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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark one)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended July 31, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________ to ________
Commission File No. 0-24015
STEELCLOUD, INC.
(Exact name of Registrant as specified in its charter)
VIRGINIA
(State or other jurisdiction of incorporation or organization)
54-1890464
(I.R.S. Employer Identification No.)
1306 Squire Court, Sterling, VA. 20166
(Address of principal executive offices) (zip code)
(703) 450-0400
(Registrant's telephone number, including area code)
(Former name or former address, if changed since last report)
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 |_|.
As of September 1, 2003 there were 10,416,011 shares of the registrant's common
stock outstanding.
SteelCloud, Inc.
Form 10-Q Index
For the Quarterly period ended July 31, 2003
Description Page
- ----------- ----
Part I. Financial Information.................................................................. 3
Item 1. Financial Statements...................................................................
Consolidated Balance Sheets as of July 31, 2003 and October 31, 2002................... 3
Consolidated Statements of Operations for the three and nine month periods ended
July 31, 2003 and 2002 .......................................................... 4
Consolidated Statements of Cash Flows for the nine periods ended July 31, 2003 and
2002................................................................................... 5
Notes to the Consolidated Financial Statements......................................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations............................................................................. 9
Item 3. Quantitative and Qualitative Disclosures About Market Risk............................. 16
Item 4. Controls and Procedures................................................................ 16
Part II. Other Information...................................................................... 16
Item 1. Legal Proceedings...................................................................... 16
Item 4. Submission of Matters to a Vote of Security Holders.................................... 17
Item 6. Exhibits and Reports on Form 8-K....................................................... 17
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
STEELCLOUD, INC.
CONSOLIDATED BALANCE SHEET
October 31, July 31,
2002 2003
------------ ------------
(unaudited)
ASSETS
Current assets
Cash and cash equivalents $ 751,323 $ 1,046,552
Accounts receivable, net of allowance for doubtful
accounts of $293,000 as of October 31, 2002 and July 31, 2003 6,082,340 3,917,127
Inventory, net 4,180,812 3,585,883
Deferred tax asset 400,000 400,000
Income tax receivable 55,392 55,392
Prepaid expenses and other current assets 208,892 298,792
Deferred contract costs 2,039,339 312,888
Assets held for sale 953,320 386,981
------------ ------------
Total current assets 14,671,418 10,003,615
Property and equipment, net 304,081 397,788
Equipment on lease, net 574,272 373,494
Goodwill and other intangible assets, net 1,778,059 1,778,059
Other assets 304,922 266,856
------------ ------------
Total assets $ 17,632,752 $ 12,819,812
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable $ 3,620,580 $ 2,472,398
Accrued expenses 1,542,277 1,706,714
Notes payable, current 503,823 152,644
Unearned revenue 4,507,859 620,662
Liabilities held for sale 641,145 518,843
------------ ------------
Total current liabilities 10,815,684 5,471,261
Note payable, long-term 60,000 63,548
Stockholders' equity
Common stock, $.001 par value: 50,000,000 shares authorized,
10,447,611 and 10,775,511 shares issued and outstanding at October
31, 2002 and July 31, 2003, respectively 10,448 10,776
Additional paid in capital 39,553,017 39,833,146
Treasury stock, 400,000 shares at October 31, 2002 and July 31, 2003,
respectively (3,432,500) (3,432,500)
Accumulated deficit (29,373,897) (29,126,419)
------------ ------------
Total stockholders' equity 6,757,068 7,285,003
------------ ------------
Total liabilities and stockholders' equity $ 17,632,752 $ 12,819,812
============ ============
The accompanying notes are an integral part of these consolidated financial
statements.
