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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 September 30, 2004
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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 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 October
29, 2004 was 41,451,577.
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 Financial Condition
and Results of Operations......................................... 14
Item 3. Quantitative and Qualitative Disclosures About Market Risk........ 22
Item 4. Controls and Procedures........................................... 22
PART II - OTHER INFORMATION
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases
of Equity Securities.............................................. 23
Item 4. Submission of Matters to a Vote of Security Holders............... 23
Item 6. Exhibits.......................................................... 24
2
PART I - FINANCIAL INFORMATION
1. Consolidated Financial Statements.
SCAN-OPTICS, INC., AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(thousands, except share data) September 30, 2004 December 31, 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Assets
Current Assets:
Cash and cash equivalents $ 989 $ 585
Accounts receivable less allowance of $309 at
September 30, 2004 and $1,206 at December 31, 2003 3,520 6,043
Unbilled receivables - contracts in progress 424 415
Inventories 8,508 7,282
Prepaid expenses and other 588 597
-----------------------------------------------------------
Total current assets 14,029 14,922
Equipment and Leasehold Improvements:
Equipment 3,880 3,682
Leasehold improvements 4,010 4,010
Office furniture and fixtures 757 745
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8,647 8,437
Less accumulated depreciation and amortization 7,704 7,422
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943 1,015
Goodwill 9,040
9,040
Other assets 1,502 1,096
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Total Assets $ 25,514 $ 26,073
===========================================================
3
(thousands, except share data) September 30, 2004 December 31, 2003
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Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 2,966 $ 2,323
Note payable 90
Salaries and wages 649 1,484
Taxes other than income taxes 729 758
Income taxes 96 189
Customer deposits 614 929
Deferred revenues 3,951 2,787
Other 1,349 1,495
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Total current liabilities 10,444 9,965
Note payable 10,410 7,989
Other liabilities 668 1,390
Mandatory redeemable preferred stock, at redemption
value
Series B, 3,800,000 shares issued and outstanding 4,286
Series I, 420,857 shares issued and outstanding 847
Stockholders' Equity
Preferred stock, par value $.02 per share; 5,000,000
Shares authorized
Common Stock, par value $.02 per share,
authorized 65,000,000 shares; issued,
41,865,077, including treasury shares at
September 30, 2004 and 7,439,732 shares
at December 31, 2003 837 149
Capital in excess of par value 41,558 38,354
Accumulated retained earnings deficit (35,564) (32,570)
Accumulated other comprehensive loss -
currency translation adjustment (1,040) (844)
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5,791 5,089
Less cost of Common Stock in treasury,
413,500 shares 2,646 2,646
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Total stockholders' equity 3,145 2,443
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Total Liabilities and Stockholders' Equity $ 25,514 $ 26,073
=================================================================
See accompanying notes.
4
SCAN-OPTICS, INC., AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months Ended Nine Months Ended
September 30 September 30
(thousands, except share data) 2004 2003 2004 2003
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Revenues
Hardware and software $ 1,935 $ 3,451 $ 7,911 $ 11,752
Professional services 1,440 1,241 4,447 3,864
Access services 2,812 2,673 8,040 7,966
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Total revenues 6,187 7,365 20,398 23,582
Costs of Revenue
Hardware and software 1,527 2,410 6,046 7,348
Professional services 626 645 2,264 2,097
Access services 2,174 2,172 7,011 6,683
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Total costs of revenue 4,327 5,227 15,321 16,128
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Gross Margin 1,860 2,138 5,077 7,454
Operating Expenses
Sales and marketing 871 767 2,363 2,614
Research and development 381 207 1,561 986
General and administrative 1,060 900 3,558 2,729
Interest 187 185 545 667
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Total operating expenses 2,499 2,059 8,027 6,996
-------------------------------------- ----------------------------------
Operating income (loss) (639) 79 (2,950) 458
Other income (loss), net (14) (56) 16 5
--------------------------------------- ----------------------------------
Income (loss) before income taxes (653) 23 (2,934) 463
Income taxes 10 11 60 41
-------------------------------------- ----------------------------------
Net Income (Loss) $ (663) $ 12 $ (2,994) $ 422
====================================== ==================================
Basic earnings (loss) per share $ (0.02) $ 0.00 $ (0.21) $ 0.06
====================================== ==================================
Diluted earnings (loss) per share $ (0.02) $ 0.00 $ (0.21) $ 0.05
====================================== ==================================
See accompanying notes.
