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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended October 31, 2001
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 number 0-24015
STEELCLOUD, INC
(Exact name of registrant as specified in its charter)
Commonwealth of Virginia 54-1890464
- ------------------------ ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1306 Squire Court
Dulles, Virginia 20166
- ----------------- -----
(Address of principal executive offices) (Zip Code)
(703) 450-0400
--------------
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12 (b) of the Exchange Act
Title of each class Name of exchange on which registered
- ------------------- ------------------------------------
None.
Securities registered pursuant to Section 12 (g) of the Act:
Title of each class Name of exchange on which registered
- ------------------- ------------------------------------
Common Stock, $.001
par value per share Nasdaq National Market System
Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if there is disclosure of delinquent filers in
response to Item 405 of Regulation S-K contained herein and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. |X|
The aggregate market value of the voting stock held by non-affiliates
of the issuer as of January 28, 2002 was $30,017,290.
ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS
Indicate by check mark whether the registrant has filed all documents
and reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes |_| No |_|
APPLICABLE ONLY TO CORPORATE REGISTRANTS
The number of shares outstanding of the registrant's Common Stock,
$.001 par value per share, on January 28, 2002 was 10,214,545.
Documents incorporated by reference: None
STEELCLOUD, INC
2001 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I
Page Number
Item 1. Description of Business 2
Item 2. Description of Properties 6
Item 3. Legal Proceedings 7
Item 4. Submission of Matters to a Vote of Security Holders 7
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters 8
Item 6. Selected Financial Data 10
Item 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations 11
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 14
Item 8. Financial Statements and Supplementary Data 14
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosures 14
PART III
Item 10. Directors and Executive Officers of the Registrant 14
Item 11. Executive Compensation
Item 12. Security Ownership of Certain Beneficial Owners and Management
Item 13. Certain Relationships and Related Transactions
(Part III information is incorporated by reference from portions of the
Company's definitive Proxy Statement to be filed pursuant to Regulation 14A)
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 15
Signatures 18
1
PART I
ITEM 1. DESCRIPTION OF BUSINESS
General
SteelCloud, Inc. (formerly Dunn Computer Corporation) or (the "Company") was
founded in 1987 as a company that manufactured and marketed custom computers,
primarily to the Federal government.
Today, the company is principally engaged in the design and development of
custom and customized server appliances for software and technology companies.
SteelCloud develops these OEM (original equipment manufacturer) platform
configurations to significantly reduce the end-users' implementation time and
expense. The Company's appliance approach shortens its OEM partners' sales
cycles while allowing them to increase their revenue and reinforce their
branding strategies. SteelCloud sells OEM server appliances to leading software
and technology companies that, in turn, distribute the uniquely "branded"
products through their own direct sales and distribution channels worldwide.
The Company was incorporated as Dunn Computer Corporation in Virginia on
February 26, 1998 in connection with the reorganization of Dunn Computer
Corporation, a Delaware Corporation, which was incorporated on April 22, 1997.
The Company's operating subsidiary, Dunn Computer Operating Company, was
incorporated in Virginia in July 1987. The Company's other subsidiaries are
International Data Products (IDP), acquired May 1998, STMS, Inc (STMS), acquired
September 1997, and Puerto Rico Industrial Manufacturing Operations Acquisition
Corporation (PRIMOA), incorporated in Puerto Rico in May 1998.
On September 25, 2000, the Company began doing business as ("d/b/a") SteelCloud
Company. On October 19, 2000, the Company changed its NASDAQ ticker symbol from
DNCC and began trading as SCLD. On May 15, 2001, the shareholders of the Company
unanimously approved the name change of the Company to SteelCloud, Inc.
effective on that date. Unless the context otherwise requires, the "Company" or
"Dunn Computer Corporation" refers to SteelCloud Inc., its predecessor and its
subsidiaries. The principal executive offices are located at 1306 Squire Court,
Dulles, Virginia 20166. The Company's main telephone number is (703) 450-0400.
Inquiries may also be sent to SteelCloud at info@steelcloud.com for sales and
general information or ir@steelcloud.com for investor relations information.
Products and Services
The Company offers network appliances, infrastructure server products,
outsourced manufacturing, and consulting services. The Company believes it
operates in one segment, information technology.
Network Server Appliances: SteelCloud partners with leading software and
technology companies to create uniquely branded, ready-to-use turnkey network
server appliance solutions combining both hardware and software. SteelCloud
integrates the partner's software onto a custom designed server platform,
running Linux or Microsoft NT/2000. This process results in an optimized,
tested, and certified appliance, unique to the OEM partner, that is ready to
deploy and use when it arrives at the customer site. The company has leveraged
its years of experience, developing and managing custom server platforms for
mission-critical Department of Defense ("DOD") and security programs, to create
a unique methodology for addressing the OEM market. The appliance becomes a
"product" of the respective OEM partner, which in turn markets the appliance
through their normal distribution channels. For its appliance customers,
SteelCloud offers much more than hardware manufacturing. The Company assembles a
package of design, support, and logistical services that are custom tailored for
each particular software company, thereby augmenting the partner's internal
capabilities. In essence, SteelCloud takes responsibility for those tasks
necessary to successfully bring an appliance to market, which are impractical
for its software partners to perform.
The Company believes that its unique approach to the server appliance market
(collaborating with leading software manufacturers and leveraging their
significant product marketing and sales efforts) enables it to realize economies
of scale in development, sales, and marketing far greater than its revenue would
indicate under a more traditional strategy. The Company also believes that risks
relating to R&D (research and development) and inventory are also greatly
reduced through its OEM partnership approach.
2
Infrastructure Products: The Company designs, develops and manufactures
specialized custom servers, which are configured with single, dual, or quad
Intel Pentium III, IV, or Xeon processors. These servers are designed to give
data center customers the highest level of performance, reliability, and
manageability available in the market today. The company combines its hardware
offerings with specialized software integration and logistics programs to give
its data center customers, unique solutions unavailable from the traditional
hardware-only vendors.
The Company believes that the infrastructure/server market offers opportunities
for higher profit margins compared to other sectors in the industry. With the
continuing acceptance of Internet data center and ASP (application service
provider) concepts, this market represents a significant growth opportunity for
the Company.
Outsourced Manufacturing: Puerto Rico Industrial Manufacturing Operations
Acquisition Corporation (PRIMOA) manufacturers a wide variety of computers and
provides contract manufacturing services for companies who want to serve the
Puerto Rican Market through a Puerto Rican manufacturer with localized services.
PRIMOA operates a 20,000 square foot, ISO 9002 manufacturing facility in
Guayama, Puerto Rico, and as part of the local community, PRIMOA's facility
qualifies for incentives when bidding on Puerto Rican Government contracts.
PRIMOA augments its computer products with localized, bi-lingual IT services
such as training, maintenance, and consulting.
Consulting Services: SteelCloud provides a complete array of consulting services
surrounding the technologies addressed by its server appliances. The Company's
consulting services include network and security analysis, design and
implementation, as well as help desk consulting. These services are primarily
delivered in the form of short-term (less than three months) projects. The
Company's consulting services are performed for a fixed-fee or on an hourly
labor basis at the pre-negotiated price and estimated levels of effort.
SteelCloud acts as a value-added reseller for certain software products that are
delivered as a part of its consulting services. In many cases, SteelCloud
provides its appliance customers with additional technical services that
complement their appliance implementation.
Specific project-based services SteelCloud performs include network analysis,
network design, systems implementation, virus protection, network security,
software migrations, messaging system migrations and complete help desk
implementation and support. SteelCloud maintains expertise in specific areas and
technologies rather than general knowledge in many IT (information technology)
areas. By maintaining a rigorous focus, SteelCloud provides highly skilled
professionals and services that leverage our experience for maximum benefit to
the client. Project management is the key component of SteelCloud's strategy and
success in project-based engagements.
SteelCloud also provides network support services in the form of fixed-rate
hourly engineering services. Client contracts range anywhere from one month to
three years in length. Staffing services consist of placing one or more network
engineers, user support technicians, or programmers on-site with a client. These
professionals perform work as a "virtual" employee for the client and typically
work under the direction of the client's management. Hourly rates for staffing
engagements are normally lower than for project-based engagements; however, the
contracts usually have substantially longer periods of performance. SteelCloud's
success in this area is achieved largely due to contract renewals and increasing
staffing requirements from existing customers.
Government Contracts
In fiscal 2001, the Company derived approximately 14% of its revenues from sales
of hardware and services to the U.S. Federal Government pursuant to contracts
with the General Services Administration (GSA) or other agency-specific
contracts.
GSA Contract. The Company has a multiple award schedule contract with GSA (the
"GSA" Contract). The Company's GSA contract was awarded in April 1996 and is
valid through March 31, 2002. The GSA contract enables Government IT purchasers
to acquire all of their requirements from a particular vendor and largely limits
the competition to selected vendors holding GSA contracts. For fiscal year 2001,
the Company's GSA contract had sales of $2.6 million, which accounted for
approximately 9% of the Company's revenues. The Company expects to have its GSA
contract renewed in 2002.
In fiscal 2001, the Company derived approximately 14% of its revenues from sales
of hardware and services to the Puerto Rican Government.
Commercial Contracts
In fiscal year 2001, SteelCloud derived approximately 86% of its revenues from
sales of hardware and services to the commercial marketplace and state and local
government. The Company's commercial customer base consists of several Fortune
500 companies as well as medium-size local commercial customers. The Company
derived approximately 51% of its revenues from three customers during fiscal
2001. The Company intends to continue to increase its commercial customer base
in the upcoming fiscal year. The Company's Appliance Partner program and its own
sales and marketing activities are concentrated on expanding the Company's
commercial customer base. Strategic partnerships with industry leading companies
such as Microsoft, Cisco, and Intel enable the Company to further diversify its
product mix and attract high quality customers.
3
Manufacturing and Production
The Company's production capacity is 100,000 systems per year in its existing
Dulles, Virginia facility on a three-shift basis. The Company's production
capacity at its Puerto Rico facility is 100,000 systems per year. Both
facilities are currently operating on a single shift basis.
Competition and Marketing
The markets for the Company's products and services are highly competitive. Many
of the Company's competitors offer broader product lines and have substantially
greater financial, technical, marketing and other resources. These competitors
may benefit from component volume purchasing and product and process technology
license arrangements that are more favorable in terms of pricing and
availability than the Company's arrangements.
The Company competes with a large number of computer systems integrators, custom
computer manufacturers, resellers, and IT services companies. The Company
believes it is likely that these competitive conditions will continue in the
future. There can be no assurance the Company will continue to compete
successfully against existing or new competitors that may enter markets in which
the Company operates.
There has been a consolidation in the industry as a result of acquisitions, the
failure of many firms, and the decision of firms to focus on other markets. The
following companies are significant competitors of the Company in at least one
of its market segments:
Company Type
------- ----
Sun Microsystems (Cobalt Networks) .................. Manufacturer
Avnet ............................................... Manufacturer
Pioneer-Standard Electronics ........................ Systems Integrator
Nokia ............................................... Manufacturer
Federal Government Market. The emergence of the GSA Schedule, which is a list of
pre-approved vendors from which the Government and/or federal agencies may
purchase goods and services, as a significant procurement vehicle has enabled
traditional mass-market commercial computer companies to be more responsive to
government requirements and become more competitive with the Company in the
Federal Government Market. The Company believes that the Government's selection
criteria for vendor selection consist of price, quality, familiarity with the
vendor, and size and financial capability of the vendor. The government has
increased the amount of information technology products acquired through the GSA
Schedule. Because the company primarily targets custom computer procurements, it
rarely competes with national commercial computer manufacturers such as Dell
Computer Corporation and Compaq in the federal market.
Commercial Market. The information technology industry is highly competitive.
Pricing is very aggressive in the industry and the Company expects pricing
pressures to continue. The industry is also characterized by rapid changes in
technology and consumer preferences, short product life cycles and evolving
industry standards.
The commercial market for the Company's IT products and services is a highly
fragmented market served by thousands of small value-added resellers and
specialized manufacturers. These companies typically service a small geographic
area and resell national brand computer and/or network hardware. The Company
believes its consulting services group can compete effectively in the local
market because it provides engineering services in conjunction with its turnkey
server appliances and products from its strategic partners; e.g., Cisco,
Microsoft, and Intel. The Company believes that its ability to integrate its
server systems with networking products also gives its consulting services group
a competitive advantage.
4
In the OEM server appliance market, the principal elements of competition are
product reliability, quality, customization, price, customer service, technical
support, value-added services, and product availability. There can be no
assurance that the Company will, in the future, be able to compete effectively
against existing and future competitors.
