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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended March 31, 2004
----------------
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
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Commission File No. 0-5265
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SCAN-OPTICS, INC.
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(Exact name of registrant as specified in its charter)
Delaware 06-0851857
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
169 Progress Drive, Manchester, CT 06040
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(Address of principal executive offices) Zip Code
(860) 645-7878
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(Registrant's telephone number, including area code)
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. ( X ) YES ( ) NO
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). ( ) YES ( X ) NO
The number of shares of common stock, $.02 par value, outstanding as of May 14,
2004 was 7,026,232.
1
SCAN-OPTICS, INC.
FORM 10-Q
I N D E X
PAGE
NO.
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements......................................................... 3
Item 2. Management's Discussion and Analysis of Consolidated Financial Condition
and Results of Operations.................................................. 14
Item 3. Quantitative and Qualitative Disclosures About Market Risk.................... 21
Item 4. Controls and Procedures....................................................... 21
PART II - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K............................................. 22
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements.
SCAN-OPTICS, INC., AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
March December
(thousands, except share data) 31, 2004 31, 2003
- -------------------------------------------------------------------------
(UNAUDITED)
Assets
Current Assets:
Cash and cash equivalents $ 2,420 $ 585
Accounts receivable less allowance of $1,202 at
March 31, 2004 and $1,206 at December 31, 2003 3,221 6,043
Unbilled receivables - contracts in progress 801 415
Inventories 6,825 7,282
Prepaid expenses and other 831 597
------------------
Total current assets 14,098 14,922
Plant and equipment:
Equipment 3,766 3,682
Leasehold improvements 4,010 4,010
Office furniture and fixtures 754 745
------------------
8,530 8,437
Less allowances for depreciation and amortization 7,536 7,422
------------------
994 1,015
Goodwill 9,040 9,040
Other assets 1,171 1,096
------------------
Total Assets $25,303 $26,073
===================
3
March December
(thousands, except share data) 31, 2004 31, 2003
- ----------------------------------------------------------------------------
(UNAUDITED)
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 2,732 $ 2,323
Salaries and wages 804 1,484
Taxes other than income taxes 614 758
Income taxes 226 189
Customer deposits 443 929
Deferred revenues 2,807 2,787
Other 1,236 1,495
----------------------
Total current liabilities 8,862 9,965
Notes payable 9,000 7,989
Other liabilities 1,897 1,876
Mandatory redeemable preferred stock, par value $.02
per share, authorized 3,800,000 shares;
3,800,000 issued and outstanding 3,800 3,800
Stockholders' Equity
Preferred stock, par value $.02 per share,
authorized 1,200,000 shares; none
issued or outstanding
Common stock, par value $.02 per share,
authorized 15,000,000 shares; issued, 7,439,732,
including treasury shares at March 31, 2004
and December 31, 2003 149 149
Common stock Class A Convertible, par
value $.02 per share, authorized 3,000,000
shares; available for issuance 2,145,536
shares; none issued or outstanding
Capital in excess of par value 38,354 38,354
Accumulated retained earnings deficit (33,282) (32,570)
Accumulated other comprehensive loss (831) (844)
----------------------
4,390 5,089
Less cost of common stock in treasury,
413,500 shares 2,646 2,646
----------------------
Total stockholders' equity 1,744 2,443
----------------------
Total Liabilities and Stockholders' Equity $ 25,303 $ 26,073
======================
See accompanying notes.
