Back to GetFilings.com

Table of Contents

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended December 31, 2004

OR

Commission file number: 001-31265

Avatech Solutions, Inc.

(Exact Name of Registrant as Specified in its Charter)

(410) 581 - 8080

(Registrant’s telephone number, including area code)

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date.

Table of Contents

AVATECH SOLUTIONS, INC. AND SUBSIDIARIES

INDEX

2

Table of Contents

Part I. Financial Information

Avatech Solutions, Inc. and Subsidiaries

Consolidated Balance Sheets

See accompanying notes.

3

Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Balance Sheets

See accompanying notes.

4

Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statements of Operations

See accompanying notes.

5

Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statements of Operations

See accompanying notes.

6

Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Deficit (Unaudited)

See accompanying notes.

7

Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

See accompanying notes.

8

Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

December 31, 2004

1. Basis of Presentation

Avatech Solutions, Inc. (the “Company”) provides design automation and data management software, hardware, training, technical support and professional services to corporations, government agencies and educational institutions throughout the United States.

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and in accordance with the instructions to Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to those rules or regulations. The interim financial statements are unaudited, but reflect all adjustments (consisting of normal recurring accruals), which are, in management’s opinion, necessary to present a fair statement of results of the interim periods presented. These financial statements should be read in conjunction with the financial statements and the notes thereto in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2004. Operating results for the three and six months ended December 31, 2004 are not necessarily indicative of results for any future period.

The consolidated financial statements include the accounts of Avatech Solutions, Inc. and its majority owned subsidiaries. One of the Company’s subsidiaries had issued convertible preferred stock, which was accounted for as minority interest until its conversion into common stock of Avatech Solutions, Inc. on November 19, 2004. All intercompany accounts and transactions between the Company and its consolidated affiliated companies have been eliminated in consolidation.

2. Discontinued Operations of Certain Operating Segments

In June 2003, due to poor operating results, the Company closed a total of three offices located in New York, Michigan and Ohio. These locations were authorized software dealers subject to the Company’s channel partner agreement with its principal supplier. By virtue of these closings, the Company is no longer authorized to market or distribute software products subject to the channel partner agreements in those areas.

Additionally, the Company closed another office located in California in August 2003, which was also an authorized software dealer for which the Company is no longer authorized to market or distribute software products subject to the channel partner agreement with its principal supplier. In connection with the closing of the California office in August 2003, the Company did not incur a gain or loss. The Company has accounted for these closures as discontinued operations, and accordingly, the results of operations of these offices are reported as a separate component of net income (loss) in the accompanying consolidated statements of operations.

9

Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

December 31, 2004 (continued)

2. Discontinued Operations of Certain Operating Segments (continued)

Summarized operating results of the discontinued operations are as follows:

3. Stock Options

The following table illustrates the effect on net income (loss) and income (loss) per common share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“Statement 123”) to stock-based employee compensation:

10

Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

December 31, 2004 (continued)

3. Stock Options (continued)

A summary of stock option activity during the six months ended December 31, 2004 and related information is included in the table below:

As permitted by Statement 123, the Company currently accounts for share-based payments to employees using Opinion 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. In December 2004, the Financial Accounting Standards Board issued Statement No. 123(R), Share-Based Payment, which is a revision of Statement 123. Statement 123(R) requires all share-based payments to employees and directors to be recognized in the financial statements based on their fair values, using prescribed option-pricing models. Upon adoption of Statement 123(R) on July 1, 2005, pro forma disclosure will no longer be an alternative to financial statement recognition. Accordingly, the adoption of Statement 123(R)’s fair value method will have a significant impact on our results of operations, although it will have no impact on our overall financial position. The impact of adoption of Statement 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted Statement 123(R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosures above. Statement 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption.

4. Borrowings Under Lines-of-Credit

The Company maintains a $3.0 million revolving line of credit limited to 85% of the Company’s aggregate outstanding eligible accounts receivable, payable within 60 days of demand by the lender, and expiring in September 2006. Borrowings under this line-of-credit bear interest at the greater of 7.5%, or the prime rate plus 2.0% (7.5% at December 31, 2004) and are secured by the assets of the Company. In addition, the bank has the right to restrict any prepayment of other indebtedness by the Company.

11

Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

December 31, 2004 (continued)

4. Borrowings Under Lines-of-Credit (continued)

As part of a loan agreement with a software vendor (see Note 5), a financial covenant exists that limits the outstanding balance on the revolving line-of-credit to $2.0 million. The Company has obtained a waiver from the software vendor to allow borrowings under the line-of-credit up to $3.0 million. This waiver expires February 15, 2005. The Company has obtained informal assurances that the waiver will be extended to March 31, 2005. As of February 15, 2005, the Company had not received the executed waiver extension agreement from the software vendor. The balance outstanding under this line-of-credit was $1,640,180 and $2,396,035 at June 30, 2004 and December 31, 2004, respectively.

