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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 September 30,
2002.
[ ] 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 0-26392
LEVEL 8 SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
Delaware 11-2920559
- --------------------------------------------- ----------------------
(State or other jurisdiction of incorporation (I.R.S Employer
or organization) Identification Number)
8000 Regency Parkway, Cary, NC 27511
(Address of principal executive offices) (Zip Code)
(919) 380-5000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15d 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 the number of shares outstanding in each of the issuer's classes of
common stock, as of the latest practicable date.
19,022,142 common shares, $.001 par value, were outstanding as of October 29,
2002
1
Level 8 Systems, Inc.
Index
PART I. Financial Information Page
----
Number
Item 1. Financial Statements
Consolidated balance sheets as of September 30, 2002 (unaudited)
and December 31, 2001 3
Consolidated statements of operations for the three and nine
months ended September 30, 2002 and 2001 (unaudited) 4
Consolidated statements of cash flows for the nine
months ended September 30, 2002 and 2001 (unaudited) 5
Consolidated statements of comprehensive loss for the three and nine
months ended September 30, 2002 and 2001 (unaudited) 6
Notes to consolidated financial statements (unaudited) 7
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 16
Item 3. Quantitative and Qualitative Disclosures about Market Risk 24
Item 4. Controls and Procedures 24
PART II. Other Information 24
SIGNATURES 27
2
Part I. Financial Information
Item 1. Financial Statements
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
(unaudited)
September 30, December 31,
2002 2001
------------------- ----------------
ASSETS
Cash and cash equivalents...................................................... $ 295 $ 698
Available-for-sale securities.................................................. -- 155
Asset held for sale............................................................ 1,638 10,948
Trade accounts receivable, net................................................. 256
590
Receivable from related party.................................................. 303 1,045
Notes receivable............................................................... 511
1,977
Note receivable from related party............................................. 0
1,082
Prepaid expenses and other current assets...................................... 1,545
2,044
------------------- ----------------
Total current assets................................................. 4,548 18,539
Property and equipment, net.................................................... 458 763
Software product technology, net............................................... 8,771 15,651
Note receivable................................................................ -- 500
Other assets................................................................... 265 291
------------------- ----------------
Total assets......................................................... $ 14,042 $ 35,744
=================== ================
LIABILITIES AND STOCKHOLDERS' EQUITY
Short term debt................................................................ $ 191 $ 245
Accounts payable............................................................... 3,298 2,768
Accrued expenses:
Salaries, wages, and related items........................................... 721 1,070
Restructuring................................................................ 965 853
Other..................................................................... 3,746 5,864
Due to related party........................................................... -- 56
Liabilities held for sale...................................................... 349 1,295
Deferred revenue............................................................... 204 2,115
------------------- ----------------
Total current liabilities............................................ 9,474 14,266
Long-term debt, net of current maturities...................................... 2,512 4,600
Warrant liability.............................................................. 328 2,985
Commitments and contingencies..................................................
Stockholders' equity:
Preferred Stock..............................................................
Common Stock................................................................. 19 16
Additional paid-in-capital................................................... 202,496 196,043
Accumulated other comprehensive loss......................................... (980) (778)
Accumulated deficit.......................................................... (199,807) (181,388)
------------------- ----------------
Total stockholder's equity........................................... $ 1,728 $ 13,893
------------------- ----------------
Total liabilities and stockholders' equity........................... $ 14,042 $ 35,744
=================== ================
The accompanying notes are an integral part of the consolidated financial statements.
3
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)
Three Months Ended Nine Months Ended
Sept 30 Sept 30
2002 2001 2002 2001
-------------------------- ---------------------------
Revenue:
Software $ 324 $ 686 $ 440 $ 1,545
Maintenance............................................ 28 2,613 511 9,091
Services............................................... 471 1,727 949 5,725
-------------------------- ---------------------------
Total operating revenue.......................... 823 5,026 1,900 16,361
Cost of revenue:
Software . 841 3,113 6,797 9,429
Maintenance............................................ 11 1,062 149 3,122
Services............................................... 393 1,909 672 4,787
-------------------------- ---------------------------
Total cost of revenue............................ 1,245 6,084 7,618 17,338
Gross margin............................................. (422) (1,058) (5,718) (977)
Operating expenses:
Sales and marketing.................................... 582 1,973 2,226 10,442
Research and product development....................... 310 1,511 1,557 4,848
General and administrative............................. 551 1,574 2,766 8,266
Amortization of intangible assets...................... -- 1,962 -- 6,153
Impairment of intangible assets........................ -- 10,898 -- 10,898
(Gain)/Loss on disposal of assets...................... (21) (341) 317 (1,371)
Restructuring, net..................................... -- -- 1,300 8,650
-------------------------- ---------------------------
Total operating expenses......................... 1,422 17,577 8,166 47,886
Loss from operations..................................... (1,844) (18,635) (13,884) (48,863)
Other income (expense):
Interest income........................................ 65 149 115 710
Unrealized loss on marketable securities............... -- (3,765) -- (3,765)
Interest expense....................................... (129) (1,049) (431) (3,934)
Change in fair value of warrant liability.............. (32) -- 2,657 --
Other income (expense)................................. (8) 12 (182) (146)
-------------------------- ---------------------------
Loss before provision for income taxes................... (1,948) (23,288) (11,725) (55,998)
Income tax provision................................... -- 357 (123) 631
-------------------------- ---------------------------
Loss from continuing operations........................... $ (1,948) (23,645) (11,602) (56,629)
Income (loss) from discontinued operations................ 484 (1,313) (6,488) (29,747)
-------------------------- ---------------------------
Net loss... $ (1,464) $(24,958) $(18,090) $ (86,376)
Loss per share from continuing operations.................. $ (0.12) $ (1.50) $ (0.64) $ (3.64)
Loss per share from discontinued operations............... .03 (0.08) (0.34) (1.87)
-------------------------- ---------------------------
Net loss per share--basic and diluted..................... $ (0.09) $ (1.58) $ (0.98) $ (5.51)
========================== ===========================
Weighted average common shares outstanding............... 19,022 16,056 18,819 15,916
========================== ===========================
The accompanying notes are an integral part of the consolidated financial statements.
4
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands, except share data)
(unaudited)
Nine Months Ended
Sept 30,
2002 2001
--------------- --------------
Cash flows from operating activities:
Net loss ........................................................................... $ (18,090) $ (86,376)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization....................................................... 7,372 19,147
Change in fair value of warrant liability........................................... (2,657) --
Stock compensation expense.......................................................... 92 1,045
Impairment of intangible assets and software product technology..................... -- 10,898
Unrealized loss on marketable securities......................................... -- 3,765
Provision for doubtful accounts..................................................... (91) 3,793
Accretion of preferred stock...................................................... 329 --
Loss on disposal of assets.......................................................... 256 --
Other ........................................................................... 138 (1,192)
Changes in assets and liabilities, net of assets acquired and liabilities assumed:
Trade accounts receivable and related party receivables........................... 1,022 3,623
Assets and liabilities held for sale......................................... 108 --
Due from Liraz.................................................................... (56) --
Prepaid expenses and other assets................................................. 224 198
Discontinued operations 8,160 32,585
Accounts payable and accrued expenses............................................. (1,332) (1,159)
Deferred revenue.................................................................. (1,820) 1,437
--------------- --------------
Net cash used in operating activities........................................... (6,782) (15,110)
Cash flows from investing activities:
Proceeds from sale of assets 521 3,086
Purchases of property and equipment................................................... -- (174)
Cash payments secured through notes receivable........................................ -- (80)
Repayment of note receivable.......................................................... 2,021 --
Investment held for resale............................................................ 145 --
Cash received from sale of line of business assets.................................... 1,000 --
Notes receivable: -- 500
--------------- --------------
Net cash provided by investing activities....................................... 3,687 3,332
Cash flows from financing activities:
Proceeds from issuance of common shares, net of issuance costs........................ 1,973 --
Proceeds from issuance of preferred shares.......................................... 1,380 --
Dividends paid for preferred shares................................................... -- (1,046)
Payments under capital lease obligations and other liabilities........................ -- (124)
Borrowings on line of credit......................................................... 179 --
Repayments of term loans, credit facility and notes payable........................... (638) (2,009)
--------------- --------------
Net cash provided by (used in) financing activities............................. 2,894 (3,179)
Effect of exchange rate changes on cash................................................. (202) (231)
Net decrease in cash and cash equivalents............................................... (403) (15,188)
Cash and cash equivalents:
Beginning of period................................................................... 698 23,856
--------------- --------------
End of period......................................................................... $ 295 $ 8,668
=============== ==============
The accompanying notes are an integral part of the consolidated financial statements.
5
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(in thousands)
(unaudited)
Three Months Ended Nine Months Ended
Sept 30, Sept 30,
2002 2001 2002 2001
-------------- -------------- -----------------------------
Net loss................................................. $ (1,464) $ (24,958) $ (18,090) $ (86,376)
Other comprehensive income, net of tax:
Foreign currency translation adjustment............... (10) 101 (202) (186)
Unrealized loss on available-for-sale securities...... -- -- -- (353)
Reclassification of unrealized loss included in income... -- 3,765 -- 3,765
-------------- -------------- -----------------------------
Comprehensive loss $(1,474) $ (21,092) $ $ (83,150)
============== ============== =============================
The accompanying notes are an integral part of the consolidated financial statements.
6
LEVEL 8 SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(amounts in thousands, except share and per share data)
(unaudited)
NOTE 1. INTERIM FINANCIAL STATEMENTS
The accompanying financial statements are unaudited, and have been prepared
pursuant to the rules and regulations of the Securities and Exchange Commission
("SEC"). Certain information and note disclosures normally included in annual
financial statements prepared in accordance with generally accepted accounting
principles of the United States of America have been condensed or omitted
pursuant to those rules and regulations. Accordingly, these interim financial
statements should be read in conjunction with the audited financial statements
and notes thereto contained in the Level 8 Systems, Inc.'s (the "Company")
Annual Report on Form 10-K/A (Amendment No. 1) for the year ended December 31,
2001. The results of operations for the interim periods shown in this report are
not necessarily indicative of results to be expected for other interim periods
or for the full fiscal year. In the opinion of management, the information
contained herein reflects all adjustments necessary for a fair statement of the
interim results of operations. All such adjustments are of a normal, recurring
nature, except for the impairment charges as discussed in Note 7 and the
restructuring charge as discussed in Note 8.