4
SCAN-OPTICS, INC., AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months Ended
March 31
(thousands, except share data) 2004 2003
- -----------------------------------------------------------------------
Revenues
Hardware and software $ 3,427 $ 4,222
Professional services 1,510 1,384
Access services 2,396 2,504
----------------------------
Total revenues 7,333 8,110
Costs of Revenue
Hardware and software 2,605 2,628
Professional services 879 768
Access services 2,332 2,131
----------------------------
Total costs of revenue 5,816 5,527
Gross Margin 1,517 2,583
Operating Expenses
Sales and marketing 690 928
Research and development 551 339
General and administrative 833 928
Interest 167 199
----------------------------
Total operating expenses 2,241 2,394
----------------------------
Operating income (loss) (724) 189
Other income, net 32 17
----------------------------
Income (loss) before income taxes (692) 206
Income tax expense 20 10
============================
Net Income (loss) $ (712) $ 196
============================
Basic earnings (loss) per share $ (.10) $ .03
============================
Basic weighted-average common shares 7,026,232 7,026,232
Diluted earnings (loss) per share $ (.10) $ .03
============================
Diluted weighted-average common shares 7,026,232 7,162,754
See accompanying notes
5
SCAN-OPTICS, INC., AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Three Months Ended
March 31
(thousands) 2004 2003
- --------------------------------------------------------------------------------
Operating Activities
Net Income (loss) $ (712) $ 196
Adjustments to reconcile net income (loss)
to net cash provided (used) by operating activities:
Depreciation 90 97
Amortization of customer service inventory and
development costs 429 491
Changes in operating assets and liabilities:
Accounts receivable and unbilled receivables 2,436 (1,476)
Inventories 62 20
Prepaid expenses and other (234) 33
Accounts payable 409 (14)
Accrued salaries and wages (680) 338
Taxes other than income taxes (144) (115)
Income taxes 37 8
Deferred revenues 20 107
Customer deposits (486) (100)
Other (337) 267
----------------------
Net cash provided (used) by operating activities 890 (148)
Investing Activities
Purchases of plant and equipment, net (66) (15)
----------------------
Net cash used by investing activities (66) (15)
Financing Activities
Proceeds from borrowings 3,211 1,700
Principal payments on borrowings (2,200) (1,150)
----------------------
Net cash provided (used) by financing activities 1,011 550
Increase in cash and cash equivalents 1,835 387
Cash and Cash Equivalents at Beginning of Period 585 274
----------------------
Cash and Cash Equivalents at End of Period $ 2,420 $ 661
======================
See accompanying notes
6
NOTE 1 - Basis of Presentation and Significant Accounting Policies
The accompanying unaudited interim consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the three month period ended March 31, 2004
are not necessarily indicative of the results that may be expected for the year
ending December 31, 2004. For further information, refer to the consolidated
financial statements and footnotes thereto included in the Company's Annual
Report on Form 10-K for the year ended December 31, 2003.
New Accounting Pronouncements
In May 2003, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150").
This statement establishes standards for classifying and measuring, as
liabilities, certain financial instruments that embody obligations of the issuer
and have characteristics of both liabilities and equity. SFAS 150 generally
requires liability classification for financial instruments, including
mandatorily redeemable equity instruments and other non-equity instruments
requiring, from inception, the repurchase by the issuer of its equity shares.
This statement is applicable to the Company as of the beginning of the first
interim financial reporting period beginning after June 15, 2003. The adoption
of this Statement did not have a significant effect on the Company's financial
position as of March 31, 2004 or on the results of operations for the
three-month period ending March 31, 2004.
In May 2003, the FASB's Emerging Issues Task Force defined the scope of Issue
00-21, "Revenue Arrangements With Multiple Deliverables" ("EITF No. 00-21") and
its interaction with other authoritative literature. This statement is
applicable to agreements entered into for reporting periods beginning after June
15, 2003 and requires companies with revenue arrangements including multiple
deliverables to be divided into separate units of accounting for revenue
recognition purposes, if the deliverables in the arrangement meet certain
criteria, including standalone value to the customer, objective and reliable
evidence of the fair value of the undelivered items exists and if the
arrangement includes a general right of return relative to the delivered item,
delivery or performance of the undelivered item is considered probable and
substantially in the control of the vendor. The adoption of this Statement did
not have a significant effect on the Company's financial position as of March
31, 2004 or on the results of operations for the three-month period ending March
31, 2004.
7
As required, the Company adopted FASB Interpretation No. 46, Consolidation of
Variable Interest Entities, an Interpretation of Accounting Research Bulletin
No. 51 beginning in January 2004. Based on management's evaluation, adoption did
not have a significant impact on the Company's financial position or results of
operations.
Stock Based Compensation
The Company grants stock options to key employees and members of the Board of
Directors with an exercise price equal to the fair value of the shares on the
date of grant. The Company accounts for stock option grants in accordance with
APB Opinion No. 25, Accounting for Stock Issued to Employees, and, accordingly,
recognizes no compensation expense for the stock option grants. Therefore, the
Company has elected the disclosure provisions only of FASB Statement No. 123,
"Accounting for Stock-Based Compensation".
For the purpose of pro forma disclosures, the estimated fair value of the stock
options is expensed ratably over the vesting period, which is generally 36
months for key employees and 6 months for the Board of Directors.
