power business.
On January 1, 2004, the Company entered into a Management Services
Agreement with GP Strategies Corporation in which GP Strategies agreed to
provide corporate support services to GSE, including accounting, finance, human
resources, legal, network support and tax. GSE will pay an annual fee of
$685,000 ($171,250 per quarter) for these services. The term of the agreement is
one year, subject to earlier termination only upon the mutual consent of the
parties to the agreement. The agreement can be renewed for successive one-year
terms.
Cautionary Statement Regarding Forward-Looking Statements
This report contains certain forward-looking statements. Any statements
contained herein that are not statements of historical facts may be deemed
forward-looking statements. These statements are based on management's current
beliefs and expectations and are subject to numerous risks and uncertainties and
changes in circumstances. Actual results may differ materially from these
forward-looking statements due to changes in global, economic, business,
governmental, technical, competitive, market and regulatory factors.
General Business Environment
GSE Systems, Inc. ("GSE Systems", "GSE" or the "Company") is a world leader
in real-time power plant simulation. The Company provides simulation solutions
and services to the nuclear and fossil electric utility industry, as well as the
chemical and petrochemical industries. In addition, the Company provides plant
monitoring and signal analysis monitoring and optimization software primarily to
the power industry.
Effective January 1, 2004, the Company reorganized, creating a dedicated
worldwide business development organization under the direction of one manager,
and consolidating all of its operations in Columbia, Maryland, St. Mary's,
Georgia and Nykoping, Sweden under another manager. The Company entered into a
Management Services Agreement with GP Strategies effective January 1, 2004 in
which the Company outsourced most of its corporate functions (accounting, human
resources, etc.) and terminated most of its corporate staff at the end of 2003.
The Company's Power Simulation Business Unit ("Power") is positioning
itself to take advantage of emerging trends in the power industry. The operating
licenses for numerous nuclear power plants will expire over the next several
years. Fourteen plants have already received license extensions, and sixteen
more have applications pending. Many plants are also planning significant
upgrades to the physical equipment and control room technology in conjunction
with the license extensions. Both will result in the need to modify or replace
the existing plant control room simulators. The Company, having the largest
installed base of existing simulators, is well positioned to capture the
majority of this business.
In 2004, the Company is working on embedding its full scope simulator
software into classroom training materials. This will provide dynamic training
and feedback to the student, versus just static text. The Company is segmenting
its simulation software into "pieces" so that the software can be utilized to
teach specific skills in operating the nuclear electric utilities without the
need for control room panels.
The Company is completing the modification of its simulation technology to
simulate the operation of Emergency Operations Centers (EOC) run by municipal
and state governments. REMITS is a Real-time Emergency Management Interactive
Training System designed to simulate emergency situations and enable EOC staff
to train without requiring human participation in the field. REMITS enables the
EOC staff to stay current with the technology and enables instructors to
introduce new problems and challenges during the exercise to test the EOC staff
response to changing situations. As the Federal Government spends billions of
dollars in first responder training, management believes the Company's REMITS
product will be useful in training for disaster recovery and terrorist threat
response.
