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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549-1004
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OF THE SECURITIES EXCHANGE ACT OF
1934
For the quarterly period ended September 30, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OF THE SECURITIES EXCHANGE ACT
OF 1934
For the transition period from to
Commission file number 0-21485
SUPERIOR CONSULTANT HOLDINGS CORPORATION
(Exact name of Registrant as Specified in Its Charter)
STATE OF DELAWARE 38-3306717
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
5225 Auto Club Drive, Dearborn, Michigan 48126
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (248) 386-8300
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
As of November 12, 2004 10,532,705 shares of the registrant's common stock (par
value $.01) were outstanding, excluding treasury shares.
SUPERIOR CONSULTANT HOLDINGS CORPORATION AND SUBSIDIARIES
QUARTER ENDED SEPTEMBER 30, 2004
INDEX
PAGE NO.
--------
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2004 and
December 31, 2003 (unaudited) 3
Consolidated Statements of Operations for the three and nine months ended
September 30, 2004 and 2003 (unaudited) 4
Consolidated Statements of Cash Flows for the nine months ended September 30,
2004 and 2003 (unaudited) 5
Notes to Consolidated Financial Statements (unaudited) 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations 12
Item 3. Quantitative and Qualitative Disclosures About Market Risk 20
Item 4. Controls and Procedures 20
PART II - OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders 21
Item 6. Exhibits and Reports on Form 8-K 21
SIGNATURES 22
Page 2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SUPERIOR CONSULTANT HOLDINGS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
(UNAUDITED)
SEPTEMBER 30, DECEMBER 31,
2004 2003
------------- -------------
ASSETS
Current assets
Cash and cash equivalents $ 12,093 $ 12,688
Accounts receivable, net 15,688 12,592
Accrued interest receivable and prepaid expenses 3,899 3,852
Refundable income taxes 117 148
------------- -------------
Total current assets 31,797 29,280
Property and equipment, net 26,407 24,235
Other long-term assets 199 338
------------- -------------
Total Assets $ 58,403 $ 53,853
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Notes payable to bank $ 4,400 $ 1,900
Current portion of long-term obligations 2,625 2,793
Accounts payable 9,222 8,829
Accrued liabilities, deferred bonuses and compensation 4,632 2,758
Deferred revenue 1,745 1,920
------------- -------------
Total current liabilities 22,624 18,200
Senior subordinated debentures, net 7,640 7,552
Long-term obligations 2,910 4,307
Other long-term liabilities 473 878
Commitments and contingencies (Note 11) - -
Stockholders' equity
Preferred stock; authorized, 1,000,000 shares of $.01 par value;
no shares issued as of September 30, 2004 and December 31, 2003 - -
Common stock; authorized, 30,000,000 shares of $.01 par value;
issued, 10,989,330 shares as of September 30, 2004 and
10,801,630 shares as of December 31, 2003 110 108
Additional paid-in capital 116,168 115,520
Stockholders' notes receivable (600) (749)
Treasury stock - at cost, 469,250 shares as of September 30, 2004
and 428,600 shares as of December 31, 2003 (3,780) (3,601)
Accumulated deficit (87,142) (88,362)
------------- -------------
Total stockholders' equity 24,756 22,916
------------- -------------
Total Liabilities and Stockholders' Equity $ 58,403 $ 53,853
============= =============
See notes to consolidated financial statements.
Page 3
SUPERIOR CONSULTANT HOLDINGS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- --------------------
2004 2003 2004 2003
-------- -------- -------- --------
Revenue
Revenue before reimbursements (net revenue) $ 27,707 $ 22,589 $ 79,186 $ 67,366
Out-of-pocket reimbursements 1,930 1,872 5,509 5,747
-------- -------- -------- --------
Total revenue 29,637 24,461 84,695 73,113
Operating costs and expenses
Cost of services before reimbursements
(net cost of services) 20,731 16,342 58,688 48,792
Out-of-pocket reimbursements 1,930 1,872 5,509 5,747
-------- -------- -------- --------
Total cost of services 22,661 18,214 64,197 54,539
Selling, general and administrative expenses 6,037 6,493 18,004 19,863
Loss on sale of building - - 562 -
-------- -------- -------- --------
Total operating costs and expenses 28,698 24,707 82,763 74,402
-------- -------- -------- --------
Earnings (loss) from operations 939 (246) 1,932 (1,289)
Other expense, net (251) (344) (712) (573)
-------- -------- -------- --------
Earnings (loss) before income tax benefit 688 (590) 1,220 (1,862)
Income tax benefit - - - -
-------- -------- -------- --------
Net earnings (loss) $ 688 $ (590) $ 1,220 $ (1,862)
======== ======== ======== ========
Net earnings (loss) per share
Basic $ 0.07 $ (0.06) $ 0.12 $ (0.17)
======== ======== ======== ========
Diluted $ 0.06 $ (0.06) $ 0.10 $ (0.17)
======== ======== ======== ========
Weighted average number of common shares outstanding
Basic 10,495 10,478 10,423 10,668
======== ======== ======== ========
Diluted 11,926 10,478 11,812 10,668
======== ======== ======== ========
See notes to consolidated financial statements.
Page 4
SUPERIOR COSULTANT HOLDINGS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30,
---------------------------------
2004 2003
--------------- ---------------
Cash flows from operating activities:
Net earnings (loss) $ 1,220 $ (1,862)
Adjustments to reconcile net earnings (loss) to net cash
provided by operating activities:
Depreciation and amortization of property and equipment 4,079 3,722
Bad debt (recovery) expense (350) 19
Loss on sale of building 562 -
Non-cash interest expense 171 100
Changes in operating assets and liabilities that provided
(used) cash:
Accounts receivable (2,746) (711)
Accrued interest receivable and prepaid expenses (19) 11
Refundable income taxes 31 109
Other long-term assets - (47)
Accounts payable 817 (450)
Accrued liabilities, deferred bonuses and compensation 1,874 985
Deferred revenue (175) 138
Other long-term liabilities (405) (599)
--------------- ---------------
Net cash provided by operating activities 5,059 1,415
Cash flows from investing activities:
Purchase of property and equipment (8,301) (5,165)
Proceeds from sale of real estate 1,681 991
--------------- ---------------
Net cash used in investing activities (6,620) (4,174)
Cash flows from financing activities:
Proceeds from (repayment of) line of credit 2,500 (1,025)
Exercise of stock options 648 78
Proceeds from senior subordinated debentures - 8,000
Costs associated with senior subordinated debentures - (450)
Stock repurchased - (275)
Repurchase and retirement of common stock - (1,280)
Costs associated with "Dutch Auction" Tender Offer - (25)
Payments on long-term obligations (2,182) (1,784)
Principal payment on stockholder's notes receivable - 156
--------------- ---------------
Net cash provided by financing activities 966 3,395
--------------- ---------------
Net increase (decrease) in cash and cash equivalents (595) 636
Cash and cash equivalents, beginning of period 12,688 14,575
--------------- ---------------
Cash and cash equivalents, end of period
$ 12,093 $ 15,211
=============== ===============
Supplemental disclosure of cash flow information - cash paid for interest $ 982 $ 642
Non-Cash Transactions:
Purchase of property and equipment financed by long-term obligations $ 617 $ 6,763
Purchase of property and equipment included in accounts payable 424 -
Purchase of a support and maintenance agreement financed by a long-term obligation - 139
Purchase of treasury stock by surrender of full recourse note
receivable and accrued interest 179 -
See notes to consolidated financial statements.