The year-end condensed balance sheet data was derived from audited financial
statements in accordance with the rules and regulations of the SEC, but does not
include all disclosures required for financial statements prepared in accordance
with generally accepted accounting principles of the United States of America.
The accompanying consolidated financial statements include the accounts of the
Company and its subsidiaries. All of the Company's subsidiaries are wholly owned
for the periods presented.
NOTE 2. LIQUIDITY
The accompanying financial statements have been prepared on a going concern
basis, which contemplates the realization of assets and the satisfaction of
liabilities in the normal course of business. The Company has incurred a loss of
$105 million and has experienced negative cash flows from operations for the
year ended December 31, 2001. For the nine months ended September 30, 2002, the
Company continued to incur losses of approximately $18.1 million and had a
working capital deficiency of approximately $4.9 million. The Company's future
revenues are largely dependent on acceptance of a newly developed and marketed
product - Cicero. These factors among others may indicate the Company will be
unable to continue as a going concern for a reasonable period of time.
In order to address these issues and to obtain adequate financing for the
Company's operations for the next twelve months, the Company is actively
promoting and expanding its product line and has entered into preliminary sales
negotiations with significant customers that have begun the "proof of concept"
stage. Additionally, the Company successfully completed a common stock private
financing round wherein it raised approximately $3.5 million, of which $1.6
million in new funds was received prior to December 31, 2001. In August 2002,
the Company completed a Series C Convertible Redeemable Preferred Stock offering
that raised approximately $1.4 million of new funds and converted $200 in debt
and payables (see Note 10). Furthermore, management has and is continuing to
review the Company's strategic options, such as non-strategic asset sales with
third parties. The Company has completed the sale of the Star/SQL and CTRC
components of the Messaging and Application Engineering segment and has decided
to pursue a sale of the assets in the former Systems Integration segment. The
Systems Integration assets have been reclassified as Assets held for Sale on the
accompanying consolidated balance sheets. The Company does not intend to sell
Cicero. There can be no assurance that management will be successful in
executing these strategies as anticipated or in a timely manner or that
increased revenues will reduce further operating losses. If the Company is
unable to increase cash flow, obtain financing or close a sale of non-strategic
assets, it may not be able to generate enough capital to fund operations for the
next twelve months and may be required to pursue other means of financing that
may not be on terms favorable to the Company or its stockholders. The
accompanying consolidated financial statements have been prepared on a going
concern basis, which contemplates the realization of assets and the satisfaction
of liabilities in the normal course of business. The financial statements
presented herein do not include any adjustments relating to the recoverability
of assets and classification of liabilities that might be necessary should Level
8 be unable to continue as a going concern.
7
NOTE 3. USE OF ACCOUNTING ESTIMATES
The preparation of financial statements in conformity with accounting principals
generally accepted in the United States of America 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 financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual amounts could differ from these estimates.
NOTE 4. CHANGE IN ACCOUNTING ESTIMATES
Effective July 2002, the Company determined that the estimated asset life of the
Cicero technology has been extended as a result of the amended license agreement
with Merrill Lynch wherein the exclusive right to modify, commercialize and
distribute the technology was extended in perpetuity. Accordingly, the Company
reassessed the estimated life of the technology and extended it from three years
to five years. The effect of the change on the current quarter ending September
30, 2002 was to lower software amortization expense from $1,893 to $741.
NOTE 5. RECENT ACCOUNTING PRONOUNCEMENTS
In June of 2001, the FASB issued Statement of Financial Accounting Standards
No. 143 ("SFAS No. 143"), "Accounting for Asset Retirement Obligations". SFAS
No. 143 applies to the accounting and reporting obligations associated with the
retirement of tangible long-lived assets and the associated asset retirement
costs. This Statement applies to legal obligations associated with the
retirement of long-lived assets that result from the acquisition, construction,
and development and (or) the normal operation of a long-lived asset, except for
certain obligations of lessees. Adoption of this Statement is required for
fiscal years beginning after June 15, 2002. The Company does not believe that
adoption of this standard will have an impact on its results of operations and
financial position.
In August 2001, the FASB issued Statement of Financial Accounting Standards No.
144 ("SFAS 144"), "Accounting for the Impairment or Disposal of Long-Lived
Assets," which supercedes 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" and certain provisions of APB Opinion No.
30, "Reporting Results of Operations - Reporting the Effects of Disposal of a
Segment of Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions." SFAS 144 requires that long-lived assets to be
disposed of by sale, including discontinued operations, be measured at the lower
of carrying amount or fair value less cost to sell, whether reported in
continuing operations or in discontinued operations. SFAS 144 also broadens the
reporting requirements of discontinued operations to include all components of
an entity that have operations and cash flows that can be clearly distinguished,
operationally and for financial reporting purposes, from the rest of the entity.
The Company has adopted the provisions of SFAS 144 as of January 1, 2002 and the
adoption of the statement had no impact on the Company's results of operations
and financial position.
In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with
Exit or Disposal Activities ("SFAS No. 146".) This statement requires companies
to recognize costs associated with exit or disposal activities when they are
incurred rather than at the date of a commitment to an exit or disposal plan.
SFAS No. 146 is to be applied prospectively to exit or disposal activities
initiated after December 31, 2002. We do not anticipate that the adoption of
SFAS No. 146 will have a material impact on our results of operations and
financial conditions.
In January 2002, Emerging Issues Task Force 01-14, Income Statement
Characterization of Reimbursements Received for "Out-of-Pocket" Expenses
Incurred, was issued, and considered whether reimbursements received for
"out-of-pocket" expenses incurred would be characterized in the income statement
as revenue or as a reduction of expenses incurred. The FASB staff believes that
the reimbursements received should be characterized as revenue. The Company has
adopted this policy effective January 1, 2002. Reimbursements for
"out-of-pocket" expenses of $100 and $196 for the three and nine months ended
September 30, 2002, and $176 and $535 for the three and nine months ended
September 30, 2001, respectively, have been included in service revenues and
service cost of revenues.
8
NOTE 6. ACCOUNTING FOR GOODWILL AND INTANGIBLE ASSETS
In June 2001, the FASB also issued Statement of Financial Accounting Standards
No. 142, "Goodwill and Intangible Assets" ("SFAS 142") which supersedes APB
Opinion No. 17, Intangible Assets. SFAS 142 eliminates the current requirement
to amortize goodwill and indefinite-lived intangible assets, addresses the
amortization of intangible assets with a defined life and addresses the
impairment testing for goodwill and intangible assets and the identification of
reporting units for purposes of assessing potential future impairment of
goodwill. SFAS 142 also requires the Company to complete a transitional goodwill
impairment test six months from the date of adoption. SFAS 142 will apply to
goodwill and intangible assets arising from transactions completed before and
after the statement's effective date. As of January 1, 2002, the Company adopted
SFAS 142. However, during 2001 the Company recorded an impairment of all of its
goodwill and intangible balances totaling $43.9 million and had no remaining
goodwill or intangible balances as of January 1, 2002. Goodwill amortization for
the three and nine months ended September 30, 2001 was $2,671 and $9,398.
Pro-forma consolidated net loss and net loss per share, as if the provisions of
SFAS 142 had been adopted for the three and nine months ended September 30,
2001, would have been $(22,287) and $(1.41), and $(76,978) and $(4.91),
respectively.
NOTE 7. DISPOSITIONS
In June 2002, the Company entered into an Asset Purchase Agreement with
Starquest Ventures, Inc., a California company and an affiliate of Paul Rampel,
a member of the Company's Board of Directors and a former executive officer.
Under the terms of the Asset Purchase Agreement, Level 8 sold its StarSQL and
CTRC products and certain fixed assets to Starquest Ventures for $365 and the
assumption of certain maintenance liabilities. The Company received $300 in
cash, and a note receivable of $65. The loss on sale of the assets was $74. The
Company used $150 from the proceeds to repay borrowings from Mr. Rampel. The $65
note was repaid as of September 30, 2002.
In May 2002, the Company received unsolicited offers from several parties
including Starquest Ventures for the StarSQL and CTRC products, which the
Company identified to be non-strategic to its future operations. As a result of
those offers, the Company reviewed and assessed the net realizable value of the
software product technology assets associated with StarSQL and CTRC and, based
upon this assessment, the Company determined that an additional impairment had
occurred in the amount of $1,564 which was recorded as software amortization
NOTE 8. SOFTWARE PRODUCT TECHNOLOGY AND ASSETS HELD FOR SALE
In 2001, the Company and Amdocs Ltd. ("Amdocs") entered into a multi-year
agreement to fund the development of the next generation of Level 8's Geneva
Enterprise Integrator ("GEI") and Geneva Business Process Automator ("GBPA")
software. The terms of the agreement provided for Amdocs to pay the Company $6.5
million to funding research and development over the next 18 months in exchange
for future fully paid and discounted licensing arrangement.
In May 2002, the Company entered into a non-exclusive perpetual license to
develop and sell its GEI and GBPA and Geneva J2EE technology with Amdocs. Under
the agreement, Amdocs paid to the Company a license fee of $1,000 for the source
and object code for Geneva J2EE, a license of the GEI and GBPA embedded into
other Amdocs products and relieved the Company of its obligation to perform
under the funded research and development agreement.
The Company was able to reduce its operating costs and retain its intellectual
property rights to Geneva J2EE in its current state of development, as well as
Geneva Enterprise Integrator and Geneva Business Process Automator. In
connection with this transaction, the Company reassessed the recoverability of
the software product technology associated with the Geneva Enterprise Integrator
and Geneva Business Process Automator products based on its net realizable value
and determined that no impairment had occurred.
Subsequent to its license agreement with Amdocs, the Company has been approached
by several investment groups to explore the potential sale of the intellectual
property rights to Geneva J2EE, Geneva Enterprise Integrator and Geneva Business
Process Automator, which comprise the entire Systems Integration segment. As a
result of these unsolicited offers, and the Company's continuing focus on the
Desktop Integration segment, the Company reviewed and assessed the net
realizable value of the software product technology assets associated with
Geneva J2EE, Geneva Enterprise Integrator and Geneva Business Process Automator.
Based upon this assessment, the Company determined in June 2002 that an
additional impairment had occurred in the amount of $6.4 million, which was
recorded as software amortization.
9
As of September 30, 2002, the Company approved a plan to sell the Geneva Assets.
