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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934 For the fiscal year ended June 30, 1998
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File Number 000-21240
---------
NEOWARE SYSTEMS, INC.
(Exact name of registrant as specified in its charter.)
Delaware 23-2705700
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
400 Feheley Drive, King of Prussia, Pennsylvania 19406
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (610) 277-8300
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
None None
- ------------------- -----------------------------------------
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.001 per share; and Redeemable Common Stock Purchase
Warrants each to purchase one share of Common Stock for $5.50 per share
- --------------------------------------------------------------------------------
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days. YES __X__ NO _____
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulations S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. ___
The aggregate market value of the voting stock held by non-affiliates of the
registrant is approximately $9,066,276. Such aggregate market value was computed
by reference to the last reported sale price of the Common Stock as reported on
the NASDAQ National Market on September 21, 1998. In making such calculation,
the registrant does not determine whether any director, officer or other holder
of Common Stock is an affiliate for any other purpose.
The number of shares of the registrant's Common Stock outstanding as of
September 21, 1998 was 6,264,158.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive Proxy Statement for the Annual
Meeting of Shareholders to be held on December 10, 1998 are incorporated by
reference into Part III. Those portions of the Proxy Statement included in
response to Item 402(k) and 402(1) of Regulation S-K are not incorporated by
reference into Part III.
TABLE OF CONTENTS PAGE
----------------- ----
PART I ..................................................................... 1
ITEM 1. BUSINESS......................................................... 1
ITEM 2. PROPERTIES....................................................... 8
ITEM 3. LEGAL PROCEEDINGS................................................ 8
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.............. 9
PART II .................................................................... 9
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
SHAREHOLDER MATTERS ............................................. 9
ITEM 6. SELECTED FINANCIAL DATA ......................................... 10
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS ............................. 11
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ..................... 17
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE ............................. 17
PART III ................................................................... 17
PART 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT .............. 17
PART 11. EXECUTIVE COMPENSATION .......................................... 18
PART 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT ...................................................... 18
PART 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS .................. 19
PART IV .................................................................... 19
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS
ON FORM 8-K ..................................................... 19
PART I
ITEM 1. BUSINESS.
General
Neoware Systems, Inc. (the "Company") designs, manufactures and markets
a family of Windows-based terminals and thin client computers that are designed
to allow users to access Windows-based applications from a multi-user Windows(R)
NT server, plus connect to mainframes, minicomputers and the Internet. The
Company's NeoStationTM family of Windows-based terminals and related software
allows users to utilize all of their existing computer systems and applications
running on Windows platforms, UNIX, mainframes and minicomputers, and access
them across a network. Unlike Java network computers, an alternative type of
thin client, Neoware's products do not require customers to rewrite their
applications in the Java language or to use Java emulators to access their
existing systems. Unlike personal computers, the Company's products are designed
primarily to run applications on a server, not on the desktop. This offers a
number of significant advantages compared to an architecture based upon personal
computers. Windows-based terminals and thin clients such as the Company's
NeoStation line of products are designed to be easier to install, maintain and
administer than traditional personal computers. Such lower administration costs
are designed to lower the total cost of ownership of systems utilizing the
Company's products when compared to personal computers.
Prior to focusing on the Windows-based terminal market, the Company
produced a line of network computers which offered similar capabilities. The
Company's network computer product line was introduced in June 1996. Prior to
the introduction of its line of network computers, the Company manufactured and
marketed a family of X Window terminals which were targeted primarily at the
UNIX market. The X terminal product line was designed around industry standards
and allowed users to access multiple forms of information simultaneously, using
the industry standard X protocol and industry standard networking interfaces.
On March 2, 1995, Human Designed Systems, Inc. ("HDS") was merged into
a wholly-owned subsidiary of the Company (the "Merger"). Pursuant to the Merger,
all of the outstanding shares of HDS were converted into the right to receive a
total of 2,810,000 shares of the Company's Common Stock, 618,200 redeemable
common stock purchase warrants and $5,500,000 in cash, in accordance with the
exchange ratios set forth in the Merger Agreement. Upon completion of the
Merger, the former shareholders of HDS owned approximately 50.1% of the
outstanding Common Stock of the Company. At the time of the Merger, the Company
changed its name to HDS Network Systems, Inc. In April 1996, HDS was merged into
the Company.
In September 1996, the Company entered into an agreement with Hitachi
Data Systems Corporation whereby the Company, among other things, agreed to sell
to Hitachi all of the Company's rights in the mark "HDS" and to cancel certain
petitions filed by the Company in the United States Patent and Trademark Office
to cancel Hitachi's trademark registrations relating to the mark "HDS." At a
Special Meeting of Stockholders held on July 30, 1997, the Company's
stockholders approved the Company's name change to Neoware Systems, Inc.
1
In August 1996, the Company formed a new subsidiary, Information
Technology Consulting, Inc. ("ITC") for the purpose of acquiring companies in
the computer services field, including information technology staffing companies
and client-server consulting companies. During fiscal 1997, ITC entered into
definitive agreements to acquire Global Consulting Group and The Reohr Group,
Inc., subject to consummation by ITC of a public offering of its stock. In
October 1997, ITC merged with The Reohr Group, Inc. and Global Consulting Group.
The Company, as the sole stockholder of ITC, received stock of the surviving
entity representing approximately 2% ownership of the entity after the merger.
The Company was also reimbursed for the expenses incurred by the Company and ITC
in connection with ITC's efforts to complete these transactions.
In February 1997, the Company formed a new subsidiary, Bridging Data
Technology, Inc. ("BDT"). BDT acquired and further developed a software product,
SmartBridge(TM), which utilizes the "intelligent bridging" approach to upgrading
programs and data for Year 2000 compliance.
The Company entered into an agreement effective January 1, 1998 which
reduced the Company's ownership position in Bridging Data Technology, Inc. and
eliminated the Company's requirement to fund future operations. In addition,
effective March 31, 1998, the Company wrote off the full amount of its
investment in BDT. The write-off reflects the Company's evaluation that
recovery, if any, of its investment in BDT will not occur in the near future.
Future cash distributions, if any, from BDT will be recorded as income in the
period during which the transaction occurs. Expenses related to BDT, including
the investment write-off, have been reclassified as expenses of BDT venture in
the Consolidated Financial Statements included under Item 8. herein.
In June 1998, the Company entered into a joint marketing and
development agreement and an equity purchase agreement with Motorola, Inc.,
under which Motorola purchased approximately 6% of the Company's outstanding
Common Stock. Under the joint marketing and development agreement, the two
companies agreed to collaborate on technology for the Windows-based terminal
market, and to jointly promote this technology to OEM customers. Although the
Company believes that its agreements with Motorola allow it to compete more
effectively in the market for customers who wish to create Windows-based
terminals under their own brand names, there can be no assurance that the
Company will generate significant revenue from this agreement.
Product Strategy
The Company's objective is to establish and maintain a leadership
position in the emerging market for Windows-based terminals and thin clients.
The Company has invested significant resources in sales and marketing and
research and development in the current and prior years to bring its new product
families to market. The Company's Windows-based terminal and thin client
products incorporate the following elements:
o A choice of operating environments. The Company's products are
designed to run both its netOS operating environment and Microsoft's
Windows(R)CE. The Company has announced its intention to license the
Windows CE operating system from Microsoft, although it has not yet
finalized an agreement with Microsoft to permit this. Until such a
license agreement is signed there can be no assurance that the Company
will be successful in entering into an agreement with Microsoft to
permit the Company to offer Windows CE
2
with its products. During the current and prior years, the Company
developed and enhanced netOS , a set of cross-platform software tools
for Windows-based terminals and thin clients based on industry
standard protocols and technologies. The Company's netOS allows users
to utilize a wide variety of operating systems and access applications
and information on multiple platforms, including Windows(R)95,
Windows(R)NT, Windows 3.1, UNIX(TM), mainframe and midrange computers,
the Internet and Java(TM). The Company intends to offer both
environments on its hardware products in order to give its customers a
high level of flexibility.
o Cost-effective, High-Performance Windows-based terminal and thin
client products. The Company's primary products, the NeoStation 200
family, are based upon a highly integrated line of microprocessors
from Motorola. The Company believes that this line of microprocessors
offers it a very cost effective hardware platform, especially compared
to personal computers. The primary microprocessor used in the
Company's products, the Motorola MPC 8XX, includes a number of
important components built into the processor that required additional
components on the Company's older products. This integration reduces
the cost of the Company's products and makes them easier to produce.
The NeoStation family is offered in a very small enclosure that is
approximately the size of a hardcover book. As a result, it takes up
significantly less space than a personal computer, although it offers
similar capabilities when connected to a server. The Company's
products are designed to operate in network environments, and include
an Ethernet connection, serial ports, and connections for printers and
monitors. The Company also produces older products utilizing
microprocessors from other companies.
o Focus on central administration and lower total cost of ownership. The
Company's products are designed to be centrally administered in order
to lower total cost of ownership. Customers who utilize the Company's
products typically run applications and store files on a server, not
on the desktop as with a personal computer. This makes administration
of networks of the Company's products much simpler than administration
of personal computer networks, since administration takes place at a
small number of servers. Additionally, the Company includes certain
software capabilities in its products that make them easier to update
and administer centrally.
o Diverse Technology Expertise. The Company has significant expertise in
a wide range of technical disciplines, including operating systems,
windowing and networking software, applications software development,
graphics acceleration, multimedia design and compression algorithms.
o Low-Cost Design and Manufacturing. The Company plans, implements and
manages the manufacturing of its products to take advantage of
industry-standard components that are widely available in the personal
computer industry. This reduces the Company's risks and costs, and
allows the Company more easily to increase production of products
quickly to meet customer demand. The Company can add to its
manufacturing capabilities by outsourcing some or all of its
production to contract manufacturing companies.
o Modularity and Use of Standard Peripherals. The Company's line of thin
clients and Windows-based terminals are designed to be compatible with
a wide range of standard off-the-shelf peripherals, including
keyboards and monitors, PC card flash and network cards.
3
Customers
The Company's customers span a wide range of industries, including
aerospace, automotive, education, financial services, government, healthcare,
manufacturing and telecommunications. The Company's products have been adopted
by such customers as 1-800-Flowers, IBM, Intel Corporation, Arrow Electronics,
and Hollywood Video.