3
STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
Three Months Ended Nine Months Ended
July 31, July 31,
---------------------------- ----------------------------
2002 2003 2002 2003
------------ ------------ ------------ ------------
Net revenues $ 6,390,414 $ 8,156,414 $ 23,370,526 $ 24,011,858
Cost of revenue 4,592,834 6,498,483 16,934,104 18,973,582
------------ ------------ ------------ ------------
Gross profit 1,797,580 1,657,931 6,436,422 5,038,276
Selling and marketing 324,264 292,626 885,460 927,575
General and administrative 1,178,209 1,139,723 3,683,546 3,515,543
Research and product development - 186,140 - 296,735
Amortization of goodwill 98,554 - 295,662 -
------------ ------------ ------------ ------------
Income from operations 196,553 39,442 1,571,754 298,423
Interest expense (income), net 6,339 (937) 64,535 12,802
Other expense, net 42,897 - 111,686 -
------------ ------------ ------------ ------------
Income from operations before income taxes
147,317 40,379 1,395,533 285,621
Provision for income taxes - - 1,200 -
------------ ------------ ------------ ------------
Net income from continuing operations 147,317 40,379 1,394,333 285,621
Loss from discontinued operations (46,145) (30,071) (457,348) (86,526)
------------ ------------ ------------ ------------
Net income 101,172 10,308 936,985 199,095
============ ============ ============ ============
Earnings per share (basic):
Earnings from continuing operations 0.01 0.01 0.14 0.03
Discontinued operations 0.00 0.00 (0.05) (0.01)
------------ ------------ ------------ ------------
Net earnings per share 0.01 0.01 0.09 0.02
============ ============ ============ ============
Earnings per share (diluted):
Earnings from continuing operations 0.01 0.01 0.13 0.03
Discontinued operations 0.00 0.00 (0.04) (0.01)
------------ ------------ ------------ ------------
Net earnings per share 0.01 0.01 0.09 0.02
============ ============ ============ ============
Weighted-average shares outstanding, basic 9,915,645 10,164,928 9,863,110 10,078,815
Weighted-average shares outstanding, diluted 11,121,418 11,014,984 10,787,035 10,577,491
The accompanying notes are an integral part of these consolidated statements.
4
STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Nine Months Ended
July 31,
2002 2003
----------- -----------
Operating activities
Net income $ 936,985 $ 199,095
Loss from discontinued operations 457,348 86,526
----------- -----------
Net income from continuing operations 1,394,333 285,621
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation and amortization of property and equipment 565,342 251,915
Amortization of goodwill and other intangibles 295,662
Provision for bad debt 261,740
Loss (gain) on sale of lease 5,396
Impairment charge - investment 112,500
Stock compensation expense 17,500
Changes in operating assets and liabilities:
Accounts receivable 1,066,375 2,165,213
Income tax receivable 1,315,674
Inventory (200,120) 631,395
Prepaid expenses and other assets (26,769) (51,833)
Deferred contract costs (1,766,488) 1,726,451
Accounts payable (683,876) (1,051,371)
Accrued expenses 558,946 164,437
Unearned revenue and other liabilities 2,226,981 (3,887,197)
----------- -----------
Net cash provided (used) by operating activities 5,143,196 234,631
Investing activities
Purchase of property and equipment (206,662) (99,421)
Financing activities
Proceeds from issuance of common stock 56,166
Proceeds from exercise of common stock options 272,694 224,291
Proceeds (payments) on notes payable 367,289 (477,950)
Repayments on line of credit, net (3,836,754)
----------- -----------
Net cash used in financing activities (3,196,771) (197,493)
Net increase (decrease) in cash and cash equivalents of continuing 1,739,763 (62,283)
operations
Net cash (used in) provided by operating activities of discontinued (614,763) 357,512
operations
Cash and cash equivalents at beginning of period 282,318 751,323
----------- -----------
Cash and cash equivalents at end of period $ 1,407,317 $ 1,046,552
=========== ===========
Supplemental cash flow information
Interest paid $ 52,383 $ 19,647
Income taxes paid $ 1,200 $ 0
The accompanying notes are an integral part of these consolidated financial
statements.
5
STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation
The consolidated financial statements for the three and nine month periods ended
July 31, 2003 and 2002 are unaudited and include all adjustments which, in the
opinion of management, are necessary to present fairly the results of operations
for the periods then ended. All such adjustments are of a normal and recurring
nature. These consolidated financial statements should be read in conjunction
with the Annual Report on Form 10-K of SteelCloud, Inc. (the "Company") filed on
January 29, 2003 with the Securities and Exchange Commission.