Page 5
SUPERIOR CONSULTANT HOLDINGS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
SEPTEMBER 30, 2004
NOTE 1 - BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been
prepared pursuant to the rules of the Securities and Exchange Commission for
quarterly reports on Form 10-Q. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
in the United States of America for complete financial statements. In our
opinion, all adjustments (consisting of normal recurring accruals and estimated
provisions for bonus and profit-sharing arrangements) considered necessary for a
fair presentation have been included. Operating results for the three and nine
month periods ended September 30, 2004, are not necessarily indicative of the
results that may be expected for the year ended December 31, 2004.
These financial statements should be read in conjunction with our audited
consolidated financial statements and notes thereto included in our 2003 annual
report on Form 10-K filed by us with the Securities and Exchange Commission on
March 30, 2004.
NOTE 2 - STOCK-BASED COMPENSATION
We apply the intrinsic value method under Accounting Principles Board
("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" and its
related interpretations, for options granted to employees and Board members. No
compensation expense is recognized because we award options at the fair market
value of the underlying common stock on the date of grant. For options and
warrants to non-employees, we apply Statement of Financial Accounting Standards
No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), and
accordingly, recognize expense using a fair market value method.
The following table illustrates the effect on net earnings (loss) and net
earnings (loss) per share if we had applied the fair value recognition
provisions of SFAS 123, as amended by Statement of Financial Accounting
Standards No. 148, "Accounting for Stock-Based Compensation - Transition and
Disclosure - an amendment of FASB Statement No. 123" ("SFAS 148") to options
issued to employees and Board members (in thousands, except per share amounts):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- ---------------------
2004 2003 2004 2003
--------- --------- --------- ---------
Net earnings (loss), as reported $ 688 $ (590) $ 1,220 $ (1,862)
Deduct: Total stock-based employee
compensation expense
determined under the fair value-
based method for awards
granted, modified or settled,
net of related tax effects (837) (1,042) (2,489) (3,126)
--------- --------- --------- ---------
Pro forma net loss $ (149) $ (1,632) $ (1,269) $ (4,988)
========= ========= ========= =========
Net earnings (loss) per share
Basic - as reported $ 0.07 $ (0.06) $ 0.12 $ (0.17)
========= ========= ========= =========
Basic - pro forma $ (0.01) $ (0.16) $ (0.12) $ (0.47)
========= ========= ========= =========
Diluted - as reported $ 0.06 $ (0.06) $ 0.10 $ (0.17)
========= ========= ========= =========
Diluted - pro forma $ (0.01) $ (0.16) $ (0.12) $ (0.47)
========= ========= ========= =========
Page 6
NOTE 2 - STOCK-BASED COMPENSATION (CONTINUED)
The fair value of these stock options was estimated at the date of grant
using the Black-Scholes option-pricing model with the following weighted-average
assumptions:
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------
2004 2003
------ -------
Risk free interest rate 2.82% 3.28%
Dividend yield 0% 0%
Volatility factor .60 .85
Expected option term life in years 5.0 5.0
NOTE 3 - NET EARNINGS (LOSS) PER SHARE
We account for Earnings (Loss) Per Share under the rules of Statement of
Financial Accounting Standards No. 128, "Earnings Per Share." Our basic and
diluted net earnings (loss) per share amounts have been computed by dividing net
earnings (loss) by the weighted average number of common shares outstanding and
the dilutive effect of common shares potentially issuable upon the exercise of
stock options and warrants ("common share equivalents") during the period.
The computation of diluted net earnings per share for the nine months
ended September 30, 2004 includes approximately 1.4 million of common share
equivalents. Options and warrants to purchase approximately 3.4 million and 4.6
million shares of common stock with a weighted average exercise price of $8.59
and $10.31 were outstanding at September 30, 2004 and 2003, respectively, but
were excluded from the computation of diluted net earnings (loss) per share
because to do so would have been antidilutive for the periods presented.
NOTE 4 - SEGMENT FINANCIAL INFORMATION
We are organized into the two business segments of outsourcing and
consulting. The outsourcing segment includes a full range of flexible business
process and information technology solutions, including data center services,
24/7/365 network monitoring and help desk services, facility management, interim
management, and application outsourcing services. The consulting segment
provides information technology, as well as strategic and operations management
consulting and solutions, and application support to a broad cross-section of
healthcare industry participants and information systems vendors with particular
emphasis on hospitals, health systems, and other providers. We evaluate segment
performance and allocate resources based on gross profit. Intrasegment services
are provided at cost.
Page 7
NOTE 4 - SEGMENT FINANCIAL INFORMATION (CONTINUED)
The following is a summary of certain financial information by segment,
for the three and nine months ended September 30, 2004 and 2003 (in thousands).
Due to the nature of our business, the majority of the reimbursable
out-of-pocket expenses are incurred on consulting engagements.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- ---------------------
2004 2003 2004 2003
--------- --------- --------- ---------
Revenue
Consulting
Revenue before reimbursements (net revenue) $ 13,149 $ 13,244 $ 40,085 $ 40,953
Out-of-pocket reimbursements 1,875 1,698 5,245 5,348
--------- --------- --------- ---------
Total consulting revenue 15,024 14,942 45,330 46,301
Outsourcing
Revenue before reimbursements (net revenue) 14,558 9,345 39,101 26,413
Out-of-pocket reimbursements 55 174 264 399
--------- --------- --------- ---------
Total outsourcing revenue 14,613 9,519 39,365 26,812
--------- --------- --------- ---------
Consolidated revenue $ 29,637 $ 24,461 $ 84,695 $ 73,113
========= ========= ========= =========
Gross Profit and Statement of Operations Reconciliation
Consulting $ 5,125 $ 4,959 $ 15,493 $ 15,493
Outsourcing 1,851 1,288 5,005 3,081
--------- --------- --------- ---------
Consolidated gross profit 6,976 6,247 20,498 18,574
Unallocated
Selling, general and administrative expenses 6,037 6,493 18,004 19,863
Loss on sale of building - - 562 -
Other expense, net 251 344 712 573
--------- --------- --------- ---------
Subtotal 6,288 6,837 19,278 20,436
--------- --------- --------- ---------
Consolidated earnings (loss) before income
tax benefit $ 688 ($ 590) $ 1,220 ($ 1,862)
========= ========= ========= =========
Our reportable segments are business units that offer and provide
different services through different means. Our training, information
technology, accounting and finance, facilities, sales and marketing, human
resources, legal, senior management and other selling, general and
administrative ("SG&A") functions are combined into the unallocated SG&A
expenses.
NOTE 5 - INCOME TAXES
Income tax benefits have not been recorded on the losses we have
experienced in recent years, primarily due to the provision of a valuation
allowance for all net deferred tax assets as a result of the uncertainty
regarding their realization. Income tax expense is not recorded for the three
and nine months ended September 30, 2004, because our valuation allowance has
been decreased for the corresponding amount of tax expense that would otherwise
have been recognized. As of September 30, 2004, we have net operating and
capital loss carryforwards for federal income tax purposes of approximately
$55.9 million, the last of which will expire in 2023 if not utilized.
Page 8
NOTE 6 - LINE OF CREDIT
In May 2004, we extended our line of credit agreement with Fifth Third
Bank through May 2005. The new line of credit allows for borrowings up to $9.0
million, bears interest at 0.50% below the prime rate and is based on qualifying
accounts receivable and other operating metrics. Based on the eligibility
provisions and accounts receivable at September 30, 2004, we could have borrowed
the full amount of $9.0 million. At September 30, 2004, $4.4 million was
outstanding. The prime interest rate at September 30, 2004, was 4.75%. The line
is collateralized by accounts receivable, any deposits held by the bank,
equipment and other personalty. The loan agreement contains financial covenants,
including working capital and ratios concerning liquidity and debt coverage. We
were in compliance with all financial covenants as of September 30, 2004. We
have letters of credit outstanding of approximately $1.9 million issued by
various banks, of which, approximately $0.4 million is secured by bank deposits.