In December 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") 148, "Accounting for
Stock-Based Compensation--Transition and Disclosure". SFAS 148 amends the
disclosure requirements of SFAS 123 to require prominent disclosures in both
annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. The following table illustrates the effect on net income (loss) and
income (loss) per share if the Company had applied the fair value recognition
provisions of SFAS No. 123:
For the three months ended
March 31
(thousands, except per share amounts) 2004 2003
- ---------------------------------------------------------------------------------------------
Net income (loss), as reported $ (712) $ 196
Stock option expense (14) (14)
---------------------------------------
Pro forma net income (loss) $ (726) $ 182
=======================================
Basic earnings (loss) per share, as reported $ (.10) $ .03
Stock option expense .00 .00
Pro forma basic earnings (loss) per share $ (.10) $ .03
=======================================
Diluted earnings (loss) per share, as reported $ (.10) $ .03
Stock option expense .00 .00
Pro forma diluted earnings (loss) per share $ (.10) $ .03
=======================================
8
NOTE 2 - Inventories
The components of inventories were as follows:
March 31 December 31
(thousands) 2004 2003
- --------------------------------------------------------------------------------
Finished goods $ 57 $ 57
Work-in-process 560 1,066
Service parts 3,236 3,291
Materials and component parts 2,972 2,868
------------------------------
$ 6,825 $ 7,282
=============================
NOTE 3 - Credit Arrangements
Effective March 30, 2004, the Company entered into a new credit agreement with
lenders affiliated with Patriarch Partners, LLC. (the "Lenders") that, among
other things, extends from December 31, 2004 through June 1, 2005 the repayment
date for all of the Company's secured debt. At March 31, 2004 and December 31,
2003, the Company's outstanding borrowings were $9.0 million and $8.0 million,
respectively, all of which are classified as long-term as the Company has
refinanced the notes on a long-term basis. The available balance on the credit
agreements was $4.0 million and $3.6 million at March 31, 2004 and December 31,
2003, respectively. The weighted average interest rate on borrowings during the
first quarter of 2004 was 4.5% compared to 5.1% in the comparative period of
2003.
The Company's new secured term loan is payable in annual amounts of $90,000
beginning April 1, 2005 with the balance due at maturity, June 1, 2005. A new
$2.5 million revolving credit facility is also provided as part of the debt
restructuring, which can be used for working capital and other general business
purposes. Borrowings against both such loans will continue to accrue interest at
a rate of prime plus 2%.
An additional $1.5 million term loan working capital facility is available to
the Company, with the Company obligated to repay $2.0 million at maturity on
June 1, 2005. The working capital term loan will accrue interest on $2.0 million
at the prime rate.
The Company's financial covenants with respect to backlog, capital expenditure
and EBITDA have been modified to enhance the financial flexibility of the
Company.
Pursuant to the March 30, 2004 debt restructuring, the Company also exchanged
the $3.8 million mandatorily redeemable Series A preferred stock held by the
Lenders for $3.8 million of mandatorily redeemable Series B preferred stock,
which Series B preferred stock has substantially the same terms as the Series A,
except that the redemption date is extended from December 31, 2004 to June 1,
2005.
9
Further, the Company has agreed to use its best efforts, subject to the
fiduciary duties of the Board of Directors, to complete a recapitalization of
the Company by July 1, 2004. The Lenders currently hold both the Series B
preferred stock noted above and a warrant to purchase common stock issued to the
Lenders in December 2001 currently valued at $2.7 million. The Lenders are
entitled to exercise the warrant, upon the earlier of January 1, 2005 or a
triggering event, for 33.2% of the fully-diluted common stock of the Company at
$.02 per share. In addition, upon the Lender's exercise of the warrant, the
Series B preferred would be entitled to vote with the common stock and would
have 46.67% of the voting power of the Company, on a fully-diluted basis. The
recapitalization will include, among other terms, the cancellation of the $3.8
million mandatorily redeemable Series B preferred stock including accrued
interest and the existing warrants, and the issuance of common stock of the
Company to the Lenders so that following such issuance the Lenders will own
79.8% of the fully-diluted common stock of the Company, subject to dilution for
certain current and future compensatory stock options issued by the Company. The
recapitalization is subject to the approval by the stockholders of the Company
of an amendment to the certificate of incorporation of the Company to increase
the authorized common stock of the Company and related matters, which approval
will be sought at the Company's annual meeting currently scheduled to be held on
June 30, 2004.
Upon approval by the Company's shareholders of the recapitalization described
above, the maturity date for all of the Company's secured indebtedness to the
Lenders will be extended from June 1, 2005 to March 30, 2007. Without
shareholder approval, the maturity date would remain unchanged.
The carrying value of the notes payable, which is secured by all of the
Company's assets, approximates fair value.
NOTE 4 - Income Taxes
At March 31, 2004, the Company recorded $20,000 of tax expense, which is an
effective tax rate of 2.9%. No federal tax expense has been recorded due to the
Company's available federal net operating loss carryforwards. For financial
reporting purposes, a valuation allowance has been recorded to fully offset
deferred tax assets relating to federal, state and foreign taxes due to net
operating loss carryforwards and other temporary differences as it is not more
likely than not that the Company will benefit from future utilization of the net
deferred tax assets.
