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 June 30, 2004
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________________ to __________________
Commission File No. 0-5265
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 Identification Number)
incorporation or organization)
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 July 30,
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. Consolidated 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
S PAPART I - FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements.
SCAN-OPTICS, INC., AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(thousands, except share data) June 30, 2004 December 31, 2003
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(UNAUDITED)
Assets
Current Assets:
Cash and cash equivalents $ 916 $ 585
Accounts receivable less allowance of $311 at
June 30, 2004 and $1,206 at December 31, 2003 5,017 6,043
Unbilled receivables - contracts in progress 805 415
Inventories 7,371 7,282
Prepaid expenses and other 1,131 597
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Total current assets 15,240 14,922
Plant and equipment:
Equipment 3,815 3,682
Leasehold improvements 4,010 4,010
Office furniture and fixtures 755 745
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8,580 8,437
Less allowances for depreciation and amortization 7,614 7,422
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966 1,015
Goodwill 9,040 9,040
Other assets 1,143 1,096
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Total Assets $ 26,389 $ 26,073
==============================================================
3
(thousands, except share data) June 30, 2004 December 31, 2003
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(UNAUDITED)
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 2,843 $ 2,323
Salaries and wages 652 1,484
Taxes other than income taxes 677 758
Income taxes 101 189
Customer deposits 620 929
Deferred revenues 3,687 2,787
Other 1,558 1,495
------------------------------------------------------------------
Total current liabilities 10,138 9,965
Note payable 10,500 7,989
Other liabilities 1,939 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
June 30, 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 (34,901) (32,570)
Accumulated other comprehensive loss (944) (844)
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2,658 5,089
Less cost of common stock in treasury,
413,500 shares 2,646 2,646
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Total stockholders' equity 12 2,443
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Total Liabilities and Stockholders' Equity $ 26,389 $ 26,073
==================================================================
See accompanying notes.
4
SCAN-OPTICS, INC., AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months Ended Six Months Ended
June 30 June 30
(thousands, except share data) 2004 2003 2004 2003
- ----------------------------------------------------------------------------------------------------------------------------------
Revenues
Hardware and software $ 2,549 $ 4,079 $ 5,976 $ 8,301
Professional services 1,497 1,239 3,007 2,623
Access services 2,832 2,789 5,228 5,293
----------------------------------- ----------------------------------
Total revenues 6,878 8,107 14,211 16,217
Costs of Revenue
Hardware and software 1,914 2,310 4,519 4,938
Professional services 759 684 1,638 1,452
Access services 2,505 2,380 4,837 4,511
----------------------------------- ----------------------------------
Total costs of revenue 5,178 5,374 10,994 10,901
Gross Margin 1,700 2,733 3,217 5,316
Operating Expenses
Sales and marketing 802 919 1,492 1,847
Research and development 629 440 1,180 779
General and administrative 1,665 901 2,498 1,829
Interest 191 283 358 482
----------------------------------- ----------------------------------
Total operating expenses 3,287 2,543 5,528 4,937
----------------------------------- ----------------------------------
Operating income (loss) (1,587) 190 (2,311) 379
Other income (loss), net (2) 44 30 61
----------------------------------- ----------------------------------
Income (loss) before income taxes (1,589) 234 (2,281) 440
Income tax expense 30 20 50 30
----------------------------------- ----------------------------------
Net Income (loss) $ (1,619) $ 214 $ (2,331) $ 410
=================================== ==================================
Basic earnings (loss) per share $ (0.23) $ 0.03 $ (0.33) $ 0.06
=================================== ==================================
Basic weighted-average shares 7,026,232 7,026,232 7,026,232 7,026,232
Diluted earnings (loss) per share $ (0.23) $ 0.03 $ (0.33) $ 0.05
=================================== ==================================
Diluted weighted-average shares 7,026,232 7,812,441 7,026,232 7,487,598
See accompanying notes.