NOTE 7 - SENIOR SUBORDINATED DEBENTURES
In June and July 2003, we entered into an Agreement (the "Purchase
Agreement") whereby we agreed to issue Senior Subordinated Debentures (the
"Debentures") and Warrants (the "Warrants") to purchase 860,800 shares of our
$0.01 par value common stock (the "common stock"), in exchange for a cash
investment of $8.0 million from two investors. The unsecured Debentures mature
three years from the date of their issuance (the "Issuance Date"), with an
option to extend the term for one additional year at our sole option, subject to
certain conditions. Pursuant to the terms of the Debentures, we are required to
make quarterly interest payments at the rate of (i) 7.2% per annum until
repayment in full, and (ii) if we elect to extend the maturity date, 12% per
annum during the extension period. We are entitled, at any time, to make up to
three partial prepayments of the Debentures in the amount of at least 33% of the
total initial indebtedness, which if the Debentures are pre-paid in full, would
result in a reduction to the number of outstanding Warrants as provided for in
the Warrant Agreement. As of September 30, 2004 and December 31, 2003, $8.0
million was outstanding on the debt.
The Warrants to purchase up to 860,800 shares of our common stock have an
exercise price of $3.046 per share, subject to certain anti-dilution
adjustments. All Warrants were immediately available for exercise. The Warrants
expire during 2008, or, if earlier, two (2) years after the repayment of the
Debentures in full. In addition, Warrants may be cancelled as follows: in the
event of prepayment of the debentures in full prior to the second anniversary of
issuance, seventeen percent (17%) of the Warrants will be cancelled; or in the
event of prepayment of the debentures in full after the second anniversary of
issuance and before the third anniversary of issuance, a pro rata portion of
seventeen percent (17%) of the Warrants will be cancelled based on the number of
full months between the prepayment and the third anniversary of issuance.
In accordance with APB Opinion No. 14, "Accounting for Convertible Debt
and Debt Issued with Stock Purchase Warrants" we allocated the proceeds received
to the debt instruments and detachable warrants on a relative fair value basis.
An external valuation firm completed an independent valuation of the Warrants,
which resulted in $526,000 of proceeds allocated to the Warrants and "additional
paid-in capital", with the remaining $7,474,000 initially allocated to debt. The
$526,000 allocated to the value of the Warrants is treated as a debt discount
and is being amortized to interest expense over the initial term of the debt. As
of September 30, 2004 and December 31, 2003, the unamortized discount is
approximately $360,000 and $448,000, respectively.
We incurred investment banking and legal costs associated with these
transactions totaling approximately $520,000. The costs are being amortized to
interest expense over the initial term of the debt.
Under the Purchase Agreement, we agreed not to incur additional
indebtedness while the Debentures remain outstanding except for (a) capital
leases, purchase money indebtedness, mortgage debt, performance bonds and
similar instruments in the ordinary course of business, and (b) other
indebtedness for borrowed money not to exceed the greater of $8.0 million or ten
times EBITDA for the most recent quarter. As of the most recent quarter ended
September 30, 2004, the limit was approximately $23.0 million.
Page 9
NOTE 8 - LONG-TERM OBLIGATIONS
During 2003, we entered into an unsecured financing arrangement for $8.5
million for software and professional fees related to the implementation of a
new healthcare application platform for an existing outsourcing client. The
agreement provides for sixty monthly payments in the amount of $170,046,
including interest at an annual rate of 7.35%, commencing on February 1, 2003.
During the nine months ended September 30, 2004, we capitalized approximately
$0.5 million related to professional fees we incurred. As of September 30, 2004,
we have capitalized approximately $6.7 million related to software and
professional services we have received through that date. The liability
associated with the capitalized software and professional fees is $4.2 million
as of September 30, 2004. We currently anticipate the implementation project
should be completed during the first half of 2005 and we will continue to
capitalize the remaining $1.8 million of software and professional fees
throughout the project as those costs are incurred. During the nine months ended
September 30, 2004, we have also capitalized approximately $0.3 million of
interest related to the project.
NOTE 9 - RESTRUCTURINGS
In connection with our restructuring activities, we recorded restructuring
charges (recoveries) of approximately $3.3 million and $(193,000) during the
years ended December 31, 2002 and 2003, respectively. Refer to our audited
consolidated financial statements and notes thereto, on our Form 10-K filed on
March 30, 2004, for further details on the components of these charges.
During the three months ended March 31, 2004, we sublet office space that
was previously included in our restructuring estimate. As a result of subletting
the space for an amount less than our original estimate, we recorded a net
expense of $51,000.
A summary of the activity of the restructuring-related liabilities,
included in accounts payable and other long-term liabilities is as follows (in
thousands):
LIABILITIES AS OF 2004 2004 2004 CHANGE LIABILITIES AS OF
JANUARY 1, 2004 ADDITIONS PAYMENTS IN ESTIMATE SEPTEMBER 30, 2004
----------------- --------- -------- ----------- ------------------
Severance $ 4 $ - $ (4) $ - $ -
Future lease obligations 1,464 - (460) 51 1,055
----------------- --------- -------- ----------- ------------------
Total $ 1,468 $ - $ (464) $ 51 $ 1,055
================= ========= ======== =========== ==================
The obligation is payable as follows: $155,000 throughout the remainder of
2004, $497,000 during 2005, $235,000 during 2006 and $168,000 during 2007.
NOTE 10 - LOSS ON SALE OF BUILDING
During the second quarter of 2004, we completed the sale of an office
building. The net sale price was approximately $1.7 million, and we recorded a
non-cash charge of $562,000 to reflect the difference between the net sale price
and the net book value of the building.
NOTE 11 - CONTINGENCIES
We are involved in various legal proceedings, including business and
employment matters of a nature considered normal to our operations. We accrue
for amounts related to these legal matters if it is probable that a liability
has been incurred and an amount is reasonably estimable. In our opinion,
although the outcome of any legal proceeding cannot be predicted with certainty,
our ultimate liability in connection with our current legal proceedings will not
have a material adverse effect on our financial position or results of
operations.
NOTE 12 - RELATED PARTY TRANSACTION
During the quarter ended March 31, 2004, we acquired approximately 41,000
shares of common stock for treasury from an officer at a cost of approximately
$179,000.
Page 10
NOTE 13 - RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In January 2003, the FASB issued FASB Interpretation No. 46 ("FIN 46"),
"Consolidation of Variable Interest Entities." The objective of this
interpretation is to provide guidance on how to identify a variable interest
entity ("VIE") and determine when the assets, liabilities, non-controlling
interests and results of operations of a VIE need to be included in a company's
consolidated financial statements. A company that holds variable interests in an
entity will need to consolidate the entity if the company's interest in the VIE
is such that the company will absorb a majority of the VIE's expected losses
and/or receive a majority of the VIE's expected residual returns, if they occur.
FIN 46 also requires additional disclosures by primary beneficiaries and other
significant variable interest holders. The provisions of this interpretation
applied to the quarter ending March 31, 2004 to VIEs in which a company holds a
variable interest that it acquired before February 1, 2003. The adoption of FIN
46 had no impact on our consolidated financial statements.