2. Employee Stock Options
The Company accounts for employee stock option grants using the intrinsic method
in accordance with Accounting Principles Board (APB) Opinion No. 25 "Accounting
for Stock Issued to Employees" and accordingly associated compensation expense,
if any, is measured as the excess of the underlying stock price over the
exercise price on the date of grant. The Company complies with the disclosure
option of Statement of Financial Accounting Standards (SFAS) No. 123 "Accounting
for Stock Based Compensation", as amended by SFAS No. 148 "Accounting for
Stock-Based Compensation--Transition and Disclosure" which requires pro-forma
disclosure of compensation expense associated with stock options under the fair
value method.
The Company's pro forma information follows:
Three Months Ended Nine Months Ended
July 31, July 31,
2002 2003 2002 2003
-------- -------- ------- ----------
Net earnings, as reported ................................... $101,172 10,308 936,985 199,095
Less: Total stock based employee compensation
expense determined under the fair-value based
method ...................................................... 222,651 113,405 796,447 324,813
-------- -------- ------- ----------
Pro-Forma net (loss) earnings ............................... (121,479) (103,097) 140,538 (125,718)
======== ======== ======= ==========
Basic earnings per share as reported ........................ 0.01 0.00 0.09 0.02
======== ======== ======= ==========
Basic pro-forma net earnings per share ...................... (0.01) (0.01) 0.01 (0.01)
======== ======== ======= ==========
Diluted earnings per share as reported ...................... 0.01 0.00 0.09 0.02
======== ======== ======= ==========
Diluted pro-forma net earnings per share .................... (0.01) (0.01) 0.01 (0.01)
======== ======== ======= ==========
6
3. Discontinued Operations
The Company continually evaluates its operating facilities with regard to its
long-term strategic goals established by management and the Board of Directors.
Operating facilities, which are not expected to contribute to the Company's
future operations are either closed or sold. On October 25, 2002, management,
with the approval of the Board of Directors, determined that its Puerto Rico
Industrial Manufacturing Operation ("PRIMO") would no longer contribute to
future operations and therefore adopted a plan to dispose that operation
effective on that date. Accordingly, the Company has reflected PRIMO as
discontinued operations in the current financial statements. As a result, prior
year amounts have been reclassified to segregate the continuing operations from
the discontinued operations. The Company anticipates that the losses for the
remainder of the fiscal year associated with PRIMO will not be material. The
loss associated with the discontinued operation was approximately $30,000 and
$87,000 for the three and nine-month periods ended July 31, 2003. The Company
believes that given the current environment of that market, discontinuing the
operation was the best alternative.
A summary of the financial information for the discontinued operation is as
follows:
Three Months Ended Nine Months Ended
July 31, July 31,
2002 2003 2002 2003
---------- ----------- ----------- -----------
Net revenues ............................... $ 648,388 $ 223,849 $ 1,431,709 $ 228,355
Gross profit (loss) ........................ 178,872 12,963 291,429 80,800
Loss from discontinued operations .......... (46,145) (30,071) (457,348) (86,526)
October 31, July 31,
2002 2003
---------- -----------
Accounts receivable, net ................... $ 682,978 $ 262,434
Inventory, net ............................. 188,698 60,736
Other assets ............................... 81,644 63,811
---------- -----------
Total assets ............................... 953,320 386,981
========== ===========
Accrued expenses ........................... $ 590,526 $ 518,843
Accounts payable and other liabilities ..... 50,619 -
---------- -----------
Total liabilities .......................... 641,145 518,843
========== ===========
7
4. Inventory and Deferred Contract Costs
Inventory consists of materials and components used in the assembly of the
Company's products and are 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. As of July 2003, the Company had an inventory reserve of approximately
$585,637. Of that reserve, approximately $460,000 relates to inventory on-hand
resulting from the termination of a significant contract with the Federal
Government for which a claim has been submitted to recover those inventory
costs. The Company believes that as part of the adjudication process, there will
be negotiations of our initial claim amount. Accordingly, our reserve is based
on our best estimate of that adjudication process. The remainder of our reserve
represents estimates of potential shrinkage that are inherent in the purchasing
and assembly process.
Deferred contract costs represents costs associated with products where title
has transferred but revenue has been deferred in accordance with the Company's
revenue recognition policy. At July 31, 2003, the Company had recorded
approximately $312,888 of deferred contract costs of which approximately
$242,000 related to its server appliance contract.