Results of Operations
The following table sets forth the results of operations for the periods
presented expressed in thousands of dollars and as a percentage of revenues:
(in thousands) Three months ended March 31,
-----------------------------------------------------
2004 % 2003 %
-------- --------- --------- ----------
Contract revenue $ 7,561 100.0 % $ 4,975 100.0 %
Cost of revenue 5,784 76.5 % 3,794 76.3 %
-------- --------- --------- ----------
Gross profit 1,777 23.5 % 1,181 23.7 %
-------- --------- --------- ----------
Operating expenses:
Selling, general and administrative 1,238 16.4 % 1,237 24.9 %
Administrative charges from GP Strategies 246 3.2 % - 0.0 %
Depreciation and amortization 69 0.9 % 101 2.0 %
-------- --------- --------- ----------
Total operating expenses 1,553 20.5 % 1,338 26.9 %
-------- --------- --------- -----------
Operating income (loss) 224 3.0 % (157) (3.2)%
Interest expense, net (143) (1.9)% (51) (1.0)%
Other income (expense), net - 0.0 % (5) (0.1)%
-------- --------- --------- -----------
Income (loss) from continuing operations before income taxes 81 1.1 % (213) (4.3)%
Provision for income taxes 17 0.3 % 37 0.7 %
-------- --------- --------- -----------
Income (loss) from continuing operations 64 0.8 % (250) (5.0)%
Loss from discontinued operations - 0.0 % (268) (5.4)%
-------- --------- --------- -----------
Net income (loss) $ 64 0.8 % $(518) (10.4)%
======== ========= ========= ===========
Critical Accounting Policies and Estimates
In preparing the Company's financial statements, management makes several
estimates and assumptions that affect the Company's reported amounts of assets,
liabilities, revenues and expenses. Those accounting estimates that have the
most significant impact on the Company's operating results and place the most
significant demands on management's judgment are discussed below. For all of
these policies, management cautions that future events rarely develop exactly as
forecast, and the best estimates may require adjustment.
Revenue Recognition on Long-Term Contracts. The Company uses the
percentage-of-completion revenue recognition methodology to record revenue under
its long-term fixed-price contracts in accordance with the AICPA Statement of
Position 81-1, Accounting for Performance of Construction-Type and Certain
Production-Type Contracts. This methodology recognizes income as work progresses
on the contract and is based on an estimate of the income earned to date, less
income recognized in earlier periods. The Company bases its estimate of the
degree of completion of the contract by reviewing the relationship of costs
incurred to date to the expected total costs that will be incurred on the
project. The Company's project managers are responsible for estimating the costs
to be incurred at the beginning of each project and are responsible for updating
the estimate as the project progresses. Management reviews the status of each
project periodically with the project managers and determines whether the cost
estimates are reasonable. If changes in the estimated costs to complete the
projects are required, the cumulative impact on the percentage of completion
revenue calculation is recognized in the period identified. Whenever evidence
indicates that the estimated total cost of a contract will exceed its total
contract value, the Company's operating results are charged for the full amount
of the estimated losses immediately. Uncertainties inherent in the performance
of contracts include labor availability and productivity, material costs, change
order scope and pricing, software modification issues and customer acceptance
issues. The reliability of these cost estimates is critical to the Company's
revenue recognition as a significant change in the estimates can cause the
Company's revenue and related margins to change significantly from the amounts
estimated in the early stages of the project.
Capitalization of Computer Software Development Costs. In accordance with
Statement of Financial Accounting Standards (SFAS) No. 86 Accounting for the
Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, the
Company capitalizes computer software development costs incurred after
technological feasibility has been established, but prior to the release of the
software product for sale to customers. Once the product is available to be
sold, the Company begins to amortize the costs over the estimated useful life of
the product, which normally ranges from three to five years. At March 31, 2004,
the Company has net capitalized software development costs of $958,000. On an
annual basis, the Company assesses the recovery of the unamortized software
computer costs by estimating the net undiscounted cash flows expected to be
generated by the sale of the product. If the undiscounted cash flows are not
sufficient to recover the unamortized software costs the Company will write-down
the investment to its estimated fair value based on future discounted cash
flows. The excess of any unamortized computer software costs over the related
net realizable value is written down and charged to income. Significant changes
in the sales projections could result in an impairment with respect to the
capitalized software that is reported on the Company's balance sheet.