Marketing. The Company markets its products and services to software
manufacturers, their channel partners, select commercial accounts and the
federal government. The Company uses an in-house sales force and program
managers to market its products and services. SteelCloud markets its products
and services worldwide; either directly through its own sales personnel, or
through the marketing organizations of its appliance partners. The Company
believes that marketing is important for all of its target markets, although
less so in its OEM appliance business because its success relies on the OEM
partner's sales and marketing capabilities.
The Company strives to build a strong relationship with its customers. The
Company believes that a key to building customer loyalty is a team of
knowledgeable and responsive account executives and a knowledgeable technical
and support staff. The Company assigns each customer a trained account
executive, to whom subsequent calls to the Company will be directed. The account
executive is augmented with a program manager for SteelCloud's larger customers.
The Company believes that these strong one-on-one relationships improve the
likelihood that the customer may consider the Company for future purchases. The
Company intends to continue to provide its customers with products and technical
services that offer the customer the best value.
The Company uses electronic commerce technologies in its marketing efforts and
believes that its customers will continue to expand and utilize these
technologies. The internet is being used by customers to advertise opportunities
and to reference vendor information. The Company maintains a web site on the
Internet referencing its GSA catalogue and product offerings. In addition, the
Company provides the capability for customers to download updated software and
drivers that become available.
Suppliers
The Company devotes significant resources to establishing and maintaining
relationships with its key suppliers. The Company, where possible, purchases
directly from component manufacturers such as Intel, Microsoft and Cisco among
others. The Company also purchases multiple products directly from large
national and regional distributors such as TechData Corporation and Ingram
Micro.
Certain suppliers provide the Company with incentives in the form of discounts,
rebates, credits, and cooperative advertising, and market development funds. The
Company must continue to obtain products at competitive prices from leading
suppliers in order to provide competitively priced products for its customers.
In the event the Company is unable to purchase components from existing
suppliers, the Company has alternative suppliers it can rely upon. The Company
believes its relationships with its key suppliers to be good and believes that
generally, there are multiple sources of supply available should the need arise.
Patents, Trademarks and Licenses
The Company works closely with computer product suppliers and other technology
developers to stay abreast of the latest developments in computer technology.
While the Company does not believe its continued success depends upon the rights
to a patent portfolio, there can be no assurance that the Company will continue
to have access to existing or new technology for use in its products.
The Company conducts its business under the trademarks and service marks of
"SteelCloud", "SteelCloud Company", "Dunn Computer Corporation," "International
Data Products," and "IDP." The Company believes its trademarks and service marks
have significant value and are an important factor in the marketing of its
products.
Because most software used on the Company's computers is not owned by the
Company, the Company has entered into software licensing arrangements with
several software manufacturers.
Employees
As of October 31, 2001, the Company had 90 employees. Of this total, 4 were
employed in an executive capacity, 11 in sales and marketing, 18 in
administrative capacities, 29 in technical and/or services and 28 in operations.
As of January 23, 2002, the Company had 95 employees. None of SteelCloud's
employees are covered by a collective bargaining agreement. SteelCloud considers
its relationships with its employees to be good.
5
The Company believes that its future success depends in large part upon its
continued ability to attract and retain highly qualified management, technical,
and sales personnel. The computer industry's shortage of trained and experienced
technicians has eased over the past twelve months. SteelCloud has an in-house
training and mentoring program to develop its own supply of highly qualified
technical support specialists. There can be no assurance, however, that the
Company will be able to attract and retain the qualified personnel necessary for
its business.
ITEM 2. DESCRIPTION OF PROPERTY
The Company leases approximately 35,000 square feet at its facility in Dulles,
Virginia, which is used as its principal executive offices, for manufacturing
and administrative services. Pursuant to the lease, which expires in February,
2005, the Company pays approximately $27,000 per month in rent.
The Company also leases a 20,000 square-foot facility in Guayama, Puerto Rico,
which is used for manufacturing, technical support, and personal computer board
level repair. Pursuant to the lease, which expires in 2004, the Company pays
approximately $4,000 per month in rent. The Company believes that its current
facilities are adequate for its existing needs and that additional suitable
space will be available as required.
ITEM 3. LEGAL PROCEEDINGS
On July 31, 1998, the Company received notice from the SBA that it was denying
the request of the U.S. Air Force to waive the requirement to terminate IDP's
Desktop V contract for the convenience of the Government upon the change in
control of IDP to the Company. The Company appealed the denial of the SBA to the
SBA's Office of Hearings and Appeals. On August 31, 1999, the SBA denied the
appeal and ruled that the U.S. Air Force must terminate-for-convenience the
Desktop V contract. Prior to this ruling by the SBA, the U.S. Air Force
determined not to exercise any of the remaining option years under the Desktop V
contract on May 1, 1999. In October 1999, the U.S. Air Force issued a
termination-for-convenience letter to the Company. Under a
termination-for-convenience, the government is required generally to reimburse a
contractor for all costs incurred in the performance of the contract. The
Company is in the process of attempting to recover from the government a portion
or all of unreimbursed costs associated with the Desktop V Contract.
In November 1998, IDP entered into a Government Integrator Agreement, as
amended, with Microsoft Corporation (Microsoft) for the licensing of certain
Microsoft software. During 1999, Microsoft asserted that IDP owed approximately
$800,000 under this agreement due primarily to amended billing by Microsoft
concerning sales by IDP to the U.S. Air Force in conjunction with the Desktop V
contract. On October 31, 2000, Microsoft filed suit against the Company for
breach of contract. In conjunction with the filing of the lawsuit, Microsoft
increased its claim by asserting further amendments to billing and relating
issues, resulting in a claim against the Company of approximately $1.3 million.
Subsequent to October 31, 2000, the Company submitted a motion to dismiss the
case and filed a counterclaim of fraud on behalf of IDP in the amount of
$500,000. The Company believes that it has meritorious defenses to the claim and
intends to vigorously defend itself. The Company cannot estimate at this time
the amount of the liability to be incurred, if any, but does not believe that
this matter will have a material adverse effect upon the Company's financial
position or results of operations. The Company has accrued for amounts due
Microsoft based on the original billing terms.
On October 19, 2000, the Company received a cease and desist letter from
LoudCloud, Inc. alleging that the use of the "SteelCloud" mark and name would
constitute an infringement of LoudCloud's rights to its "LoudCloud" mark and
name and family of "Cloud" marks, that use of "SteelCloud" would dilute the
distinctiveness and fame of the LoudCloud mark and name and, that such acts by
the Company violated federal and state law regarding unfair competition. In
response, the Company filed a declaratory judgment action in the U.S. District
Court for the Eastern District of Virginia, seeking a judicial determination
that its use of the "SteelCloud" mark and name would not violate the proprietary
rights of LoudCloud nor dilute the alleged fame and distinctiveness of the
"LoudCloud" mark and name. In this action, the Company also alleged a new claim
that LoudCloud, Inc. has violated federal law through its misuse of the
trademark provisions under the Lanham Act as amended in 1988. A hearing has been
held on the LoudCloud motion to dismiss and the court has taken the matter under
advisement. On January 10, 2001, the US District Court for the Eastern District
of Virginia dismissed the case.
Other than the above, there are no material claims pending against the Company.
6
There are routine legal claims pending against the Company, but in the opinion
of management, liabilities, if any, arising from such claims will not have a
material adverse effect on the financial condition and results of operation of
the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the fourth
quarter of the fiscal year covered by this report.
7
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Market Information
Prior to the quotation of the Company's Common Stock beginning on April 22,
1997, there was no established trading market for the Company's common stock.
The Company's Common Stock is listed on The Nasdaq Stock Market, Inc.'s National
Market System. The Company changed its symbol from "DNCC" to "SCLD" on October
19, 2000. The following table sets forth the high and low selling prices as
reported by The Nasdaq National Market System for each fiscal quarter during the
fiscal years ended October 31, 2001 and 2000, as well as for the first quarter
of fiscal 2002 through January 28, 2002. These quotations reflect inter-dealer
prices without retail mark-up, mark-down or commission and may not represent
actual transactions.
Fiscal 2000
High Low
--------------------
First Quarter..................................... $4.84 $1.00
Second Quarter.................................... $4.28 $2.00
Third Quarter..................................... $2.50 $1.63
Fourth Quarter.................................... $1.84 $1.00
Fiscal 2001
High Low
--------------------
First Quarter..................................... $1.38 $0.69
Second Quarter.................................... $1.25 $0.50
Third Quarter..................................... $0.75 $0.45
Fourth Quarter.................................... $1.05 $0.62
Fiscal 2002
High Low
--------------------
First Quarter (through January 28, 2002).......... $3.89 $0.78
On January 28, 2002 the closing price of the Company's Common Stock as reported
on The Nasdaq National Market was $3.89 per share. There were approximately
5,085 shareholders of the Common Stock of the Company as of such date.
The Company has not paid cash dividends on its Common Stock and does not intend
to do so in the foreseeable future.
8
Recent Sales of Unregistered Stock
On May 1, 1998, in connection with the IDP acquisition, the Company acquired all
of the issued and outstanding capital stock of IDP Co. and substantially all of
the net assets of PRIMO. In consideration for the IDP acquisition, the Company
paid the former owners an aggregate of $14.9 million in cash and an aggregate of
750,000 shares of Common Stock. In November 1998, the Company received 350,000
shares of the stock previously issued to the former owners of IDP (Fusters) in
connection with a Purchase Price Adjustment Agreement. The shares sold to the
Fusters in the IDP acquisition were sold in reliance upon the exemption from
registration afforded by Section 4(2) of the Securities Act of 1933, as amended.
In March 2000, the Company sold 3,000 shares of its Series A Convertible
Preferred Stock to one investor. In connection with the sale, the Company
received an aggregate of $3,000,000. The shares of preferred stock were sold in
reliance upon the exemption from registration provided by Regulation D Rule 506
of the Securities Act of 1933, as amended. In August 2001, the Company redeemed
2,620 shares of the Series A Convertible Preferred Stock which represented all
of then outstanding Preferred Stock.
In March 2000, the Company issued 225,000 shares of its common stock in
connection with the settlement of a lawsuit with a former employee. The shares
of common stock were issued in reliance upon the exemption from registration
afforded by Section 4(2) of the Securities Act of 1933, as amended.
9
ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL DATA
(In thousands, except per share data)
The following selected consolidated financial data of SteelCloud should be read
in conjunction with the consolidated financial statements and the notes thereto
and "Management's Discussion and Analysis of Financial Condition and Results of
Operations". The consolidated statement of operations data set forth below with
respect to the fiscal years ended October 31, 1999, 2000 and 2001 and the
consolidated balance sheet data as of October 31, 2000 and 2001 is derived from
and is referenced to the audited consolidated financial statements of SteelCloud
included elsewhere in this Annual Report on Form 10-K. The consolidated
statement of income data set forth below with respect to the fiscal years ended
October 31, 1997 and 1998 and the consolidated balance sheet data as of October
31, 1997, 1998 and 1999 is derived from audited consolidated financial
statements of SteelCloud not included in this annual report.
Year ended October 31,
1997(2) 1998(3) 1999 2000 2001
----------------------------------------------------------------
Consolidated Statement of Operations Data:
Net revenues..................................................... $21,766 $66,888 $34,475 $39,766 $30,138
Costs of revenues................................................ 17,549 54,969 27,981 32,636 22,510
Gross profit..................................................... 4,217 11,919 6,494 7,130 7,628
Selling, general and administrative, and amortization............ 2,198 9,983 37,749 6,716 6,235
Income (loss) from operations.................................... 2,019 1,936 (31,255) 414 1,393
Other (expense) income, net...................................... 98 (270) (2,911) (298) (274)
Income (loss) before income taxes and extraordinary gain......... 2,117 1,666 (34,166) 116 1,119
Provision for (benefit from) income taxes........................ 795 686 (559) 65 105
Income (loss) before extraordinary gain.......................... 1,322 980 (33,607) 51 1,014
Extraordinary gain............................................... - - - 750 -
Cumulative effect of change in accounting principle.............. - - - - (576)
Preferred stock dividends........................................ - - - (625) (112)
Increase to income available to common stockholders from
repurchase of preferred stock.................................. - - - - 721
Net income (loss) available to common stockholders............... $1,322 $980 $(33,607) $176 $1,047
Basic earnings (loss) per share(1)............................... $0.29 $0.14 $(3.57) $0.02 $0.10
Earning (loss) per share assuming dilution(1).................... $0.28 $0.13 $(3.57) $0.02 $0.08
Weighted average shares outstanding(1)........................... 4,552 7,231 9,404 9,581 10,111
Weighted average shares outstanding assuming dilution(1)......... 4,679 7,492 9,404 9,581 12,463
Pro forma basic earnings (loss) per share assuming the
accounting change is applied retroactively..................... $0.29 $0.14 $(3.57) $(0.04) $0.16
Pro forma earnings (loss) per share assuming the accounting
change is applied retroactively, assuming dilution............. $0.28 $0.13 $(3.57) $(0.04) $0.08
At October 31,
1997 1998 1999 2000 2001
----------------------------------------------------------------
Consolidated Balance Sheet Data:
Working capital (deficit)........................................ $4,339 $5,773 $(1,422) $5,733 $7,289
Total assets..................................................... 18,703 62,965 22,287 23,005 17,135
Long-term debt................................................... 75 51 2,845 2,598 3,837
Total liabilities................................................ 10,465 24,592 17,470 14,149 9,736
Stockholders' equity............................................. 8,238 38,373 4,817 8,856 7,398
- -----------
(1) The earnings per share amounts prior to fiscal 1998 have been restated
as required to comply with Statement of Financial Accounting Standards
No. 128, Earnings Per Share. For further discussion of earnings per
share see Note 2 to the Company's consolidated financial statements.