Net revenues from International Business Machines Corporation ("IBM")
represented 15%, 15% and 27% of total net revenues for fiscal 1998, 1997 and
1996, respectively. Net revenues from Intel Corporation represented 14%, 25% and
16% of total net revenues for fiscal 1998, 1997 and 1996, respectively. Sales to
IBM and Intel declined significantly during the last six months of fiscal 1998,
as a result of completing delivery of product under existing purchase orders.
Revenues to these two customers are expected to remain at this reduced level for
the foreseeable future.
Product Development
The Company believes that its ability to expand the market for its
Windows-based terminal products will depend in large part upon its ability to
develop enhancements to the Windows CE environment, enhance its netOS software,
and continue to develop new products which incorporate the latest improvements
in performance, capability and manageability. Accordingly, the Company is
committed to investing significant resources in software and hardware
development activities. During fiscal 1998, 1997 and 1996 the Company's
expenditures for research and development totaled $1,443,720; $1,071,991 and
$585,770, respectively.
The Company's current research and development programs include:
o Development of enhancements to the Windows CE environment that
make it more manageable in enterprise environments and allow
users to connect to a variety of enterprise systems.
o Development of enhanced connectivity to Windows application
servers.
o Development of lower cost and higher performance versions of its
hardware products.
There can be no assurance that any of these development efforts will
result in the introduction of new products or that any such products will be
commercially successful.
Marketing and Sales
The principal objectives of the Company's marketing strategy are to
increase awareness of the benefits of the Company's Windows-based terminal
products, maintain the Company's position as a recognized innovator in the
Windows-based terminal industry and differentiate the Company's products from
other thin clients and personal computers. The Company's marketing activities
include participation in trade shows and conferences, advertising and press
relations with leading trade publications and the publication of technical
articles.
4
The Company's products have won numerous awards in the thin client and
Windows-based terminal market, including "Best Windows-based Terminal" from
Network Computing, "Editor's Choice" from PC Magazine, "Byte Best" from Byte
Magazine, "Editors' Choice" from Network Computing Magazine, "Top of the World"
from SCO World, "Crossroads A-List" from Open Systems Advisors, "Best Buy" from
PC Dealer, "Gold Award for Excellence" from Computing Magazine, "Five Stars for
Features and Overall Performance" from PC Pro, "Best Buy" from PC Week UK,
"5-Star PC Digest Recommends" from PC Digest and "Best Buy" from Network
Solutions.
The Company distributes its products in North America through direct
sales to end user customers, through resellers and through systems integration
partners. The timing of sales to the Company's customers and the continued
evolution of the market for Windows-based terminals will impact the Company's
future operating results.
The Company utilizes distributors for its products throughout the
world, including relationships with distributors in the United Kingdom, France,
Scandinavia, Germany, Switzerland, Italy, Spain, Russia, Israel, Australia, and
India. Foreign revenues, which accounted for approximately 20%, 22%, and 3% of
net revenues, respectively, in fiscal 1998, 1997, and 1996, may be subject to
government controls and other risks, including export licenses, federal
restrictions on the export of technology, changes in demand resulting from
currency exchange fluctuations, political instability, trade restrictions and
changes in tariffs. To date, the Company has experienced no material
difficulties due to these factors.
Service and Support
The Company believes that its ability to provide service and support is
an important element in the marketing of its products. The Company maintains
in-house repair facilities and also provides telephone and electronic mail
access to its technical support staff. The Company's technical support
specialists not only provide assistance in diagnosing problems but work closely
with customers to address system integration issues and to assist in increasing
the efficiency and productivity of their systems. The Company provides system
level hardware support through its factory-based technical maintenance
organization and primarily through contracted field system engineers.
The Company typically warrants its products against defects in
materials and workmanship for one year after purchase by the end user, and
offers an extended warranty of up to an additional two years. To date, the
Company has not encountered any material product maintenance problems.
Competition
The desktop computer market is characterized by rapidly changing
technology and evolving industry standards. The Company experiences significant
competition from suppliers of workstations and personal computers, as well as
providers and prospective providers of Windows-based terminals, thin clients and
network computers.
Competitive thin client products are offered by a number of established
computer manufacturers, including IBM, Sun Microsystems, Inc. ("Sun"), Wyse
Technology, Network Computing Devices, and Boundless Technologies. Each of these
companies has substantially greater name recognition, engineering, manufacturing
and marketing capabilities and greater financial resources than those of the
Company. The Company believes that the principal competitive factors among thin
client suppliers include breadth of
5
product line, product price/performance, capabilities of the products, software
features, network expertise, service and support, and market presence. The
Company believes that it competes favorably with respect to all of these factors
except market presence. Workstation and personal computer manufacturers who also
offer thin client products may have advantages over independent thin client
vendors, including the Company, based on their ability to "bundle" their thin
clients, workstations and personal computers in certain large system sales. The
Company anticipates increased competition from these system suppliers as the
thin client market evolves and also expects that other established domestic and
foreign computer equipment manufacturers may enter the thin client market.
The Company, as well as other manufacturers of thin clients, also faces
competition from established computer manufacturers whose personal computer
products offer alternatives to thin clients for most applications. Thin clients
compete with personal computers offered by such manufacturers as Dell, IBM,
Gateway, Compaq and Hewlett Packard. Personal computers can be configured with
software, such as an ICA client from Citrix Systems, or an RDP client from
Microsoft, that allows them to operate as Windows-based terminals. As the cost
of personal computers declines, the difference in cost between thin clients and
personal computers may continue to decline. Thin clients compete favorably on a
price/performance basis with personal computer networks and offer cost
advantages in initial system installation, as well as subsequent system
upgrading and administration. However, the significant market presence and
reputation of personal computer manufacturers, and customer perceptions
regarding their need for desktop application processing capability, constitute
obstacles to the penetration of this market segment by thin client
manufacturers. Increased competition could result in price reductions, reduced
profit margins and loss of market share, which would adversely affect the
Company's operating results. There can be no assurance that the Company will be
able to continue to compete successfully against current and future competitors
as the thin client market evolves and competition increases.
At the low end of the commercial segment of the desktop computer
market, the Company competes with suppliers of lower cost ASCII and 3270
terminals. These products do not offer the graphics and windowing capabilities
offered by the Company's network computers, but are still appealing to certain
price sensitive customers. The Company believes that thin clients will become
increasingly competitive with ASCII and 3270 terminal systems.
Manufacturing and Suppliers
The Company's production activities are conducted at its King of
Prussia, Pennsylvania facility. These operations consist primarily of final
assembly, configuration, testing and quality control of material components,
sub-assemblies and systems. The Company utilizes an automated manufacturing
control system which integrates purchasing, inventory control and cost
accounting. The Company tests each thin client in a network environment prior to
shipment. In addition, the Company maintains an approved vendor list and control
of engineering changes of parts and components. Incoming material is inspected
for conformance with the Company's specifications. The Company conducts regular
on-site inspection at its vendors' facilities to maintain quality control.
The components and sub-assemblies used in the Company's products are
either standard, commercially available components or are manufactured to the
Company's specifications by independent suppliers, including foreign suppliers
who are subject to risks associated with foreign operations such as the
imposition of unfavorable governmental controls or other trade restrictions,
changes in tariffs and political instability.
6
Although most of the video monitors used in the Company's products are
available from more than one supplier, monitors used in some of its products are
currently available from a single source. The Company has, from time to time,
experienced delays in the receipt of monitors from certain of these suppliers.
In addition, the Company is required to place orders for some monitors several
months in advance of its anticipated requirements, and its ability to react to
short-term increases or decreases in customer demands of these models is,
therefore, limited. A number of other components and parts used in the Company's
products, including microprocessors, also are currently available only from
single sources. Prolonged or repeated delays in the receipt of these components
could have a material adverse effect on the Company's operations.
The Company has no long-term purchase agreements or other guaranteed
supply arrangements with suppliers of these single or limited source components
and purchases such components, as well as its other parts and components,
pursuant to its standard form of purchase order. The Company has generally been
able to obtain adequate supplies of parts and components in a timely manner from
existing sources under purchase orders and endeavors to maintain inventory
levels adequate to guard against interruptions in supplies. The Company's
inability to develop alternative supply sources in the future, or to obtain
sufficient components from existing suppliers as required, could adversely
affect the Company's operating results.
The Company's products also incorporate memory components, such as
DRAMs and VRAMs, that are available from multiple sources but have been subject
to substantial fluctuations in availability and price. To date, these
fluctuations have not had a material effect on the Company's operating results
and the Company has been able to obtain an adequate supply of such components.
There can be no assurance, however, that the Company will be able to obtain
adequate supplies of these components in the future or that price fluctuations
will not adversely affect the Company's operating results.
Proprietary Rights and Licenses
The Company believes that its success will depend primarily on the
innovative skills, technical competence and marketing abilities of its personnel
rather than upon the ownership of patents or other intellectual property
protection methods. In addition, there can be no assurance that any patents
issued to the Company will not be challenged, invalidated or circumvented, or
that any rights granted thereunder will provide adequate protection to the
Company.
Certain technology used in the Company's products is licensed from
third parties on a royalty-bearing basis. Generally, such licenses grant to the
Company non-exclusive, worldwide rights with respect to the subject technology
and terminate upon a material breach by the Company. The Company has licensed
technology from Citrix Systems, Inc., Spyglass, Inc. and Network Computer, Inc.
(formerly Navio Communications, Inc.). In addition to these licensing
agreements, the Company holds a license agreement with the Open Software
Foundation (OSF), and various other licenses which it does not consider to be
material.
Although the Company has not received any claims that its products
infringe on the proprietary rights of third parties, there can be no assurance
that third parties will not assert infringement claims against the Company in
the future with respect to current or future products or that any such assertion
may not require the Company to enter into royalty arrangements or result in
costly litigation.
7
Employees
As of June 30, 1998, the Company had 71 employees and initiated a
workforce reduction. As of August 31, 1998, the Company had 57 full time
employees and one part-time employee.
ITEM 2. PROPERTIES.
The Company's principal administrative, marketing, manufacturing and
research and development operations are located in King of Prussia,
Pennsylvania. The facility consists of approximately 22,000 square feet under a
lease which expires in 2001. The annual gross rent for the facility currently
approximates $92,100. The Company believes that its facilities are adequate for
its present requirements, and that suitable additional space will be available
as needed.
ITEM 3. LEGAL PROCEEDINGS.