5
SCAN-OPTICS, INC., AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Nine Months Ended
September 30
(thousands) 2004 2003
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Operating Activities
Net Income (loss) $ (2,994) $ 422
Adjustments to reconcile net income (loss)
to net cash provided (used) by operating activities:
Depreciation 270 259
Amortization of customer service inventory and
software license 1,548 1,532
Amortization of debt transaction fees 143
Provision for losses on accounts receivable 543
Disposal of equipment 46
Changes in operating assets and liabilities:
Accounts receivable and unbilled receivables 1,971 (971)
Inventories (2,638) (948)
Prepaid expenses and other 9 (423)
Accounts payable 643 406
Accrued salaries and wages (835) 242
Taxes other than income taxes (29) (128)
Income taxes (93) 2
Deferred revenues 1,164 431
Customer deposits (315) 11
Other (360) 360
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Net cash provided (used) by operating activities (973) 1,241
Investing Activities
Purchases of equipment, net (198) (63)
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Net cash used by investing activities (198) (63)
Financing Activities
Debt and equity transaction fees (936)
Proceeds from borrowings 4,711 5,300
Principal payments on borrowings (2,200) (6,353)
------------------------------------------------------
Net cash provided (used) by financing activities 1,575 (1,053)
Change in cash and cash equivalents 404 125
Cash and Cash Equivalents at Beginning of Period 585 274
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Cash and Cash Equivalents at End of Period $ 989 $ 399
=====================================================
See accompanying notes.
6
NOTE 1 - Basis of Presentation
- ------
The accompanying unaudited condensed 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 interim periods are not necessarily
indicative of the results that may be expected for the year.
The condensed consolidated balance sheet as of December 31, 2003 was derived
from the audited financial statements for the year then ended. Certain prior
period amounts have been reclassified to conform to the current period
presentation.
NOTE 2 - 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
recognized 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.
Required pro forma information follows:
7
For the three months For the nine months
ended ended
September 30 September 30
(thousands, except per share amounts) 2004 2003 2004 2003
- ----------------------------------------------------------------------------------------------------------------------------
Net income (loss), as reported $ (663) $ 12 $ (2,994) $ 422
Stock option expense (732) (25) (764) (38)
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Pro forma net income (loss) $ (1,395) $ (13) $ (3,758) $ 384
===============================================================
Basic earnings (loss) per share, as reported $ (.02) $ .00 $ (.21) $ .06
Stock option expense (.05) .00 (.06) (.01)
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Pro forma basic earnings (loss) per share $ (.07) $ .00 $ (.27) $ .05
===============================================================
Diluted earnings (loss) per share, as reported $ (.02) $ .00 $ (.21) $ .05
Stock option expense (.05) .00 (.06) (.01)
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Pro forma diluted earnings (loss) per share $ (.07) $ .00 $ (.27) $ .04
===============================================================
NOTE 3 - Inventories
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Inventories consist of:
September 30 December 31
(thousands) 2004 2003
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Finished goods $ 57 $ 57
Work-in-process 633 1,066
Service parts 2,670 3,291
Materials and component parts 5,148 2,868
------------------------------------
$ 8,508 $ 7,282
====================================
8
NOTE 4 - Credit Arrangements
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Effective March 30, 2004, the Company entered into a new credit agreement (the
Credit Agreement) with lenders affiliated with Patriarch Partners, LLC. (the
Lenders). Among other things, under the Credit Agreement the Company's existing
revolving and term loans with outstanding amounts of $9.0 million were exchanged
for a $9.0 million term loan, a $2.5 million revolving credit facility and a
$1.5 million term loan working capital facility. The $9.0 million term loan
bears interest at prime plus 2% and is payable in two annual installments of
$90,000 on April 1, 2005 and 2006 with the balance of $8,820,000 due on March
30, 2007.
In the second quarter of 2004, the Company borrowed $1.5 million under the term
loan working capital facility of the Credit Agreement. Such borrowings bear
interest at prime. The Credit Agreement requires the Company to repay the
borrowed amount plus $500,000 at March 30, 2007. The additional $500,000 is
being expensed as a transaction fee over the term of the loan.