(2) Includes the activity of STMS from September 12, 1997 (date of
acquisition).
(3) Includes the activity of IDP and PRIMO from May 1, 1998 (date of
acquisition).
10
ITEM7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Founded in 1987, SteelCloud based in Dulles, Virginia, designs,
develops and manufactures custom and customized server appliances and network
solutions. In addition, the Company provides Information Technology ("IT")
solutions support to clients for those hardware and networking solutions
implemented.
The following discussion should be read in conjunction with the
consolidated financial statements. Certain statements contained herein may
constitute forward-looking statements within the meaning of the Private
Securities Litigation Reform Act of 1995. Because such statements include risks
and uncertainties, actual results may differ materially from those expressed or
implied by such forward-looking statements. Factors that could cause actual
results to differ materially include, but are not limited to, risks associated
with the integration of businesses following an acquisition, competitors with
broader product lines and greater resources, emergence into new markets, the
termination of any of the Company's significant contracts, the Company's
inability to maintain working capital requirements to fund future operations or
the Company's inability to attract and retain highly qualified management,
technical and sales personnel.
Overview of Fiscal 2001
In fiscal 2001, the Company modified its business strategy to focus on the
server appliance sector. As a result, the Company has partnered with software
and technology companies in order to design and develop custom and customized
network server appliances that are delivered to the commercial marketplace. The
efficiencies realized on the development and production of these appliances has
enabled the Company to increase its gross margin significantly over fiscal 2000.
The increase in gross margins has offset the decrease in net revenues from
fiscal 2000. The Company believes that this trend will continue during fiscal
2002.
In addition to the Company's modification of its business strategy, the
following summarizes significant activity for fiscal 2001.
Completion of a significant contract
In fiscal 2000, the Company received a contract award from the Government of
Puerto Rico for approximately $16.5 million. The contract commenced in March
2000 and deliveries were completed in January 2001. The completion of this
contract primarily attributed to the overall decrease in net revenues. It is
important to note that the margins realized on this contract were significantly
lower than the server appliance model and as such the decrease in these revenues
was offset by the increase in gross margin. During fiscal 2001, approximately
$335,000 in revenue was recognized relating to this contract.
Redemption of the Company's Series A Convertible Preferred Stock
In March 2000, the Company sold 3,000 shares of its Series A Convertible
Preferred Stock for net proceeds of approximately $2.7 million. The sale was
executed in reliance upon the exemptions from registration provided by
Regulation D Rule 506 promulgated by the Securities and Exchange Commission
under the Securities Act of 1933, as amended. The sale was executed in order to
obtain capital to fund current and future operations.
In July 2001, the Company entered into an agreement with its Preferred
Shareholders to redeem all of its outstanding Series A Convertible Preferred
Stock for $2.5 million in cash. Under the terms of the redemption agreement, the
preferred shareholders retained approximately 247,000 warrants previously
issued.
In August 2001, the Company completed the transaction by delivering $2.5 million
to its preferred shareholders in exchange for the then outstanding 2,620 shares
of its Series A Convertible Preferred Stock. As a result of this redemption, the
Company had no outstanding preferred shares as of October 31, 2001.
11
Settlement of Malpractice Claim
In August 2000, the Company's former legal counsel filed a claim against the
Company for approximately $343,087 plus accrued interest for legal fees and
costs. In response to the claim, the Company filed a counter claim for
professional malpractice and breach of fiduciary duty in the amount of
$1,568,000.
In June 2001, the Company reached a settlement agreement with its former legal
counsel whereby both parties agreed to relinquish all claims against the other,
release each other from liability and waive the payment of all outstanding
claims. The Company reversed the liability that had been previously recorded for
this claim, which reduced general and administrative expenses for the fiscal
year.
Fiscal 1999 Termination of a Significant Contract
On July 31, 1998, the Company received notice from the SBA that it was denying
the request of the U.S. Air Force to waive the requirement to terminate IDP's
Desktop V contract for the convenience of the Government upon the change in
control of IDP to the Company. The Company appealed the denial of the SBA to the
SBA's Office of Hearings and Appeals. On August 31, 1999, the SBA denied the
appeal and ruled that the U.S. Air Force must terminate-for-convenience the
Desktop V contract. On May 1, 1999, prior to the SBA ruling the U.S. Air Force
determined not to exercise any of the remaining option years under the Desktop V
contract and terminated the contract for all participating vendors. Initially
awarded to IDP, the Desktop V contract was the Company's largest contract.
Management believed at the date of the IDP acquisition, the contract would be
renewed by the government through fiscal year 2003 and would generate over $100
million in revenues during that period. As a result of the termination of this
contract, the recoverability of the Company's goodwill associated with the IDP
acquisition was significantly impaired. Accordingly, management recorded an
impairment charge of approximately $21 million during fiscal 1999.
In October 1999, the U.S. Air Force issued a termination-for-convenience letter
to the Company. Under a termination-for-convenience, the government is required
generally to reimburse a contractor for all costs incurred in the performance of
the contract. The Company is in the process of attempting to recover from the
government a portion or all of unreimbursed costs associated with the Desktop V
Contract.
Critical Accounting Policies
The Company believes the following represent its critical accounting policies:
Revenue Recognition
The Company recognizes revenue in accordance with SEC Staff Accounting Bulletin
No. 101, Revenue Recognition in Financial Statements (SAB 101), as amended by
SAB 101A and 101B. SAB 101 requires that four basic criteria must be met before
revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2)
delivery has occurred or services rendered; (3) the fee is fixed and
determinable; and (4) collectibility is reasonably assured. Determination of
criteria (3) and (4) are based on management's judgments regarding the fixed
nature of the fee charged for services rendered and products delivered and the
collectibility of those fees. Should changes in conditions cause management to
determine these criteria are not met for certain future transactions, revenue
recognized for any reporting period could be adversely affected.
Hardware products sold are generally covered by a warranty for periods ranging
from one to three years. The Company accrues a warranty reserve for estimated
costs to provide warranty services. The Company's estimate of costs to service
its warranty obligations is based on historical experience and expectation of
future conditions. To the extent the Company experiences increased warranty
claim activity or increased costs associated with servicing those claims, its
warranty accrual will increase resulting in decreased gross profit.
Legal Contingencies
We are currently involved in certain legal proceedings. As discussed in Note 12
of our consolidated financial statements, as of October 31, 2001, we have
accrued our estimate of the probable costs for the resolution of these claims.
This estimate has been developed in consultation with outside counsel handling
our defense in these matters and is based upon an analysis of potential results,
assuming a combination of litigation and settlement strategies. We do not
believe these proceedings will have a material adverse effect on our
consolidated financial position. It is possible, however, that future results of
operations for any particular quarterly or annual period could be materially
affected by changes in our assumptions, of the effectiveness of our strategies,
related to these proceedings.
Impairment of Goodwill
We periodically evaluate acquired businesses for potential impairment
indicators. Our judgments regarding the existence of impairment indicators are
based on legal factors, market conditions and operational performance of our
acquired businesses. Future events could cause us to conclude that impairment
indicators exist and that goodwill associated with our acquired businesses is
impaired. Any resulting impairment loss could have a material adverse impact on
our financial condition and results of operations.
Results of Operations
The following table sets forth for the fiscal years ended October 31,
1997, 1998, 1999, 2000 and 2001, certain income and expense items of SteelCloud
as a percentage of net revenues.
1997 1998 1999 2000 2001
---- ---- ---- ---- ----
Net revenues....................................... 100.00% 100.00% 100.00% 100.00% 100.00%
Costs of revenues.................................. 80.63% 82.18% 81.16% 82.07% 74.69%
Gross profit....................................... 19.37% 17.82% 18.84% 17.93% 25.31%
Selling, general and administrative and
amortization..................................... 10.10% 14.92% 109.50% 16.88% 20.69%
Income (loss) from operations...................... 9.27% 2.90% -90.66% 1.04% 4.62%
Other (expense) income............................. 0.45% -0.40% -8.44% 0.75% 0.91%
Income (loss) before income taxes.................. 9.72% 2.50% -99.10% 0.29% 3.71%
Provision for (benefit from) income taxes.......... 3.65% 1.03% -1.62% 0.16% 0.35%
Net income (loss) to common stockholders........... 6.07% 1.47% -97.48% 0.44% 3.47%
Fiscal Year Ended October 31, 2001 Compared to Fiscal Year Ended October 31,
2000
Net revenues of SteelCloud for fiscal year ended October 31, 2001
("fiscal 2001") decreased approximately 24% to $30.1 million from $39.8 million
for fiscal year ended October 31, 2000 ("fiscal 2000"). The decrease was
primarily due to the completion of a significant contract with the Puerto Rican
Government which represented approximately $16.2 million of fiscal 2000
revenues. Excluding the contract with the Puerto Rican Government, net revenues
increased by approximately 26% to $29.8 million from fiscal 2000 revenues of
$23.6 million which was the result of the Company's growth with their OEM
arrangements, consulting services and server appliance sales. During Fiscal
2001, the Company derived approximately 51% of its revenues from three
customers. During fiscal 2001, the Company's revenues from its reselling
activities increased to approximately $2.1 million from approximately $176,000
in fiscal 2000. The increase is a result of the Company's partnerships with
certain software companies.
12
Gross profit for fiscal 2001 increased by approximately 7% to $7.6
million from $7.1 million. The increase is the result of the Company's
successful efforts in developing and deploying customized server appliances to
the commercial marketplace. Gross profit as a percentage of net revenues during
the same periods significantly increased to 25.3% from 17.9% which is the result
of lower sales volume at higher margins.
Selling and marketing expense significantly decreased for fiscal 2001
by 27% to approximately $755,000 from approximately $1.0 million for fiscal
2000. During fiscal 2001, the Company continued to reduce its expensive
marketing programs and increased its marketing efforts through the use of
cooperative marketing dollars which resulted in an overall decrease. In
addition, the Company's new business strategy relies more heavily on combined
sales and marketing efforts by the Company and the software and technology
partner.
General and administrative expense for fiscal 2001 decreased 4% to $5.1
million from $5.3 million for fiscal 2000. As a percentage of net revenues,
general and administrative expense slightly increased to 16.9% for fiscal 2001
from 13.3% for fiscal 2000. This was due to the reduced revenue base compared to
the relatively stable general and administrative cost structure. The overall
decrease from fiscal 2000 resulted primarily from the Company's efforts to
manage general and administrative costs relative to its net revenue and gross
margin.
Other expense, including interest, for fiscal 2001 decreased to
approximately $274,000 from approximately $299,000 for fiscal 2000. This was the
result a continual decrease in the short-term borrowing rates throughout fiscal
2001. In addition, the Company sold certain assets in fiscal 2000 for which
gains of $228,000 were recognized.
Cumulative Effect of Accounting Change. During 2001, the Company
implemented Emerging Issues Task Force Issue No. 00-27, Application of EITF
Issue No. 98-5, "Accounting for Convertible Securities with Beneficial
Conversion Features or Contingently Adjustable Conversion Ratios," to Certain
Convertible Instruments (EITF 00-27). Issue 1 of EITF 00-27 modified the
calculation of beneficial conversion feature discounts for convertible
securities issued with detachable instruments for all transactions subject to
EITF Issue No. 98-5. As a result of implementation of EITF 00-27, the beneficial
conversion feature discount associated with the Company's Series A Convertible
Preferred Stock increased by $576,001. This non-cash item has been recorded by
the Company as a cumulative effect of a change in accounting principle in
accordance with EITF 00-27.
