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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2004

OR

For the transition period from              to             

COMMISSION FILE NUMBER: 000-25590

DATASTREAM SYSTEMS, INC.

Incorporated pursuant to the laws of the State of Delaware

Internal Revenue Service — Employer Identification No. 57-0813674

50 DATASTREAM PLAZA, GREENVILLE, SC 29605

(864) 422-5001

NOT APPLICABLE

(Former Name, Former Address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: August 6, 2004: 19,961,303 shares, $0.01 par value.

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Datastream Systems, Inc.

FORM 10-Q

Quarter ended June 30, 2004

Index

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PART I. FINANCIAL INFORMATION

“SAFE HARBOR” STATEMENT UNDER THE PRIVATE

SECURITIES LITIGATION REFORM ACT OF 1995

From time to time, we make oral and written statements that may constitute “forward looking statements” (rather than historical facts) as defined in the Private Securities Litigation Reform Act of 1995 or by the Securities and Exchange Commission (the “SEC”) in its rules, regulations and releases, including Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We desire to take advantage of the “safe harbor” provisions in the Private Securities Litigation Reform Act of 1995 for forward looking statements made from time to time, including, but not limited to, the forward looking statements made in this Quarterly Report on Form 10-Q (the “Report”), as well as those made in other filings with the SEC.

Forward looking statements can be identified by our use of forward looking terminology such as “may,” “will,” “expect,” “anticipate,” “estimate,” “believe,” “continue” or other similar words. Such forward looking statements are based on our management’s current plans and expectations and are subject to risks, uncertainties and changes in plans that could cause actual results to differ materially from those described in the forward looking statements. In the preparation of this Report, where such forward looking statements appear, we have sought to accompany such statements with meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those described in the forward looking statements. Such factors include, but are not limited to: a highly competitive market; our ability to keep pace with rapid technological changes and demands in our markets; volatility of our quarterly results due to increasing sales cycles; engagements that require longer implementations; reduced profitability due to our hosting services strategy; our ability to generate future revenue and profits from our Datastream 7i Buy strategy; significant delays in product development and our ability to be an innovator in the industry; third party relationships on which our success is substantially dependent; third party technologies on which our future success is substantially dependent; our ability to detect software bugs or errors to avoid a correction to or delay in the release of our products; our ability to manage our international operations; risks unique to government contracts that may have a detrimental impact on our operating results; deterioration of economic and political conditions; continued acceptance of the Internet for business transactions; recruiting and retaining key employees; our ability to adequately protect our proprietary rights; security risks and concerns that may deter use of the Internet for our applications; fluctuations in our stock price since our initial public offering; and our articles of incorporation and bylaws may inhibit a takeover that would be in the stockholders’ best interest. The preceding list of risks and uncertainties, however, is not intended to be exhaustive, and should be read in conjunction with other cautionary statements that we make including, but not limited to, the “Risk Factors” set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Form 10-K for the fiscal year ended December 31, 2003, as well as other risks and uncertainties identified from time to time in our SEC reports, registration statements and public announcements

We do not have, and expressly disclaim, any obligation to release publicly any updates or any changes in our expectations or any changes in events, conditions or circumstances on which any forward-looking statement is based.

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ITEM 1. Consolidated Financial Statements

Datastream Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

(unaudited)

See accompanying notes to consolidated financial statements.

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Datastream Systems, Inc. and Subsidiaries

Consolidated Statements of Operations

(unaudited)

Three months ended June 30, 2004 and 2003

See accompanying notes to consolidated financial statements.

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Datastream Systems, Inc. and Subsidiaries

Consolidated Statements of Operations

(unaudited)

Six months ended June 30, 2004 and 2003

See accompanying notes to consolidated financial statements.

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Datastream Systems, Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Equity and Comprehensive Income

(unaudited)

Six months ended June 30, 2004

See accompanying notes to consolidated financial statements.

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Datastream Systems, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(unaudited)

Six months ended June 30, 2004 and 2003

See accompanying notes to consolidated financial statements.

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Datastream Systems, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

1. Basis of Presentation

The interim financial information included herein is unaudited. Certain information and footnote disclosures normally included in the consolidated financial statements have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). In the opinion of management, such unaudited information reflects all adjustments, consisting only of normal recurring accruals and other adjustments as disclosed herein, necessary for a fair presentation of the unaudited information. These consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes contained in the Company’s Form 10-K and Form 10-K/A for the year ended December 31, 2003 filed with the SEC on March 10, 2004 and March 16, 2004, respectively. Certain amounts in the prior year financial statements have been reclassified to conform to the 2004 presentation. These reclassifications had no impact on stockholders’ equity or net income as previously reported.