5
SCAN-OPTICS, INC., AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Six Months Ended
June 30
(thousands) 2004 2003
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Operating Activities
Net Income (loss) $ (2,331) $ 410
Adjustments to reconcile net income (loss)
to net cash provided (used) by operating activities:
Depreciation 150 194
Amortization of customer service inventory and
software license 1,092 1,023
Changes in operating assets and liabilities:
Accounts receivable and unbilled receivables 636 (2,210)
Inventories (1,096) (570)
Prepaid expenses and other (534) 112
Accounts payable 520 313
Accrued salaries and wages (832) 298
Taxes other than income taxes (81) (145)
Income taxes (88) (3)
Deferred revenues 900 301
Customer deposits (309) 177
Other (106) 565
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Net cash provided (used) by operating activities (2,079) 465
Investing Activities
Purchases of plant and equipment, net (101) (63)
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Net cash used by investing activities (101) (63)
Financing Activities
Proceeds from borrowings 4,711 2,850
Principal payments on borrowings (2,200) (2,792)
------------------------------------------------------
Net cash provided by financing activities 2,511 58
Increase in cash and cash equivalents 331 460
Cash and Cash Equivalents at Beginning of Year 585 274
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Cash and Cash Equivalents at End of Period $ 916 $ 734
=====================================================
See accompanying notes.
6
NOTE 1 - Basis of Presentation and Significant Accounting Policies
The accompanying unaudited 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 six month period ended June 30, 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 June 30, 2004 or on the results of operations for the three and
six-month periods ending June 30, 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 June 30,
2004 or on the results of operations for the three and six-month periods ending
June 30, 2004.
As required, the Company adopted FASB Interpretation No. 46, Consolidation of
Variable Interest Entities, an Interpretation of Accounting Research Bulletin
7
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 generally 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". The Company did
recognize compensation expense of $29,000 in the second quarter of 2004
associated with options granted to non-employees.
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 members of 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 For the six months ended
June 30 June 30
(thousands, except per share amounts) 2004 2003 2004 2003
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Net income (loss) , as reported $ (1,619) $ 214 $ (2,331) $ 410
Stock option expense (17) (25) (32) (38)
-----------------------------------------------------------------
Pro forma net income (loss) $ (1,636) $ 189 $ (2,363) $ 372
=================================================================
Basic earnings (loss) per share, as reported $ (.23) $ .03 $ (.33) $ .06
Stock option expense .00 .00 .00 (.01)
-----------------------------------------------------------------
Pro forma basic earnings (loss) per share $ (.23) $ .03 $ (.33) $ .05
=================================================================
Diluted earnings (loss) per share, as reported $ (.23) $ .03 $ (.33) $ .05
Stock option expense .00 .00 .00 (.01)
-----------------------------------------------------------------
Pro forma diluted earnings (loss) per share $ (.23) $ .03 $ (.33) $ .04
================================================================
8
NOTE 2 - Inventories
Inventories, determined by the lower of cost (first-in, first-out) or market,
consist of:
June 30 December 31
(thousands) 2004 2003
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Finished goods $ 58 $ 57
Work-in-process 597 1,066
Service parts 2,893 3,291
Materials and component parts 3,823 2,868
------------ ----------
$ 7,371 $ 7,282
============ ==========
During the quarter-ended June 30, 2004, the Company reduced inventory by $.3
million. The adjustment which represented a change in management's estimate of
the required reserve for excess and obsolete inventory related to service parts
held by its wholly-owned subsidiary Scan Optics, Ltd., was recorded as $.2
million (or $0.04 per share) of additional amortization expense and reflected in
costs of revenue for the period and the remaining $.1 million represented the
impact of foreign exchange and was charged to other comprehensive loss.
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 June 30, 2004 and December 31,
2003, the Company's outstanding borrowings were $10.5 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 $2.5 million and $3.6 million at June 30, 2004 and December 31,
2003, respectively. The weighted average interest rate on borrowings during the
second quarter of 2004 was 6.3% compared to 5.4% in the comparative period of
2003.