Net income available to common shareholders includes certain one-time
and non-recurring increase to income available to common stockholders of
$721,816 relating to the Series A Convertible Preferred Stock private placement
with Briarcliff Investors LLC, which closed in March 2000 and the redemption of
those preferred shares in August 2001 for $2.5 million. Net income available to
common shareholders is also comprised of the accumulating 5% dividends on the
Series A Convertible Preferred Stock for the period those shares were
outstanding. For fiscal 2000, dividends to preferred stockholders included a
non-cash deemed dividend of $529,411 for the beneficial conversion feature
discount associated with the private placement of the preferred stock and
$95,417 for the 5% dividend on the convertible preferred stock for the period
those shares were outstanding. Net income available to common shareholders
increased approximately 495% to $1,047,041 in fiscal 2001 from $175,837 in
fiscal 2000. The increase is attributable to the growth in gross margins which
resulted from the Company moving away from its low margin legacy business and
increasing its focus on the customized server appliance market. In addition, the
Company has managed its selling, general and administrative costs relative to
its net revenues and gross margin thereby increasing net income in fiscal 2001.
Fiscal Year Ended October 31, 2000 Compared to Fiscal Year Ended October 31,
1999
Net revenues of SteelCloud for fiscal year ended October 31, 2000
("fiscal 2000") increased approximately 16% to $39.8 million from $34.5 million
for fiscal year ended October 31, 1999 ("fiscal 1999"). The increase was
primarily due to the contract award with the Puerto Rican Government which
represented approximately $16.2 million of fiscal 2000 revenues. In addition,
the Company experienced a significant growth with their OEM arrangements,
consulting services and server appliance sales which offset the decline in
government sales which was a result of (a) a loss of a significant government
contract in 1999 and (b) the Company's focus to the commercial environment.
Gross profit for fiscal 2000 increased by approximately 10% to $7.1
million from $6.5 million. The increase is in proportion with the increase in
net revenues. Gross profit as a percentage of net revenues during the same
periods slightly decreased to 17.9% from 18.8% which is the result of higher
sales volume at slightly lower margins.
13
Selling and marketing expense significantly decreased for fiscal 2000
by 55% to approximately $1 million from $2.3 million for fiscal 1999. During
fiscal 2000, the Company reduced expensive marketing programs while increasing
their marketing efforts through the use of cooperative marketing dollars which
resulted in a significant decrease.
General and administrative expense for fiscal 2000 decreased 63% to
$5.3 million from $14.1 million for fiscal 1999. As a percentage of net
revenues, general and administrative expense decreased to 13.3% for fiscal 2000
from 40.9% for fiscal 1999. This decrease resulted primarily from the Company's
efforts to manage general and administrative costs relative to its net revenue
and gross margin. It should be noted that the Company incurred significant
non-recurring general and administrative costs in fiscal 1999. These
non-recurring expenses consisted of costs associated with the termination of the
DTV contract, termination of certain benefit plans, and legal expenses
associated with all of these factors.
Other expense, including interest, for fiscal 2000 decreased to
approximately $298,000 from approximately $2.9 million for fiscal 1999. The
reduction primarily relates to the settlement agreement with a former employee
and the Company's significant debt reduction. In addition, the company recorded
gains on the sales of certain leased assets.
Net income available to common shareholders increased approximately
100% to $175,837 in fiscal 2000 from a loss of $33,607,145 in fiscal 1999. The
increase is attributable to the Company's efforts to manage its selling, general
and administrative costs relative to its net revenues and gross margins. In
addition, the Company recorded an impairment charge of approximately $21 million
in fiscal 1999 related to the impairment of goodwill associated with the
acquisition of IDP.
Liquidity and Capital Resources
In fiscal 2001, the Company generated approximately $2.1 million in
cash flow from operations. The Company generated cash from the significant
reduction of receivables of approximately $4.6 million and the collection of
income tax receivables of approximately $233,000. The cash generated was used to
reduce accounts payable by approximately $4.6 million, accrued expenses by
approximately $384,000 and increase inventory by approximately $261,000. The
Company's investing activities consisted of the purchases of approximately
$519,000 for property and equipment, primarily for lease transactions with its
customers.
The Company's financing activities during fiscal 2001 were provided by
the Company's bank line of credit with First Union Bank. The line of credit
expires on March 31, 2003 and currently bears interest at the lower of (a) prime
or (b) the LIBOR Market Index Rate plus two and one-half percent. As of December
31, 2001, the Company had an outstanding balance on the line of credit of
approximately $3.3 million and available borrowing capacity of approximately
$1.7 million.
In fiscal 2001, the Company redeemed 2,620 shares of its Series A
Convertible Preferred Stock, which represented all of its outstanding preferred
shares, for $2.5 million. As a result, there are no preferred shares outstanding
at October 31, 2001.
14
In fiscal 1999, SteelCloud's subsidiary, IDP, had borrowing agreements
with Deutsche Financial Services (DFS) for an aggregate of $25 million. The
outstanding balance as of October 31, 1999 was approximately $4.7 million. In
fiscal 2000, the Company executed an agreement terminating the borrowing
arrangement whereby $3.25 million was repaid to DFS prior to December 31, 1999.
Of the remaining outstanding balance, approximately $832,000 was converted to a
24 month note accruing interest at the prime rate and $750,000 was forgiven by
DFS. The Company recorded the $750,000 as an extraordinary gain on the early
extinguishment of debt in fiscal 2000. As of October 31, 2001, the balance on
the note payable was approximately $103,000. The balance was paid in full on
January 1, 2002.
As of October 31, 2001, the Company had working capital of
approximately $7.3 million. The Company believes the bank facility, together
with cash on hand, projected cash generated from operations and income tax
refunds due will provide sufficient financial resources to finance the current
operations of the Company through fiscal 2002.
The Company has obligations under its operating lease commitments of
approximately $687,000 for fiscal 2002. In addition, the Company will receive
approximately $375,000 in rental income which will be used to offset its lease
commitments.
From time to time, the Company may pursue strategic acquisitions or
mergers which may require significant additional capital. In such event, the
Company may seek additional financing of debt and/or equity.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to market risk related to fluctuations in
interest rates on its debt. Increases in prevailing interest rates could
increase the Company's interest payment obligations relating to variable rate
debt. For example, a 100 basis point increase in interest rates would increase
annual interest expense by 38,000.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Financial Statements of SteelCloud, Inc.
Page
----
Report of Ernst & Young LLP, Independent Auditors............... F-1
Consolidated Balance Sheets..................................... F-2
Consolidated Statements of Operations........................... F-3
Consolidated Statements of Stockholders' Equity................. F-4
Consolidated Statements of Cash Flows........................... F-5
Notes to the Consolidated Financial Statements.................. F-6
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
The Notice and Proxy Statement for the 2001 Annual Meeting of
Stockholders to be filed pursuant to Regulation 14A under the Securities and
Exchange Act of 1934, as amended, which is incorporated by reference in this
Annual Report on Form 10-K pursuant to General Instruction G (3) of Form 10-K,
will provide the information required under Part III, including Item 10
(directors and executive officers of the Company), Item 11 (Executive
Compensation), Item 12 (security ownership of certain beneficial owners and
management), and Item 13 (certain relationships and related transactions), which
will be filed within 120 days after the end of the fiscal year covered by this
Form 10-K.
15
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report
1. Financial Statements
SteelCloud, Inc.
Report of Ernst & Young LLP, Independent Auditors
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholders' Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
2. Financial Statement Schedules
Schedule II Valuation and Qualifying Accounts
Statements not listed above have been omitted because they are not
applicable or the information required to be set forth therein is included in
the Consolidated Financial Statements or the notes thereto under Item 8.
3. Exhibits.
Exhibit
Number Description
- ------ -----------
3.1 Articles of Incorporation of the Company, dated February 25, 1998,
and effective as of February 26, 1998. (Filed as Exhibit 3.1 to
the Company's Registration Statement on Form S-1, Amendment No. 1,
dated April 23, 1998 (File No. 333-47631) and hereby incorporated
by reference.)
3.2 By-laws of the Company, effective as of March 5, 1998. (Filed as
Exhibit 3.2 to the Company's Registration Statement on Form S-1,
Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and
hereby incorporated by reference.)
4.1 Specimen common stock certificate for the Company. (Filed as
Exhibit 4.1 to the Company's Registration Statement on Form S-1,
Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and
hereby incorporated by reference.)
16
10.8 Employment Agreement by and between Dunn and Thomas P. Dunne
(Filed as Exhibit 99.2 to Dunn's Registration Statement on Form
SB-2, Amendment 2, dated April 4, 1997 (File No. 333-19635) and
hereby incorporated by reference).
10.10 Deed of Lease, dated February 7, 1997, between APA Properties No.
6 L.P. and STMS, Inc. and First Amendment thereto, dated July 23,
1997 (Filed as Exhibit 10.10 to Dunn's Form 10-KSB, dated January
30, 1998 (File No. 0-22263) and hereby incorporated by reference).
10.11 1997 Stock Option Plan, as amended. (Filed as Exhibit 10.11 to the
Company's Registration Statement on Form S-1, Amendment No. 2,
dated April 23, 1998 (File No. 333-47631) and hereby incorporated
by reference.)
10.12 General Service Administration Schedule for International Data
Products, Corp. (Filed as Exhibit 10.12 to the Company's
Registration Statement on Form S-1, Amendment No. 2, dated April
23, 1998 (File No. 333-47631) and hereby incorporated by
reference.)
10.13 Agreement, dated May 5, 1997, by and between International Data
Products, Corp. and the U.S. Air Force, the Desktop V Contract.
(Filed as Exhibit 10.13 to the Company's Registration Statement on
Form S-1, Amendment No. 2, dated April 23, 1998 (File No.
333-47631) and hereby incorporated by reference.)
10.16 Deed of Lease, dated July 15, 1994, between Puerto Rico Industrial
Development Company and Puerto Rico Industrial Manufacturing
Operations, Corp. (Filed as Exhibit 10.16 to the Company's
Registration Statement on Form S-1, Amendment No. 2, dated April
23, 1998 (File No. 333-47631) and hereby incorporated by
reference.)
10.22 Employee Stock Purchase Plan.
10.25 Termination agreement, Promissory Note, dated December 29, 1999 by
and between Dunn and Deutsche Financial Services.
10.26 Loan and Security Agreement, dated May 27, 1999 by and between
Dunn and First Union Commercial Corporation.
10.27 Modification Agreement, dated February 11, 2000 by and between
Dunn and First Union National Bank.
10.29 Modification Agreement, dated January 18, 2002 by and between
SteelCloud, Inc. and First Union National Bank.
*21.1 List of Subsidiaries.
*23.1 Consent of Ernst & Young LLP, Independent Auditors.
- -----------
* Filed herewith
(b) Reports on Form 8-K
On August 8, 2001, the Company filed a report on Form 8-K pursuant to
Item 5 Other Events.
17
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
STEELCLOUD, INC.
Date: January 29, 2002 By:
/s/ Thomas P. Dunne
-----------------------
Thomas P. Dunne
Chief Executive Officer
Pursuant to and in accordance with the requirements of the Securities
Exchange Act of 1934, this report has been signed by the following persons on
behalf of the registrant and in the capacities and on the dates indicated.
Name Title Date
---- ----- ----
/s/ Thomas P. Dunne
- -----------------------------------------
Thomas P. Dunne Chief Executive Officer and Director January 29, 2002
/s/ Edward Spear
- -----------------------------------------
Edward Spear President, Chief Operating Officer and Director January 29, 2002
/s/ VADM E. A. Burkhalter
- -----------------------------------------
VADM E. A. Burkhalter USN (Ret.) Director January 29, 2002
/s/ James Bruno
- -----------------------------------------
James Bruno Director January 29, 2002
/s/ Jay Kaplowitz
- -----------------------------------------
Jay Kaplowitz Director January 29, 2002
/s/ Benjamin Kreiger
- -----------------------------------------
Benjamin Kreiger Director January 29, 2002
/s/ Richard Prins
- -----------------------------------------
Richard Prins Director January 29, 2002
18
Index to Financial Statements
SteelCloud, Inc (a Virginia Corporation)
Report of Ernst & Young LLP, Independent Auditors.................................................................. F-1
Consolidated Balance Sheets as of October 31, 2000 and 2001........................................................ F-2
Consolidated Statements of Operations for the three years ended October 31, 2001................................... F-3
Consolidated Statements of Stockholders' Equity for the three years ended October 31, 2001......................... F-4
Consolidated Statements of Cash Flows for the three years ended October 31, 2001 F-5
Notes to Consolidated Financial Statements......................................................................... F-6
19
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
Board of Directors
SteelCloud, Inc.