In December 2003, the FASB issued FASB Interpretation No. 46R ("FIN46R"),
a revision to FIN 46. FIN46R clarifies some of the provisions of FIN 46 and
exempts certain entities from its requirements. FIN46R is effective at the end
of the first interim period ending after March 15, 2004. Entities that have
adopted FIN 46 prior to this effective date can continue to apply the provisions
of FIN 46 until the effective date of FIN46R or elect early adoption of FIN46R.
The adoption of FIN46R had no impact on our consolidated financial statements.
In March 2004, the FASB's Emerging Issues Task Force approved the
consensus reached on Issue No. 03-1 ("EITF 03-01"), "The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments." The
objective of this consensus is to provide guidance for identifying impaired
investments. EITF 03-1 also provides new disclosure requirements for investments
that are deemed to be temporarily impaired. Originally, the accounting
provisions of EITF 03-1 were effective for all reporting periods beginning after
June 15, 2004, while the disclosure requirements are effective only for annual
periods ending after June 15, 2004. In September 2004, the FASB issued two Staff
Positions (FSP), FSP EITF 03-1-a and FSP EITF 03-1-1, which delayed the
measurement and recognition paragraphs of the consensus for further discussion.
The disclosure requirements remain effective as originally issued under EITF
03-1. We have evaluated the impact of the adoption of EITF 03-1, as written, and
believe it will have no impact on our consolidated financial statements.
On March 31, 2004, the FASB issued a proposed Statement, Share-Based
Payment an Amendment of FASB Statements No. 123 and APB No. 95, that addresses
the accounting for share-based payment transactions in which an enterprise
receives employee services in exchange for (a) equity instruments of the
enterprise or (b) liabilities that are based on the fair value of the
enterprise's equity instruments or that may be settled by the issuance of such
equity instruments. Under the FASB's proposal, all forms of share-based payments
to employees, including employee stock options, would be treated the same as
other forms of compensation by recognizing the related cost in the income
statement. The expense of the award would generally be measured at fair value at
the grant date. Current accounting guidance requires that the expense relating
to so-called fixed plan employee stock options only be disclosed in the
footnotes to the financial statements. The proposed Statement would eliminate
the ability to account for share-based compensation transactions using APB
Opinion No. 25, Accounting for Stock Issued to Employees. We have not assessed
the impact of the proposed statement on our consolidated financial statements.
Page 11
ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
Statements included in Management's Discussion and Analysis of Financial
Condition and Results of Operations, which are not historical in nature, are
intended to be, and are hereby identified as "forward-looking statements" for
purposes of the safe harbor provided by Section 21E of the Securities Exchange
Act of 1934, as amended by Public Law 104-67. Forward-looking statements may be
identified by words including, but not limited to: "anticipate," "believe,"
"intends," "estimates," "promises," "expect," "should," "conditioned upon" and
similar expressions. This release contains forward-looking statements relating
to future financial results or business expectations. Business plans may change
as circumstances warrant. Actual results may differ materially as a result of
factors and events which the company is unable to accurately predict or over
which the company has no control. Such factors include, but are not limited to:
the award or loss of significant client assignments, timing of contracts,
recruiting and new business solicitation efforts, the healthcare market's
acceptance of and demand for the company's offerings, demands upon and
consumption of the company's cash and cash equivalent resources or changes in
the company's access to working capital, regulatory changes and other factors
affecting the financial constraints on the company's clients, competitive
pressures (both domestic and foreign), including competition for business and
for personnel, the ability to successfully manage currency risk, obtain foreign
work permits and otherwise successfully execute and manage international
contracts, economic factors specific to healthcare, general economic conditions,
unforeseen disruptions in transportation, communications or other infrastructure
components, acquisitions under consideration and the ability to integrate
acquisitions on a timely basis. Additional information regarding these risk
factors and others, and additional information concerning the company are
included in the company's reports on file with the Securities and Exchange
Commission.
We are organized into the two business segments of outsourcing and
consulting. The outsourcing segment helps healthcare providers simplify their
management agendas, improve their return on information systems investments and
strengthen their technology management by taking on responsibility for managing
and operating all or part of the client's IT function. We deploy specialized
resources to deliver higher quality IT functionality and help clients avoid or
reduce certain capital expenses. The outsourcing segment offers the client an
array of services, functions and economic elements that can be tailored to the
specific client agenda, including business process management, IT management, IT
planning and budgeting, applications support, applications implementation, IT
operations, data center consolidation in our processing center, 24/7/365 network
monitoring and help desk in our network control center, financial management and
risk sharing, facility management, application unification, application
outsourcing and interim management. The consulting segment provides information
technology, as well as strategic and operations management consulting and
solutions, and application support to a broad cross-section of healthcare
industry participants and information systems vendors. The consulting segment
also provides tools, strategies and solutions designed to transform clinical
operations and improve patient safety, enhance financial performance, and
promote secure and private Health Insurance Portability and Accountability Act
("HIPAA") compliant transactions.
In recent years, we have expanded our outsourcing and solution sales
capabilities. As healthcare and other sectors implement web-based technologies
and applications, we may incur risks related to participation in such
opportunities, markets and quickly evolving lines of business. Such risks can
include, but are not limited to: new and unforeseen technologies superseding
development of web-based applications and/or the systems integration platforms
and other technologies in which we have invested; increased competition in the
outsourcing business from larger and better capitalized competitors who may also
enjoy better name recognition and other competitive advantages; the growth of
foreign competition from markets with lower cost structures; failure by us to
develop and offer new services and solutions demanded by the market; failure of
our services and solutions to generate sufficient demand in the market;
potential government regulation of the Internet or of other activities that
affect our business; slowness of traditional healthcare clients to adopt new
technologies; and increased competition for consultant talent, increasing our
cost of providing services.
We derive substantially all of our revenue from fees for professional
services. We establish standard-billing guidelines based on the type and level
of service offered. Actual billing rates are established on a project-by-project
basis and may vary from the standard guidelines. Billings for time and materials
engagements are generally contracted to be made on a bi-weekly basis to monitor
client satisfaction and manage outstanding accounts receivable balances. Revenue
on time and materials contracts is recognized as the services are provided.
Fixed-fee projects, pre-packaged solution sales and outsourcing contracts are
billed by deliverable or on a periodic basis, typically monthly. We generally
recognize revenue on fixed-fee projects and pre-packaged solution sales based on
progress toward project milestones. Revenue on outsourcing contracts is
generally recognized ratably over annual periods within our multi-year
contracts. In addition, our outsourcing contracts may have incentives based on
performance metrics. Such incentive revenue is recognized once we are
Page 12
reasonably certain that it has been earned and will be paid. As of September 30,
2004, we have eight significant contracts to provide healthcare IT outsourcing
services. We also provide help desk and call center support, which are typically
billable on a per seat per month basis. On occasion, we may collect payment
prior to providing services. These payments are recorded as deferred revenue and
reflected as a liability on our consolidated balance sheet.
There can be no assurance that we will be able to achieve profit margins
on existing and new contracts that are consistent with our historical levels of
profitability. In addition, profit margins on outsourcing and support contracts
are generally lower than profit margins on traditional consulting engagements.
Increased use of fixed-fee contracts subjects us to increased risks, including
cost overruns. Moreover, we incur significant expense in the process of seeking,
developing and negotiating large fixed-fee contracts, such as outsourcing
contracts. In addition, the implementation of certain outsourcing contracts, as
well as large consulting engagements, requires significant initial investment by
us in the hiring of personnel and, in the case of outsourcing contracts, the
acquisition of software applications and equipment to perform the contract. Such
expenses are expected to be recovered over the life of the agreement. Some of
our agreements call for penalties, risk-sharing, or allow for early termination
in the event we fail to meet certain service levels. If we fail to meet required
performance standards in our outsourcing, or other engagements, we could incur
contractual penalties, or the agreements could terminate before we are able to
recover the investments we made in the pursuit and initiation of the engagement.