The Company's future ability to utilize the available net operating loss
carryforwards may be restricted due to utilization limitations effected by
change in control ramifications that would be triggered upon shareholder
approval of the proposed restructuring (Note 3).
10
NOTE 5 - Earnings Per Share
The following table sets forth the computation of basic and diluted earnings
(loss) per share:
March 31 March 31
2004 2003
- ------------------------------------------------------------------------------------------
Numerator:
Net earnings (loss) $ (712) $ 196
================================
Denominator:
Denominator for basic earnings
per share (weighted-average shares) 7,026,232 7,026,232
Effect of dilutive securities:
Employee stock options - 136,522
--------------------------------
Denominator for diluted earnings
per share (adjusted weighted-average
shares and assumed conversions) 7,026,232 7,162,754
================================
Basic earnings (loss) per share $ (.10) $ .03
================================
Diluted earnings (loss) per share $ (.10) $ .03
================================
NOTE 6 - Comprehensive Income
The components of comprehensive income (loss), for the three-months ended March
31, 2004 and 2003 are as follows:
March 31 March 31
(thousands) 2004 2003
- -----------------------------------------------------------------------------------------------
Net income (loss) $ (712) $ 196
Foreign currency translation adjustments 13 (4)
---------------------------------------
Comprehensive income (loss) $ (699) $ 192
=======================================
11
The components of accumulated comprehensive loss, at March 31, 2004 and December
31, 2003 are as follows:
March 31 December 31
(thousands) 2004 2003
- -----------------------------------------------------------------------------------------------
Foreign currency translation adjustments $ (831) $ (844)
---------------------------------------
Accumulated comprehensive loss $ (831) $ (844)
=======================================
NOTE 7 - Segment Information
The Company views its business in three distinct revenue categories: Solution
and products sales, Access services, and Contract manufacturing services.
Revenues are used by management as a guide to determine the effectiveness of the
individual segment. The Company manages its operating expenses through a
traditional functional perspective and accordingly, does not report operating
expenses on a segment basis.
Three Months Ended
March 31
(thousands) 2004 2003
- ------------------------------------------------------------------------------------------
Revenues
Solutions and products $ 4,827 $ 5,598
Access services 2,396 2,504
Contract manufacturing services 110 8
----------------------------------
Total revenues 7,333 8,110
Cost of solutions and products 3,484 3,396
Service expenses 2,332 2,131
----------------------------------
Gross margin 1,517 2,583
Operating and other expenses, net 2,209 2,377
-----------------------------------
Income (loss) before income taxes $ (692) $ 206
==================================
Total expenditures for additions to long-lived assets $ 66 $ 53
The Solutions and Products Division includes the sale of hardware and software
products as well as professional services. Contract Manufacturing Services
provides assembly and test services under contracts with customers who develop
and sell a variety of equipment.
12
NOTE 8 - Bill and Hold Transactions
Revenues relating to sales of certain equipment (principally optical character
recognition equipment) are recognized upon acceptance, shipment, or installation
depending on the contract specifications. When customers, under the terms of
specific orders or contracts, request that the Company manufacture and invoice
the equipment on a bill and hold basis, the Company recognizes revenue based
upon an acceptance received from the customer. The Company recorded no bill and
hold revenue during the first three months of 2004. Revenues satisfying the bill
and hold revenue recognition criteria recorded during the first quarter of 2003
totaled $1.7 million. Accounts receivable included no bill and hold receivables
at March 31, 2004 and $1.5 million at March 31, 2003, respectively.
NOTE 9 - Contingencies
Since 2001, an action has been pending against Scan-Optics alleging, among other
things, breach of contract in connection with a contract for the delivery of
hardware, software and professional services. Scan-Optics has denied the
material allegations of the complaint and counterclaimed for breach of contract
and seeks recovery of unpaid receivables, totaling $1.4 million. Although the
ultimate outcome is uncertain, based on currently known facts, the Company
believes that it has strong defenses against the lawsuit and valid claims for
recovery for the net amount of unpaid receivables recorded in the financial
statements, and that the resolution of this matter will not have a material
adverse effect on the Company's financial position or annual operating results.
13
Item 2. Management's Discussion and Analysis of Consolidated Financial
Condition and Results of Operations.
Overview
Certain statements contained in this Quarterly Report on Form 10-Q may contain
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities and Exchange Act of 1934 and as
such may involve known or unknown risks, uncertainties and other factors which
may cause the Company's actual results, performance or achievements to be
materially different from future results, performance or achievements expressed
or implied by such forward-looking statements. Forward-looking statements, which
are based on certain assumptions and describe the Company's future plans,
strategies and expectations are generally identifiable by use of the words
"may," "will," "should," "expect," "anticipate," "estimate," "believe," "intend"
or "project" or the negative thereof or other variations thereon or comparable
terminology. Factors which could have a material adverse effect on the
operations and future prospects of the Company include, but are not limited to
those set forth below. These risks and uncertainties should be considered in
evaluating any forward-looking statements contained or incorporated by reference
herein.