On March 11, 1998, a complaint entitled Cerrato, Inc. v. Neoware
Systems, Inc., 98 Civ. 1748 (JSM), was filed in the United States District Court
for the Southern District of New York, naming as defendants the Company, its
Chairman, and its former CFO. The Complaint asserts claims under ss. 10(b) of
the Securities and Exchange Act of 1934 (the "Exchange Act"), Rule 10b-5
promulgated thereunder, and common law. The complaint, which was filed as a
purported class action on behalf of purchasers of the Company's common stock
during the period from June 15, 1996 through August 15, 1997, alleges, among
other things, that the defendants made misrepresentations related to plans for
various potential acquisitions by a subsidiary of the company and a spin-off. A
First Amended Complaint ("FAC") was filed on or about May 1, 1998. The FAC adds
claims on behalf of a second purported class -- purchasers of the Company's
stock from November 13, 1997 through May 1, 1998 -- related to the Company's
announcement, on April 30, 1998, that it would be restating certain financial
results previously reported for the first two quarters of fiscal year 1998.
Defendants' time to respond to the FAC has not yet expired nor has lead
plaintiff been appointed by the court.
Thereafter four separate purported securities class actions: Galitzer
v. Neoware Systems, Inc., 98CV2582 (BWK), Pollison v. Neoware Systems, Inc.,
98CV2879 (BWK), Tuchman v. Neoware Systems, Inc., 98CV2868 (BWK), and Grubin v.
Neoware Systems, Inc., 98CV3651 (BWK), were filed in the United States District
Court for the Eastern District of Pennsylvania (the "Pennsylvania actions"). The
Pennsylvania actions name some of the same individual defendants as the FAC, as
well as certain additional directors and officers, and alleges violations of
ss.ss. 10(b) and 20(a) of the Exchange Act and Rule 10b-5 based on factual
allegations similar to those added to the New York action in the FAC on behalf
of a purported class of purchasers of the Company's securities between October
30, 1997 and April 30, 1998. The Pennsylvania actions have been consolidated
under the heading In re Neoware Systems, Inc. Securities Litigations, Master
File No. 98-CV-2582 and lead co-plaintiffs have been appointed. Defendants' time
to respond to the Pennsylvania actions has not yet expired.
The Company disputes the validity of these claims and intends to defend
the cases vigorously.
On May 5, 1998, a complaint was filed in the Court of Common Pleas of
Montgomery County against the Company by Development Concepts, Inc. The
complaint asserts claims for common law
8
breach of contract, fraud, misrepresentation, breach of warranty and violations
of the federal Lanham Act arising primarily from the parties' contractual
relationships. The complaint seeks an indeterminate amount of monetary damages
in excess of $1,500,000. The Company disputes the validity of these claims and
intends to defend the claims vigorously.
Management does not anticipate that resolution of the pending
litigation, either separately or in the aggregate, will have a material effect
on the Company's financial position or results of operations. This is a
forward-looking assessment, which may change as the cases develop. While
management may reassess this from time to time, it does not undertake to do so
on any regular basis.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of security holders of the Company
during the fourth quarter of fiscal 1998.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS.
The Common Stock and the Warrants are traded on the NASDAQ National
Market. Prior to August 1, 1997, the Common Stock and the Warrants traded under
the symbols HDSX and HDSXW, respectively. On August 1, 1997, the Company's
Common Stock and the Warrants began trading under the symbols NWRE and NWREW,
respectively. The following table sets forth the high and low closing bid
quotations for the periods indicated.
Common Stock Warrants
------------ --------
1998 High Low High Low
- ---- ---- --- ---- ---
First Quarter................... 6 13/16 4 1/16 2 5/16 1 9/32
Second Quarter.................. 5 1/16 2 1/8 1 3/4 1/2
Third Quarter................... 3 2 1/4 3/4 5/16
Fourth Quarter.................. 5 1/16 1 3/4 1 3/16 3/8
Common Stock Warrants
------------ --------
1997 High Low High Low
- ---- ---- --- ---- ---
First Quarter................... 9 6 3/8 3 5/8 2 1/4
Second Quarter.................. 8 7/8 6 7/8 3 1/2 2 11/32
Third Quarter................... 9 1/2 5 1/2 3 7/8 1 3/4
Fourth Quarter.................. 7 7/8 4 5/16 2 15/16 1 3/8
9
The above quotations represent prices between dealers and do not
include retail markups or markdowns or commissions. They may not necessarily
represent actual transactions.
There were approximately 49 holders of record of Common Stock as of
September 18, 1998. The Company has never declared or paid any cash dividends on
its capital stock and does not intend to pay any cash dividends in the
foreseeable future.
On June 30, 1998, the Company sold 396,226 shares of the Company's
Common Stock to Motorola for an aggregate purchase price of $1,000,000. The
shares were issued in reliance upon the exemption from the registration
requirements of the Securities Act of 1933 (the "Securities Act") under Section
4(2) thereof. The shares were acquired for investment and not with a view to the
distribution thereof by an institutional investor which has access to
information respecting the Company and its business.
During April 1998, the Company issued 100,000 shares of the Company's
Common Stock in exchange for Unit Purchase Options to acquire 540,495 Units at
an exercise price of $2.44 per Unit, each Unit consisting of one share of the
Company's Common Stock and two common stock purchase warrants. The Unit Purchase
Options had been issued in connection with the Company's initial public offering
in March 1993. The shares were issued in reliance upon the exemption from the
registration requirements of the Securities Act under Section 3(a)(9) thereof.
In January 1998, in connection with consulting services to be provided
to the Company by a financial consultant, the Company granted to the consultant
warrants to purchase 300,000 shares of the Company's Common Stock at exercise
prices ranging from $3.00 to $7.00 per share until January 2001, subject to
certain conditions and to adjustment under certain conditions. The warrants were
issued in reliance upon the exception from the registration requirements of the
Securities Act under Section 4(2) thereof. The warrants were acquired for
investment and not with a view to the distribution thereof by an accredited
investor which had access to information respecting the Company and its
business.
ITEM 6. SELECTED FINANCIAL DATA.
The following table sets forth selected financial data with respect to
the Company for the periods indicated. The data below has been derived from the
Company's consolidated financial statements which have been audited by Arthur
Andersen LLP, independent public accountants. The data set forth below should be
read in conjunction with the Consolidated Financial Statements of the Company
together with the related notes thereto included elsewhere herein and Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations. Upon the consummation of the Merger, the Company changed its fiscal
year for accounting and reporting purposes to June 30.
10
Year Ended June 30,
---------------------------------------------------------------------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
STATEMENT OF OPERATIONS DATA:
Net revenues $ 19,976,423 $ 25,467,487 $ 20,819,444 $ 21,841,229 $ 19,495,642
--------------- --------------- --------------- --------------- ---------------
Gross profit 3,637,368 8,393,642 5,115,850 4,990,123 3,596,141
Operating expenses 9,389,393 7,942,846 4,390,344 2,680,209 2,742,126
--------------- --------------- --------------- --------------- ---------------
Operating (loss) income (5,752,025) 450,796 725,506 2,309,914 854,015
Interest (expense) income, net (338,354) 69,224 220,277 (23,239) (161,012)
---------------- --------------- --------------- ---------------- ----------------
Income (loss) before income taxes
and cumulative effect of change
in accounting for income taxes (6,090,379) 520,020 945,783 2,286,675 693,003
Income taxes (1,121,554) 182,791 322,898 843,405 319,561
Cumulative effect of change in
accounting for income taxes (1) -- -- -- -- 81,023
--------------- ---------------- -------------------------------- ---------------
Net (loss) income $ (4,968,825) $ 337,229 $ 622,885 $ 1,443,270 $ 454,465
=============== ================ =============== =============== ===============
Basic earnings per share $ (0.86) $ 0.06 $ 0.11 $ 0.42 $ 0.19
Diluted earnings per share $ (0.86) $ 0.05 $ 0.10 $ 0.39 $ 0.16
Weighted average number of shares
used in basic earnings per share
computation (2) 5,784,366 5,712,309 5,612,386 3,456,990 2,399,844
Weighted average number of shares used
in diluted earnings per share
computation (2) 5,784,366 7,132,898 6,069,012 3,747,633 2,809,983
BALANCE SHEET DATA:
Current assets $ 10,861,643 $ 16,002,051 $ 11,165,185 $ 12,373,592 $ 6,474,654
Current liabilities 6,180,319 7,555,703 2,449,010 4,554,720 4,971,611
Working capital 4,681,324 8,446,348 8,716,175 7,818,872 1,503,043
Total assets 13,021,393 18,327,115 12,023,903 13,161,155 6,920,222
Long-term debt excluding current
portion -- -- 3,733 9,293 388,119
Stockholders' equity 6,841,074 10,771,412 9,481,890 8,494,565 1,503,190
- ------------------
(1) Effective July 1, 1993, the Company adopted Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes," and
reported the cumulative effect of the change in accounting in fiscal
1994. Prior to fiscal 1994, the Company accounted for income taxes in
accordance with Accounting Principles Board Opinion No. 11.
(2) Weighted average number of shares in fiscal 1994 reflects the number
of equivalent shares of Common Stock received by the shareholders of
HDS in connection with the Merger with the Company on March 2, 1995.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
Introduction
The Company designs, manufactures and markets a family of Windows-based
terminals and thin client
11
computers that allow users to access Windows-based applications from a
multi-user Windows NT server, plus connect to mainframes, minicomputers and the
Internet. The Company's NeoStation family of Windows-based terminals and related
software allows users to utilize substantially all of their existing computer
systems and applications running on Windows platforms, UNIX, mainframes and
minicomputers, and access them across a network.
Prior to focusing on the Windows-based terminal market, the Company
produced a line of network computers which offered similar capabilities but
without the same level of focus on Windows-based environments. The Company's
network computer product line was introduced in June 1996. Prior to the
introduction of its line of network computers, the Company manufactured and
marketed a family of desktop computing devices, including multimedia-capable X
Window terminals.
The Company's current strategy is to become a leader in the emerging
market for Windows-based terminals and thin clients. The Company sells its
products in North America directly to end users and through resellers, system
integrators and OEMs. International sales are generally made through
distributors.
Results of Operations
The following table sets forth, for the periods indicated, certain
items from the Company's consolidated statements of operations as a percentage
of net revenues.