As of June 30, 2004, the Company was in default of the EBITDA covenant. The
default was subsequently waived by the Lenders by allowing certain one-time
charges incurred during the quarter to be eliminated for purposes of calculating
rolling EBITDA. Should the Company be unable to satisfy the EBITDA and other
financial covenants in future periods, the debt may need to be classified as a
current obligation, as the Lenders could exercise their right to call the debt
as a result of future covenant violations.
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. There is a $2.5
million revolving credit facility, provided as part of the debt restructuring,
which can be used for working capital and other general business purposes.
9
Borrowings against both such loans will continue to accrue interest at a rate of
prime plus 2%. There is no balance outstanding on the revolving credit facility
at June 30, 2004.
An additional $1.5 million term loan working capital facility was made available
to the Company, effective March 30, 2004 with the Company obligated to repay
$2.0 million at maturity. The working capital term loan will accrue interest on
$2.0 million at the prime rate. The Company borrowed $1.5 million against this
facility during the second quarter.
As part of the restructuring, 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 was extended to coincide with the Company's
secured debt.
On August 6, 2004, the Company completed a recapitalization with its Lenders,
after obtaining stockholder approval of an amendment to the certificate of
incorporation of the Company to increase the authorized common stock of the
Company in order to permit the recapitalization at the July 15, 2004 annual
meeting. The recapitalization included, among other terms, the cancellation of
the $3.8 million mandatorily redeemable Series B preferred stock, including
accrued dividends, and the existing warrants held by the Lenders, and the
issuance of common stock of the Company to the Lenders so that following such
issuance the Lenders own 79.8% of the fully-diluted common stock of the Company,
subject to dilution for certain current and future compensatory stock options
granted by the Company.
Effective upon the closing of the recapitalization on August 6, 2004, the
maturity date for all of the Company's secured indebtedness to the Lenders has
been extended through March 30, 2007.
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 June 30, 2004, the Company recorded $50,000 of tax expense for the first six
months, which is an effective tax rate of 2.2%. No federal tax expense has been
recorded due to the Company's available federal net operating loss carry
forwards. For financial reporting purposes, a valuation allowance has been
recorded to fully offset deferred tax assets relating to federal, state and
10
foreign taxes due to net operating loss carry forwards 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).
NOTE 5 - Earnings Per Share
The following table sets forth the computation of basic and diluted earnings
(loss) per share:
Three Months Ended Six Months Ended
June 30 June 30
2004 2003 2004 2003
Numerator:
Net earnings (loss) $ (1,619) $ 214 $ (2,331) 410
===============================================================
Denominator:
Denominator for basic earnings (loss)
per share (weighted-average shares) 7,026,232 7,026,232 7,026,232 7,026,232
Effect of dilutive securities:
Employee stock options - 786,209 - 461,366
---------------------------------------------------------------
Denominator for diluted earnings (loss)
per share (adjusted weighted-average
shares and assumed conversions) 7,026,232 7,812,441 7,026,232 7,487,598
===============================================================
Basic earnings (loss) per share $ (.23) $ .03 $ (.33) $ .06
===============================================================
Diluted earnings (loss) per share $ (.23) $ .03 $ (.33) $ .05
===============================================================
11
NOTE 6 - Comprehensive Income
The components of comprehensive income (loss), net of related tax, for the three
and six months ended June 30, 2004 and 2003 are as follows:
Three Months Ended Six Months Ended
June 30 June 30
(thousands) 2004 2003 2004 2003
------------ ------------- ------------ ------------
Net Income (loss) $ (1,619) $ 214 $ (2,331) $ 410
Foreign currency translation adjustments (113) 107 (100) 103
------------ ------------- ------------ ------------
Comprehensive income (loss) $ (1,732) $ 321 $ (2,431) $ 513
============ ============= ============ ============
The components of accumulated comprehensive loss, at June 30, 2004 and December
31, 2003 are as follows:
June 30 December 31
(thousands) 2004 2003
Foreign currency translation adjustments $ (944) $ (844)
------------------ ---------------
Accumulated comprehensive loss $ (944) $ (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.