Through September 30, 2004, there have been no borrowings under the $2.5 million
revolving credit facility portion of the Credit Agreement. Outstanding
borrowings bear interest at prime plus 2% and are due March 30, 2007.
As part of the Credit Agreement the Company is required to meet financial
covenants with respect to backlog, capital expenditures and EBITDA. The Company
is in compliance with the modified covenants.
On August 6, 2004, the Company completed a recapitalization with its Lenders,
which had been approved by the Company's shareholders on July 15, 2004. The
recapitalization included, among other terms, the cancellation of the $3.8
million of Mandatorily Redeemable Series B Preferred Stock, including dividends
of $0.6 million and outstanding warrants held by the Lenders, in exchange for
34,425,345 shares of Common Stock. As such, the Lenders own 79.8% of the
fully-diluted Common Stock of the Company at the date of issuance, subject to
dilution for certain current and future compensatory stock options granted by
the Company. The Company also issued an aggregate of 420,857 shares of 4% Series
I Preferred Stock with a mandatory redemption on March 30, 2007 for $841,714
plus unpaid dividends at 4%.
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 through March 30, 2007.
Borrowings under the Credit Agreement are secured by all of the Company's
assets.
9
NOTE 5 - Income Taxes
- ------
Income tax expense relates to minimum tax requirements in certain states and
Canadian income taxes. A valuation allowance has been provided for U.S. income
tax benefits applicable to the operating losses since it is not more likely than
not that the Company will benefit from their future utilization.
The Company's future ability to utilize the available net operating loss
carryforwards may be restricted due to limitations effected by the change in
control related to the credit agreements described in Note 4.
NOTE 6 - Earnings Per Share
- ------
The following table sets forth the computation of basic and diluted earnings (loss) per share:
Three Months Ended Nine Months Ended
September 30 September 30
2004 2003 2004 2003
- -----------------------------------------------------------------------------------------------------------------
Numerator:
Net earnings (loss) $ (663) $ 12 $ (2,994) $ 422
================================================================
Denominator:
Denominator for basic earnings (loss)
per share - weighted-average shares 27,606,601 7,026,232 13,961,741 7,026,232
Effect of dilutive securities:
Employee stock options - 1,145,697 - 689,476
----------------------------------------------------------------
Denominator for diluted earnings (loss)
per share - adjusted weighted-average
shares and assumed conversions 27,606,601 8,171,929 13,961,741 7,715,708
================================================================
Basic earnings (loss) per share $ (.02) $ .00 $ (.21) $ .06
================================================================
Diluted earnings (loss) per share $ (.02) $ .00 $ (.21) $ .05
================================================================
10
NOTE 7 - Comprehensive Income
- ------
Comprehensive income (loss) follows:
Three Months Ended Nine Months Ended
September 30 September 30
(thousands) 2004 2003 2004 2003
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Net income (loss) $ (663) $ 12 $ (2,994) $ 422
Foreign currency translation adjustments (96) (34) (196) 69
----------------------------------------------------------------
Comprehensive income (loss) $ (759) $ (22) $ (3,190) $ 491
================================================================
11
NOTE 8 - 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 Nine Months Ended
September 30 September 30
(thousands) 2004 2003 2004 2003
- -------------------------------------------------------------------------------------------------------------------
Revenues
Solutions and products $ 2,881 $ 4,446 $ 11,411 $ 15,290
Access services 2,812 2,673 8,040 7,966
Contract manufacturing services 494 246 947 326
---------------------------------------------------------------
Total revenues 6,187 7,365 20,398 23,582
Cost of solutions and products 2,153 3,055 8,310 9,445
Service expenses 2,174 2,172 7,011 6,683
---------------------------------------------------------------
Gross profit margin 1,860 2,138 5,077 7,454
Operating expenses
and other income, net 2,513 2,115 8,011 6,991
---------------------------------------------------------------
Income (loss) before income taxes $ (653) $ 23 $ (2,934) $ 463
===============================================================
Total expenditures for additions
to long-lived assets $ 65 $ 3 $ 198 $ 63
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. Access Services provides enterprise-wide
maintenance services for the Company's equipment and third-party equipment.
12
NOTE 9 - 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 third quarter of 2003 and $2.3 million in the first nine
months of 2003. At September 30, 2003, accounts receivable included bill and
hold receivables of $.7 million. There were no significant bill and hold
transactions in the first nine months of 2004 and there are no significant bill
and hold accounts receivable at September 30, 2004.