Year Ended June 30,
-----------------------------------------------------
1998 1997 1996
------- ------- -------
Gross profit 18.2% 33.0% 24.6%
Operating expenses:
Sales and Marketing 22.4 17.0 11.3
Research and Development 7.2 4.2 2.8
General and administrative 13.3 8.6 7.0
Restructuring charge 1.0 -- --
Bridging Data Technology venture 3.1 1.4 --
------- ------- -------
Operating (loss) income (28.8) 1.8 3.5
Interest (expense) income (1.7) 0.2 1.0
(Loss) income before taxes (30.5) 2.0 4.5
Income tax (benefit) expense (5.6) 0.7 1.5
------- ------- -------
Net (loss) income (24.9)% 1.3% 3.0%
======= ======= =======
Year Ended June 30, 1998 Compared to Year Ended June 30, 1997
For the year ended June 30, 1998, net revenues decreased by 21.6% to
$19,976,423 from $25,467,487 for the prior fiscal year. The Company's net
revenues for the current year primarily represent a transition from its line of
network computers and X Window terminals to its new NeoStation family of
Windows-based terminals which were introduced in December 1997. Net revenues for
the year ended June 30, 1997 represent shipments of the Company's network
computer product line and revenues earned from licensing agreements for its
netOS system software. The decrease in net revenues was attributable to the
aforementioned transition to the NeoStation family of products which have lower
selling prices than older
12
products, and the delay in the full scale implementation of thin client
computers by corporate customers as they awaited the deployment of Windows
Terminal Server from Microsoft. In addition, sales to two of the Company's major
customers declined significantly during the last six months of fiscal 1998, as a
result of completing delivery of product under existing purchase orders.
Revenues to such customers are expected to remain at this reduced level for the
foreseeable future. The Company is subject to significant variances in its
operating results because of the fluctuations in the timing of the receipt of
large orders.
The Company's gross profit as a percentage of net revenues decreased to
18.2% for the year ended June 30, 1998 from 33.0% for the prior fiscal year. The
decrease was primarily attributable to the write-down of certain software
licenses, a charge for a reduction in the carrying value of inventory, higher
fixed overhead as a percentage of sales and the impact of reduced selling
prices. The reduced gross profit was also attributable to the Company deriving
substantially less revenue from software licensing as well as an increase in the
percentage of sales through third party sales channels and reduced sales to two
of its major customers. The Company anticipates that gross margins will vary
from quarter to quarter depending on the source of the Company's business,
including the percentage of revenue derived from hardware and software. The
gross profit margin also varies in response to competitive market conditions as
well as periodic fluctuations in the cost of memory and other significant
components. The market in which the Company competes remains very competitive,
and although the Company intends to continue its efforts to reduce the cost of
its products, there can be no certainty that the Company will not be required to
reduce prices of its products without compensating reductions in the cost to
produce its products in order to increase its market share or to meet
competitors' price reductions.
Operating expenses for the year ended June 30, 1998 were $9,389,393, an
increase from operating expenses of $7,942,846 in the prior fiscal year. Sales
and marketing expenses increased by $151,449 to $4,484,289 for the year ended
June 30, 1998 as compared to $4,332,840 in fiscal 1997. The increase reflects
the cost of additions to the Company's sales and technical staff offset by
reduced expenditures for advertising expense. Research and development expenses
for the year ended June 30, 1998 increased by 34.7%, or $371,729, to $1,443,720
from $1,071,991 in the prior year which reflects the Company's commitment to
developing, adapting or acquiring technologies that will expand the market for
its current and future products. The increase in general and administrative
expenses to $2,649,800 for the year ended June 30, 1998 from $2,172,886 in the
prior year reflects the addition of the Company's Chief Executive Officer and
MIS staff and legal costs incurred in connection with the shareholder suit and
other litigation. These amounts were partially offset by the reimbursement of
expenses related to the Company's former subsidiary, Information Technology
Consulting, Inc. The restructuring charge incurred in fiscal 1998 is primarily
related to a reduction in the Company's workforce in the United States and the
United Kingdom.
The Company entered into an agreement effective January 1, 1998 which
reduced the Company's ownership position in Bridging Data Technology, Inc.
("BDT") and eliminated the Company's requirement to fund future operations. In
addition, effective March 31, 1998, the Company wrote off the full amount of its
investment in BDT. The write-off reflects the Company's evaluation that
recovery, if any, of its investment in BDT will not occur. Future cash
distributions to the Company from BDT, if any, will be recorded as income in the
period during which the transaction occurs. Expenses related to BDT including
the investment write-off, have been reclassified as expenses of BDT venture in
the Company's Consolidated Financial Statements included under Item 8. hereof.
The increase in net interest expense to $338,354 for the year ended
June 30, 1998 from net interest income of $69,224 for the prior year reflects
the increase in average line of credit borrowings during fiscal 1998 needed to
finance the losses from operations and higher inventory and accounts receivable
balances during much of the year.
13
The effective income tax rates were approximately 18.4% as compared to
35.2% in the prior fiscal year. The reduced rate during the year ended June 30,
1998 reflects the recording of a valuation reserve of $679,749 against deferred
tax assets.
For the year ended June 30, 1998, the Company incurred a net loss of
$4,968,825 as compared to net income of $337,229 for the prior year. The net
loss resulted from decreased revenues, increased cost of sales and operating
expenses during the period, as well as increased net interest expense, which was
partially offset by the reimbursement of expenses related to the Company's
former subsidiary, Information Technology Consulting, Inc.
Year Ended June 30, 1997 Compared to Year Ended June 30, 1996
For the year ended June 30, 1997, net revenues increased by 22.3% to
$25,467,487 from $20,819,444 for the prior fiscal year. The Company's net
revenues for the current year primarily represent shipments of its line of
network computers, which was introduced at the end of June 1996, and revenues
earned from licensing agreements for its netOS software. Net revenues for the
year ended June 30, 1996 represent shipments of the Company's X terminal product
line, which the Company marketed and manufactured prior to the introduction of
its network computers. The Company is subject to significant variances in its
operating results because of the fluctuations in the timing of the receipt of
large orders.
The Company's gross profit as a percentage of net revenues increased to
33.0% for the year ended June 30, 1997 from 24.6% for the prior fiscal year. The
improvement was a result of achieving higher gross margins on the network
computer product line, despite comparatively lower selling prices, and from the
addition of software licensing revenues. The Company anticipates that gross
margins will vary from quarter to quarter depending on the source of the
Company's business, including the percentage of revenue derived from hardware
and software. The gross profit margin also varies in response to competitive
market conditions as well as periodic fluctuations in the cost of memory and
other significant components. The market in which the Company competes remains
very competitive, and although the Company intends to continue its efforts to
reduce the cost of its products, there can be no certainty that the Company will
not be required to reduce prices of its products without compensating reductions
in the cost to produce its products in order to increase its market share or to
meet competitors' price reductions.
Operating expenses for the year ended June 30, 1997 were $7,942,846, an
increase from operating expenses of $4,390,344 in the prior fiscal year. Sales
and marketing expenses increased by $1,980,742 to $4,332,840 for the year ended
June 30, 1997 as compared to $2,352,098. These increases were the result of
significantly increasing the Company's sales and marketing staff, including
opening new sales offices in the United States and in Europe, and increased
expenditures for advertising and public relations. Research and development
expenses for the year ended June 30, 1997 increased by 83%, or $486,221, to
$1,071,991 from $585,770 in the prior year as the Company expanded its
investment in engineering resources to develop, adapt or acquire technologies
complementary to its current business that will expand the market for its
current and future products. General and administrative expenses increased to
$2,172,886 for the year ended June 30, 1997 from $1,452,476 in the prior year
due to an increase in corporate staff relating to the formation of the Company's
Information Technology Consulting subsidiary and expenses relating to the
recruitment of the Company's new Chief Executive Officer. The increase in
operating expenses was also attributable to costs related to BDT.
Net interest income decreased in the year ended June 30, 1997 due to
lower interest rates and lower investment balances caused by financing of higher
inventory and accounts receivable balances.
The effective income tax rates were approximately 35.2% as compared to
34.1% in the prior fiscal year.
14
For the year ended June 30, 1997, net income decreased to $337,229 from
$622,885 for the prior year. The decrease in net income resulted from increased
operating expenses during the period, as well as lower net interest income,
which was partially offset by significant increases in revenues and in gross
profit percentages.
Liquidity and Capital Resources
At June 30, 1998, the Company had net working capital of $4,681,324
composed primarily of cash and cash equivalents, accounts receivable and
inventory. The Company's principal sources of liquidity included approximately
$1,303,000 of cash and cash equivalents and a $5,000,000 bank line of credit
facility, of which $1,926,000 was available as of June 30, 1998. The bank line
of credit, which is subject to annual renewal, expires on November 30, 1998.
Management is currently negotiating an extension of its credit facility;
however, there is no assurance that management will be successful in negotiating
terms and conditions as favorable as its current line of credit facility.
Cash and cash equivalents decreased by $149,425 during the year ended
June 30, 1998, primarily as a result of the operating loss, acquisition costs
incurred in connection with the formation of the Company's subsidiary, ITC, for
which the Company was reimbursed $300,000 in cash and a $700,000 note
receivable, purchases of equipment, investment in purchased and capitalized
software and a net decrease in accounts payable and accrued expenses which were
partially offset by a decrease in accounts receivable and proceeds from the sale
of common stock.
The Company generated $347,386 in cash from operating activities in
fiscal 1998 compared to using cash of approximately $3,397,512 during fiscal
1997. The increase in cash generated from operations during fiscal 1998 is
primarily due to significant reductions in accounts receivable and inventories,
which were partially offset by the net loss and a net decrease in accounts
payable and accrued expenses. Cash flow from operations can vary significantly
from quarter to quarter depending on the timing of payments from, and shipments
to, large customers.
Net cash of $786,195 was used in investing activities in fiscal 1998
primarily due to the capitalization of development costs related to new software
products and enhancements to existing software products. Net cash of $1,813,601
was used in investing activities in fiscal 1997 due to the licensing of software
from others and prepayment of royalties on such licensed software.
The Company expects to fund current operations and other cash
expenditures through the use of available cash, cash from operations, funds
available under its credit facility, possible new debt sources and the sale of
its equity securities. In addition, the Company has recorded the benefit for its
net operating loss carryback in the 1998 Statement of Operations and expects to
recover approximately $1,122,000 of federal income taxes paid in prior years.