In either event, we could suffer adverse financial consequences, as well as
damage to our reputation in the industry, which could adversely and materially
affect our business, financial condition, results of operations and the price of
our common stock.
With the addition of new outsourcing contracts, we may require additional
capital for the acquisition of hardware and software with which to perform the
contracts. If our capital resources or access to capital is restricted, we may
be unable to pursue or complete new outsourcing contracts, which could adversely
and materially affect our business, financial condition, results of operations
and the price of our common stock.
We seek to increase revenue through various means, including an increased
emphasis on outsourcing contracts, an increase in the value and duration of
projects for existing and new clients, as well as continued additions to our
recurring revenue base. In addition, we seek to increase revenue by expanding
our range of specialty services with a focus on opportunities arising from the
demand for clinical quality and patient safety, financial improvement, digital
communications and system security and privacy. We manage our consulting client
development efforts through our internal Client Partner Organizations ("CPO")
having specific geographic responsibility and focus. Within a geographical area,
our CPO members develop relationships and pursue opportunities with strategic
clients, maintain relationships with various stakeholders (buyers, suppliers and
advisors) and develop other business opportunities. In addition, we have a
separate sales force focused entirely on outsourcing opportunities. Once an
opportunity has been identified, individual sales members, along with executive
oversight, are responsible for developing, responding to, and tracking the
opportunity through completion. Our success in increasing our revenue will be
dependent upon, among other factors, timely sales, the type, range and quality
of our services and solutions, competitive prices, growth and improvement in
proposal acceptance rates in outsourcing and consulting and successful
competition in the marketplace. Pursuit of significant contracts is becoming
increasingly competitive, and the process surrounding client decisions has
become more deliberate, rigorous, and protracted. Many of the entities with whom
we compete have greater name recognition and financial resources, larger
customer bases and greater technical and sales and marketing resources, which
may adversely impact our ability to compete against them successfully. In
addition, our revenue has and can be adversely affected by unforeseen
disruptions in transportation, communications or other infrastructure
components. Should we be unsuccessful in increasing or sustaining our revenue,
for these or for other reasons, we may fail to meet the public market's
expectations of our financial performance and operating results, which could
have a material adverse effect on our common stock price.
Our most significant expense is cost of services, which consists primarily
of consultant compensation expense and operating costs associated with our full
outsourcing contracts.
Historically, consultant compensation expense has grown faster than
consultant billing rates. We have sought to address the consultant compensation
issue by adding a variable portion of compensation payable upon the achievement
of measurable performance goals. In addition, we have sought to address
compensation expense pressures through increased use of stock options as an
overall part of our compensation package. These efforts have been hampered in
the past by the impact of our stock price and could be affected in the future
depending upon market conditions. The market in which we compete for our
talented and highly skilled consultant work force is highly competitive. Many of
the entities with whom we compete for employees have greater financial and other
resources than we do, and may be able to offer more attractive compensation
packages to candidates than we can, including salary, benefits, stock and stock
options. Our ability to successfully operate our business and compete in our
market is dependent upon our ability to recruit and retain skilled and motivated
sales, management, administrative and technical personnel. If we are unable to
Page 13
recruit and retain consultants to perform new and existing client engagements,
our reputation in the industry and our ability to generate revenue will both
suffer, which could have a material adverse effect on our business, financial
condition and on the price of our common stock. Moreover, our consultants are
often key to our client relationships. Loss of key consultants could impair
client relationships and adversely affect our ability to gain recurring
engagements, which could adversely affect our financial condition.
Our operating costs associated with the full outsourcing contracts have
and will continue to increase as additional clients are serviced. Additionally,
as we continue to migrate clients to the processing center, we expect to incur
incremental costs, which will be offset with anticipated savings over time as
additional clients are added and we are able to leverage our investment. These
costs consist primarily of, but are not limited to: equipment lease costs,
depreciation, telecommunication and facility related expenditures. We expect to
recover our investment in our processing and network management centers through
the performance of multiple outsourcing contracts and network management
("NetLinc") contracts utilizing processing center resources. If we are
unsuccessful in winning sufficient new outsourcing and NetLinc contracts, or if
the terms of outsourcing or NetLinc contracts are not sufficiently favorable to
us, or if any of the existing outsourcing or NetLinc contracts were to be
terminated early for any reason, our ability to recover our processing center
investments would be impaired, which could have a material adverse effect on our
financial condition. In addition, we will be performing data processing and
other client information systems functions through our processing centers. Any
failure by us to successfully perform our processing center functions could
adversely affect our clients' operations, which could result in contractual
performance penalties to us, early termination of one or more contracts,
potential legal liabilities and damage to our reputation in the industry, any or
all of which could have a material adverse effect on our financial condition,
results of operations and the price of our common stock.
Our net cost of services as a percentage of net revenue is primarily
driven by how efficiently we utilize our consultant resources and deliver our
consulting and outsourcing services and solutions. We attempt to optimize
efficient deployment of our consultants through initial engagement planning and
by continuously monitoring project requirements, timetables and service and
solution deliveries. The number of consultants assigned to a project will vary
according to the type, size, complexity, duration and demands of the project.
Project terminations, completions and scheduling delays and incremental costs
associated with the full outsourcing contracts and new service offerings have
and can continue to cause us to experience lower gross margins.
In addition, our establishment of new services and market offerings and
hiring of consultants in peak hiring periods have and can from time to time
adversely affect margins. Also, seasonal factors, such as vacation days,
holidays and total business days in a quarter have and can affect margins.
Further, our consulting segment has historically experienced seasonality
especially with respect to revenue in the second half of our calendar year. This
has and can result in variability in this segment's quarterly revenue.
Variations in services and market offering solution sales, longer outsourcing
sales cycles, uneven deployment of resources and failure to secure large
engagements can also result in quarterly variability of our net cost of services
as a percentage of net revenue. Our consultants are generally employed on a
full-time basis and therefore we will, in the short run, incur substantially all
of our employee-related costs even during periods of low utilization, as the
majority of employment costs of these personnel are fixed. In addition, we have
and may from time to time discontinue service offerings that have not been
successful in the market. Exiting a service offering can result in lower
margins, as there may not be immediate opportunities for the reassignment of
personnel, or there may be costs associated with the separation of personnel
from us. In addition, as we have responded to the diminishing demand for certain
of our consulting services by contracting operations and reducing costs, we have
and may again incur costs associated with business contractions, and may also
lose the ability to recover investments made in personnel, equipment, office
space and other assets associated with the service lines that are reduced or
eliminated. In the event that we close office space, there can be no assurance
that we will be able to sublease that space, or that sublease rents will offset
our obligations under our prime lease(s). In addition, there can be no assurance
that existing sublessees under our leases will not default in their rent or
other obligations. Default by our sublessees, or an inability by us to sublease
excess office space could have an adverse effect on our financial condition.
Further, if we close office space and consolidate or relocate our operations we
could experience some business disruption, as well as additional costs
associated with such changes.
During 2004, we have signed contracts to perform consulting services in
Europe. There is no assurance that we will be successful in our efforts to win
additional work overseas. In addition, there is no assurance that we will be
successful in our efforts to manage the risk of currency fluctuations, or to
obtain foreign work permits to allow our employees to perform the services. If
we are not successful in our efforts to manage these and other risks associated
with international business, it could have an adverse effect on our financial
condition, results of operations, and the price of our common stock.