We have audited the accompanying consolidated balance sheets of SteelCloud, Inc.
(a Virginia Corporation) as of October 31, 2000 and 2001, and the related
consolidated statements of operations, stockholders' equity and cash flows for
each of the three years in the period ended October 31, 2001. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the consolidated financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the consolidated
financial statements. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
SteelCloud, Inc. as of October 31, 2000 and 2001, and the consolidated results
of its operations and its cash flows for each of the three years in the period
ended October 31, 2001, in conformity with accounting principles generally
accepted in the United States.
As discussed in Note 2 of the Notes to the Consolidated Financial Statements, in
2001 the Company changed its method of accounting for convertible securities
with beneficial conversion features.
/s/ ERNST & YOUNG LLP
December 21, 2001, except for Note 5
as to which the date is January 18, 2002
McLean, Virginia
F-1
STEELCLOUD, INC.
CONSOLIDATED BALANCE SHEETS
OCTOBER 31,
-------------------------------------
2000 2001
------------------ ------------------
ASSETS
Current assets:
Cash and cash equivalents $ 363,958 $ 313,054
Accounts receivable, net of allowance for doubtful
accounts of $100,000 and $112,000 as of October 31, 2000 and 2001,
respectively 10,851,270 6,201,621
Inventory, net 4,318,936 5,099,436
Deferred tax asset 1,326,745 -
Income tax receivable 230,681 1,400,424
Prepaid expenses and other current assets 191,897 173,695
------------------ ------------------
Total current assets 17,283,487 13,188,230
Property and equipment, net 819,798 319,944
Equipment on lease, net 1,443,704 597,202
Goodwill and other intangible assets, net 3,164,789 2,770,572
Investments 150,000 150,000
Other assets 143,193 108,599
------------------ ------------------
Total assets $23,004,971 $17,134,547
================== ==================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 7,886,342 $ 3,293,030
Accrued expenses 2,753,361 2,277,993
Accrued litigation costs 343,087 -
Notes payable, current portion 431,597 114,985
Unearned revenue 135,690 213,385
----------------- ------------------
Total current liabilities 11,550,077 5,899,393
Notes payable, long-term portion 115,290 -
Line of credit, long term 2,483,203 3,836,754
Stockholders' equity:
Preferred stock $.001 par value; 2,000,000 shares authorized, 3,000 and 0
shares issued and outstanding at October 31, 2000 and 2001,
respectively; aggregate liquidation preference of $2,945,417 at
October 31, 2000 3 -
Common stock, $.001 par value; 20,000,000 shares authorized, 9,806,962 and
10,214,545 shares issued and outstanding at October 31, 2000 and
2001, respectively 9,807 10,215
Additional paid-in capital 41,584,844 39,079,397
Treasury stock, 400,000 shares at October 31, 2000 and 2001, respectively (3,432,500) (3,432,500)
Accumulated deficit (29,305,753) (28,258,712)
----------------- ------------------
Total stockholders' equity 8,856,401 7,398,400
----------------- ------------------
Total liabilities and stockholders' equity $ 23,004,971 $ 17,134,547
================= ==================
See accompanying notes.
F-2
STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED OCTOBER 31,
--------------------------------------------
1999 2000 2001
------------ ------------ ------------
Net revenues $ 34,475,297 $ 39,766,393 $ 30,138,379
Costs of revenues 27,981,691 32,636,410 22,509,978
------------ ------------ ------------
Gross profit 6,493,606 7,129,983 7,628,401
Selling and marketing 2,311,091 1,035,698 755,184
General and administrative 14,112,227 5,285,767 5,086,460
Amortization of goodwill 675,743 394,216 394,216
Impairment of goodwill 20,649,335 -- --
------------ ------------ ------------
Income (loss) from operations (31,254,790) 414,302 1,392,541
Other income (expense):
Interest income 27,998 34,276 88,485
Interest expense (962,004) (654,329) (336,128)
Settlement of litigation (2,000,000) -- --
Gain on sale of assets 193,516 228,062 --
Other, net (170,621) 93,354 (26,396)
------------ ------------ ------------
Income (loss) from operations before income taxes,
and extraordinary gain (34,165,901) 115,665 1,118,502
Provision for (benefit from) income taxes (558,756) 65,000 104,776
------------ ------------ ------------
Income (loss) before extraordinary gain (33,607,145) 50,665 1,013,726
Extraordinary gain - early extinguishment of debt -- 750,000 --
------------ ------------ ------------
Net income (loss) $(33,607,145) $ 800,665 $ 1,013,726
Dividends to preferred stockholders -- (624,828) (112,500)
Cumulative effect of change in accounting principle -- -- (576,001)
Increase to income available to common stockholders
from repurchase of preferred stock -- -- 721,816
------------ ------------ ------------
Net income (loss) available to common stockholders $(33,607,145) $ 175,837 $ 1,047,041
============ ============ ============
Earnings (loss) per share, basic
Earnings (loss) before extraordinary gain $ (3.57) $ (.06) $ .10
Extraordinary gain -- .08 --
------------ ------------ ------------
Net earnings (loss) per share $ (3.57) $ .02 $ .10
============ ============ ============
Earnings (loss) per share, fully diluted
Earnings (loss) before extraordinary gain (3.57) (.06) $ .08
Extraordinary gain -- .08 --
------------ ------------ ------------
Net earnings (loss) per share $ (3.57) $ .02 $ .08
============ ============ ============
Pro forma amounts assuming the accounting change
is applied retroactively:
Net income (loss) to common stockholders $(33,607,145) $ (400,164) $ 1,623,042
============ ============ ============
Net earnings (loss) per share, basic $ (3.57) $ (0.04) $ 0.16
============ ============ ============
Net earnings (loss) per share, fully diluted $ (3.57) $ (0.04) $ 0.08
============ ============ ============
See accompanying notes
F-3
STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Preferred Stock Common Stock
------------------------------ -----------------------------
Shares Amount Shares Amount
------------ ------------ ------------ ------------
Balance at October 31, 1998 9,391,493 $ 9,392
Issuance of common stock under
employee stock purchase plan 28,016 28
Net loss -- --
------------ ------------ ------------ ------------
Balance at October 31, 1999 9,419,509 9,420
Issuance of Common Stock in connection
with exercise of employee incentive
stock option plan -- -- 4,900 5
Issuance of Series A Convertible
Preferred Stock 3,000 3 -- --
Issuance of Common Stock -- -- 225,000 225
Paid in Capital and Deemed Dividend on -- -- -- --
Preferred Stock
Conversion of Series A Convertible
Preferred Stock (150) -- 153,150 153
Conversion of Preferred Stock dividends
to shares of Common Stock -- -- 4,403 4
Dividend Declared on Series A
Convertible Preferred Stock
Net Income -- -- -- --
------------ ------------ ------------ ------------
Balance at October 31, 2000 2,850 3 9,806,962 9,807
Conversion of Series A Convertible (230) -- 390,267 391
Preferred Stock
Conversion of Preferred Stock dividends -- -- 17,316 17
payable to shares of Common Stock
Dividend Declared on Series A
Convertible Preferred Stock -- -- -- --
Cumulative effect of change in -- -- -- --
accounting principle
Redemption of Preferred Stock (2,620) (3) -- --
Net Income -- -- -- --
------------ ------------ ------------ ------------
Balance at October 31, 2001 -- -- 10,214,545 $ 10,215
============ ============ ============ ============
Retained
Additional Earnings
Paid-In Treasury (Accumulated
Capital Stock Deficit) Total
------------ ------------ ------------ ------------
Balance at October 31, 1998 $ 37,670,245 $ (3,432,500) $ 4,125,555 $ 38,372,692
Issuance of common stock under
employee stock purchase plan 51,504 -- -- 51,532
Net loss -- -- (33,607,145) (33,607,145)
------------ ------------ ------------ ------------
Balance at October 31, 1999 37,721,749 (3,432,500) (29,481,590) 4,817,079
Issuance of Common Stock in connection
with exercise of employee incentive
stock option plan 15,308 -- -- 15,313
Issuance of Series A Convertible
Preferred Stock 2,716,711 -- -- 2,716,714
Issuance of Common Stock 597,420 -- -- 597,645
Paid in Capital and Deemed Dividend on 529,411 -- (529,411) --
Preferred Stock
Conversion of Series A Convertible
Preferred Stock (153) -- --
Conversion of Preferred Stock dividends
to shares of Common Stock 4,398 -- -- 4,402
Dividend Declared on Series A (95,417) (95,417)
Convertible Preferred Stock
Net Income -- -- 800,665 800,665
------------ ------------ ------------ ------------
Balance at October 31, 2000 41,584,844 (3,432,500) (29,305,753) 8,856,401
Conversion of Series A Convertible (391) -- -- --
Preferred Stock
Conversion of Preferred Stock dividends 10,019 -- -- 10,036
to shares of Common Stock
Dividend Declared on Series A
Convertible Preferred Stock -- -- (112,500) (112,500)
Cumulative effect of change in 576,001 -- (576,001) --
accounting principle
Redemption of Preferred Stock (3,091,076) -- 721,816 (2,369,263)
Net Income -- -- 1,013,726 1,013,726
------------ ------------ ------------ ------------
Balance at October 31, 2001 $ 39,079,397 $ (3,432,500) $(28,258,712) $ 7,398,400
============ ============ ============ ============
See accompanying notes.
F-4
STEELCLOUD, INC
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED OCTOBER 31,
------------------------------------------------
1999 2000 2001
------------ ------------ ------------
Operating activities
Net income (loss) $(33,607,145) $ 800,665 $ 1,013,726
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization of property and equipment 2,779,926 2,841,210 1,346,129
Amortization of goodwill and other intangibles 675,743 394,216 394,216
Impairment of goodwill 20,649,335 -- --
Gain on sale of assets (193,516) (228,062) --
Gain on settlement of litigation -- (495,709) (343,087)
Gain on redemption of preferred stock -- --
Extraordinary debt extinguishment gain -- (750,000) --
Changes in operating assets and liabilities:
Accounts receivable, net 11,801,135 (5,788,229) 4,649,649
Income tax receivable 11,556 355,088 234,378
Investment in sales-type leases 3,099,342 -- --
Inventory 5,431,102 1,178,698 (261,317)
Prepaid expenses and other assets 175,823 (71,375) 52,796
Accounts payable (7,328,184) 3,063,363 (4,593,312)
Accrued expenses (211,112) (416,865) (384,355)
Deferred tax asset (credit) (652,695) (44,050) (77,376)
Unearned revenue and other liabilities (2,296,764) (956,772) 77,695
------------ ------------ ------------
Net cash provided by (used in) operating activities 334,546 (117,822) 2,109,142
Investing activities
Purchases of property and equipment (2,532,509) (509,737) (518,956)
Acquisitions, net of cash acquired (652,231) -- --
Proceeds from sale of assets 740,023 784,838 --
------------ ------------ ------------
Net cash (used in) provided by investing activities (2,444,717) 275,101 (518,956)
Financing activities
Proceeds from issuance of preferred stock -- 2,716,714 --
Payments made to redeem preferred stock -- -- (2,562,739)
Proceeds from issuance of common stock 51,532 --
Proceeds from exercise of common stock options -- 15,313 --
Payments on notes payable (46,248) (323,296) (431,902)
Payments on notes payable to related parties (905,960) -- --
Proceeds from (repayments on) lines of credit, net 3,666,297 (2,857,502) 1,353,551
------------ ------------ ------------
Net cash provided by (used in) financing activities 2,765,621 (448,771) (1,641,090)
Net increase (decrease) in cash and cash equivalents 655,450 (291,492) (50,904)
Cash and cash equivalents at beginning of year -- 655,450 363,958
------------ ------------ ------------
Cash and cash equivalents at end of year $ 655,450 $ 363,958 $ 313,054
============ ============ ============
Supplemental cash flow information
Interest paid $ 962,004 $ 654,329 $ 336,128
------------ ------------ ------------
Income taxes paid $ 223,850 $ 116,630 $ 185,210
============ ============ ============
See accompanying notes
F-5
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
OCTOBER 31, 1999, 2000 AND 2001
1. Organization
Dunn Computer Corporation was incorporated on July 27, 1987 under the laws of
the Commonwealth of Virginia. On January 3, 1997, Dunn Computer Corporation, a
Delaware corporation, was formed as a holding company for the stock of Dunn
Computer Corporation, the Virginia corporation. On February 26, 1998, Dunn
Computer Corporation was incorporated in Virginia in connection with the
reorganization of Dunn Computer Corporation, the Delaware Corporation. The
Company's subsidiaries are International Data Products ("IDP") acquired May
1998, STMS, Inc (STMS) acquired September 1997 and Puerto Rico Industrial
Manufacturing Operations Acquisition Corporation, (PRIMOA), incorporated in
Puerto Rico on May 1, 1998. Unless the context otherwise requires, the "Company"
or "Dunn Computer Corporation" refers to SteelCloud, its predecessor and its
subsidiaries.