Results for interim periods are not necessarily indicative of results expected for the full year.

2. Segment and Geographic Information

The Company has identified one business segment for reporting purposes: Asset Performance Management. The Company manages the Asset Performance Management business over geographical regions. The principal areas of operation include the United States and Canada, Europe, Latin America and Asia. Financial information concerning the Company’s operations in different geographical regions is as follows:

As of and for the three months ended June 30, 2004 and 2003:

As of and for the six months ended June 30, 2004 and 2003:

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3. Reconciliation of Basic and Diluted Net Income Per Share

Basic net income per share is computed by dividing net income by the weighted average number of common shares outstanding. Diluted net income per share is computed by dividing net income by the weighted average number of common and potential common shares outstanding. Diluted weighted average common shares include common shares and stock options using the treasury stock method, except when those potential common shares result in antidilution. The reconciliation of basic and diluted income per share as of June 30, 2004 and 2003 is as follows:

Antidilutive shares totaling 2,884,697 and 1,537,561 were excluded from the diluted net income per share calculations for the three months ended June 30, 2004 and 2003, respectively, and antidilutive shares totaling 2,339,942 and 2,823,206 were excluded from the diluted net income per share calculations for the six months ended June 30, 2004 and 2003, respectively.

4. Stock Option Plans

The Company applies the intrinsic-value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, as amended, to account for its stock-based employee compensation plans. Under this method, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeds the exercise price. Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, as amended, established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of SFAS No. 123. The following table illustrates the effect on net income if the fair-value-based method had been applied for the three and six months ended June 30, 2004 and 2003.

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The Company uses the Black Scholes option-pricing model to value the employee and director stock-based compensation plans. The following assumptions were used for grants and purchase rights valued during the quarter ended June 30, 2004 and 2003: an expected dividend rate of 0% and 0%, an expected volatility of 87.5% and 91.3%, a risk-free rate of 3.62% and 2.99% and an expected life of 4.4 years and 4.6 years, respectively.

5. Commitments and Contingencies

The Company is occasionally involved in claims arising out of its operations in the normal course of business. No such current claims are expected, individually or in the aggregate, to have a material adverse effect on the Company’s consolidated financial statements.

The Company has been contacted by tax authorities in China regarding import taxes withheld by our subsidiary in Shanghai, China since September 2001. The Company believes that a claim or assessment is reasonably possible but cannot be reasonably estimated due to the unknown nature of the review. Due to the relatively small size of the subsidiary, management believes the resolution of this matter will not have a material impact on our liquidity, financial condition or results of operations.

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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Report contains certain forward-looking statements with respect to the Company’s operations, industry, financial condition and liquidity. These statements reflect the Company’s assessment of a number of risks and uncertainties. The Company’s actual results could differ materially from the results anticipated in these forward-looking statements as a result of certain factors set forth in this Report. An additional statement made pursuant to the Private Securities Litigation Reform Act of 1995 and summarizing certain of the principal risks and uncertainties inherent in the Company’s business is included in Part I of this Report under the caption “‘Safe Harbor’ Statement Under the Private Securities Litigation Reform Act of 1995.” Readers of this Report are encouraged to read such statement carefully.

Overview

We provide asset performance management software and services to enterprises worldwide, including more than 60 percent of the Fortune 500. Through asset performance management, customers can maintain, manage, and improve the performance of their capital asset infrastructure, such as manufacturing equipment, fleet, and facilities.

Growth in profits for a software company is strongly tied to license revenues. License revenues typically result in subsequent service and support revenues. Growth in profits is also strongly tied to product quality, functionality and performance, and we can only achieve this by continuing to invest in our product offering.

When we sell to a customer, we typically commit to an arrangement consisting of application licenses, services and support. We also sell services to host the licensed application. During the second quarter of 2004, we experienced higher support revenue per customer than the second quarter of 2003, which was an important contributor to our profitability. Our support revenue is a key source of recurring revenue and profitability in our business.

Our gross margin, which measures net revenues less cost of revenues sold as a percentage of total revenues, improved in the second quarter of 2004 compared to the second quarter of 2003 because of reduced services costs and increased support revenue as a percentage of our total revenues which carries a higher gross margin than service revenues. Our operating margin, which measures operating income as a percentage of total revenues, improved in the second quarter of 2004 compared to the second quarter of 2003 due largely to aforementioned higher gross margins in conjunction with improved sales productivity. Our cost structure primarily consists of salaries, wages, and benefits provided to our employees.