Page 14
In recent years the healthcare industry has experienced a slow-down in
consulting expenditures as fiscal constraints imposed by federal, state and
commercial/private payers, have dampened overall industry demand for new IT
service consulting projects. Some of these forces and others have continued to
hamper demand for certain types of our services. Furthermore, changes in
federal, state and commercial/private payer reimbursement may continue to
adversely affect the financial stability and viability of our clients and may
impact their ability to contract for and pay for professional services such as
those offered by us. We record a provision for estimated uncollectible amounts
based on a number of factors, including the length of time trade accounts
receivable are past due, our previous loss history, the customer's current
ability to pay its obligation to us, and the condition of the general economy
and the industry as a whole. On occasion, we may collect a receivable that was
previously written off. In that instance, we make an adjustment to our allowance
for uncollectible amounts through bad debt recovery.
During 2001, the events of September 11 and resulting disruptions in air
travel adversely affected our business. In addition, the aftermath of September
11, including increased federal spending on defense, homeland security and the
Iraq War, as well as federal and/or state tax cuts, could adversely affect the
federal and state governments' spending on Medicare, Medicaid and other
healthcare initiatives. In addition, state budget deficits could adversely
affect our clients' revenues and cause them to defer or cancel projects that
would create demand for our services. In addition, our consultants often perform
services at the client's site, away from their own city or state of residence.
We are, therefore, highly dependent upon effective air travel and other means of
transportation for the performance of a majority of our client engagements. If,
as a result of terrorist attacks, conflicts in the Middle East and other
unsettling world events, air travel and other means of transportation become
increasingly costly, time consuming, limited or unreliable, or should our
employees become reluctant to travel, it could harm our ability to timely and
cost effectively perform our client engagements, which could have a material
adverse effect on our financial condition and results of operations.
Selling, general and administrative expenses include the costs of
recruiting, training and re-training, continuing education, technology, sales
and marketing, facilities, administration, corporate insurance expense, outside
professional fees and depreciation.
In November 2001, the Financial Accounting Standards Board issued Staff
Announcement Topic No. D-103, "Income Statement Characterization of
Reimbursements Received for Out-of-Pocket Expenses Incurred," which states that
reimbursements received for out-of-pocket expenses should be characterized as
revenue in the income statement. We will continue to use net revenue (revenue
before out-of-pocket reimbursements) and net cost of services (cost of services
before out-of-pocket reimbursements) to compute percentage and margin
calculations, as well as for purposes of comparing the results of operations for
the three and nine months ended September 30, 2004, to the three and nine months
ended September 30, 2003. We believe excluding out-of-pocket reimbursements,
although a non-GAAP financial measure, provides investors a better comparison
from period to period by removing the impact of fluctuations in out-of-pocket
reimbursements that do not reflect on operating performance.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of consolidated financial statements and related
disclosures in conformity with accounting principles generally accepted in the
United States of America, requires us to make judgments, assumptions and
estimates that affect the amounts reported in our consolidated financial
statements and the accompanying notes to consolidated financial statements. Our
estimates are based on prior experience, current business and market conditions,
as well as various other assumptions we believe are necessary to form a basis
for making judgments related to the reported amounts of assets and liabilities
and disclosure of contingent assets and liabilities at the date of the
consolidated financial statements and the reported amounts of revenue and
expenses during the reporting period. Actual results could differ from these
estimates. Refer to our audited consolidated financial statements and notes
thereto for the year ended December 31, 2003 for information regarding our
critical accounting policies. There have been no changes in these policies
during the current quarter.
Page 15
THREE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2003
Net Revenue.
Consulting. Net revenue in this segment remained consistent at $13.1
million for the three months ended September 30, 2004 as compared to net revenue
of $13.2 million for the three months ended September 30, 2003.
Outsourcing. Net revenue in this segment increased by $5.2 million, or
55.8%, to $14.6 million for the three months ended September 30, 2004, as
compared to $9.4 million for the three months ended September 30, 2003. The
revenue increase was primarily the result of the signing of three new full
outsourcing contracts subsequent to September 30, 2003.
Net Cost of Services.
Consulting. Net cost of services in this segment decreased by $0.3, or
3.2% to $8.0 million for the three months ended September 30, 2004, as compared
to $8.3 million for the three months ended September 30, 2003. The decrease was
due primarily to the redeployment of personnel to perform similar services
within the outsourcing segment. Net cost of services as a percentage of net
revenue for this segment was 61.0% for the three months ended September 30,
2004, as compared to 62.6% for the three months ended September 30, 2003. The
decrease was primarily due to the redeployment of personnel to perform similar
services within the outsourcing segment.
Outsourcing. Net cost of services in this segment increased by $4.7
million, or 57.7%, to $12.7 million for the three months ended September 30,
2004, as compared to $8.0 million for the three months ended September 30, 2003.
The increase was primarily due to the costs incurred as the result of the
signing of three new outsourcing contracts subsequent to September 30, 2003. Net
cost of services as a percentage of net revenue for this segment increased to
87.3% for the three months ended September 30, 2004, as compared to 86.2% for
the three months ended September 30, 2003. The increase was primarily due to the
costs incurred as the result of the signing of three new outsourcing contracts
subsequent to September 30, 2003.
Selling, general and administrative expenses. Selling, general and
administrative expenses decreased by $0.5 million, or 7.0%, to $6.0 million for
the three months ended September 30, 2004, as compared to $6.5 million for the
three months ended September 30, 2003. The decrease was primarily attributable
to reductions in: personnel and related costs, facility expenditures, technology
related costs and bad debt expense. Selling, general and administrative expenses
as a percentage of net revenue decreased to 21.8% for the three months ended
September 30, 2004, as compared to 28.7% for the three months ended September
30, 2003. The decrease was primarily attributable to: an increased revenue base,
reductions in personnel and related costs, bad debt expense and increased
operating efficiencies as a result of our disciplined cost controls.
Other income and expense. Other expense was $251,000 for the three months
ended September 30, 2004, as compared to $344,000 for the three months ended
September 30, 2003. The change was primarily the result of lower interest
expense which includes the amortization of the costs and warrant value
associated with our senior subordinated debentures.
Page 16
NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
2003
Net Revenue.
Consulting. Net revenue in this segment decreased by $0.9 million or 2.1%,
to $40.1 million for the nine months ended September 30, 2004, as compared to
$41.0 million for the nine months ended September 30, 2003. The revenue decrease
was primarily the result of an increase in the amount of consulting services
delivered as part of our outsourcing contracts.
Outsourcing. Net revenue in this segment increased by $12.7 million, or
48.0%, to $39.1 million for the nine months ended September 30, 2004, as
compared to $26.4 million for the nine months ended September 30, 2003. The
revenue increase was primarily the result of the signing of three new full
outsourcing contracts subsequent to September 30, 2003.
Net Cost of Services.
Consulting. Net cost of services in this segment decreased by $0.9
million, or 3.4% to $24.6 million for the nine months ended September 30, 2004,
as compared to $25.5 million for the nine months ended September 30, 2003. The
decrease was due primarily to the redeployment of personnel to perform similar
services within the outsourcing segment. Net cost of services as a percentage of
net revenue for this segment remained consistent at 61.3% for the nine months
ended September 30, 2004, as compared to 62.2% for the nine months ended
September 30, 2003.
Outsourcing. Net cost of services in this segment increased by $10.8
million, or 46.1%, to $34.1 million for the nine months ended September 30,
2004, as compared to $23.3 million for the nine months ended September 30, 2003.