5. Debt
On March 31, 2003, the Company amended its primary line of credit whereby the
maximum availability was decreased from $7.5 million to $3.5 million. The note
bears interest at the lower of (a) the Lender's Prime Rate per annum or (b) the
LIBOR Market Index Rate plus 2.5%. The line of credit expires on March 31, 2004.
There was no outstanding balance on the line of credit at October 31, 2002 and
July 31, 2003.
On February 1, 2002, the Company executed a promissory note in conjunction with
their line of credit in the amount of $725,000. The note bears interest at the
lower of (a) the Lender's Prime Rate per annum or (b) the LIBOR Market Index
Rate plus 2.5% and matures on July 5, 2003. The Company's monthly principal
payments are approximately $43,000. The outstanding balance on the promissory
note at October 31, 2002 and July 31, 2003 was approximately $384,000 and $0
respectively.
On April 1, 2002, the Company executed a two-year promissory note in conjunction
with a litigation settlement reached in March 2002 for approximately $240,000.
The promissory note bears interest at the prime rate and matures in May 2004.
The Company makes monthly payments of $10,000 plus accrued interest. The
outstanding balance on the note at October 31, 2002 and July 31, 2003 was
approximately $180,000 and $90,000 respectively.
6. Unearned Revenue
For the nine-month period ended July 31, 2003, the unearned revenue was
approximately $621,000, which represents payments received for products and
services prior to performance. Approximately $315,000 of unearned revenue
relates to the Company's server appliance contract. Revenue under this contract
will be recognized over the remaining life of the contract as units are shipped,
which is scheduled for completion in October 2003.
7. Earnings Per Share
Basic earnings per share is based on the weighted average number of common
shares outstanding during the period and is calculated by dividing the net
income (loss) by the weighted average number of common shares outstanding.
Diluted earnings per share is based on the weighted average number of common
shares outstanding plus common stock equivalents associated with stock options
and is calculated by dividing net income (loss) by the weighted average number
of common shares outstanding used in the basic earnings per share calculation
plus the number of common stock equivalents determined under the treasury stock
method.
8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
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.
The following discussion should be read in conjunction with the consolidated
financial statements and notes thereto included in Item 1 in this Quarterly
Report on Form 10-Q and our Annual Report on Form 10-K for the fiscal year ended
October 31, 2002 filed by the Company with the Securities and Exchange
Commission.
OVERVIEW
Founded in 1987 and based in Dulles, Virginia, SteelCloud, Inc, designs,
develops and manufactures network security appliances and custom computer
servers. The Company also develops proprietary software to optimize the
performance of its security appliances. In addition, the company provides
technical consulting and general information technology services directly to
organizations in both the public and private sectors.
SteelCloud's network security appliances are developed in collaboration with
some of the world's premiere software companies. Recently, SteelCloud began to
brand and co-brand appliances that are specially designed and optimized to
deliver a dedicated network service such as antivirus gateway protection,
intrusion detection and secure content management.
Custom computer servers are designed to meet the precise needs of volume
customers. These systems reduce the customer's investments in logistics,
integration capacity and support.
SteelCloud's consulting services organization provides clients with a seamless
extension of their own IT organizations. As an element of its cosulting
business, the Company resells hardware and software products. Expert technical
services include network analysis, security, design, troubleshooting and
implementation. These services also complement the company's network security
appliance offerings.
9
FISCAL 2003
Product Development
In fiscal 2003, SteelCloud undertook initiatives to enhance its product
offerings and improve its margins. The Company is developing a family of
hardened (highly secured operating system) security appliances that it will
offer as SteelCloud product or as co-branded appliances with its software
partners. Accordingly, the Company commenced its research and development
("R&D") activities associated with these new product offerings in its second
quarter of fiscal 2003. The result of this work has been new appliance platforms
that can be easily tailored to the needs of a particular software package or
technology and SteelCloud Secure Console (SC2).
The Company believes that this intellectual property ("IP") it has developed
will enable it to improve margins and increase revenues. With its goal of
increasing margins, SteelCloud expanded its appliance business model to
encompass more direct control in the development and marketing of its
appliances. For the nine months ended July 31, 2003, the Company incurred
research and development costs of approximately $296,735 in support of its new
business strategy. The Company will continue to incur these costs as these
products are brought to market. The Company anticipates that these products will
be released to market in the latter part of fiscal 2003.