The following list is not intended to be an exhaustive list of all the risks to
which the Company's business is subject, but only to highlight certain
substantial risks faced by the Company. Although the Company completed a debt
restructuring effective March 30, 2004 (see "Liquidity and Capital Resources"
for further information), the Company remains highly leveraged and could be
adversely affected by a significant increase in interest rates. A one percent
increase in the prime rate would increase the annual interest cost on the
outstanding loan balance at March 31, 2004 of approximately $9.0 million by $0.1
million. Further, if the recapitalization occurs (see Note 3 for further
details), as contemplated by the 2004 debt restructuring, the Company's lenders
will acquire significant voting control and will accordingly have the right and
the ability to influence the way in which the Company does business, including
its strategy and tactics. If the recapitalization fails to occur, the Company's
secured obligations (including the Company's mandatorily redeemable preferred
stock), which exceeds in the aggregate $13.6 million as of March 30, 2004, will
be due and payable June 1, 2005. The Company's business could be adversely
affected by downturns in the domestic and international economy. The Company's
international sales and operations are subject to various international business
risks. The Company's revenues depend in part on contracts with various state or
federal governmental agencies, and could be adversely affected by patterns in
government spending. The Company faces competition from many sources, and its
products and services may be replaced by alternative technologies. The Company's
business could be adversely affected by technological changes. The foregoing
factors should not be construed as exhaustive.
The Company reported a net loss of $0.7 million in the first quarter of 2004
compared to net income of $0.2 million in the first quarter of 2003. The
quarterly operating results were below management's expectations. Management has
recognized the challenges associated with these first quarter issues and is
taking measures to address the challenges in the second quarter and the
remainder of 2004. The Company's ability to effectively address these issues
14
will have a direct impact on its operating results and its ability to comply
with existing debt covenants.
The Company has three major initiatives currently underway to improve revenue
growth and profitability. They are designed to emphasize the "Business of
Solutions" focus in targeted markets, introduce the Business Process Outsourcing
Service and expand the Access Services Division to include enterprise-wide
maintenance services. The inability of the Company to carry out these
initiatives may have a material adverse effect on revenue growth and earnings.
The first initiative is to provide cost-effective solutions through the
Company's development of target market data capture applications combined with
its high speed transports and archival systems. The Company has refined its
target market approach and has chosen to focus primarily on the government and
assessment markets, while continuing to address the transportation, insurance,
financial and order fulfillment markets. The Company expects to continue to
emphasize its "Business of Solutions" focus on these targeted markets for the
foreseeable future. As other market opportunities emerge, the Company will
evaluate the potential of using its products and services to provide solutions
in these new markets. The Company's revenue in the solutions initiative
decreased $1.0 million or 25% from the first three months of 2003 to the first
three months of 2004, mainly due to a decrease in the government market.
The second initiative, introduced in early 2003, is a Business Process
Outsourcing ("BPO") Service to capture images of documents for subsequent
document management, storage and retrieval. The Company's new BPO Services
provide a low-risk, cost-effective solution for customers with document imaging
needs. As increasing numbers of both government and commercial clients migrate
from paper-based filing systems to image-based storage and retrieval systems,
they are faced with the need to convert their existing paper files or to
outsource the activity. The BPO Services offer customers a high quality, turnkey
outsourcing solution utilizing the Company's proprietary hardware technology, as
well as its software skills, resources and process controls.
The third initiative, by our Access Services Division, is an expansion to
include enterprise-wide maintenance services for network and network-related
equipment. Leveraging off the experience it has gained through its many third
party agreements, Access Services is well positioned to expand maintenance
coverage and provide customers with "one number to call" for maintenance
services regardless of the equipment manufacturer. Through the division's 120
technical service representatives strategically located throughout the U.S., the
Company believes that it can provide high quality, cost-effective enterprise
maintenance to its existing customer base as well as new accounts.
While the Company is principally focused on improving the profitability of its
existing operations, the Company may consider acquiring key strategic products
or enterprises. Acquisitions will be considered based upon their individual
merit and benefit to the Company.
15
Results of Operations for the Three Months Ended March 31, 2004 vs. 2003
Total revenues decreased $0.8 million or 10% from the first quarter of 2003 to
the first quarter of 2004.