Traditionally, a significant portion of our revenue in any quarter had been the result of a large number of relatively small orders received during the period. We expect the average size of our license sales transactions, however, to continue to increase in the coming years. An increase in average deal size typically increases the length of an average sales cycle. Potential customers spend significant time and resources determining which software to purchase. This requires us to spend substantial time, effort and money educating and convincing prospective customers to purchase our software. A customer’s decision to license our software generally involves evaluation by a number of the customer’s personnel in various functional and geographic areas. Due to these and other factors, our sales cycle may be extended. Since the sales cycle can be unpredictable and can be affected by events beyond our control, we cannot always forecast the timing or amount of specific customer transactions, and sales may vary from quarter to quarter. We expect to continue to experience a decline in the large number of relatively small orders that had been a staple of our marketing and sales efforts in the past. In addition, our prospective customers may delay purchase commitments or extend sales cycles as they enter the control testing and attestation period related to Sarbanes-Oxley Section 404 compliance. Such a delay would have a material adverse affect on our results.

We typically see reduced service revenues in the third and fourth quarters of our calendar year due to lower utilization of our services from Europe in the summer and fewer available billable days in the November and December months due to holidays and customer site shutdowns. The first and third quarters have traditionally been weaker for license sales, but this has become harder to predict given larger deal sizes and less predictable sales cycles associated with Datastream 7i. This seasonality, combined with the extended sales cycles, may cause our results to vary from quarter to quarter.

Results of Operations

Total Revenues. Total revenues increased 2% to $23,830,723 in the second quarter of 2004 from $23,388,559 in the second quarter of 2003. The slight increase is due to an increase in Datastream 7i license sales and greater customer

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acceptance of the application hosting business. Total revenues increased 2% to $46,917,563 for the first six months of 2004 from $46,172,791 for the first six months of 2003 due to an increase in Datastream 7i license sales and an increase in application hosting revenue. International revenues, including Canada, increased 1% to $9,212,302 (39% of total revenues) in the second quarter of 2004, as compared to $9,100,832 (39% of total revenues) in the second quarter of 2003. International revenues, including Canada, increased 9% to $19,355,905 (41% of total revenues) for the first six months of 2004, as compared to $17,762,612 (38% of total revenues) in the first six months of 2003. The increase in international revenues, including Canada, as a percentage of total revenues is due primarily to an increase in Datastream 7i revenue in Europe. See Note 2 to the consolidated financial statements.

Software Product Revenues: Software product revenues increased 4% to $6,544,443 (27% of total revenues) in the second quarter of 2004 from $6,271,635 (27% of total revenues) in the second quarter of 2003 and 2% to $13,001,218 (28% of total revenues) for the first six months of 2004 from $12,793,281 (28% of total revenues) for the first six months of 2003 as a result of increased Datastream 7i software sales.

Professional Services and Support Revenues: Professional services and support revenues increased 1% to $17,286,280 (73% of total revenues) in the second quarter of 2004 from $17,116,924 (73% of total revenues) in the second quarter of 2003 and increased 2% to $33,916,345 (72% of total revenues) for the first six months of 2004 from $33,379,510 (72% of total revenues) for the first six months of 2003. Support revenue increased due to an increase in average customer support renewal revenue and an increase in the number of hosted customers. The increase in support revenue was partially offset by a decrease in service revenue, resulting from increased third party service provider competition.

Cost of Product Revenues: Cost of product revenues consists of software purchased for resale, royalties paid to vendors of third party software, cost of product packaging, cost of media, and shipping expenses. Cost of product revenues decreased 45% to $211,261 (3% of product revenues) in the second quarter of 2004, as compared to $382,218 (6% of product revenues) in the second quarter of 2003. This decrease relates primarily to a reduction in third party royalty fees. Cost of product revenues increased 16% to $699,029 (5% of product revenues) for the first six months of 2004, as compared to $602,948 (5% of product revenues) for the first six months of 2003 due to higher third party royalty fees.