On September 25, 2000 the Company began doing business as ("dba") SteelCloud
Company. On October 19, 2000, the Company changed its NASDAQ ticker symbol from
DNCC and began trading as SCLD.
On May 15, 2001, the shareholders approved an amendment to the Company's
articles of incorporation to change the corporate name from Dunn Computer
Corporation to SteelCloud, Inc. The name change became effective as of July 30,
2001 pursuant to a certificate of amendment issued by the Virginia State
Corporation Commission.
The Company is engaged in the design and development of original equipment
manufacturer (OEM) server appliances for software and technology companies.
SteelCloud augments the capabilities of its OEM customers by providing them a
quick and cost-effective approach to introducing new appliances to the
marketplace. The Company also works with major integrators to address the custom
hardware needs of its public sector customers. In addition, the Company provides
Information Technology (IT) support and consulting services to both the
commercial and public sector clients. Although SteelCloud operates in a
competitive environment subject to technological change and the emergence of new
technologies, the Company believes that its products and services are, or would
be, compatible or upgradeable to new technologies.
2. Significant Accounting Policies
Use of Estimates
The preparation of the consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the consolidated
financial statements and the reported amounts of revenues and expenses during
the reporting period. Actual results could differ from those estimates.
F-6
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated.
Cash and Cash Equivalents
The Company maintains demand deposits with several financial institutions. At
times, deposits exceed federally insured limits, but management does not
consider this a significant concentration of credit risk. The Company considers
all highly liquid investments with a maturity of three months or less at the
time of purchase to be cash equivalents.
Financial Instruments
The carrying value of the Company's financial instruments including cash and
cash equivalents, accounts receivable, accounts payable, accrued liabilities,
notes payable and its line of credit approximates fair value.
Investments
At October 31, 2000 and 2001, investments consisted of shares of common stock of
a privately-held internet company, Worldwide Internet Solutions Network, Inc.
("WIZnet"), with a cost basis of approximately $150,000. The Company is
accounting for this investment using the cost method since the Company's
investment represents less than 20% of the privately-held internet company's
outstanding stock and the Company does not exert significant influence over
WIZnet's operations. The Company is not aware of any factors that would indicate
its investment is permanently impaired.
Inventory
Inventory is stated at the lower of cost or market as determined by the first-in
first-out (FIFO) method. The Company periodically evaluates its inventory
obsolescence reserve to ensure inventory is recorded at net realizable value.
Impairment of Long-Lived Assets
Each year, management determines whether any property and equipment or any other
assets have been impaired based on the criteria established in Statement of
Financial Accounting Standards No. 121 (SFAS 121), "Accounting for the
Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed of." The
carrying amount of a long-lived asset is considered impaired when the estimated
undiscounted cash flow from each asset is less than its carrying amount. In that
event, the Company records a loss equal to the amount by which the carrying
amount exceeds the fair value of the long-lived asset. During fiscal year 1999,
management determined that goodwill associated with the purchase of IDP was
impaired. The fair value of the IDP goodwill was estimated using discounted cash
flows. Accordingly, the Company recorded an impairment charge of approximately
$20.6 million (see Note 4). During fiscal 2000 and 2001, the Company made no
adjustments to the carrying values of the long-lived assets.
F-7
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
Goodwill and Other Intangible Assets
Goodwill and other intangibles represent the unamortized excess of the cost of
acquiring subsidiary companies over the fair values of such companies' net
tangible assets at the dates of acquisition. Goodwill related to the Company's
acquisitions as described in Note 4 is being amortized on a straight-line basis
over periods ranging from five to twenty years. Other intangibles, including
contracts, are being amortized on a straight-line basis over a five year period.
Acquisition-Related Liabilities
During fiscal year 1998, the Company recorded $1,376,000 of acquisition-related
liabilities in connection with the IDP Acquisition. These liabilities were
recorded after certain actions had been identified, quantified and approved by
management of the Company having authority to commit the Company to the plan.
Those certain actions included closing the IDP facility in Maryland, integrating
IDP and the Company's production, warehouse, sales, marketing and administrative
functions, eliminating duplicative jobs and expanding space in the Company's
office space in Virginia. During fiscal year 1999, $894,000 of costs were
charged against the liability. The acquisition-related liabilities remaining at
October 31, 2000 and 2001 amounted to $250,000.
Stock Compensation
Statement of Financial Accounting Standards No. 123 (SFAS 123), "Accounting for
Stock-Based Compensation" allows companies to account for stock-based
compensation under either the provisions of SFAS 123 or the provisions of
Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock
Issued to Employees," but requires pro forma disclosure in the footnotes to the
consolidated financial statements as if the measurement provisions of SFAS 123
had been adopted. The Company continues accounting for its stock-based
compensation in accordance with the provisions of APB 25.
Revenue Recognition
In December 1999, the SEC released Staff Accounting Bulletin No, 101, "Revenue
Recognition in Financial Statements" (SAB101) as amended by SAB 101A and 101B.
SAB 101 requires that four basic criteria must be met before revenue can be
recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has
occurred or services rendered; (3) the fee is fixed and determinable: and (4)
collectibility is reasonably assured. The Company adopted SAB 101 during the
fourth quarter of fiscal year 2001. The adoption has not had a material effect
on the Company's financial position, results of operations or cash flows.
The Company derives its revenue from the following sources: Product revenue,
information technology support services, software license and support revenue
and software training and customization revenue.
F-8
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
For product sales the Company generally recognizes revenue at the time of
shipment when both title and risk of loss transfers to the customer. For
technology support services under time and material contracts, the Company
recognizes revenue as services are provided. Revenue from hardware leased to
customers under operating lease arrangements is recognized over the contract
term. When product and installation services that are not essential to the
functionality of the product are sold as part of a bundled agreement, the fair
value of the installation services, based on the price charged for the services
when sold separately, is deferred and recognized when the services are
performed. The products sold are generally covered by a warranty for periods
ranging from one to three years. The Company accrues a warranty reserve for
revenues recognized during the year to record estimated costs to provide
warranty services.
The Company is a value-added reseller for certain software products. When resold
software licenses, and related maintenance, customization and training services
are all provided together to an individual customer the Company recognizes
revenue for the arrangement after the Company has delivered the software license
and the customer has approved all customization and training services provided.
In instances were the Company only resells the software license and maintenance
to the customer, the Company recognizes revenue after the customer has
acknowledged delivery of the software. The software manufacturer is responsible
for providing software maintenance. Accordingly, revenue from maintenance
contracts is recognized upon delivery or acceptance, as the Company has no
future obligation to provide the maintenance services.
F-9
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
Revenue Recognition (continued)
The Company incurs shipping and handling costs, which are recorded in cost of
revenues.
During the years ended October 31, 1999, 2000 and 2001, the Company had revenues
from the Federal government, which represented 12%, 27%, and 18%, respectively,
of total revenue. As of October 31, 2000 and 2001, accounts receivable from
agencies of the Federal government represented 56%, and 8%, respectively, of
total accounts receivable. In addition, the Company had revenues from two
commercial customers that represents 11% and 51% of fiscal year 2000 and 2001
revenues, respectively and 7% and 61% of accounts receivable at October 31, 2000
and 2001, respectively.
Advertising Expenses
The Company expenses advertising costs as incurred. Advertising costs amounted
to approximately $130,000, $41,000 and $67,000 during fiscal 1999, 2000, and
2001, respectively.
Income Taxes
The Company provides for income taxes in accordance with the liability method.
Change in Accounting Principle
During 2001, the Company implemented Emerging Issues Task Force Issue No. 00-27,
Application of EITF Issue No. 98-5, "Accounting for Convertible Securities with
Beneficial Conversion Features or Contingently Adjustable Conversion Ratios," to
Certain Convertible Instruments ("EITF 00-27"). Issue 1 of EITF 00-27 modified
the calculation of beneficial conversion features for convertible securities
issued with detachable instruments for all transactions subject to EITF Issue
No. 98-5. In accordance with the transition provision of EITF 00-27 companies
are required to report any changes in a beneficial conversion feature as a
result of applying Issue 1 of EITF 00-27 as a cumulative effect of a change in
accounting principle at the time of implementation in accordance with APB
Opinion No. 20, "Accounting Changes". As a result of the implementation of EITF
00-27, the Company has recorded a charge representing an additional allocation
of value to the beneficial conversion feature, of $576,001, or $0.06 per share,
as a cumulative effect of a change in accounting principle.
Supplemental Information of Non-Cash Investing and Financing Activities:
Year Ended October 31,
---------------------------------------------------
1999 2000 2001
--------------- ------------------ ----------------
Common stock issued in connection with legal settlement - $ 597,645 -
=============== ================== ================
Deemed dividend on preferred stock - $ 529,411 $ 112,500
=============== ================== ================
Increase to income to common shareholders for repurchase of
preferred stock - - $ 721,816
=============== ================== ================
Conversion of preferred stock and accrued dividends to common
stock - $4,404 $ 10,036
=============== ================== ================
Cumulative effect of change in accounting principle - - $ 576,001
=============== ================== ================
F-10
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
Earnings Per Share
The Company follows the provisions of Statement of Financial Accounting
Standards No. 128, Earnings Per Share ("SFAS 128") which requires the Company to
present basic and fully diluted earnings per share. Basic earnings per share is
based on the weighted average shares outstanding during the period. Diluted
earnings per share increases the shares used in the basic share calculation by
the dilutive effect of stock options, warrants and convertible preferred stock.
For fiscal years 1999 and 2000, the Company's common stock equivalent shares
outstanding from stock options, warrants and convertible preferred stock are
excluded from the diluted earnings per share calculation as their effect is
antidilutive to net income (loss) to common stockholders before extraordinary
items.
Financial Instruments and Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentrations of
credit risk consist primarily of cash, investments and accounts receivable. The
cash is held by high credit quality financial institutions. For accounts
receivable, the Company performs ongoing credit evaluations of its customers'
financial condition and generally does not require collateral. The Company
maintains reserves for credit losses. The concentration of credit risk is
mitigated by the amount of receivables due by the Federal government. The
carrying amount of the receivables approximates their fair value.
Recent Pronouncements
In June 2001, the FASB issued SFAS No. 141, "Business Combinations", which
requires the purchase method of accounting for business combinations initiated
after June 30, 2001 and eliminates the pooling-of-interests method. Currently,
the Company does not believe the adoption of SFAS No. 141 will have any impact
on its financial statements
In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets", effective for fiscal years beginning after December 15, 2001. Under the
new rules, goodwill and intangible assets deemed to have indefinite lives will
no longer be amortized but will be subject to annual impairment tests. In
addition, the statement includes provisions for the reclassification of certain
existing recognized intangibles to goodwill, reassessment of the useful lives of
existing recognized intangibles, reclassification of certain intangibles out of
previously reported goodwill and the identification of reporting units for
purposes of assessing potential future impairments of goodwill. Goodwill and
other intangibles, acquired prior to July 1, 2001, are amortized until the
adoption of the statement. The Company is required to apply the new rules on
accounting for goodwill and other intangible assets beginning in the first
quarter of the fiscal year ending October 31, 2003. The Company is currently
assessing, but has not yet determined, the impact of SFAS No. 142 on its
financial position and results of operations.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets", effective for fiscal years beginning after
December 15, 2001. The new rules on asset impairment supersede FASB Statement
No. 121 and provide a single accounting model for long-lived assets to be
disposed of. Although retaining many of the fundamental recognition and
measurement provisions of Statement 121, the new rules significantly change the
criteria that would have to be met to classify an asset as held-for-sale. Under
SFAS No. 144, assets to be disposed of are stated at the lower of their fair
values or carrying amounts and depreciation is no longer recognized. Statement
144 also supersedes the provisions of APB Opinion 30 with regard to reporting
the effects of a disposal of a segment of a business and require expected future
operating losses from discontinued operations to be displayed in discontinued
operations in the period(s) in which the losses are incurred (rather than as of
the measurement date as presently required by APB 30). In addition, the criteria
for discontinued operation presentation is changed to a component of the
business rather than a segment of the business. The Company is required to adopt
Statement 144 in the first quarter of the fiscal year ending October 31, 2003.
The Company is currently assessing, but has not determined, the impact of SFAS
No. 144 on its financial position and results of operations.
F-11
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. Property and Equipment and Equipment on Lease
Property and equipment, including leasehold improvements, are stated at cost.