NOTE 10 - Contingencies
- -------
In August 2004, Millenium, L.P. filed suit in the United States District Court
for the Southern District of New York against the Company for patent
infringement. As of November 1, 2004, the parties have reached an agreement in
principal under which Millenium, L.P. will release the Company from all
liability for patent infringement and the Company will be free to practice all
claims under patents owned by Millenium, L.P. The Company has accrued an
estimated amount required to be paid under the confidential settlement agreement
in two quarterly installments commencing fourth quarter of 2004, which amount,
alone, will not have a material affect on operating results.
NOTE 11 - Capital Stock
- -------
An amended and restated certificate of incorporation was approved by the
shareholders at the Company's annual meeting held July 15, 2004. As such, the
total authorized capital stock of the Corporation is 70,000,000 shares
consisting of 65,000,000 shares of Common Stock, par value $.02 per share and
5,000,000 shares of Preferred Stock, par value $.02 per share. As of September
30, 2004 420,857 shares of Preferred Stock have been designated as Series I,
with dividends at 4%, and are outstanding.
On August 6, 2004 the Company issued 420,857 shares of Series I Preferred Stock
in exchange for cancellation of lease obligations aggregating $841,714 that the
Lenders acquired from the lessor. The Series I Preferred Stock and accrued 4%
annual dividends are redeemable March 30, 2007. As of September 30, 2004 the
carrying value of Preferred Stock is $847,000.
The recapitalization which was effective August 6, 2004 included, among other
terms, the cancellation of the 380,000 shares of $3.8 million mandatorily
redeemable Series B Redeemable Preferred Stock, par value $.02, the cancellation
of existing warrants exercisable for Common Stock held by the Lenders, and the
issuance of 34,425,345 shares of Common Stock of the
13
Company to the Lenders. There are 41,451,577 shares issued and outstanding as of
September 30, 2004. There are also 413,500 shares of treasury stock.
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 September 30, 2004 of approximately $10.5 million by
$0.1 million. The recapitalization became effective on August 6, 2004 (see Note
4 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.
14
The Company reported a net loss of $0.7 million in the third quarter of 2004
compared to net income of $12,000 in the third quarter of 2003 and a net loss of
$3.0 million year to date compared to net income of $0.4 million in 2003. The
Company's ability to effectively address these 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. The Company's
quarterly operating results continue to be significantly adversely affected
compared to 2003 by certain non-recurring and transitional events, including the
settlement of outstanding litigation, the phasing out of the sale of the
Company's mature line of 9000 Series scanners, the phased market introduction of
varied models of the Company's new generation of SO Series scanners, and the
development of new channels of distribution for the Company's hardware and
software.
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 $4.4 million or 38% from the first nine months of 2004 to 2003 and
$1.5 million or 47% in a comparison of the third quarter of 2004 vs. 2003,
mainly due to a decrease in the government market.
The second initiative, introduced in 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
15
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.
Results of Operations for the Three and Nine Months Ended September 30, 2004 vs.
2003
Total revenues decreased $3.2 million or 14% from the first nine months of 2003
to the first nine months of 2004 and decreased $1.2 million or 16% from the
third quarter of 2003 to the third quarter of 2004.
Hardware and software revenues decreased $3.8 million or 33% in the first nine
months of 2004 compared with the same period in 2003 and decreased $1.5 million
or 44% from the third quarter of 2003 compared to 2004. Compared to the first
nine months of 2003, North American sales decreased $6.2 million or 54% and
decreased $1.5 million or 45% during the third quarter of 2004 compared to the
third 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 nine months of 2004 as compared with the first nine
months of 2003 and remained consistent with the third 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, while simultaneously introducing to the
market, in phases, varied models of the Company's new generation of SO Series
scanners and developing new channels of distribution for the Company's hardware
and software, which concurrent activities accounted for a majority of the
decreased hardware and software revenue.
Professional services revenues increased $0.6 million or 15% in the first nine
months of 2004 compared with the first nine months of 2003 and increased $0.2
million or 16% during the third quarter of 2004 compared to the third quarter of
2003. These changes relate to increased solution sales to the Company's target
customer base.