Hardware and software revenues decreased $0.8 million or 19% in the first
quarter of 2004 compared with the first quarter of 2003. North American sales
decreased $3.0 million or 72% due to reduced order activity related to the
Series 9000M scanners. International sales increased to $2.2 million in the
first quarter of 2004 as compared to the same period in 2003 when no such sales
occurred.
Professional services revenues increased $0.1 million or 9% in the first quarter
of 2004 compared with the first quarter of 2003, due mainly to increased
contract revenue and program change requests.
Access Services revenues decreased $0.1 million or 4% from the first quarter of
2003, due mainly to a decrease in revenue from the Company's proprietary
maintenance contracts as a result of lower maintenance rates for the latest
generation of the Series 9000 scanner, the 9000M, as compared to the earlier
Series 9000 scanner. The Company was also impacted by a few customers
discontinuing maintenance due to changes in their business.
Cost of hardware and software remained consistent with the first quarter of 2003
despite lower unit volume. Cost of hardware and software sales as a percentage
of revenue was 76% for the first quarter of 2004, compared to 62% in the prior
year, resulting in lower margins due to the composition of the sales mix.
Cost of professional services increased $0.1 million or 14% from the first
quarter of 2003. The Professional Services organization includes software
product support and professional services implementation. The product support
organization recorded a gross margin of 63% in the first quarter of 2004
unchanged from the prior year. The professional services implementation group
recorded a gross margin of 15% in the first quarter of 2004 vs. 23% in the prior
year. The decrease in margin is mainly due to increased costs related to a
specific project implementation in the quarter.
Cost of Access Services increased $0.2 million or 9% in the first quarter of
2004 in comparison with the first quarter of 2003. The increase was mainly due
to employee salaries and benefits, outside contractor costs, and travel expenses
associated with equipment maintenance activity, partially offset by lower
depreciation expense.
Sales and marketing expenses decreased $0.2 million or 26% from the first
quarter of 2003 mainly due to reduced commission expenses driven by lower
revenue in the first quarter of 2004 compared to the first quarter of 2003 and
lower salary costs due to reduced headcount.
16
Research and development expenses increased $0.2 million or 63% from the first
quarter of 2003 mainly due to higher salary and benefit costs, increased
software amortization expense related to the new SO series scanner and higher
external consulting costs.
General and administrative expenses decreased $0.1 million or 10% compared to
the same period in 2003. The decrease is mainly due to lower legal and
consulting fees.
Interest expense remained consistent with the first quarter of 2003. The
weighted average interest rate for the first three months of 2004 was 4.5%
compared to 5.1% for the same period in 2003.
Liquidity and Capital Resources
- -------------------------------
Cash and cash equivalents at March 31, 2004 increased $1.8 million from December
31, 2003 levels.
Total borrowings increased $1.0 million at March 31, 2004 from $8.0 million at
the end of 2003. The available balance on the line of credit was $4.0 million at
March 31, 2004. The Company is in compliance with all of the financial covenants
as of March 31, 2004 and expects to remain in compliance throughout 2004. The
Company's ability to do so, however, will be directly impacted by its ability to
achieve planned operating results for the remainder of 2004. The Company
anticipates meeting its current obligations and resource needs through the funds
generated from operations and the available line of credit. (See Note 3 for
further details.)
Effective March 30, 2004, the Company entered into a new credit agreement with
lenders affiliated with Patriarch Partners, LLC. (the "Lenders") that, among
other things, extends from December 31, 2004 through June 1, 2005 the repayment
date for all of the Company's secured debt and provides additional working
capital in the amount of $1.5 million. Subject to approval by the shareholders
at the Company's Annual Meeting scheduled to be held on June 30, 2004, the
Company will issue to the Lenders 79.8% of the fully-diluted Common Stock of the
Company in consideration for, among other things, the Lenders' agreement to
extend the repayment date for outstanding secured debt through March 30, 2007.
More specifically, the financing arrangement includes the following items:
o The Company's secured term and revolving debt was exchanged for a $9.0
million term loan and a $2.5 million revolving loan. The new term loan
is payable in annual amounts of $90,000 beginning April 1, 2005 with
the balance due at maturity. Borrowings against both such loans will
continue to accrue interest at a rate of prime plus 2%. The maturity
date for these loans was extended from December 31, 2004 to June 1,
2005.