The increase was primarily due to the costs incurred as the result of the
signing of three new outsourcing contracts subsequent to September 30, 2003,
partially offset by efficiencies gained on other contracts and at our processing
centers. Net cost of services as a percentage of net revenue for this segment
decreased to 87.2% for the nine months ended September 30, 2004, as compared to
88.3% for the nine months ended September 30, 2003. The decrease was primarily
due to increased revenue and efficiencies gained on other contracts and at our
processing centers.
Selling, general and administrative expenses. Selling, general and
administrative expenses decreased by $1.9 million, or 9.4%, to $18.0 million for
the nine months ended September 30, 2004, as compared to $19.9 million for the
nine months ended September 30, 2003. The decrease was primarily attributable to
reductions in: personnel and related costs, facility expenditures, technology
related costs and bad debt expense. Selling, general and administrative expenses
as a percentage of net revenue decreased to 22.7% for the nine months ended
September 30, 2004, as compared to 29.5% for the nine months ended September 30,
2003. The decrease was primarily attributable to: an increased revenue base,
reductions in personnel and related costs, bad debt expense and increased
operating efficiencies as a result of our disciplined cost controls.
Loss on sale of building. During the second quarter of 2004, we completed
the sale of an office building. The net sale price was approximately $1.7
million, and we recorded a non-cash charge of $562,000 to reflect the difference
between the net sale price and the net book value of the building.
Other income and expense. Other expense was $712,000 for the nine months
ended September 30, 2004, as compared to $573,000 for the nine months ended
September 30, 2003. The change was primarily the result of increased interest
expense incurred on our long-term obligations, including the amortization of the
costs and warrant value associated with our senior subordinated debentures which
were issued in September and July 2003.
Page 17
LIQUIDITY AND CAPITAL RESOURCES
In connection with our restructuring activities, we recorded restructuring
charges of approximately $3.3 million during the year ended December 31, 2002.
These charges consisted primarily of costs associated with the termination of a
business alliance, which included the accelerated expense associated with a
certain lease obligation and the write-off of leasehold improvements and
capitalized software development costs. The restructuring charges also included
severance costs related to our organizational restructuring and the write-off of
property and equipment, partially offset by a reduction to the 2001 accrual for
restructuring costs. During the year ended December 31, 2003, we recorded
restructuring recoveries of approximately $193,000, which consisted primarily of
a reduction to the 2002 accrual for future lease obligations, partially offset
by severance costs related to our organizational restructuring. During the nine
months ended September 30, 2004, we had cash outflows associated with these
restructuring items of approximately $464,000, of which approximately $460,000
related to certain lease obligations, which were accrued for as of December 31,
2003, and approximately $4,000 related to severance costs, which were accrued
for as of December 31, 2003. During the three months ended March 31, 2004, we
sublet office space that had been previously included in our restructuring
estimate. As a result of subletting the space for an amount less than our
original estimate, we recorded a net expense of $51,000. The current accrued
liability for additional cash outflows, related to certain lease obligations, is
approximately $1.1 million and is anticipated to be payable as follows: $155,000
during the remainder of 2004, $497,000 during 2005, $235,000 during 2006 and
$168,000 during 2007.
During 2003, we entered into an unsecured financing arrangement for $8.5
million for software and professional fees related to the implementation of a
new healthcare application platform for an existing outsourcing client. The
agreement provides for sixty monthly payments in the amount of $170,046,
including interest at an annual rate of 7.35%, commencing on February 1, 2003.
During the nine months ended September 30, 2004, we capitalized approximately
$0.5 million related to professional fees we incurred. As of September 30, 2004,
we have capitalized approximately $6.7 million related to software and
professional services we have received through that date. The liability
associated with the capitalized software and professional fees is $4.2 million
as of September 30, 2004. We currently anticipate the implementation project
should be completed during the first half of 2005 and we will continue to
capitalize the remaining $1.8 million of software and professional fees
throughout the project as those costs are incurred. During the nine months ended
September 30, 2004, we have also capitalized approximately $0.3 million of
interest related to the project.
In May 2004, we extended our line of credit agreement with Fifth Third
Bank through May 2005. The new line of credit allows for borrowings up to $9.0
million, bears interest at 0.50% below the prime rate and is based on qualifying
accounts receivable and other operating metrics. Based on the eligibility
provisions and accounts receivable at September 30, 2004, we could have borrowed
the entire amount of $9.0 million. At September 30, 2004, $4.4 million was
outstanding. The prime interest rate at September 30, 2004, was 4.75%. The line
is collateralized by accounts receivable, any deposits held by the bank,
equipment and other personalty. The loan agreement contains financial covenants,
including working capital and ratios concerning liquidity and debt coverage. We
were in compliance with all financial covenants as of September 30, 2004. We
have letters of credit outstanding of approximately $1.9 million issued by
various banks, of which, approximately $0.4 million is secured by bank deposits.
In addition, we have secured $16.0 million in financing for recent and future
capital expenditures associated with new outsourcing contracts and for general
capital requirements.
In June and July 2003, we agreed to issue Senior Subordinated Debentures
(the "Debentures") and warrants (the "Warrants") to purchase 860,800 shares of
our $0.01 par value common stock (the "common stock"), in exchange for a cash
investment of $8.0 million from investors pursuant to the Securities Purchase
Agreement dated as of September 9, 2003, by and between us and the Purchasers
thereto (the "Purchase Agreement"). The unsecured Debentures have an initial
maturity date of September 9, 2006, with an option to extend the term for one
additional year to September 9, 2007, at our sole option, subject to certain
conditions. Pursuant to the terms of the Debentures, we are required to make
quarterly interest payments at the rate of (i) 7.2% per annum commencing on July
1, 2003, until repayment in full, and (ii) if we elect to extend the maturity
date, 12% per annum from September 9, 2006 through September 9, 2007. We are
entitled, at any time, to make up to three partial prepayments of the Debentures
in the amount of at least 33% of the total initial indebtedness, which if the
Debentures are pre-paid in full, would result in a reduction to the number of
outstanding Warrants as provided for in the Warrant Agreement. As of September
30, 2004, $8.0 million was outstanding on the debt.
Page 18
Under the Purchase Agreement, we agreed not to incur additional
indebtedness while the Debentures remain outstanding except for (a) capital
leases, purchase money indebtedness, mortgage debt, performance bonds and
similar instruments in the ordinary course of business, and (b) other
indebtedness for borrowed money not to exceed the greater of $8.0 million or ten
times EBITDA for the most recent quarter. As of the most recent quarter ended
September 30, 2004, the limit was approximately $23.0 million. Depending upon
the circumstances, these restrictions may make it difficult for us to make
acquisitions or grow our business and may restrict our access to needed capital.
Our Board of Directors approved the repurchase of up to 650,000 shares of
our common stock. As of September 30, 2004, we have repurchased approximately
469,000 shares of our common stock for approximately $3.8 million. During the
three months ended March 31, 2004, we repurchased approximately 41,000 shares of
our common stock from an officer for approximately $179,000.
Our primary capital needs relate to the initial costs associated with new
outsourcing contracts, continuing costs associated with projects for ongoing
outsourcing contracts, and to fund outsourcing and solution sales initiatives.