Property and equipment are depreciated and amortized using the straight-line
method over the estimated useful lives ranging from three to five years.
Leasehold improvements are amortized over the lesser of the related lease term
or the useful life.
Property and equipment consisted of the following:
October 31,
------------------------------------
2000 2001
------------------------------------
Computer and office equipment $ 1,577,145 $ 1,610,335
Furniture and fixtures 302,741 304,600
Leasehold improvements 491,059 492,936
Other 412,766 411,256
------------------------------------
2,783,711 2,819,127
Less accumulated depreciation and amortization (1,963,913) (2,499,183)
------------------------------------
$ 819,798 $ 319,944
====================================
The Company owns equipment that is currently at customer sites under operating
lease agreements (See Note 2 Revenue Recognition). The cost of the equipment was
$6,309,864 and $6,345,508 at October 31, 2001 and 2000, respectively. The
related accumulated depreciation on the equipment was $5,712,662 and $4,901,804
at October 31, 2001 and 2000, respectively.
4. Goodwill and Other Intangible Assets
Goodwill and other intangible assets were comprised of:
October 31,
-------------------------------------
2000 2001
-------------------------------------
Goodwill $3,485,855 $3,485,855
Contracts 600,000 600,000
Less accumulated amortization (921,066) (1,315,283)
-------------------------------------
$3,164,789 $2,770,572
=====================================
F-12
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. Goodwill and Other Intangible Assets (continued)
Impairment of Goodwill
Statement of Financial Accounting Standards No. 121 (SFAS 121) "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of," requires that long-lived assets and certain identifiable intangibles to be
held and used by an entity be reviewed for impairment whenever events or changes
in circumstances indicate that the carrying amount of an asset may not be
recoverable.
In May 1999, the U.S. Government determined not to exercise the remaining option
years on one of the Company's significant contracts. This contract was a
significant component of the Company's acquisition of IDP. The Company
anticipated that the contract would have generated future revenues of
approximately $65 million had all option years been renewed. The former IDP
operations have been substantially curtailed as a result of this contract loss.
In addition, significant future business is not expected from IDP operations as
the majority of its sales force has separated from the Company.
The Company determined that these factors indicated that the carrying amount of
goodwill associated with the IDP and PRIMO acquisition may not be recoverable.
The Company performed an analysis of the goodwill in accordance with SFAS 121
and determined that the fair value of the remaining goodwill (estimated using
the present value of expected future cash flows) was approximately $1.1 million
at the time of the analysis. Accordingly, the Company recorded an impairment
charge of approximately $20.6 million during fiscal year 1999.
5. Bank Lines of Credit and Notes Payable
IDP Line of Credit
In conjunction with the purchase of IDP, the Company assumed a credit facility
of $25,000,000 secured by inventory and accounts receivable of IDP. On November
8, 1999, the Company executed an agreement with the financial institution to
terminate this facility. Under the terms of the agreement, the Company repaid
approximately $3.0 million of the principal outstanding at October 31, 1999
prior to December 31, 1999. In addition, outstanding principal totaling
approximately $832,000 was converted to a term note bearing interest at the
prime rate (5.5% at October 31, 2001) and maturing in January 2002. The
outstanding balance on this term note at October 31, 2001 was approximately
$103,000. The remaining amount of approximately $750,000 was forgiven by the
financial institution and has been reflected as an extraordinary gain on early
extinguishment of debt in fiscal year 2000.
F-13
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. Bank Lines of Credit and Notes Payable (continued)
Operating Line of Credit
The Company has a line of credit agreement, as amended, with a bank that allows
the Company to borrow an amount limited to the minimum of its borrowing base or
$5 million. The interest rate is the prime rate and the line of credit expires
on February 28, 2002.
As of October 31, 2000 and 2001, the Company's borrowing base, which is based on
certain percentages of total accounts receivable and inventory, was
approximately $3.2 million and $4.7 million, respectively.
As of October 31, 2000 and 2001, the Company had borrowed approximately $2.5
million and $3.8 million, respectively, against this line of credit facility and
had an unused borrowing capacity of approximately $600,000 and $800,000,
respectively. The line of credit is secured by all assets of the Company and its
subsidiaries. In January 2002, the Company amended its line of credit agreement
whereby the maximum availability under the line of credit increased from $5.0
million to $7.5 million. Under the terms of the amendment, the Company may make
advances against their eligible receivables. The interest rate of the amended
line of credit is the lower of (a) the prime rate or (b) the LIBOR Market Index
Rate plus two and one-half percent. The line of credit expires on March 31,
2003. The Company has classified this line of credit as long-term based on the
amended maturity date.
Notes Payable
Notes payable consisted of the following:
October 31,
-------------------------------
2000 2001
-------------------------------
Bank term note, bearing interest at the prime rate; payable in monthly
installments of $34,652 plus accrued interest, due in January 2002. $519,119 $103,233
Asset loans, bearing interest at annual interest rates ranging from 7.9% to
10.46%; due in aggregate monthly payments of $1,303 and $139 due through
August 2002 and January 2002, respectively, secured by certain assets of
the Company 27,768 11,752
-------------------------------
546,887 114,985
Less current portion 431,597 114,985
-------------------------------
Notes payable, long-term $115,290 $ -
===============================
F-14
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. Bank Lines of Credit and Notes Payable (continued)
Receivable Financing Program
In December 1999, the Company entered a Short Term Accounts Receivable Financing
Program with one of its vendors. Under the terms of the program, the vendor
extended credit to the Company for specific pre-approved sales orders in
exchange for the assignment of the associated receivable once the product was
delivered to the customer. During fiscal 2000 and 2001, the Company assigned
approximately $1.56 million and $0, respectively of specific receivables under
the program. As of October 31, 2000 and 2001 there were $112,000 and $0
uncollectible receivables assigned under this agreement.
6. Commitments
Operating Leases
The Company leases office space for its corporate headquarters under a
noncancelable operating lease agreement. The lease agreement was renewed in
October 1999 and expires in February 2005. Additionally, the Company leases
various office equipment and other office space under non-cancelable operating
leases. Rent expense under all leases was approximately $321,000, $330,147 and
$284,000 for the years ended October 31, 1999, 2000, and 2001, respectively.
Future minimum lease payments under noncancelable operating leases, including
the leases assumed in the STMS and IDP acquisitions, at October 31, 2001 are as
follows:
2002 686,804
2003 628,546
2004 401,259
2005 91,554
------------------
Total $1,808,163
==================
The Company will receive $749,661 in aggregate sublease income through fiscal
2003.
7. Employment Agreements
The Company has an employment agreement with Thomas P. Dunne, the Company's
Chairman and Chief Executive Officer. The agreement for Mr. Dunne has a term of
three years commencing April 1997 and automatically renews for additional one
year terms unless terminated by either the Company or the employee.
All other employment agreements the company had with certain key executives
expired in September 2000.
F-15
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. Stockholders' Equity
Equity Transactions
On March 3, 2000, the Company executed a settlement for a judgment in favor of a
former employee relating to an employment contract. Under the terms of the
settlement, the Company paid $1 million and issued 225,000 shares of its common
stock to the former employee.
On March 13, 2000, the Company sold 3,000 shares of its Series A Convertible
Preferred Stock in a private placement, which is exempt from registration
provided by Regulation D Rule 506 promulgated by the Securities and Exchange
Commission under the Securities Act of 1933, as amended. The Company received
net proceeds of approximately $2.7 million, which was used to fund current and
future operations. In addition, the Company issued warrants to the preferred
investor and the broker of the transaction in the amount of 247,525 and 75,000
to purchase shares of the Company's common stock at $3.64 and $4.57 per share,
respectively. The warrants expire on March 13, 2005.
The holders of the preferred shares were entitled to cumulative dividends of 5%
of the liquidation preference of $1,000 per share plus accrued but unpaid
dividends whether or not declared. For fiscal year 2000 and 2001 the Company
accrued dividend of $95,417 and $112,500, respectively and $91,000 and $0 were
accrued and unpaid as of October 31, 2000 and 2001, respectively. Each holder of
preferred shares was entitled to voting rights equal to the number of shares of
common stock into which such preferred shares were convertible.
The Series A Convertible Preferred Stock were convertible at the shareholders
option into common stock at the price equal to the lesser of 85% of the average
of the three lowest closing bid prices of the common stock for the 25 days prior
to the conversion date or $3.64. In fiscal year 2000, the Company recorded a
non-cash deemed dividend of $529,411 for the beneficial conversion feature. The
transaction was reported as "Dividend to Preferred Stockholders" on the
Company's 2000 Consolidated Statement of Operations.
In August 2001, the Company completed a transaction with its Preferred
Shareholders to redeem all of its outstanding Series A Convertible Preferred
stock for $2,500,000 in cash. Under the redemption agreement, the Preferred
Shareholders retained approximately 247,000 warrants previously issued. As a
result of the transaction, the Company recorded an increase to income available
to common stockholders of $721,816, representing the excess of the carrying
value of the preferred stock plus the beneficial conversion feature discount
over the repurchase price.
Stock Options
On January 6, 1997, the Company adopted the 1997 Stock Option Plan (the Option
Plan) which permits the Company to grant up to 600,000 options to officers,
directors and employees who contribute materially to the success of the Company.
In September 1997, the Company increased the number of options available for
grant under the plan to 2,200,000. In June 1999, the Company increased the
number of options available for grant under the plan to 2,500,000. Stock options
are generally granted at prices which the Company's Board of Directors believes
approximates the fair market value of its common stock at the date of grant. The
options vest ratably over a stated period of time not to exceed four years. The
contractual term of the options is five years.
F-16
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. Stockholders' Equity (continued)
Stock Options (continued)
Common stock option activity was as follows:
Weighted-Average
Shares Exercise Price
-------------------------------------
Outstanding at October 31, 1998 2,495,817 $6.70
Options granted 413,000 2.87
Options canceled or expired (1,026,384) 5.56
-------------------------------------
Outstanding at October 31, 1999 1,882,433 $5.22
Options granted 1,147,000 1.26
Options exercised (4,900) 3.13
Options canceled or expired (582,600) 2.74
-------------------------------------
Outstanding at October 31, 2000 2,441,933 $3.95
Options granted 984,000 0.74
Options canceled or expired (387,599) 3.20
-------------------------------------
Outstanding at October 31, 2001 3,038,334 3.01
-------------------------------------
Exercisable at October 31, 2001 1,126,167 $1.10
=====================================
The total options outstanding include 600,000 options granted to the former IDP
stockholders that are not included in the Option Plan.
As of October 31, 2001, there were 61,666 options available for future grants
under the Option Plan.
During fiscal 1999, the Company repriced certain stock options granted to
certain executives in accordance with their employment agreements, of which,
approximately 547,000 remain outstanding at October 31, 2001. No compensation
expense has been recognized as the exercise price for the repriced options was
at or above fair market value of the underlying stock at the end of each
reporting period subsequent to June 30, 2000.
F-17
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. Stockholders' Equity (continued)
Stock Options (continued)
The following table summarizes information about fixed-price stock options
outstanding at October 31, 2001:
Average Weighted-
Remaining Average
Range of Exercise Prices Number Contractual Exercise
Outstanding Life Price
-------------------------------------------------------
$0.55-$1.75 1,736,500 4.50 $0.97
$2.00-$4.50 701,834 5.92 3.16
$5.00-$8.75 600,000 7.00 8.75
-------------------------------------------------------
$0.55-$8.75 3,038,334 4.99 $3.01
=======================================================
Had compensation expense related to the stock options been determined based on
the fair value at the grant date for options granted during the years ended
October 31, 1999, 2000, and 2001 consistent with the provisions of SFAS 123, the
Company's net income and earnings per share would have been as follows:
Year ended October 31,
------------------------------------------------------
1999 2000 2001
-------------------------------------------------------
Net income (loss) - pro forma $(34,865,823) $(491,904) $503,444
Net income (loss) per share - pro forma $ (3.71) $(0.05) $0.05
Net income (loss) per share - assuming
dilution pro forma $ (3.71) $ (0.05) $ (0.01)
The effect of applying SFAS 123 on pro forma net income as stated above is not
necessarily representative of the effects on reported net income for future
years due to, among other things, the vesting period of the stock options and
the fair value of additional options in the future years.
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing fair value model with the following weighted-
average assumptions used for grants in 1999, 2000 and 2001: dividend yield of
0%, expected volatility of .86, 1.59 and 1.52 respectively; risk-free interest
rates of 6.70%, 6.01% and 4.50% respectively; and expected life of the option
term of five years. The weighted average fair values of the options granted in
1999, 2000 and 2001 with a stock price equal to the exercise price is $2.02,
$1.26 and $0.74 respectively.