On October 28, 2004, the Company entered into a loan agreement with the bank to provide for another $0.7 million revolving credit facility expiring on February 15, 2005. Borrowings under this credit facility bear interest at the greater of 7.5%, or the prime rate plus 2.0% (7.5% at December 31, 2004), and are secured by the assets of the Company and the guaranties of the Company and the Chairman of the Board of Directors. In December 2004, the Company paid the Chairman of the Board of Directors a commitment fee of $28,000 and issued warrants to purchase 100,000 shares of common stock for $0.35 per share in consideration for a guarantee of the line-of-credit through October 28, 2005. The estimated fair value of the warrants of $34,136 was determined using a generally accepted option valuation model. On December 31, 2004, the balance outstanding of $0.7 million represented a violation of a covenant provision under the software vendor loan agreement. On January 28, 2005, the Company repaid the outstanding balance on the $0.7 million credit facility, thereby curing the violation of the loan covenant.

Because the interest rates adjust with changes in the prime rate, the estimated fair value of the borrowings under the lines-of-credit are equal to the carrying amount.

5. Long-Term Debt

On July 22, 2003, the Company entered into a loan agreement with a software vendor to fund working capital needs related to the distribution of their products. The terms of the agreement provide for a $1.5 million loan, with repayment of principal plus interest accruing at 6% per annum due in thirty-five equal quarterly installments commencing in January 2005. The entire $1.5 million loan was outstanding at December 31, 2004. The Company is required to meet certain financial and non-financial covenants in connection with this agreement. As described in Note 4, as of December 31, 2004, the Company was not in compliance with a certain covenant under this loan agreement. However, on January 28, 2005, the Company cured the covenant violation and expects to remain in compliance until the loan is repaid.

12

Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

December 31, 2004 (continued)

6. Earnings (Loss) Per Share

The following summarizes the computations of basic and diluted loss per common share:

As of December 31, 2004, 4,635,526 shares of common stock were issuable upon the conversion or exercise of options, warrants and preferred stock.

7. Income Taxes

Income tax expense for the six months ended December 31, 2003 and 2004 was $21,000 and $15,000, respectively. For the periods reported, income tax expense related solely to estimated state and local tax expense.

8. Subsequent Event

On January 26, 2005, the Company entered into an agreement to sell “Proof Positive,” a proprietary software product developed internally by PlanetCad, an acquired business. The software was sold to the Company’s principal supplier, Autodesk Inc., for a sum payable in cash of $1.9 million. As part of the sales agreement, the Company agreed to refrain from developing a comparable software product for two years. On January 26, 2005, the Company received cash proceeds from the sale and recorded a gain on asset disposal of $1.8 million.

Also in January 2005, the Company repaid all borrowings outstanding under its $0.7 million line-of-credit from a bank, which cured the violation of a covenant contained in the Company’s loan agreement with a software vendor prohibiting the Company from incurring additional indebtedness without consent.

13

Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

December 31, 2004 (continued)

9. Liquidity and Capital Resources

The Company has incurred significant operating losses since inception that have depleted capital resources and caused deficiencies in available working capital. At December 31, 2004, the Company has a deficiency of working capital of approximately $4.9 million.

The Company’s operating results are expected to improve in the near term as a result of revenue increases from new product and service offerings and efforts to improve the effectiveness of sales and marketing activities. Because of these projected revenue increases and continuing efforts to reduce operating expenses, management expects to generate operating income for the remainder of fiscal year 2005.

Additional capital was obtained in January 2005 as a result of the sale of a proprietary software product for cash of $1.9 million (see Note 8). Cash proceeds from the sale were principally used to reduce outstanding borrowings under lines of credit. Upon reduction of these borrowings, certain covenant violations were cured and sufficient cash resources were obtained to ensure compliance with debt covenants in the near term (see Note 4). The Company maintains a $3.0 million demand line of credit with a bank that expires in September 2006, and although borrowings under this line of credit are classified as current due to the demand provisions of the credit agreement, management does not expect the bank to demand repayment prior to the line’s expiration date.

Based on an evaluation of the likely cash to be generated from operations in the near term and available capital resources, management believes that it has sufficient sources of working capital to fund its operations in the normal course of business for the next twelve months. Management continues to seek additional sources of capital to improve the Company’s capital structure and provide for growth.

14

Table of Contents

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

THE FOLLOWING DISCUSSION AND ANALYSIS OF THE FINANCIAL CONDITION AND RESULTS OF OPERATIONS SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND THE RELATED NOTES THERETO INCLUDED ELSEWHERE IN THIS REPORT.