12
Three Months Ended Six Months Ended
June 30 June 30
(thousands) 2004 2003 2004 2003
Revenues
Solutions and products $ 3,703 $ 5,246 $ 8,530 $ 10,844
Access services 2,832 2,789 5,228 5,293
Contract manufacturing services 343 72 453 80
------------ ------------- ------------ ------------
Total revenues 6,878 8,107 14,211 16,217
Cost of solutions and products 2,673 2,994 6,157 6,390
Service expenses 2,505 2,380 4,837 4,511
------------ ------------- ------------ ------------
Gross profit margin 1,700 2,733 3,217 5,316
Operating expenses
and other income, net 3,289 2,499 5,498 4,876
------------ ------------- ------------ ------------
Income (loss) before income taxes $ (1,589) $ 234 $ (2,281) $ 440
============ ============= ============ ============
Total expenditures for additions
to long-lived assets $ 58 $ 7 $ 124 $ 60
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.
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 $.6 million
of bill and hold revenue during the second quarter of 2003 and $2.3 million in
the first six months of 2003. At June 30, 2003, accounts receivable included
bill and hold receivables of $1.9 million. There were no bill and hold
transactions in the first six months of 2004 and there are no bill and hold
receivables at June 30, 2004.
NOTE 9 - Contingencies
In July 2004, Scan-Optics settled a long-standing dispute with a customer
involving, among other matters, outstanding accounts receivable owed to
Scan-Optics. As a result, each party has agreed to terminate litigation that has
been pending since 2001. Earlier, the Company had recorded $.8 million as a
reserve against the disputed accounts receivable. As part of the settlement
terms, Scan-Optics has agreed to forgive the disputed account receivable in the
amount of $1.3 million, which resulted in a $.5 million charge against current
earnings (or $0.08 per share).
The Company is aware that Millennium, L.P. has filed a complaint dated August 3,
2004 in the United States District Court for the Southern District of New York
against the Company for patent infringement. The complaint alleges infringement
of unspecified claims of five separate United States patents. The complaint has
not been served on the Company, and the Company has not had an opportunity to
analyze the claims to determine whether the suit has any merit.
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 June 30, 2004 of approximately $10.5 million by $0.1
million. The recapitalization became effective on August 6, 2004 (see Note 3 for
further details), and as a result the Company's lenders have acquired a
significant voting control and accordingly have the right and the ability to
influence the way in which the Company does business, including its strategy and
tactics. 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 $1.6 million in the second quarter of 2004
compared to net income of $0.2 million in the second quarter of 2003 and a net
loss of $2.3 million year to date compared to net income of $0.4 million in
2003. The Company's ability to effectively address business issues will have a
direct impact on its operating results, its ability to generate sufficient cash
to fund operations and its ability to comply with existing debt covenants.
Although, the quarterly operating results were significantly adversely affected
by one-time events, including the settlement of some long outstanding
litigation, and the Company's transition to the marketing and production of our
14
new SO Series image-scanning platform, we did have some encouraging successes in
the form of new business activities. The launch of our new SO Series
image-scanning platform continues to generate interest and orders in the United
States and internationally.
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
insurance markets, while continuing to address the transportation, assessment,
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 $2.9 million or 34% from the first six months of 2004 to 2003 and $1.9
million or 43% in a comparison of the second quarter of 2004 vs. 2003, mainly
due to an 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 and Six Months Ended June 30, 2004 vs. 2003
Total revenues decreased $2.0 million or 12% from the first six months of 2003
to the first six months of 2004 and decreased $1.2 million or 15% from the
second quarter of 2003 to the second quarter of 2004.
Hardware and software revenues decreased $2.3 million or 28% in the first six
months of 2004 compared with the same period in 2003 and decreased $1.5 million
from the second quarter of 2003 compared to 2004. Compared to the first six
months of 2003, North American sales decreased $4.7 million or 57% and decreased
$1.7 million or 42% during the second quarter of 2004 compared to the second
quarter of 2003 mainly due to a significant order in 2003, which replaced
existing equipment at a current customer. International sales increased $2.4
million during the first six months of 2004 as compared with the first six
months of 2003 and remained consistent with the second quarter of 2003 compared
to 2004. The Company is in the process of phasing out the sale and production of
its mature line of 9000 Series scanners and the Company is in the launch phase
of its new generation of SO Series scanners which accounted for a majority of
the decreased hardware revenue.