Cost of Services and Support Revenues: Cost of services and support revenues decreased 4% to $7,276,509 (42% of services and support revenues) in the second quarter of 2004, as compared to $7,550,852 (44% of services and support revenues) in the second quarter of 2003. Cost of services and support revenues decreased 6% to $14,133,502 (42% of services and support revenues) for the first six months of 2004, as compared to $15,109,137 (45% of services and support revenues) for the first six months of 2003. The decreases are primarily due to decreased reimbursed services costs and overall reductions in both internal and third party services expenditures.

Sales and Marketing Expenses: Sales and marketing expenses decreased 8% to $7,320,988 (31% of total revenues) in the second quarter of 2004 from $7,975,082 (34% of total revenues) in the second quarter of 2003. The decrease in sales and marketing expenses is a result of reduced advertising and field marketing activities and reduced expenditures associated with non-productive sales support personnel. Sales and marketing expenses decreased 4% to $14,650,290 (31% of total revenues) for the first six months of 2004 from $15,226,354 (33% of total revenues) for the first six months of 2003. The decrease in sales and marketing expenses is due to a reduction in advertising, field marketing, and sales personnel.

Product Development Expenses: Total product development expenditures increased 16% to $3,515,524 (15% of total revenues) in the second quarter of 2004 from $3,019,990 (13% of total revenues) in the second quarter of 2003 and increased 17% to $6,907,897 (15% of total revenues) for the first six months of 2004 from $5,890,310 (13% of total revenues) for the first six months of 2003. The increase in total product development expense is a result of increased investment in asset performance management functionality associated with the Company’s next release of Datastream 7i.

General and Administrative Expenses: General and administrative expenses increased 18% to $3,167,053 (13% of total revenues) in the second quarter of 2004 from $2,690,858 (12% of total revenues) in the second quarter of 2003 due primarily to increased fees associated with the Sarbanes-Oxley Act of 2002 and a benefit in the second quarter of 2003 from a reduction in bad debt expense as a result of improved days sales outstanding. General and administrative expenses increased 1% to $6,313,735 (13% of total revenues) for the first six months of 2004 from $6,260,282 (14% of total revenues) for the first six months of 2003 due primarily to increased fees associated with Sarbanes-Oxley compliance. General and administrative expenses may continue to increase due to compliance related to the Sarbanes-Oxley Act of 2002.

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Tax Rate: Our effective tax rate was 38.0% and 39.0% for the second quarter of 2004 and 2003, respectively. Our effective tax rate was 36.6% and 35.9% for the first six months of 2004 and 2003, respectively.

Net income: Net income increased to $1,537,949 (6% of total revenues) in the second quarter of 2004 from net income of $252,462 (1% of total revenues) in the second quarter of 2003 and increased to $2,851,212 (6% of total revenues) for the first six months of 2004 from net income of $1,210,200 (3% of total revenues) for the first six months of 2003. The improvement is attributed to improved operating efficiency in the second quarter of 2004 and a non-operating charge of $1.5 million recognized in the second quarter of 2003 related to a write-down on an investment.

Financial Condition

Consolidated total assets were $84.5 million at June 30, 2004, an increase of approximately $415,000 from $84.0 million at December 31, 2003. The increase resulted from a $1.5 million increase in cash and an increase of approximately $505,000 in unbilled revenue offset by a $1.4 million decrease in deferred income taxes.

Consolidated total liabilities were $28.5 million at June 30, 2004, a decrease of approximately $176,000 from $28.7 million at December 31, 2003. The decrease was primarily from a reduction in accrued liabilities, offset by an increase in accounts payables. The increase in accounts payable relates primarily to the timing of payments associated with increased capital expenditures in the second quarter of 2004.

Cash and cash equivalents increased 14% to $46.4 million at June 30, 2004 compared to $40.8 million at June 30, 2003. Cash and cash equivalents increased 3% to $46.4 million at June 30, 2004 compared to $44.9 million at December 31, 2003. Cash increased due to improvements in profitability, reductions in accounts receivable and increases to accounts payable.

Liquidity and Capital Resources

We have funded our operating activities primarily with cash generated from operations. We ended the second quarter of 2004 with $46.4 million in cash and cash equivalents, which are defined as highly liquid securities with maturities of 90 days or less.

On August 15, 2003, we announced that the board of directors had authorized a plan to repurchase up to 1,000,000 shares of our outstanding common stock. This plan expires August 15, 2005. Subject to availability, the repurchases may be made from time to time in the open market or otherwise at prices that management deems appropriate. The repurchased shares are classified as treasury shares on the balance sheet and are reported at cost. The shares may be used, when needed, for general corporate purposes, including the grant of stock options. We repurchased 122,500 shares for approximately $837,000 during the second quarter of 2004, and 439,800 shares overall for $3.3 million under the current plan. The aggregate number of shares repurchased under all prior and current plans was 1,594,200 as of June 30, 2004.