17
o An additional $1.5 million term loan working capital facility was made
available to the Company, with the Company obligated to repay $2
million at maturity on June 1, 2005. The working capital term loan
will accrue interest on $2 million at the prime rate.
o The Company's financial covenants with respect to backlog, capital
expenditure and EBITDA were modified to enhance the financial
flexibility of the Company.
o The Company exchanged the $3.8 million mandatorily redeemable Series A
preferred stock held by the Lenders for $3.8 million of mandatorily
redeemable Series B preferred stock, which Series B preferred stock
has substantially the same terms as the Series A, except that the
redemption date is extended from December 31, 2004 to June 1, 2005.
o The Company agreed to use its best efforts, subject to the fiduciary
duties of the Board of Directors, to complete a recapitalization of
the Company by July 1, 2004. The Lenders currently hold both the
Series B preferred stock noted above and a warrant to purchase common
stock issued to the Lenders in December 2001. The Lenders are entitled
to exercise the warrant, upon the earlier of January 1, 2005 or a
triggering event, for 33.2% of the fully-diluted common stock of the
Company at $0.02 per share. In addition, upon the Lender's exercise of
the warrant, the Series B preferred would be entitled to vote with the
common stock and would have 46.67% of the voting power of the Company,
on a fully-diluted basis. The recapitalization will include, among
other terms, the cancellation of the $3.8 million mandatorily
redeemable Series B preferred stock and the existing warrant, and the
issuance of common stock of the Company to the Lenders so that
following such issuance the Lenders will own 79.8% of the
fully-diluted common stock of the Company, subject to dilution for
certain current and future compensatory stock options issued by the
Company. The recapitalization is subject to the approval by the
stockholders of the Company of an amendment to the certificate of
incorporation of the Company to increase the authorized common stock
of the Company and related matters, which approval will be sought at
the Company's annual meeting currently scheduled to be held on June
30, 2004.
o Upon approval by the Company's shareholders of the recapitalization
described above, the maturity date for all of the Company's secured
indebtedness to the Lenders will be further extended from June 1, 2005
to March 30, 2007.
The Company believes that the 2004 loan restructuring will allow execution of
the Company's business plan through the term of the credit agreement by reducing
required payments under the borrowing arrangements with the Lenders and
increasing available funds through the working capital term loan facility,
thereby enhancing the Company's ability to invest in its business, by lowering
the thresholds of the financial covenants and by extending the loan maturities
through June 2005, and through March 2007 if the shareholders approve the
recapitalization transaction. In the event that shareholders fail to approve the
recapitalization transaction or the recapitalization transaction fails to occur
for any other reason, the Company's
18
secured obligations (including the Company's mandatorily redeemable preferred
stock), which exceeded $13.6 million as of March 30, 2004, will be due and
payable on June 1, 2005.
Operating activities provided $0.9 million of cash in the first three months of
2004, as compared to the use of $0.1 million in the first three months of 2003.
The increase is mainly due to strong accounts receivable collections during the
first quarter of 2004.
Non-cash expenses recorded during the quarter were $0.5 million vs. $0.6 million
for the same period in 2003. These expenses relate to depreciation of fixed
assets (discussed in net plant and equipment below), amortization of customer
service inventory and amortization of software development costs.
Net accounts receivable and unbilled receivables at March 31, 2004 decreased
$2.4 million from December 31, 2003 due to the timing of collection of
outstanding receivables.
Total inventories at March 31, 2004 decreased $0.5 million from December 31,
2003. Manufacturing inventory decreased $0.4 million, from the beginning of the
year mainly due to lower product costs of the new SO series scanner relative to
the series 9000M scanner, which was manufactured in the fourth quarter of 2003.
Customer service inventory decreased $0.1 million as compared to December 31,
2003 levels mainly due to amortization of inventory.
Net plant and equipment at March 31, 2004, remained consistent with the balance
at December 31, 2003.
Other assets increased $0.1 million from December 31, 2003 due to the
capitalization of software development costs in the quarter.
Accounts payable increased $0.4 million from December 31, 2003 mainly due to the
timing of vendor payments.
Salaries and wages decreased $0.7 million mainly due to the payout of the bonus
accrual related to the 2003 bonus plan.
Taxes other than income taxes decreased $0.1 million from December 31, 2003 due
to payments made for sales and use taxes in various states.
Customer deposits decreased $0.5 million from December 31, 2003 due to the
transfer of deposits to accounts receivable to offset recorded product sales.
Deferred revenues remained consistent with the December 31, 2003 balance.
Other liabilities decreased $0.3 million due to reduced accruals for group
insurance, accounting fees and interest.
19
Critical Accounting Policies
Our critical accounting policies are discussed in Management's Discussion and
Analysis of Consolidated Financial Condition and Results of Operations in our
Annual Report on Form 10-K for the year ended December 31, 2003. The preparation
of our financial statements requires us to make estimates that affect the
reported amounts of assets, liabilities, revenue and expenses and related
disclosures of contingent assets and liabilities. We base our accounting
estimates on historical experience and other factors that are believed to be
reasonable under the circumstances. However, actual results may vary from these
estimates under different assumptions or conditions.