Professional services revenues increased $.4 million or 15% in the first six
months of 2004 compared with the first six months of 2003 and increased $.3
million or 21% during the second quarter of 2004 compared to the second quarter
of 2003. These changes relate to increased solution sales to the Company's
target customer base.
Access services revenues decreased $.1 million or 1% in the first six months of
2004 compared with the first six months of 2003 and was flat during the second
quarter of 2004 compared to the second quarter of 2003. The Company was impacted
by a few customers discontinuing maintenance contracts due to changes in their
businesses, which was partially offset by increased spare parts purchases.
Cost of hardware and software decreased $.4 million or 8% in the first six
months of 2004 compared to the first six months of 2003 and decreased $.4
million or 17% in the second quarter of 2004 compared to the second quarter of
2003. The gross margin was 24% for the first six months of 2004, compared to 41%
in the first six months of the prior year. The gross margin was 25% during the
second quarter of 2004, compared to 43% in the second quarter of the prior year.
The decreases in gross margin are mainly due to changes in product mix as a
result of the phase out of its mature 9000 series scanners and the launch of the
new SO Series scanners.
Cost of professional services increased $.2 million or 13% in a comparison of
the first six months of 2004 vs. 2003 and increased $.1 million in the second
16
quarter of 2004 compared to the prior year. The gross margin was 46% for the
first six months and 49% in the second quarter of 2004, compared to 45% in the
first six months and second quarter of 2003. The increase in gross margin was
mainly due to increased sales volume, which results in higher utilization rates
of available resources.
Cost of Access Services increased $.3 million in the first six months of 2004
vs. 2003 and increased $.1 million in the second quarter of 2004 compared to the
prior year. The gross margin was 7% for the first six months of 2004, compared
to 15% in the first six months of 2003. The gross margin was 12% during the
second quarter of 2004, compared to 15% in the second quarter of the prior year.
The decrease in gross margin during the first six months of 2004 as compared to
2003 is due to $.3 million inventory provision related to operations in the
United Kingdom.
Sales and marketing expenses decreased $.4 million or 19% in the first six
months of 2004 compared to the first six months of 2003 and decreased $.1
million in the second quarter of 2004 compared to the second quarter of 2003
mainly due to lower commission expenses which reflects lower sales revenue
relative to prior periods.
Research and development expenses increased $.4 million or 51% from the first
six months of 2003 and increased $.2 million from the second 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 increased $.6 million or 34% from the first
six months of 2003 and $.7 million from the second quarter of 2003 due to the
recording of a $.5 million provision for accounts receivable as a result of the
settlement of a legal action and increased legal expenses.
Interest expense decreased $.1 million or 26% from the first six months of 2003
and decreased $.1 million from the second quarter of 2003 due to lower average
interest rates. The weighted average interest rate for the first six months of
2004 was 5.4% compared to 5.6% in 2003.
Liquidity and Capital Resources
Cash and cash equivalents at June 30, 2004 increased $.3 million from December
31, 2003 levels.
Total borrowings increased $2.5 million at June 30, 2004 from $8.0 million at
the end of 2003. The available balance on the line of credit was $2.5 million at
June 30, 2004. As of June 30, 2004, the Company is in compliance with all of the
financial covenants with the exception of the EBITDA (earnings before interest,
taxes, depreciation and amortization) covenant. The company has received a
waiver of the EBITDA covenant with respect to the covenant default for the
period ending June 30, 2004 from its Lenders. Although the Company anticipates
meeting
17
its current obligations and resource needs from funds generated through
operations and use of the available line of credit, its ability to remain in
compliance with these financial covenants could have a direct impact on its
ability to do so. (See Note 3 for further details.)