Cash provided by operations decreased 23% to $5.6 million for the six months ended June 30, 2004 from $7.3 million at June 30, 2003. The decrease was primarily the result of significant reductions in accounts receivable and unbilled revenue in 2003 relative to 2004, associated with improvements in collections in the 2003 period. Additionally, the decrease reflects an increase in unearned revenue in 2003 relative to 2004, due to longer support terms in 2003.

Net cash used in investing activities decreased 22% to $1.8 million for the six months ended June 30, 2004 compared to approximately $2.3 million for the six months ended June 30, 2003. The decrease was primarily due to building renovations at our corporate headquarters that occurred during the first half of 2003.

Net cash used in financing activities was $2.0 million for the six months ended June 30, 2004 resulting from increased activity to acquire treasury stock as a part of the Company’s authorized stock repurchase plan. This compares to net cash provided by financing activities of $1.0 million for the six months ended June 30, 2003 due to proceeds from the exercise of employee stock options in 2003.

As of June 30, 2004, we had no long-term debt commitments and no material commitments for capital expenditures. We believe that our current cash balances and cash flows from operations will be sufficient to meet our working capital and capital expenditure needs for the next 12 months.

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Critical Accounting Estimates and Polices

In preparation of our financial statements we make estimates and assumptions that can significantly affect the reported amounts of net income and the value of certain assets and liabilities. Our critical accounting estimates are those that are material due to the level of subjectivity and judgment necessary to account for matters that are either highly uncertain or highly susceptible to change and have a material effect on our financial condition or operating performance. We believe critical accounting estimates related to revenue recognition, income taxes and the allowance for doubtful accounts receivable encompass critical judgments and our accounting policies provide a basis upon which management considers significant judgments and uncertainties; however, each of these judgments and estimates may potentially result in materially different results under different assumptions and conditions. For additional discussion on the application of these and other accounting policies, see Note 1 in the notes to the consolidated financial statements included in our Form 10-K for the fiscal year ended December 31, 2003 and our form 10-Q form the quarter ended March 31, 2004.

Revenue Recognition - Our revenues consist primarily of fees for product sales, professional services, hosting and customer support.

Product Revenues - We generally recognize product revenues when a non-cancelable license agreement has been signed, the product has been shipped, the fees are fixed or determinable, collectibility is probable and vendor-specific objective evidence (“VSOE”) of fair value for any undelivered element in a multiple element arrangement exists to allocate the total fee to the multiple elements of an arrangement. Fees are generally considered fixed or determinable upon receipt of a signed license agreement and completion of negotiations. Management sets payment terms depending on market and customer specific conditions. If payment terms on license fees extend beyond a period of time that is out of our historical collection period for each geographic region, then revenue is recognized as payments are received.

The amount of product revenues recognized is determined based on the residual amount of the multiple element contract value that is not assigned to the undelivered elements based on VSOE of those elements. If substantial customer acceptance terms for the licensed product exist, we recognize revenue upon customer acceptance or the expiration of the acceptance period. If it is determined that professional services are essential to the functionality of the product as delivered, then product revenue is recognized as the services are performed.

Support Revenues - We recognize support revenues, which consist of fees for ongoing support and product updates, ratably over the term of the contract support period, typically one year. The amount of support revenue invoiced but not yet recognized is recorded as unearned revenue in the accompanying consolidated balance sheets. Support VSOE is either the stated contract renewal rate or the support renewal rate as a percentage of the past product sales if there is no stated contract renewal rate.

Professional Services Revenues - Professional services revenues are primarily related to implementation, integration and training services performed on a time-and-materials basis or a fixed fee arrangement under separate service arrangements. On time and material and fixed-price projects, revenue is generally recognized as the services are performed. For our fixed-price engagements we recognize revenue based on the relationship of incurred labor hours to our estimate of the total labor hours we expect to incur over the term of the contract. Based on our historical experience of estimating the total effort required to complete fixed-price contracts, we believe this methodology achieves a reliable measure of the revenue from the consulting services that we provide to our customers. Significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period. These judgments and estimates include an estimate as to the total effort required to complete the project. If we made different judgments or utilized different estimates, the amount and timing of our revenue for any period could be materially different. Losses on fixed-price contracts are recognized during the period in which the loss first becomes evident. Contract losses are determined to be the amount by which the estimated total costs of the contract exceeds the total fixed price of the contract.