Access services revenues increased $0.1 million or 1% in the first nine months
of 2004 compared with the first nine months of 2003 and increased $0.1 million
or 5% during the third quarter of 2004 compared to the third quarter of 2003.
The Company was impacted by a few customers discontinuing maintenance contracts
due to changes in their businesses, which was offset by increased spare parts
purchases.
Cost of hardware and software decreased $1.3 million or 18% in the first nine
months of 2004 compared to the first nine months of 2003 and decreased $0.9
million or 37% in the third quarter of 2004 compared to the third quarter of
2003. The gross margin was 24% for the first nine months of 2004, compared to
37% in the first nine months of the prior year. The gross margin
16
was 21% during the third quarter of 2004, compared to 30% in the third quarter
of the prior year. The decrease in gross margin is 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 $0.2 million or 8% in a comparison of
the first nine months of 2004 vs. 2003 and was flat in the third quarter of 2004
compared to the prior year. The gross margin was 49% for the first nine months
and 57% in the third quarter of 2004, compared to 46% in the first nine months
and 48% in the third 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 $0.3 million or 5% in the first nine months of
2004 vs. 2003 and was flat in the third quarter of 2004 compared to the prior
year. The gross margin was 13% for the first nine months of 2004, compared to
16% in the first nine months of 2003. The gross margin was 23% during the third
quarter of 2004, compared to 19% in the third quarter of the prior year. The
decrease in gross margin during the first nine months of 2004 as compared to
2003 is due to $0.3 million inventory provision related to operations in the
United Kingdom. The increase in gross margin in the third quarter of 2004
relative to the third quarter of 2003 was due to higher spare parts revenue.
Sales and marketing expenses decreased $0.3 million or 10% in the first nine
months of 2004 compared to the first nine months of 2003 mainly due to lower
salary and commission expenses and increased $0.1 million of 14% in the third
quarter of 2004 compared to the third quarter of 2003 primarily as a result of
higher commission expenses.
Research and development expenses increased $0.6 million or 58% from the first
nine months of 2003 and increased $0.2 million or 84% from the third quarter of
2003 largely due to higher salary and benefit costs, and external consulting
costs in 2004 as compared to 2003. These costs were lower in 2003 due to the
capitalization of software development costs.
General and administrative expenses increased $0.8 million or 30% from the first
nine months of 2003 and $0.2 million or 18% from the third quarter of 2003 due
to the recording of a $0.5 million provision for accounts receivable as a result
of the settlement of a legal action during the second quarter of 2004 and
increased legal expenses.
Interest expense decreased $0.1 million or 18% from the first nine months of
2003 and was flat relative to the third quarter of 2003 due to reduced interest
expense related to deferred operating lease payments. The weighted average
interest rate for the first nine months of 2004 was 5.7% compared to 4.8% in
2003.
17
Liquidity and Capital Resources
Cash and cash equivalents at September 30, 2004 increased $0.4 million from
December 31, 2003 levels.
Total borrowings increased $2.5 million at September 30, 2004 from $8.0 million
at the end of 2003. The available balance on the line of credit was $2.5 million
at September 30, 2004. As of September 30, 2004, the Company is in compliance
with all of the financial covenants. Although the Company anticipates meeting
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 4 for further details.)
On August 6, 2004, the Company completed a recapitalization with its Lenders,
after obtaining stockholder approval at the Company's July 15, 2004 annual
meeting 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. 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 such
that 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.
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 $2.0 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.
* 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 Common Stock 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.
18
* 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 through 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 March 2007.
Operating activities used $1.0 million of cash in the first nine months of 2004.
Non-cash expenses recorded during the first nine months of the 2004 were $2.5
million compared to $1.8 million for 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, software development, and
provision for losses on accounts receivable.
Net accounts receivable and unbilled receivables at September 30, 2004 decreased
$2.5 million from December 31, 2003 due mainly to the timing of collections and
lower sales levels in the third quarter of 2004.
Total inventories at September 30, 2004 increased $1.2 million from December 31,
2003. Total manufacturing inventories increased $1.8 million from the beginning
of the year due to the production build schedule of the new SO series scanner.
Customer service inventories decreased $0.6 million mainly due to an inventory
adjustment related to operations in the UK and lower inventory purchases.
Prepaid expenses and other increased remained flat from December 31, 2003.
Net plant and equipment decreased $0.1 million relative to December 31, 2003.