Accordingly, these assets have been reclassified to Assets held for sale on the
accompanying consolidated balance sheets and the results of operation from the
Systems Integration Segment have been reclassified as Income (loss) from
discontinued operations in the accompanying consolidated statements of
operations for all periods presented. Operating revenues and net income (loss)
before taxes for the Systems Integration Segment were:
Three Months Nine Months
Sept 30, Sept 30,
2002 2001 2002 2001
---------- ----------- ---------- -----------
Operating revenues...................... $ 880 $ 1,036 $ 3,673 $ 5,172
Net income (loss) before taxes.......... $ 484 $ (1,313) $(6,488) $(29,747)
NOTE 9. RESTRUCTURING
During the second quarter of 2002, the Company began another round of
operational restructurings to further reduce its operating costs and streamline
its operations. The restructuring plan includes the closure of the development
facility in Berkeley, California and the significant reduction of its employees
in EMEA and terminated approximately 12 people. The Company recorded a
restructuring charge in the amount of $1.3 million during the second quarter of
2002. The Company anticipates that all remaining obligations as of the balance
sheet date will be expended by November 2006.
In 2001, the Company began an initial operational restructuring to reduce its
operating costs and streamline its organizational structure. This operational
restructuring involves the reduction of employee staff throughout the Company in
all geographical regions in sales, marketing, services and development and
administrative functions. The Company recorded restructuring charges of $8,650
during 2001.
The following table sets forth a summary by category of accrued expenses and
cash paid for the nine months ended September 30, 2002:
Accrued at Accrued at
December 31, Additional Cash September
2001 Accrual Paid 30, 2002
------------ ------------ ------------ ------------
Employee termination........................... $ 43 $ 396 $ (208) $ 231
Excess office facilities....................... 647 880 (835) 712
Marketing obligations......................... 53 0 (53) 0
Other miscellaneous restructuring costs........ 110 24 (112) 22
------------ ------------ ------------ ------------
Total.......................................... $ 853 $ 1,300 $(1,208) $ 965
============ ============ ============ ============
NOTE 10. STOCKHOLDER'S EQUITY
On August 14, 2002, the Company completed a $1.6 million private placement of
Series C Convertible Preferred Stock ("Series C Preferred Stock"), convertible
at a conversion ratio of $0.38 per share of common stock into an aggregate of
4,184,211 shares of common stock. As part of the financing, the Company has also
issued warrants to purchase an aggregate of 1,046,053 shares of common stock at
an exercise price of $0.38 per share. As consideration for the $1.6 million
private placement, the Company received approximately $1.4 million in cash and
allowed certain debt holders to convert approximately $150 of debt and $50
accounts payable to equity. The Chairman and CEO of the Company, Tony Pizi,
converted $150,000 of debt owed to Mr. Pizi into shares of Series C Preferred
Stock and warrants. Both existing and new investors participated in the
financing. The Company also agreed to register the common stock issuable upon
conversion of the Series C Preferred Stock and exercise of the warrants for
resale under the Securities Act of 1933, as amended. The Company allocated the
proceeds received from the sale of the Series C Preferred Stock and warrants to
the preferred stock and the detachable warrants on a relative fair value basis,
resulting in the allocation $1,271 to the Series C Preferred Stock and $329 to
the detachable warrants. Based on the allocation of the proceeds, the Company
determined that the effective conversion price of the Series C Preferred Stock
was less than the fair value of the Company's common stock on the date of
issuance. As a result, the Company recorded a beneficial conversion feature in
the amount of $329 based on the difference between the fair market value of the
Company's common stock on the closing date of the transaction and the effective
conversion price of the Series C Preferred Stock. The beneficial conversion
feature was recorded as a discount on the value of the Series C Preferred Stock
and an increase in additional paid-in capital. Because the Series C Preferred
Stock was convertible immediately upon issuance, the Company fully amortized
such beneficial conversion feature on the date of issuance.
In connection with the sale of Series C Preferred Stock, the Company agreed with
the existing holders of its Series A1 Convertible Preferred Stock (the "Series
A1 Preferred Stock") and the Series B1 Convertible Preferred Stock (the "Series
B1 Preferred Stock"), in exchange for their waiver of certain anti-dilution
provisions, to reprice an aggregate of 1,801,022 warrants to purchase common
stock from an exercise price of $1.77 to $0.38. Furthermore, the Company will
10
promptly enter into an Exchange Agreement with such holders providing for the
issuance of 11,570 shares of Series A2 Convertible Preferred Stock ("Series A2
Preferred Stock") and 30,000 Series B2 Convertible Preferred Stock ("Series B2
Preferred Stock"), respectively. Series A2 Preferred Stock and Series B2
Preferred Stock are convertible into an aggregate of 1,388,456 and 2,394,063
shares of the Company's common stock at $8.33 and $12.531 per share,
respectively. The exchange is being undertaken in consideration of the temporary
release of the anti-dilution provisions of the Series A1 Preferred Stockholders
and Series B1 Preferred Stockholders.
Following the consummation of the transactions contemplated by the Exchange
Agreement, holders of the Series A2 Preferred Stock and Series B2 Preferred
Stock will have one vote per share of Series A2 Preferred Stock and Series B2
Preferred Stock, voting on an as-converted basis, subject to certain conversion
limitations, together with the common stock and not as a separate class except
on certain matters adversely affecting the rights of holders of the Series A2
Preferred Stock and Series B2 Preferred Stock, respectively. The Series A2
Preferred Stock and B2 Preferred Stock may be redeemed at the option of the
Company at a redemption price equal to the original purchase price at any time
if the closing price of the Company's common stock over 20 consecutive trading
days is greater than $16.00 and $25.0625 per share, respectively. The conversion
prices of the Series A2 Preferred Stock and Series B2 Preferred Stock are
subject to certain anti-dilution provisions, including adjustments in the event
of certain sales of common stock at a price of less than $8.33 and $12.531 per
share. The Company may issue equity securities representing $5,000,000 in
aggregate gross proceeds to the Company without triggering the anti-dilution
provisions. As part of the Exchange Agreement and of the waiver of the
anti-dilution provisions, the Series A2 holders will be entitled to a maximum of
4,600,000 warrants to purchase common stock. The warrants to be issued shall be
the product of 4,600,000, multiplied by the quotient where (x) the numerator is
the amount of gross proceeds received by the Company in connection with a
financing and (y) the denominator is 5,000,000. Such warrants described above
shall be exercisable at the lowest effective per share of common stock price at
which the financing was consummated. Moreover, the holders of Series A2
Preferred Stock and Series B2 Preferred Stock shall receive one warrant, on
substantially the same terms as the issued warrants, for every warrant issued to
a lender in connection with the Company's borrowings. In the event the Company
breaches its obligations to issue common stock upon conversion, or the Company's
common stock is delisted, dividends will be payable on the Series A2 Preferred
Stock and Series B2 Preferred Stock at a rate of 14% per annum.
In January 2002, the Company amended its August 2000 license agreement with
Merrill Lynch. Under the terms of the previous agreement, the Company had a
perpetual license to commercialize and sell the Cicero technology, however, the
Company's exclusivity under that contract expired in August 2002. The amendment
provides for an exclusive, perpetual license to develop and sell the Cicero
application integration software and to obtain ownership of the Cicero
registered trademark. In exchange, a Merrill Lynch affiliate, MLBC, Inc.,
received 250,000 shares of the Company's common stock with a fair market value
of $623. Merrill Lynch now beneficially owns approximately 1.2 million shares of
the Company's common stock. In addition, Merrill Lynch and the Company entered
into a revenue sharing agreement that provides for royalties on future Cicero
software sales. Under the agreement, royalties are capped at $20 million.
In January 2002, the Company entered into a Securities Purchase Agreement with
several investors wherein the Company agreed to sell up to three million shares
of its common stock and warrants. The common stock was valued at $1.50 per share
and warrants to purchase additional shares at $2.75 per share were offered. At
December 31, 2001, the Company had received bridge financing of $1.6 million,
which was convertible to common stock subject to closing conditions. The
offering closed on January 16, 2002. The Company sold 2,381,952 shares of common
stock for a total of approximately $3,573 and granted 476,396 warrants to
purchase the Company's common stock at a price of $2.75 per share. The warrants
expire in three years from the date of grant and have a call feature that forces
exercise if the Company's common stock exceeds $5.50 per share. As part of an
agreement with Liraz Systems Ltd., the guarantor of the Company's term loan, the
Company agreed to use 10% of the proceeds of any financing to reduce the
principal on the term loan. Accordingly, the Company utilized $350,000 from its
private placement and reduced the principal on the term loan to $2,650,000.
NOTE 11. INCOME TAXES
The Company accounts for income taxes in accordance with Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes." The Company's
effective tax rate differs from the statutory rate primarily due to the fact
that no income tax benefit was recorded for the net loss for the three and six
months. Because of the Company's recurring losses, the deferred tax assets have
been fully offset by a valuation allowance.
The income tax provision for the fiscal years 2000 and 2001 is primarily related
to income taxes and tax benefit from foreign operations and foreign withholding
taxes.
NOTE 12. LOSS PER SHARE
Basic loss per share is computed based upon the weighted average number of
common shares outstanding. Diluted earnings/(loss) per share is computed based
upon the weighted average number of common shares outstanding and any
potentially dilutive securities. Potentially dilutive securities outstanding
during the periods presented include stock options, warrants and preferred
stock.
11
The following table sets forth the reconciliation of net loss to loss available
to common stockholders:
Three months ended Nine months ended
Sept. 30, Sept. 30,
2002 2001 2002 2001
----------------------------- ---------------------------
Net loss................................................. $ (1,464) $ (24,958) $ (18,090) $ (86,376)
Preferred stock dividends................................ -- (419) -- (1,244)
Accretion of Preferred Stock............................. $ (329) -- (329) --
----------------------------- ---------------------------
Loss available to common stockholders.................... $ (1,793) $ (25,377) $ (18,419) $ (87,620)
============================= ===========================
Basic and diluted loss per share:
Loss per share from continuing operations............. $ (0.12) $ (1.50) $ (0.64) $ (3.64)
Loss per share from discontinued operations........... .03 (0.08) (0.34) (1.87)
----------------------------- ---------------------------
Net loss per share attributable to common stockholders $ (0.09) $ (1.58) $ (0.98) $ (5.51)
============================= ===========================
Weighted common shares outstanding - basic and diluted.... 19,022 16,056 18,819 15,916
============================= ===========================
The following table sets forth the potential shares that are not included in the
diluted net loss per share calculation because to do so would be anti-dilutive
for the periods presented:
Sept. 30
2002 2001
----------- -----------
Stock options, common share equivalent 3,172 3,606
Warrants, common share equivalent 4,091 2,662
Preferred stock, common share equivalent 7,967 2,354
----------- -----------
15,230 8,622
=========== ===========
NOTE 13. SEGMENT INFORMATION AND GEOGRAPHIC INFORMATION
Management makes operating decisions and assesses performance of the Company's
operations based on the following reportable segments: (1) Desktop Integration
Products, and (2) Messaging and Application Engineering Products.