Certain statements set forth below constitute “forward-looking statements”. Such forward-looking statements involve known and unknown risk, uncertainties and other factors including, but not limited to, those discussed in our annual and quarterly reports, that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements implied by such forward-looking statements. These forward-looking statements may generally be identified by the use of the words “may”, “will”, “believe”, “should”, “expects”, “anticipates”, “estimates”, and similar expressions. Given these uncertainties, investors and prospective investors are cautioned not to place undue reliance on such forward-looking statements. We disclaim any obligation to update information contained in any forward-looking statement.

Overview

Avatech Solutions is a leading provider of design automation and data management solutions for the manufacturing, building design, engineering, and total infrastructure and facilities and asset management (“F/AM”) markets. We specialize in technical support, training and consulting aimed at improving design and documentation efficiencies and the seamless integration of workflow processes. These technology solutions enable our customers to enhance productivity, profitability and competitive position. We are one of the largest Autodesk software integrators worldwide and a leading provider of engineering document management solutions.

In the first six months of fiscal 2005, we have continued our efforts to attract and employ highly qualified professionals in specialized areas throughout the organization, including salespeople, applications engineers, programmers and consultants. Our portfolio of products and services has been expanded to include new relationships with other software manufacturers and additional service offerings. Geographic expansion will be supported by targeted mergers and acquisitions, the opening of new locations, and expanded product distribution relationships. This diversification strategy is intended to match our product and service offerings more precisely with the needs of our customers. By implementing these strategies, we expect to show profitable operating results over the next two quarters. For the remainder of fiscal 2005, continuing operations are anticipated to generate positive operating income on revenues of $16 – $18 million for the six month period. Our goals for fiscal 2006, if met, will generate positive operating income on $40 – $50 million of revenues and we hope to reach revenue levels of $100 million through organic growth and targeted acquisitions by fiscal 2008.

In fiscal 2005, we formed a Research and Development (R&D) team within our professional services group. This group is focused on providing custom application development services to our customers and developing and packaging intellectual property. The R&D team was instrumental in preparing our Proof Positive software (quality control software developed internally by our predecessor, PlanetCad) for sale to our major vendor, Autodesk Inc. The sale of this internally developed software resulted in a $1.8 million gain in January 2005 and significantly improves our financial and cash flow positions.

During fiscal 2003 and in August 2003, we closed certain offices due to operating performance issues. These office locations were authorized software dealers subject to a channel partner agreement with our principal suppliers. In accordance with Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-lived Assets, the results of operations of these operating units are treated as discontinued operations, and reported as a separate component of operating results in our consolidated statements of operations. Unless otherwise indicated, all amounts included in Management’s Discussion and Analysis of Financial Condition and Results of Operations are from continuing operations. We have included in Note 2 – Discontinued Operations of Certain Operating Segments to the Consolidated Financial Statements a more comprehensive discussion about our discontinued operations.

15

Table of Contents

In July 2003, we entered into an Authorized Reseller Agreement with Dassault Systemes Corp., a French developer and distributor of product lifecycle management (“PLM”) application software and services, whereby we will market and distribute Dassault’s SMARTEAM PLM products in the United States. In connection with this agreement, Dassault provided us with certain financial assistance during fiscal 2004 to create a dedicated PLM sales force and related marketing efforts.

Product Sales. Our product sales consist primarily of the resale of packaged design software programs that are installed on a user workstation, on a local area network server, or in a hosted environment. The programs perform and support a wide variety of functions related to design, modeling, drafting, mapping, rendering, and facilities management tasks. We are one of the largest domestic resellers of design software developed by Autodesk, one of the world’s leading design software and digital content companies for building design and land development, manufacturing, utilities, telecommunications, wireless data services and digital media. Approximately 90% of our total product revenues are related to Autodesk products.

Service Revenue. We also provide services in the form of training, technical support, and professional services. Our training offerings include product and process education classes at our training facilities or directly at a customer site. Our class instructors are application engineers who have formal training or industry experience in the course content.

We provide technical support services primarily through our telephone support center located in Omaha, Nebraska. Through our staff of full time consultants, we provide assistance to customers making inquiries concerning the software products that we sell.

We also provide project-focused professional consulting services through our own application engineers and programmers, as well as software customization, data migration, computer aided design standards consulting, workflow analysis, and implementation assistance for complex software products.