Other assets increased $0.4 million from December 31, 2003 reflecting legal and
investment banking costs related to the Company's recapitalization and debt
restructuring.
Accounts payable increased $0.6 million from December 31, 2003 due to the timing
of payments.
Salaries and wages decreased $0.8 million from December 31, 2003 due mainly to
the bonus accrual made in 2003 related to the 2003 bonus plan that did not occur
in 2004 in connection with the 2004 bonus plan.
19
Taxes other than income taxes remained consistent with December 31, 2003.
Customer deposits decreased $0.3 million from December 31, 2003 due to the
transfer of deposits to accounts receivable to offset recorded product sales.
Deferred revenues increased $1.2 million from December 31, 2003 due to the
timing of annual billings.
Other liabilities decreased $0.1 million from December 31, 2003.
20
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 September 30, 2004 or on the results of operations for the
three-month period ending September 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
September 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
September 30, 2004 or on the results of operations for the three-month period
ending September 30, 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
September 30, 2004 or on the results of operations for the three-month period
ending September 30, 2004.
21
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
In 2004, the Company completed a total debt restructuring (see Note 4 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 September 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 Overview
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-15(e) and 15d-15(e), 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.
22
PART II - OTHER INFORMATION
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities
In connection with the recapitalization, which was effective August 6, 2004, the
Company issued 34,425,345 shares of its Common Stock to the Lenders in exchange
for, among other things, the Lenders' agreement to extend the repayment date for
the Company's outstanding secured debt from June 30, 2005 to March 30, 2007, the
cancellation of $3.8 million mandatorily redeemable Series B preferred stock and
the cancellation of an existing Common Stock warrant held by the Lenders
entitling them to purchase 33.2% of the Company's Common Stock on a fully
diluted basis as of December 31, 2001. Of the 34,425,345 shares of the Company's
Common Stock issued to the Lenders, 6,470,929 shares are subject to repurchase
by the Company at $0.02 per share to cover the exercise of options for up to
6,470,929 shares held by certain members of management of the Company. The
issuance of these shares is exempt from registration pursuant to Section 4(2) of
the Securities Act of 1933, as amended.
Item 4. Submission of Matters to a Vote of Security Holders.
The Company held its Annual Meeting of Stockholders on July 15, 2004 to elect
three directors, to adopt the amended and restated certificate of incorporation,
to adopt the Scan-Optics, Inc. 2004 Incentive and Non-Qualified Stock Option
Plan and to appoint the Company's independent auditors for the fiscal year
ending December 31, 2004.
Scott Schooley, Lynn Tilton and Michael Scinto were elected directors with terms
expiring in 2006 by favorable votes of not less than 6,061,034. There were a
total of not more than 474,561 abstentions in the vote for the directors and no
broker nonvotes. The other members of the Board of Directors continuing in
office are James C. Mavel and Ralph J. Takala whose terms expire in 2006, and
John J. Holton whose term expires in 2005.
The amended and restated certificate of incorporation was adopted by a vote of
3,807,816 in favor, 580,045 against, 67,998 abstentions and 2,079,736 broker
nonvotes.
The Scan-Optics, Inc. 2004 Incentive and Non-Qualified Stock Option Plan was
adopted by a vote of 3,069,095 in favor, 1,318,586 against, 68,178 abstentions
and 2,079,736 broker nonvotes.
Ernst & Young LLP was appointed as the Company's independent auditors for the
year ending December 31, 2004 by a vote of 6,357,280 in favor, 122,947 against,
55,368 abstentions and no broker nonvotes. Ernst & Young LLP subsequently
resigned as the Company's independent auditors and have been replaced by UHY
LLP.
23
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* Amended and Restated Certificate of Incorporation
dated July 16, 2004.
* Filed herewith.
(b) Reports on Form 8-K.
Report on Form 8-K filed August 24, 2004 regarding financial results for
the second quarter of 2004.
Report on Form 8-K filed September 8, 2004 regarding changes in the
registrant's certifying accountant.
24
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 November 12, 2004 /s/ James C. Mavel
---------------------- -------------------------------------
James C. Mavel
Chairman, Chief Executive Officer and
President
Date November 12, 2004 /s/ Peter H. Stelling
---------------------- -------------------------------------
Peter H. Stelling
Chief Financial Officer,
Vice President and Treasurer
25