The principal product in the Desktop Integration segment is Cicero. Cicero is a
business integration software product that maximizes end-user productivity,
streamlines business operations and integrates disparate systems and
applications.
The products that comprise the Messaging and Application Engineering segment are
Geneva Integration Broker, Geneva Message Queuing, Geneva XIPC, Geneva
AppBuilder, CTRC and Star/SQL. During 2001, the Company sold three of its
messaging products, Geneva Message Queuing, Geneva XIPC and AppBuilder. During
2002, the Company sold its CTRC and Star/SQL products.
Segment data includes a charge allocating all corporate-headquarters costs to
each of its operating segments based on each segment's proportionate share of
expenses. During 2002, the Company reported the operations of its Systems
Integration segment as discontinued operations and has reallocated the corporate
overhead for the Systems Integration segment in 2002 and 2001. The Company
evaluates the performance of its segments and allocates resources to them based
on earnings (loss) before interest and other income/(expense), taxes, in-process
research and development, restructuring and amortization of goodwill (EBITA).
While EBITA should not be construed as a substitute for operating income or a
better indicator of liquidity than cash flows from operating activities, which
are determined in accordance with accounting principles generally accepted in
the United States of America, it is included herein to provide additional
information with respect to our ability to meet our future debt service, capital
expenditure and working capital requirements. EBITA is not necessarily a measure
of our ability to fund our cash needs. The non-GAAP measures presented may not
be comparable to similarly titled measures reported by other companies.
12
The table below presents information about reported segments for the three and
nine months ended September 30, 2002:
Desktop Integration Messaging/Application Total
Engineering
------------------------------ --------------------------- ---------------------------
September 30, 2002 September 30, 2002 September 30, 2002
Three Nine Three Nine Three Nine
months months months months months months
ended ended ended ended ended ended
----------- ----------- ----------- ----------- ----------- -----------
Total revenue $ 690 $ 1,066 $ 133 $ 834 $ 823 $ 1,900
Total cost of revenue
1,215 5,706 30 1,912 1,245 7,618
----------- ----------- ----------- ----------- ----------- -----------
Gross profit/(loss)
(525) (4,640) 103 (1,078) (422) (5,718)
Total operating
expenses (A) 1,363 6,316 80 233 1,443 6,549
----------- ----------- ----------- ----------- ----------- -----------
EBITA (A) $ (1,888) $(10,956) $ 23 $ (1,311) $(1,865) $ (12,267)
=========== =========== =========== =========== =========== ===========
(A) See reconciliation below
The table below presents information about reported segments for the three and
nine months ended September 30, 2001:
Desktop Integration Messaging/Application Total
Engineering
---------------------------- -------------------------- --------------------------
September 30, 2001 September 30, 2001 September 30, 2001
Three Nine Three Nine Three Nine
months months months months months months
ended ended ended ended ended ended
----------- ----------- ---------- ----------- ---------- ------------
Total revenue $ 53 $ 132 $ 4,973 $ 16,229 $ 5,026 $ 16,361
Total cost of revenue
2,247 7,248 3,837 10,090 6,084 17,338
----------- ----------- ---------- ----------- ---------- ------------
Gross profit/(loss)
(2,194) (7,116) 1,136 6,139 (1,058) (977)
Total operating
expenses (A) 2,830 16,648 2,228 6,908 5,058 23,556
----------- ----------- ---------- ----------- ---------- ------------
EBITA (A) $(5,024) $ (23,764) $ (1,092) $ (769) $ (6,116) $(24,533)
=========== =========== ========== =========== ========== ============
(A) See reconciliation below
A reconciliation of total segment operating expenses to total operating expenses
for the quarters ended September 30:
Three Months Ended Nine Months Ended
September 30 September 30
-------------------------------- ---------------------------------
2002 2001 2002 2001
-------------- ------------- ------------- ---------------
Total segment operating expenses $ 1,443 $ 5,058 $ 6,549 $ 23,556
Amortization of intangible assets 0 1,962 0 6,153
Restructuring 0 0 1,300 8,650
Impairment of intangible assets 0 10,898 0 10,898
(Gain)/loss on disposal of assets (21) (341) 317 (1,371)
-------------- ------------- ------------- ---------------
Total operating expenses $ 1,422 $ 17,577 $ 8,166 $ 47,886
============== ============= ============= ===============
13
A reconciliation of total segment EBITA to loss before provision for income
taxes for the quarters ended September 30:
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------------- ---------------------------------
2002 2001 2002 2001
-------------- ------------- ------------- --------------
Total EBITA $ (1,865) $ (6,116) $(12,267) $ (24,533)
Amortization of intangible assets -- (1,962) -- (6,153)
Restructuring and Impairment of
intangible assets -- (10,898) (1,300) (19,548)
Change in fair value of derivative (32) -- 2,657 --
Gain/(loss) on disposal of assets 21 341
(317) 1,371
Unrealized loss on marketable securities -- (3,765) -- (3,765)
Interest and other income/(expense), net (72) (888) (498) (3,370)
-------------- ------------- ------------- ---------------
Total loss before income taxes $ (1,948) $ (23,288) $ (11,725) $ (55,998)
============== ============= ============= ===============
The following table presents a summary of assets by segment:
--------------- -- -----------------
September 30, December 31,
2002 2001
--------------- -----------------
Desktop Integration $ 9,149 $ 14,045
Messaging/Application Engineering 80 2,369
--------------- -----------------
Total assets $ 9,229 $ 16,414
=============== =================
NOTE 14. CONTINGENCIES
Litigation. Various lawsuits and claims have been brought against the Company in
the normal course of business. On September 30, 2002, an action was brought
against the Company in the United States District Court for the District of
Colorado by Access International Financial Services, Inc claiming the Company
had breached a contract. The plaintiff seeks damages of approximately $660. The
Company will vigorously defend against this action and has reserved $210 as a
liability in this case.
NOTE 15. SUBSEQUENT EVENTS
On October 25, 2002, the Company effected an exchange of all of our outstanding
shares of Series A2 Convertible Redeemable Preferred Stock ("Series A2 Preferred
Stock") and Series B2 Convertible Redeemable Preferred Stock ("Series B2
Preferred Stock") and related warrants for an equal number of shares of newly
created Series A3 Convertible Redeemable Preferred Stock ("Series A3 Preferred
Stock") and Series B3 Convertible Redeemable Preferred Stock ("Series B3
Preferred Stock") and related warrants. This exchange was made to correct a
deficiency in the conversion price from the prior exchange of Series A1 and B1
Preferred Stock and related warrants for Series A2 and B2 Preferred Stock and
related warrants on August 29, 2002. The conversion price for the Series A3
Preferred Stock and the conversion price for the Series B3 Preferred Stock
remain the same as the previously issued Series A1 and A2 Preferred Stock and
Series B1 and B2 Preferred Stock, at $8.333 and $12.531, respectively. The
exercise price for the aggregate 753,640 warrants relating to the Series A3
Preferred Stock was increased from $0.38 to $0.40 per share which is a reduction
from the $1.77 exercise price of the warrants relating to the Series A1
Preferred Stock. The exercise price for the aggregate 1,047,382 warrants
relating to the Series B3 Preferred Stock was increased from $0.38 to $0.40 per
share which is a reduction from the $1.77 exercise price of the warrants
relating to the Series B1 Preferred Stock. The adjusted exercise price was based
on the closing price of the Company's Series C Convertible Redeemable Preferred
Stock and warrants on August 14, 2002, plus $0.02, to reflect accurate current
market value according to relevant Nasdaq rules. This adjustment was made as
part of the agreement under which the holders of the Company's Preferred Stock
agreed to waive their price-protection anti-dilution protections to allow the
Company to issue the Series C Preferred Stock and warrants without triggering
the price-protection anti-dilution provisions and excessively diluting its
common stock.
Under the terms of the agreement, the Company is authorized to issue equity
securities in a single or series of financing transactions representing
aggregate gross proceeds to the Company of approximately $5.0 million, or up to
an aggregate 17.5 million shares of common stock, without triggering the
price-protection anti-dilution provisions in the Series A3 Preferred Stock and
B3 Preferred Stock and related warrants. In exchange for the waiver of these
price-protection anti-dilution provisions, the Company repriced the warrants as
described above and have agreed to issue on a pro rata basis up to 4.6 million
warrants to the holders of Series A3 Preferred Stock and Series B3 Preferred
Stock at such time and from time to time as the Company closes subsequent
financing transactions up to the $5.0 million issuance cap or the 17.5 million
share issuance cap. As a result of the Series C Preferred Stock financing which
represented approximately $1.6 million of the Company's $5.0 million in
allowable equity issuances, the Company is obligated to issue an aggregate of
1,451,352 warrants at an exercise price of $0.40 per share to the existing
14
Preferred Stockholders. Additionally, the Company has agreed to issue a warrant
to purchase common stock to the existing Preferred Stockholders on a pro rata
basis for each warrant to purchase common stock that the Company issues to a
third-party lender in connection with the closing of a qualified loan
transaction. The above referenced warrants will have the same exercise price as
the exercise price of the warrant, or equity security, that the Company issues
in connection with the Company's subsequent financing or loan transaction or
$0.40, whichever is greater.
In connection with the required issuances to the holders of the Series A3
Preferred Stock and Series B3 Preferred Stock, all new issuances of warrants are
subject to the Company getting stockholder approval for an increase in the
number of shares that it is authorized to issue. If the Company's stockholders
do not approve an increase in the authorized shares or a reverse split to
increase the available authorized shares, for any reason, the Company will be
obligated to make dividend payments to such holders at 14% per annum.