On August 6, 2004, the Company completed a recapitalization with its Lenders,
after obtaining stockholder approval of an amendment to the certificate of
incorporation of the Company to increase the authorized common stock of the
Company in order to permit the recapitalization at the July 15, 2004 annual
meeting. The recapitalization included, among other terms, the cancellation of
the $3.8 million mandatorily redeemable Series B preferred stock, including
accrued dividends, and the existing warrants held by the Lenders, 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 granted by the Company.
More specifically, the financing arrangement includes the following items:
* 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%.
* 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. The working capital term loan will accrue interest on $2 million at
the prime rate.
* The Company's financial covenants with respect to backlog, capital
expenditure and EBITDA were modified to enhance the financial flexibility of the
Company.
* Effective March 30, 2004, 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 was extended to coincide with the Company's secured debt.
* The recapitalization which was effective August 6, 2004 included,
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
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.
* Effective upon the closing of the recapitalization on August 6,
2004, the maturity date for all of the Company's secured indebtedness to the
Lenders was extended from through March 30, 2007.
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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 March 2007.
Operating activities used $2.1 million of cash in the first six months of 2004.
Non-cash expenses recorded during the first six months of the year were $1.2
million, which is consistent with the same period in 2003. These expenses relate
to depreciation of fixed assets (discussed in net plant and equipment below) and
amortization of customer service inventory and software license.
Net accounts receivable and unbilled receivables at June 30, 2004 decreased $.6
million from December 31, 2003 due mainly to the timing of collections and lower
sales levels in the second quarter of 2004.
Total inventories at June 30, 2004 increased $.1 million from December 31, 2003.
Total manufacturing inventories increased $.5 million from the beginning of the
year due to the production build schedule of the new SO series scanner. Customer
service inventories decreased $.4 million mainly due to an inventory provision
related to operations in the UK and lower inventory purchases.
Prepaid expenses and other increased $.5 million from December 31, 2003
reflecting legal and investment banking costs related to the Company's
recapitalization and debt restructuring.
Net plant and equipment remained flat relative to December 31, 2003.
Other assets remained at December 31, 2003 levels.
Accounts payable increased $.5 million from December 31, 2003 due to the timing
of payments.
Salaries and wages decreased $.8 million from December 31, 2003 due mainly to
the payout of the bonus accrual related to the 2003 bonus plan.
Taxes other than income taxes decreased $.1 million from December 31, 2003 due
to payments made for sales and use taxes in various state.
Customer deposits decreased $.3 million from December 31, 2003 due to the
transfer of deposits to accounts receivable to offset recorded product sales.
19
Deferred revenues increased $.9 million from December 31, 2003 due to the timing
of annual billings.
Other liabilities remained consistent with December 31, 2003 levels.
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 June 30, 2004 or on the results of operations for the three-month
period ending June 30, 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 June 30,
2004 or on the results of operations for the three-month period ending June 30,
2004.
20
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 June 30,
2004 or on the results of operations for the three-month period ending June 30,
2004.
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 June 30, 2004 of approximately $10.5 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.
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PART II - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits.
Exhibit Number Description
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.
Exhibit 10.1* Executive severance agreement between Peter H. Stelling
and Scan-Optics, Inc. dated April 1, 2004.
Exhibit 10.2* The Scan-Optics, Inc. 2004 Incentive and Non-qualified
Stock Option Plan.
Exhibit 10.3* The Scan-Optics, Inc. Amended and Restated Senior
Executive Stock Option Plan.
* Filed herewith.
(b) Reports on Form 8-K.
Report on Form 8-K filed May 18, 2004 regarding financial results for the
first quarter of 2004.
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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 August 16, 2004 /s/ James C. Mavel
---------------- -----------------------------------------
James C. Mavel
Chairman, Chief Executive Officer and
President
Date August 16, 2004 /s/ Peter H. Stelling
---------------- -----------------------------------------
Peter H. Stelling
Chief Financial Officer,
Vice President and Treasurer
23