Deferred Income Tax Valuation Allowance. Deferred income taxes arise
from temporary differences between the tax bases of assets and liabilities and
their reported amounts in the financial statements. As required by SFAS No. 109
Accounting for Income Taxes, management makes a regular assessment of the
realizability of the Company's deferred tax assets. In making this assessment,
management considers whether it is more likely than not that some or all of the
deferred tax assets will not be realized. The ultimate realization of deferred
tax assets is dependent upon the generation of future taxable income during the
periods in which those temporary differences become deductible. Management
considers the scheduled reversal of deferred tax liabilities and projected
future taxable income of the Company in making this assessment. A valuation
allowance is recorded to reduce the total deferred income tax asset to its
realizable value. At March 31, 2004, the Company's deferred tax assets related
primarily to a U.S. net operating loss carryforward of $15.9 million which
expire in various amounts over the next twenty years. The amount of loss
carryforward which can be used by the Company may be limited to approximately
$500,000 annually. The recovery of the remaining net deferred tax asset could
not be substantiated by currently available objective evidence, and,
accordingly, the Company has established a full valuation allowance for the
balance of its deferred tax asset of $8.6 million at March 31, 2004. If the
Company is able to realize taxable income in the future, the valuation allowance
will be reduced.
Results of Operations - Three Months ended March 31, 2004 versus Three Months
ended March 31, 2003.
Contract Revenue. Total contract revenue for the quarter ended March 31,
2004 totaled $7.6 million, which was 52.0% higher than the $5.0 million total
revenue for the quarter ended March 31, 2003. The increase reflects the
significant order volume logged in 2003. Total orders in 2003 exceeded $35
million, a 26% increase over 2002, and backlog had increased 59% to $30.4
million at December 31, 2003. At March 31, 2004, the Company's backlog was $26.8
million.
Gross Profit. Gross profit totaled $1.8 million (23.5% of revenue) for the
quarter ended March 31, 2004, as compared with $1.2 million (23.7% of revenue)
for the quarter ended March 31, 2004. The slight decrease in gross profit
percentage is mainly attributable to an increase in the amortization of
capitalized software development costs.
Selling, General and Administrative Expenses. Selling, general and
administrative ("SG&A") expenses totaled $1.2 million in the quarter ended March
31, 2004, which was essentially unchanged from the same period in 2003, however
the components of the SG&A varied between the quarters. Business development
costs increased from $410,000 in the first quarter 2003 to $572,000 in the first
quarter 2004. This reflects the Company's renewed focus on business development
in 2004 and the reassignment of four operating personnel into the business
development function on January 1, 2004. The Company's corporate and G&A
expenses decreased from $752,000 to $664,000 reflecting the outsourcing of the
Company's corporate function to GP Strategies on January 1, 2004. Finally, the
Company's net research and product development expenditures ("R&D") have
decreased as discussed below.
Gross R&D totaled $97,000 in the first quarter of 2004, as compared with
$283,000 in the same period of 2003. Capitalized software development costs
totaled $97,000 and $208,000 for the first quarter of 2004 and 2003,
respectively. Accordingly, net R&D expensed and included in SG&A was $0 and
$75,000 for the first quarter of 2004 and 2003, respectively. The Company's R&D
expenditures in the first quarter 2004 were related to:
* The development of new functionality for the Company's Jtools software
modeling tools.
* The modification of the Company's simulation technology to simulate the
operation of Emergency Operations Centers (EOC) run by municipal and state
governments.
* The embedding of the Company's full scope simulator software into classroom
training materials by segmenting its simulation software into "pieces" so
that the software can be utilized to teach specific skills in operating the
nuclear electric utilities without the need for control room panels.
Administrative Charges from GP Strategies. On January 1, 2004, the Company
entered into a Management Services Agreement with GP Strategies Corporation in
which GP Strategies agreed to provide corporate support services to GSE,
including accounting, finance, human resources, legal, network support and tax.
GSE will pay an annual fee of $685,000 ($171,250 per quarter) for these
services. The term of the agreement is one year, subject to earlier termination
only upon the mutual consent of the parties to the agreement. The agreement can
be renewed for successive one-year terms.