Also in October 2002, the Company entered into an assignment agreement with a
consortium that included two members of the current Board of Directors and the
Chief Executive Officer along with another independent party wherein the Company
agreed to assign its rights title and interest in a Note Receivable from Profit
Key Acquisition LLC. Under the terms of the agreement, the Company assigned its
right to a $500 Note plus accrued interest due March 31, 2003 in exchange for
$400 in cash.
The Company continues to close non-productive facilities and reduce
underutilized infrastructure. The Company recently filed for voluntary
liquidation of its French subsidiary after dismissing all employees. The Company
plans to pursue similar action with respect to the Italian and UK subsidiaries.
15
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
General Information
Level 8 Systems is a global provider of business integration software that
enables organizations to integrate new and existing information and processes at
the desktop with Cicero and at the server level with the Geneva Integration
products. Business integration software addresses the emerging need for a
company's information systems to deliver enterprise-wide views of the company's
business information processes.
In addition to software products, Level 8 also provides technical support,
training and consulting services as part of its commitment to providing its
customers industry-leading integration solutions. Level 8's worldwide consulting
team has in-depth experience in developing successful enterprise-class solutions
as well as valuable insight into the business information needs of customers in
the Global 5000. Level 8 offers services around its integration software
products.
This discussion contains forward-looking statements relating to such matters as
anticipated financial performance, business prospects, technological
developments, new products, research and development activities, liquidity and
capital resources and similar matters. The Private Securities Litigation Reform
Act of 1995 provides a safe harbor for forward-looking statements. In order to
comply with the terms of the safe harbor, the Company notes that a variety of
factors could cause its actual results to differ materially from the anticipated
results or other expectations expressed in the Company's forward-looking
statements. See "Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations--Forward Looking and Cautionary Statements."
The Company's results of operations include the operations of the Company and
its subsidiaries. Unless otherwise indicated, all information is presented in
thousands (`000s).
As a result of the Company's acquisition activity, the nature of its operations
has changed significantly from 1998 to 2002. Due to the Company's acquisition
and divestiture activities, year-to-year comparisons of results of operations
are not necessarily meaningful. Additionally, as a result of the Company's
pursuit of a growth strategy focusing on its software product sales and
synergies gained as a result of eliminating duplicative functions, the results
of operations are significantly different than the result of combining the
previous operations of each acquired company into Level 8. Pro forma comparisons
are therefore not necessarily meaningful either. In 2001, the Company shifted
its primary focus from selling multiple Enterprise Application Integration
("EAI") products to selling Cicero, a desktop integration package, to the
financial services industry with a decreased focus on services. Further, during
the last two fiscal quarters of 2001, the Company sold most of the products that
comprised its Messaging and Application Engineering segment and thus will have
significantly reduced revenue streams within that segment.
RISK ASSESSMENT
Going Concern Risk
The Company has incurred a loss of $105 million and has experienced negative
cash flows from operations for the year ended December 31, 2001. For the nine
months ended September 30, 2002, the Company incurred an additional loss of
$18.1 and has a working capital deficiency of approximately $4.9 million. The
Company's future revenues are largely dependent on acceptance of a newly
developed and marketed product - Cicero. Accordingly, there is substantial doubt
that the Company can continue as a going concern. In order to address these
issues and to obtain adequate financing for the Company's operations for the
next twelve months, the Company is actively promoting and expanding its product
line and has entered into preliminary sales negotiations with significant
customers that have begun the "proof of concept" stage. Additionally, the
Company successfully completed a private financing round wherein it raised
approximately $3.5 million, of which $1.6 million of the funds were received
prior to December 31, 2001. In August 2002, the Company has completed a Series C
Convertible Redeemable Preferred Stock offering that raised approximately $1.4
million of new funds. Furthermore, management has and is continuing to review
the Company's strategic options, such as non-strategic asset sales with third
parties. The Company has completed the sale of the StarSQL and CTRC components
of the Messaging and Application Engineering segment and has agreed to pursue
the sale of the assets in the former Systems Integration segment. The Company
does not intend to sell Cicero. There can be no assurance that management will
be successful in executing these strategies as anticipated or in a timely manner
or that increased revenues will reduce further operating losses. If the Company
is unable to increase cash flow, obtain financing or close a sale of
non-strategic assets, it may not be able to generate enough capital to fund
operations for the next twelve months and may be required to pursue other means
of financing that may not be on terms favorable to the Company or its
stockholders. The accompanying consolidated financial statements have been
prepared on a going concern basis, which contemplates the realization of assets
and the satisfaction of liabilities in the normal course of business. The
financial statements presented herein do not include any adjustments relating to
the recoverability of assets and classification of liabilities that might be
necessary should Level 8 be unable to continue as a going concern. The Systems
Integration assets have been reclassified as assets held for sale in the
accompanying consolidated Balance Sheet.
16
Nasdaq National Market Delisting
The Company's common stock is currently traded on the Nasdaq National Market.
For continued listing, the Nasdaq National Market requires, among other things,
that listed securities maintain a minimum bid price of not less than $1.00 per
share and that the issuer maintain stockholder's equity of at least $10,000,000.
As of June 30, 2002, the Company reported stockholder's equity of $1,611,000.
Consequently, Nasdaq notified the Company that it had failed to maintain the
stockholder's equity continued listing requirement for the National Market, and
that it would commence procedures to delist the Company's securities from the
Nasdaq National Market unless the Company can show that it has a plan to regain
compliance with the stockholder's equity requirement by September 5, 2002. On
September 5, 2002, the Company applied for transfer to the Nasdaq SmallCap
Market. The stockholder's equity requirement for continued listing on the
SmallCap Market is $2,500,000. The Company believed that it qualified for
listing on the SmallCap Market in part because the closing of the sale of Series
C Preferred Stock on August 14, 2002. On October 4, 2002, Nasdaq notified the
Company that it was denying the Company's application to transfer to the
SmallCap Market and was commencing delisting procedures from the Nasdaq National
Market. The Company has appealed the Nasdaq Staff Determination and needs to
show, as part of its definitive plan of compliance, a definitive plan to get the
trading price of our Common Stock over $1.00 to show compliance with the minimum
bid price requirements of both the Nasdaq National Market and the Nasdaq
SmallCap Market. Our appeal has stayed the delisting process and our hearing
before a Nasdaq Review Panel is scheduled for November 14, 2002. Accordingly,
delisting from the National Market may occur in late November or early December
if the Company's appeal is rejected.
If Nasdaq grants the Company's appeal of the denial of its application to
transfer to the SmallCap Market, the Company should receive the benefit of the
SmallCap Market's 180-day period to regain compliance with the minimum bid price
requirement of $1.00. If, at anytime before January 13, 2003, the bid price of
the company's common stock closes at $1.00 per share or more for a minimum of 10
consecutive trading days, the Company will regain compliance with the continued
listing requirements. If the Company is unable to cure the minimum bid price
deficiency or if its falls below the $2,500,000 stockholder's equity continued
listing standard, it may be delisted from the Nasdaq SmallCap Market.
If the Company is delisted from the National Market and/or the SmallCap Market,
the Company's common stock may be eligible for trading on the OTC Bulletin Board
or on other over-the-counter markets, although there can be no assurance that
the Company's common stock will be eligible for trading on any alternative
exchanges or markets. Among other consequences, moving from the Nasdaq National
or SmallCap Markets, or delisting from the Nasdaq National or SmallCap Markets
may cause a decline in the stock price, reduced liquidity in the trading market
for the common stock, and difficulty in obtaining future financing. Furthermore,
a failure to be listed on the Nasdaq National Market or the SmallCap Market will
obligate the Company to make dividend payments to the holders of its Series A3
Preferred Stock and Series B3 Preferred Stock at 14% per annum.
Business Strategy
Management makes operating decisions and assesses performance of the Company's
operations based on the following reportable segments: (1) Desktop Integration
Products, and (2) Messaging and Application Engineering Products. The Company
had also segregated its business into a Systems Integration segment, however;
recently the Company has made a decision to sell the assets that comprise the
Systems Integration segment. Accordingly, these assets have been reclassified to
Assets held for sale on the accompanying consolidated balance sheets and removed
from the segment analysis.
The principal product in the Desktop Integration segment is Cicero. Cicero is a
business integration software product that maximizes end-user productivity,
streamlines business operations and integrates disparate systems and
applications.
The products that comprise the Messaging and Application Engineering segment are
Geneva Integration Broker, Geneva Message Queuing, and Geneva XIPC. Geneva
Integration Broker is a transport independent message broker that enables an
organization to rapidly integrate diverse business systems regardless of
platform, transport, format or protocol. Geneva Message Queuing is an enterprise
connectivity product for Microsoft and non-Microsoft applications. The primary
use is for transactional, once and only once connectivity of Window-based Web
applications to back-office information resources like mainframes and other
legacy systems. Geneva XIPC provides similar delivery of information between
applications. While Geneva Message Queuing is based around a Microsoft standard,
Geneva XIPC is for use with Linux and other brands of UNIX operating systems.
Prior to the sale of the Geneva AppBuilder, CTRC and StarSQL products as
discussed below, the Messaging and Application Engineering segment also included
these products. Geneva AppBuilder is a set of application engineering tools that
assists customers in developing, adapting and managing enterprise-wide computer
applications for the Internet/intranets and client/server networks. During 2001,
the Company sold the Geneva AppBuilder product along with all receivables,
unbilled and deferred revenues as well as all maintenance contracts. The Geneva
AppBuilder product accounted for approximately 79% of total year 2001 revenue
within the Messaging and Application Engineering segment and approximately 59%
of total year 2001 revenue for all segments. While future revenues will be
negatively impacted by the sale of Geneva AppBuilder, the associated costs of
doing business will be positively impacted by the overall reduction in operating
costs.
17
In early 2001, the Company entered into an exclusive distribution agreement with
a certain software distributor for the StarSQL products. During the third
quarter of 2001, the distributor returned the StarSQL products back to Level 8
under the assumption that their legal obligation was satisfied. The Company
provided an allowance for the receivable, pursued collection for the reseller's
outstanding obligations and eventually settled the dispute. At the same time,
the Company had begun to re-enlist StarSQL customers under maintenance contracts
directly with the Company. Also during 2001, the Company was notified by one of
its resellers that it would no longer engage in resales of the Company's CTRC
products acquired from StarQuest. This reseller accounted for substantially all
of the product sales. In May 2002, the Company received an unsolicited offer to
purchase the StarSQL and CTRC products. As a result, the Company reviewed and
assessed the net realizable value of the software product technology assets
associated with StarSQL and CTRC based on the potential sale to a third party.