We believe after giving effect to the restructuring plan, and assuming
appropriate cost control initiatives and revenue consistent with recent levels,
that our current cash and cash equivalents, cash generated from operations,
funds received from the prior private placement of senior subordinated
debentures, plus available credit under our current and/or anticipated credit
agreements with our lenders, will be sufficient to finance our working capital
and capital expenditure requirements for at least the next twelve months. The
nature, amount and timing of our long-term capital needs can be affected by a
number of factors. For example, our strategic plan includes a heightened focus
on the development of our outsourcing business and the securing of large
contracts. Implementation of a new outsourcing contract has and can involve the
need for capital investment by us, including the hiring of new personnel and the
acquisition of a client's IT assets, including hardware and software. An
additional element of our outsourcing business strategy includes offering data
center consolidation to our clients, which has and will continue to require
investment by us in data or processing center hardware and software as we sign
additional contracts. Additional infrastructure costs are anticipated to be
minimal for the next several years as we have capacity for additional clients in
our current processing centers. The timing, number and scale of potential future
outsourcing contracts can impact our need for capital resources. In addition,
our future long-term capital needs will be affected by the nature and timing of
our market and service offerings, in addition to outsourcing, and the degree and
timing of success enjoyed by such offerings in the market. A failure of our
offerings to meet success in the market, and our inability to adjust our
operating expenses to an appropriate level commensurate with our revenue, can
also affect our need for capital resources. For all of these reasons and those
identified in the other risk factors discussed herein, our ability to project
long-term revenue levels and capital needs is subject to substantial
uncertainty.
If our available funds and cash generated from operations are insufficient
to satisfy our long-term liquidity requirements, or if we do not obtain other
expected credit agreements, or if an event of default occurs under our current
and/or anticipated credit agreements with our lenders and we are required to
repay all outstanding indebtedness under the credit agreements, we may need to
seek additional sources of funding, such as selling additional equity or debt
securities or obtaining additional lines of credit. We could also, in such
event, face the need to delay or reduce the development of services or the
pursuit of contracts that would require significant investment to complete. We
could also face the need to reduce staffing levels and related expenses or
potentially to liquidate certain assets.
If we decide that it is in our best interest to continue to raise cash to
strengthen our balance sheet, broaden our investor base, increase the liquidity
of our pool of publicly traded stock or for any other reason, we may decide to
issue additional equity or debt, notwithstanding that our currently available
funds are sufficient to meet our anticipated needs for working capital and
capital expenditures through the next twelve months. We may decide to continue
entering into such transactions to raise cash even if all of our current funding
sources remain available to us. If we issue additional securities to raise
funds, those securities may have rights, preferences, or privileges senior to
those of our common stock and our stockholders may experience dilution. We
cannot be certain that additional financing will be available to us on favorable
terms when required, or at all. Our inability to obtain additional financing
when needed could impair our ability to develop products and services for the
market; to enter into or implement new outsourcing contracts; to implement our
business strategies; and may otherwise materially and adversely affect our
financial condition.
At September 30, 2004, we had cash and cash equivalents of $12.1 million
and working capital of $9.2 million, as compared with cash and cash equivalents
of $12.7 million and working capital of $11.1 million at December 31, 2003.
Page 19
Our net cash provided by operations increased to $5.1 million for the nine
months ended September 30, 2004, compared with $1.4 million for the nine months
ended September 30, 2003. The increase in net cash provided by operations was
due to our improved operating results partially offset by changes in our
operating assets and liabilities, during the nine months ended September 30,
2004, as compared to nine months ended September 30, 2003.
Net cash of $6.6 million used in investing activities during the nine
months ended September 30, 2004, consists of additions to property, equipment
and software, which primarily relate to our full service outsourcing contracts;
partially offset by proceeds of $1.7 million from the sale of a building.
Net cash of $1.0 million was provided by financing activities during the
nine months ended September 30, 2004, was primarily the result of proceeds from
our line of credit and cash received from stock option exercises; offset by
payments on our long-term obligations.
We do not believe that inflation has had a material effect on the results
of our operations.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to interest rate change market risk in connection with our
credit facility with our bank. The interest rate on this facility is tied to the
bank's prime rate, and changes in the variable rate will have an impact on our
interest expense. In the future, we will be exposed to foreign currency exchange
rate risk in connection with some of our engagements. We will seek to minimize
this risk through the use of forward contracts and other financial instruments
available to us.
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
As of the end of the most recent period covered by this report, our
management, under the supervision of our Chief Executive Officer and Chief
Financial Officer, carried out an evaluation of the effectiveness of the design
and operation of our disclosure controls and procedures pursuant to Rules 13a-14
and 15d-14 under the Securities Exchange Act of 1934 (the "Exchange Act"), as
amended. We do not expect that our disclosure controls and procedures will
prevent all errors and fraud. A control system, irrespective of how well it is
designed and operated, can only provide reasonable assurance, and cannot
guarantee, that it will succeed in its stated objectives. Based upon their
evaluation, our Chief Executive Officer and Chief Financial Officer concluded
that our disclosure controls and procedures are effective in alerting them
timely to material information required to be included in our Exchange Act
filings.
CHANGES IN INTERNAL CONTROLS
There were no significant changes in our internal controls or any other
factors that could significantly affect these controls subsequent to the date of
the evaluation referred to above.
Page 20
PART II - OTHER INFORMATION
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On July 27, 2004, we held our annual meeting of stockholders, at which our
stockholders voted in favor of the election of Reginald M. Ballantyne III and
John L. Silverman to our Board of Directors. Messrs. Ballantyne and Silverman
were each elected to serve a three-year term expiring at our 2007 Annual
Meeting. In the election of Mr. Ballantyne, 9,181,052 votes were cast in favor
and 0 votes were cast against. In addition, there were 177,508 abstentions and 0
broker non-voters. In the election of Mr. Silverman, 9,088,003 votes were cast
in favor and 0 votes were cast against. In addition, there were 270,557
abstentions and 0 broker non-voters. The remaining directors whose terms
continue until 2005 include Richard D. Helppie, Jr., Richard P. Saslow and
Ronald V. Aprahamian. The remaining directors whose terms continue until 2006
include Charles O. Bracken, Douglas S. Peters and Satish K. Tyagi.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
31.1 Certification by our Chief Executive Officer with respect to our Form 10-Q
for the quarterly period ended September 30, 2004, pursuant to Rule 13A-14
or 15D-14 of the Securities Exchange Act of 1934, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification by our Chief Financial Officer with respect to our Form 10-Q
for the quarterly period ended September 30, 2004, pursuant to Rule 13A-14
or 15D-14 of the Securities Exchange Act of 1934, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certifications by our Chief Executive Officer and Chief Financial Officer
with respect to our Form 10-Q for the quarterly period ended September 30,
2004, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K
On July 30, 2004, we furnished a Current Report on Form 8-K, dated July
29, 2004, under Item 2.02, "Results of Operations and Financial Condition"
and Item 9.01, "Financial Statements and Exhibits," attaching our July 29,
2004, press release announcing our financial results for the fiscal
quarter ended June 30, 2004.
Page 21
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Superior Consultant Holdings Corporation
Date: November 15, 2004 /s/ Richard D. Helppie, Jr.
---------------------------------------
Richard D. Helppie, Jr.
Chief Executive Officer
(Principal Executive Officer)
Date: November 15, 2004 /s/ Richard R. Sorensen
-------------------------------------
Richard R. Sorensen
Chief Financial Officer
(Principal Financial and Accounting Officer)
Page 22
EXHIBIT INDEX
EXHIBIT NO DESCRIPTION
31.1 Certification by our Chief Executive Officer with respect to our
Form 10-Q for the quarterly period ended September 30, 2004,
pursuant to Rule 13A-14 or 15D-14 of the Securities Exchange Act of
1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002.
31.2 Certification by our Chief Financial Officer with respect to our
Form 10-Q for the quarterly period ended September 30, 2004,
pursuant to Rule 13A-14 or 15D-14 of the Securities Exchange Act of
1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002.
32.1 Certifications by our Chief Executive Officer and Chief Financial
Officer with respect to our Form 10-Q for the quarterly period ended
September 30, 2004, pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.