In July 2003, the Company announced its family of network security appliances in
collaboration with Computer Associates International, Inc. (CA). The co-branded
(SteelCloud and CA) appliances incorporate CA eTrust(TM) software technology
with SC2, SteelCloud's new proprietary secure management software. The hardened
(highly secured), ready-to-deploy family of enterprise-class appliances optimize
application performance and lowers the customer's total cost of ownership. The
appliances are marketed through CA's worldwide sales channels.
Discontinued Operations
The Company continually evaluates its operating facilities with regard to its
long-term strategic goals established by management and the Board of Directors.
Operating facilities, which are not expected to contribute to the Company's
future operations are either closed or sold. On October 25, 2002, management,
with the approval of the Board of Directors, determined that its Puerto Rico
Industrial Manufacturing Operation ("PRIMO") would no longer contribute to
future operations and therefore adopted a plan to dispose that operation
effective on that date. Accordingly, the Company has reflected PRIMO as
discontinued operations in the current financial statements. As a result, prior
year amounts have been reclassified to segregate the continuing operations from
the discontinued operations. The Company anticipates that the losses for the
remainder of the fiscal year associated with PRIMO will not be material. The
loss associated with the discontinued operation was approximately $30,000 and
$87,000 for the three and nine-month periods ended July 31, 2003. The Company
believes that given the current environment of that market, discontinuing the
operation was the best alternative.
10
Goodwill and Other Intangible Assets
Effective November 1, 2002, the Company adopted SFAS No. 142, "Goodwill and
Other Intangible Assets". As a result, the Company no longer amortizes goodwill
and periodically tests goodwill for possible impairment. For the three and nine
month periods ended July 31, 2003, reduction in goodwill amortization was
approximately $99,000 and $296,000. Summarized below are the effects on net
income and net income per share if we had not amortized goodwill pursuant to the
provisions of SFAS No. 142 for all periods presented.
Three Months Ended Nine Months Ended
July 31, July 31,
2002 2003 2002 2003
----------- ---------- ------------- -----------
Net income
As reported .................................. $ 101,172 $ 10,308 $ 936,985 $ 199,095
Add goodwill amortization .................... 98,554 0 295,662 0
----------- ---------- ------------- -----------
Adjusted net income .......................... 199,726 10,308 1,232,647 199,095
Earnings per share:
Basic:
As reported .................................. 0.01 0.01 0.09 0.02
Add goodwill amortization .................... 0.01 0.00 0.03 0.00
----------- ---------- ------------- -----------
Adjusted earnings per share (basic) .......... 0.02 0.01 0.12 0.02
Diluted:
As reported .................................. 0.01 0.01 0.09 0.02
Add goodwill amortization .................... 0.01 0.00 0.03 0.00
----------- ---------- ------------- -----------
Adjusted earnings per share (diluted) ........ 0.02 0.01 0.12 0.02
Significant Contract
In January 2002, the Company was awarded several contracts by Lockheed Martin
valued at more than $10.5 million for customized servers. The Company commenced
work under the contracts in February 2002 and is expected to complete the
contracts by October 2003. For the three-month and nine-month periods ended July
31, 2003, the Company recognized revenue of approximately $2.8 million and $7.2
million, respectively (or approximately 34% and 30%, respectively, of total net
revenues). The Company has deferred revenues of approximately $315,000 and
deferred contract costs of approximately $242,000 associated with this contract
as of July 31, 2003. These amounts will be recognized over the life of the
contracts as units are shipped. In addition, for the nine-month period ended
July 31, 2003, the Company had other contracts with Lockheed Martin totaling
approximately $239,000 or 1% of its net revenues.
11
CRITICAL ACCOUNTING POLICIES
The Company believes the following represents an update of its critical
accounting policies from October 31, 2002:
Significant Customers
As of July 31, 2003, the Company generated approximately $7.4 million or 31% of
its total net revenues from contracts and awards with Lockheed Martin for the
nine-month period then ended. Given the nature of the products manufactured by
the Company as well as the delivery schedules established by its partners,
revenue and accounts receivable concentration by any single customer will
fluctuate from quarter to quarter. The Company anticipates that concentration
levels will decrease as its customer base and new product offerings expand in
future periods. Future revenues and results of operations could be adversely
affected should these customers reduce their purchases, eliminate product lines
or choose not to continue to buy products and services from SteelCloud.