Based upon this review and assessment, the Company determined that an additional
impairment had occurred in the amount of $1,564, which was recorded as software
amortization. In June 2002, the Company completed the sale of the StarSQL and
CTRC products to Starquest Ventures, Inc., a California company and an affiliate
of Paul Rampel, a member of the Level 8 Board of Directors and a former
executive officer of Level 8. See Note 6 for further discussion.
In May 2002, the Company entered into a non-exclusive perpetual license to
develop and sell its Geneva J2EE technology with Amdocs Ltd. Under the
agreement, Amdocs will pay to the Company a license fee for the source and
object code for Geneva J2EE and relieve the Company of its obligation to perform
under the funded research and development agreement. Additionally, Amdocs
assumed full responsibility for the development team of professionals located in
the Company's Dulles facility and subleased a portion of that facility for a
limited period. The Company was able to reduce its operating costs and retain
its intellectual property rights to Geneva J2EE in its current state of
development, as well as Geneva Enterprise Integrator and Geneva Business Process
Automator. In connection with this transaction, the Company reassessed the
recoverability of the software product technology associated with the Geneva
Enterprise Integrator and Geneva Business Process Automator products based on
its net realizable value and determined that no impairment had occurred.
Subsequent to its license agreement with Amdocs, the Company was approached by
several prospective buyers to explore the potential sale of the intellectual
property rights to Geneva J2EE, Geneva Enterprise Integrator, and Geneva
Business Process Automator. As a result of these unsolicited offers, and the
Company's continuing focus on the Desktop Integration segment, the Company
reviewed and assessed the net realizable value of the software product
technology assets associated with Geneva J2EE, Geneva Enterprise Integrator and
Geneva Business Process Automator. Based upon this assessment, the Company
determined that an additional impairment had occurred in the amount of $6,500,
which was recorded as software amortization. In September 2002, the Company
approved a plan to sell the remaining assets of the System Integration segment.
Accordingly, the Company has reclassified these assets on its September 30, 2002
and December 31, 2001 consolidated balance sheets and has segregated the results
of operations as Income or loss from discontinued operations on its consolidated
statement of operations for all periods presented.
18
Results of Operations
The table below presents information about reported segments for the three and
nine months ended September 30, 2002:
Desktop Integration Messaging/Application Total
Engineering
------------------------------ --------------------------- ---------------------------
September 30, 2002 September 30, 2002 September 30, 2002
Three Nine Three Nine Three Nine
months months months months months months
ended ended ended ended ended ended
----------- ----------- ----------- ----------- ----------- -----------
Total revenue $ 690 $ 1,066 $ 133 $ 834 $ 823 $ 1,900
Total cost of revenue
1,215 5,706 31 1,912 1,245 7,618
----------- ----------- ----------- ----------- ----------- -----------
Gross profit/(loss)
(525) (4,640) 103 (1,078) (422) (5,718)
Total operating
expenses 1,363 6,316 80 233 1,443 6,549
----------- ----------- ----------- ----------- ----------- -----------
EBITA $ (1,888) $(10,956) $ 23 $ (1,311) $(1,865) $ (12,267)
=========== =========== =========== =========== =========== ===========
The table below presents information about reported segments for the three and
nine months ended September 30, 2001:
Desktop Integration Messaging/Application Total
Engineering
------------------------------ -------------------------- ---------------------------
September 30, 2001 September 30, 2001 September 30, 2001
Three Nine Three Nine Three Nine
months months months months months months
ended ended ended ended ended ended
----------- ----------- ----------- ----------- ----------- -----------
Total Revenue $ 53 $ 132 $ 4,973 $ 16,229 $ 5,026 $ 16,361
Total cost of revenue
2,247 7,248 3,837 10,090 6,084 17,338
----------- ----------- ----------- ----------- ----------- -----------
Gross profit/(loss)
(2,194) (7,116) 1,136 6,139 (1,058) (977)
Total operating
expenses 2,830 16,648 2,228 6,908 5,058 23,556
----------- ----------- ----------- ----------- ----------- -----------
EBITA $(5,024) $ (23,764) $ (1,092) $ (769) $ (6,116) $ (24,533)
=========== =========== =========== =========== =========== ===========
The Company has three categories of revenue: software products, maintenance, and
services. Software products revenue is comprised primarily of fees from
licensing the Company's proprietary software products. Maintenance revenue is
comprised of fees for maintaining, supporting, and providing periodic upgrades
to the Company's software products. Services revenue is comprised of fees for
consulting and training services related to the Company's software products.
The Company's revenues vary from quarter to quarter, due to market conditions,
the budgeting and purchasing cycles of customers and the effectiveness of the
Company's sales force. The Company typically does not have any material backlog
of unfilled software orders and product revenue in any quarter is substantially
dependent upon orders received in that quarter. Because the Company's operating
expenses are based on anticipated revenue levels and are relatively fixed over
the short term, variations in the timing of the recognition of revenue can cause
significant variations in operating results from quarter to quarter.
Fluctuations in operating results may result in volatility of the price of the
Company's common stock.
19
Total revenues decreased 83.6% for the quarter ended September 30, 2002 from the
same period in 2001 and 88.4% for the nine months ended September 30, 2002 as
compared to the same period of the previous year. The significant decrease in
revenues is primarily the result of the sale of substantially all of the
Messaging and Application Development products at the start of the fourth
quarter in 2001. Revenues in the Messaging and Application Engineering segment
in the third quarter of 2002 were approximately $133 as compared to $4,973 of
revenues in the same period of 2001. For the nine months ended September 30,
2002, revenues for the Messaging and Application Engineering segment amounted to
$834as compared to $16,229 for the same period in 2001. Revenues in the Desktop
Integration segment amounted to approximately $690 for the three months ended
September 30, 2002 as compared to $53 in the same period of the previous year.
Revenues for the nine months ended September 30, 2002 amounted to $1,066 as
compared to $132 for the same period in 2001. The Company anticipates that this
segment will continue to grow exponentially. Gross profit margins were (51.3)%
for the quarter ended September 30, 2002 and (21.1%) for the quarter ended
September 30, 2001. For the nine months ended September 30, 2002, gross profit
margins were (300.9)% as compared to (6.0%) in the same period in 2001. The
negative gross profit margins reflect the additional software amortization
charges for the StarSQL, CTRC products. See Notes 6 and 7 for further
discussion.
Software Products. Software product revenue decreased approximately 52.8% in the
quarter ended September 30, 2002 from the same period in 2001 and reflects the
impact of the sale of the messaging products at the end of Q3 2001. For the nine
months ended September 30, 2002, software product revenues decreased
approximately 71.5%.
The gross margin on software products was (159.6)% and (353.8)% for the quarter
ended September 30, 2002 and 2001, respectively. Gross margin for the Quarter
ended September 30, 2002 reflects the amortization of acquired software not
offset by revenues. Cost of software is composed primarily of amortization of
software product technology, amortization of capitalized software costs for
internally developed software and royalties to third parties, and to a less
extent, production and distribution costs. As noted in Note 4, during the
quarter ended September 30, 2002, the Company revised its estimate of the asset
life of the Cicero technology from 3 years to 5 years. This change reduced the
quarterly amortization charge from $1,893 to $741.
The Company expects to see significant increases in software sales related to
the Desktop Integration segment coupled with improving margins on software
products as Cicero gains acceptance in the marketplace. The Company's
expectations are based on its review of the sales cycle that has developed
around the Cicero product since being released by the Company, its review of the
pipeline of prospective customers and their anticipated capital expenditure
commitments and budgeting cycles, as well as the status of in-process proof of
concepts or beta sites with select corporations. The Messaging and Application
Engineering segment revenue is expected to decrease significantly along with
related expenses as the majority of the products comprising this segment have
been sold.
Maintenance. Maintenance revenue for the quarter ended September 30, 2002
decreased by approximately 98.9% or $2,585 as compared to the similar quarter
for 2001. For the nine months ended September 30, 2002, maintenance revenue
decreased by approximately 94.4% or $8,580 as compared to the same period of
2001. The decline in overall maintenance revenues is primarily due to the sale
of the majority of the Messaging and Application Engineering products at the
beginning of the fourth quarter of 2001 and in the second quarter of 2002.
The Desktop Integration segment accounted for approximately 43.0% of total
maintenance revenue for the quarter. The Messaging and Application Engineering
segment accounted for approximately 57% of total maintenance revenues.
Cost of maintenance is comprised of personnel costs and related overhead and the
cost of third-party contracts for the maintenance and support of the Company's
software products. Gross margins on maintenance products for the quarter ended
September 30, 2002 amounted to 60.7%, however, the dollar amount recognized is
immaterial. By comparison, gross margin on maintenance for the three months
ended September 30, 2001 amounted to 59.4%. For the nine months ended September
30, 2002, maintenance gross margins were 70.8% as compared to 65.7% in the same
period of the previous year.
The Desktop Integration segment had a negative gross margin for the nine months
ended September 30, 2002 as future sales of the Cicero product are subject to
favorable proofs-of-concepts at several large installations. The Messaging and
Application Engineering segment had a gross margin of approximately 35.2% for
the quarter and 97.9% for the year to date period.
Maintenance revenues are expected to increase, primarily in the Desktop
Integration segment. The majority of the products comprising the Messaging and
Application Engineering segment have been sold and thus future revenues will be
significantly lower as will the cost of maintenance associated with this
segment. The cost of maintenance should increase slightly for the Desktop
Integration segment.
20
Services. Services revenue for the quarter ended and nine months ended September
30, 2002 decreased approximately 72.7% and 83.4%, respectively, from comparable
periods in 2001. The overall decline in service revenues reflects the reduced
headcounts resulting from the Company's restructuring plan that occurred in the
early part of 2001 as well as the impact of the sale of the Geneva AppBuilder
product to BluePhoenix Solutions in October 2001. In that transaction,
approximately 20 consultants were transferred as part of the overall
transaction.
The Desktop Integration segment accounted for approximately 87.0% of the service
revenues for the quarter ended September 30, 2002, which reflects the deployment
of the Cicero application at several customers under paid pilot programs. The
Messaging and Application Engineering segment accounted for approximately 13.0%
of service revenue. The Desktop Integration segment accounted for 76.5% of
service revenues and the Messaging and Application Engineering segment accounted
for 23.5% of service revenues for the nine months ended September 30, 2002.