In December 2003, GSE's Board of Directors elected John Moran, a GP
Strategies executive with experience in the power industry and simulation
technology, as Chief Executive Officer. Mr. Moran will continue as a GP
Strategies employee, however, Mr. Moran will devote 100% of his time to the
performance of his duties as CEO of GSE. For 2004, GSE will reimburse GP
Strategies $300,000 ($75,000 per quarter) for his compensation and benefits.
Depreciation and Amortization. Depreciation expense totaled $69,000 and
$101,000 during the quarters ended March 31, 2004 and 2003, respectively. The
reduction reflects certain assets becoming fully depreciated.
Operating Income (Loss). The Company had operating income of $224,000 (3.0%
of revenue) in the first quarter 2004, as compared with operating loss of
$157,000 (3.2% of revenue) for the same period in 2003. The increase was due to
the factors outlined above.
Interest Expense, Net. Net interest expense increased from $51,000 in the
quarter ended March 31, 2003 to $143,000 for the same quarter in 2004. In March
2003, GP Strategies extended their $1.8 million limited guarantee of the
Company's bank facility for a one-year period. In consideration for the
extension of the guarantee, the Company issued 150,000 shares of its common
stock to GP Strategies. The number of shares was calculated based upon a 10% fee
divided by the closing price of GSE's common shares on March 21, 2003. The cost
of the guarantee was amortized over the one year period; GSE recognized $45,000
of interest expense in the first quarter 2004 which completed the amortization
of these costs.
The fees paid to the Company's financial institution as consideration for
the extension of the Company's credit facility for a one-year period beginning
March 23, 2003 were amortized over the one year extension. In the first quarter
2004, the Company recognized $94,000 of interest expense which completed the
amortization of these costs.
Other Income (Expense), Net. For the three months ended March 31, 2003,
other income (expense) mainly reflects the Company's proportionate share of the
income of the Company's investment in RedStorm Scientific, Inc.
Provision for Income Taxes. The Company's effective tax rate was 21.0% and
7.7% for the three months ended March 31, 2004 and March 31, 2003, respectively.
The increase in the effective tax rate is attributable primarily to taxes on
income earned by the Company's Swedish subsidiary. For 2004, the Company's
combined U.S. Federal and State effective tax rate is projected to be 5% and the
Swedish effective tax rate is projected to be 28%.
Liquidity and Capital Resources
As of March 31, 2004, the Company's cash and cash equivalents totaled $1.1
million compared to $1.4 million at December 31, 2003.
Cash provided by (used in) operating activities. Net cash used in operating
activities was $158,000 for the three months ended March 31, 2004. The only
significant change in the Company's assets and liabilities during these three
months was the decrease of billings in excess of revenues earned by $980,000. In
2003, the Company had entered into a $6.0 million contract with a Mexican
customer for a full scope simulator that allowed the Company to invoice the
customer for 20% of the contract upon the receipt of the purchase order as an
advance payment. The reduction in billings in excess of revenues earned mainly
reflects the completion of work which has reduced the Company's liability to the
customer for the advance payment.
Net cash provided by operating activities was $805,000 for the quarter
ended March 31, 2003; $486,000 was used by continuing operations and $1.3
million was provided by discontinued operations. The only significant change in
the Company's assets and liabilities in the first quarter 2003 was an increase
in contract receivables of $597,000. The Company's unbilled receivables
increased during the quarter due to the timing of contract-specified milestone
billings.
Cash used in investing activities. Net cash used in investing activities
was $152,000 for the three months ended March 31, 2004, consisting of $97,000 of
capitalized software development costs, $16,000 of capital expenditures and the
reduction of a reserve against a cash-collateralized letter of credit of
$39,000. The letter of credit expired on March 31, 2004 and the Company received
the full cash collateral in April.