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.
For technology support services under time and material contracts, the Company
recognizes revenue as services are provided based on contracted rates and
materials are delivered.
12
RESULTS OF OPERATIONS
For the three and nine months ended July 31, 2003 compared to the three and nine
months ended July 31, 2002
Net revenues for the three months ended July 31 were $8,156,414 in fiscal 2003
as compared to $6,390,414 in fiscal 2002, an increase of approximately 28%.
Revenues from contracts and government awards increased to approximately $3.4
million in fiscal 2003 from approximately $1.2 million in fiscal 2002, an
increase of 183%. The increase was primarily the result of increased deliveries
on the Company's $10 million server appliance contract with Lockheed Martin.
Revenues under the server appliance contract for the three months ended July 31,
2003 was approximately $2.9 million compared to approximately $655,000 for the
same period in fiscal 2002. In addition, the Company experienced revenue growth
in its OEM products, reselling activities and consulting services. These
increases offset a decrease in revenue from one of the Company's significant
customers, Network Associates, for which the supply agreement expired on
December 31, 2002. Revenues from this customer were approximately $6,000 for the
three months ended July 31, 2003 compared to approximately $3.0 million for the
three months ended July 31, 2002, a decrease of approximately $2.9 million.
Revenues from this customer for the nine months ended July 31, 2003 and 2002
were approximately $440,000 and $14.2 million, respectively. For the nine-month
period ended July 31, 2003 and 2002, the Company's net revenues increased to
$24,011,858 from $23,370,526, respectively. The increase in revenues was the
result of the Company's efforts to expand its sales force and diversify its
revenue sources. During the second quarter of fiscal 2003, the Company began to
develop new product offerings, which are anticipated to achieve such
diversification and revenue growth. The Company anticipates sales from these new
products to commence in the fourth quarter of fiscal 2003.
Gross margins, as a percentage of net revenues, decreased to 20% for the three
months ended July 31, 2003 from 28% for the three months ended July 31, 2002.
Gross margins, as a percentage of net revenues, decreased to 21% for the nine
months ended July 31, 2003 from 27% for the nine months ended July 31, 2002. The
decrease in gross margin is primarily the result of the Company's shift in its
product mix and revenue sources during fiscal 2003. Accordingly, gross margins
as a percentage of revenues, will fluctuate from quarter to quarter. In
addition, the Company has not begun to realize the anticipated effects of its
new strategy to boost margins via new product development.
For the three months ended July 31, selling and marketing expenses decreased
approximately 10% to $292,626 in fiscal 2003 from $324,264 in fiscal 2002. The
decrease is the result of sales incentives and commissions paid in fiscal 2002.
In fiscal 2003, the Company increased its sales force to support its new
software partnerships and expand markets for its new products. Accordingly, the
Company anticipates that its selling and marketing costs will increase in future
periods. For the nine months ended July 31, selling and marketing expenses
increased to $927,575 in fiscal 2003 from $885,460 in fiscal 2002, an increase
of approximately 5%. The Company will continue to invest in its selling and
marketing activities in order to support its new business initiatives and
partnerships.
13
General and administrative expense for the three months ended July 31, 2003
decreased slightly to $1,139,723 from $1,178,209 for the same period in fiscal
2002. As a percentage of net revenues, general and administrative costs
decreased slightly to 14% for fiscal 2003 from 18% in fiscal 2002. The decrease
is attributable to a reduction in rent, maintenance and depreciation expense of
approximately $33,000, a reduction in professional services of approximately
$10,000 and increase of approximately $5,000 in salaries and benefits. For the
nine-month period ended July 31, general and administrative expenses decreased
approximately 5% to $3,515,543 in fiscal 2003 from $3,683,546 in fiscal 2002.
The reduction of approximately $168,000 primarily is the result of overall
decreased salaries and benefits in fiscal 2003 compared to fiscal 2002. Given
its new business strategy, the Company has focused its resources on its
development efforts and therefore has managed its general and administrative
expenses relative to its revenue.
The Company commenced its research and product development (R&D) efforts in its
second quarter of fiscal 2003. As a result the Company announced two of its new
product offerings in the third quarter of fiscal 2003. The Company anticipates
that sales for these products will commence during its fourth quarter of fiscal
2003. Accordingly, the Company incurred approximately $186,140 and $296,735
related to its research and product development efforts for the three and nine
month periods ended July 31, 2003, respectively. The Company will continue to
incur these expenses as new products are brought to market.