Cost of services primarily includes personnel and travel costs related to the
delivery of services. Services gross margins were 16.6% for the quarter ended
September 30, 2002 as compared to (10.5%) for the same period in 2001. For the
nine months ended September 30, 2002, services gross margins were 29.2% compared
to 16.4% in the same period of the previous year.
Services revenues are expected to increase for the Desktop Integration segment
as the Cicero product gains acceptance. The Messaging and Application
Engineering segment service revenues will decrease dramatically as the majority
of the relevant products have been sold.
Sales and Marketing. Sales and marketing expenses primarily include personnel
costs for salespeople, marketing personnel, travel and related overhead, as well
as trade show participation and promotional expenses. Sales and marketing
expenses for the quarter ended September 30, 2002 decreased by 70.5% or
approximately $1,391 from a comparable period in 2001 due to a reduction in the
Company's sales and marketing workforce, as well as decreased promotional
activities. For the nine months ended September 30, 2002, sales and marketing
expenses decreased by 78.7% or $8,216.
Sales and marketing expenses are expected to remain fairly constant now that the
Company's restructuring efforts are complete. The Company's emphasis for the
sales and marketing groups will be the Desktop Integration segment.
Research and Development. Research and development expenses primarily include
personnel costs for product authors, product developers and product
documentation and related overhead. Research and development expense decreased
by 79.5% or approximately $1,201 in the period ending September 30, 2002 as
compared to the same period in 2001. For the nine months ended September 30,
2002 research and development expenses decreased by approximately 67.9% or
$3,291 over the same period of the previous year. The decrease in costs in 2002
reflects the restructuring efforts completed during the first two quarters of
2001.
The Company anticipates that research and development expenses will decrease
slightly over the next few quarters as the Company has further reduced its
research and development headcount. Level 8 intends to continue to invest in
research and development on its Cicero product while enhancing efficiencies in
this area.
General and Administrative. General and administrative expenses consist of
personnel costs for the executive, legal, financial, human resources, IT and
administrative staff, related overhead, and all non-allocable corporate costs of
operating the Company. General and administrative expenses for the quarter ended
September 30, 2002 decreased by 65.0% or $1,023 over the same period in the
prior year and primarily influenced by the recovery of approximately $200 of bad
debts. For the nine months ended September 30, 2002, general and administrative
expenses decreased by 66.5% or $5,500 over the same period in the previous year.
The decrease is primarily attributable to the Company's provision for doubtful
accounts (approximately $3.8 million) relating to a bankruptcy filing from one
customer and the overall restructuring plan that was affected on the Company's
operations in 2001.
General and administrative expenses are expected to increase slightly going
forward as the Company would expect continuing recoveries of previously recorded
bad debts.
Restructuring. During the second quarter of 2002, the Company began another
round of operational restructurings to further reduce its operating costs and
streamline its operations. The decision was made to close its development
facility in Berkeley, California and centralize the future development of Cicero
within its Princeton, New Jersey facility. Additionally, the company decided to
significantly reduce its employees in EMEA and terminated approximately 12
people. The Company recorded a restructuring charge in the amount of $1,300
during the second quarter of 2002. The Company anticipates that all remaining
obligations as of the balance sheet date will be expended by November 2006.
As part of the overall restructuring movement, the Company has closed its Paris,
France offices and is in the process of closing down the Milan, Italy and
Uxbridge, United Kingdom offices.
21
In 2001, the Company began an initial operational restructuring to reduce its
operating costs and streamline its organizational structure. This operational
restructuring involves the reduction of employee staff throughout the Company in
all geographical regions in sales, marketing, services and development and
administrative functions. The Company recorded restructuring charges of $8,650
during 2001.
The following table sets forth a summary by category of accrued expenses and
cash paid for the nine months ended September 30, 2002:
Accrued at Accrued at
December 31, Additional Cash September
2001 Accrual Paid 30, 2002
------------ ------------ ------------ ------------
Employee termination $ 43 $ 396 $ (208) $ 231
Excess office facilities........................ 647 880 (835) 712
Marketing obligations........................... 53 0 (53) 0
Other miscellaneous restructuring costs......... 110 24 (112) 22
------------ ------------ ------------ ------------
Total........................................... $ 853 $ 1,300 $ 1,208 $ 965
============ ============ ============ ============
The Company believes the accrued restructuring cost of $965 at September 30,
2002 represents its remaining cash obligations for the restructuring charges
included above.
Impairment of Intangible Assets. During the third quarter of 2001, the Company
was notified by one of its resellers that they would no longer engage in
re-sales of the Company's CTRC product sales. As a result, the Company performed
an assessment of the recoverability of those related long-lived assets in
accordance with SFAS 121. The results of the Company's analysis of undiscounted
cash flows indicated that an impairment had occurred with regard to the
intangible assets related to the CTRC products. The Company estimated the fair
market value of the related assets through a discounted future cash flow
valuation technique. The results of this analysis indicated the carrying value
of the tangible assets exceeded their fair market values. The Company has
reduced the carrying value by this amount by approximately $10,989 as of
September 30, 2001 of which $3,070 was recorded in cost of software revenue as a
write-down of software product technology.
Change in Fair Value of Warrant Liability. The Company has recorded a warrant
liability for derivatives in accordance with EITF 00-19 for its common stock
warrants with redemption features outside the control of the Company. The fair
value of the warrants as of September 30, 2002 has been determined using
valuation techniques consistent with the valuation performed as of December 31,
2001 and recorded as a warrant liability. As a result of the valuation, the
Company has recorded a change in the fair value of the warrant liability of
($32) and $2,657 for the quarter ended and nine months ended September 30, 2002.
Provision for Taxes. The Company's effective income tax rate for continuing
operations differs from the statutory rate primarily because an income tax
benefit was not recorded for the net loss incurred in the first quarter of 2002
or 2001. Because of the Company's recurring losses, the deferred tax assets have
been fully offset by a valuation allowance. The income tax provision for the
first quarter of 2002 is primarily related to income taxes and benefit from
foreign operations and foreign withholding taxes.
EBITA. EBITA represents loss before income taxes, interest and other income
(expense), amortization of goodwill, restructuring charges, gain (loss) on sale
of assets, and impairment charges. EBITA for the three months and nine months
ended September 30, 2002 was ($1.9) million and ($12.3) million as compared to
($6.1) million and ($24.5) for the same periods of the previous year. The
decrease in the loss before income taxes, interest and other income and expense,
amortization of goodwill, restructuring charges, gain or loss on sale of assets
and impairment charges is primarily attributable to the reduced operations of
the Company as a result of the significant restructuring of operations conducted
in 2001.
EBITA is not a measure of performance under accounting principles generally
accepted in the United States of America and should not be considered as a
substitute for net income, cash flows from operating activities and other income
or cash flow statement data prepared in accordance with accounting principles
generally accepted in the United States of America, or as a measure of
profitability or liquidity. We have included information concerning EBITA one
measure of our cash flow and historical ability to service debt and because we
believe investors find this information useful. EBITA as defined herein may not
be comparable to similarly titled measures reported by other companies.
Impact of Inflation. Inflation has not had a significant effect on the Company's
operating results during the periods presented.
22
Liquidity and Capital Resources
Operating and Investing Activities
The Company used $403 of cash for the nine months ended September 30, 2002.
Operating activities utilized approximately $6.8 million of cash, which is
primarily comprised of the loss from operations of $18.1 million, offset by
non-cash charges for depreciation and amortization $7.4 million and a non-cash
adjustment to the fair value of a warrant liability in the amount of $2.7
million. In addition, the Company had a reduction in accounts receivable of $1.0
million and net assets held for sale of $8.2 million and used approximately $1.3
million in fulfillment of its obligations to its creditors through its accounts
payable and other accrued liabilities and a reduction in its deferred
liabilities of $1.8 million. The reduction in accounts receivable is the result
of the reduction in overall revenues resulting from the sale of substantially
all of the Messaging and Application Engineering products.
The Company generated approximately $3.7 million in cash from investing
activities, which is comprised of approximately $1.0 million in final proceeds
from the sale of the Geneva AppBuilder assets, approximately $2.0 million from
the collection of Notes Receivable and approximately $500 from the sale of
assets.
The Company generated approximately $2.9 million of cash during the first nine
months for financing activities from the proceeds of two investment rounds. In
January, the Company closed on an additional round of investment from several
new investors (approximately $3.5 million) offset by approximately $1.6 million
that was received prior to the end of the year from the same investor group. In
addition, in August 2002, the Company completed a Series C Convertible
Redeemable Preferred Stock offering wherein it raised an additional $1.4 million
of cash. As part of its agreement with Liraz as the guarantor on the outstanding
bank loan, the Company used approximately 10% of the proceeds ($638) from its
financings and asset sales to pay down the principal on the loan.
By comparison, in 2001, the Company used approximately $15.2 million in cash
during the first nine months.
Net cash used in operations during the first nine months of 2001 was
approximately $13.6 million, which is primarily comprised of the net loss for
the period of $86.4 million and approximately $2.4 million for fulfillment of
vendor obligations, offset by non-cash charges for depreciation and amortization
of approximately $23.9 million, an impairment of assets of approximately $32.7
million, a provision for doubtful accounts of approximately $3.7 million, an
unrealized loss on marketable securities of $3.8 million and a $9.5 million
reduction in accounts receivable.
Net cash generated from investing activities during 2001 was $1.6 million, which
consisted of approximately $3.0 million, which represented the proceeds from the
sale of assets offset by capitalization of product software in the amount of
$1.5 million
Net cash used in financing activities for the first nine months of 2001 amounted
to $3.2 million which includes a reduction of the Company's outstanding bank
indebtedness (approximately $2.0 million) as well as dividends paid to preferred
shareholders during the period (approximately $1.0 million.)
Financing Activities
The Company funded its cash needs during the nine months ended September 30,
2002 with cash on hand from December 31, 2001, with cash from operations and
with the cash realized from the private placement, which closed in January 2002
and from the proceeds of the Series C Convertible Redeemable Preferred Stock
offering in August 2002.
The Company has a $2,512 term loan bearing interest at LIBOR plus 1%
(approximately 2.97% at September 30, 2002), interest on which is payable
quarterly. There are no financial covenants and the term loan is guaranteed by
Liraz, the Company's principal shareholder. The loan matures on November 15,
2003.