Management believes that there will be sufficient funds from current cash,
operations and available financing to fund operations and cash expenditures
through fiscal 1999. However, the Company must achieve profitable operations in
order to provide adequate funding for the long term.
Inflation
The Company believes that inflation has not had a material effect on
its sales and net revenues during the past three years.
15
Year 2000 Compliance
The Company has made a preliminary evaluation of its Year 2000
exposures. The following areas were evaluated: internal management information
and embedded systems, products, vendors and customers.
The Company utilizes various computer software programs and systems as
part of its internal management information systems which are primarily
off-the-shelf products purchased from commercial sources with minor
customization. Updates to these products are routinely installed by the Company
to upgrade the systems and correct known defects in the software. All major
systems have been reviewed for Year 2000 issues. The Company's financial
accounting software is not Year 2000 compliant. An upgrade to the current
software, which is Year 2000 compliant and will cost approximately $30,000 for
the software and training, is scheduled for installation by June 30, 1999. The
Company's engineering department utilizes UNIX based systems which are not Year
2000 compliant; however, the nature of the utilization is not date sensitive.
The operating systems can be upgraded for less than $5,000 but the Company
anticipates replacing the hardware and software as part of its annual management
information systems expenditures. The Company is in the process of implementing
a contact management and service data base software application which is Year
2000 compliant. Total cost is expected to be less than $15,000. All other
significant internal systems are either compliant or not critical to ongoing
operations. The Company does not utilize any significant systems with embedded
technology.
All of the Company's products sold after March 1997 were tested and
found to be compliant with Year 2000.
None of the Company's vendors provide more than 20% of the Company's
annual raw material requirements and alternative sources are generally
available. The Company will evaluate the Year 2000 readiness of its sole source
vendors by June 30, 1999. Contingency plans will be developed to ensure
continued supply in the event a vendor expects to incur difficulties achieving
Year 2000 compliance. In addition, customers which represent more than 10% of
the Company's annual revenues will be surveyed for compliance with Year 2000 by
June 30, 1999 in an effort to identify possible interruptions to the Company's
revenue streams. There can be no assurance that the Company will not be
adversely affected by the failure of distributors, suppliers, customers and
vendors with which it interacts to become Year 2000 compliant.
The Company estimates the total cost to complete its Year 2000
evaluation and remediation, including normal planned system upgrades, of all
internal systems will approximate $100,000. Funding for these costs is expected
to be provided by cash flows from operations. The Company has not deferred any
significant system projects due to its Year 2000 efforts.
Forward-Looking Statements
Certain statements under "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and certain other statements
contained in this Form 10-K are forward-looking statements within the meaning of
the Private Securities Litigation Reform Act of 1995, and relate to the
development of the Company's products and future operating results that are
subject to certain risks and uncertainties that could cause actual results to
differ materially from those in such forward looking statements. Forward looking
statements include anticipated purchases by customers, future margins and margin
trends, future revenues and operating losses and the Company's competitive
position. The words "believe," "expect," "intend," "anticipate," variations of
such words, and similar expressions identify forward-looking statements, but
their absence does not mean that the
16
statement is not forward-looking. These statements are not guarantees of future
performance and are subject to certain risks, uncertainties and assumptions that
are difficult to predict. Factors that could affect the Company's actual results
include the ability of the Company to market its products with Motorola to OEM
customers, market acceptance of products utilizing the Windows CE operating
system, customers' acceptance of Neoware's line of thin clients and newly
introduced options, pricing pressures, rapid technological changes in the
industry, growth of the thin client computer market and increased competition.
Additional factors which could affect the Company's actual results include,
quarterly fluctuations in operating results, general economic conditions
affecting the demand for computer products, the timing of significant orders,
failure to reduce product costs or maintain quality, delays in the receipt of
key components, seasonal patterns of spending by customers and the outcome of
various litigation.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The financial statements of the Company are filed under this Item 8,
beginning on page F-2 of this Report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information with respect to directors required by this Item is
incorporated by reference to the Section entitled "Election of Directors" in the
Company's definitive Proxy Statement for its 1998 Annual Meeting of
Stockholders.
The following individuals are the current executive officers of the
Company:
Name Age Position
---- --- --------
Edward C. Callahan, Jr. 52 President and Chief Executive Officer
Michael G. Kantrowitz 38 Executive Vice President
Steven B. Ahlbom 48 Vice President of Operations
Edward M. Parks 46 Vice President of Engineering
Edward T. Lack, Jr. 42 Vice President of Finance and Administration
17
Mr. Callahan has been President and Chief Executive Officer and a
Director of the Company since June 1997. Prior to joining the Company, Mr.
Callahan was President and Chief Operating Officer of Summa Four, Inc. of
Manchester, NH, a provider of telecommunications switches, from June 1995 until
November 1996. Beginning in 1985, Mr. Callahan also held various executive
positions during a ten year tenure at Sun Microsystems Computer Corporation. He
was most recently Vice President of Global Telecom and Cable; previously, he was
Vice President of Strategic Accounts and Vice President of the Northeast Area.
Mr. Kantrowitz has been Executive Vice President and a Director of the
Company since March 2, 1995. Prior to that, he was an employee of HDS from 1983,
holding the positions of Executive Vice President from 1991 until March 1995 and
Vice President of Marketing and Sales from 1987 until 1991. Prior to joining
HDS, Mr. Kantrowitz held positions with Raytheon Company and Adage Corporation.
Mr. Ahlbom has been Vice President of Operations of the Company since
March 2, 1995. Prior to that, he held the positions of Vice President of
Operations and Manager of Operations of HDS from 1988. Prior to joining HDS, Mr.
Ahlbom was World-Wide Quality Assurance Manager for Commodore International from
1987 until 1988, and served as Quality Assurance Manager of Burroughs
Corporation.
Mr. Parks has been Vice President of Engineering of the Company since
March 2, 1995. Prior to that, he held the position of Vice President of
Engineering of HDS from 1987. Prior to joining HDS, Mr. Parks was Corporate
Director for Product and Market Development and Director of Engineering for
Commodore Business Machines from 1984 until 1987, and was employed by Eastman
Kodak in engineering management positions from 1974 to 1984.
Mr. Lack has been Vice President of Finance and Administration since
February 2, 1998. Prior to joining the Company, he served as Chief Financial
Officer for Penn Warehousing and Distribution, Inc. during 1997. From 1994 until
1996, Mr. Lack served as Chief Financial Officer for Pilz America, Inc. From
1993 until 1994, Mr. Lack served as Corporate Controller for Ellis and Everard
(U.S. Holdings), Inc. From 1989 until 1993, Mr. Lack held various management
positions with Computone Corporation. Prior to that, Mr. Lack was employed by
Price Waterhouse from 1978 through 1989 in various positions, with the latest
position being Senior Manager, Accounting and Auditing.
All officers of the Company are appointed annually by the Company's
Board and serve at its discretion.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by this Item is incorporated by reference to
the section entitled "Executive Compensation" in the Company's definitive proxy
statement for its 1998 Annual Meeting of Stockholders.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required by this Item is incorporated by reference to
the section entitled
18
"Beneficial Ownership of Common Stock" in the Company's definitive proxy
statement for its 1998 Annual Meeting of Stockholders.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this Item is incorporated by reference to
the section entitled "Certain Transactions" in the Company's definitive proxy
statement for its 1998 Annual Meeting of Stockholders.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
Financial Statements
See Index to Financial Statements at page F-1.
Financial Statement Schedules
All schedules have been omitted because they are not applicable, or not
required, or the information is shown in the financial statements or notes
thereto.
Exhibits
The following is a list of exhibits filed as part of this annual report
on Form 10-K. Where so indicated by footnote, exhibits which were previously
filed are incorporated by reference.
Exhibit
Numbers Description
- ------- -----------
2.1 Agreement of Merger dated as of December 2, 1994 among the Company,
ISAC Acquisition Co. and HDS (Exhibit 2.1)(3)
3.1 Certificate of Incorporation (2 3.1(1)
3.2 Amendment to Certificate of Incorporation (Exhibit 3.2)(2)
3.3 By-laws (Exhibit 3.2)(1)
3.4 Amendment to By-laws, dated July 20, 1995
4.1 Form of Warrant Certificate (Exhibit 4.2)(2)
4.2 Warrant Agreement between Continental Stock Transfer & Trust Company
and Registrant (Exhibit 4.4)(3)
19
4.3 Warrant Agreement, dated March 2, 1995, between Continental Stock
Transfer & Trust Company and the Registrant (Exhibit 4.5)(2)
4.4* Line of Credit Agreement from First Union National Bank (formerly
CoreStates Bank, N.A.) to the Registrant, dated February 17, 1998.
4.5* Common Stock Purchase Warrants held by Kirlin Holding Corp. and two
related persons (Pursuant to Instruction 2 to Item 601 of Regulation
S-K, the Common Stock Purchase Warrants, which are identical in all
material respects except as to the parties thereto and the number of
Warrants, held by such related persons are not being filed).
10.1 Letter Agreement between Safeguard Scientifics, Inc. and Registrant
(Exhibit 10.5)(3)
10.2 Lease between the Registrant and GBF Partners, as amended (Exhibit
10.9)(4)
10.3+ 1995 Stock Option Plan (Exhibit 10.9)(2)
10.4+ 1995 Stock Option Plan (as amended on November 12, 1996)
10.5+ Employment Agreement, dated March 2, 1995, between the Registrant and
Michael G. Kantrowitz (Exhibit 99.2)(5)
10.6+* Letter agreement, dated May 29, 1997, between the Registrant and Edward
C. Callahan, Jr.
10.7+* Employment Agreement, dated June 10, 1997, between the Registrant and
Edward M. Parks.
21.* Subsidiaries
23.* Consent of Arthur Andersen LLP
- ----------
* Filed herewith.
+ Management contract or arrangement.
(1) Filed as an Exhibit to the Company's Registration Statement on Form S-1
(File No. 33-56834) filed with the SEC on January 7, 1993.
(2) Filed as an Exhibit to the Company's Annual Report on Form 10-K for the
year ended December 31, 1994.
(3) Filed as an Exhibit to Amendment No. 1 to the Company's Registration
Statement on Form S-1 (No. 33-56834) filed with the SEC on February 11,
1993.
(4) Filed as an Exhibit to the Company's Registration Statement on Form S-4
(File No. 33-87036) filed with the SEC on December 6, 1994.