The Company reported net interest income of $937 for the three months ended July
31, 2003 compared to a net interest expense of approximately $6,339, for the
same period in fiscal 2002. For the nine months ended July 31, 2003, other
expense, including interest, decreased to $12,802 from $176,221 for the nine
months ended July 31, 2002. The decrease is the result of the Company recording
an impairment charge of $112,500 relating to the decline in market value of one
of its investments during the second quarter of fiscal year 2002. In addition,
the decrease can be attributable to the Company's reduction in its outstanding
debt during fiscal 2003 as well as an overall decline in the short-term interest
rate in fiscal 2003 compared to fiscal 2002.
For the three and nine month periods ending July 31, 2003, there was no
provision for income taxes, as the Company has approximately $8.5 million in net
operating loss carryforwards for income tax reporting purposes, which are
available to offset current and future taxable income. A valuation allowance has
been established against the associated deferred tax asset to reflect the asset
at an amount that more likely than not will be realized.
The Company reported net income from continuing operations of $40,379 for the
three months ended July 31, 2003, as compared to net income of $147,317 for the
same period in the prior year. For the nine months ended July 31, the Company
reported net income from continuing operations of $285,621 for fiscal 2003 as
compared to a net income of $1,394,333 for fiscal 2002. This decrease was
primarily the result of the Company's decline in gross margins during the three
and nine months ended July 31, 2003.
14
LIQUIDITY AND CAPITAL RESOURCES
The principal source of the Company's cash is from its operations. For the nine
months ended July 31, 2003, the Company produced approximately $234,631 in cash
flow for its operating activities. The Company generated net income from
continuing operations of $285,621, collected approximately $2,165,213 of its
receivables, reduced and sold inventory of $631,395 and recognized deferred
costs of $1,726,451. The cash generated was primarily used to pay accounts
payable and accrued expenses of approximately $886,934. In addition, the Company
recognized deferred revenue of $3,887,197.
Funds used for investing activities consisted of the purchase of property,
equipment and leased assets of approximately $99,421. Net cash used for
financing activities consisted of repayments of notes payable of $197,493.
On March 31, 2003, the Company amended its existing line of credit from $7.5
million to $3.5 million, with an expiration date of March 31, 2004, bearing
interest at the lower of (a) prime rate or (b) the LIBOR Market Index Rate plus
2.5%. As of July 31, 2003, the Company had no advances on its line of credit;
however, the available borrowing capacity was approximately $3.1 million.
On February 1, 2002, the Company executed a promissory note in conjunction with
their line of credit in the amount of $725,000 with a maturity date of July 5,
2003. The note bears interest at the lower of (a) the Lender's Prime Rate per
annum or (b) the LIBOR Market Index Rate plus 2.5%. On July 5, 2003, the Company
satisfied the terms of the promissory note and repaid the outstanding balance.
Accordingly, there was no outstanding balance on the promissory note as of July
31, 2003.
On April 1, 2002, the Company settled its litigation with Microsoft. In
conjunction with the settlement, the Company executed a two-year promissory note
with Microsoft for approximately $240,000 bearing interest at the prime rate and
with a maturity date of May 2004. The note is payable in monthly payments of
$10,000 plus accrued interest. As of September 1, 2003 the outstanding balance
on the note was approximately $60,000.
As of July 31,, 2003, the Company had working capital of approximately $4.5
million and cash on hand of approximately $1.0 million compared to working
capital of approximately $3.9 million and cash on hand of approximately $751,323
as of October 31, 2002. The increase in working capital is due the collection of
receivables, reduction of inventory and recognition of deferred contract
revenues and costs. The Company believes the bank facility, together with cash
on hand, and projected cash generated from operations will provide sufficient
financial resources to finance the current operations of the Company through
fiscal 2003.
From time to time, the Company may pursue strategic acquisitions or mergers,
which may require significant additional capital, and additional capital may be
required to satisfy unusual or infrequent expenses. In such event, the Company
may seek additional financing of debt and/or equity.