The Company is attempting to secure a revolving credit facility and on an
interim basis has pledged certain accounts receivable from time to time against
promissory notes as a means to provide liquidity.
23
In January 2002, the Company entered into a Securities Purchase Agreement with
several investors wherein the Company agreed to sell up to three million shares
of its common stock and warrants. The common stock was sold at $1.50 per share
and warrants to purchase additional shares were issued at an exercise price of
$2.75 per share. This offering closed on January 16, 2002 and $1.6 million in
proceeds were received prior to December 31, 2001. The Company sold 2,381,952
shares of common stock for a total of $3.5 million and granted 476,396 warrants
to purchase the Company's common stock at an exercise price of $2.75 per share.
The warrants expire in three years from the date of grant and have a call
feature that forces exercise if the Company's common stock exceeds $5.50 per
share.
On August 14, 2002, the Company completed a $1.6 million private placement of
Series C Convertible Redeemable Preferred Stock ("Series C Preferred Stock"),
convertible at a conversion ratio of $0.38 per share of common stock into an
aggregate of 4,184,211 shares of common stock. As part of the financing, the
Company has also issued warrants to purchase an aggregate of 1,046,053 shares of
common stock at an exercise price of $0.38 per share. As consideration for the
$1.6 million private placement, the Company received approximately $1.4 million
in cash and allowed certain debt holders to convert approximately $200 of debt
to equity. The Chairman and CEO of the Company, Tony Pizi, converted $150,000 of
debt owed to Mr. Pizi into shares of Series C Preferred Stock and warrants. Both
existing and new investors participated in the financing. The Company also
agreed to register the common stock issuable upon conversion of the Series C
Preferred Stock and exercise of the warrants for resale under the Securities Act
of 1933, as amended. The Company plans to use the funds to support working
capital needs
Risk Assessments
See a discussion of risk assessments under Item 2 Management Discussion and
Analysis
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Approximately 36% of the Company's 2002 revenues were generated by sales outside
the United States. The Company is exposed to risks of foreign currency
fluctuation primarily from receivables denominated in foreign currency and is
subject to transaction gains and losses, which are recorded as a component in
determining net income. Additionally, the assets and liabilities of the
Company's non-U.S. operations are translated into U.S. dollars at exchange rates
in effect as of the applicable balance sheet dates, and revenue and expense
accounts of these operations are translated at average exchange rates during the
month the transactions occur. Unrealized translation gains and losses are
included as a component of accumulated other comprehensive income or loss in
shareholders' equity. The Company no longer hedges foreign currency transactions
and balances.
Item 4. Controls and Procedures
(a) Within 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 Company's President and Chief Executive Officer, and
Vice President and Chief Financial Officer, have concluded that the Company's
disclosure controls and procedures are effective.
(b) There have been 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.
Part II. Other Information
Item 1. Legal Proceedings
From time to time, the Company is a party to routine litigation
incidental to its business. On September 30, 2002, an action was
brought against the Company in the United States District Court for the
District of Colorado by Access International Financial Services, Inc
claiming the Company had breached a contract. The plaintiff seeks
damages of approximately $660. The Company will vigorously defend
against this action and has reserved $210 as a liability in this case.
24
Item 2. Changes in Securities
On August 14, 2002, the Company completed a $1.6 million private
placement of Series C Convertible Redeemable Preferred Stock ("Series C
Preferred Stock"), convertible at a conversion ratio of $0.38 per share
of common stock into an aggregate of 4,184,211 shares of common stock.
As part of the financing, the Company has also issued warrants to
purchase an aggregate of 1,046,053 shares of common stock at an
exercise price of $0.38 per share. As consideration for the $1.6
million private placement, the Company received approximately $1.4
million in cash and allowed certain debt holders to convert
approximately $200,000 of debt to equity. The Chairman and CEO of the
Company, Tony Pizi, converted $150,000 of debt owed to Mr. Pizi into
shares of Series C Preferred Stock and warrants. Both existing and new
investors participated in the financing. These shares were issued in
reliance upon the exemption from registration under Rule 506 of
Regulation D and on the exemption from registration provided by Section
4(2) of the Securities Act of 1933 for transactions by an issuer not
involving a public offering.
On August 29, 2002, the Company entered into an exchange agreement with
its existing preferred shareholders. Under the terms of the agreement,
the holders of the Series A1 and Series B1 4% convertible redeemable
preferred stock and related common stock warrants received an equal
number of preferred shares of the new Series A2 and Series B2
convertible redeemable preferred stock and related warrants. The
conversion price of both the Series A1 and Series B1 preferred stock
remained the same. The exercise price for the warrants received in the
exchange was reduced to $0.38 per share. A total of 1,801,022 warrants
were exchanged. The shares issued pursuant to the exchange agreement
were issued in reliance upon the exemption from registration provided
by Section 3(a)(9) of the Securities Act of 1933 for an exchange by an
issuer with its exiting security holders.
Subsequent to the end of the quarter, on October 25, 2002, the Company
effected an exchange of all of our outstanding shares of Series A2
Convertible Redeemable Preferred Stock ("Series A2 Preferred Stock")
and Series B2 Convertible Redeemable Preferred Stock ("Series B2
Preferred Stock") and related warrants for an equal number of shares of
newly created Series A3 Convertible Redeemable Preferred Stock ("Series
A3 Preferred Stock") and Series B3 Convertible Redeemable Preferred
Stock ("Series B3 Preferred Stock") and related warrants. This exchange
was made to correct a deficiency in the conversion price from the prior
exchange of Series A1 and B1 Preferred Stock and related warrants for
Series A2 and B2 Preferred Stock and related warrants on August 29,
2002. The conversion price for the Series A3 Preferred Stock and the
conversion price for the Series B3 Preferred Stock remain the same as
the previously issued Series A1 and A2 Preferred Stock and Series B1
and B2 Preferred Stock, at $8.333 and $12.531, respectively. The
exercise price for the aggregate 753,640 warrants relating to the
Series A3 Preferred Stock was increased from $0.38 to $0.40 per share
which is a reduction from the $1.77 exercise price of the warrants
relating to the Series A1 Preferred Stock. The exercise price for the
aggregate 1,047,382 warrants relating to the Series B3 Preferred Stock
was increased from $0.38 to $0.40 per share which is a reduction from
the $1.77 exercise price of the warrants relating to the Series B1
Preferred Stock. The adjusted exercise price was based on the closing
price of the Company's Series C Convertible Redeemable Preferred Stock
and warrants on August 14, 2002, plus $0.02, to reflect accurate
current market value according to relevant Nasdaq rules. This
adjustment was made as part of the agreement under which the holders of
the Company's Preferred Stock agreed to waive their price-protection
anti-dilution protections to allow the Company to issue the Series C
Preferred Stock and warrants without triggering the price-protection
anti-dilution provisions and excessively diluting its common stock. The
shares issued pursuant to the exchange agreement were issued in
reliance upon the exemption from registration provided by Section
3(a)(9) of the Securities Act of 1933 for an exchange by an issuer with
its exiting security holders.
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
25
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit
No. Description
------ -----------
3.1 Certificate of Designation relating to the Company's Series A3
Convertible Redeemable Preferred Stock (filed herewith).
3.2 Certificate of Designation relating to the Company's Series B2
Convertible Redeemable Preferred Stock (filed herewith).
10.1 First Amendment to Exchange Agreement dated as of October 25,
2002 among the Company and the investors named on the signature
pages thereof (filed herewith).
10.2 Form of Series A3 Warrant issued on October 25, 2002 in exchange
for Series A2 Warrants originally issued August 29, 2002 (filed
herewith).
10.3 Form of Series B3 Warrant issued on October 25, 2002 in exchange
for Series B2 Warrants originally issued August 29, 2002 (filed
herewith).
10.4 Amendment to Registration Rights Agreement dated as of October
25, 2002 among the Company and the investors named on the
signature pages thereof (filed herewith).
99.1 Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 (filed herewith).
99.2 Certification of Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 (filed herewith).
(b) Reports on Form 8-K
On August 27, 2002, Level 8 Systems filed a Form 8-K reporting the
closing of the sale of the Series C Preferred Stock and related
warrants.
On August 30, 2002, Level 8 Systems filed a Form 8-K reporting the
exchange of Series A2 Preferred Stock and new warrants and Series B2
Preferred Stock and new warrants for Series A1 Preferred Stock and old
warrants and Series B1 Preferred Stock and old warrants.
On September 13, 2002, Level 8 Systems filed a Form 8-K reporting a pro
forma balance sheet in response to NASDAQ's request in connection with
the Company's application for transfer to The NASDAQ SmallCap Market.
26
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.
Level 8 Systems, Inc.
/s/ Anthony Pizi
Date: November 14, 2002 ....................................
Anthony Pizi
President & Chief Executive Officer
/s/ John Broderick
Date: November 14, 2002 ....................................
John Broderick
Chief Financial Officer/Chief
Operating Officer
27
I, Anthony C. Pizi, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Level 8
Systems, Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material
fact necessary to make the statements made, in light of the
circumstances under which such statements were made, not
misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements and other
financial information included in this quarterly report, fairly
present in all material respects the financial condition, results
of operations and cash flows of the registrant as of, and for, the
periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible
for establishing and maintaining disclosure controls and
procedures (as defined in Exchange Act Rules 13a-14 and 15d- 14)
for the registrant and we have:
(a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
(b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors
and the audit committee of the board of directors (or persons
fulfilling the equivalent function):
(a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
(b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated
in this quarterly report whether or not there were significant changes
in internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ Anthony C. Pizi
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Anthony C. Pizi
Chief Executive Officer
28
I, John P. Broderick, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Level 8
Systems, Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material
fact necessary to make the statements made, in light of the
circumstances under which such statements were made, not
misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements and other
financial information included in this quarterly report, fairly
present in all material respects the financial condition, results
of operations and cash flows of the registrant as of, and for, the
periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible
for establishing and maintaining disclosure controls and
procedures (as defined in Exchange Act Rules 13a-14 and 15d- 14)
for the registrant and we have:
(a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date"); and
(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors
and the audit committee of the board of directors (or persons
fulfilling the equivalent function):
(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
(b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
Date: November 14, 2002
/s/ John P. Broderick
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John P. Broderick
Chief Operating and Financial Officer
29