Commission Revenue. We generate commission revenue from the resale of Autodesk software to various customers, a number of which Autodesk considers to be “strategic accounts.” Autodesk designates these customers as strategic accounts based on specific criteria, primarily sales volume, and typically gives these customers volume discounts. We are responsible for managing and reselling Autodesk products to a number of these strategic account customers; however, software product is shipped directly from Autodesk to the customers. We receive commissions upon shipment of the product from Autodesk to the customer based on the product sales price, the product type, total volume, and overall performance. Additionally, we report software subscription revenues as commission revenue. Because of the nature of the subscription arrangements, we act as an agent between the customers and our software vendor; such an arrangement requires us to record these subscription sales net of cost.

Cost of Product Sales. Our cost of product sales consists of the cost of purchasing products from software suppliers or hardware manufacturers. Additionally, we include the associated shipping and handling costs in cost of product sales.

Cost of Service Revenue. Cost of service revenue includes the direct costs associated with the implementation of software and hardware solutions as well as the direct costs of providing training, support services, and professional services. These costs consist primarily of compensation, benefits, travel, and the costs of third-party contractors engaged by us. Cost of service revenue does not include an allocation of overhead costs.

Selling, General and Administrative Expense. Selling, general and administrative expense consists primarily of compensation and other expenses associated with management, finance, human resources, and information systems. Additionally, advertising and public relations expense, as well as expenses for facilities such as rent and utilities, are included in selling, general and administrative expense.

Depreciation and Amortization Expense. Depreciation and amortization expense represents the period costs associated with our investment in property and equipment, consisting principally of computer equipment, software, furniture and fixtures, and leasehold improvements. Depreciation and amortization expense is computed using the straight-line method. Additionally, we lease all of our facilities and depreciate leasehold improvements over the lesser of the lease term or the useful life of the asset.

16

Table of Contents

Interest Expense. Interest expense consists primarily of interest on our revolving line-of-credit and subordinated debt, which we incurred to fund operations over the past three years.

Three and Six Months Ended December 31, 2003 Compared to the Three and Six Months Ended December 31, 2004

The following tables set forth a comparison of the three and six month periods ended December 31, 2003 to the three and six month periods ended December 31, 2004. The amounts are derived from selected items reflected in our unaudited Consolidated Statements of Operations included elsewhere in this report. The three and six month financial results are not necessarily indicative of future results.

Revenues

Revenues. Our total revenues increased $319,000 or 4.1% for the three months ended December 31, 2004 as compared to the same period in the prior fiscal year. For the three months ended December 31, 2004, revenues in two of three categories – service and commission revenues – increased while product revenue remained consistent with the same period last fiscal year. Total revenues for the six month period included $390,000 of product sales and $208,000 of service revenue related to our PLM product line. F/AM revenues for the same period totaled $48,000 and $398,000 of product sales and service revenue, respectively.

For the six months ended December 31, 2004, our total revenues increased $1.2 million, or 8.8%. There were significant increases in both product and commission revenues during the period, while service revenue remained consistent with the same period last fiscal year. The increase in product revenues during the six month period occurred solely in the first quarter of fiscal 2005, when a newly formed, regional sales management structure helped refocus the sales force, which was distracted by executive management changes that occurred in the last quarter of fiscal 2004. For the three months ended December 31, 2004, product sales remained consistent with the prior year as revenues for the same period last year were strong due to Autodesk price promotions.

Service revenues increased $151,000 or 11.7% for the three months ended December 31, 2004 as compared to the same period in the prior fiscal year. Of this increase, $94,000 is attributable to PLM service revenue for this period. Overall service revenues for the six month period ended December 31, 2004 were consistent with the same period in the prior fiscal year, while $606,000 of those services were attributable to new PLM and F/AM business. The 22% reduction in services related to our design automation business is attributed primarily to lower training class sales. During the six month period ended December 31, 2003, we reduced the number of training coordinators at training locations, which caused a reduction in enrollments in subsequent periods. Additionally, we experienced significant turnover of the service employees who perform training in the six month period ended December 31, 2004. While we recruited and hired replacements, gaps in staffing, as well as the length of time needed to acclimate and train new employees have impacted our service revenues during fiscal 2005. We remain focused on recruiting and retaining highly qualified professional service personnel and expect to initiate marketing programs in the remaining six months of fiscal 2005 to stimulate demand for our service offerings, especially in the areas of open enrollment and customized training classes.

17

Table of Contents

Commission revenue steadily increased throughout the first six months of fiscal 2005. Compared to the same periods in the prior fiscal year, we reported commission revenue increases of $200,000, or 14.3%, in the three months ended December 31, 2004, and increases of $283,000, or 12.4% for the first six months of fiscal 2005. We were able to capitalize on industry-wide increases in demand for Autodesk products due to an improving economy and the retirement of Autodesk software version 2000i. Additionally, subscription revenue, which is reported net of cost as commission revenue, was 15.1% higher than the previous fiscal year because of both greater market demand for Autodesk products and the improved management of our sales force.

Cost of Revenues