20
(5) Filed as an Exhibit to Company's Current Report on Form 8-K dated March 2,
1995. Reports on Form 8-K.
The following report on Form 8-K was filed during the last quarter of
fiscal 1998:
Report on Form 8-K dated April 3, 1998.
21
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
NEOWARE SYSTEMS, INC.
Date: September 28, 1998 By: /s/ Edward C. Callahan, Jr.
------------------- -------------------------------------
Edward C. Callahan, Jr.
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant in the capacities and on the dates indicated.
Each person in so signing also makes, constitutes and appoints
Edward C. Callahan, President and Chief Executive Officer, Michael G.
Kantrowitz, Executive Vice President and Edward T. Lack, Jr., Vice
President-Finance and Administration, and each of them severally, his or her
true and lawful attorney-in-fact, in his or her name, place and stead to execute
and cause to be filed with the Securities and Exchange Commission any or all
amendments to this report.
Signature Title Date
--------- ----- ----
/s/ Arthur R. Spector Chairman of the Board September 28, 1998
- -----------------------------------------
Arthur R. Spector
/s/ Edward C. Callahan, Jr. President, Chief Executive September 28, 1998
- ----------------------------------------- Officer and Director (Principal
Edward C. Callahan, Jr. Executive Officer)
/s/ Michael G. Kantrowitz Executive Vice President and September 28, 1998
- ----------------------------------------- Director
Michael G. Kantrowitz
/s/ Edward T. Lack, Jr. Vice President of Finance and September 28, 1998
- ----------------------------------------- Administration (Principal Financial
Edward T. Lack, Jr. Officer and Principal Accounting
Officer)
/s/ Howard L. Morgan Director September 28, 1998
- -----------------------------------------
Howard L. Morgan
/s/ John Ryan Director September 28, 1998
- -----------------------------------------
John M. Ryan
/s/ Carl G. Sempier Director September 28, 1998
- -----------------------------------------
Carl G. Sempier
22
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Neoware Systems, Inc. and Subsidiaries
Report of Independent Public Accountants F-2
Consolidated Financial Statements--
Consolidated Balance Sheets F-3
Consolidated Statements of Operations F-4
Consolidated Statements of Stockholders' Equity F-5
Consolidated Statements of Cash Flows F-6
Notes to Consolidated Financial Statements F-7
F-1
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Neoware Systems, Inc.:
We have audited the accompanying consolidated balance sheets of Neoware Systems,
Inc. (a Delaware corporation) and subsidiaries as of June 30, 1998 and 1997, and
the related consolidated statements of operations, stockholders' equity and cash
flows for each of the three years in the period ended June 30, 1998. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Neoware Systems, Inc. and
subsidiaries as of June 30, 1998 and 1997, and the results of their operations
and their cash flows for each of the three years in the period ended June 30,
1998 in conformity with generally accepted accounting principles.
/s/Arthur Andersen LLP
Philadelphia, Pa.,
August 31, 1998
F-2
NEOWARE SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
June 30,
---------------------------------
ASSETS 1998 1997
------ ------------- -------------
CURRENT ASSETS:
Cash and cash equivalents $ 1,302,984 $ 1,452,409
Accounts receivable, net of allowance for doubtful accounts of
$168,710 and $124,086 4,777,957 9,308,731
Inventories 3,119,043 4,035,202
Recoverable income taxes 1,121,554 --
Prepaid expenses and other 123,575 789,179
Deferred income taxes 416,530 416,530
------------ ------------
Total current assets 10,861,643 16,002,051
PROPERTY AND EQUIPMENT, net 636,414 680,859
CAPITALIZED AND PURCHASED SOFTWARE, net 809,470 1,630,339
NOTE RECEIVABLE 700,000 --
DEFERRED INCOME TAXES 13,866 13,866
------------ ------------
$ 13,021,393 $ 18,327,115
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Line of credit $ 3,074,000 $ 3,071,000
Accounts payable 1,834,400 3,796,549
Accrued expenses 1,106,607 516,148
Deferred revenue 165,312 172,006
------------ ------------
Total current liabilities 6,180,319 7,555,703
------------ ------------
COMMITMENTS AND CONTINGENCIES (Note 10)
STOCKHOLDERS' EQUITY:
Preferred stock, $.001 par value, 1,000,000 shares authorized and none
issued and outstanding -- --
Common stock, $.001 par value, 50,000,000 shares
authorized, 6,264,158 and 5,760,820 shares issued and outstanding 6,264 5,761
Additional paid-in capital 10,154,052 9,168,171
Retained earnings (deficit) (3,301,874) 1,666,951
Deferred compensation (17,368) (69,471)
------------ ------------
Total stockholders' equity 6,841,074 10,771,412
------------ ------------
$ 13,021,393 $ 18,327,115
============ ============
The accompanying notes are an integral part of these financial statements.
F-3
NEOWARE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Year Ended June 30,
----------------------------------------------------
1998 1997 1996
--------------- --------------- ---------------
NET REVENUES $ 19,976,423 $ 25,467,487 $ 20,819,444
COST OF REVENUES 16,339,055 17,073,845 15,703,594
--------------- --------------- ---------------
Gross profit 3,637,368 8,393,642 5,115,850
--------------- --------------- ---------------
OPERATING EXPENSES:
Sales and marketing 4,484,289 4,332,840 2,352,098
Research and development 1,443,720 1,071,991 585,770
General and administrative 2,649,800 2,172,886 1,452,476
Restructuring charge 198,105 -- --
Bridging Data Technology venture 613,479 365,129 --
--------------- --------------- --------------
Total operating expenses 9,389,393 7,942,846 4,390,344
--------------- --------------- ---------------
Operating (loss) income (5,752,025) 450,796 725,506
INTEREST (EXPENSE) INCOME, net (338,354) 69,224 220,277
---------------- --------------- ---------------
(Loss) income before income taxes (6,090,379) 520,020 945,783
INCOME TAX (BENEFIT) EXPENSE (1,121,554) 182,791 322,898
---------------- --------------- ---------------
NET (LOSS) INCOME $ (4,968,825) $ 337,229 $ 622,885
================ =============== ===============
BASIC EARNINGS PER SHARE $ (.86) $ .06 $ .11
================ =============== ===============
DILUTED EARNINGS PER SHARE $ (.86) $ .05 $ .10
================ =============== ===============
Weighted average number of shares used in basic
earnings per share computation 5,784,366 5,712,309 5,612,386
=============== =============== ===============
Weighted average number of shares used in
diluted earnings per share computation 5,784,366 7,132,898 6,069,012
=============== =============== ===============
The accompanying notes are an integral part of these financial statements.
F-4
NEOWARE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Common Stock Additional
------------------- Paid-in Retained Deferred
Shares Amount Capital Earnings Compensation Total
--------- ------- ------------ ----------- ---------- -----------
BALANCE AT JUNE 30, 1995 5,609,983 $ 5,610 $ 7,955,796 $ 706,837 $(173,678) $8,494,565
Tax benefit of acquired net operating loss
carryforward -- -- 300,000 -- -- 300,000
Exercise of stock options 9,612 10 12,327 -- -- 12,337
Amortization of deferred compensation -- -- -- -- 52,103 52,103
Net income -- -- -- 622,885 -- 622,885
---------- ------- ------------ ----------- --------- ------------
BALANCE AT JUNE 30, 1996 5,619,595 5,620 8,268,123 1,329,722 (121,575) 9,481,890
Exercise of Common Stock warrants 18,050 18 99,257 -- -- 99,275
Exercise of stock options 123,175 123 733,655 -- -- 733,778
Tax benefit on options exercised -- -- 67,136 -- -- 67,136
Amortization of deferred compensation -- -- -- -- 52,104 52,104
Net income -- -- -- 337,229 -- 337,229
---------- ------- ------------ ----------- --------- ------------
BALANCE AT JUNE 30, 1997 5,760,820 5,761 9,168,171 1,666,951 (69,471) 10,771,412
Exercise of stock options 7,112 7 (7) -- -- --
Unit Purchase Options exchanged for Common Stock 100,000 100 (100) -- -- --
Sale of Common Stock, net of expenses 396,226 396 985,988 -- -- 986,384
Amortization of deferred compensation -- -- -- -- 52,103 52,103
Net loss -- -- -- (4,968,825) -- (4,968,825)
---------- ------- ------------ ----------- --------- ------------
BALANCE AT JUNE 30, 1998 6,264,158 $ 6,264 $ 10,154,052 $(3,301,874) $ (17,368) $ 6,841,074
========== ======= ============ =========== ========= ============
The accompanying notes are an integral part of these financial statements.
F-5
NEOWARE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Year Ended June 30,
---------------------------------------------------
1998 1997 1996
----------- ----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) income $(4,968,825) $ 337,229 $ 622,885
Adjustments to reconcile net (loss) income to net cash
provided by (used in) operating activities-
Depreciation and amortization 881,295 361,121 357,878
Amortization of deferred compensation 52,103 52,104 52,103
Write-down of purchased software 610,984 -- --
Write-off investment in Bridging Data Technology 159,231 -- --
Deferred income taxes -- (84,196) (66,860)
Changes in operating assets and liabilities-
(Increase) decrease in:
Accounts receivable 4,530,774 (4,394,724) 850,669
Inventories 916,159 (1,680,948) (138,239)
Recoverable income taxes (1,121,554) -- --
Prepaid expenses and other 665,603 (28,023) (594,479)
Increase (decrease) in:
Accounts payable (1,962,149) 1,868,652 (869,755)
Accrued expenses 590,459 199,211 (83,637)
Deferred revenue (6,694) (27,938) 62,740
Income taxes payable -- -- (626,375)
----------- ----------- -----------
Net cash provided by (used in)
operating activities 347,386 (3,397,512) (433,070)
----------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment, net (245,459) (216,661) (291,227)
Redemption of short-term investments -- -- 1,959,324
Capitalized and purchased software (540,736) (1,596,940) (137,806)
----------- ----------- -----------
Net cash provided by
(used in) investing activities (786,195) (1,813,601) 1,530,291
----------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from (repayment of) line of credit 3,000 3,071,000 (589,000)
Issuance of note receivable (700,000) -- --
Sale of Common Stock 986,384 -- --
Principal payments on long-term debt -- (7,965) (5,243)
Exercise of stock options -- 733,778 12,337
Tax benefits on options exercised -- 67,136 --
Exercise of warrants -- 99,275 --
----------- ----------- -----------
Net cash provided by (used in)
financing activities 289,384 3,963,224 (581,906)
----------- ----------- -----------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (149,425) (1,247,889) 515,315
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 1,452,409 2,700,298 2,184,983
----------- ----------- -----------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 1,302,984 $ 1,452,409 $ 2,700,298
=========== =========== ===========
SUPPLEMENTAL DISCLOSURES OF NONCASH
OPERATING ACTIVITIES:
Cash paid for income taxes $ 53,032 $ 27,213 $ 1,026,500
Cash paid for interest 313,112 61,560 10,069
The accompanying notes are an integral part of these financial statements.