Revenues from hosted software service arrangements are recognized ratably over the term of the hosting arrangement. Hosting services VSOE is either the stated contract renewal rate or the renewal rate as a percentage of the past product sales if there is no stated contract renewal rate. Professional services VSOE is based on the day rate we are able to negotiate when services are sold separately. Reimbursed expenses are recorded gross as revenue with an offsetting amount recorded to service cost of sales.

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Our standard agreements do not contain product return rights. We provide a standard warranty of 30 days from the date of sale. We continually evaluate our obligations with respect to warranties, returns and refunds. Based on historical trends and management’s evaluation of current conditions, any potential obligations that are inherent in the accounts receivable balance are adequately provided for through the allowance for doubtful accounts. We may, in certain circumstances, grant discounts for product sales. The discounts are recognized as a reduction of product revenue.

Income Taxes - We account for income taxes under the asset and liability method in accordance with SFAS No. 109, Accounting for Income Taxes. We recognize deferred income taxes, net of valuation allowances, for the estimated future tax effects of temporary differences between the financial statement carrying amounts of existing assets and liabilities and their tax bases and net operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Changes in deferred tax assets and liabilities are recorded in the provision for income taxes. As of June 30, 2004 and December 31, 2003, we had approximately $5.1 million and $5.3 million, respectively, in deferred tax assets, net of valuation allowances.

We evaluate our ability to realize deferred tax assets on a regular basis for each taxable jurisdiction. In making this assessment, management considers whether it is more likely than not that some portion or all of its deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers all available evidence, both positive and negative, in making this assessment. Positive evidence supporting our ability to realize deferred tax assets includes: our strong earnings history prior to operating losses realized in 2001, the ability to carry back losses to prior years, positive results in recent years, projections of future taxable income in 2004, the existence of significantly appreciated net assets, and the availability of prudent and feasible tax planning strategies to accelerate taxable amounts.

Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that we will realize the benefits of these deductible differences, net of the existing valuation allowances, at June 30, 2004.

In the future, if we determine that we expect to realize deferred tax assets in excess of the recorded net amounts, a reduction in the deferred tax asset valuation allowance would decrease income tax expense in the period such determination is made. Alternatively, if we determine that we no longer expect to realize a portion of our net deferred tax assets, an increase in the deferred tax asset valuation allowance would increase income tax expense in the period such determination is made.

Allowance for Doubtful Accounts Receivable - We maintain allowances for doubtful accounts receivable for estimated losses resulting from the inability of our customers to make required payments. In determining the allowance for doubtful accounts receivable, we review the rolling twelve month average of account write-offs, customer specific account risks and geographic specific factors that may impact international accounts. These factors combine to establish the allowance for doubtful accounts balance. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

The above is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States of America, with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result.

ITEM 3. Quantitative and Qualitative Disclosures about Market Risk

The Company did not experience any material changes in market risk in the second quarter of 2004.

ITEM 4. Controls and Procedures

The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Company’s disclosure controls and procedures as of June 30, 2004. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have

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concluded that, as of June 30, 2004, the Company’s disclosure controls and procedures were effective to provide reasonable assurance that the information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

There have been no changes in the Company’s internal controls over financial reporting during the quarter ended June 30, 2004 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II. OTHER INFORMATION

ITEM 1. Legal Proceedings

The Company is occasionally involved in legal proceedings and other claims arising out of its operations in the normal course of business. No such current claims are expected, individually or in the aggregate, to have a material adverse effect on the Company’s consolidated financial statements.

ITEM 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

Issuer Purchases of Equity Securities

ITEM 3. Defaults Upon Senior Securities

None

ITEM 4. Submission of Matters to a Vote of Security Holders

The annual meeting of the Company’s shareholders was held on June 3, 2004. At the annual meeting, the following nominees were elected to serve as Class II Directors for a term of three years, which expires at the 2007 annual meeting.

The following persons continue as directors following the annual meeting: Larry G. Blackwell, James R. Talton, Jr., Robert C. Davis and James C. Ryan, Jr.

ITEM 5. Other Information

None

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ITEM 6. Exhibits and Reports on Form 8-K

The Company furnished a Current Report on Form 8-K on April 28, 2004, pursuant to Item 12, to announce its financial results for the quarter ended March 31, 2004.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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EXHIBIT INDEX

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