Net cash used in investing activities was $442,000 in the first quarter
2003; $237,000 was used by continuing operations and $205,000 was used by
discontinued operations. The $237,000 used by continuing operations included
$209,000 of capitalized software development costs, $13,000 for capital
expenditures, and the issuance of a $15,000 bid bond that was cash
collateralized. Bid bonds are issued by the Company in the ordinary course of
business through banks as required by certain contracts and proposal
requirements.
Cash used in financing activities. In the three months ended March 31,
2004, the Company used $8,000 in financing activitiesrelated to the pay down of
a note payable.
During the quarter ended March 31, 2003, the Company used $1.8 million net
cash in financing activities. The Company decreased its borrowings under its
bank line of credit by $1.8 million to a total of $3.7 million. Additionally,
the Company paid down a note payable by $7,000.
Credit Facilities
General Physics Corporation is a wholly owned subsidiary of GP Strategies.
On March 30, 2004, the Company was added as an additional borrower under the
Financing and Security Agreement between General Physics Corporation and a
financial institution. Under the terms of the agreement, $1.5 million of General
Physics' available credit facility has been carved out for use by GSE. The line
is collateralized by substantially all of the Company's assets and provides for
borrowings up to 80% of eligible accounts receivable and 80% of eligible
unbilled receivables. The interest rate on this line of credit is based upon the
LIBOR Market Index Rate plus 3% (4.09% as of March 31, 2004), with interest only
payments due monthly. At March 31, 2004, the Company's available borrowing base
was $1.5 million, none of which had been utilized. The credit facility expires
on August 23, 2005.
The credit facility requires the Company to comply with certain financial
ratios. At March 31, 2004, the Company was in compliance with its financial
ratio covenants.
Item 3. Quantitative and Qualitative Disclosure about Market Risk
The Company's market risk is principally confined to changes in foreign
currency exchange rates and potentially adverse effects of differing tax
structures. The Company's exposure to foreign exchange rate fluctuations arises
in part from inter-company accounts in which costs incurred in one entity are
charged to other entities in different foreign jurisdictions. The Company is
also exposed to foreign exchange rate fluctuations as the financial results of
all foreign subsidiaries are translated into U.S. dollars in consolidation. As
exchange rates vary, those results when translated may vary from expectations
and adversely impact overall expected profitability.
The Company is also subject to market risk related to the interest rate on
its existing line of credit. As of March 31, 2004, such interest rate is based
on the Libor Market Index Rate plus 300 basis-points.
As of March 31, 2004, the Company did not have any outstanding debt that
was subject to variable interest rates.
Item 4. Controls and Procedures
Within the 90-day period prior to the filing of this report, GSE
management, including the Chief Executive Officer and Chief Financial Officer,
conducted an evaluation of the effectiveness of the design and operation of the
Company's disclosure controls and procedures as defined in Exchange Act Rule
13a-14(c). Based on that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that the Company's disclosure controls and
procedures were effective as of the date of that evaluation. There have been no
significant changes in internal controls, or in factors that could significantly
affect internal controls, subsequent to the date the Chief Executive Officer and
Chief Financial Officer completed their evaluation.
GSE SYSTEMS, INC. AND SUBSIDIARIES
FORM 10-Q
For the Quarters ended March 31, 2004 and 2003
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
In accordance with its conduct in the ordinary course of business,
certain actions and proceedings are pending to which the Company is a party. In
the opinion of management, the aggregate liabilities, if any, arising from such
actions are not expected to have a material adverse effect on the financial
condition of the Company.
Item 2. Changes in Securities and Use of Proceeds
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
31.1 Certification of the Chief Executive Officer pursuant to Section
302 of the Sarbanes- Oxley Act of 2002.
31.2 Certification of the Chief Financial Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of the Chief Executive Officer and Chief Financial
Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K
None
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.
Date: May 17, 2004 GSE SYSTEMS, INC.
/S/ JOHN V. MORAN
John V. Moran
Chief Executive Officer
(Principal Executive Officer)
/S/ JEFFERY G. HOUGH
Jeffery G. Hough
Senior Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)