New Accounting Pronouncements
In May 2003, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150").
This statement establishes standards for classifying and measuring, as
liabilities, certain financial instruments that embody obligations of the issuer
and have characteristics of both liabilities and equity. SFAS 150 generally
requires liability classification for financial instruments, including
mandatorily redeemable equity instruments and other non-equity instruments
requiring, from inception, the repurchase by the issuer of its equity shares.
This statement is applicable to the Company as of the beginning of the first
interim financial reporting period beginning after June 15, 2003. The adoption
of this Statement did not have a significant effect on the Company's financial
position as of March 31, 2004 or on the results of operations for the
three-month period ending March 31, 2004.
In May 2003, the FASB's Emerging Issues Task Force defined the scope of Issue
00-21, "Revenue Arrangements With Multiple Deliverables" ("EITF No. 00-21") and
its interaction with other authoritative literature. This statement is
applicable to agreements entered into for reporting periods beginning after June
15, 2003 and requires companies with revenue arrangements including multiple
deliverables to be divided into separate units of accounting for revenue
recognition purposes, if the deliverables in the arrangement meet certain
criteria, including standalone value to the customer, objective and reliable
evidence of the fair value of the undelivered items exists and if the
arrangement includes a general right of return relative to the delivered item,
delivery or performance of the undelivered item is considered probable and
substantially in the control of the vendor. The adoption of this Statement did
not have a significant effect on the Company's financial position as of March
31, 2004 or on the results of operations for the three-month period ending March
31, 2004.
In January 2004, the Company adopted FASB Interpretation No. 46, Consolidation
of Variable Interest Entities, an Interpretation of Accounting Research Bulletin
No. 51 beginning in January 2004. Based on management's evaluation, adoption did
not have a significant impact on the Company's financial position as of March
31, 2004 or on the results of operations for the three-month period ending March
31, 2004.
20
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
In 2004, the Company completed a total debt restructuring (see Note 3 for
further information), however, the Company remains highly leveraged and could be
adversely affected by a significant increase in interest rates. A one percent
increase in the prime rate would increase the annual interest cost on the
outstanding loan balance at March 31, 2004 of approximately $9.0 million by $0.1
million. The Company has minimal foreign currency translation risk. All
international sales other than sales originating from the UK and Canadian
subsidiaries are denominated in United States dollars. Refer to the Outlook
section of Management's Discussion and Analysis of Consolidated Financial
Condition and Results of Operations.
Item 4. Controls and Procedures.
The Company evaluated the design and operation of its disclosure controls and
procedures to determine whether they are effective in ensuring that the
disclosure of required information is timely made in accordance with the
Securities Exchange Act of 1934 (the "Exchange Act") and the rules and forms of
the Securities and Exchange Commission. This evaluation was made under the
supervision and with the participation of management, including the Company's
principal executive officer and principal financial officer as of the end of the
period covered by this Quarterly Report on Form 10-Q. The principal executive
officer and principal financial officer have concluded, based on their review,
that the Company's disclosure controls and procedures, as defined at Exchange
Act Rules 13a-14(c) and 15d-14(c), are effective to provide reasonable assurance
that information required to be disclosed by the Company in reports that it
files or submits under the Exchange Act is recorded, processed, summarized and
reported within the time periods specified in Securities and Exchange Commission
rules and forms. There were no changes in the Company's internal control over
financial reporting that occurred during the Company's most recent fiscal
quarter that materially affected, or are reasonably likely to materially affect,
the Company's internal control over financial reporting.
21
PART II - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits.
Exhibit Number Description
Exhibit 10.1* Subscription and Repurchase Agreement
Exhibit 31.1* CEO Certification Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
Exhibit 31.2* CFO Certification Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
Exhibit 32.1* CEO Certification Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
Exhibit 32.2* CFO Certification Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
* Filed herewith.
(b) Reports on Form 8-K.
Report on Form 8-K filed March 2, 2004 regarding the death of the
Company's Chief Financial Officer and Chief Operating Officer, Michael J.
Villano.
Report on Form 8-K filed March 31, 2004 regarding earnings for the
quarter and year ending December 31, 2003, debt restructuring and restatement of
2002 financial statements.
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SIGNATURES
----------
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SCAN-OPTICS, INC.
Date May 14, 2004 / s/ James C. Mavel
--------------------------- -------------------------------------------
James C. Mavel
Chairman, Chief Executive Officer
and President
Date May 14, 2004 / s/ Peter H. Stelling
--------------------------- --------------------------------------------
Peter H. Stelling
Chief Financial Officer, Vice
President and Treasurer
23