F-6
NEOWARE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. COMPANY BACKGROUND:
Neoware Systems, Inc. (the "Company"), formerly HDS Network Systems, Inc.,
designs, manufactures and markets a family of Windows-based terminals and thin
client computers that allow users to access Windows-based applications from a
multi-user Windows(R) NT server, plus connect to mainframes, minicomputers and
the Internet. The Company's NeoStation(TM) family of Windows-based terminals and
related software allows users to utilize all of their existing computer systems
and applications running on Windows platforms, UNIX, mainframes and
minicomputers, and access them across a network.
In August 1996, the Company formed a new subsidiary, Information Technology
Consulting, Inc. ("ITC") for the purpose of acquiring companies in the computer
services field, including information technology staffing companies and
client-server consulting companies. In October 1997, ITC merged with The Reohr
Group, Inc. ("Reohr") and Global Consulting Group. The Company, as the sole
stockholder of ITC, received stock of the surviving entity representing
approximately 2% ownership of the entity after the merger. The Company was also
reimbursed for the expenses incurred by the Company and ITC in connection with
ITC's efforts to complete these transactions. (see Note 5.)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and
its wholly owned subsidiaries. All significant intercompany profits, accounts
and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Cash Equivalents
The Company considers all highly liquid investments purchased with an original
maturity of three months or less to be cash equivalents for the purpose of
determining cash flows. Cash equivalents at June 30, 1998 and 1997 consist of
money market funds.
F-7
Inventories
Inventories are stated at the lower of cost or market. Cost is determined by the
first-in, first-out method.
Long-Lived Assets
The Company follows Statement of Financial Accounting Standards ("SFAS") No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed of." Accordingly, in the event that facts and
circumstances indicate that property and equipment, and intangible or other
assets may be impaired, an evaluation of recoverability would be performed. If
an evaluation is required, the estimated future undiscounted cash flows
associated with the assets is compared to the assets' carrying amount to
determine if a write-down to market value or discounted cash flow value is
necessary.
Property and Equipment
Property and equipment are stated at cost. Additions and improvements that
significantly extend the useful life of an asset are capitalized. Expenditures
for repairs and maintenance are charged to operations as incurred. Depreciation
and amortization are provided using the straight-line and accelerated methods
over the estimated useful lives of the assets as follows:
Computer equipment 3-5 years
Office furniture and equipment 5-7 years
Leasehold improvements Lease term
Other 3-5 years
Revenue Recognition
Product revenue is recognized at the time of title transfer, which ordinarily
occurs at the time of shipment. From time to time, customers request delayed
shipment, usually because of customer scheduling for systems integration and
lack of storage space at customers' facility during the implementation. In such
"bill and hold" transactions, the Company recognizes revenues when the following
conditions are met: the equipment is complete, ready for shipment and segregated
from other inventory; the Company has no further significant performance
obligations in connection with the completion of the transaction; the commitment
and delivery schedule is fixed; the customer requested the transaction be
completed on this basis; and the risks of ownership have passed to the customer.
Revenues recognized from "bill and hold" transactions for products which had not
shipped by fiscal year-end were $814,120, $7,488,222 and $2,023,200 for the
years ended June 30, 1998, 1997 and 1996, respectively. Accounts receivable
relating to "bill and hold" transactions were $804,234 and $6,240,564 at June
30, 1998 and 1997, respectively. Service contract revenue is recognized ratably
over the contract period. Product warranty costs and an allowance for sales
returns are accrued at the time revenues are recognized.
F-8
Research and Development
Costs incurred in the development of new software products and enhancements to
existing software products are charged to expense as incurred until the
technological feasibility of the product has been established. After
technological feasibility has been established, any additional costs are
capitalized in accordance with SFAS No. 86, "Accounting for the Costs of
Computer Software to be Sold, Leased or Otherwise Marketed." Capitalized
software costs are amortized to cost of revenues over the expected life of the
product, not to exceed three years. The Company capitalized $351,136,
$285,968,and $137,806 of software development cost and amortized $220,877,
$147,977 and $134,795 in fiscal 1998, 1997 and 1996, respectively. Accumulated
amortization was $316,352 and $753,280 at June 30, 1998 and 1997, respectively.
The Company also enters into various licensing agreements which require up front
cash payments and/or royalties based on unit sales. Such amounts are capitalized
and amortized over the term of the license agreement or based on the units sold.
The Company continually evaluates whether events and circumstances have occurred
that indicate that unamortized product development costs may not be recoverable
or that the amortization period should be revised. During fiscal 1998, the
Company wrote down the carrying value of certain prepaid licenses, as such
amounts were not deemed recoverable from future sales. The write-down which
totaled $610,984 was charged against cost of revenues in the accompanying
consolidated statements of operations.
Earnings Per Share
Effective December 31, 1997, the Company adopted SFAS No. 128, "Earnings per
Share," which supersedes Accounting Principles Board Opinion No. 15, "Earnings
per Share." SFAS 128 requires dual presentation of basic and diluted earnings
per share ("EPS") for complex capital structures on the face of the income
statement. Basic EPS is computed by dividing income (loss) by the weighted
average number of common shares outstanding for the period. Diluted EPS reflects
the potential dilution from the exercise or conversion of securities into common
stock, such as stock options. For fiscal 1997 and 1996, the weighted average
number of shares outstanding for purposes of calculating diluted earnings per
share included 1,420,589 and 456,626 shares, respectively, attributable to stock
options and warrants. For the year ended June 30, 1998, there were no dilutive
effects of stock options or warrants as the Company incurred a net loss. Options
and warrants to purchase 7,265,079 shares of Common Stock at prices ranging from
$1.76 to $8.75 per share were outstanding at June 30, 1998. In accordance with
the provisions of SFAS 128, EPS for prior periods have been restated.
Income Taxes
The Company accounts for income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes." Under the asset-and-liability method of SFAS No.
109, deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. Under SFAS No. 109, the
effect on deferred tax assets and liabilities of a change in tax rates is
recognized in income in the period that includes the enactment date.
F-9
New Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board issued SFAS No. 130,
"Reporting Comprehensive Income" ("SFAS130"). This statement requires companies
to classify items of other comprehensive income by their nature in a financial
statement and display the accumulated balance of other comprehensive income
separately from retained earnings and additional paid-in capital in the equity
section of a statement of financial position. SFAS 130 is effective for
financial statements issued for fiscal years beginning after December 15, 1997.
Management believes that SFAS 130 will not have a material effect on the
Company's consolidated financial statements.
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
"Disclosures About Segments of an Enterprise and Related Information" ("SFAS
131"). This statement establishes additional standards for segment reporting in
the financial statements and is effective for fiscal years beginning after
December 15, 1997. Management is currently evaluating the need to make
additional disclosures under SFAS No. 131. However, this statement will not have
any impact on the Company's reported consolidated financial position or results
of operations.
Reclassifications
Certain reclassifications have been made to the 1997 and 1996 consolidated
financial statements to conform to the current year presentation.
3. MAJOR CUSTOMERS AND FOREIGN REVENUES:
Net revenues from two customers represented 15% and 14% of total net revenues in
fiscal 1998, 15% and 25%of total net revenues in fiscal 1997 and 27% and 16% of
total net revenues in fiscal 1996. Revenues from one of the significant
customers in fiscal 1997 and 1996 were under subcontracts for systems
integration contracts for major U.S. government procurements. At June 30, 1998
and 1997, the Company had total receivables from the two major customers of
approximately $1,672,000 and $5,937,000, respectively.
The Company's products are used in a broad range of industries for a variety of
applications. Sales are made to both domestic and international customers. Net
foreign revenues in fiscal 1998, 1997 and 1996 were approximately 20%, 22% and
3%, respectively, and were transacted in US dollars.
F-10
4. CONSOLIDATED BALANCE SHEET COMPONENTS:
Inventories consist of the following:
June 30,
---------------------------------
1998 1997
------------- -------------
Purchased components and subassemblies $ 1,599,136 $ 1,566,161
Work-in-process 283,587 301,565
Finished goods 1,236,320 2,167,476
------------- -------------
$ 3,119,043 $ 4,035,202
============= =============
Property and equipment consist of the following:
June 30,
---------------------------------
1998 1997
------------- -------------
Computer equipment $ 922,621 $ 749,082
Office furniture and equipment 342,208 318,989
Leasehold improvements 362,518 357,053
Other 121,921 127,712
------------- -------------
1,749,268 1,552,836
Less- Accumulated depreciation and amortization (1,112,854) (871,977)
-------------- --------------
$ 636,414 $ 680,859
============= =============
5. NOTE RECEIVABLE:
In October 1997, the Company merged ITC, a wholly-owned subsidiary, into Reohr
in exchange for a 2% stock interest in Reohr and the reimbursement of $1,000,000
of expenses incurred by the Company in connection with its efforts to make
certain acquisitions in the information technology consulting and staffing
field. Of the total reimbursement, $300,000 was paid in cash and the remaining
$700,000 under a note which is due on the earlier of three years or upon the
completion of the initial public offering of Reohr. The note bears interest at
8% per annum. Of the total reimbursement, $292,000 was offset against general
and administrative expenses during fiscal 1998 for costs previously incurred and
charged to expense.
6. LINE OF CREDIT:
The Company has a $5,000,000 revolving line of credit with a bank which expires
on November 30, 1998, subject to annual renewal. Borrowings under the line bear
interest at the bank's prime rate (8.5% at June 30, 1998). At June 30, 1998,
there was $1,926,000 available for borrowing under the line. Under the line, the
Company is required to maintain specified ratios of working capital and debt to
net worth, as defined. The maximum amount borrowed under the line of credit was
$5,000,000 in fiscal 1998, $3,071,000 in fiscal 1997 and $1,206,000 in fiscal
1996. The average amounts outstanding were $3,434,000, $997,269 and $247,917 in
fiscal 1998, 1997 and 1996,respectively, and the weighted average interest rate
during such years was 8.5%, 6.2% and 8.69%, respectively.