F-18
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. Income Taxes
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes.
Components of the Company's net deferred tax asset balance are as follows:
October 31,
------------------------------------
2000 2001
------------------------------------
Deferred tax asset:
Accrued expenses $ 776,714 $ 401,752
Net operating loss carryforwards 4,834,470 3,052,019
Depreciation 26,469 540,680
Asset reserves 648,318 284,617
Other 52,339 69,539
------------------------------------
Total deferred tax asset 6,338,310 4,348,607
------------------------------------
Deferred tax credit:
Acquisition of intangible assets - -
Depreciation - -
Valuation allowance (5,011,565) (4,348,607)
------------------------------------
Net deferred tax asset $1,326,745 $ -
====================================
As of October 31, 2001, the Company had approximately $7.9 million in net
operating loss carryforwards which expire between 2012 and 2020. Approximately
$1.3 million of those net operating loss carryforwards relate to STMS and IDP
and may be significantly limited under Section 382 of the Internal Revenue
Service Code and the SRLY rules. The Company has recorded a full valuation
allowance for the deferred tax assets because realizability of those assets is
uncertain.
F-19
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. Income Taxes (continued)
The components of the provision for income taxes are as follows:
Years ended October 31,
--------------------------------------------------
1999 2000 2001
--------------------------------------------------
Current tax expense (benefit):
Federal $(974,781) $ - $ 27,400
State (213,975) - -
--------------------------------------------------
(1,188,756) - 27,400
Deferred tax expense:
Federal 535,500 49,000 58,032
State 94,500 16,000 19,344
--------------------------------------------------
630,000 65,000 77,376
--------------------------------------------------
Total provision for (benefit from) income taxes $(558,756) $ 65,000 $ 104,776
==================================================
The reconciliation of income tax from the Federal statutory rate of 34% is:
Years ended October 31,
------------------------------------------------------
1999 2000 2001
------------------------------------------------------
Tax at statutory rates: $(11,536,368) $ 49,089 $ 380,291
Non-deductible expenses 7,277,936 68,966 145,641
Valuation allowance and other 4,278,322 (69,097) (492,621)
State income tax, net of federal benefit (578,646) 16,042 71,465
------------------------------------------------------
$(558,756) $ 65,000 $ 104,776
======================================================
In September 1997 and in May 1998, respectively, the Company acquired the stock
of STMS and IDP in tax-free exchanges. The stock acquisitions were accounted for
using the purchase method. Deferred tax assets include differences between the
assigned values and tax bases of the assets and liabilities acquired, as well as
net operating loss carryforwards acquired. To the extent these deferred tax
assets are subsequently realized, the resulting tax benefit will be applied to
reduce goodwill recorded in connection with the acquisitions and there will be
no impact on income tax expense.
F-20
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. Retirement Plans
401(k) Plans
The Company maintains a 401(k) (the "Plan") for all current employees. Under the
Plan, employees are eligible to participate after completing 90 days of service
and attaining the age of 18. Employees can defer up to 15% of compensation.
Employee contributions are subject to Internal Revenue Service limitations. All
employees who contributed to the Plan are eligible to share in discretionary
Company matching contributions. Company contributions vest over 5 years. In
fiscal 2000 and 2001, the Company contributed approximately $18,000 and $60,000
to the participants of the 401(k), respectively.
Defined Benefit Plan
On October 31, 1999, the Company amended and terminated its Defined Benefit
Plan. Under the termination, no additional benefits accrued to participants in
the Plan after that date. In addition, all existing participants in the Plan
became 100% vested in their accrued benefits in the Plan as of that date. No
gain or loss was recognized as a result of the termination of the Pension Plan.
The Company began to distribute the vested benefits to the participants in
fiscal year 2000 and completed the distributions is fiscal 2001.
F-21
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
11. Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per
share:
Years ended October 31,
-------------------------------------------------------
1999 2000 2001
-------------------------------------------------------
Numerator:
Net income (loss) before extraordinary gain $(33,607,145) $50,665 $1,013,726
Preferred Stock dividends - (624,828) (112,500)
Redemption of preferred stock - - 721,816
Cumulative effect of change in accounting
principle - - (576,001)
-------------------------------------------------------
Net (loss) income available to common
stockholders before extraordinary gain (33,607,145) (574,163) 1,047,041
=======================================================
Denominator:
Denominator for basic earnings per share-
weighted-average shares 9,403,775 9,580,112 10,111,364
Effect of dilutive securities:
Employee stock options - - 36,899
Convertible preferred stock - - 2,314,969
-------------------------------------------------------
Dilutive potential common shares - - 2,351,868
-------------------------------------------------------
Denominator for diluted earnings per share -
adjusted weighted-average shares and assumed
conversions 9,403,775 9,580,112 12,463,232
-------------------------------------------------------
Earnings per share before extraordinary gain,
basic: $ (3.57) $ (0.06) $ 0.10
=======================================================
Earnings per share before extraordinary gain,
diluted: $ (3.57) $ (.06) $ 0.08
=======================================================
F-22
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. Contingencies
IDP Acquisition
On July 31, 1998 the Company received notice from the SBA that it was denying
the request of the U.S. Air Force to waive the requirement to terminate IDP's
Desktop V contract for the convenience of the Government upon the change in
control of IDP to the Company. The Company appealed the denial by the SBA to the
SBA's Office of Hearings and Appeals. On August 31, 1999, the SBA denied the
appeal and ruled that the U.S. Air Force must terminate-for-convenience the
Desktop V contract. Under a termination-for-convenience, the Government shall
reimburse the Company for all costs incurred in the performance of the contract.
The Company expects to recover from the Government a portion or all of its
unreimbursed costs. The Company is currently in negotiations with the Government
regarding this matter.
Microsoft Licensing Agreement
In November 1998, IDP entered into a Government Integrator Agreement, as
amended, with Microsoft Corporation (Microsoft) for the licensing of certain
Microsoft software. During 1999, Microsoft asserted that IDP owed approximately
$800,000 under this agreement due primarily to amended billing by Microsoft
concerning sales by IDP to the U.S. Air Force in conjunction with the Desktop V
contract. On October 31, 2000, Microsoft filed suit against the Company, and its
subsidiary IDP, for breach of contract. In conjunction with the filing of the
claim, Microsoft further amended the original billings, which resulted in a
claim against the Company of approximately $1.3 million. Subsequent to October
31, 2000, the Company submitted a motion to dismiss the case and filed a
counterclaim of fraud on behalf of IDP in the amount of $500,000. The Company
believes that it has meritorious defenses to the claim and intends to vigorously
defend itself. The Company cannot estimate at this time the amount of the
liability to be incurred, if any. In the event the Company is not successful in
its defense and a judgment is entered on behalf of Microsoft for the full amount
sought, the payment would have a material adverse effect upon the Company's
financial position and results of operations. The Company has accrued for
amounts due Microsoft based on the original billing terms. On February 20, 2001,
the Court ruled in favor of SteelCloud thereby dismissing that entity from the
claim. The Company will continue to vigorously defend its subsidiary, IDP, for
which it believes to have meritorious defenses.
Trademark Infringement
On October 19, 2000, the Company received a cease and desist letter from
LoudCloud, Inc. alleging that the use of the "SteelCloud" mark and name would
constitute an infringement of LoudCloud's rights to its "LoudCloud" mark and
name and family of "Cloud" marks, that use of "SteelCloud" would dilute the
distinctiveness and fame of the LoudCloud mark and name and, that such acts by
the Company violated federal and state law regarding unfair competition. In
response, the Company filed a declaratory judgment action in the U.S. District
Court for the Eastern District of Virginia, seeking a judicial determination
that its use of the "SteelCloud" mark and name would not violate the proprietary
rights of LoudCloud nor dilute the alleged fame and distinctiveness of the
"LoudCloud" mark and name. In this action, the Company also alleged a new claim
that LoudCloud, Inc. has violated federal law through its misuse of the
trademark provisions under the Lanham Act as amended in 1988. A hearing has been
held on the LoudCloud motion to dismiss and the court has taken the matter under
advisement. On January 10, 2001, the U.S. District Court for the Eastern
District of Virginia dismissed the case. The Company has appealed such decision.
The Company cannot estimate at this time the amount of the liability to be
incurred, if any, but does not believe that this matter will have a material
adverse effect upon the Company's financial position or results of operations.
Professional Services Malpractice Claim
In August of 2000, the Company's former legal counsel filed a claim against the
Company for approximately $343,087 plus accrued interest for legal fees and
costs. In response to the claim, the Company filed a counter claim for
professional malpractice and breach of fiduciary duty in the amount of
$1,568,000. In June 2001, the Company reached a settlement agreement with its
former legal counsel whereby both parties agreed to relinquish all claims
against the other, release each other from liability and waive the payment of
outstanding claims. The Company reversed the liability that was previously
accrued for the legal fees and costs, reducing general and administrative
expenses for fiscal 2001 by $343,087.
F-23
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
13. Quarterly Financial Information (unaudited)
Quarterly financial information for fiscal 2001 and 2000 is presented in the
following tables:
Previously Restated
Reported 1st 2nd 3rd 4th
1st Quarter Quarter(1) Quarter Quarter Quarter
------------- ------------- --------------- -------------- ---------------
2001
- ----
Revenue $7,188,899 $7,188,899 $7,328,384 $7,203,426 $8,417,670
Gross Profit 1,748,338 1,748,338 1,808,880 1,904,110 2,167,073
Net income (loss) available to common
shareholders 69,722 (506,279) 129,590 506,330 917,400
Per Share Data
- --------------
Net income (loss)
Basic 0.01 (0.05) 0.01 0.05 0.09
Diluted 0.01 (0.05) 0.01 0.04 0.02
2000
- ----
Revenue $7,128,063 $10,602,548 $10,328,950 $11,706,832
Gross Profit 1,481,318 2,007,347 1,797,071 1,844,247
(Loss) income before extraordinary item (589,298) (240,744) 228,065 171,154
Extraordinary item 750,000 - - -
Net income (loss) available to common
shareholders 160,702 (288,667) 190,565 113,237
Per Share Data
- --------------
Loss (income) before extraordinary item (0.06) (0.03) 0.02 0.01
Net income (loss), basic and diluted 0.02 (0.03) 0.02 0.01
(1) The Company has restated its results for the quarter ended January 31,
2001 to reflect the implementation of Emerging Issues Task Force No.
00-27 as of November 1, 2000. As discussed in Note 2 to the financial
statements, the implementation of Issue 1 of EITF 00-27 modified the
calculation of the beneficial conversion feature discount associated
with the Company's Series A Convertible Preferred Stock. The
implementation of EITF 00-27 resulted in a charge of $576,001 or $0.06
per share, reflected as a cumulative effect of a change in accounting
principle. The restatement had no effect on income from operations,
cash flows or net stockholders' equity as of and for the quarter ended
January 31, 2001.
F-24
REPORT OF ERNST & YOUNG, LLP, INDEPENDENT AUDITORS
The Board of Directors
SteelCloud, Inc.
We have audited the consolidated financial statements of SteelCloud, Inc. (a
Virginia corporation) as of October 31, 2000 and 2001, and for each of the three
years in the period ended October 31, 2001 and have issued our report thereon
dated December 21, 2001, except for Note 5 as to which the date is January 18,
2002 (included elsewhere in this Form 10-K). Our audits also included the
consolidated financial statement schedule listed in Item 14 of this Form 10-K.
The schedule is the responsibility of the Company's management. Our
responsibility is to express an opinion based on our audits.
In our opinion, the consolidated financial statement schedule referred to above,
when considered in relation to the basic consolidated financial statements taken
as a whole, presents fairly in all material respects, the information set forth
herein.
/s/ Ernst & Young LLP
McLean, Virginia
December 21, 2001
SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS
STEELCLOUD, INC.
Balance at Balance
Beginning of at End of
Classification Year Additions Deductions Year
- -------------- ---- --------- ---------- ----
Allowance for doubtful accounts:
Year ended October 31, 1999................................... $46,000 $1,400,000 $1,346,000(1) $100,000
Year ended October 31, 2000................................... $100,000 $0 $0 $100,000
Year ended October 31, 2001................................... $100,000 $12,000 $0 $112,000
Inventory reserve:
Year ended October 31, 1999................................... $250,000 $2,241,000 $362,000(2) $2,129,000
Year ended October 31, 2000................................... $2,129,000 $0 $575,000(2) $1,554,000
Year ended October 31, 2001................................... $1,554,000 $120,000 $466,438(2) $1,207,562
- -----------
(1) Write-offs of accounts receivable
(2) Write-offs of inventory
S-1