15
OFF-BALANCE SHEET ARRANGEMENTS
Contractual Obligations and Commercial Commitments
The Company's significant contractual obligations as of July 31, 2003 are for
debt and operating leases. Debt by year of maturity and future rental payments
under operating lease agreements are presented below. As of July 31, 2003, the
Company does not have an outstanding balance on its line of credit and does not
have any purchase obligations. The Company has not engaged in off-balance sheet
financing, commodity contract trading or significant related party transactions.
- ----------------------------------- ------------------------------------------------------------------------------
Contractual Obligations Payments Due by Period
- ----------------------------------- ----------------- ---------------- --------------- ------------- -------------
Total Less than 1 1-3 years 4-5 years After 5
year years
- ----------------------------------- ----------------- ---------------- --------------- ------------- -------------
Notes payable - current $152,644 $152,644 - - -
- ----------------------------------- ----------------- ---------------- --------------- ------------- -------------
Notes payable - long term $63,548 - $45,033 $18,515 -
- ----------------------------------- ----------------- ---------------- --------------- ------------- -------------
Operating lease $543,990 $421,918 $122,072 - -
- ----------------------------------- ----------------- ---------------- --------------- ------------- -------------
Management believes that these commitments will be satisfied with current
operating cash flow.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to market risk related to fluctuations in interest rates
on its debt. Increase 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 4. CONTROLS AND PROCEDURES
Within the 90 days prior to the date of this report, the Company carried out an
evaluation, under the supervision and with the participation of the Company's
management, including the Company's Chief Executive Officer and Chief Financial
Officer, of the effectiveness of the design and operation of the Company's
disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based
upon that evaluation, the Chief Executive Officer and Chief Financial Officer
concluded that the Company's disclosure controls and procedures are effective.
There were no significant changes in the Company's internal controls or in other
factors that could significantly affect these controls subsequent to the date of
their evaluation.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
There are routine legal claims pending against the Company, that occur in the
ordinary course of business 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.
Other than the items previously disclosed, we are not a party in any other
material legal proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On May 15, 2003, the Company held its 2002 Annual Meeting of Shareholders. At
the annual meeting, the Company's shareholders were asked to vote upon: (i) the
election of two Class II directors, and (ii) the appointment of Grant Thornton
LLP to act as the Company's independent accounting firm for the ensuing year.
The following persons were elected as directors of the company for the
ensuing year by the votes next to such persons name:
For Withheld Against
VADM E.A. Burkhalter, Jr. USN 9,327,246 58,809 0
--------- ------
James Bruno 9,333,196 52,859 0
--------- ------
VADM E.A. Burkhalter, Jr. USN and James Bruno were duly elected as Class II
Directors of the Company to serve for the next three years and shall serve until
their respective successors have been duly elected and qualified.
Grant Thornton LLP was approved to act as the Company's independent
certified public accountants for the ensuing year by the following vote:
For Against Abstain
9,364,010 17,285 4,760
--------- ------ -----
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
Exhibit 11.1: Statement of computation of earnings per share.
Exhibit 31. Rule 13a-14(a)/15d-14(a) Certifications.
Exhibit 32.1 Certification by the Chief Executive Officer Relating to a Periodic
Report Containing Financial Statements.*
Exhibit 32.2 Certification by the President and Chief Operating Officer Relating
to a Periodic Report Containing Financial Statements.*
Exhibit 32.3 Certification by the Chief Financial Officer Relating to a Periodic
Report Containing Financial Statements.*
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(b) Reports on Form 8-K
On June 11, 2003, the Company filed a report on Form 8-K pursuant to Item 7
"Financial Statements, Pro Forma Financial Information and Exhibits" and Item 9
"Regulation FD Disclosure".
* The Exhibit attached to this Form 10-Q shall not be deemed "filed" for
purposes of Section 18 of the Securities Exchange Act of 1934 (the "Exchange
Act") or otherwise subject to liability under that section, nor shall it be
deemed incorporated by reference in any filing under the Securities Act of 1933,
as amended, or the Exchange Act, except as expressly set forth by specific
reference in such filing.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SteelCloud, Inc.
Date: September 12, 2003 By: /s/ Thomas P. Dunne
----------------------------------
Thomas P. Dunne
Chief Executive Officer
Date: September 12, 2003 By: /s/ Kevin M. Murphy
----------------------------------
Kevin M. Murphy
Vice President, Finance
19