F-11
7. INCOME TAXES:
The components of income taxes are as follows:
For the Year Ended June 30,
------------------------------------------------
1998 1997 1996
------------- ------------- -------------
Current-
Federal $(1,121,554) $ 258,515 $ 377,528
State -- 8,472 12,230
------------- ------------- -------------
(1,121,554) 266,987 389,758
-------------- ------------- -------------
Deferred-
Federal -- (70,725) (57,551)
State -- (13,471) (9,309)
------------- -------------- --------------
-- (84,196) (66,860)
------------- -------------- --------------
$ (1,121,554) $ 182,791 $ 322,898
============== ============= =============
The federal statutory income tax rate is reconciled to the effective tax rate as
follows:
For the Year Ended June 30,
------------------------------------------------
1998 1997 1996
------------- ------------- -------------
Federal statutory rate 34.0% 34.0% 34.0%
State income taxes, net -- 0.8 0.8
Expenses not deductible
for tax 0.1 0.2 0.4
Valuation allowance (11.2) -- --
Other (4.5) 0.2 (1.1)
------------ ------------ -----------
18.4% 35.2% 34.1%
------------ ----------- -----------
Deferred taxes are determined based on the estimated future tax effects of
differences between the financial statement and tax basis of assets and
liabilities given the provisions of enacted tax laws. Deferred taxes are
comprised of the following:
June 30,
----------------------
1998 1997
---------- ---------
Gross current deferred income tax asset $1,016,787 $ 543,852
Gross current deferred income tax liability (106,133) (127,322)
----------- ----------
Total current deferred tax asset 910,654 416,530
---------- ---------
Gross non-current deferred income tax asset 386,657 144,226
Gross non-current deferred income tax liability (187,166) (130,360)
---------- ---------
Total non-current deferred tax asset 199,491 13,866
---------- ---------
Valuation allowance (679,749) --
---------- ---------
Net deferred tax asset $ 430,396 $ 430,396
========== =========
F-12
The tax effect of significant temporary differences representing deferred tax
assets and liabilities are as follows:
June 30,
---------------------
1998 1997
--------- ---------
Net operating loss carryforwards $ 865,533 $ 444,426
Expenses not currently deductible for tax purposes 472,613 175,710
Deferred revenue 65,298 67,942
Basis difference in property and equipment and
capitalized software (187,166) (130,360)
Capitalized inventory costs (106,133) (127,322)
Valuation allowance (679,749) --
--------- ---------
Net deferred tax asset $ 430,396 $ 430,396
========= =========
In fiscal 1996, the Company recognized a $300,000 income tax benefit from a net
operating loss carryforward of Information Systems Acquisition Corp. ("ISAC"),
an entity with which the Company merged in March 1995. The income tax benefit
was recorded as a deferred tax asset and an increase in additional paid-in
capital.
8. STOCK OPTIONS AND WARRANTS:
The Company has a stock option plan (the "Plan") for employees and directors.
The Company is authorized to issue options for the purchase of up to 1,500,000
shares of Common Stock. Under the terms of the Plan, the exercise price of
options granted cannot be less than fair market value on the date of grant.
Employee options generally vest and become exercisable ratably over four years.
Director options vest and become exercisable ratably six months and one year
from the date of grant. All options expire five years from the grant date. As of
June 30, 1998, the Company had options outstanding under the Plan for the
purchase of 1,253,125 shares of Common Stock at prices ranging from $2.44 to
$8.75 per share. Options to purchase 219,625 shares of Common Stock were vested
at June 30, 1998.
In November 1994, a stock option to purchase 20,000 shares of Common stock of
HDS at $2.50 per share was granted, which has been exchanged in connection with
the merger with ISAC (see Note 7) into an option to purchase 28,448 shares of
Common Stock of the Company at $1.76 per share. Deferred compensation of
$191,046 was recorded for the difference between the exercise price and merger
consideration, and is being amortized over the option vesting period. As of June
30, 1998, the options outstanding under this grant were for 7,112 shares, none
of which were vested.
After giving effect to the merger with ISAC discussed in Note 7, there are
5,704,842 warrants outstanding to purchase Common Stock at $5.50 per share. The
warrants are exercisable over seven years and expire in March 2000 through March
2002. The warrants will be redeemable at a price of $.01 per warrant upon 30
days notice at any time, only in the event that the last price of the Common
Stock is at least $10 per share for 20 consecutive trading days ending on the
third day prior to the one on which notice of redemption is given.
F-13
During fiscal 1998, the Company issued 300,000 warrants to purchase Common Stock
at prices ranging from $3.00 to $7.00 in connection with entering into a
financial advisory and investment banking agreement. Warrants for 100,000 shares
are exercisable immediately and 200,000 shares upon meeting certain provisions,
as defined. The warrants expire in January 2001.
During fiscal 1998, the Company issued 100,000 shares of Common Stock in
exchange for the termination of 540,495 Unit Purchase Options with an exercise
price of $2.44. The Unit Purchase Options had been issued in connection with the
initial public offering of ISAC in March 1993 and provided the holder with the
option to acquire Units consisting of one share of Common Stock and two Common
Stock purchase warrants.
9. ACCOUNTING FOR STOCK-BASED COMPENSATION:
In October 1995, the Financial Accounting Standards Board adopted SFAS No. 123,
"Accounting for Stock-Based Compensation. The Company adopted this standard
during the year ended June 30, 1997. The Company has elected to adopt the
disclosure requirement of this pronouncement only. The adoption of this
pronouncement, therefore, had no impact on the Company's financial position or
results of operations. Had compensation cost been calculated based on the fair
value at the grant date for awards in 1998, 1997 and 1996 consistent with the
provisions of SFAS 123, the Company's net income (loss) and net income (loss)
per share would have been changed to the following pro forma amounts:
1998 1997 1996
----------- -------- --------
Net income (loss) As reported $(4,968,825) $337,229 $622,885
Pro forma $(6,069,420) $ 69,953 $557,673
Basic EPS As reported $ (.86) $ .06 $ .11
Pro forma $ (1.05) $ .01 $ .10
Diluted EPS As reported $ (.86) $ .05 $ .10
Pro forma $ (1.05) $ .01 $ .09
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted-average
assumptions used for grants in 1998, 1997 and 1996; no dividend yield; expected
volatility of 70.0%; risk-free interest rates of approximately 5.44% - 6.94%;
and an expected life of 5 years. The pro forma effect on net income (loss) for
1998, 1997 and 1996 is not representative of the pro forma effect on net income
(loss) in future years because it does not take into consideration pro forma
compensation expense related to grants made prior to fiscal 1996.
10. COMMITMENTS AND CONTINGENCIES:
The Company leases its principal facility and an automobile under noncancelable
operating leases. The facility lease expires in 2001 and the auto lease expires
in fiscal 2000. Rent expense under these leases was $108,486, $73,168 and
$72,929 in fiscal 1998, 1997 and 1996,
F-14
respectively. Minimum required lease payments are $112,332 in 1999, $98,651 in
2000 and $23,025 in 2001.
The Company sponsors a profit sharing/401(k) plan (the "Plan") for all of its
employees who meet certain age and years of employment requirements.
Participants may make voluntary contributions to the Plan and the Company makes
a matching contribution of 50% of the first 4% of such contributions. Effective
January 1, 1998, the Company's matching contribution is limited to $500 per
participant per year. The Company's contributions were $46,501, $47,600 and
$20,139 in fiscal 1998, 1997 and 1996, respectively.
On March 11, 1998, a complaint entitled Cerrato, Inc. v. Neoware Systems, Inc.,
98 Civ. 1748 (JSM), was filed in the United States District Court for the
Southern District of New York, naming as defendants the Company, its Chairman,
and its former CFO. The Complaint asserts claims under ss. 10(b) of the
Securities and Exchange Act of 1934 (the "Exchange Act"), Rule 10b-5 promulgated
thereunder, and common law. The complaint, which was filed as a purported class
action on behalf of purchasers of the Company's common stock during the period
from June 15, 1996 through August 15, 1997, alleges, among other things, that
the defendants made misrepresentations related to plans for various potential
acquisitions by a subsidiary of the company and a spin-off. A First Amended
Complaint ("FAC") was filed on or about May 1, 1998. The FAC adds claims on
behalf of a second purported class -- purchasers of the Company's stock from
November 13, 1997 through May 1, 1998 -- related to the Company's announcement,
on April 30, 1998, that it would be restating certain financial results
previously reported for the first two quarters of fiscal year 1998. Defendants'
time to respond to the FAC has not yet expired nor has lead plaintiff been
appointed by the court.
Thereafter four separate purported securities class actions: Galitzer v. Neoware
Systems, Inc., 98CV2582 (BWK), Pollison v. Neoware Systems, Inc., 98CV2879
(BWK), Tuchman v. Neoware Systems, Inc., 98CV2868 (BWK), and Grubin v. Neoware
Systems, Inc., 98CV3651 (BWK), were filed in the United States District Court
for the Eastern District of Pennsylvania (the "Pennsylvania actions"). The
Pennsylvania actions name some of the same individual defendants as the FAC, as
well as certain additional directors and officers, and alleges violations of
ss.ss. 10(b) and 20(a) of the Exchange Act and Rule 10b-5 based on factual
allegations similar to those added to the New York action in the FAC on behalf
of a purported class of purchasers of the Company's securities between October
30, 1997 and April 30, 1998. The Pennsylvania actions have been consolidated
under the heading In re Neoware Systems, Inc. Securities Litigations, Master
File No. 98-CV-2582 and lead co-plaintiffs have been appointed. Defendants' time
to respond to the Pennsylvania actions has not yet expired.
On May 5, 1998, a complaint was filed in the Court of Common Pleas of Montgomery
County against the Company by Development Concepts, Inc. The complaint asserts
claims for common law breach of contract, fraud, misrepresentation, breach of
warranty and violations of the federal Lanham Act arising primarily from the
parties' contractual relationships. The complaint seeks an indeterminate amount
of monetary damages in excess of $1,500,000.
The Company disputes the validity of these cases and intends to defend the
claims vigorously. Management does not anticipate that resolution of the pending
litigation, either separately or in the aggregate, will have a material adverse
effect on the Company's financial position or results of operations.
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